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Market discipline in banking reconsidered: the roles of deposit insurance reform, funding manager decisions and bond market liquidity

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  • Daniel M. Covitz
  • Diana Hancock
  • Myron L. Kwast
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    Abstract

    This paper demonstrates that the risk sensitivity of a banking organization's subordinated debt yield spreads may understate the potential for market discipline in some periods and overstate in others because such spreads contain liquidity premiums that are driven, in part, by the risk-sensitivity of funding manager decisions. Once such decisions are accounted for, new evidence is provided that indicates that subordinated debt spreads were sensitive to organization-specific risks in the mid-1980s, and that the risk- sensitivity of such spreads was about the same in the pre- and post-FDICIA periods. These results resolve some anomalies in the existing literature. In addition, it is argued that mandating the regular issuance of subordinated debt would, by reducing the endogeneity of liquidity premiums, improve the information content of both primary and secondary market debt spreads, thereby augmenting both direct and indirect market discipline.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2002-46.

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    Date of creation: 2002
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    Handle: RePEc:fip:fedgfe:2002-46

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    Keywords: Banks and banking ; Risk management;

    This paper has been announced in the following NEP Reports:

    References

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    Cited by:
    1. Allen N. Berger & Gregory F. Udell, 2003. "The institutional memory hypothesis and the procyclicality of bank lending behavior," Finance and Economics Discussion Series 2003-02, Board of Governors of the Federal Reserve System (U.S.).
    2. Goyal, Vidhan K., 2005. "Market discipline of bank risk: Evidence from subordinated debt contracts," Journal of Financial Intermediation, Elsevier, vol. 14(3), pages 318-350, July.
    3. Fred Furlong & Simon Kwan, 2006. "Safe and sound banking, 20 years later: what was proposed and what has been adopted," Working Paper Series 2006-27, Federal Reserve Bank of San Francisco.
    4. Frederick T. Furlong & Simon Kwan, 2006. "Safe & sound banking, 20 years later: what was proposed and what has been adopted," Proceedings, Federal Reserve Bank of San Francisco.
    5. R. Alton Gilbert & Andrew P. Meyer & Mark D. Vaughan, 2006. "Can feedback from the jumbo CD market improve bank surveillance?," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 135-175.

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