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. The authors 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.
JEL classification: G2, G3, L5
Keywords: bank regulation, subordinated debt, capital adequacy, prompt corrective action
The authors thank Mark Flannery, Xavier Freixas, George Kaufman, and William Perraudin for helpful comments and suggestions in earlier discussions about the topic. The authors also acknowledge the input and help of Nancy Andrews, Mark Murawski, and George Simler in developing the database used in the study; Andy Meyer, Alton Gilbert, and Mark Vaughan for graciously providing detailed information about their “early warning model” and our discussants—Ben Gup and Alan Hess—for their comments at the special session on market discipline and prompt corrective action in banking at the 2002 Western Economic Association meetings in Seattle. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
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