The Effect of Subordinated Debt Issuance on Commercial Bank Profitability and Insolvency Risk

This study is the first to thoroughly investigate the effect of subordinated debt issuance on commercial banks’ profitability and insolvency risk as well as the effect of the Basel III capital framework on this relationship. This study empirically examines the subjectwww.earticle.net of interest by using random-effects panel-data models after controlling for potential determinants of bank profitability and insolvency risk. The Basel III framework, established by the Basel Committee on Banking Supervision (BCBS) and first introduced in 2010, provides reinforced regulatory standards on capital requirements, leverage measurements, and liquidity measurements for the banking sector (BCBS, 2010; Eubanks, 2010; Financial Supervisory Service, 2012). Specifically, the capital framework includes increased minimum capital adequacy ratios, and owing to this, the effect and importance of subordinated debt, a type of debt capital recognized as Tier 2 capital, have changed. However, despite this change in the role of subordinated debt in the banking sector, academic and empirical investigations of this debt are lacking. Our study fills this gap. We analyze the relationship between subordinated debt and banks by using a random-effects panel-data analysis method. Our sample data, ranging from 2001 to 2018, are an annually collected dataset from the six commercial banks that currently operate in the Korean banking sector. We proxy bank profitability using the return on assets (ROA) and the return on equity (ROE), and insolvency risk using the distance-to-insolvency Z-score (Boyd and Graham, 1986; Hannan and Hanweck, 1988). We examine the effect of subordinated debt issuance after controlling for other potential determinants of bank profitability and insolvency risk, including banks’ financial ratios, industry-relevant variables, and macroeconomic factors (Athanasoglou et al., 2008). The results of the analyses suggest that subordinated bond issuance negatively affects bank profitability and insolvency risk. The profitability models use either ROA or ROE as the response variable and show that increases in the growth rate of subordinated debt reduce bank profitability. Furthermore, our study considers the interaction between the subordinated debt variable and a dummy variable for Basel III adoption that takes a value of one after 2013, and zero otherwise. We find that the coefficients of the interaction terms are positive for all estimated models, indicating that the negative effect of subordinated debt issuance on bank profitability was substantially mitigated after 2013, when the Basel III accord was first implemented. We also investigate whether the size of previously issued subordinated debt influences the relationship between bank profitability and the issuance of such debt. We measure the relative size of subordinated debt held by a bank as the ratio of subordinated debt to the total debt in period t-1 and sort it into four subgroups based on its quartiles. We find that issuing this debt negatively affects profitability for all subgroups except the subgroup with the largest relative size of subordinated debt, suggesting that banks are not significantly affected by the issuance of additional subordinated debt when they have already issued a sufficiently large amount of subordinated debt relative to their total debt. The Z-score models use the distance-to-insolvency Z-score as the response variable and show that an increase in the growth rate of subordinated debt decreases (increases) the Z-score (insolvency risk). We include the interaction term between subordinated debt issuance and the dummy variable for the adoption of the Basel III regulation in the models. We find that the negative effect of subordinated debt issuance on bank insolvency risk was mitigated after 2013. This finding can be interpreted as resulting from either thewww.earticle.net enhancement of the integrity of banks’ capital structures after the Basel III regulation or the fact that banks are encouraged to only issue subordinated debt that conforms to reinforced regulation. Finally, we analyze the specific mechanism for the relationship between subordinated debt issuance and bank performance. We find that the growth rate of subordinated debt positively affects banks’ interest costs, indicating that issuing subordinated debt increases banks’ interest costs. We also find that interest costs significantly decrease concurrent profitability and increase concurrent insolvency risk. These results empirically support the hypothesis that subordinated debt issuance incurs costs to banks owing to the relatively high interest rate and can negatively affect bank performance, as prior studies theoretically suggest (Blum, 2002; Kim, 2000). The empirical analyses in this study provide information not only for investors and decision-makers in banks but also for supervisory authorities and policymakers regarding the issuance of subordinated debt. Furthermore, the research methodology used in this study is convenient and practical in that the model uses the financial ratios of banks, industrial variables, and macroeconomic factors that are easily accessible and uses the Z-score as a proxy for bank insolvency risk. Thus, the Z-score can be utilized for insolvency risk analyses in research environments in which the conventional panel logit model is not applicable.