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Enhancing market discipline in banking: The role of subordinated debt in financial regulatory reform

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  • Evanoff, Douglas D.
  • Jagtiani, Julapa A.
  • Nakata, Taisuke

Abstract

The increasing complexity of large financial firms has led to consideration of alternative regulatory structures. This has intensified recently because of the worldwide turmoil in financial markets. One important consideration has been to increase reliance on market discipline—most notably, increased reliance on subordinated debt (sub-debt) in the bank capital structure to discipline banks’ risk taking. This proposal, however, has been subject to criticism related to the quality of the signal generated in current sub-debt markets. We argue that previous studies evaluating the potential usefulness of sub-debt proposals have evaluated sub-debt spreads in a very different environment from that characterized by a fully implemented sub-debt program, where the market will become deeper, issuance will be more frequent, debt will be viewed as a more viable means to raise capital, bond dealers will be less reluctant to publicly disclose more details on debt transactions, and generally, the market will be more closely followed. As a test to see how the quality of the signal may change, we evaluate the risk-spread relationship—accounting for the enhanced liquidity and market transparency surrounding new debt issues. Our empirical results indicate a superior risk-spread relationship surrounding the period of new debt issuance due, we posit, to greater liquidity and transparency. Our results overall suggest that the degree of market discipline would be significantly enhanced by a mandatory sub-debt program, thus suggesting a potential role for sub-debt in the banking regulatory reform.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economics and Business.

Volume (Year): 63 (2011)
Issue (Month): 1 ()
Pages: 1-22

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Handle: RePEc:eee:jebusi:v:63:y:2011:i:1:p:1-22

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Web page: http://www.elsevier.com/locate/jeconbus

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Keywords: Regulatory reform; Market discipline; Subordinated debt; Bank capital; Financial regulation;

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References

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Citations

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Cited by:
  1. Inoguchi, Masahiro, 2013. "Interbank market, stock market, and bank performance in East Asia," Pacific-Basin Finance Journal, Elsevier, vol. 25(C), pages 136-156.
  2. Zhang, Zhichao & Song, Wei & Sun, Xin & Shi, Nan, 2014. "Subordinated debt as instrument of market discipline: Risk sensitivity of sub-debt yield spreads in UK banking," Journal of Economics and Business, Elsevier, vol. 73(C), pages 1-21.
  3. Cecile Casteuble & Emmanuelle Nys & Philippe Rous, 2013. "Bank Risk - Return Efficiency and Bond Spread: Is There Evidence of Market Discipline in Europe," Working Papers hal-00916717, HAL.
  4. Mehdi Beyhaghi & Chris D'Souza & Gordon S. Roberts, 2013. "Funding Advantage and Market Discipline in the Canadian Banking Sector," Working Papers 13-50, Bank of Canada.

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