Does the market discipline banks New evidence from bank capital mix

1
Does the market discipline banks? New evidence
from bank capital mix

• October 27, 2006
• Adam B. Ashcraft
• Federal Reserve Bank of NY

2
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

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direct market discipline?

• the influence of the market on target bank
  capital ratios
• the influence of the market on a banks recovery
  from financial distress

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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

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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

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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

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outline

• empirical strategy
• ols
• iv
• conclusions

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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?

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bank data

• commercial bank call reports 19841 to 20044
• bank holding company Y-9C reports 19861 to
  20044
• 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

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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

11
subordinated debt
12
financial distress
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analysis

• Pr(distress)i,t1 ß0ß1CAPITALi,tß2MIXi,t
• ß3Xbaselinei,tß4Xextendedei,t
• Xbaseline ln(assets), BHC, MBHC, time effects
• Xextended loan and asset portfolio controls,
  large deposits, loan loss provisions, ROA

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capital mix and distress
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does it matter who holds the debt?
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capital mix and fdicia
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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

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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

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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

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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)

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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.

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iv estimates
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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