Market discipline prior to failure

This paper examines pricing behavior for bonds issued by bank holding companies in the period prior to failure of their bank subsidiaries. The results indicate that bond prices are related to the financial condition of the issuing bank holding companies, and that bonds spreads start rising as early as six quarters prior to failure as the issuing firm's financial condition and credit rating deteriorate. Strong market discipline exists during the critical period -- bond spreads for troubled banking organizations are many times those of healthy ones. Our results suggests that bond spreads could potentially be useful to bank supervisors as a warning signal from the financial markets. In addition, our finding implies that the proposals to require bank holding companies to issue publicly traded debt in a greater volume and frequency will likely enhance market discipline in the banking system when it is most needed.