First of all, subordinated debt is the most junior of all bank liabilities. Therefore, these bondholders are the least likely to be bailed out in the event of bank failure, and the most likely to demand disclosures of a bank’s condition. Second, subordinated debt holders do not partake in the upside gains associated with risk-taking.
Hence, at least in principle, the issuance and secondary market spreads on subordinated debt should be particularly sensitive to banking organization risk. In contrast, since equity holders may also benefit from the upside gains associated with risk-taking, equity issuance may provide inadequate direct market discipline, and the signals of bank risk derived from secondary market prices may be blurred and difficult to interpret.