Using Subordinated Debt to Monitor Bank Holding Companies: Is It Feasible?

Academics, policymakers and bank supervisors have expressed considerable interest in using subordinated debt and other market data in the surveillance of banking organizations, especially large and complex financial institutions. However, little research has been devoted to developing practical means of implementing such an approach for subordinated debt. This paper attempts to fill a portion of this gap. A major problem with using subordinated debt spreads is that accurate prices of individual subordinated debt issues are difficult to come by. The bond market is largely an over-the-counter market where dealer prices are proprietary. The approach used here is to evaluate a number of data sources, including price series from vendors and broker-dealers. Our results indicate that subordinated debt spreads are most consistent across sources for the most liquid bond issues. We also find that the most liquid bonds are those that have a relatively large issuance size, have a relatively young age, have been issued by a relatively large banking organization, and are traded in a relatively robust overall bond market. Moreover, although there are substantial differences in spread levels for individual bonds across data sources, there is a high degree of concordance in rankings of banking organizations by their minimum spreads across issues. There is especially strong agreement about which large banking organizations are in the tails of the spread distribution at a given point in time. However, time series results indicate that movements of subordinated debt spreads at individual institutions are sensitive to the data source for bond prices, thus complicating interpretation of such movements. On balance, our results support and provide guidance for the use of subordinated debt spreads in supervisory monitoring. However, they also support the need for careful judgment when interpreting such spreads, highlight difficulties with currently available data sources, and motivate the need for further research. April 27, 2001 (4:36pm) The views expressed are those of the authors and do not necessarily reflect those of the Board of Governors or its staff. The authors thank Mark Flannery, Erik Heitfield, Arthur Kennickell and Anthony Saunders for their comments and suggestions. In addition, the authors thank Matthew Cox and Kara Meythaler for their outstanding research assistance. All errors remain those of the authors. See Flannery (1998) for a discussion of the academic literature relevant to using market information in prudential bank supervision. Meyer (1999), in particular, has stressed the importance of differentiation in regulatory standards and supervisory practice between the largest, most complex and internationally active banks and all others. For example, Covitz, Hancock and Kwast (2000) present evidence that subordinated bonds with atypically long or short maturities appear to have significantly higher issuance spreads on average than do subordinated bonds with maturities in the 10 to 20 year range. Covitz, Hancock and Kwast (2000) report that coupon frequency significantly affects issuance spreads for subordinated bonds issued by banking organizations. See Sarig and Warga (1989). 1