Monitoring Matters: Debt Seniority, Market Discipline and Bank Conduct

Abstract

We examine if debtholders monitor banks and if such monitoring constrains risk-taking. Leveraging an unexplored experiment in the U.S. that changes the priority structure of claims on banks’ assets, we provide novel insights into the debate on market discipline. We document asymmetric effects for monitoring effort depending on whether a creditor class moves up or down the priority ladder. Conferring priority to depositors reduces deposit rates but increases interest rates for non-deposit liabilities, suggesting greater incentives for junior debtholders to exert monitoring effort. Consistent with the idea that senior claims require lower risk premiums, banks increasingly rely on deposit funding following changes in the priority structure. More intensive monitoring also influences conduct: subordinating non-depositor claims reduces risk taking. Our results highlight that changes in the priority structure are a complementary tool to regulation which has received little attention in prior work.

Keywords: market discipline, debt priority structure, natural experiment, bail-ins

JEL Classification: G21, G28