END OF THE CONVOY SYSTEM AND THE SURGE OF MARKET DISCIPLINE: EVIDENCE FROM JAPANESE SMALL FINANCIAL INSTITUTIONS

This paper tests for the presence of market discipline by examining the effects of deposit-taking institutions' risk on the growth of deposits. The study analyzes a large panel of 689 small deposit-taking institutions (shinkin banks and credit cooperatives) in Japan during the period from FY 1992 to FY 2002. This study on Japanese institutions, which experienced financial crises and shifts in regulatory schemes in the 1990s, allows us to evaluate the interaction between market discipline and regulatory schemes and the impacts of the banking crises on the discipline. Our empirical findings support the effective role of market discipline by depositors. Riskier institutions attract smaller amounts of deposits. Depositor sensitivity to bank risk changed over time, complying with the historical development of regulatory schemes and the deposit insurance system. Disciplinary behavior of small-account depositors, who are fully insured, suggests that depositors are unwilling to bear certain non-pecuniary costs that accompany bank failures. Key words: governance, market discipline, deposit insurance, small financial institution JEL Classification: G21,G32