Subordinated Debt and Market Discipline – Evidence from the UK Banking Industry

Abstract

This research empirically investigates how and to what extent bank subordinated debt plays a role in providing market discipline whereby the private sector is deployed to monitor and influence bank risk taking, hence complement government supervision and regulation of banks. The study comprises four essays on the use of subordinated debt as an instrument for creating direct and indirect market discipline, with specific reference to the case of the UK banking industry. Broadly, Chapters 2, 3 and 4 examine the effectiveness of subordinated debt as an instrument of direct market discipline; Chapter 5 approaches the issue of indirect market discipline.
First, we analyse whether the risk premiums or yield spreads of subordinated debt indicate banks’ financial health. Our results show that yield spreads contain timely and accurate information on issuing banks’ risk taking, and this underpins the proposals that advocate forcing large financial institutions to issue subordinated debt to the public on a regular basis. Then we examine whether the issued subordinated debt and its price have any impact on banks’ performance. The results have positive signs, implying that the signalling and influencing effects of subordinated debt can induce banks to act prudently and restrain them from assuming unsound risk. However, the final chapter finds that the UK financial regulator, the Financial Services Authority (FSA) has little enthusiasm for utilizing the subordinated debt to indirectly discipline financial institutions. This reflects the FSA’s doubt as to the usefulness of the market in providing disciplining effects. In contrast, the evidence documented in this research shows that the subordinated market proves to be sensitive to bank risk, and banks do respond to market information, hence it can be an effective mechanism for generating useful market discipline. In reforming the financial regulation regime, adding new regulations to the old is therefore not the best way forward. Rather, priority should be given to reforming the paradigm of financial regulation by allowing more room for the subordinated market to discipline the regulators to take more prompt and rigorous corrective actions.