Market discipline on bank bond issues through the lens of a new forward-looking measure of loan quality

Using unsecured bond spreads over the 2007 to mid-2014 period, we test investors' ability to price bank loan risk. We use a new measure of loan risk that incorporates forward-looking information embedded in ratings assigned by external rating agencies to bank loan portfolios. Only Italian banks are required to systematically disclose this specific information. We find that investors do price forward-looking information inherent in bank loan portfolios. This finding reflects the increase in risk perception following the sovereign debt crisis, which had the strongest effects on peripheral countries, with tensions in the lending market. Overall, these results suggest that our new forward-looking measure provides an additional channel through which market discipline can operate.