Three essays on market discipline in the banking industry

This thesis presents the reuslts of empirical research on the pricing and liquidity of various funding instruments issued by Australian banks and investigates the effects ofthe Basel III regulatory framework in promoting the risk-based pricing of banks’ funding instruments and reducing the implicit subsidies realised by systemically important banks. The research focuses on three related areas: the impact of more stringent capital regulation on the value extracted from implicit government guarantees and the associated funding cost advantage realised by systemically important banks; the impact of the Basel III bail-in mechanism (the discretionary point of non-viability trigger mechanism) on the pricing of banks’ subordinated debt securities; and the impact of the Basel III contingent convertible loss absorbency requirements (the discretionary point of non-viability trigger mechanism and the mechanical common equity capital ratio trigger mechanism) on the pricing and liquidity of banks’ hybrid debt-equity securities. An overview of previous literature identifies some important questions that this thesis aims to resolve for the benefit of regulators and industry practitioners. The first study reported in this thesis examines whether systemically important banks realise an implicit subsidy when raising wholesale debt funding and evaluates the effectiveness of the Basel III capital reforms in reducing the subsidy. The estimations suggest that, before the reforms, systemically important banks realise a subsidy of around 29-35 basis points when they raise senior unsecured borrowings and that, after the reforms are implemented, the subsidy is reduced by approximately one-half. This study finds evidence that the default protection provided by a stronger capital base substitutes for the protection provided by implicit government guarantees in lifting investor confidence in a systemically important bank. The second study examines the extent to which a bail-in risk premium is embedded in the credit spreads of bank subordinated debt securities issued with a discretionary point of non-viability trigger mechanism under the Basel III rules. Using monthly credit spreads of subordinated bonds issued by Australian banks and traded in the secondary market from 2013 to 2017, the results suggest that the Basel III point of non-viability trigger mechanism is assessed by investors when they price the subordinated debt securities issued by banks. The average bail-in risk premium is estimated to be approximately 73 basis points for fixed-rate subordinated bonds and 45 basis points for floating-rate subordinated bonds relative to old-style subordinated bonds without the bail-in mechanism. In addition, this study finds the pricing of Basel III bail-in subordinated debt has become more sensitive to bank-specific risk, 20as captured by market-based risk measures, than the old-style subordinated debt securities. The third study examines whether investors in Basel III contingent convertible capital instruments (CoCos) demand an additional risk premium when transacting the instruments in the secondary market and which of the trigger mechanisms, the regulatory discretionary trigger or the mechanical trigger, has a greater impact on the pricing of the instruments.The estimations suggest that: (i) investors in Basel III CoCos with the discretionary trigger mechanism demand an additional risk premium of around 50-60 basis points compared with hybrid securities issued without the loss absorption triggers; (ii) the additional risk premium can be attributed to the discretionary point of non-viability trigger mechanism rather than the mechanical 5.125% common equity capital ratio trigger mechanism prescribed under the Basel III rules; and (iii) compared with conventional hybrid securities, the pricing of Basel III CoCos issued with both the discretionary and mechanical trigger mechanisms is more sensitive to systematic bank risk, however, the pricing is less sensitive to bank-specific risk as captured by the distance-to-default and idiosyncratic equity volatility. Furthermore, this study investigates whether the Basel III loss absorption triggers have had an impact on the secondary market liquidity for bank hybrid securities and finds no evidence that liquidity has deteriorated overall. The results suggest that the Basel III loss absorption features have enhanced the loss-absorbing capacity of banks without disrupting the liquidity of the capital instruments in the secondary market.