Market discipline of banks: Why are yield spreads on bank-issued subordinated notes and debentures not sensitive to bank risks? Bhanu Balasubramnian a, * , Ken B. Cyree b a Emporia State University, 1200 Commercial Street, Emporia, KS 66801, USA b The University of Mississippi, School of Business Administration, University, MS 38667, USA article info Article history: Received 8 September 2009 Accepted 11 July 2010 Available online 15 July 2010 JEL classification: G01 G12 G20 G21 G28 Keywords: Subordinated debt Trust-preferred securities Yield spread Too-big-to-fail Default risk abstract The default risk sensitivity of yield spreads on bank-issued subordinated notes and debentures (SNDs) decreased after banks started issuing trust-preferred securities (TPS). The too-big-to-fail (TBTF) discount on yield spreads is absent prior to the LTCM bailout, but the size discount doubles after the LTCM bailout. Prior to TPS issuance and the LTCM bailout, SND yield spreads are sensitive to conventional firm-specific default risk measures, but not after the bailout. We find paradigm shift in determinants of yield spreads after the LTCM bailout. Yield spreads on TPS are sensitive to default risks and can provide an additional source of market discipline. Ó 2010 Elsevier B.V. All rights reserved. 1. Introduction Our purpose in this study is to find reasons for the lack of de- fault risk sensitivity in yield spreads on bank-issued subordinated notes and debentures (SNDs) documented in earlier studies. We also identify new determinants of yield spreads that are sensitive to default risks. We define yield spreads as the difference between the yield to maturity of risky debt and the yield to maturity of a risk-free debt of similar characteristics. Krishnan et al. (2005) point out that both yield spread levels and changes should reflect risk along the entire yield spread curve. When bank risks increase, we expect yield spreads on SNDs to increase and provide market discipline because SNDs are uninsured junior claims and are trea- ted as Tier 2 capital for banks. Flannery and Sorescu (1996) and several later studies find that SND spreads are sensitive to bank risks, particularly after the enactment of the Federal Deposit Insurance Corporation Improve- ment Act (FDICIA) in 1991 because implicit guarantees, such as too-big-to-fail policy, were removed after FDICIA. Similarly, Imai (2007) shows that sensitivity of yield spreads increased after the removal of implicit guarantees in Japan. Studies prior to FDICIA find that yield spreads are not sensitive to bank risks (Avery et al., 1988; Gorton and Santomero, 1990). A study by the Federal Reserve Board (FRB) concludes that SND spreads are less risk sensitive during the 1993–1997 period and that market discipline is weak (The Board of Governors, 1999). Krishnan et al. (2005) conclude that yield spreads do not provide useful signals for market discipline of banks because changes in yield spreads do not reflect changes in default risk during the 1994–1999 period, although yield spread levels do reflect firm- specific risks. Collin-Dufresne et al. (2001), Krishnan et al. (2005) find that tra- ditional default risk variables do not adequately explain yield spread changes on bonds also issued by non-financial firms. Driessen (2005) finds that the premium attributable to firm- specific default risk in a non-default situation is rather small even in yield spread levels. Hence, the bond market signals for banks through yield spreads on bank-issued SNDs in non-default situa- tions is likely to be small for yield spread levels, and even smaller for yield spread changes due to changes in default risks. 0378-4266/$ - see front matter Ó 2010 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2010.07.015 * Corresponding author. Tel.: +1 620 341 6376; fax: +1 620 341 6345. E-mail addresses: bbalasub@emporia.edu (B. Balasubramnian), kcyree@bus. olemiss.edu (K.B. Cyree). Journal of Banking & Finance 35 (2011) 21–35 Contents lists available at ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf