Re-Examining the Role of Market Discipline for Bank Supervision : Evidence from the Subprime Crisis

We reexamine the effectiveness of markets in monitoring bank riskiness using a panel of large commercial and investment banks for the period just before and during the subprime financial crises. We find that market based bank specific indicators such as credit default swap premiums, implied volatilities of equity options, credit ratings from rating firms, short interest and equity analysts' recommendations were informative about future cross-sectional bank performance. Therefore, our panel analysis supports the view that markets are able to distinguish between risky and less risky banks reinforcing the role of ‘market discipline' as one of the pillars of bank supervision