Using subordinated debt as an instrument of market discipline

A growing number of observers have proposed using subordinated notes and debentures (SND) as a way of increasing market discipline on banks and banking organizations. Although policy proposals vary, all would mandate that banks subject to the policy must issue and maintain a minimum amount of SND. In recent years, the perceived need for more market discipline has derived primarily from the realization that the increasing size and complexity of the major banking organizations has made the supervisor's job of protecting bank safety and soundness ever more difficult. A second important motivation is the desire to find market-based ways of better insulating the banking system from systemic risk. In light of the ongoing interest in using SND as an instrument of market discipline, in mid-1998 staff of the Federal Reserve System undertook a study of the issues surrounding an SND policy.1 The study begins by carefully defining market discipline, discusses the motivation for and theory behind a subordinated debt policy, and presents an extensive summary of existing policy proposals. The study then reviews the economic literature on the potential for SND to exert market discipline on banks and presents a wide range of new evidence acquired by the study group. This includes information gathered from extensive interviews with market participants, new econometric work, and the experience of bank supervisors. The third major section of the study analyzes many characteristics that an SND policy could have, in terms of both their contribution to market discipline and their operational feasibility. These potential characteristics include the types of institutions that should be subject to an SND policy; the amount that should be required; the maturity, optionality, interest rate cap, and other possible features of the debt instrument; the frequency of issuance; and the way a transition period might work. The study also includes appendixes that (1) provide a detailed summary of the study group's interviews with market participants, (2) examine the potential for banks to avoid SND discipline, (3) analyze the potential macroeconomic effects of an SND policy, and (4) review the Argentine experience with implementing a mandatory subordinated debt policy. Because the overall purpose of the study is to conduct a broad review and evaluation of the issues, no policy conclusions are advanced. However, the overall tone of the study suggests that a properly designed SND policy is operationally feasible and would likely impose significant additional market discipline on the banking institutions to which it applied. In addition, the study makes clear that assessment of a policy proposal would be helped greatly by additional research in several areas: for example, the marginal costs and benefits of required SND issuance relative to those of the existing subordinated debt market and the potential costs and benefits of using the existing SND market, along with existing markets for bank equity and other uninsured liabilities, to aid in bank supervisory surveillance activities. Footnotes 1 This study was completed in May 1999, before enactment of the Gramm-Leach-Bliley Act in November 1999. That act requires that the Federal Reserve Board and the U.S. Department of the Treasury conduct a joint study of the feasibility and appropriateness of requiring large insured depository institutions and depository holding companies to hold a portion of their capital in subordinated debt. The joint study must be submitted to the Congress within eighteen months of the date of enactment.