Bank Sub-Debt has been in the news lately, with Deutsche Bank’s refusal to execute a pretend-maturity, and I have dug up another theoretical paper: What does the Yield on Subordinated Bank Debt Measure, by Urs W. Birchler (Swiss National Bank) & Diana Hancock (Federal Reserve):
We provide evidence that the yield spread on banks’ subordinated debt is not a good measure of bank risk. First, we use a model with heterogeneous investors in which subordinated debt is primarily held by investors with superior knowledge (i.e., the“informed investor hypothesis”). Subordinated debt, by definition, coexists with non-subordinated, or “senior,” debt. The yield spread on subordinated debt thus must not only compensate investors for expected risk (i.e., to satisfy their participation constraint), but also offer an “incentive premium” above a “fair” return to induce informed investors to prefer it to senior debt (i.e., to satisfy an incentive constraint). Second, we test the model using data we collected on the timing and pricing of public debt issues made by large U.S. banking organizations in the 1986-1999 period. Findings with respect to issuance decisions lend strong support for the informed investor hypothesis. But rival explanations for the use of subordinated debt, such as differences in investor risk aversionor such as the signaling of earnings prospects by the bank, are rejected.A sample selection model on observed issuance spreads provides evidence for the existence of the postulated subordinated incentive premium. In line with predictions from the model, the influence of sophisticated investors’ information on the subordinated yield spread became weaker after the introduction of prompt corrective actions and depositor preference regulatory reforms, while the influence of public risk perception grew stronger. Finally, our model explains some results from the empirical literature on subordinated debt spreads and from market interviews — such as limited spread sensitivity to bank specific-risk or of the “ballooning” of spreads in bad times.
The conclusions are consistent with those of other researchers.
There’s a good line in the discussion:
These results are consistent with the “informed investor hypothesis” that claims that banking organizations would issue debt of different priority status to separate investors with different, yet unobservable, beliefs on the probability of bank failure.
I claim that a good definition of an “informed investor”, suitable for ex ante assignment of investors into different groups is: “one who knows that there is a difference”. The authors would not, I think, disagree too violently with this definition:
Paradoxically, the quality of the subordinated debt spread to measure banking organizations’ risks as they are perceived by most sophisticated investors has deteriorated after the introduction of FDICIA or, more precisely, of depositor preference rules. With depositor preference rules, the risk characteristics of senior debt have become more similar to those of subordinated debt; at the same time, the subordinated debt spread has become (even) more dependent on factors influencing the senior spread.
The deterioration of the risk measurement quality of the subordinated spread after the introduction of depositor preference, however, is likely to understate the longer term virtues of the reform. Once senior debtors realize that their claims are subordinated to depositors, senior spreads may well more fully reflect specialist information. Therefore, we expect that senior debt will be held by more sophisticated investors in the future.
Assiduous Readers will remember that in my essay on Fixed-Reset Analysis I pointed out a very low spread between deposit notes and sub-debt in February 2007.
[…] with her desire to have contingent capital priced like debt. As has been discussed on PrefBlog, the Fed has found that sub-debt pricing is not well correlated with risk and there is not much theoretical difference between the risk of sub-debt as it is and her vision […]