This paper explores the impact of market discipline on bank risk taking. We examine a broad sample of financial institutions from the G7 nations over the period 1996–2010. We apply System Generalized Method of Moments estimation to control for endogeneity and other unobserved heterogeneity in a dynamic panel setting. Our analysis suggests that market discipline helps reduce bank risk (both equity and credit risk). Moreover, we find that this negative impact of market discipline is stronger: (a) in the presence of a risk-adjusted insurance premium; and (b) during the post-global financial crisis period. However, the disciplinary effect of market discipline is not enhanced in the presence of bank capital. We highlight the policy implications of these findings.

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We employ a characteristic-based model to decompose total analyst coverage into abnormal and expected components and show that abnormal coverage contains valuable information about firm-level ex ante crash risk (proxied by implied volatility smirk from options data). Specifically, one standard deviation increase in unexpected or abnormal coverage is associated with a 5.5 percent decrease in the ex ante crash risk. The abnormal coverage signal is more useful for firms with a more transparent information environment, proxied by lower probability of informed trading, lower financial opacity, and more comparable financial statements. Moreover, the abnormal coverage effect is stronger for firms followed by analysts who issue more accurate and less dispersed forecasts. Collectively, these results suggest that options market investors utilise abnormal coverage to identify and assess crash risk of mispriced firms.

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