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

The Relation among SND Policy, Increased Disclosure, and an Improved Basel Accord

If SND are to exert appropriate market discipline, market participants clearly need to be well informed regarding the true financial condition of banks and bank holding companies. Study group interviews with market participants indicated some concern among participants about the current ''opacity'' of banks, including the lack of good information on some key business lines such as off-balance-sheet products. Some interviewees suggested that banks will occasionally shrink assets rather than issue SND because the banking organization does not want to disclose adverse information.

That some major participants in today's market feel that existing disclosures are insufficient is troubling. This unease with current disclosures is especially disturbing given that the current market for the SND of large bank holding companies and some large banks is substantial and well developed. Whatever the reason, market participants' feelings may suggest that there is room for supervisory and regulatory efforts to improve disclosures. Such improvement seems particularly appropriate if any mandatory SND policy were adopted because the spotlight would be focused more strongly on the quality of the market discipline imposed by the SND market. In short, these arguments highlight that a viable SND policy and an effective disclosure policy are closely connected.

As is well known, ''regulatory capital arbitrage'' is a prime motivator behind current efforts to revise the Basel Accord. 61 But it is also a potential problem for an SND policy. Assuming that a minimum SND requirement would be some percentage of total or risk-weighted assets, one way for banks or bank holding companies to lower the amount of SND they would need to issue would be to remove assets from their balance sheets. Removing assets from the balance sheet, while retaining much or all of the risk of those assets, is of course the primary goal of regulatory capital arbitrage. Regulatory capital arbitrage would be unlikely to subvert SND market discipline completely because the rate on a bank's SND would presumably remain little changed if risk remained the same (assuming that the market could accurately assess the risk of the capital arbitrage transaction through, among other things, additional public disclosure). Indeed, the rate might even rise somewhat if the holders of the smaller amount of SND came to feel more exposed to losses. Nevertheless, the possibility of using regulatory capital arbitrage to evade an SND policy reinforces the view that SND policy and Basel Accord policy are best viewed as complements, not substitutes. 62

  1. For a discussion of regulatory capital arbitrage, see Jones (1999).

  2. Using risk-weighted assets as the denominator for an SND requirement would also allow the SND policy to evolve along with the risk measure used for regulatory capital purposes.