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

36 Pages Posted: 5 Apr 2003

See all articles by Diana Hancock

Diana Hancock

Federal Reserve Board - Division of Research and Statistics

Daniel M. Covitz

Federal Reserve Board - Division of Research & Statistics

Myron L. Kwast

Federal Reserve Board - Division of Research & Statistics

Date Written: October 2002

Abstract

This paper demonstrates that the risk sensitivity of a banking organization's subordinated debt yield spreads may understate the potential for market discipline in some periods and overstate in others because such spreads contain liquidity premiums that are driven, in part, by the risk-sensitivity of funding manager decisions. Once such decisions are accounted for, new evidence is provided that indicates that subordinated debt spreads were sensitive to organization-specific risks in the mid-1980s, and that the risk-sensitivity of such spreads was about the same in the pre- and post-FDICIA periods. These results resolve some anomalies in the existing literature. In addition, it is argued that mandating the regular issuance of subordinated debt would, by reducing the endogeneity of liquidity premiums, improve the information content of both primary and secondary market debt spreads, thereby augmenting both direct and indirect market discipline.

Keywords: Market discipline, subordinated debt, market efficiency

JEL Classification: G14, G21

Suggested Citation

Hancock, Diana and Covitz, Daniel M. and Kwast, Myron L., Market Discipline in Banking Reconsidered: The Roles of Deposit Insurance Reform, Funding Manager Decisions and Bond Market Liquidity (October 2002). FEDS Working Paper No. 2002-46. Available at SSRN: https://ssrn.com/abstract=347341 or http://dx.doi.org/10.2139/ssrn.347341

Diana Hancock (Contact Author)

Federal Reserve Board - Division of Research and Statistics ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-3019 (Phone)
202-452-5295 (Fax)

Daniel M. Covitz

Federal Reserve Board - Division of Research & Statistics ( email )

20th and C Streets, NW
Mailstop 153
Washington, DC 20551
United States
202-452-5267 (Phone)
202-452-5295 (Fax)

Myron L. Kwast

Federal Reserve Board - Division of Research & Statistics

20th and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2909 (Phone)
202-452-3819 (Fax)

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