Recently there have been a number of recommendations to increase the role of subordinated debt (SND) in satisfying bank capital requirements as a preferred means to discipline the risk-taking behavior of systemically important banks. One such proposal recommended using SND yield spreads as the triggers for mandatory supervisory action under prompt corrective action guidelines introduced in U.S. banking legislation in the early 1990s. Currently such action is prompted by bank capital ratios. Evidence from previous research suggests that yield information may be a better predictor of bank problems. This paper empirically analyzes potential costs and benefits of using SND signals to trigger prompt corrective action.
JEL classification: G12
Key words: bank regulation, subordinated debt, capital adequacy, prompt corrective action
The authors gratefully acknowledge helpful comments by Mark Flannery, Xavier Freixas, William Perraudin, an anonymous referee, and participants at the Conference on Banks and Systemic Risk hosted by the Bank of England, May 23-25, 2001. They also acknowledge the help of Nancy Andrews, Mike Murawski, and George Simler in developing the database and thank Lynn Foley and Kathryn Moran for editorial assistance. The authors are particularly grateful to Robert Bliss and Mark Flannery for providing the bond yield indices and to Andy Meyer, Al Gilbert, and Mark Vaughan for providing detailed information about their “early warning model.” The opinions expressed, however, are the authors’ and not necessarily those of the people mention above, 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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