Market Discipline in the Secondary Bond Market: The Case of Systemically Important Banks

54 Pages Posted: 17 Mar 2017

See all articles by Elyas Elyasiani

Elyas Elyasiani

Temple University - Department of Finance

Jason Keegan

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Date Written: 2017-03-10

Abstract

We investigate the association between the yields on debt issued by U.S. systemically important banks (SIBs) and their idiosyncratic risk factors, macroeconomic factors, and bond features, in the secondary market. Although greater SIB risk levels are expected to increase debt yields (Evanoff and Wall, 2000), prevalence of government safety nets complicates the market discipline mechanism, rendering the issue an empirical exercise. Our main objectives are twofold. First, we study how bond buyers reacted to elevation of SIB-specific and macroeconomic risk factors over the recent business cycle. Second, we investigate the degree to which the proportion of variance in yields explained by SIB and macroeconomic risk factors changed across the phases of the cycle. Our data include over 8 million bond trades across 26 SIBs. We divide our sample period into the pre-crisis (2003:Q1 to 2007:Q3), crisis (2007:Q4 to 2009:Q2), and post-crisis (2009:Q3 to 2014:Q3) sub-periods to contrast the findings. We obtain several results. First, bond buyers do react to changes in the SIB-specific risk factors (leverage, credit risk, inefficiency, lack of profitability, illiquidity, and interest rate risk) by demanding higher yields. Second, bond buyers’ responses to risk factors are sensitive to the phase of the business cycle. Third, the proportion of variance in yields driven by SIB-specific and bond-specific risk factors increased from 23 percent in the pre-crisis period to 47 percent and 73 percent, respectively, during the crisis and post-crisis periods. These findings indicate that the force of market discipline improved greatly during the crisis and post-crisis periods, at the expense of macroeconomic factors. The strengthening of market discipline in the crisis and post-crisis periods, despite the unprecedented regulatory intervention in the form of quantitative easing programs, the Troubled Asset Relief Program, large bail outs, and generally accommodative fiscal and monetary policies adopted during these periods, demonstrates that regulatory intervention and market discipline can work in tandem.

Keywords: Bank Risk, Financial Crisis, U.S. Bank Holding Companies, Risk Management, Market Discipline

JEL Classification: G01, G2, G21, G28

Suggested Citation

Elyasiani, Elyas and Keegan, Jason, Market Discipline in the Secondary Bond Market: The Case of Systemically Important Banks (2017-03-10). FRB of Philadelphia Working Paper No. 17-5. Available at SSRN: https://ssrn.com/abstract=2934817

Elyas Elyasiani (Contact Author)

Temple University - Department of Finance ( email )

Fox School of Business and Management
Philadelphia, PA 19122
United States
215-204-5881 (Phone)
215-204-5698 (Fax)

Jason Keegan

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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