Subordinated Debt, Market Discipline, and Bank Risk


  • We are grateful to an anonymous referee for the invaluable suggestions. We also thank Jyh-Bang Jou, Tan Lee, and participants in the 27th Australasian Economic Theory Workshop for helpful comments. Chen thanks the National Science Council of Taiwan for the financial support.


This paper demonstrates that subordinated debt (subdebt thereafter) regulation can be an effective mechanism for disciplining banks. By reducing the chance that managers of distressed banks can take value-destroying actions to benefit themselves, subdebt regulation may encourage banks to lower asset risk. Moreover, subdebt regulation and bank capital requirements can be complements for alleviating the banks’ moral hazard problems. To make subdebt regulation effective, regulators may need impose ceilings on the interest rates of subdebt, prohibit collusion between banks and subdebt investors, and require subdebt to convert into the issuing bank's equity when the government provides assistance to the bank.