Abstract: We provide evidence that a bank's subordinated debt yield spread is not,
by itself, a sufficient measure of default risk. We use a model in which subordinated
debt is held by investors with superior knowledge ("informed
investor hypothesis"). First, we show that in theory the yield spread on
subordinated debt must compensate investors for expected loss plus give
them an incentive not to prefer senior debt. Second we present strong
empirical evidence in favor of the informed investor hypothesis and of the
existence of the incentive premium predicted by the model. Using data on
the timing and pricing of public debt issues made by large U.S. banking
organizations during the 1985-2002 period, we find that banks issue relatively
more subordinated debt in good times, i.e. when informed investors
have good news. Spreads at issuance (corrected for sample selection bias)
react to (superior) private and to public information, in line with the
comparative statics of the postulated incentive premium. Interestingly, as
the model predicts, the influence of sophisticated investors' information
on the subordinated yield spread became weaker after the introduction of
prompt corrective action and depositor preference reforms, while the influence
of public risk perception grew stronger. Finally, our model explains
anomalies from the empirical literature on subordinated debt spreads and
from market interviews (e.g. limited sensitivity to bank-specific risk and
the "ballooning" of spreads in bad times). We conclude that a bank's
subordinated yield spread conveys important information if interpreted
together with its senior spread and with other banks' subordinated yield
spreads.
Keywords: Market discipline, subordinated debt, bank supervision.
Full paper (1312 KB PDF)
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