The Relation between Market Discipline of Banks and Bond Market Transparency: Evidence from the Risk Sensitivity of Subordinated Notes and Debenture Yield Spreads

We investigate the effects of increased bond market transparency on the risk sensitivity of yield spreads for bank-issued subordinated notes and debentures after bond markets became more transparent in 2002. Models of yield spread levels and yield spread changes show improvement in normal economic times after markets became more transparent. Risk-sensitivity of yield spreads increases strongly prior to crises. We show that firm-specific default risk variables are significant determinants of yield spread changes around earnings announcements and we observe a stronger effect for lower rated bonds. Our results imply that market discipline poorly complements regulatory discipline during good economic times. In general, increased transparency improves risk sensitivity in all cases.