Market Discipline and EU Corporate Governance Reform in the Banking Sector: Merits, Fallacies, and Cognitive Boundaries

Much contemporary analysis has concluded that the recent financial crisis and bank failures were, inter alia, the result of a breakdown in corporate governance regimes and market discipline. New EU regulations strongly advocate market-based remedies such as tighter investor monitoring and greater control over executives' remuneration, in order to safeguard financial stability. We argue that this approach largely ignores three very important aspects of modern financial markets that cannot be constrained through market discipline: (a) socio-psychological phenomena; (b) the epistemological properties of financial market innovation; and (c) the inherent inability of market participants to predict uncertain risk correlations. Therefore, this article argues that excessive EU focus on corporate governance reforms, as a means to improve financial stability, detracts attention from much more significant concerns, chiefly the issue of optimal bank structure.