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Essays on market discipline in commercial and central banking

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The thesis studies how financial markets discipline commercial and central banks’ behavior invarious ways. In the first part, two papers test different aspects of market discipline ofcommercial banks’ risk taking, using a dataset of several hundred banks worldwide. In thefirst paper, it is shown that the risk-shifting opportunity of shareholders introduced by depositinsurance depends on ownership structure and the extent of market discipline by uninsuredcreditors. I find that the effect of shareholder control on risk is convex, and that creditordiscipline tempers this effect but has little individual influence on risk. The second papertests the monitoring dimension of market discipline and formulates a two-step procedurewhich makes it possible to sidestep the common methodological problem that banks’ ‘true’risk is unobserved. Results suggest that if the quality of institutions is sufficiently high, somemarket-based indicators may be more accurate measures of banks’ true risk than a set ofcommonly used accounting-based benchmark indicators – a possibility effectively precludedby much of previous research.In the second part of the thesis, three papers study constraints on central bank behaviorintroduced by financial markets, using data from a set of small, open European economiesduring the 1980s and 1990s. The first of these papers tests how capital account liberalizationand exchange-rate regime constrain monetary policy autonomy. Contrary to traditional theory,the paper finds no autonomy effect of exchange rate flexibility, whereas capital controlsprovided some (albeit limited) independence from innovations in foreign money marketinterest rates. The remaining two papers address how deregulation, innovation, and growth indomestic money markets interplay with central banks’ choices of monetary policy operatingprocedures. The analysis of the European countries suggests that while deregulation and theemergence of short-term financial markets constrained central bank discretion and compelledincreased reliance on open market operations, the paths of money market development indifferent countries were also partially determined by the respective central banks’ decisions.In the final paper, the same framework of analysis is applied to China, which has announcedits intention to rely increasingly on market operations in monetary policy. The results suggestthat the disciplining effect of domestic financial markets on central bank behavior in China isso far very small, largely due to remaining de facto financial repression.

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Jens Forssbæck

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