Is the Bond Market a Reliable Partner in the Regulation of Banks? An Examination of Subordinated Debt and the Pricing of Residential Mortgage Risk During the Financial Crises

Abstract

Toxic mortgage related assets in bank portfolios have tested the pervasive free market wisdom that markets can effectively discipline the risk taking behavior of financial firms. In the buildup to the current crises, banks over-leveraged themselves by investing in risky mortgage securities. In an efficient and perfectly informed market investors punish firms for outsized risk taking, however when the assets in question are opaque, hard to price, and new it is difficult for investors and bank regulators alike to unveil the true risk inherent in management actions. Subordinated debt can act as an effective tool for market discipline of US banks because the debt falls outside the protection provided by regulators, since it is subordinate to deposits and outside the deposit insurance safety net. The role of subordinated debt in achieving market discipline is twofold: first, by demonstrating its spread over US treasuries of similar maturities, subordinated debt reveals the market evaluation of the riskiness of a particular bank. Second, subordinated debt issuance is thought to fulfill a preventive role such that banks that issue subordinated risks are less likely to engage in riskier investment precisely due to the fact that they face a higher level of investor scrutiny. The purpose of paper is to test the effectiveness of subordinated debt holders in fulfilling these two roles. Our paper updates the literature on the market disciplining mechanism of subordinated bond spreads by examining the role of underlying mortgage assets in the pricing of subordinated bonds by investors. Our preliminary results indicate that investors did indeed discipline banks that held or securitized high risk mortgage pools by requiring higher yields on subordinated debt.

Keywords: bank regulation, market discipline, subprime

JEL Classification: G21, G28