The Erosion of Market Discipline During the Financial Crisis

A new publication by junior researchers from the faculty documents the consequences of public interventions in the banking market for investors' expectations

The recent financial crisis triggered a series of unprecedented government interventions in the financial system. These interventions raised fears about a loss of market discipline: If investors perceive a higher likelihood of future support to troubled financial institutions, this may reduce their incentives to monitor and control the banks’ risk-taking. In turn, this investor behavior might increase the probability and severity of future crises. In sum, the indirect costs of bailouts might outweigh the positive short-run gains from improved financial stability, which makes this issue critically important for policymakers. In a new paper, forthcoming in the Journal of Financial Economics, Florian Hett (Goethe University) and Alexander Schmidt (prev. Goethe University, now Deutsche Bundesbank) provide a novel approach to analyzing the strength of market discipline during the financial crisis in order to quantify this effect.

The theoretical approach draws upon the fact that public bailouts favor debt over equity such that the effective debt-to-equity elasticity in the presence of bailouts will be lower than the fundamental elasticity in the absence of bailouts. The authors theoretically derive that the relation between the debt-to-equity hedge ratio, a specific measure of how debt prices react to changes in stock prices, and individual firm risk depends on the strength of market participants’ bailout expectations. It follows that observing changes in this debt-to-equity sensitivity allows to infer changes in bailout expectations and hence market discipline.

A considerable decline of market discipline

The authors apply their approach to several key events relevant to market discipline: the outbreak of turmoil in the asset backed commercial paper market in August 2007, the rescue of Bear Stearns in March 2008, the failure of Lehman Brothers and subsequent support measures during the autumn of 2008 and the implementation of the Dodd-Frank Act in July 2010. The results show a considerable decline of market discipline following the outbreak of the asset backed commercial paper crisis. Bailout expectations further increased after the rescue of Bear Stearns and ultimately peaked after the Lehman collapse and the unprecedented series of public interventions thereafter. Following the announcement of the Dodd-Frank Act in June 2009, estimated bailout probabilities started to decline again, reaching pre-crisis levels after the signing of the law in July 2010 (see figure).

Cross-sectional differences

The paper reveals significant cross-sectional differences in estimated bailout probabilities for government-sponsored enterprises (e.g. Freddie Mac), investment banks and systemically important banks. Market participants perceive actual default risk of government-sponsored enterprises to be almost negligible. For investment banks, perceived bailout probabilities are substantially lower than for other financial institutions, which is in line with the historical interpretation according to which investment banks, in the spirit of the Glass-Steagall Act, are regarded as having a smaller impact on the real economy as compared to deposit banks. For systemically important banks, perceived bailout probabilities are significantly higher.

Overall, the results suggest that market participants rationally adjust their bailout expectations in response to government interventions. Given these findings, policymakers need to take into account the potential effects on market discipline when considering future public responses to financial crises.

The paper is accepted for publication in the Journal of Financial Economics and is available as SAFE Working Paper No. 36.