Although greater SIB risk levels are expected to increase debt yields (Evanoff and Wall, 2000), prevalence of government safety nets complicates the market discipline mechanism, rendering the issue an empirical exercise. Their main objectives are twofold. First, they study how bond buyers reacted to elevation of SIB-specific and macroeconomic risk factors over the recent business cycle. Second, they investigate the degree to which the proportion of variance in yields explained by SIB and macroeconomic risk factors changed across the phases of the cycle. Their data include over 8 million bond trades across 26 SIBs. The authors divide their sample period into the pre-crisis (2003:Q1 to 2007:Q3), crisis (2007:Q4 to 2009:Q2), and post-crisis (2009:Q3 to 2014:Q3) sub-periods to contrast the findings. They obtain several results. First, bond buyers do react to changes in the SIB-specific risk factors (leverage, credit risk, inefficiency, lack of profitability, illiquidity, and interest rate risk) by demanding higher yields. Second, bond buyers’ responses to risk factors are sensitive to the phase of the business cycle. Third, the proportion of variance in yields driven by SIB-specific and bond-specific risk factors increased from 23 percent in the pre-crisis period to 47 percent and 73 percent, respectively, during the crisis and post-crisis periods. These findings indicate that the force of market discipline improved greatly during the crisis and post-crisis periods, at the expense of macroeconomic factors. The strengthening of market discipline in the crisis and post-crisis periods, despite the unprecedented regulatory intervention in the form of quantitative easing programs, the Troubled Asset Relief Program, large bailouts, and generally accommodative fiscal and monetary policies adopted during these periods, demonstrates that regulatory intervention and market discipline can work in tandem.View the Full Working Paper
Market Discipline in the Secondary Bond Market: The Case of Systemically Important Banks
WP 17-05 - The authors investigate the association between the yields on debt issued by U.S. systemically important banks (SIBs) and their idiosyncratic risk factors, macroeconomic factors, and bond features in the secondary market.