Market Discipline in International Banking Regulation: Keeping the Playing Field Level

Abstract

The focus of this article is the debt market as a powerful disciplinarian source for large and complex banking organizations around the world. We empirically study the interactions between (1) reinforcing banks' market discipline and (2) preserving the 'level playing field' principle put forward by the Basel Committee since the adoption of the first Capital Adequacy Accord. Our approach consists of conducting cross-country comparisons of the secondary market prices sensitivity to market measures of bank risk (traditional & financial strength ratings). The final sample includes major internationally active banks headquartered in Canada, Europe, Japan, and the United States, over the 1995 - 2002 period. We find that: (i) the spread/rating relationship is statistically significant and comparable for the European and North American banks; (ii) the debt securities issued by the US banks are traded at higher spreads on average that those of their international competitors, probably due to conjectural government guarantees perceived in the European and Japanese banking sectors; (iii) in fact, the variable measuring this kind of guarantees is statistically significant in explaining spreads for the European banks, but insignificant for the North American banks; (iv) in accordance with the market discipline theory, the subordinated creditors are more sensitive than the senior ones to the risk profile of bank issuers; and finally (v), rating downgrades during the year significantly affect spread variability. All in all, although these results are generally consistent with the market discipline paradigm, they arouse serious reflections about the asymmetric transmission of market discipline in various national banking sectors. Much progress remains to be done (especially in Japan and certain European countries) in order to make the 'level playing field' principle compatible with the reinforcement of market discipline at international level.