The Indirect Channel of Market Discipline: Evidence from European Bank Debt Markets (1995-2002) - Testing the 'Sine Qua Non' Hypothesis

Abstract

Market discipline of bankdebtholders has recently become a particularly attractive tool of bank regulation and supervision in a complex and rapidly changing environment. Basically, there are two main channels of market discipline transmission mechanisms in the banking industry. First, the debtholders can punish risky behaviors of banking organizations by refusing to deal with them or by setting high prices for financing risky activities (direct channel). Thus, the appropriate pricing of risk in the primary market could ex-ante deter banks from choosing risk profiles in stark contrast with supervisory goals. Second, the pricing of bank debt in the secondary market, if accurate, could convey to supervisor and other market participants a reliable signal of a bank's financial conditions and default risk. The supervisor could use this market information, in addition to other public and private information, to trigger Prompt Corrective Action, to set sensitive deposit insurance premia, to allocate scarce supervisory resources, and so forth (indirect channel). In this perspective, the market seems a huge alembic where information, beliefs, expectations, and fears of investors are 'distilled' and finally reflected in securities prices. A necessary (albeit non-sufficient) condition for the indirect channel's efficiency is the sensitivity of secondary market prices to bank risk. That is what we call the sine qua non hypothesis. By collecting a unique dataset of spreads, ratings, and accounting measures of bank risk for a sample of large European banking organizations during the 1995-2002 period, we attempt to empirically test the aforesaid 'sine qua non' hypothesis.