A Study of Market Discipline in Indian Banking: Role of Subordinated Debt Market

TLDR: In this article, the authors examined risk sensitivity of Indian banks' subordinated debt (SND) spreads (primary market) to ascertain whether debt investors act as a disciplinarian by discriminating across banks based on risk.

Abstract: Though Basel II has been adopted by many emerging economies and guidelines on Market Discipline have been issued, question may be raised as to what extent market can act as an effective disciplinary force in these immature financial markets. This paper examines risk sensitivity of Indian banks' subordinated debt (SND) spreads (primary market) to ascertain whether debt investors act as a disciplinarian by discriminating across banks based on risk. A unique dataset of SND issues is compiled from issue documents filed with National Stock Exchange (NSE) at the time of issue/listing. The dataset includes issues listed with NSE as on 31st August 2007 and covers the period March 1999 to July 2007. Significant issue clustering in the highest rating-low risk categories is observed, both in terms of number and aggregate issue size. The pooled panel OLS results suggest sort of equi-spread clustering along the rating scale giving rise to a step-wise weakly monotonous increase in spread with enhanced issue risk. Dominance by government owned Public sector banks (PSB) in the SND market considerably weakens market discipline. The spread on PSB SND issues are generally lower relative to Private issues in the same rating scale. Even though more than half of the SNDs were issued over the last 28 months of the data period, no increased risk sensitivity of spreads is noticed. Issue ratings perform better as risk proxy relative to accounting measures of risks. Overall, market disciplinary role of the Indian SND market participants proves to be rather weak.