Recent developments in the banking sector such as consolidation, geographical expansion, new product ranges, the growing complexity and variety of the financial instruments issued and purchased by banks have been increasingly exposing certain inadequacies in the regulatory arrangements, whose inherently static nature is particularly apparent during crisis situations, thus creating pressure to step up efforts to strengthen market discipline in banking. Rather than abandon the regulatory discipline, however, virtually all countries have opted to improve regulatory measures and the prospect of a permanent coexistence of the regulatory and market disciplinary mechanism is becoming a fact of life. The two systems not only co-exist, but also influence each other. The paper is based on published empirical research and aims to identify and discuss the areas where the regulatory discipline influences the market discipline.

Firstly, it emerges that supervisory activity has a beneficial effect on the quality of financial statements. The supervisory bodies not only review the finished product but also inspect banks during the drafting stages of financial statements. In a majority of cases regulatory discipline mechanisms have revealed figures showing poor aspects of the financial situation of banks. The necessary corrections tend to be considerable and investors, in their pricing of stocks, take advantage of the information that was included in the financial statements resulting from supervisory activities. More reliable financial statements mean that investors are in a better position to monitor the banking sector and to influence management policies in a more precise way.

Secondly, empirical research has hitherto been unable to answer the question as to what extent such assessments of banks' condition by supervisory bodies are important to investors. In those rare cases when supervisory ratings have been disclosed indirectly, the investors' reaction was influenced not only by the new information, but also took into account the anticipated response of the supervisory bodies.

Thirdly, there are two ways in which market discipline mechanisms restrict the scope of the market to influence the banking risk. Banks can alleviate market pressure by increasing secured deposits in their financing structure. Additionally, bank management is far less exposed to the direct disciplinary pressure experienced by non-financial sectors in the form of hostile takeovers and shareholders' actions, which in the banking sector are largely substituted by supervisory interventions. From the point of view of market monitoring, the co-existence of regulatory and market disciplines causes the markets to reflect not merely the condition of a given bank, but also the ramifications of having the deposit security system in place, the existence of the presumed safety net for the largest corporations and the predicted extent of the supervisory intervention.

In summary, the effect of regulatory discipline on market discipline must be seen as a mixed one. Indeed, we seem to be seeing both complementary and contradictory effects of regulatory and market disciplines.