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Using Subordinated Debt as an Instrument of Market Discipline
Source: Federal Reserve

Empirical Results

First, we consider whether the banking organization's risk, size, and frequency of SND issuance affect its probability of issuance. In table 2, parameter estimates for a ''bare bones'' probit model with only accounting measures of risk, bank holding company size, and an indicator variable for whether the bank holding company issued in the previous six-month interval are presented for separate two-year sample periods. 36 Many of the parameter estimates are of the expected sign, and such estimates are indicated with an ''X.''

In the first column, the parameter estimates for the 1986:Q2 to 1987:Q4 period suggest that accounting measures of risk individually did not significantly affect the SND issuance decision. Indeed, the five accounting measures of risk taken together did not provide significant explanatory power during this period. 37 These results are consistent with those of Flannery and Sorescu (1996), who found that such accounting risk measures did not significantly affect SND secondary prices in this time interval. 38

In the 1988:Q1 to 1989:Q4 period and in the 1990:Q1 to 1991:Q4 period, the parameter estimate for the ratio of accruing loans past due ninety days or more to total assets is significant and has the expected negative sign. In the latter of these two periods, the parameter estimate for the ratio of total book liabilities to the sum of market value of common stock and book value of preferred stock is also significant and is of the expected negative sign.  Also, the five accounting measures of risk, taken together, have a significantly negative effect on the issuance decision both in the 1988:Q1 to 1989:Q4 period and in the 1990:Q1 to 1991:Q4 period. These results are also consistent with Flannery and Sorescu, who found that secondary SND prices were significantly affected by such accounting measures of risk in the 1989-91 period. These results also suggest that riskier banking organizations chose not to issue SND during 1988-91.

In each of the next three periods (1992:Q1 to 1993:Q4, 1994:Q1 to 1995:Q1, and 1996:Q1 to 1997:Q4), the accounting measures of risk were as likely to have positive parameter estimates as to have negative ones. Indeed, taken together the five accounting measures of risk had a significant positive effect on the issuance decision in each of these three periods.39 These results may at first seem counterintuitive, but data on SND spreads at issuance over comparable-maturity Treasury securities for the top fifty bank holding companies over 1991-97 offer a partial explanation. These spreads can be used to explain why there is not a negative relationship, but not why there is a positive relationship, between risk measures and the issuance decision during this period.

We first consider figure 2, which shows box plots for such spreads in each quarter for the 1991:Q1 to 1997:Q4 period. These box plots are graphical representations of the center and width of a distribution, along with outliers. The height of each black box is equal to the interquartile width, which is the difference between the third quartile and first quartile of data. This width has narrowed considerably since 1992:Q1. It is also notable that in the middle to late 1990s the top quartile of the SND spread over comparable-maturity Treasuries is below the medians of such spreads (which are represented by horizontal lines in the interior of each box) that were observed during 1991. The brackets ([ ]) for each box plot are located at extreme values of the data for the quarter or at a distance equal to 1.5 times the interquartile distance from the center, whichever is less. 40 During the middle to late 1990s, there are many quarters in which the upper brackets are considerably below the median SND spread over comparable maturities that were observed in 1991. Therefore, although market discipline may have been imposed in terms of relative prices of issuance during 1992-97, these spreads may have been too small to induce any change in issuance decisions. However, the general low level of spreads does not explain why relatively risky banks were more likely than safer banks to issue during this period.

To interpret the latter result, we consider the possibility that SND spreads during 1993-97 did not reflect the risk of banking organizations to the same degree that spreads did in the early 1990s. 41 On the margin, a drop in relative spreads would have provided the riskiest banks with the greatest incentive to issue SND. Therefore, our finding that the riskiest banks were most likely to issue SND from 1992 to 1997 is consistent with a reduction in the risk sensitivity of SND and weaker market discipline during this period, a view supported by a number of market participants that the study group interviewed. 42

In all two-year periods considered in table 2, the coefficients on the frequency of issuance and the banking organization's asset size are of the expected (positive) sign, and almost all are significantly different from zero at the 5 percent level. These positive coefficients are consistent with studies of SND secondary market spreads over comparablematurity Treasuries, which find that larger banking organizations have narrower secondary market spreads than smaller banking organizations. The only discernible pattern in the significance of the coefficients is that issuance in the previous six-month interval is becoming more important over time.  This finding suggests a trend toward more-frequent issuance by some top fifty bank holding companies in recent years, a view that was supported by study group interviews with market participants.

We next consider how private benefits, bond market volatility, and macroeconomic conditions are estimated to affect the decision to issue SND by top fifty bank holding companies. In table 3, parameter estimates for a probit model that includes the ''bare bones'' model variables, additional bank-specific variables, and variables for bond market and macroeconomic conditions are presented. Based on the findings presented in table 2, we provide parameter estimates for the period in which market discipline is strongest (1989-92) and for the entire sample period (1986:Q2 through 1997:Q4). With regard to private benefits, neither the variable for foreign and domestic income taxes as a percentage of net income (AVGTAX) nor the variable for the ratio of book equity to total assets (KA) was significant. The sign of the bond market volatility parameter estimate was in the predicted direction in both periods, although bond market conditions appear to be significant only for the longer sample. Despite the reduction in the number of top fifty bank holding companies issuing SND during the 1991 recession (see figure 2), after controlling for differences in the bank holding company (BHC) risks and other BHC-specific factors, there does not appear to be a statistically significant relationship between macroeconomic conditions (NBER) and the issuance decision.

  1. The exception is that the first sample period is only eighteen months.

  2. The Wald test of the restriction that all accounting measures of risk coefficients are zero was not significant at the 5 percent confidence level.

  3. Flannery and Sorescu used a different sample of banks.

  4. The Wald tests reject the restrictions that all five coefficients of the accounting measure of risk are zero at the 5 percent confi- dence level. Moreover, the sums of all the marginal effects were positive for each of the three periods.

  5. For data having a Gausian distribution, approximately 99.3 percent of the data fall inside the brackets. Horizontal dashes represent ''unusually deviant data points'' that are further than 1.5 times the interquartile distance from the center of the box.

  6. This interpretation is not inconsistent with market discipline studies that have found evidence of spread sensitivity to risk in the mid-1990s (for example, Jagtiani, Kaufman, and Lemieux, 1999). The interpretation requires only that spreads be relatively insensitive to a banking organization's risk, which does not rule out the possibility that the spreads are statistically sensitive to an organization's risk.

  7. An alternative explanation for the positive coefficients on risk variables is that relatively risky banks during 1988-91 were unable to issue SND and, therefore, issued in 1992-97 to ease the banks' pent-up desire to issue debt.

2.  Top bank holding company SND spreads over Treasury securities with comparable maturities, 1991:Q1-1997:Q4

2. Does the Banking Organization's Risk, Size, and Frequency of SND Issuance Affect Its Probability of Issuance?

Explanatory variables

Dependent variable: the decision to issue

Sample
86:Q2-87:Q4

Expected
sign?

Sample
88:Q1-89:Q4

Expected
sign?

Sample
90:Q1-91:Q4

Expected
sign?

Accounting risk measures
The ratio of non-accruing loans to total assets (NATA)

.023
(0.00)

 

10.238
(.86)

 

-15.512
(-1.42)

X

The ratio of accruing loans past due 90 days or more to total assets (PDTA)

45.372
(.86)

 

-171.250
(-2.35)

X

-135.636
(-2.11)

X

The ratio of other real estate owned to total assets (OREO)

-37.503
(-.82)

X

-38.501
(-1.08)

X

42.509
(1.75)

 

The absolute value of the difference between assets and liabilities maEagleTraders.comg or repricing within one year as a proportion of equity value (AGAP)

-.026
(-.86)

X

.014
(2.00)

 

.008
(1.36)

 

The ratio of total book liabilities to the sum of the market value of common stock and the book value of preferred stock (MKTLEV)

.024
(.75)

 

.020
(.62)

 

-.073
(-2.08)

X

Other bank-specific factors
The natural log of total assets (ln[ASSET])

.712
(3.57)

X

.093
(.48)

X

1.102
(5.91)

X

An indicator variable that equals one if the banking organization issued SND in the preceding six-month period, and zero otherwise (ISSUEi - 1)

.046
(.19)

X

.334
(1.31)

X

.717
(3.21)

X

Goodness-of-fit measures
Fraction of correct predictions
Percent that issued SND

.866
16.66

 

.886
11.37

 

.840
18.09

 

NOTE. All specifications include a constant term that was significant at the 5 percent level. Year indicator variables, which were equal to one in the first year of each panel and zero otherwise, were also included, though those coefficient estimates are not reported here. Numbers in parentheses are t-statistics.

2.  Continued

Explanatory variables

Dependent variable: the decision to issue

Sample
92:Q1-93:Q4

Expected
sign?

Sample
94:Q1-95:Q4

Expected
sign?

Sample
96:Q1-97:Q4

Expected
sign?

Accounting risk measures
The ratio of non-accruing loans to total assets (NATA)

13.516
(.96)

 

-33.397
(-.98)

X

-.029
(-.00)

X

The ratio of accruing loans past due 90 days or more to total assets (PDTA)

114.618
(1.89)

 

113.623
(1.05)

 

44.794
(1.45)

 

The ratio of other real estate owned to total assets (OREO)

-67.462
(-2.37)

X

8.472
(.14)

 

300.890
(2.81)

 

The absolute value of the difference between assets and liabilities maEagleTraders.comg or repricing within one year as a proportion of equity value (AGAP)

-.014
(-.45)

X

-.035
(-.79)

X

-.102
(-1.12)

X

The ratio of total book liabilities to the sum of the market value of common stock and the book value of preferred stock (MKTLEV)

.093
(2.20)

 

.090
(1.77)

 

.093
(1.97)

 

Other bank-specific factors
The natural log of total assets (ln[ASSET])

.609
(4.90)

X

.641
(4.89)

X

.565
(5.13)

X

An indicator variable that equals one if the banking organization issued SND in the preceding six-month period, and zero otherwise (ISSUEi - 1)

.733
(4.06)

X

.567
(2.88)

X

.428
(2.34)

X

Goodness-of-fit measures
Fraction of correct predictions
Percent that issued SND

.819
31.47

 

.837
24.78

 

.795
28.81

 

3. How Do Bank-Specific Factors, Bond Market Risk, and Macroeconomic Conditions Affect the Probability of Issuance?

Explanatory variables

Dependent variable: the decision to issue

Sample
89:Q1-92:Q4

Expected
sign?

Sample
86:Q2-97:Q4

Expected
sign?

Accounting risk measures
  The ratio of non-accruing loans to total assets (NATA)

-10.078
(-1.45)

X

-6.896
(-1.39)

X

The ratio of accruing loans past due 90 days or more to total assets (PDTA)

-41.949
(-1.01)

X

7.137
(.35)

 

The ratio of other real estate owned to total assets (OREO)

7.322
(.47)

 

-4.698
(-.40)

X

The absolute value of the difference between assets and liabilities maEagleTraders.comg or repricing within one year as a proportion of equity value (AGAP)

.001
(.41)

 

-.001
(-.39)

X

The ratio of total book liabilities to the sum of the market value of common stock and the book value of preferred stock (MKTLEV)

.010
(.36)

 

.024
(1.56)

 

Other bank-specific factors
 
The natural log of total assets (ln[ASSET])

.625
(6.03)

X

.637
(11.79)

X

An indicator variable that equals one if the banking organization issued SND in the preceding six-month period, and zero otherwise (ISSUEi - 1)

.724
(5.20)

X

.641
(7.90)

X

Foreign and domestic income taxes as a percentage of net income (AVGTAX)

-.0001
(-.15)

 

-.182
(-.42)

X

The ratio of book equity to book total assets (KA)

4.424
(.50)

 

5.857
(1.37)

 

Bond market risk
The implied stock volatility measure calculated from option prices traded on the Chicago Board Option Exchange (MKTVOL)

-.032
(-1.03)

X

-.049
(-4.22)

X

Macroeconomic conditions
National Bureau of Economic Research recession indicator that equals one during a recession and zero otherwise (NBER)

.227
(1.07)

 

.247
(1.26)

 

Goodness-of-fit measures
Fraction of correct predictions
Percent that issued SND


.82
21.17

 


.83
21.89

 

NOTE. All specifications include a constant term that was significant at the 5 percent level. Year indicator variables, which were equal to one in each specific year of each panel and zero otherwise, were also included for all years except the first year, though those coefficient estimates are not reported here. Numbers in parentheses are t-statistics.

Implications for direct and indirect market discipline