When risk premiums decrease as the bank's risk increases—a caveat on the use of subordinated bonds as an instrument of banking supervision

Abstract

Many new proposals advocate the use of subordinated bonds in banking supervision. These proposals explicitly or implicitly assume that the prices and yields (i.e., risk premiums) of subordinated bonds are unbiased signals on the bank's risk exposure. We show that in general this assumption does not hold. In actuality, the risk premiums may decrease even as the bank's risk increases. This may also hold when the bank is solvent, that is, when total assets exceed total liabilities. This result occurs with both general density functions as well as the more positively skewed density functions that are intended to reflect the return of a bank's asset portfolio. As this distortion of market prices is more likely to occur with sufficiently large volume of subordinated debt, we advocate the implementation of an upper bound on subordinated debt—as a complement to the minimum level recommended by the literature.