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Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page Market Discipline in Banking Reconsidered: The Roles of Deposit Insurance Reform, Funding Manager Decisions and Bond Market Liquidity
Daniel M. Covitz, Diana Hancock, and Myron L. Kwast

Abstract: This paper demonstrates that the risk sensitivity of a banking organization's subordinated debt yield spreads may understate the potential for market discipline in some periods and overstate in others because such spreads contain liquidity premiums that are driven, in part, by the risk-sensitivity of funding manager decisions. Once such decisions are accounted for, new evidence is provided that indicates that subordinated debt spreads were sensitive to organization-specific risks in the mid-1980s, and that the risk- sensitivity of such spreads was about the same in the pre- and post-FDICIA periods. These results resolve some anomalies in the existing literature. In addition, it is argued that mandating the regular issuance of subordinated debt would, by reducing the endogeneity of liquidity premiums, improve the information content of both primary and secondary market debt spreads, thereby augmenting both direct and indirect market discipline.

Keywords: Market discipline, subordinated debt, market efficiency

Full paper (678 KB PDF)

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Last update: October 10, 2002