Bank Stability and Market Discipline: Debt-for-Equity Swap versus Subordinated Notes

Several studies have recommended reliance on subordinated debt as a tool for monitoring banks by investors and for enhancing depositors’ protection. However, subordinated debenture increases the level of leverage and thus the probability of costly failure. We propose a novel financial instrument, ‘Debt-for-Equity Swap’ contract (DES), that pays to its holder a fixed income unless the value of the bank’s assets falls below a predetermined threshold. In such an event, the debt obligation is automatically converted to the bank’s common equities. By using a contingent claims valuation approach we present closed-form solutions for the valuation of liabilities, the cost of deposit insurance and the value of bankruptcy costs of a bank that includes DES or alternatively subordinated debt in its capital structure. We compare and evaluate quantitatively the effects of DES contract versus subordinated debt on bank stability, depositor protection, incentives for risk taking, the ability to provide market discipline and the value of bankruptcy costs. The implications of the paper highlight the fact that the DES contract has salient advantages over subordinated debt as an efficient tool for enhancing market stability and bank efficiency, since it reduces the value of bankruptcy costs. The advantage of the DES over subordinated debt as a provider of depositors’ protection depends on the level of mandatory intervention, assets value and volatility as well as on the ratio of bankruptcy costs. The model illustrates the pros and cons of each of the two capital instruments as a tool for enhancing market discipline. While the value of subordinated debt increases with the value of assets, its disadvantage as a monitoring tool derives from its low sensitivity to changes in assets volatility when the level of regulatory intervention is relatively high in terms of capital adequacy and the rate of bankruptcy costs is relatively low. The DES contract is beneficial as a tool for monitoring due to its negative sensitivity to increase in assets risk. However, when the conversion ratio is relatively high its price might increase as the leverage ratio increases.