Did covenants distort risk signals from bank subordinated debt yields before the financial crisis?

Kevin K. Lee and Scott A. Miller

The North American Journal of Economics and Finance, 2020, vol. 51, issue C

Abstract: Restrictive covenants on bank debt require a bank to take or refrain from specific actions that affect the riskiness of that debt. Although covenants all but disappeared in the 1990s, they re-emerged after 2004 with an increase in bank risk leading up to the financial crisis. Subordinated debt yields potentially enable better risk monitoring by supervisors, but covenants can shift risk from bondholders to stockholders without reducing overall bank risk. This can distort the risk signal used by market participants to discipline excessive risk taking. Because covenants are endogenous and increase during periods of bank stress, the yield signal is dampened the most precisely when regulators most need accurate risk monitoring.

Keywords: Bond covenants; Subordinated debt; Financial constraints; Financial distress; Business cycle (search for similar items in EconPapers)
JEL-codes: G1 G2 (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecofin:v:51:y:2020:i:c:s1062940818302882

DOI: 10.1016/j.najef.2018.10.008

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