Financial Update (First Quarter 2002)
Subordinated Debt and Bank Risk
everal recent studies have recommended a greater reliance on subordinated debt as a tool to discipline bank risk taking. Some of these proposals suggest using subordinated-debt yield spreads to supplement capital ratios as triggers for the prompt corrective action provisions of the Federal Deposit Insurance Corporation Improvement Act. Two Atlanta Fed working papers by Douglas D. Evanoff and Larry D. Wall take a closer look at this idea.
Working Paper 2001-11 provides the first empirical analysis of the relative accuracy of various capital adequacy ratios and three sub-debt yield spreads (spreads over U.S. Treasury bonds and over two corporate bond indexes) in predicting supervisory ratings. The authors find that the sub-debt yield spreads were statistically and economically significant and that the spreads outperformed the capital ratios. However, they also find that numerous banks rated as low risk by examiners were categorized as high risk by their sub-debt yield spread.
In Working Paper 2001-25, the authors follow up on this seeming contradiction to assess the potential costs and benefits of using sub-debt signals to trigger prompt corrective action. They evaluate several possible explanations for why some banks’ sub-debt yield spreads were high although the examiners rated the banks as satisfactory. This evaluation suggests that many of these banks may indeed have been high risk, and the overall results support a larger role for subordinated-debt yield spreads in the supervisory process.
The full text of these papers is available on the Atlanta Fed’s Web site at www.frbatlanta.org/publica/work_papers