Keywords: Market discipline, subordinated debt, market efficiency
Abstract: This paper demonstrates that the risk sensitivity of a banking
organization's subordinated debt yield spreads may understate the
potential for market discipline in some periods and overstate in
others because such spreads contain liquidity premiums that are
driven, in part, by the risk-sensitivity of funding manager decisions.
Once such decisions are accounted for, new evidence is provided that
indicates that subordinated debt spreads were sensitive to
organization-specific risks in the mid-1980s, and that the risk-
sensitivity of such spreads was about the same in the pre- and
post-FDICIA periods. These results resolve some anomalies in the
existing literature. In addition, it is argued that mandating the
regular issuance of subordinated debt would, by reducing the
endogeneity of liquidity premiums, improve the information content of
both primary and secondary market debt spreads, thereby augmenting
both direct and indirect market discipline.
Full paper (678 KB PDF)
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Last update: October 10, 2002