Market discipline of bank risk: Evidence from subordinated debt contracts

Abstract

Do bank debtholders discipline excessive risk taking? I investigate this question by examining how a bank's incentives to take risks affect offering yield spreads and restrictive covenants in their debt contracts. Results suggest that bank charter values, which determine a bank's risk taking incentives, significantly affect the likelihood of restrictive covenants in bank debt contracts. This effect is most pronounced during the 1980s, when greater competition and relatively less stringent regulation increased the severity of moral hazard problems in the U.S. banking industry. Overall, the results suggest that an important channel for market investors to discipline bank risk taking is through writing restrictive covenants in bank debt.

The disciplinary effect of subordinated debt on bank risk taking

“…More recently, Evanoff et al (2007) show results indicating a superior, more informative risk-spread relationship surrounding the period of new debt issuance relative to other periods which they attribute to enhanced market transparency and liquidity surrounding new debt issues. In addition, Goyal (2005) provides evidence that subordinated debt holders can use restrictive covenants as an alternative channel to discipline bank risk taking. 16 However, Krishnan et al (2005) call into question the risk monitoring effect of subordinated debt.…”

Bank reputation in the private debt market

“…In response to agency problems, debt covenants may serve as an ex post monitoring device to protect the lenders' renegotiation position. In general, researchers consider covenants and co-agents as substitutes from the perspective of mitigating asymmetries within loan syndicates (Goyal, 2005). Another strand of the literature analyses the costs and benefits of lending relationship (Boot, 2000;Boot and Thakor, 2000).…”

Bank Insolvencies, Priority Claims and Systemic Risk

“…Their empirical analysis indicates that depositor preference will lead to a considerable increase in collateralization thus taking away funds during a resolution that would have been available for distribution to depositors.. As we have already observed unintended consequences are also associated with proposals aiming to delegate the monitoring role to subordinated debtholders. The evidence comes primarily from comparing yields of subordinated bonds and the performance of the issuing banks and, once more, is mixed (see Evano¤ and Wall, 2002;Flannery and Sorescu, 1996;Goyal, 2005;Hancock and Kwast, 2001;Sironi, 2003).…”