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Bond market discipline of banks: is the market tough enough?

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Author Info

  • Donald P. Morgan
  • Kevin J. Stiroh

Abstract

As the banking business grows more complex, government supervisors of banks seem increasingly willing to share the role of policing bank risk with private investors, especially bondholders. This paper investigates the disciplinary role of markets using bond spreads, ratings, and bank portfolio data on over 4,100 new bonds issued between 1993 and 1998, including almost 600 bond issues by banks and bank holding companies. We find that the bond spread/rating relationship is the same for the bank issues as for nonbank issues, especially among the investment grade issues. This suggests that the bond market prices public measures of bank risk efficiently. Investors also look beyond the ratings, as spreads on the bank issues depend on the underlying portfolio of assets and loans. Banks contemplating a shift into riskier activities like trading, for example, can expect to pay higher spreads as a result. That is market discipline. The market, however, appears relatively soft on bigger banks and less transparent banks, pointing to possible slippage in the disciplinary mechanism for banks either considered too big to fail or too hard to understand by the bond market.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 95.

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Date of creation: 1999
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Handle: RePEc:fip:fednsr:95

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Related research

Keywords: Bank supervision ; Bonds ; Risk management;

This paper has been announced in the following NEP Reports:

References

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  1. Donald P. Morgan, 2002. "Rating Banks: Risk and Uncertainty in an Opaque Industry," American Economic Review, American Economic Association, vol. 92(4), pages 874-888, September.
  2. Simon H. Kwan & Mark J. Flannery & M. Nimalendran, 1999. "Market evidence on the opaqueness of banking firms' assets," Working Papers in Applied Economic Theory 99-11, Federal Reserve Bank of San Francisco.
  3. George G. Kaufman, 1999. "Banking and currency crises and systemic risk: a taxonomy and review," Working Paper Series WP-99-12, Federal Reserve Bank of Chicago.
  4. Richard Cantor & Frank Packer, 1994. "The credit rating industry," Quarterly Review, Federal Reserve Bank of New York, issue Sum, pages 1-26.
  5. Avery, Robert B & Belton, Terrence M & Goldberg, Michael A, 1988. "Market Discipline in Regulating Bank Risk: New Evidence from the Capital Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(4), pages 597-610, November.
  6. Stewart C. Myers & Raghuram G. Rajan, 1995. "The Paradox of Liquidity," NBER Working Papers 5143, National Bureau of Economic Research, Inc.
  7. Flannery, Mark J, 1998. "Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(3), pages 273-305, August.
  8. Kenneth Spong, 1994. "Banking regulation : its purpose, implementation, and effects," Monograph, Federal Reserve Bank of Kansas City, number 1994bria.
  9. Donald P. Morgan & Ian Toll, 1997. "Bad debt rising," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 3(Mar).
  10. Gorton, Gary & Santomero, Anthony M, 1990. "Market Discipline and Bank Subordinated Debt," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 22(1), pages 119-28, February.
  11. Flannery, Mark J & Sorescu, Sorin M, 1996. " Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983-1991," Journal of Finance, American Finance Association, vol. 51(4), pages 1347-77, September.
  12. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
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Citations

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Cited by:
  1. Robert R. Bliss, 2001. "Market discipline and subordinated debt: a review of some salient issues," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 24-45.
  2. Kane, Edward J., 2001. "Dynamic inconsistency of capital forbearance: Long-run vs. short-run effects of too-big-to-fail policymaking," Pacific-Basin Finance Journal, Elsevier, vol. 9(4), pages 281-299, August.
  3. Yehning Chen & Iftekhar Hasan, 2011. "Subordinated Debt, Market Discipline, and Bank Risk," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(6), pages 1043-1072, 09.
  4. Caprio, Gerard & Honohan, Patrick, 2004. "Can the unsophisticated market provide discipline?," Policy Research Working Paper Series 3364, The World Bank.
  5. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt and bank capital reform," Working Paper Series WP-00-7, Federal Reserve Bank of Chicago.
  6. Sironi, Andrea, 2003. " Testing for Market Discipline in the European Banking Industry: Evidence from Subordinated Debt Issues," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(3), pages 443-72, June.
  7. Daniel M. Covitz & Diana Hancock & Myron L. Kwast, 2004. "Market discipline in banking reconsidered: the roles of funding manager decisions and deposit insurance reform," Finance and Economics Discussion Series 2004-53, Board of Governors of the Federal Reserve System (U.S.).
  8. Adam Ashcraft & Hoyt Bleakley, 2006. "On the market discipline of informationally opaque firms: evidence from bank borrowers in the federal funds market," Staff Reports 257, Federal Reserve Bank of New York.
  9. Herring, Richard J., 2004. "The subordinated debt alternative to Basel II," Journal of Financial Stability, Elsevier, vol. 1(2), pages 137-155, December.
  10. Cecile Casteuble & Emmanuelle Nys & Philippe Rous, 2013. "Bank Risk - Return Efficiency and Bond Spread: Is There Evidence of Market Discipline in Europe," Working Papers hal-00916717, HAL.
  11. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2006. "Equity and Bond Market Signals as Leading Indicators of Bank Fragility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 399-428, March.
  12. Hartarska, Valentina M., 2006. "Rating in Microfinance: Cross-Country Evidence," 2006 Annual Meeting, August 12-18, 2006, Queensland, Australia 25506, International Association of Agricultural Economists.
  13. Donald Morgan & Kevin Stiroh, 2001. "Market Discipline of Banks: The Asset Test," Journal of Financial Services Research, Springer, vol. 20(2), pages 195-208, October.
  14. Greg Caldwell, 2005. "Subordinated Debt and Market Discipline in Canada," Working Papers 05-40, Bank of Canada.
  15. Donald P. Morgan, 2000. "Rating risks: risk and uncertainty in an opaque industry," Staff Reports 105, Federal Reserve Bank of New York.
  16. Adam B. Ashcraft, 2006. "Does the market discipline banks? New evidence from the regulatory capital mix," Staff Reports 244, Federal Reserve Bank of New York.
  17. Ashcraft, Adam B., 2008. "Does the market discipline banks? New evidence from regulatory capital mix," Journal of Financial Intermediation, Elsevier, vol. 17(4), pages 543-561, October.

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