Market discipline on bank bond issues through the lens of a new forward‐looking measure of loan quality

• Published date: 01 November 2020
• Author: Giorgia Simion,Elisa Cavezzali,Siva Nathan,Ugo Rigoni
• Date: 01 November 2020
• DOI: http://doi.org/10.1111/eufm.12262

Eur Financ Manag. 2020;26:1350–1384.wileyonlinelibrary.com/journal/eufm1350

|

© 2020 John Wiley & Sons Ltd.

DOI: 10.1111/eufm.12262

ORIGINAL ARTICLE

Market discipline on bank bond issues through

the lens of a new forward‐looking measure of

loan quality

Giorgia Simion

1

|Elisa Cavezzali

2

|Siva Nathan

3

|Ugo Rigoni

2

1

Department of Finance, Accounting and

Statistics, Vienna University of Economics

and Business, Vienna, Austria

2

Department of Management, Ca’Foscari

University of Venice San Giobbe, Venice,

Italy

3

School of Accountancy, J. Mack Robinson

College of Business, Georgia State

University, Atlanta, Georgia

Correspondence

Siva Nathan, School of Accountancy,

J. Mack Robinson College of Business,

Georgia State University, 35 Broad St. NW,

Atlanta, GA 30303, USA.

Email: snathan@gsu.edu

Abstract

Using unsecured bond spreads over the 2007 to mid‐

2014 period, we test investors’ability to price bank loan

risk. We use a new measure of loan risk that in-

corporates forward‐looking information embedded in

ratings assigned by external rating agencies to bank

loan portfolios. Only Italian banks are required to sys-

tematically disclose this specific information. We find

that investors do price forward‐looking information

inherent in bank loan portfolios. This finding reflects

the increase in risk perception following the sovereign

debt crisis, which had the strongest effects on periph-

eral countries, with tensions in the lending market.

Overall, these results suggest that our new forward‐

looking measure provides an additional channel

through which market discipline can operate.

KEYWORDS

bank loan quality, banks, market discipline, sovereign debt crisis,

unsecured bond issues

JEL CLASSIFICATION

G21

EUROPEAN

FINANCIAL MANAGEMENT

The authors would like to thank the Editor, John Doukas, and the anonymous referee for their suggestions. We would

like to thank participants at the GSU Finance Department Brownbag, Finance Department Research Workshop at

Syracuse University, the 2018 Financial Engineering and Banking Society (FEBS) conference, and the 2018 India

Finance Conference for their comments. The authors gratefully acknowledge the Center for the Economic Analysis of

Risk (CEAR) in the Robinson College of Business at Georgia State University for its financial support. We would like to

dedicate this publication to Nicola Agnoletto, who left us before his time. We will remember him fondly as a friend, an

excellent research assistant, and a reliable colleague.

1|INTRODUCTION

In this research, we examine a new forward‐looking loan quality measure to study how bond

market discipline has changed after the 2007 financial crisis. Effective market discipline is

important, since it can reduce banks’incentives to take excessive risk and provide important

signals to regulators on the soundness of banking firms.

1

This requires a correct assessment of

bank financial conditions that must be reflected in the price of its financial securities and cost of

funding. The Basel Committee on Banking Supervision (BCBS) explicitly recognizes the

relevance of market discipline as a key pillar to enhance and promote financial stability, which

is expected to be reinforced with increasing disclosure requirements.

An extensive stream of research has examined bond spread‐to‐risk sensitivity (e.g.,

DeYoung, Hughes, & Moon, 2001; Flannery & Sorescu, 1996; Sironi, 2003), claiming that the

increased use of government supports to troubled banks during the recent financial crisis has

reduced unsecured investors’incentives to penalize institutions for excessive risk‐taking

(Acharya, Anginer, & Warburton, 2016). Bearing in mind the importance of information dis-

closed to the markets, which is stressed in Pillar 3 of the Basel Capital Accord and supported by

prior literature (Stephanou, 2010), we test whether disclosure of higher‐quality and more re-

levant information helped investors to preserve and strengthen market discipline during the

recent financial crisis.

Our new loan quality measure examines whether a forward‐looking perspective of a bank's

activities provides a more reliable and incrementally value‐relevant test of market discipline.

The loan portfolio is typically the largest asset on a bank's balance sheet and is commonly

considered as informationally opaque. Therefore, for financial stability it is of great value to

have a comprehensive and informative measure of loan risk. For this purpose, we use loan

ratings supplied by external rating agencies (e.g., Standard & Poor's Ratings Services and

Moody's Investors Service) to construct a novel variable measuring the average loan portfolio

risk over a 1‐year horizon. More specifically, the variable is a weighted average of borrowers’

external credit ratings, which convey information about their future creditworthiness, weighted

based on the banks’credit exposure to the borrowers.

2

This is a previously unexplored indicator

of asset quality with a forward‐looking focus, which better estimates the risks to which financial

institutions are exposed. Prior research in this field has typically used traditional accounting‐

based measures of risk, with a backward‐looking view (Flannery & Sorescu, 1996; Jagtiani,

Kaufman, & Lemieux, 2002; Sironi, 2003), such as, among others, nonperforming loan ratios

and loan loss reserves to nonperforming loans. These latter indicators, although informative,

have a set of shortcomings. They reflect bank choices undertaken in the past that already had

an impact on its performance (as such, they are ex post performance indicators), since losses

have already been reported. They are also subject to the accounting discretion of banks, which

can strategically manage their reporting.

3

In contrast to previous research, our study attempts to examine an important channel for

effective market discipline: whether bank bond spreads reflect the (ex ante) risks that banks

take when granting credit (Morgan & Stiroh, 2001). Understanding this dimension in the

financial crisis context is fundamental to shedding light on the bond spread‐to‐risk relationship

for one of the main activities that banks undertake, that is, providing funding, which expose

1

Sironi (2003) defines market discipline as the ability of the market to price debt according to an issuer's risk profile.

2

Further information on the variable construction is available in section 3.3.1.

3

There is research that supports this argument (e.g., Hasan & Wall, 2004).

SIMION ET AL.EUROPEAN

FINANCIAL MANAGEMENT

|

1351

them to credit risk. Furthermore, to the best of our knowledge, we are the first to consider

external ratings as ex ante measures of the quality of bank credit portfolios.

The scope of traditional risk indicators is limited and reflect different disclosure require-

ments. Bank accounting standards are mostly comparable across countries: Europe and many

other countries endorse the IFRS principles, with the relevant exceptions of the United States,

applying GAAP (even though many foreign SEC registrants use IFRS standards in their filings),

Japan, with voluntary IFRS adoption allowed, and China, following Chinese Accounting

Standards, which have been amended to be generally consistent with IFRS. Nevertheless, it is

important to note that information disclosed through annual reports is not perfectly coincident

also among countries endorsing the same standards. National rules, in fact, can require specific

information disclosure in the notes to the financial statements. To the best of our knowledge,

only Italian banks are required by national financial reporting regulation to disclose in their

financial statements their credit risk exposure by external ratings.

4

This disclosure occurs in a

systematic way, across both different banks and over time. This provides a unique context to

consistently construct our new forward‐looking measure, which is defined as the weighted

average of external ratings on the loan portfolio.

Italy is therefore an ideal setting to test whether this unexplored information of loan risk is

relevant for market discipline. Furthermore, market discipline is expected to be particularly

relevant for Italian banks. Italy has been one of the most adversely affected by the financial

crisis (Albertazzi, Ropele, Sene, & Signoretti, 2014) and, in Europe, Italian banks were among

major issuers of bonds (Grasso, Linciano, Pierantoni, & Siciliano, 2010).

Over the 2007 to mid‐2014 period, we gather data on unsecured bond issues from the 15

largest Italian banks which were the target of the 2014 asset quality review (AQR) per-

formed by the European Central Bank (ECB). These banks together account for almost 87%

of the Italian banking system total assets. The remaining share includes smaller banks that

either do not issue bonds or issue only a marginal fraction of bonds over our time frame. We

focusonthistimeintervalasitischaracterizedbyalargeuseofbondsassourceoffunding

for (mainly) large banks. Furthermore, it follows the first release in 2005 of a regulation by

the Bank of Italy entitled ‘Banks’Financial Statements: Layout and Preparation.’

5

This

regulation, beside adopting the IAS/IFRS standards, introduces a richer disclosure of

financial information that banks are required to produce, where, among other items,

information on external ratings is included for the first time. We hand‐collect this data from

the notes to the financial statements. The analysis was then conducted in two stages. First,

we examine whether our forward‐looking variable of asset risk, together with standard bank

risk measures, is incrementally priced by market participants. Second, we test whether

market discipline has changed from the pre‐to the post‐sovereign debt crisis period by

performing a structural break analysis and then repeating the first stage analysis for two

sub‐periods.

For the entire time interval of our study, we find that the bond market incrementally prices

the forward‐looking information reflected in bank loan portfolios. Further analyses show that

this result is primarily driven by the time period following the sovereign debt crisis. Our

4

We examined the annual reports of the 15 largest US banks and a representative dataset of large banks from other

(non‐Italian) EU countries. With respect to the former, none of the banks disclosed any information like the forward‐

looking information on loan risk that is disclosed by Italian banks. With respect to the latter, we found that some banks

disclose related information, but this information is neither homogenous among banks of the same country or sys-

tematic over time.

5

This regulation is known as Bank of Italy Circular no. 262 and was issued on 22 December 2005.

1352

|

EUROPEAN

FINANCIAL MANAGEMENT

SIMION ET AL.