Market discipline of subordinated debt in banking: The case of costly bankruptcy

This paper extends the contingent-claim valuation framework of subordinated debt by explicitly incorporating bankruptcy cost in the model. The model is then used to investigate the role of subordinated debt in alleviating the moral hazard problem in banking. The incorporation of bankruptcy cost in the framework of the analysis provides new evidence about subordinated debt. The reaction of subordinated debt prices can completely remove risk-shifting incentives of equityholders only when bankruptcy costs are accounted for. The extent of subordinated debt's discipline is shown to depend critically on the relative magnitude of subordinated debt, senior debt and bankruptcy costs.