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

A Transition Period

How a transition period might work depends upon the specific details of the SND policy. For example, somewhat different approaches would be appropriate depending on whether the SND policy required ''qualifying'' subordinated debt to be issued at the bank level or at the holding company level or if all subordinated debt would qualify wherever issued.  Related issues are which asset or other measure to use as a base for the minimum subordinated debt requirement and the size of the minimum requirement.  The universe of institutions that would be covered by an SND rule would also have a significant effect on transition and grandfathering issues.  Each of these factors could determine whether an institution would be in immediate compliance with the mandated minimum and, if not, how long a period would reasonably be needed to allow institutions to comply with the rules.

If the SND policy required that qualifying subordinated debt be issued at the bank level, existing SND that were issued by bank holding companies would generally need to be replaced by bank-level SND as the holding company debt matured or was redeemed. If, under this scenario, policymakers did not wish to require the consolidated banking organizations that now issue sufficient SND to issue more SND than is currently outstanding, a rather long transition period would be necessary. Given that the existing SND in the marketplace are typically noncallable with an original maturity of ten years, banking organizations could need as much as ten years to substitute bank SND for existing BHC SND. 60 Even with such a long transition period, both direct and indirect market discipline would be imposed on the bank with the first (and each subsequent) bank issue. Additional market discipline would be provided by any new bank SND that were issued because of bank growth. If the SND requirement were imposed at the BHC level, virtually no transition period would be needed unless the minimum requirement exceeded current levels of outstanding BHC SND.

With regard to grandfathering, costs to banking organizations that currently issue SND would be minimized if existing SND that currently qualify as tier 2 capital, whether issued at the bank or BHC level, including SND that did not specifically conform to any structural requirements that might be imposed by the policy, were allowed to count as qualifying SND during their remaining life.  However, if the final policy required subordinated debt to be issued at the bank level, SND issued by the holding company after implementation of the rule (that is, during or after the transition period) should not count as qualifying subordinated debt.

  1. An amortization rule on the SND that qualify for the mandatory SND requirement (like the amortization rule currently imposed on SND qualifying as tier 2 capital) could shorten this transition period by a couple of years.

How should the requirements be enforced and SND information used?