An Analysis of Subordinated Debt in Banking: the Case of Costly Bankruptcy

This paper adopts a contingent-claim valuation framework to investigate the role of subordinated debt in alleviating the moral hazard problem in banking and providing the regulator with the information on the risk of bank assets. The incorporation of bankruptcy cost in the framework of the analysis provides some new evidence about the potential role of subordinated debt. The extent of market discipline of subordinated debt critically depends on its relative magnitude to senior debt and bankruptcy costs. Under specific conditions, subordinated debt prices are found to provide additional information about the value of bank assets relative to equity prices. The credibility of existing subordinated debt proposals is also discussed. The results indicate the critical role of the regulator’s judgment in interpreting and acting upon information from subordinated debt prices. JEL Classification Numbers: G12, G13, G21, G28, G33.