Academic journal article Economic Commentary (Cleveland)

Credit Spreads and Subordinated Debt

Academic journal article Economic Commentary (Cleveland)

Credit Spreads and Subordinated Debt

Article excerpt

Ever since deposit insurance was introduced, economists and policymakers have been trying to correct its unintended consequences. The heart of the problem is that deposit insurance counteracts the natural market forces that would ordinarily keep banks from taking on too much risk. For most firms, taking on more risk means they have to pay more to raise money because investors demand a higher return to cover the risk. But banks can avoid such direct market pressure because depositors, who know that their deposits are guaranteed, have little incentive to demand a higher rate or withdraw their funds.

One proposed means of injecting more market discipline into the banking sector is a subordinated debt requirement. It would compel banks to issue some debt that the government does not guarantee and that is paid off only after all depositors have been satisfied. A mandatory subordinated debt requirement was one of the reforms recommended in a 1986 study commissioned by the American Bankers Association. In addition, the Financial Modernization Act of 1999 requires that large banking companies have outstanding, at all times, at least one (though not necessarily a subordinated) debt issue rated by a commercial credit-rating agency.

Some experts argue that subordinated debt is unnecessary because equity capital already gives depositors and other bank creditors a layer of protection. But banks' equity-that is, their stock-rises when their profits increase, so the prospect of higher equity can encourage them to take greater risks. Debt is more sensitive than equity to the loss aspect of risk because it lacks the upside inducement of higher profits. Subordinated debt thus gives a bank's depositors and general creditors the same protection from losses as equity does, without creating the incentive to assume more risk.

An important channel through which subordinated creditors can exert marketbased discipline is the pricing of subordinated debt: Risky banks would have to pay higher interest rates than safe banks to issue such debt. Because subordinated debt is paid back only after depositors are, those holding it absorb losses that would otherwise accrue to uninsured depositors and the deposit insurance fund. Unlike depositors, subordinated creditors cannot be sure they will be able to withdraw their funds from a bank whose solvency comes into question. As a result, the yield on banks' subordinated debt should vary with the riskiness of the bank, and decisions by bank managers and shareholders to increase their institutions' risk would raise the cost of issuing debt.

Whether repricing three to four percent of a bank's funds (the typical share required in most mandatory subordinated-debt proposals) would exert meaningful discipline on risk-taking remains debatable. However, to the extent that yields on new and outstanding subordinated debt reflect underlying risk, mandatory subordinated-debt requirements could give markets and bank supervisors useful information on the riskiness of banking companies. A review of recent research on the information that can be gleaned from these yields, however, suggests that much more work needs to be done on extracting useful, reliable risk indicators from them before a subordinated debt requirement for banks is warranted.

* Credit Spreads

To extract information from subordinated-debt yields about investors' perceptions of the underlying riskiness of various issuers, researchers must remove other sorts of information from the yields, such as that which reflects changes in interest rates. To do this, they can construct a credit spread, which is calculated as the difference between the yield on a risky bond and a risk-free bond of the same maturity, typically a U.S. Treasury bond. Such a credit spread is often interpreted as the premium paid to bond holders for default risk. The risky bond's yield must also be adjusted to account for other differences between the two types of bonds, such as embedded options, because these would affect the bond's yield and be reflected in the credit spread. …

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