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

3. 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

4. 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

5. 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

6. 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

7. outline • empirical strategy • ols • iv • conclusions

8. 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?

9. 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

10. 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

13. 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 effects Xextended = loan and asset portfolio controls, large deposits, loan loss provisions, ROA

14. capital mix and distress

15. does it matter who holds the debt?

16. capital mix and fdicia

17. 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

18. 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

19. 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

20. 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%)

21. 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.

22. iv estimates

23. 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