Subordinated Debt, Market Discipline, and Bank Risk

54 Pages Posted: 5 Nov 2011

See all articles by Yehning Chen

Yehning Chen

National Taiwan University

Iftekhar Hasan

Fordham University ; Bank of Finland; University of Sydney

Date Written: October 6, 2011

Abstract

This paper demonstrates that subordinated debt (‘subdebt’ thereafter) regulation can be an effective mechanism for disciplining banks. Under our proposal, investors buy the subdebt of a bank only if they receive favourable information about the bank, and the bank is subject to a regulatory examination if it fails to issue subdebt. By forcing banks to be examined when they are likely weak, subdebt regulation not only reduces the chance that managers of distressed banks can take value-destroying actions to benefit themselves, but may also encourage banks to lower asset risk. It shows that subdebt regulation and bank capital requirements can be complements for alleviating the banks’ moral hazard problems. It also suggests that to make subdebt regulation effective, regulators may need impose ceilings on the interest rates of subdebt, prohibit collusion between banks and subdebt investors, and require the subdebt to convert into the issuing bank’s equity when the government takes over or provides open assistance to the bank.

Keywords: subordinated debt regulation, bank capital regulation, market discipline, moral hazard, contingent capital certificate

JEL Classification: G21, G28

Suggested Citation

Chen, Yehning and Hasan, Iftekhar, Subordinated Debt, Market Discipline, and Bank Risk (October 6, 2011). Bank of Finland Research Discussion Paper No. 20/2011, Available at SSRN: https://ssrn.com/abstract=1954647 or http://dx.doi.org/10.2139/ssrn.1954647

Yehning Chen

National Taiwan University ( email )

1 Sec. 4, Roosevelt Road
Taipei, 106
Taiwan

Iftekhar Hasan (Contact Author)

Fordham University ( email )

45 COLUMBUS AVENUE
GBA-5TH FLOOR
NEW YORK, NY 10023
United States

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

University of Sydney ( email )

P.O. Box H58
Sydney, NSW 2006
Australia

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