Several recent studies have recommended greater reliance on subordinated debt as a tool to discipline bank risk taking. Some of these proposals recommend using sub-debt yield spreads as triggers for supervisory discipline under prompt corrective action (PCA). Currently such action is prompted by capital adequacy measures. This paper provides the first empirical analysis of the relative accuracy of various capital ratios and sub-debt spreads in predicting bank condition, measured as subsequent CAMEL or BOPEC ratings. The results suggest that some of the capital ratios, including the summary measure used to trigger PCA, have almost no predictive power. Sub-debt yield spreads performed slightly better than the best capital measure, the Tier-1 leverage ratio, albeit the difference is not significant. The performance of sub-debt yields satisfies an important prerequisite for using sub-debt as a PCA trigger. However, the prediction errors are relatively high and further work to refine the measures would be desirable.
JEL classification: G28, G21, G14, K23
Key words: bank regulation, subordinated debt, capital adequacy, prompt corrective action
The authors wish to thank Robert Bliss, Jeffrey Gunther, George Kaufman, Robert Moore, Anthony Saunders and participants at the conference on “Incorporating Market Information into Financial Supervision” cosponsored by the Federal Deposit Insurance Corporation and the Journal of Financial Services Research for helpful comments and suggestions (without necessarily implying any agreement with the final product). They especially acknowledge numerous comments by the editor, Mark Flannery, that substantially strengthened the paper. The authors also acknowledge the input and help of Nancy Andrews, Julapa Jagtiani, Mike Murawski, and George Simler in developing the database used in the study. The opinions expressed in this paper are those of the authors’ and not necessarily those of the Federal Reserve Bank of Chicago, the Federal Reserve Bank of Atlanta, or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
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