Market discipline of bank risk: Evidence from subordinated debt contracts

Do bank debtholders discipline excessive risk taking? I investigate this question by examining how a bank's incentives to take risks affect offering yield spreads and restrictive covenants in their debt contracts. Results suggest that bank charter values, which determine a bank's risk-taking incentives, significantly affect the likelihood of restrictive covenants in bank debt contracts. This effect was most pronounced during the 1980s, when greater competition and relatively less-stringent regulation increased the severity of moral hazard problems in the US banking industry. Overall, the results suggest that an important channel for market investors to discipline bank risk taking is through writing restrictive covenants in bank debt.