Bank Rescues and Bailout Expectations: The Erosion of Market Discipline During the Financial Crisis

accepted for publication in the Journal of Financial Economics
Florian Hett,
Alexander Schmidt
Reseach Area:
Financial Institutions, Transparency Lab

We show that market discipline, defined as the extent to which firm-specific risk is reflected in market prices, eroded during the financial crisis in 2008. We design a novel test of changes in market discipline based on the relation between firm-specific risk measures and debt-to-equity hedge ratios. We find that market discipline already weakened after the rescue of Bear Stearns before disappearing almost entirely after the failure of Lehman Brothers. The effect is stronger for investment banks and large financial institutions and there is no comparable effect for non-financial firms.

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