1

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 BankConference on: Bank Regulation and Corporate Finance

Washington, 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

Sub-debt (leverage)

Increased credit risk

(moral hazard)

1

2

Decreased credit risk(discipline)

Bank supervision

( - )

7

Ashcraft Methodology1. To isolate impact of sub-debt mix on risk-taking, Ashcraft

controls for regulatory capital ratio.

2. 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

1

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)

Marginal effect from Probit estimation

Distressed BHCs -1.8833***

Distressed Banks -0.7762***

Healthy Banks -0.2335**

Healthy BHCs +0.2520**

• 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 York

Journal of Financial Intermediation-World BankConference on: Bank Regulation and Corporate Finance

Washington, DC — October 27, 2006

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