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

What Institutions Should Be Subject to an SND Policy?

Size Alone or Size Plus Other Criteria?

According to study group interviews with market participants, about fifteen to twenty, and perhaps as many as thirty, of the largest banks and bank holding companies have actively traded SND, although many more have issued some SND.  In addition, market participants argued that the principal issuers have total assets of at least $50 billion.  The secondary market for the SND of such firms was generally said to be highly liquid most of the time, to the point that the market provides a useful vehicle for trading and hedging. Market liquidity for the SND of smaller firms was, by implication, problematic. If correct, and the data presented next support the market participants' views, these arguments suggest that unless policymakers are willing to require substantial augmentation of the existing market for bank or BHC SND, an SND policy will have to be limited to the largest firms, probably considerably less than the largest fifty banks or bank holding companies.

More important, if an SND policy is focused on using market discipline to help constrain systemic risk, then limiting an SND policy to the largest institutions has considerable appeal. Clearly, the largest institutions are generally the firms that hold the most significant potential for systemic risk.  However, a criterion based solely on total assets, or even risk-weighted assets, may be too rough to capture the banks or bank holding companies most likely to pose significant systemic risks.  An appealing alternative set of criteria is that used by the Federal Reserve Board's Division of Bank Supervision and Regulation to define large, complex banking organizations (LCBOs). These criteria are meant to capture those banking organizations most likely to raise concerns about systemic risk.  In general, LCBOs (1) have significant on- and off-balance-sheet risk exposures, (2) offer a broad range of products and services at the domestic and international levels, (3) are subject to multiple supervisors in the United States and abroad, and (4) participate extensively in large-value payment and settlement systems.

Tables 4 and 5 provide a variety of data on SND issuance by U.S. banks and bank holding companies, respectively. Each table is arranged in selected years in the 1990s and selected size classes. As is clear from the tables, SND issuance at both the bank and the BHC levels is overwhelmingly accounted for by the largest institutions. For example, as of the end of 1998, 90 percent of the top fifty banks and 96 percent of the top fifty bank holding companies had SND outstanding.⁴⁶ In contrast, even among size class 3 banks and bank holding companies (those with total assets between $500 million and $10 billion), less than 20 percent of banks and less than 12 percent of bank holding companies issued SND.

With the exception of the group of the very largest (the top fifty) institutions, the percentage of both banks and bank holding companies issuing SND declined over the 1990s. For the three smallest size classes of firms, the declines were substantial. Although the reasons for this decline are uncertain, part of the explanation may lie in the increasing minimum size of an individual SND issue, which was noted by many of the market participants interviewed by the study group.⁴⁷ This hypothesis is supported by the dramatic increase in outstanding SND at both banks and bank holding companies during the 1990s, virtually all of which occurred at the largest institutions (see tables 4 and 5). Indeed, the total amount of BHC SND outstanding grew from $24.6 billion (in 1998 dollars) at the end of 1991 to $102.8 billion at the end of 1998, a compound annual growth rate of 23 percent. At the end of 1998, $100.0 billion (97 percent) of outstanding SND had been issued by the top fifty bank holding companies. In short, over the 1990s a rapidly growing amount of SND was accounted for by an increasingly small number of institutions, which were overwhelmingly in the top fifty.

Even the level of disaggregation given in tables 4 and 5 can hide important characteristics of the market for bank and BHC SND. Thus, tables 6 and 7 provide data, as of the end of 1998, for the fifty largest U.S. banks and bank holding companies, respectively, ranked by total assets. As may be seen in the tables, the $50 billion asset size cutoff indicated by market participants suggests that an SND policy would apply only to the top fifteen banks or the largest twenty bank holding companies.

The LCBO columns of tables 6 and 7 identify whether the bank or bank holding company is a large, complex banking organization. Clearly, the link between size and the LCBO list is close. The largest eighteen of the top twenty banks are part of an LCBO organization, and all the largest twenty bank holding companies are LCBOs. Of the thirtytwo LCBOs, all but eight foreign banking organizations are among the top fifty bank holding companies. However, once below the top twenty banks and bank holding companies ranked by total assets, the link with size deteriorates. Only six of the twelve banks ranked from 21 through 32 are LCBOs, and just two of the twelve bank holding companies so ranked are LCBOs.

An alternative criterion that might be considered is to apply an SND policy to those banks or banking organizations that use market risk models to meet a portion of their risk-based capital requirements.  Such banks must have met several criteria established by the bank regulators that identify them as having acceptable, normally state-of-the-art, riskmanagement policies and procedures. Thus, by this definition they are ''sophisticated'' banking organizations, although the link with systemic risk concerns is not so clear as with the criteria of either size or size plus complexity. In addition, as of mid-March 1999, only thirteen banks or bank holding companies were using market risk models to meet their riskbased capital requirements. These organizations are identified in the MRMB columns of tables 6 and 7.  As can be seen in the tables, all of the banks and bank holding companies that are MRMB organizations are also currently listed as LCBOs. In addition, eleven of the twelve banks that are on the MRMB list are among the top twenty banks ranked by total assets, and eleven of the thirteen bank holding companies that are on the MRMB list are among the top twenty.

46. It is important to note that most bank SND are not traded, a point that will be discussed later.

47. Currently, the minimum size of issuance appears to be about $150 million. For more on this point, see appendix B.

4. Subordinated Debt Issuance by U.S. Insured Commercial Banks, 1991-98

NOTE. 

Size 1: total assets < $150 million;

Size 2: $150 million £ total assets < $500 million;

Size 3: $500 million £ total assets < $10 billion;

Size 4: total assets ³ $10 billion;

Top 50: top fifty banks by total assets.

1. As of December 31 of each year.

5. Subordinated Debt Issuance by Top-Tier U.S. Bank Holding Companies (BHCs) with Consolidated Assets of Greater than $150 Million

NOTE.

Size 1: total assets < $150 million;

Size 2: $150 million £ total assets < $500 million;

Size 3: $500 million £ total assets < $10 billion;

Size 4: total assets ³ $10 billion;

Top 50: top fifty banks by total assets.

1. As of December 31 of each year.

6. The Fifty Largest U.S. Insured Commercial Banks by Total Assets, 1998:Q4

NOTES. LCBO = Large, complex banking organization. MRMB = Market risk model bank. 1 = member of group, 0 = not member.

1. Includes Nations Bank.

7. The Fifty Largest U.S. Bank Holding Companies (BHCs) by Total Assets, 1998:Q4

NOTE. RWA = risk-weighted assets. SND = subordinated notes and debentures. LCBO = Large, complex banking organization. MRMB = Market risk model bank. . . . = a missing value. 1 = member of group, 0 = not member.

1. BHC banking assets = BHC total assets - BHC net nonbank assets. BHC net nonbank assets = Total nonbank assets - Balances due from parent BHC - Balances due from other nonbank subsidiaries of the BHC