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> Manual 172 > This page
Using Subordinated Debt as
an Instrument of Market Discipline
Source:
Federal Reserve
SND Proposals
Banking analysts have suggested
several ways in which SND could be used to enhance market discipline imposed
on banking organizations. A summary of these proposals is provided in
table 1.
The first generation of proposals
focused on the use of SND as a method of providing direct discipline by
increasing the bank's cost of funding rather than by affecting its ability
to obtain funds. In these proposals, the SND instrument was intended to
provide gradually increasing penalties for risk-taking rather than the
all-or-nothing discipline associated with runs on deposits. SND were chosen
for this purpose because they would provide an additional cushion for
the FDIC and possibly a margin of error in closing failing banks. Most
of these proposals were made between 1983 and 1986, but the proposal by
Litan and Rauch (1997) is also of this type.
The maturity of SND is generally
not specified, but typically the proposals recommend requiring sufficiently
frequent rollover to enhance direct discipline but not so frequent that
the SND holders might escape a distressed bank before it fails.
One advantage of allowing
or requiring banks to issue SND under these proposals is that regulators
can effectively set higher capital requirements without imposing excessive
costs on banks. The reason is that the cost of SND is typically lower
than the cost of equity because the tax code permits corporations to deduct
interest payments on debt but not dividend payments on equity. The FDIC
may have benefited further from a requirement that banks issue SND because
of the way its closure rule worked during the mid-1980s. Before FDICIA,
banks were not closed until the book value of their equity reached zero,
which generally implied that the value of failed banks' liabilities exceeded
the market value of their assets. If the bank had outstanding SND equal
to 3 to 5 percent of assets, then SND holders might have absorbed a large
fraction of the losses that otherwise the FDIC would have borne.
The second generation of
proposals was developed between 1988 and 1992. Proposals from this era
reflect a deep dissatisfaction with the forbearance policies of the Federal
Home Loan Bank Board during the thrift debacle, and they use SND to limit
forbearance. This generation built on the direct discipline arising from
first-generation proposals by requiring the issuance of SND and by using
each bank's ability to issue SND as a trigger to force supervisory discipline.
Each of the proposals required banks either to issue new debt on a frequent
basis or to issue debt that contained a provision allowing the holder
to ''put'' the debt back to the issuing bank. According to the proposals,
each bank's ability to issue SND would then be a market signal of its
viability. Banks that encountered problems would typically be given some
time to persuade the market that they were solvent and to issue new obligations.
However, a bank's inability to issue SND would at some point be taken
as a signal that the bank was considered insolvent by the market and that
it should be closed.
A weakness of the second-generation
proposals is that they rely exclusively on banks' ability to issue debt
as a trigger for regulatory action and fail to use the information available
in the issuance or secondary market prices of SND. The proposals allowed
banks to issue SND at whatever promised rate was necessary to attract
willing investors. 9 Thus,
banks could be operating at very high risk levels without SND's exerting
indirect discipline through supervisors. Wall (1989) would impose
the strictest limits on highly risky banks by requiring that a bank be
closed if it could not maintain a minimum level of SND. Although such
an approach may permit supervisors to take earlier action to reduce the
probability of failure, it does not guarantee supervisory intervention
until the bank cannot issue debt. Further, the market may perceive
the penalty for the inability to issue SND to be so draconian as to be
not credible. The severe nature of Wall's proposal may be softened by
requiring frequent, partial rollovers of SND and by integrating SND requirements
into prompt corrective action (see Evanoff, 1993). However, the Evanoff
SND proposal could potentially allow insolvent banks to continue in operation
for a long time. 10
Calomiris (1997 and 1999)
provides a thirdgeneration proposal that builds on the earlier proposals
by requiring monthly rollovers of SND that mature in two years but sets
a cap on the rate that a bank would be permitted to pay. As with previous
proposals, the focus is on direct discipline imposed in the issuance market.
Banks that are unable to issue SND at rates under the rate cap would be
required to shrink by approximately 1/24 per month for those months in
which they are unable to issue new SND. Calomiris's proposal is
intended to provide discipline that would start taking effect before the
bank was so distressed that it would be unable to issue new SND at any
promised interest rate. In practice, even a distressed bank is likely
to have some assets in its portfolio that it could liquidate to meet Calomiris's
requirements for a few months. However, most banks would not be able to
shrink 50 percent in one year, as his proposal would require in some circumstances.
Other possible weaknesses
of the Calomiris-type approach are that it requires banks to be in the
market very frequently to issue SND and that it allows SND levels to decline
at distressed banks. However, his recommendation that an SND proposal
incorporate the rate paid on the debt combined with Evanoff's suggestion
of integrating SND requirements into prompt corrective action suggests
another option for generating indirect discipline: The rates paid on SND
could be used to define capital adequacy for purposes of prompt corrective
action. For example, banks whose SND were issued or traded at Aaa
rates could reasonably be considered to be highly capitalized regardless
of their capital levels measured under existing regulatory requirements,
whereas banks trading at junk bond rates could be considered to be undercapitalized
(possibly severely or critically undercapitalized), again regardless of
their position under the existing regulatory capital ratios. This approach
provides the opportunity for progressively stricter supervisory action
as a bank's financial condition deteriorates, with the potential for beginning
supervisory discipline long before the bank becomes insolvent. Further,
if the SND trade in active secondary markets, then such a proposal would
permit almost continuous (indirect) market discipline.
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This is not
to say that a bank could issue SND regardless of its riskiness. The
supervisors could take action independent of the bank's ability
to issue SND. Further, at some sufficiently high promised rate, the
investors would refuse to buy a bank's SND reasoning that, if the
bank is willing to promise such high interest rates, it must be planning
on taking very high risks. Thus, even though the contract interest
rate would be very high, the expected return to holders of the debt
would likely be very low or negative.
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The proposal
would not prevent supervisors from closing insolvent banks. None of
these proposals precludes earlier intervention by the supervisors.
However, the benefit of SND from decreasing the probability of forbearance
is reduced to the extent that the proposals rely on supervisors to
close insolvent banks.
1. A Summary of Various
Subordinated Debt Proposals
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Generation
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Bibliographic citation
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Required cushion
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Debt characteristics
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Maturity
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Issuance
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1st
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Federal Deposit Insurance
Corporation (FDIC), ''Deposit Insurance in a Changing Environment:
A Study of the Current System of Deposit Insurance Pursuant to
Section 712 of the Garn-St Germain Depository Institutions Act
of 1982,'' A Report to Congress on Deposit Insurance, Washington,
D.C.: U.S. Government Printing Office, June 1983.
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Banks would be required
to maintain a minimum protective cushion to support deposits (say,
10 percent), which would be met by use of a combination of equity
and subordinated debt.
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Maturity selection
should take into consideration the desirability of frequent exposure
to market judgment. The total debt perhaps should mature serially
(say, one-third every two years).
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As banks grow, they
would be required to proportionately add to their ''capitalization.''
Those heavily dependent on debt, primarily the larger banks, would
have to go to the market frequently to expand their cushion and
to refinance maEagleTraders.comg issues.
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1st
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Benston, G., R.A.
Eisenbeis, P.M. Horvitz, E. Kane, and G.C. Kaufman, Perspectives
on Safe and Sound Banking, Cambridge, Mass.: MIT Press,
1986.
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A significant level
(say, 3 to 5 percent of deposits or a certain proportion of equity).
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Short maturity, but
long enough to prevent runs.
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Frequent.
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1st
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Horvitz, P.M., ''Subordinated
Debt Is Key to New Bank Capital Requirement,'' American Banker,
December 31, 1986.
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A minimum of 4 percent
of deposits.
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Not discussed.
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Not discussed.
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1st
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Litan, R.E., and
J. Rauch, American Finance for the 21st Century,
U.S. Treasury, U.S. Government Printing Office: November 17, 1997.
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A minimum of 1 to
2 percent of riskweighted assets.
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The subordinated
bonds would have maturities of at least one year.
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A fraction of the
subordinated debt outstanding would come due in each quarter.
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NOTE. FDICIA = Federal
Deposit Insurance Corporation Improvement Act of 1991.
SND = subordinated notes and debentures.
1. Continued
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Debt characteristics
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Covenants
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Rate cap
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Putable
debt
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Insolvency procedures
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Banks subject to
proposal
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Penalties would
be imposed on banks that fell below minimum levels. Provisions
that debt holders receive some equity interest and exercise
some management control, such as in the selection of members
of the board of directors, may be appropriate, as may convertibility
to common stock under certain provisions.
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None.
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Not discussed.
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FDIC assistance
might still be granted and serious disruption avoided in a manner
that would not benefit stockholders and subordinate creditors.
This aid could be accomplished by effecting a phantom merger
transaction with a newly chartered bank that has been capitalized
with FDIC financial assistance. The new bank would assume the
liabilities of the closed bank and purchase its high-quality
assets.
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Not discussed.
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Yes, to restrict
the ability of the banks to engage in risky activities.
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None.
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Small percentage
of the issue should be redeemed at the option of the holder.
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Prompt closure
when market value of equity is zero. To protect the FDIC, the
notes would have to allow for wide discretion by the FDIC in
arranging purchases and assumptions in cases of insolvency.
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Large banks would
be able to sell subordinated debt notes through the national
financial markets, small banks might be able to sell capital
notes over the counter to customers locally (or locally by other
means), but medium-size banks would be too large to sell sufficient
notes locally but not large enough to have access to national
markets.
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Not discussed.
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None.
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Not discussed.
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FDIC would choose
when to close the bank. Subordinated debt holders would provide
a margin of error in the determination of when a bank should
be closed and would reduce the loss to the FDIC.
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Not discussed.
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Not discussed.
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Not discussed.
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Not discussed.
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Not discussed.
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Subordinated
debt would be required only of banks in organizations above
a certain size (say, $10 billion in total assets).
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1. A Summary of Various Subordinated
Debt Proposals - Continued
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Generation
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Bibliographic citation
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Required cushion
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Debt characteristics
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Maturity
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Issuance
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1st
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The Bankers Roundtable,
Market-Based Incentive Regulation and Supervision:
A Paradigm for the Future, Washington, D.C., April
1998.
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A minimum of 2
percent of liabilities.
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Not discussed.
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Not discussed.
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2nd
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Keehn, S., Banking
on the Balance: Powers and the Safety Net: A Proposal,
mimeo, Chicago, Ill.: Federal Reserve Bank of Chicago, 1988.
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Ratio of a minimum
of 4 percent subordinated debt to risk assets along with a 4
percent equity requirement.
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The subordinated
bonds would have maturities of no less than five years.
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Issues would be
staggered to ensure that no more than 20 percent, and no less
than 10 percent, mature within any one year.
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2nd
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Cooper, K., and
D.R. Fraser, ''The Rising Cost of Bank Failures: A Proposed
Solution.'' Journal of Retail Banking, vol. 10 (fall
1988), pp. 5-12.
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A specified percentage
of deposits (say, 3 percent).
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The subordinate
putable notes would not be long-term but would be rolled over
at frequent intervals. These notes would be variable rate instruments
with rate adjustments and interest payments made frequently.
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Frequent.
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1. Continued
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Debt characteristics
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Covenants
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Rate cap
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Putable
debt
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Insolvency procedures
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Banks subject to
proposal
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Not discussed.
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Not discussed.
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Not discussed.
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Not discussed.
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Banks would have
the option of complying with either a Basel-type riskbased capital
standard or on approaches that rely on more market-based elements.
Those banks that (1) are ''adequately capitalized'' but not
subject to the leverage requirements under prompt corrective
action, or (2) determine appropriate capital levels using internal
management procedures would be required to issue subordinated
debt.
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Sanctions on bank
dividend policy, payment of management fees, deposit growth,
and deposit rates to be progressively increased as the bank's
performance deteriorated.
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None.
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Not discussed.
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Bank ownership
would be converted to the subordinated debt holders following
a judicial or regulatory determination of insolvency.
Creditors would be converted to common shareholders and would
have a prescribed period to recapitalize the bank or find an
acquirer; failing that, the bank would be liquidated.
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Small banks could
be allowed alternative means to meet the debt requirement.
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Convertible to
equity.
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Yes, bonds would
be putable at 95 percent of par value.
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The notes would
carry a ''put'' feature. They could be redeemed at the option
of the note holders at a fixed percent of par value (say, 95
percent). The subordinated put notes would be redeemable not
by the issuing bank but at the FDIC.
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When a put occurred,
the FDIC would be compensated for its payments on behalf of
the issuing bank with nonvoting equity shares of the bank. The
bank would have a prescribed period in which it could repurchase
these equity shares. If it did not do so by the end of the period,
revocation of the bank's charter would occur, and the FDIC would
deal with the insolvent bank.
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The put feature
of the proposed subordinated debt would create a viable market
for the instrument, no matter how small the issuing bank. If
not, these banks could receive assistance from the FDIC or Federal
Reserve in the placement of this debt with investors.
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1. A Summary of Various
Subordinated Debt Proposals - Continued
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Generation
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Bibliographic citation
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Required cushion
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Debt characteristics
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Maturity
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Issuance
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2nd
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Wall, L.D., ''A
Plan for Reducing Future Deposit Insurance Losses: Putable Subordinated
Debt,'' Economic Review, Federal Reserve Bank
of Atlanta (July/ August 1989), pp. 2-17.
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Par value of putable
subordinated debt greater than 4 to 5 percent of risk-weighted
assets.
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Bondholders would
be allowed to request redemption in cases in which such redemption
did not violate regulatory standards.
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At the bank level,
not the holding level.
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2nd
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Evanoff, D.D.,
''Preferred Sources of Market Discipline,'' Yale Journal
on Regulation, vol. 10 (1993), pp. 347-67.
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A significant proportion
of total capital would be held in subordinated debt. The 8 percent
minimum capital requirement could be restructured to require
a minimum of 4 percent equity and 4 percent subordinated debt.
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Short enough so
that the bank would have to go to the market on a regular basis,
but long enough to tie debt holders to the bank and make the
inability to run meaningful (e.g., five years).
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Staggered so that
banks would have to approach the market on a frequent basis
(e.g., semiannually).
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3rd
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Calomiris, C.W.,
The Postmodern Bank Safety Net: Lessons from
Developed and Developing Countries, Washington,
D.C.: American Enterprise Institute, 1997.
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2 percent of total
nonreserve assets or 2 percent of riskweighted assets.
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Not discussed.
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To roll over debt
and to accommodate growth in the bank's balance sheet.
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1. Continued
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Debt characteristics
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Covenants
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Rate cap
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Putable
debt
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Insolvency procedures
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Banks subject to
proposal
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Restrictions on
the percentage of putable debt that could be owned by insiders
individually and collectively.
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Not discussed.
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Yes. Bondholders
would be allowed to request redemption in cases in which such
redemption did not violate regulatory standards. With the exercise
of a put, a bank would have 90 days to meet the requirements
by issuing new debt or through reducing its subordinated debt
requirements-say, through the sale of assets.
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Any bank that could
not honor the redemption requests on its putable subordinated
debt at the end of 90 days without violating the regulatory
requirements would be deemed insolvent and would be closed.
If the proceeds of the sale or liquidation exceeded the total
of deposits, that excess would first be returned to the subordinated
debt holders; the remainder, if any, would be paid to equity
holders.
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Small banks, defined
as those with less than $2 billion in assets, would be exempted
because of the limited market they might face for subordinated
debt instruments. Those banks would have the option of
operating under the putable subordinated debt standard.
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Following the prompt
corrective action (PCA) provisions of FDICIA, sanctions on bank
dividend policy, payment of management fees, deposit growth,
and deposit rates to be progressively increased as the bank's
performance deteriorated. Implicit in the discussion seems
to be the incorporation of the SND requirements into PCA.
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None.
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A variant of the
proposal would require the bank to issue putable subordinated
debt. The bank would have 90 days to issue replacement debt.
If it could not do so, it would be taken over by the regulators.
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Once a bank's debt
capital fell below the required level, existing subordinated
debt holders would be given an equity position and would have
a prescribed period to recapitalize the bank or find an acquirer;
failing that, the bank would be liquidated.
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Suggests that a
few investment bankers had indicated some interest in establishing
mutual funds for the subordinated debt instruments issued by
small banks. Also, author's conversations with small bankers
suggested that they could raise this type of debt relatively
easily.
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''Insiders'' would
not be permitted to hold subordinated debt. Further, holders
of subordinated debt would have no direct or indirect interest
in the stock of the bank that issues the debt. Author
suggested that the ideal subordinated debt holders would be
unrelated foreign financial institutions.
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The subordinated
debt would earn a yield no greater than 50 basis points above
the riskless rate.
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Not discussed.
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Subordinated debt
holders must have their money at stake when a bank becomes insolvent.
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Yes.
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1. A Summary of Various
Subordinated Debt Proposals - Continued
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Generation
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Bibliographic citation
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Required cushion
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Debt characteristics
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Maturity
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Issuance
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3rd
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Calomiris, C.W.,
''Building an Incentive-Compatible Safety Net,'' Journal
of Banking and Finance, forthcoming. NOTE:
This plan is labeled ''A subordinated debt plan for a developing
country.'' (We understand from discussions with the author
that although a plan targeted at the United States would differ
in some important details [especially in terms of acceptable
investors], such a plan would generally work along the lines
of the developing country proposal.)
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Banks must ''maintain''
a minimum fraction (say, 2 percent) of their risky (non-Treasury
bill) assets in subordinated debt (sometimes called uninsured
deposits).
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Two years.
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1/24 of the issue
would mature each month.
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1. Continued
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Debt characteristics
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Covenants
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Rate cap
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Putable
debt
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Insolvency procedures
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Banks subject to
proposal
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Debt must be issued
to large domestic banks or foreign financial institutions. (See
the ''Banks subject to proposal'' column for details.)
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Rates would be
capped at the one-year Treasury bill rate plus a ''maximum spreadē
(say, 3 percent).
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Not discussed.
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Banks that could
not issue would be required to shrink their assets by 1/24 (4.17
percent) during the next month. If additional contraction is
required (because of prior growth), then the additional shrinkage
can be achieved over three months. (The author also discusses
measuring assets and subordinated debt using a three-month moving
average.) Presumably, this would result in the bank's liquidating
all of its assets over 24 to 27 months if it could no longer
issue SND.
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The plan would
apply to all banks. Debt issued by small banks (those that might
have difficulty accessing foreign banks and international finance
markets) could be held by large domestic or foreign banks. Debt
issued by large banks must be held by foreign financial institutions.
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Evidence
on the Potential Market-Discipline Effects of Subordinated Debt
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