# Debt Priority Structure, Market Discipline, and Bank Conduct

Debt Priority Structure, Market Discipline, and Bank Conduct Abstract We examine how debt priority structure affects bank funding costs and soundness. Leveraging an unexplored natural experiment that changes the priority of claims on banks’ assets, we document asymmetric effects that are consistent with changes in monitoring intensity by various creditors depending on whether creditors move up or down the priority ladder. The enactment of depositor preference laws that confer priority on depositors reduces deposit rates but increases nondeposit rates. Importantly, subordinating nondepositor claims reduces bank risk-taking, consistent with market discipline. This insight highlights a role for debt priority structure in the regulatory framework. Received September 1, 2016; editorial decision August 31, 2017 by Editor Philip Strahan. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online. Conferring priority to depositors when banks fail is a way to protect depositors. This idea received renewed attention after the crisis, with European Union policy makers calling for depositor preference reform. With depositor preference, all depositors’ claims on failed banks are senior to those of nondepositors.1 Proponents of the reform argue that the priority for deposits increases market discipline. Prior theoretical work suggests that depositor preference affects monitoring intensity by different claimants, leading to changes in bank conduct. Birchler (2000) develops a model in which uninsured depositors and nondepositors are initially of equal rank in the debt priority ladder and engage in monitoring to acquire a signal about the bank’s condition. As nondepositors have superior monitoring technologies, their monitoring costs are lower relative to uninsured depositors’. Since depositor preference subordinates nondepositors’ claims, they monitor more intensively because of the greater losses in the event of bankruptcy. Nondepositors then demand a higher interest rate to offset the additional monitoring costs. In contrast, uninsured depositors have reduced monitoring incentives, leading to lower monitoring costs and a lower interest rate. Based on these arguments, the market discipline literature predicts that greater monitoring by nondepositors induces changes in bank behavior, in particular in terms of risk-taking (Dewatripont and Tirole 1993; Calomiris 1999). In this paper, we exploit the staggered introduction of state depositor preference laws between 1983 and 1993 in 15 U.S. states to test whether depositor preference affects various creditors’ monitoring incentives and, ultimately, bank conduct.2 Depositor preference applies to state-chartered, but not to nationally chartered banks. This allows us to use difference-in-differences estimation to exploit variation across states over time in the introduction of the laws and compare how the treatment group (state-chartered banks) respond to the law change relative to a control group (nationally chartered banks) in the same state. Our findings support the predictions: depositor preference decreases uninsured deposit interest rates but increases nondeposit rates. Depositor preference also improves soundness, as bank risk and leverage both decline. Further tests examine how market shares of different types of debt respond to depositor preference. Supply and demand for uninsured deposits and nondeposits may adjust to changes in interest rates such that the net effects of depositor preference on market shares are ex ante uncertain. We find that the market share of uninsured deposits increases, whereas that of nondeposits remains unchanged. These inferences are robust to using alternative control groups that mitigate concerns that there may be macroeconomic variation within U.S. states. While our main tests are based on within state-quarter comparisons between state-chartered and nationally charted banks, the results are unchanged when we use a 50-state sample. A further concern may be that nationally chartered and state-chartered banks do not evolve similarly over time, and differ in terms of size. We show that the treatment and control groups display parallel trends prior to the adoption of depositor preference, and we replicate our tests using a size-matched sample. We also rule out that anticipation effects, banking sector problems, changes in banking regulation and the deregulation of banking markets confound our inferences. Placebo tests show that changes in monitoring intensity and conduct can only be detected in banks affected by depositor preference. We offer the following key contributions. First, our findings inform recent policy debates about depositor preference legislation as a way to strengthen market discipline. To this extent, our results reinforce the rationale for market discipline as an integral part of regulation. In particular, we illuminate the debate about whether private sector agents engage in monitoring and influence bank behavior. We find that private sector agents monitor banks and changes in debt priority influence bank conduct. This is crucial because Bliss and Flannery (2002) argue most studies struggle to find evidence for market participants’ ability to change bank behavior. Aside from Ashcraft (2008), who shows subordinated debt claimants influence conduct by imposing constraints via covenants, there is little evidence that private sector agents influence bank conduct (Avery et al. 1988; Gorton and Santomero 1990; Flannery and Sorescu 1996; Martinez Peria and Schmukler 2001; Morgan and Stiroh 2001; Goldberg and Hudgins 2002; Bliss and Flannery 2002; Krishnan, Ritchken, and Thomson 2005). Our work advances this debate but differs from Ashcraft (2008). Our setting does not require covenants but it is sufficient to rely on the switch in monitoring incentives mandated by law. This approach is more efficient than covenants that may entail large transaction costs.3 Second, and unlike prior work on market discipline, we focus on the mechanism that makes debtholders display behavior consistent with monitoring. While previous studies emphasize the role of bondholders and depositors for market discipline, we establish an important role for general creditors, and present evidence that legislative shocks affect monitoring incentives and can improve market discipline. In contrast to research on national depositor preference in the United States, where the primary focus is on thrifts, failure rates, and the losses incurred in failures (Hirschorn and Zervos 1990; Osterberg 1996; Osterberg and Thomson 1999, 2003), we isolate the effect from the state-level depositor preference legislation that predates the introduction of national law. 1. Institutional Background: The Staggered Nature of Depositor Preference Legislation The regulatory framework in the United States prescribes guidelines for bank resolution. During the resolution process, described in Appendix A, a failed bank’s assets are transferred to the Federal Deposit Insurance Corporation (FDIC) whose task it is to identify and satisfy creditors, and maximize the net present value for the receivership claimants. The FDIC pays off claimants in line with the guidelines for receiverships established by the Banking Act of 1935.4 The FDIC assigns priority claims to the receiver as compensation for administrative expenses. Next in line are secured claimants with collateralized claims. They are followed by depositors with balances below the deposit insurance coverage limit. Uninsured depositors whose balances exceed the deposit insurance coverage limit and nondepositors follow thereafter. The latter two groups have claims of equal priority. Last in the queue are holders of subordinated debt, and shareholders. Several states departed from the Banking Act of 1935, and changed the debt priority structure for state-chartered banks. In 1909, Nebraska established priority for depositors over the claims of general, that is, nondeposit, creditors. In the following years, 29 other states adopted depositor preference. Of those 29 states, 15 states (Arizona, California, Colorado, Connecticut, Florida, Hawaii, Kansas, Louisiana, Maine, Minnesota, Missouri, New Hampshire, North Dakota, Rhode Island, and Texas) introduced depositor preference during our sample period 1983Q1– 1993Q2 as shown in Table 1. Table 1 Timing of depositor preference laws State Date effective In sample Alaska October 15, 1978 No Arizona September 21, 1991 Yes California June 27, 1986 Yes Colorado May 1, 1987 Yes Connecticut May 22, 1991 Yes Florida July 3, 1992 Yes Georgia 1974$$^{\mathrm{a}}$$ No Hawaii June 24, 1987 Yes Idaho 1979$$^{\mathrm{b}}$$ No Indiana 1943 No Iowa January 1, 1970 No Kansas July 1, 1985 Yes Louisiana January 1, 1985 Yes Maine April 16, 1991 Yes Minnesota April 24, 1990 Yes Missouri May 15, 1986 Yes Montana 1927 No Nebraska 1909 No New Hampshire June 10, 1991 Yes New Mexico June 30, 1963 No North Dakota July 1, 1987 Yes Oklahoma June 26, 1965 No Oregon January 1, 1974 No Rhode Island February 2, 1991 Yes South Dakota July 1, 1969 No Tennessee 1969 No Texas August 26, 1985$$^{\mathrm{c}}$$ Yes Utah 1983 No Virginia July 1, 1983 No West Virginia June 11, 1981 No State Date effective In sample Alaska October 15, 1978 No Arizona September 21, 1991 Yes California June 27, 1986 Yes Colorado May 1, 1987 Yes Connecticut May 22, 1991 Yes Florida July 3, 1992 Yes Georgia 1974$$^{\mathrm{a}}$$ No Hawaii June 24, 1987 Yes Idaho 1979$$^{\mathrm{b}}$$ No Indiana 1943 No Iowa January 1, 1970 No Kansas July 1, 1985 Yes Louisiana January 1, 1985 Yes Maine April 16, 1991 Yes Minnesota April 24, 1990 Yes Missouri May 15, 1986 Yes Montana 1927 No Nebraska 1909 No New Hampshire June 10, 1991 Yes New Mexico June 30, 1963 No North Dakota July 1, 1987 Yes Oklahoma June 26, 1965 No Oregon January 1, 1974 No Rhode Island February 2, 1991 Yes South Dakota July 1, 1969 No Tennessee 1969 No Texas August 26, 1985$$^{\mathrm{c}}$$ Yes Utah 1983 No Virginia July 1, 1983 No West Virginia June 11, 1981 No We present the date of depositor preference law enactment in each state. The information is taken from Marino and Bennett (1999). $$^{\mathrm{a}}$$The legislation became effective on either January 1 or July 1. $$^{\mathrm{b}}$$The law was passed by both houses on July 1, but that enactment date is unclear. Where only the year is indicated, neither the month nor the day of enactment is available and we impute January 1 as the enactment date. $$^{\mathrm{c}}$$Texas amended its law in 1993Q2 and did not have depositor preference until national depositor preference was enacted in August 1993. Utah enacted depositor preference law during 1983Q1. Table 1 Timing of depositor preference laws State Date effective In sample Alaska October 15, 1978 No Arizona September 21, 1991 Yes California June 27, 1986 Yes Colorado May 1, 1987 Yes Connecticut May 22, 1991 Yes Florida July 3, 1992 Yes Georgia 1974$$^{\mathrm{a}}$$ No Hawaii June 24, 1987 Yes Idaho 1979$$^{\mathrm{b}}$$ No Indiana 1943 No Iowa January 1, 1970 No Kansas July 1, 1985 Yes Louisian