Market Discipline and the Valuation of Bank Subordinated Debt

Gary Gorton and Anthony Santomero

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: The usual approach to determine if market prices of uninsured bank liabilities reflect the risk of default is to regress the yield spread of bank debt against accounting measures of bank risk. To date these results have been mixed. Here we argue that this is because previous investigations lack a theoretical model of bank liability pricing. Without this, linear regressions have difficulty addressing the question. In this essay we use contingent claims valuation to determine whether implied volatilities embedded in bank liability prices are correlated with accounting measures of bank risk. Observed yields on subordinated bank debt over equivalent maturity treasuries are used to compute implied bank volatility. Accounting measures of bank risk turn out to predict the volatility of bank assets and suggest the existence of market discipline.

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