Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983- 1991

Previous studies of bank subordinated debenture yields have detected scant evidence that market investors rationally price bank-specific default risks. However, investors' incentives to monitor their banks' true default risks have increased over the past decade, as federal regulators have removed the conjectural guarantees on subordinated debentures that were so prominent in the period following Continental Illinois' failure. By examining debenture yields over the period 1983-91, we demonstrate that subordinated debenture prices reflect accounting risk measures, and that the market's sensitivity to bank-specific risks has rationally reflected changes in the government's policy toward absorbing private losses in the event of a bank failure. Although this evidence does not establish that market discipline can effectively control banking firms, it soundly rejects the hypothesis that investors cannot rationally differentiate among the risks undertaken by the major U.S. banking firms.