Testing for Market Discipline in the European Banking Industry: Evidence from Subordinated Debt Issues

The question of whether private investors can discriminate between the risk taken by banks is empirically investigated by testing the risk sensitivity of European banks' subordinated notes and debentures (SND) spreads. A unique dataset of spreads, ratings, and accounting measures of bank risk is used for a sample of SND issued during the 1991-2000:Q1 period. Moody's Bank Financial Strength (MBFS) and FitchIBCA Individual (FII) ratings, which omit the influence of government and other external support on risk borne by investors, are used as bank risk proxies together with accounting variables to explain the variability of spreads. Empirical results support the hypothesis that SND investors are sensitive to bank risk, with the exception of SND issued by public sector banks, i.e., government owned or guaranteed institutions. Results also show that the sensitivity of SND spreads to measures of stand-alone risk (i.e., measures that do not incorporate external guarantees) has been increasing from the first to the second part of the 1990s, with the perception of too-big-to-fail type guarantees by private investors gradually disappearing. This result can be attributed to the joint effect of the loss of monetary policy by national central banks and the public budget constraints imposed by the European Monetary Union (EMU).