Monitoring Financial Intermediaries with Subordinated Debt: A Dynamic Signal Model for Bank Risk

Abstract

Regulatory proposals that require financial intermediaries to issue subordinated debt are based on the premise that transactions in the secondary market of subordinated debt can attenuate moral hazard on the part of management if secondary market prices are informative signals of the solvency risk of the intermediary. Owing to the proprietary nature of dealer prices and the liquidity of secondary transactions, the practical value of information provided by subordinated debt issues in isolation is questionable. We propose a novel model of a multivariate dynamic signal, combining fluctuations in equity prices, subordinated debt and senior debt yields, that could be a valuable and practical instrument for regulators and investors to monitor and assess in real time the risk profile of the issuing institution. The signal is constructed as a coincident indicator with the following characteristics: (1) it is stochastic because is based in a time series model of yield fluctuations and equity returns; (2) it is extracted from pricing data with a Kalman filter algorithm; (3) it monitors idiosyncratic risk of the intermediary because yields and equity returns are filtered from market conditions; and (4) it is predictable to a large degree because it is possible to construct a leading indicator based almost entirely on spreads to Treasury. We implement the signal with data of the Bank of America after its merger with Nations Bank in October 1, 1998. The signal points mainly to two events of uprising risk, one in January 2000 and another in November 2000. In both instances there was a substantial increase in subordinated and senior debt spreads to Treasury jointly with a substantial decline in equity prices. In January 2000, Bank of America disclosed losses in its bond and interest-rate swaps portfolios, which grew to $5.3 billions in the fourth quarter of 1999 from $3.7 billion in the third quarter. In November 2000, Bank of America wrote off $1.1 billion for bad loans. This was also a period of high uncertainty generated by speculation on the tenure of CEO Hugh McColl.