The Depositor Discipline Hypothesis

The Transition to an Interaction Effect

Abstract

This research demonstrates that the bank depositor discipline hypothesis must be analyzed in the context of an interaction effect between bank demand for deposits and customer supply of deposits. Only when this interaction effect is considered can the real effect of bank-specific risks on the equilibrium interest rate and the equilibrium quantity of funds be determined.The analysis in the paper covers three effects: 1) the interest rate effect; 2) the quantity effect;and, 3) the interaction effect. Previous empirical studies found evidence that depositors penalize riskier banks by requiring higher interest rates or by withdrawing their deposits. Empirical research using recent American and Japanese bank data make clear that including the interaction effect has substantial methodological advantages over approaches that consider only the interest rate and quantity effect.Thus, the main contribution is a theoretically explanation of why the bank depositor discipline hypothesis must be tested with a methodology that includes the interaction effect in its reduced-form equations.