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Using Subordinated Debt as an Instrument of Market Discipline
Source: Federal Reserve

Appendix E

Treatment of Subordinated Debt in Risk-Based Capital

The following extract is taken from Federal Reserve Regulation H-Membership of State Banking Institutions in the Federal Reserve System. The specific subparts below are found in Appendix A of the regulation, which contains the guidelines for the risk-based capital adequacy of state member banks (12 CFR Part 208, Appendix A.II.A.2). Substantially the same guidance is also applicable to bank holding companies and may be found in Federal Reserve Regulation Y-Bank Holding Companies and Change in Bank Control (12 CFR Part 225, Appendix A.II.A.2). Although the precise wording varies for regulations applying to national banks and state nonmember banks, the substance of their regulations is the same as that for member banks and bank holding companies.

d) Subordinated debt and intermediate term preferred stock.  The aggregate amount of term subordinated debt (excluding mandatory convertible debt) and intermediate-term preferred stock that may be treated as supplementary capital is limited to 50 percent of tier 1 capital (net of goodwill and other intangible assets required to be deducted in accordance with section II.B.1.b of this appendix). Amounts in excess of these limits may be issued, and, while not included in the ratio calculation, will be taken into account in the overall assessment of a bank's funding and financial condition.

Subordinated debt and intermediate-term preferred stock must have an original weighted average maturity of at least five years to qualify as supplementary capital.  (If the holder has the option to require the issuer to redeem, repay, or repurchase the instrument prior to the original stated maturity, maturity would be defined, for risk-based capital purposes, as the earliest possible date on which the holder can put the instrument back to the issuing bank.)

In the case of subordinated debt, the instrument must be unsecured and must clearly state on its face that it is not a deposit and is not insured by a federal agency.  To qualify as capital in banks, debt must be subordinated to general creditors and claims of depositors. Consistent with current regulatory requirements, if a state member bank wishes to redeem subordinated debt before the stated maturity, it must receive prior approval of the Federal Reserve.

e) Discount of supplementary capital instruments. As a limited-life capital instrument approaches maturity, it begins to take on characteristics of a short-term obligation.  For this reason, the outstanding amount of term subordinated debt and any long- or intermediate-life, or term, preferred stock eligible for inclusion in tier 2 is reduced, or discounted, as these instruments approach maturity: One-fifth of the original amount, less any redemptions, is excluded each year during the instrument's last five years before maturity.12

  1. For example, outstanding amounts of these instruments that count as supplementary capital include: 100 percent of the outstanding amounts with remaining maturities of more than five years; 80 percent of outstanding amounts with remaining maturities of four to five years; 60 percent of outstanding amounts with remaining maturities of three to four years; 40 percent of outstanding amounts with remaining maturities of two to three years; 20 percent of outstanding amounts with remaining maturities of one to two years; and 0 percent of outstanding amounts with remaining maturities of less than one year. Such instruments with a remaining maturity of less than one year are excluded from tier 2 capital.

Appendix F