Does the market discipline banks? New evidence from bank capital

mix

October 27, 2006Adam B. AshcraftFederal Reserve Bank of NY

market discipline?

bank debt spreads react to public information about risk, suggesting that spreads could be used by supervisors to help regulate banks

but using spreads in this fashion might make spreads less informative

the specialness of banks as lenders creates the scope for banks to manage public information

investors respond to the opaqueness of banks as borrowers with financial constraints

direct market discipline?

the influence of the market on target bank capital ratios

the influence of the market on a bank’s recovery from financial distress

why should it matter?

the leverage created by a substitution from equity to debt worsens the incentives of a distressed institution to exploit the deposit insurance subsidy

empirical evidence from the 1980s documents that debt covenants respond to bank condition, but capital rules severely limit covenants

franchise value may depend on credit rating

the key insight

bank regulators and investors have different views of capital

regulatory capital is the sum of equity and subordinated debt, but investors view capital as equity

controlling for the level of regulatory capital, the mix of debt in regulatory capital plausibly isolates the pressure by investors on the bank

overview of results

before reforms of deposit insurance that prevent the fdic from bailing out subordinated debt investors (fdicia), an increase in the mix of debt in capital worsens the future outcomes of distressed institutions

since fdicia, an increase in the mix of debt in capital has a positive impact on the future outcomes of distressed institutions

outline

1. empirical strategy2. ols3. iv4. conclusions

the empirical strategy

focus on financially-distressed institutions control for the amount of regulatory capital

(capital requirements) document the future outcomes of these

institutions across the amount of subordinated debt in regulatory capital

question: does the presence of subordinated debt help or hurt the chances of a distressed institution to recover?

bank data

commercial bank call reports 1984:1 to 2004:4 bank holding company Y-9C reports 1986:1 to

2004:4 regulatory capital measured as sum of

equity and subordinated debt capital mix measured as ratio of

subordinated debt to regulatory capital financial distress measured using the ratio of

problem loans to regulatory capital

summary statistics

about 5% of bank-quarters and 18% of bhc-quarters have debt in the capital structure

in these quarters, the mean mix is 11% for banks and 18% for bhcs

83% of banks with debt in capital are part of a bank holding company

institutions with debt in capital are larger, have lower capital ratios, higher loan-to-asset ratios, and are more likely to be distressed

subordinated debt

year

Banks BHCs

1976 1980 1984 1988 1992 1996 2000 2004

500

1000

1500

2000

2500

financial distress

year

CAMEL 3/4/5 Problem/Capital, 85th pctile

1986 1990 1994 1998 2002

0

.1

.2

.3

.4

analysis

Pr(distress)i,t+1 = β0+β1*CAPITALi,t+β2*MIXi,t

+β3*Xbaselinei,t+β4*Xextended+εi,t

Xbaseline = ln(assets), BHC, MBHC, time effectsXextended = loan and asset portfolio controls, large

deposits, loan loss provisions, ROA

capital mix and distress

(1) (2) (3) (4) (5) (6) (7) (8)

1. Capital/Assets -2.0658*** -1.7783*** -0.6980*** -0.4820*** -1.1674*** -1.1126** -0.6618*** -0.3574***

(0.1645) (0.1699) (0.0317) (0.0221) (0.4472) (0.4579) (0.1196) (0.1080)

2. Capital Mix 0.2078*** 0.1590** 0.1361*** 0.0629*** 0.0786 0.0298 0.0895*** 0.0255

(0.0671) (0.0717) (0.0209) (0.0163) (0.0995) (0.1209) (0.0300) (0.0243)

3. BHC -0.0193** -0.0133* -0.0045*** -0.0018

(0.0076) (0.0080) (0.0015) (0.0012)

4. MBHC -0.0442*** -0.0488*** -0.0017 -0.0046***

(0.0078) (0.0079) (0.0013) (0.0010)

5. Log(assets) 0.0230*** 0.0197*** -0.0070*** -0.0076*** 0.0307*** 0.0146** -0.0078*** -0.0063***

(0.0026) (0.0031) (0.0005) (0.0005) (0.0053) (0.0069) (0.0013) (0.0013)

6. Observations 31,247 31,223 173,476 172,996 4,013 4,011 21,290 21,286

7. Specification Baseline Extended Baseline Extended Baseline Extended Baseline Extended

Table 2: Regulatory Capital Mix and Future Financial DistressBanks BHCs

Distressed Healthy Distressed Healthy

does it matter who holds the debt?

(1) (2) (3) (4) (5) (6) (7) (8)

1. Capital/Assets -1.4684*** -1.3436*** -0.5310*** -0.4362*** -2.5054*** -2.1860*** -0.5415*** -0.4714***

(0.2351) (0.2252) (0.0464) (0.0367) (0.2162) (0.2273) (0.0449) (0.0246)

2. Capital Mix 0.1619 0.1409 0.1708*** 0.0747** 0.2051** 0.1537 0.1031*** 0.0459***

(0.1104) (0.1132) (0.0458) (0.0349) (0.0818) (0.0892) (0.0172) (0.0157)

3. Log(assets) 0.0093 0.0074* -0.0085*** -0.0100*** 0.02155*** 0.01775***-0.00595***-0.00685***

(0.0059) (0.0071) (0.0013) (0.0013) (0.0028) (0.0036) (0.0005) (0.0005)

4. Observations 9,702 9,652 48,902 47,768 21,657 21,631 127,836 126,222

5. Specification Baseline Extended Baseline Extended Baseline Extended Baseline Extended

Table 3: Regulatory Capital Mix and BHC AffiliationStand-alone banks BHC-affiliated banks

Distressed Healthy Distressed Healthy

capital mix and fdicia

(1) (2) (3) (4) (5) (6) (7) (8)

1. Capital/Assets -2.2657*** -1.9574*** -0.9106*** -0.8339*** -1.2353*** -1.2149*** -0.3367*** -0.2980***

(0.1937) (0.1855) (0.0814) (0.0619) (0.2810) (0.2781) (0.0287) (0.0212)

2. Capital Mix 0.2369*** 0.2364** 0.2378*** 0.1189** -0.1239 -0.3533** 0.0791*** 0.0313**

(0.0742) (0.0792) (0.0438) (0.0397) (0.1518) (0.1622) (0.0160) (0.0144)

3. BHC -0.0029 -0.004 0.0031 0.0039* -0.0620*** -0.0425*** -0.0076*** -0.0059***

(0.0083) (0.0087) (0.0031) (0.0027) (0.0144) (0.0154) (0.0013) (0.0012)

4. MBHC -0.0348*** -0.0384*** 0.0054* -0.0061*** -0.0821*** -0.0799*** -0.0045*** -0.0048***

(0.0085) (0.0086) (0.0031) (0.0027) (0.0162) (0.0163) (0.0011) (0.0009)

5. Log(assets) 0.0232*** 0.0195 -0.0060*** -0.0115*** 0.0221*** 0.0203*** -0.0066*** -0.0060***

(0.0029) (0.0034) (0.0012) (0.0012) (0.0049) (0.0058) (0.0005) (0.0005)

6. Observations 22,732 22,667 68,049 67,114 8,627 8,616 108,689 106,876

7. Specification Baseline Extended Baseline Extended Baseline Extended Baseline Extended

Table 4: Regulatory Capital Mix and FDICABefore FDICA After FDCIA

Distressed Healthy Distressed Healthy

interactions between bhc-affiliation and fdicia

fdicia plausibly had a differential impact on capital mix for banks across bhc-affiliation

conclusion: before fdicia, the capital mix had a much more severe impact on future outcomes for stand-alones, but since fdicia, the capital mix has a much stronger positive impact on future outcomes for stand-alones

potential problems

the capital mix increases as banks charge-off problem loans, so the mix might be a proxy for past asset quality problems

investors might permit banks with a better ability to recover from distress to take more leverage, implying that capital mix is a just proxy for financial strength

hypotheses about corporate income taxes and capital mix

banks with operations in states with higher corporate income tax rates will have a tax incentive to put more debt in regulatory capital

when banking subsidiaries operate in states with higher corporate income tax rates, the parent will have less cash flow to service debt, which limits leverage at the holding company level

state corporate income tax rates

measured as effective tax rate on $1 million in profits

high tax states: CT (11.21%), IA (11.18%), PA (9.98%), DC (9.96%), ND (9.74%), AZ (9.67%)

no tax states: NV, SD, TX, WA, WY (0.00%)

corporate income taxes and capital mix

an increase in the effective tax rate by 1 percentage point increases the capital mix of banks by 0.41 percentage points.

an increase in the effective tax rate by 1 percentage point reduces the capital mix of bhcs by 0.36 percentage points.

iv estimates

(1) (2) (3) (4) (5) (6) (7) (8)

1. Capital/Assets -2.0517*** -1.8135*** -0.5350*** -0.4624*** -2.2874*** -2.0875*** -0.4889*** -0.2272*

(0.1707) (0.1688) (0.0331) (0.0242) (0.6546) (0.6454) (0.1475) (0.1315)

2. Capital Mix -0.3665** -0.7762*** -0.2657*** -0.2335*** -1.6584*** -1.8833** 0.2582** 0.2520**

(0.1722) (0.2539) (0.0306) (0.0372) (0.5954) (0.8149) (0.1084) (0.1331)

3. BHC -0.0301*** -0.0337*** -0.0107*** -0.0080*** -0.0620*** -0.0425*** -0.0076*** -0.0059***

(0.0087) (0.0102) (0.0017) (0.0016) (0.0144) (0.0154) (0.0013) (0.0012)

4. MBHC -0.0279*** -0.0261** 0.0120*** 0.0023 -0.0821*** -0.0799*** -0.0045*** -0.0048***

(0.0106) (0.0107) (0.0021) (0.0016) (0.0162) (0.0163) (0.0011) (0.0009)

5. Log(assets) 0.0574*** 0.0819*** 0.0177*** 0.0111*** 0.1428*** 0.1287*** -0.0241*** -0.0213***

(0.0153) (0.0200) (0.0027) (0.0029) (0.0405) (0.0501) (0.0074) (0.0082)

6. Observations 31,359 31,283 176,738 173,990 4,013 4,011 21,290 21,286

7. Specification Baseline Extended Baseline Extended Baseline Extended Baseline Extended

Table 8: IV Estimates on the Link Between the Mix and Future DistressBanks BHCs

Distressed Healthy Distressed Healthy

conclusions

since fdicia, the mix of debt in regulatory capital has a large positive impact on future outcomes of distressed institutions

the effects are strongest for debt issued by bank holding companies

the market may have a useful direct role to play in the regulation of banks