This dissertation explores market discipline in the banking industry through bank charter values and subordinated debt covenants. The first essay discusses market discipline through bank charter values. Charter value is important in the banking industry because of its ability to reduce the moral hazard incentives that result from government-provided deposit insurance. Previous research suggests that geographic deregulation in the 1970s and 1980s increased competition and eroded charter values. However, charter value increased significantly in the 1990s even as deregulation continued. But if this resurgence resulted solely from the business cycle, it could disappear with the next economic contraction. Analyzing banks between 1988 and 2005, we decompose charter value into a business cycle component and a core component driven by bank market power. We show that even after extracting the business cycle effects, core charter value has systematically increased. Risk, however, seems to depend more on total charter value than core charter value, implying that business cycles still have important influences on incentives for bank risk-taking. The second essay discusses market discipline through subordinated debt covenants. Restrictive covenants on bank debt require a bank to take or refrain from specific actions that affect the riskiness of that debt. Historically, covenants were common in the banking industry. The 1988 Basel Accord, however, disallowed banks from including subordinated debt with certain covenants in Tier 2 capital. As a result, covenants declined and disappeared after 1994. However, covenants re-emerged after 2000. This paper develops a theory to explain these cyclical trends. Covenants appear as bank risk increases and as the financial flexibility of banks decreases. Because covenants reduce bond yields, the yield signal from subordinated debt is muted at the precise time that it could most inform market participants. If covenants reduce the overall risk of the bank, then the lower yield provides investors with an accurate signal of the bank's risk. If instead covenants shift risk from bondholders to stockholders, the reduced yield dampens the market discipline signal. The empirical evidence suggests that even after controlling for overall firm risk, covenants shift risk from bondholders to stockholders. I also argue that during times of banking industry distress, the yield spread between bonds with covenants and bonds without covenants widens because the reduction in risk becomes more valuable to the investor as the bank's probability of failure rises.
Number Of Pages: 96
Published: 11th September 2011
Dimensions (cm): 24.6 x 18.9 x 0.5
Weight (kg): 0.186