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This paper empirically investigates the determinants of subordinated debt issuance by Japanese regional banks during the period of 2000–2007 using a probit model. The empirical results suggest the following. (i) Throughout the period, Japanese regional banks with a lower capital ratio tended to have a higher incentive to issue subordinated debts due possibly to their counting as Tier 2 capital under the Basel Accord. (ii) During the period of banking instability (2000–2003), subordinated debt investors tended to use financial variables such as the non-performing loan ratio, ROA, and ROE to screen good banks. (iii) During the period after the banking system regained stability (2004–2007), investors tended to pay less attention to the above variables due chiefly to the mitigated default risk of these banks.

Why do Japanese regional banks issue subordinated debts? What kind of characteristics do the banks that issue such debts have? What is the role of market discipline in the issuance decision of those debts? These are the main questions this paper attempts to empirically address using data in the period of 2000–2007. In Japan, a restructuring of the banking industry has been in progress. Mainly due to mergers, the number of city and regional banks decreased to 115 in March 2008 from 140 in March 1994.1 Through this process, subordinated debt attracted public attention as a potential tool for disciplining banks. Since the mid-1980s, a number of proposals that would require large banks to issue subordinated debts on a mandatory basis have been made in the United States.2 Subordinated debt is a fixed-income instrument that is unsecured and senior only to common equity when a failed bank is liquidated. Thus, yields on subordinated debts should be the most sensitive to the banks’ default risk among debts because those bank creditors are likely to lose part of their principal and interest in the case of a failure.

This paper has empirically investigated the determinants of subordinated debt issuance by Japanese regional banks during the period of 2000–2007 using a probit model. The empirical results suggest the following. (i) Throughout the sample period, Japanese regional banks with a lower capital ratio tended to have a higher incentive to issue subordinated debts because they are counted as Tier 2 capital under the Basel Accord. (ii) During the period of instability in the Japanese banking system (2000–2003), investors tended to intensively use financial variables such as the NPL ratio, ROA, and ROE to screen good banks from bad banks. This screening worked as a barrier to subordinated debt finance for bad banks. In this regard, market discipline worked in the primary market for Japanese banks’ subordinated debts during this period. Also depositors’ discipline (time depositors’ discipline, in particular) seemed more important than stockholders’ discipline.