What does the yield on subordinated bank debt measure?
AbstractWe provide evidence that a bank's subordinated debt yield spread is not, by itself, a sufficient measure of default risk. We use a model in which subordinated debt is held by investors with superior knowledge ("informed investor hypothesis"). First, we show that in theory the yield spread on subordinated debt must compensate investors for expected loss plus give them an incentive not to prefer senior debt. Second we present strong empirical evidence in favor of the informed investor hypothesis and of the existence of the incentive premium predicted by the model. Using data on the timing and pricing of public debt issues made by large U.S. banking organizations during the 1985-2002 period, we find that banks issue relatively more subordinated debt in good times, i.e. when informed investors have good news. Spreads at issuance (corrected for sample selection bias) react to (superior) private and to public information, in line with the comparative statics of the postulated incentive premium. Interestingly, as the model predicts, the influence of sophisticated investors' information on the subordinated yield spread became weaker after the introduction of prompt corrective action and depositor preference reforms, while the influence of public risk perception grew stronger. Finally, our model explains anomalies from the empirical literature on subordinated debt spreads and from market interviews (e.g. limited sensitivity to bank-specific risk and the "ballooning" of spreads in bad times). We conclude that a bank's subordinated yield spread conveys important information if interpreted together with its senior spread and with other banks' subordinated yield spreads.
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Bibliographic InfoPaper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-19.
Date of creation: 2003
Date of revision:
Other versions of this item:
- Hancock Diana & Urs W. Birchler, 2004. "What Does the Yield on Subordinated Bank Debt Measure?," Working Papers 2004-02, Swiss National Bank.
- D8 - Microeconomics - - Information, Knowledge, and Uncertainty
- G2 - Financial Economics - - Financial Institutions and Services
- K2 - Law and Economics - - Regulation and Business Law
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-05-26 (All new papers)
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