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Monitoring and Controlling Bank Risk: Does Risky Debt Serve Any Purpose?

We examine whether mandating banks to issue subordinated debt would serve to enhance market monitoring and control risk taking. To evaluate whether subordinated debt enhances risk monitoring, we extract the credit-spread curve for each banking firm in our sample and examine whether changes in credit spreads reflect changes in bank risk variables, after controlling for changes in market and liquidity variables. We find that they do not. Our result is robust to firm type, examination rating, size, leverage and profitability, as well as to different model specifications. To evaluate whether subordinated debt controls risk taking, we examine whether issuing subordinated debt changes the risk-taking behavior of a bank. We find that it does not. We conclude that a mandatory subordinated debt requirement for banks is unlikely to provide the purported benefits of enhancing risk monitoring or controlling risk-taking.

JEL Classification: G12, G21, G28
Key Words: credit spreads, market discipline, subordinated debt

Suggested citation: Krishnan, C. N. V., Peter Ritchken, and James Thomson, 2003. “Monitoring and Controlling Bank Risk: Does Risky Debt Serve Any Purpose?,” Federal Reserve Bank of Cleveland, Working Paper, no. 03-01.

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