Can Financial Markets Discipline Banks? Evidence From The Markets For Preferred Stock

Abstract

This paper explores the potential benefits of allowing greater use of money-market preferred stock (MMPS) in the capital structure of banking organizations. We find that banking organizations offering MMPS tend to have lower profitability and higher credit risk than institutions offering capital-market preferred stock. This finding is consistent with the hypothesis that markets will provide incentives, in the form of lower risk premiums, for higher default-risk institutions to offer MMPS rather than CMPS, because the auction process allows investors to adjust for any shifts in risk profiles by repricing the issue every 49 days. The finding that institution-specific risk influences the financing behavior of bank managers implies that banks are subject to a degree of market discipline.