Is the market tougher with riskier banks? Evidence from the pricing of bank debt securities during a financial turmoil episode

Abstract

The philosophy behind the indirect channel of market discipline in banking regulation presumes that the pricing of bank securities, if accurate, conveys reliable signals to supervisors. In this paper, we explore empirically the possibility that markets price differently the risk profile of bank issuers along the empirical distribution of security prices. The paper uses a quantile regression framework to draw novel inferences about the functioning of debt market discipline and the quality of private monitoring in European banking during a severe financial turmoil episode: 1995--2002. This period is characterized by large swings in yields due to the Russian default and LTCM crisis, the burst of the dot-com bubble, and Enron’s failure. We find that the yield spread-risk relationship is systematically steeper at the “right-tail” of the conditional distribution of the credit spread. This result suggests that the market is somewhat “tougher” with riskier banks; that is, riskier bank issuers borrow at higher interest rates, which are increasing in their degree of riskiness.