Market Discipline and Banking Supervision: The Role of Subordinated Debt

One of the aims of mandatory subordinated debt is to enhance both direct and indirect market discipline. Indeed, on the one hand, holding subordinated debt can affect banks' behaviour by changing their funding costs and, on the other hand, the rate of return of subordinated debt can be used by supervisors as a signal of their riskiness. In this paper, we analyse how subordinated debt may affect both bank riskiness and the effectiveness of bank supervision. We take into account the ability and incentives of subordinated debt holders to exercise market discipline. We show that requiring banks to hold subordinated debt should reduce bank risk and allow a better allocation of supervisory ressources. To do so, two criteria must be fulfilled: subordinated debt holders should have access to sufficient information about bank riskiness but they should not benefit from any kind of insurance.