Financial Update (January-March 2000)


Cover Story

Technology Brings Regulatory Challenges

Golden Dollar

New $5s and $10s

New Law Expands Banks' Activities


Did You Know?

Data Bank

The Docket


Subordinated Debt Can Help Regulators Monitor Bank Risk

Congress recently passed financial modernization legislation in recognition that the increasing sophistication of the financial system has made obsolete the old laws limiting banks' activities. While this legislation, called the Gramm-Leach-Bliley Act, was necessary to accommodate unavoidable changes, it does not resolve all of the problems created by this increased sophistication.

The ongoing development of better tools for banks to measure and manage risk poses especially difficult questions for bank supervisors. These new risk-management techniques may ultimately benefit the supervision process, but for now their complexity may be making it more difficult for supervisors to assess banks' true risks and assign appropriate capital requirements.

Market discipline can be a valuable risk management tool for regulators in today's rapidly changing banking industry. One proposal for enhancing market discipline is to adopt a policy requiring banks to issue subordinated debt.

In today's environment, the tools that supervisors have traditionally used are no longer as effective in assessing bank risk. New tools are needed that are flexible enough to keep pace with rapidly changing technology. The discipline of financial markets might be one such tool that can not only help supervisors monitor larger and more complex organizations but also provide better ways of insulating the banking system from systemic risk.

Market discipline via subordinated debt

One method that has been proposed for enhancing market discipline in the banking industry is to adopt a policy requiring banks to issue subordinated debt to unaffiliated investors.

Subordinated debt refers to notes or bonds that are subordinated to, or paid after, all other liabilities if a bank were to fail. Subordinated debt is thus the most junior of all bank liabilities. Because holders of these instruments are the least likely to be bailed out if a bank fails, they are the most likely to demand disclosure of a bank's condition. Subordinated debt holders receive, at most, the promised principal and interest payments and so do not share in the profits that may be associated with risk taking; they merely suffer the losses. Such downside risk gives subordinated debt holders the incentive to monitor a bank's risk and demand a higher interest rate to compensate for higher risk. This type of direct market discipline punishes banks for taking on inappropriate risk.

Subordinated debt also exerts indirect market discipline on banks to the extent that it provides other investors with a low-cost signal of bank risk. A number of studies have shown that secondary market spreads on subordinated debt are statistically sensitive to various measures of risk. The risk sensitivity of these spreads provides a signal to market participants about banks' risk exposures as well as a low-cost summary statistic on banks' financial health.

Helping regulators monitor risk

Because they have access to all public and confidential information gathered during exams, bank examiners know more about banks' risk exposures and internal capital assessments than market participants do. But the subordinated debt markets still have a couple of information advantages over examiners. For one, financial markets are in a better position to price exposures than examiners are. In addition, potential buyers of subordinated debt focus almost solely on a bank's risks whereas bank examiners must focus on a number of concerns.

Indirect market discipline could also be strengthened if policy revisions were made so that supervisory actions were linked to subordinated debt yields. Such information could be used to help examiners time their examinations, to limit bank activities or to raise capital requirements.

Proposals for mandatory subordinated debt

Existing proposals for banks' issuing mandatory subordinated debt differ in a number of details. These details vary depending on a proposal's goals and the ways subordinated debt would contribute to these goals. Most plans focus on large banks that have direct access to financial markets. From a regulator's standpoint, it makes more sense for only large banks to be subject to the requirement since these organizations are more complex and pose the greatest hazards to systemic risk.

One recommended feature in most plans is that the bank rather than the bank holding company would issue the debt. Most of the largest bank holding companies already issue publicly traded subordinated debt. However, imposing the requirement on the banks themselves would be more helpful to regulators since the banks are the entities that have direct access to the federal safety net and pose the greatest risk of moral hazard.

One area of disagreement centers on the maturity of the subordinated debt and how often it is issued. If the maturity is too short, the debt might be redeemed before a bank fails. On the other hand, the price of the bonds at issuance may provide a better risk signal than secondary market prices.

Other features that vary from proposal to proposal include the amount of subordinated debt required, the existence of a put option on the debt, and fixed or floating rates or rate caps on the debt.

New act calls for more study

While subordinated debt may not be the only way to enhance market discipline in banking, it is one of the most promising. The Financial Modernization Act passed last November includes two important provisions related to subordinated debt. The first requires the Federal Reserve and the Treasury Department to conduct a study, to be completed within 18 months of the act's passage, of the usefulness of requiring large depositories and depository holding companies to issue subordinated debt. The study should recommend any appropriate legislative changes.

Another provision requires that large national banks with a financial subsidiary issue rated, but not necessarily subordinated, debt. The requirement would apply if the bank is one of the largest national banks and the subsidiary is engaged in activities that the national bank cannot engage in directly.