The Priority Structure of Bank Regulatory Capital: The Case of Subordinated Debt

The aftermath of a crisis often brings reflections on the adequacy of regulatory capital against financial shocks. Accordingly, succeeding regulatory interventions focus on strengthening the resilience of the banking system by improving the quality and quantity of capital, and subordinated debt (sub-debt) remains key to these reforms. Whether, however, the regulatory motive underpins the decision of banks to issue sub-debt is unclear. Moreover, the perceptions of shareholders on the regulatory function of sub-debt are less understood. This thesis attempts to answer these questions by first reviewing other roles of sub-debt then testing if regulation drives its issuance and finally revealing shareholder incentives that weaken its regulatory function. Contrasting capital requirement motives with other explanations, and accounting for equity issuance, we find that banks issue sub-debt primarily to improve their regulatory capital buffer. While a few non-regulatory factors, related to easier entry conditions to debt market, influence the issuance decision, their economic impact is smaller than the impact of the buffer. By exploring how variations in tail risk and size influence the sub-debt and equity issuance decisions by banks with low buffers, we show that issuance choices do not reflect risk-shifting incentives. Next, we review shareholders’ perceptions of the regulatory value of sub-debt vis-a-vis the risk-shifting and wealth-expropriation incentives associated with senior debt by comparing the reaction of stocks to these security announcements. We find that senior debt incentives are more valuable than the regulatory benefit of sub-debt. Contrary to regulatory expectations, announcement of sub-debt (capital-improving) offers are valueless even when undertaken by risky or less-capitalized banks; rather, senior debt offered by these vulnerable banks generate significant shareholder value. Pursuant to these risk-shifting motives, senior debt issuers get riskier post-issuance. These findings suggest that the broader debt priority structure harbours perverse incentives that dilute the regulatory effectiveness of sub-debt.