What Does the Yield on Subordinated Bank Debt Measure?

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.

Market Discipline in Banking Reconsidered: The Roles of Funding Manager Decisions and Deposit Insurance Reform

“…15 Jung, Kim, and Stulz (1996) note that financial distress and bankruptcy become more likely as debt and firm risk increase. See also Castanias (1983) and Marsh (1982 17 Birchler and Hancock (2004) provide a model where a banking organization would issue subordinated debt upon the receipt of "good" news and would issue senior debt upon the receipt of "bad" news to separate investors with different, yet unobservable, beliefs on the probability of its failure.…”

“…See Board of Governors of the Federal Reserve System, SR letter 99-18. 32 Birchler and Hancock (2004) argue that a bank's liability structure is a direct function of signals received on the quality of projects undertaken. After a bad signal, such as a poor supervisory rating, senior debt would be issued.…”

Market Discipline in Banking Reconsidered: The Roles of Funding Manager Decisions and Deposit Insurance Reform

“…16 See Board of Governors of the Federal Reserve System (1999b) and Board of Governors of the Federal Reserve System and United States Department of Treasury (2000, p.36). 17 Birchler and Hancock (2004) provide a model where a banking organization would issue subordinated debt upon the receipt of "good" news and would issue senior debt upon the receipt of "bad" news to separate investors with different, yet unobservable, beliefs on the probability of its failure.…”