Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983–1991




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    • Flannery is Professor of Finance in the Graduate School of Business, University of Florida. Sorescu is a Ph.D. Candidate in Finance at the University of Florida. This research project was inspired by an insightful conversation with Brian C. Gendreau of Morgan Guaranty Bank. We thank David Ling and Michael Giliberto for help in computing option-adjusted interest rate spreads and Rick Borgman for research assistance. Helpful comments and suggestions have been provided by George Benston, Allen Berger, Matt Billett, Dave Brown, Rebel Cole, Bob Eisenbeis, Ed Ettin, Mark Flood, Alton Gilbert, Gary Gorton (the referee), Joel Houston, Jim Moser, René Stulz (the editor), Carolyn Takeda, and seminar participants at the Atlanta Finance Forum, Laval University, University of Maryland, Berkeley, Stanford, University of Wisconsin at Madison, University of Wisconsin at Milwaukee, University of Central Florida, and the Federal Reserve Bank of San Francisco. The second author gratefully acknowledges financial support from the Social Sciences and Humanities Research Council of Canada.


We examine debenture yields over the period 1983–1991 to evaluate the market's sensitivity to bank-specific risks, and conclude that investors have rationally reflected changes in the government's policy toward absorbing private losses in the event of a bank failure. Although this evidence does not establish that market discipline can effectively control banking firms, it soundly rejects the hypothesis that investors cannot rationally differentiate among the risks undertaken by the major U.S. banking firms.