Do Markets 'Discipline' All Banks Equally?

Abstract:     
This paper investigates if the bond market disciplines all banks equally, in the sense of demanding the same relative risk premium across banks of different risk over the business cycle. To test this hypothesis, the paper compares the difference between the credit spreads in the primary market of bank and firm bonds with the same credit rating issued during expansions with that same difference of spreads for bonds issued during recessions. The paper finds that during recessions investors demand higher risk premiums. Importantly, the paper finds that the impact of recessions is not uniform across banks – it affects riskier banks more than safer ones. In other words, in recessions investors are relatively more demanding on riskier banks than on safer ones. These findings have important policy implications because they show that a bond-issuance policy aimed at promoting market discipline could affect the relative funding costs of banks over the business cycle. They also indicate that the information which can be extracted from the credit spreads on bank bonds varies across banks for reasons unrelated to their risk.

Keywords: Market discipline, bond financing, bond spreads, credit ratings

JEL Classification: E44, G32

Accepted Paper Series