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These are the opinions of the discussant, and do not necessarily reflect the views of the FDIC.

Bob DeYoung’s comments on : “Does the Market Discipline Banks? New Evidence from Regulatory Capital Mix” Adam Ashcraft, Federal Reserve Bank of New York Journal of Financial Intermediation-World Bank Conference on: Bank Regulation and Corporate Finance Washington, DC — October 27, 2006.

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These are the opinions of the discussant, and do not necessarily reflect the views of the FDIC.

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  1. Bob DeYoung’s comments on:“Does the Market Discipline Banks?New Evidence from Regulatory Capital Mix”Adam Ashcraft, Federal Reserve Bank of New YorkJournal of Financial Intermediation-World BankConference on: Bank Regulation and Corporate FinanceWashington, DC — October 27, 2006 These are the opinions of the discussant, and do not necessarily reflect the views of the FDIC.

  2. Summary of paper • Question: How does sub-debt impact bank risk-taking? • Enhance market discipline…reduce moral hazard? • Increase leverage…encourage moral hazard? • Empirical tests: • Tests whether sub-debt enhances recovery from distress. • Data from banks and BHCs in U.S., 1984-2004. • Main results: • Banks with more sub-debt recovered faster. • (Distressed) BHCs with more sub-debt recovered faster. • These are basically post-FDICIA results. • Answer: Ashcraft finds statistical associations, but neither finds nor discusses the channels of causation.

  3. The literature • Flannery and Sorescu (1996) • Sub-debt became sensitive to risk, post-FDICIA. • Several other studies support this finding. • Presumption: Market is disciplining banks. • Bliss and Flannery (1999) • Higher yields not enough. Behavior must change. • Ashcraft (2006) • Ex post credit risk (nonperf. loans) at distressed banks/BHCs declines with higher sub-debt. • But we still have a “black box.” How have bank behaviors changed? What are the channels?

  4. The sub-debt landscape in 2003 • $5 billion sub-debt issued by “stand-alone” banks. • Discipline/monitoring comes from the market. • $101 billion sub-debt issued by banks in BHCs. • Typically sold to the BHC. • Discipline/monitoring must come from the parent. • Parent can finance this any way it wants. • $246 billion sub-debt issued by BHCs. • Discipline/monitoring comes from the market.

  5. The sub-debt landscape in 2003 • 2,185 BHCs in 2003: • In 2,102 of the BHCs, bank affiliates issued no sub-debt. • In 47 of the BHCs, bank affiliate sub-debt < 50% of parent sub-debt. • In 36 of the BHCs, bank affiliate sub-debt > 50% of parent sub-debt. • Note: Affiliate sub-debt = parent sub-debt in 23 BHCs.

  6. Ashcraft Methodology 2 Increased credit risk (moral hazard) ( - ) Sub-debt (leverage) Decreased credit risk (discipline) 1 Bank supervision

  7. Ashcraft Methodology 1 • To isolate impact of sub-debt mix on risk-taking, Ashcraft controls for regulatory capital ratio. • To absorb endogeneity of sub-debt mix, Ashcraft uses state tax rates as an instrument. Instrument equation: sub-debt mixt = gt (state tax rates) + u Test equation (probit): Prob(distresst+1) = ft(sub-debt mix, regulatory capital) + e • distress = NPLs/total capital • time dummies, various control variables • clustering at bank level 2

  8. Results • Instrument regression: • BHCs: Sub-debt mix varies negatively with tax rates. • Banks: Sub-debt mix varies positively with tax rates. • Sub-debt is more associated with improved loan quality in the post-FDICIA data. • Bank sub-debt associated with improved loan quality for both distressed and healthy banks. • BHC sub-debt associated with improved (consolidated) loan quality for distressed BHCs. • …but for healthy BHCs, relationship reverses.

  9. Results (Table 8, IV model, full sample) • What about pre- and post-FDICIA? • What about stand-alone banks?

  10. Miscellaneous Comments • Corroborate BHC and stand-alone Bank findings with yield changes? • Through what channels does bank sub-debt allow parent BHCs to discipline/monitor its banks? • Imposes fixed payment discipline (e.g., Jenson). • Imposes covenants that bind bank activities. • Uses covenants do establish explicit benchmarks. • A story please: Why does distress increase with sub-debt at healthy BHCs? • Do results vary for BHCs that (a) merely pass-through their banks’ sub-debt, versus (b) issue additional sub-debt at the parent level?

  11. Bob DeYoung’s comments on:“Does the Market Discipline Banks?New Evidence from Regulatory Capital Mix”Adam Ashcraft, Federal Reserve Bank of New YorkJournal of Financial Intermediation-World BankConference on: Bank Regulation and Corporate FinanceWashington, DC — October 27, 2006 These are the opinions of the discussant, and do not necessarily reflect the views of the FDIC.

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