1 Bob DeYoung’s comments on: “Does the Market Discipline Banks? New Evidence from Regulatory Capital Mix” Adam Ashcraft, Federal Reserve Bank of New York Journal of Financial Intermediation-World Bank Conference on: Bank Regulation and Corporate Finance Washington, DC — October 27, 2006 These are the opinions of the discussant, and do not necessarily reflect the views of the FDIC.

2 Summary of paper Question: How does sub-debt impact bank risk-taking? –Enhance market discipline…reduce moral hazard? –Increase leverage…encourage moral hazard? Empirical tests: –Tests whether sub-debt enhances recovery from distress. –Data from banks and BHCs in U.S., Main results: –Banks with more sub-debt recovered faster. –(Distressed) BHCs with more sub-debt recovered faster. –These are basically post-FDICIA results. Answer: Ashcraft finds statistical associations, but neither finds nor discusses the channels of causation.

3 The literature Flannery and Sorescu (1996) –Sub-debt became sensitive to risk, post-FDICIA. –Several other studies support this finding. –Presumption: Market is disciplining banks. Bliss and Flannery (1999) –Higher yields not enough. Behavior must change. Ashcraft (2006) –Ex post credit risk (nonperf. loans) at distressed banks/BHCs declines with higher sub-debt. –But we still have a “black box.” How have bank behaviors changed? What are the channels?

4 The sub-debt landscape in 2003 $5 billion sub-debt issued by “stand-alone” banks. –Discipline/monitoring comes from the market. $101 billion sub-debt issued by banks in BHCs. –Typically sold to the BHC. –Discipline/monitoring must come from the parent. –Parent can finance this any way it wants. $246 billion sub-debt issued by BHCs. –Discipline/monitoring comes from the market.

5 The sub-debt landscape in ,185 BHCs in 2003:  In 2,102 of the BHCs, bank affiliates issued no sub-debt.  In 47 of the BHCs, bank affiliate sub-debt < 50% of parent sub-debt.  In 36 of the BHCs, bank affiliate sub-debt > 50% of parent sub-debt. Note: Affiliate sub-debt = parent sub-debt in 23 BHCs.

6 Ashcraft Methodology Sub-debt (leverage) Increased credit risk (moral hazard) 1 2 Decreased credit risk (discipline) Bank supervision ( - )

7 Ashcraft Methodology 1.To isolate impact of sub-debt mix on risk-taking, Ashcraft controls for regulatory capital ratio. 2.To absorb endogeneity of sub-debt mix, Ashcraft uses state tax rates as an instrument. Instrument equation: sub-debt mix t = g t (state tax rates) + u Test equation (probit): Prob(distress t+1 ) = f t (sub-debt mix, regulatory capital) + e –distress = NPLs/total capital –time dummies, various control variables –clustering at bank level 1 2

8 Results Instrument regression: –BHCs: Sub-debt mix varies negatively with tax rates. –Banks: Sub-debt mix varies positively with tax rates. Sub-debt is more associated with improved loan quality in the post-FDICIA data. Bank sub-debt associated with improved loan quality for both distressed and healthy banks. BHC sub-debt associated with improved (consolidated) loan quality for distressed BHCs. –…but for healthy BHCs, relationship reverses.

9 Results (Table 8, IV model, full sample) Marginal effect from Probit estimation Distressed BHCs *** Distressed Banks *** Healthy Banks ** Healthy BHCs ** What about pre- and post-FDICIA? What about stand-alone banks?

10 Miscellaneous Comments Corroborate BHC and stand-alone Bank findings with yield changes? Through what channels does bank sub-debt allow parent BHCs to discipline/monitor its banks? –Imposes fixed payment discipline (e.g., Jenson). –Imposes covenants that bind bank activities. –Uses covenants do establish explicit benchmarks. A story please: Why does distress increase with sub- debt at healthy BHCs? Do results vary for BHCs that (a) merely pass-through their banks’ sub-debt, versus (b) issue additional sub- debt at the parent level?

11 Bob DeYoung’s comments on: “Does the Market Discipline Banks? New Evidence from Regulatory Capital Mix” Adam Ashcraft, Federal Reserve Bank of New York Journal of Financial Intermediation-World Bank Conference on: Bank Regulation and Corporate Finance Washington, DC — October 27, 2006 These are the opinions of the discussant, and do not necessarily reflect the views of the FDIC.