What Does the Yield on Subordinated Bank Debt Measure?

49 Pages Posted: 29 Jun 2004

See all articles by Diana Hancock

Diana Hancock

Federal Reserve Board - Division of Research and Statistics

Urs Birchler

University of Zurich - Faculty of Economics, Business Administration and Information Technology

Date Written: April 2004

Abstract

We provide evidence that a bank's subordinated debt yield spread is not, by itself, a sufficient measure of default risk. We use a model in which subordinated debt is held by investors with superior knowledge (informed investor hypothesis). First, we show that in theory the yield spread on subordinated debt must compensate investors for expected loss plus give them an incentive not to prefer senior debt. Second, we present strong empirical evidence in favor of the informed investor hypothesis and of the existence of the incentive premium predicted by the model. Using data on the timing and pricing of public debt issues made by large U.S. banking organizations during the 1985-2002 period, we find that banks issue relatively more subordinated debt in good times, i.e., when informed investors have good news. Spreads at issuance (corrected for sample selection bias) react to (superior) private and to public information, in line with the comparative statics of the postulated incentive premium. Interestingly, as the model predicts, the influence of sophisticated investors' information on the subordinated yield spread became weaker after the introduction of prompt corrective action and depositor preference reforms, while the influence of public risk perception grew stronger. Finally, our model explains anomalies from the empirical literature on subordinated debt spreads and from market interviews (e.g., limited sensitivity to bank-specific risk and the ballooning of spreads in bad times). We conclude that a bank's subordinated yield spread conveys important information if interpreted together with its senior spread and with other banks' subordinated yield spreads.

Keywords: Market discipline, subordinated debt, bank supervision

Suggested Citation

Hancock, Diana and Birchler, Urs, What Does the Yield on Subordinated Bank Debt Measure? (April 2004). FEDS Working Paper No. 2004-19. Available at SSRN: https://ssrn.com/abstract=559527 or http://dx.doi.org/10.2139/ssrn.559527

Diana Hancock

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)

Urs Birchler (Contact Author)

University of Zurich - Faculty of Economics, Business Administration and Information Technology ( email )

Plattenstrasse 14
Z├╝rich, 8032
Switzerland
+41 44 631 29 52 (Phone)

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