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Banking Research Paper

The Potential Role of Subordinated Debt Programs In Enhancing Market Discipline in Banking

By Douglas D. Evanoff, Julapa A. Jagtiani, and Taisuke Nakata (RWP 07-07 September 2007)
Previous studies have found that subordinated debt (sub-debt) markets do differentiate between banks with different risk profiles. This finding satisfies a necessary condition for regulatory proposals which would mandate increased reliance on sub-debt in the bank capital structure to discipline banks’ risk taking. Such proposals, however, have not been implemented, partially because there are still concerns about the quality of the signal generated in current debt markets. We argue that previous studies evaluating the potential usefulness of sub-debt proposals have evaluated spreads in an environment that is very different from the one that will characterize a fully implemented sub-debt program. With a fully implemented program, the market will become deeper, issuance will be more frequent, debt will be viewed as a more viable means to raise capital, bond dealers will be less reluctant to publicly disclose more details on debt transactions, and generally, the market will be more closely followed. As a test to see how the quality of the signal may change, we evaluate the risk-spread relationship, accounting for the enhanced market transparency surrounding new debt issues. Our empirical results indicate a superior risk-spread relationship surrounding the period of new debt issuance due, we posit, to greater liquidity and transparency. Our results overall suggest that the degree of market discipline would likely be enhanced by a mandatory sub-debt program requiring banks to regularly approach the market to issue sub-debt.

JEL classification: G21, G28, G38, L51
Keywords: Financial regulation, market discipline, subordinated debt, bank capital

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