Bond Market Discipline of Banks: Is the Market Tough Enough?

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.

JEL Classification: G18, G28