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New research on US banking debt

6 November 2017

State US banking debt priority laws reduce bank risk taking, according to new study

Large banking debts and how they’re being dealt with has stayed firmly in the public eye since the global financial crash in 2008 - considered by many economists as the worst financial crisis since the Great Depression of the 1930s.

One piece of legislation put in place since then, however - the Debt Priority Structure - has already reduced bank risk-taking and increased market monitoring, according to new research published in in the Review of Financial Studies, one of the most respected global finance journals.

The study is part of a series about banking regulation by the EFM’s academics, whose work feeds into the central banking community and policy creation circles.

The paper, co-authored by EFM's Dr Piotr Danisewicz and Professor Klaus Schaeck in partnership with the University of Nottingham and Aston University, examines the priority given to debt claims after a bank goes bankrupt, and looks specifically at a previous unexplored change in U.S. state banking laws to this structure.

When a bank goes bankrupt, creditors are entitled to a claim on the remaining assets to recoup at least part of their losses. Insolvency proceedings usually prescribe a set hierarchy among those creditors.

The changes to US banking laws, introduced in in different states since 1909, altered the priority of claims on failed banks’ assets. The study shows that prioritising (or subordinating) debt claims of different types of claimants reduces bank risk-taking, as priority is given to depositors, whose claims include cash accounts, savings accounts, and time deposits.

“This research gives us valuable insight, namely that by enacting depositor preference laws, the deposits are made safer while at the same time large institutional debtholders have greater incentives to monitor banks,” said Professor Schaeck.

“It outlines a great argument in favour of depositor preference, namely that it increases market discipline,” said Dr Danisewicz. “In exposing the unsecured non-depositors of an institution, and the greater losses in the event of failure, these laws incentivise the debtholders to deal appropriately (or to decline to deal) with the institution in question. This is a very important finding, as we’re looking for better solutions to prevent risk taking within the banking sector.”

The full paper, entitled “Debt Priority Structure, Market Discipline and Bank Conduct” is available from the Review of Financial Studies website.

The work has also been featured on the Harvard Law School Bankruptcy Roundtable blog.

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