By Piotr Danisewicz (University of Bristol), Danny McGowan (University of Nottingham), Enrico Onali (Aston University; University of Wales System – Bangor University), and Klaus Schaeck (University of Bristol).
This article explores how changes in debt priority structure affect banks’ funding costs and soundness. We exploit the staggered introduction of depositor preference laws across 15 U.S. states between 1983 and 1993 which confer priority to deposit claims in case of bank liquidation. The laws are exogenous with respect to the outcomes of interest and apply to state-chartered banks but not to nationally-chartered banks, allowing us to isolate causality using difference-in-difference methods.
We document changes in monitoring intensity by various creditors depending on whether creditors move up or down the priority ladder. Enactment of depositor preference reduces deposit interest rates, consistent with the fact that deposit claims are protected in case of bankruptcy thereby reducing depositors’ monitoring incentives. However, non-deposit interest rates increase as these creditors are exposed to greater losses in bankruptcy which leads them to more intensively monitor banks’ conditions.
Subordinating non-depositor claims also reduces banks’ risk-taking and leverage, consistent with market discipline. For example, non-depositors who receive negative signals about project returns may refuse to roll over funds which motivates banks to improve soundness to maintain access to key funding sources such as Fed Funds.
These insights highlight a role for debt priority structure in the regulatory framework, and support recent innovations in banking regulation that reallocate monitoring incentives towards non-depositors.
The full paper can be found here.