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Subordinated debt and bank capital reform

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Author Info
Douglas D. Evanoff
Larry D. Wall

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Abstract

In recent years there has been a growing realization that there are significant problems with the current bank risk-based capital guidelines. As financial firms have become more sophisticated and complex they have effectively arbitraged the existing capital requirements. They have become so good at avoiding the intent of capital regulation that the regulations have essentially ceased to be a safety and soundness issue for supervisors and have become more a compliance issue. There is also a growing realization that bank regulation must more effectively incorporate market discipline to encourage prudent risk management. One means recommended to accomplish this is to increase the role of subordinated debt in the bank capital requirement. Arguments have been made that this could lead to improvements in both market and supervisory discipline. Although a number of such proposals have been made, there appears to be significant misunderstanding of how bank capital requirements would be modified and what might be accomplished by the modification. On the one extreme, some discussions of sub-debt seem to imply that merely requiring banks to issue debt would solve all safety and soundness related concerns. At the other extreme are a series of questions that raise doubts as to whether any change in the role of sub-debt could contribute toward safety and soundness goals. ; The goal of this article is to provide a comprehensive review and evaluation of the purpose and potential of subordinated debt proposals and to present a regulatory reform proposal that incorporates what we believe are the most desirable characteristics of subordinated debt. The article is intended as a reference piece from which readers new to the topic may find a thorough review of the issues, and others can draw on specific aspects of the debate. Coverage includes (1) a discussion of the characteristics of sub-debt that make it attractive for imposing market and supervisory discipline on banks; (2) explanation of how current regulatory arrangements do not allow these features to be fully utilized; (3) discussion of the role of debt markets, equity markets, and supervision in disciplining firm behavior, and how the use of sub-debt avoids many of the problems associated with alternative regulatory proposals; (4) a review of the evidence on the extent of market pricing and disciplining of risk imposed by holders of bank liabilities; (5) a review of some of the existing sub-debt proposals emphasizing their differences and the reasoning for those differences; (6) a new regulatory reform proposal which increases the role of sub-debt; and (7) a discussion of some of the standard questions raised about sub-debt proposals and, when appropriate, explanation of how our proposal addresses these concerns.

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Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2000-24.

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Date of creation: 2000
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Publication status: Published in Federal Reserve Bank of Chicago Economic Perspectives, 2nd Quarter 2000
Handle: RePEc:fip:fedawp:2000-24

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Keywords: Debt ; Bank capital ; Bank liabilities ; Bank supervision;

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This paper has been announced in the following NEP Reports: References listed on IDEAS
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Full references

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  1. Diana Hancock & Myron Kwast, 2001. "Using Subordinated Debt to Monitor Bank Holding Companies: Is it Feasible?," Journal of Financial Services Research, Springer, vol. 20(2), pages 147-187, October. [Downloadable!] (restricted)
  2. Adam B. Ashcraft, 2006. "Does the market discipline banks? New evidence from the regulatory capital mix," Staff Reports 244, Federal Reserve Bank of New York. [Downloadable!]
  3. Douglas Evanoff & Larry Wall, 2001. "Sub-debt Yield Spreads as Bank Risk Measures," Journal of Financial Services Research, Springer, vol. 20(2), pages 121-145, October. [Downloadable!] (restricted)
    Other versions:
  4. Caprio, Gerard & Honohan, Patrick, 2004. "Can the unsophisticated market provide discipline?," Policy Research Working Paper Series 3364, The World Bank. [Downloadable!]
  5. Diana Hancock & Myron L. Kwast, 2001. "Using subordinated debt to monitor bank holding companies: is it feasible?," Finance and Economics Discussion Series 2001-22, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  6. Greg Caldwell, 2005. "Subordinated Debt and Market Discipline in Canada," Working Papers 05-40, Bank of Canada. [Downloadable!]
  7. David T. Llewellyn, 2001. "A Regulatory Regime for Financial Stability," Working Papers 48, Oesterreichische Nationalbank (Austrian Central Bank). [Downloadable!]
  8. Douglas D. Evanoff & Larry D. Wall, 2001. "Measures of the riskiness of banking organizations: Subordinated debt yields, risk-based capital, and examination ratings," Working Paper 2001-25, Federal Reserve Bank of Atlanta. [Downloadable!]
    Other versions:
  9. Décamps, Jean-Paul & Rochet, Jean-Charles & Roger, Benoît, 2003. "The Three Pillars of Basel II, Optimizing the Mix," IDEI Working Papers 179, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
    Other versions:
  10. Robert R. Bliss, 2000. "The pitfalls in inferring risk from financial market data," Working Paper Series WP-00-24, Federal Reserve Bank of Chicago. [Downloadable!]
  11. Kose John & Hamid Mehran & Yiming Qian, 2007. "Regulation, subordinated debt, and incentive features of CEO compensation in the banking industry," Staff Reports 308, Federal Reserve Bank of New York. [Downloadable!]
  12. Douglas D. Evanoff & Larry D. Wall, 2003. "Subordinated debt and prompt corrective regulatory action," Working Paper Series WP-03-03, Federal Reserve Bank of Chicago. [Downloadable!]
    Other versions:
  13. Jean-Charles Rochet, 2004. "Rebalancing the three pillars of Basel II," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 7-21. [Downloadable!]
  14. Andrea Sironi, 2001. "An Analysis of European Banks' SND Issues and its Implications for the Design of a Mandatory Subordinated Debt Policy," Journal of Financial Services Research, Springer, vol. 20(2), pages 233-266, October. [Downloadable!] (restricted)
  15. Mark Flannery, 2001. "The Faces of “Market Disciplineâ€," Journal of Financial Services Research, Springer, vol. 20(2), pages 107-119, October. [Downloadable!] (restricted)
  16. Stéphanie Stolz, 2002. "The Relationship between Bank Capital, Risk-Taking, and Capital Regulation: A Review of the Literature," Kiel Working Papers 1105, Kiel Institute for the World Economy. [Downloadable!]
  17. Greg Caldwell, 2007. "Best Instruments for Market Discipline in Banking," Working Papers 07-9, Bank of Canada. [Downloadable!]
  18. Rochet, Jean-Charles, 2003. "Rebalancing the 3 Pillars of Basel 2," IDEI Working Papers 224, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
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