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Subordinated debt and prompt corrective regulatory action

  • Douglas D. Evanoff
  • Larry D. Wall

Several recent studies have recommended greater reliance on subordinated debt as a tool to discipline bank risk taking. Some of these proposals recommend using subordinated debt yield spreads as additional triggers for supervisory discipline under prompt corrective action (PCA); action that is currently prompted by capital adequacy measures. This paper provides a theoretical model describing how use of a second market-measure of bank risk, in addition to the supervisors own internalized information, could improve bank discipline. We then empirically evaluate the implications of the model. The evidence suggests that subordinated debt spreads dominate the current capital measures used to trigger PCA and consideration should be given to using spreads to complement supervisory discipline. The evidence also suggests that spreads over corporate bonds may be preferred to using spreads over U.S. Treasuries. *The authors wish to thank Mark Flannery, Xavier Freixas, Ben Gup, Alan Hess, George Kaufman, Joe Haubrich, William Perraudin and Mark Vaughan for constructive comments and suggestions on earlier drafts. The authors also acknowledge the support of Nancy Andrews, Mark Murawski and George Simler in developing the database used in the study, and Andy Meyer, Alton Gilbert, and Mark Vaughan for graciously providing detailed information about their 'early warning model. The opinions expressed, however, are those of the authors and not necessarily those of the people mentioned above, the Federal Reserve Bank of Chicago, Federal Reserve Bank of Atlanta or the Federal Reserve System.

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-03-03.

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Date of creation: 2003
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Handle: RePEc:fip:fedhwp:wp-03-03
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  1. Mark Flannery, 2001. "The Faces of “Market Discipline”," Journal of Financial Services Research, Springer, vol. 20(2), pages 107-119, October.
  2. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt as bank capital: a proposal for regulatory reform," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q II, pages 40-53.
  3. Diana Hancock & Myron L. Kwast, 2001. "Using subordinated debt to monitor bank holding companies: is it feasible?," Finance and Economics Discussion Series 2001-22, Board of Governors of the Federal Reserve System (U.S.).
  4. Harald Benink & Clas Wihlborg, 2002. "The New Basel Capital Accord: Making it Effective with Stronger Market Discipline," European Financial Management, European Financial Management Association, vol. 8(1), pages 103-115.
  5. Diana Hancock & Myron Kwast, 2001. "Using Subordinated Debt to Monitor Bank Holding Companies: Is it Feasible?," Journal of Financial Services Research, Springer, vol. 20(2), pages 147-187, October.
  6. Evanoff, Douglas D. & Wall, Larry D., 2002. "Measures of the riskiness of banking organizations: Subordinated debt yields, risk-based capital, and examination ratings," Journal of Banking & Finance, Elsevier, vol. 26(5), pages 989-1009, May.
  7. Andrea Sironi, 2000. "An analysis of European banks SND issues and its implications for the design of a mandatory subordinated debt policy," Finance and Economics Discussion Series 2000-41, Board of Governors of the Federal Reserve System (U.S.).
  8. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt and bank capital reform," Working Paper Series WP-00-7, Federal Reserve Bank of Chicago.
  9. Jeffery W. Gunther & Mark E. Levonian & Robert R. Moore, 2001. "Can the stock market tell bank supervisors anything they don't already know?," Economic and Financial Policy Review, Federal Reserve Bank of Dallas, issue Q II, pages 2-9.
  10. Rebel A. Cole & Jeffery W. Gunther, 1995. "FIMS: a new monitoring system for banking institutions," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 1-15.
  11. R. Alton Gilbert & Andrew P. Meyer & Mark D. Vaughan, 2000. "The role of a CAMEL downgrade model in bank surveillance," Working Papers 2000-021, Federal Reserve Bank of St. Louis.
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