Research Discussion Papers, Bank of Finland
No 20/2011:
Subordinated debt, market discipline, and bank risk
Yehning Chen and Iftekhar Hasan ()
Abstract: This paper demonstrates that subordinated debt (‘subdebt’
thereafter) regulation can be an effective mechanism for disciplining
banks. Under our proposal, investors buy the subdebt of a bank only if they
receive favourable information about the bank, and the bank is subject to a
regulatory examination if it fails to issue subdebt. By forcing banks to be
examined when they are likely weak, subdebt regulation not only reduces the
chance that managers of distressed banks can take value-destroying actions
to benefit themselves, but may also encourage banks to lower asset risk. It
shows that subdebt regulation and bank capital requirements can be
complements for alleviating the banks’ moral hazard problems. It also
suggests that to make subdebt regulation effective, regulators may need
impose ceilings on the interest rates of subdebt, prohibit collusion
between banks and subdebt investors, and require the subdebt to convert
into the issuing bank’s equity when the government takes over or provides
open assistance to the bank.
Keywords: subordinated debt regulation; bank capital regulation; market discipline; moral hazard; contingent capital certificate; (follow links to similar papers)
JEL-Codes: G21; G28; (follow links to similar papers)
54 pages, October 6, 2011
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