Qua nti ty Effects in the Marke t D iscipline Transmission Mechanism

Ad ri an Po p∗-- Preliminary & incomplete draft--Abstract: A st raightforward method to enhance market disc ipline in banking is the mandatory Sub-Debt Policy (SDP), i.e. a requirement by which some large banks are forced to regularly issue a certain minimum amount of subordinated and non-guaranteed debt. If the decision of issuing sub-debt is endogenous and/or subordinated creditors are really able to influence bank managers’ behavior, we should be able to detect empirically a positive correlation between the amount of sub-debt held in bank balance sheets and banking performance. By conducting statistical tests on a panel dataset comprising the largest European banks, we find that: (i) the sub-debt issues are made generally by the most profitable banking organizations; (ii) voluntary sub-debt issues allow banks to reduce their Tier 1 ratios, while improving their overall capitalization (Tier 1 + Tier 2 ratios); (iii) as far as the risk profile is concerned, the amount of sub-debt held in bank balance sheet is negatively correlated with the quality of credit portfolio, but positively correlated with the ratio of loan loss reserve to total (gross) loans. These results arouse several reflections about the virtues and limitations of market discipline in banking in the absence of a formal SDP