Stumbling blocks to increasing market discipline in the banking sector: a note on bond pricing and funding strategy prior to failure

Abstract

This paper examines pricing behavior for bonds and certificates of deposit issued by bank holding companies (BHCs) and their subsidiary banks in the period prior to failure. It is evident that strong market discipline exists in the market for BHC bonds, but there is little or no evidence of market discipline in the uninsured CD market. We also observe a significant increase in the banking firm’s reliance on insured deposits as the organization’s financial condition deteriorates prior to failure and following a Moody’s downgrade. These results have several implications for bank supervision and regulation. First, bond spreads could potentially be useful to bank supervisors as a warning signal from the financial markets. Second, proposals to increase market discipline at the BHC level through the bond market would likely be effective. However, BHCs tend to avoid market discipline by replacing uninsured debt with insured deposits as the spreads on uninsured debt rise – thus, transferring the responsibility of disciplining the organization from the market to bank supervisors. Finally, our investigation suggests that market information such as bond spreads and changes in Moody's ratings may not add value over and above information already collected in the supervisory process. Direct correspondence to Julapa Jagtiani, Supervision and Regulation, Federal Reserve Bank of Chicago, 230 South LaSalle Street, Chicago, IL 60604-1413. Phone 312-322-5798, Fax 312322-5894, E-mail: Julapa.A.Jagtiani@Chi.Frb.Org. Requests for additional copies should be directed to the Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois 60690-0834, or telephone (312) 322-5111. The Emerging Issues Series Working Papers are located on the Federal Reserve Bank of Chicago's Web site at: http://www.chicagofed.org/publications/workingpapers/emergingissues.cfm The authors thank Mark Flannery, Myron Kwast, and the referees for their helpful comments and suggestions. Thanks also to James Nelson for the research idea and Loretta Kujawa for her dedicated research assistance. The opinions expressed in this paper are those of the authors and

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