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The Potential Role of Subordinated Debt Programs In Enhancing Market Discipline in Banking By Douglas Evanoff,
Julapa Jagtiani, and Taisuke Nakata |
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Abstract 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. Back to top RWP home |