Market Discipline in Italian Bank Bond Issues: Do Investors Price Liquidity, Funding, and Asset Risk?

The global financial crisis has clearly increased concerns about bank liquidity, funding, and asset quality, especially among European peripheral countries. These issues have prompted regulators to introduce new standards and guidelines aimed at strengthening bank soundness, improving risk management and reinforcing transparency of bank risk-taking activities. Using country-specific accounting data and bond spreads over the 2007 to mid-2014 period, we test investors’ ability to timely recognize and price bank liquidity and funding risk, as defined by Basel III, together with bank asset risk, measured through forwardand backward-looking indicators of loan risk. Our analysis focuses on the 15 largest Italian banks because in the notes to the accounts, they provide a unique insight to compute our bank risk variables. Regression estimates show strong sensitivity of bond spreads to liquidity, whereas funding risk does not seem to play a role. Interestingly, investors’ perspective on asset quality takes both a backwardand forward-looking focus. Our results provide two main contributions to the market discipline literature. First, we extend the relatively scarce studies examining market discipline in adverse market conditions, thus increasing regulators’ knowledge on its complementary role in disciplining banks and on the necessary policy interventions to enhance it. Second, we introduce novel indicators on banks’ risk profile, shedding light on investors’ ability to account for characteristics other than easy-to-observe ones.