Subordinated debt as instrument of market discipline: Risk sensitivity of sub-debt yield spreads in UK banking

• UK bank's sub-debt spreads are sensitive to bank's risk-taking.
• Credit ratings and market condition indexes co-vary with UK bank's sub-debt spreads.
• Sub-debt investors have incentives to differentiate UK banks.
• UK sub-debts satisfy a precondition for market discipline in banking.

This paper empirically examines whether yield spreads of subordinated debt issued by UK banks are sensitive to bank risks, with a dataset that includes spreads, ratings, accounting measures of bank risks and market condition indexes in the sample period between 1997 and 2009. The results show that Moody's and S&P traditional ratings have significant and negative impacts on spreads, and investors have exercised sensible discrimination between different risk profiles of UK financial institutions. However, accounting measures show an absence of the explanatory power of the spreads. Market condition indicators, particularly those related to European markets, also have significant influence on credit yield spreads. The findings indicate that, in the UK, sub-debt spreads do reflect the issuing banks’ risk-taking, hence satisfying a critical precondition for sub-debts to be an instrument of market discipline in banking.