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What Does the Yield on Subordinated Bank Debt Measure?

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  • Diana Hancock
  • Urs W. Birchler

Abstract

We 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). 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.

Suggested Citation

  • Diana Hancock & Urs W. Birchler, 2004. "What Does the Yield on Subordinated Bank Debt Measure?," Working Papers 2004-02, Swiss National Bank.
  • Handle: RePEc:snb:snbwpa:2004-02
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    References listed on IDEAS

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    Cited by:

    1. Bakhshi, Hasan & Khan, Hashmat & Rudolf, Barbara, 2007. "The Phillips curve under state-dependent pricing," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2321-2345, November.
    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. Jens Forssbaeck, 2011. "Divergence of risk indicators and the conditions for market discipline in banking," Chapters in SUERF Studies, SUERF - The European Money and Finance Forum.
    4. Baba, Naohiko & Inada, Masakazu, 2009. "Why do Japanese regional banks issue subordinated debts?," Japan and the World Economy, Elsevier, vol. 21(4), pages 358-364, December.
    5. Evanoff, Douglas D. & Jagtiani, Julapa A. & Nakata, Taisuke, 2011. "Enhancing market discipline in banking: The role of subordinated debt in financial regulatory reform," Journal of Economics and Business, Elsevier, vol. 63(1), pages 1-22, January.
    6. Daniel M. Covitz & Diana Hancock & Myron L. Kwast, 2004. "A reconsideration of the risk sensitivity of U.S. banking organization subordinated debt spreads: a sample selection approach," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 73-92.
    7. Daniel M. Covitz & Diana Hancock & Myron L. Kwast, 2004. "Market discipline in banking reconsidered: the roles of funding manager decisions and deposit insurance reform," Finance and Economics Discussion Series 2004-53, Board of Governors of the Federal Reserve System (U.S.).
    8. Urs W. Birchler & Matteo Facchinetti, 2007. "Can Bank Supervisors Rely on Market Data? A Critical Assessment from a Swiss Perspective," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 143(II), pages 95-132, June.
    9. Clemens Kool, 2006. "Financial Stability in European Banking: The Role of Common Factors," Open Economies Review, Springer, vol. 17(4), pages 525-540, December.
    10. Belkhir, Mohamed, 2013. "Do subordinated debt holders discipline bank risk-taking? Evidence from risk management decisions," Journal of Financial Stability, Elsevier, vol. 9(4), pages 705-719.
    11. Naohiko Baba & Masakazu Inada & Yasuo Maeda, 2007. "Determinants of Subordinated Debt Issuance by Japanese Regional Banks," IMES Discussion Paper Series 07-E-03, Institute for Monetary and Economic Studies, Bank of Japan.

    More about this item

    Keywords

    market discipline; subordinated debt; bank supervision;

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G2 - Financial Economics - - Financial Institutions and Services
    • K2 - Law and Economics - - Regulation and Business Law

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