Several recent studies have recommended greater reliance on subordinated debt as a tool
to discipline bank risk taking. Some of these proposals recommend using subordinated
debt yield spreads as additional triggers for supervisory discipline under prompt
corrective action (PCA); action that is currently prompted by capital adequacy measures.
This paper provides a theoretical model describing how use of a second market-measure
of bank risk, in addition to the supervisors own internalized information, could improve
bank discipline. We then empirically evaluate the implications of the model. The
evidence suggests that subordinated debt spreads dominate the current capital measures
used to trigger PCA and consideration should be given to using spreads to complement
supervisory discipline. The evidence also suggests that spreads over corporate bonds
may be preferred to using spreads over U.S. Treasuries.