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.
|Date of creation:||1999|
|Date of revision:|
|Contact details of provider:|| Postal: |
Web page: http://www.federalreserve.gov/
More information through EDIRC
|Order Information:|| Email: |
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Robert DeYoung & Mark J. Flannery & William W. Lang & Sorin M. Sorescu, 1998. "The informational advantage of specialized monitors: the case of bank examiners," Working Paper Series WP-98-4, Federal Reserve Bank of Chicago.
- Fraser, Donald R. & McCormack, J. Patrick, 1978. "Large Bank Failures and Investor Risk Perceptions: Evidence from the Debt Market," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 13(03), pages 527-532, September.
- Hannan, Timothy H & Hanweck, Gerald A, 1988.
"Bank Insolvency Risk and the Market for Large Certificates of Deposit,"
Journal of Money, Credit and Banking,
Blackwell Publishing, vol. 20(2), pages 203-11, May.
- Timothy H. Hannan & Gerald A. Hanweck, 1986. "Bank insolvency risk and the market for large certificates of deposit," Working Papers in Banking, Finance and Microeconomics 86-1, Board of Governors of the Federal Reserve System (U.S.).
- R. Alton Gilbert, 1990. "Market discipline of bank risk: theory and evidence," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 3-18.
- Rebel Cole & Jeffery Gunther, 1998. "Predicting Bank Failures: A Comparison of On- and Off-Site Monitoring Systems," Journal of Financial Services Research, Springer, vol. 13(2), pages 103-117, April.
- Julapa Jagtiani & George Kaufman & Catharine Lemieux, 1999. "Do markets discipline banks and bank holding companies? evidence from debt pricing," Emerging Issues, Federal Reserve Bank of Chicago, issue Jun.
- Ellis, David M. & Flannery, Mark J., 1992. "Does the debt market assess large banks, risk? : Time series evidence from money center CDs," Journal of Monetary Economics, Elsevier, vol. 30(3), pages 481-502, December.
- Allen N. Berger, 1994.
"The relationship between capital and earnings in banking,"
Finance and Economics Discussion Series
94-2, Board of Governors of the Federal Reserve System (U.S.).
- Berger, Allen N, 1995. "The Relationship between Capital and Earnings in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 432-56, May.
- Allen Berger, 1994. "The Relationship Between Capital and Earnings in Banking," Center for Financial Institutions Working Papers 94-17, Wharton School Center for Financial Institutions, University of Pennsylvania.
- James, Christopher, 1988. "The use of loan sales and standby letters of credit by commercial banks," Journal of Monetary Economics, Elsevier, vol. 22(3), pages 395-422.
- Pettway, Richard H., 1976. "The Effects of Large Bank Failures upon Investors' Risk Cognizance in the Commercial Banking Industry," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 11(03), pages 465-477, September.
- Flannery, Mark J, 1998. "Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(3), pages 273-305, August.
- Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
- O'Hara, Maureen & Shaw, Wayne, 1990. " Deposit Insurance and Wealth Effects: The Value of Being "Too Big to Fail."," Journal of Finance, American Finance Association, vol. 45(5), pages 1587-1600, December.
- Cook, Douglas O & Spellman, Lewis J, 1994. "Repudiation Risk and Restitution Costs: Toward Understanding Premiums on Insured Deposits," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(3), pages 439-59, August.
- Park, Sangkyun, 1995. "Market discipline by depositors: Evidence from reduced-form equations," The Quarterly Review of Economics and Finance, Elsevier, vol. 35(35), pages 497-514.
- Herbert Baer & Elijah Brewer, 1986. "Uninsured deposits as a source of market discipline: some new evidence," Economic Perspectives, Federal Reserve Bank of Chicago, issue Sep, pages 23-31.
- Gorton, Gary & Santomero, Anthony M, 1990. "Market Discipline and Bank Subordinated Debt," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 22(1), pages 119-28, February.
- Avery, Robert B & Belton, Terrence M & Goldberg, Michael A, 1988. "Market Discipline in Regulating Bank Risk: New Evidence from the Capital Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(4), pages 597-610, November.
When requesting a correction, please mention this item's handle: RePEc:fip:fedgss:172. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Kris Vajs)
If references are entirely missing, you can add them using this form.