Using Subordinated Debt as
an Instrument of Market Discipline
Views of Market Participants
Early in the design of its work plan, the study group identified as critical the development of a thorough understanding of the existing market for bank and bank holding company SND. Such understanding was acquired through reviewing the existing literature, tapping the expertise of supervisory staff, developing original empirical work, and conducting many interviews with market participants. A detailed summary of these interviews is provided in appendix B, and this appendix is frequently referred to in the text of the study. This subsection summarizes the study group's judgment of the way interviewees saw the potential for SND to exert market discipline.
The typical U.S. bank or, more commonly, holding company SND instrument issued today is a fixedrate, noncallable, ten-year maturity bond with few bells and whistles. Banking organizations usually swap the interest payments on these fixed-rate bonds for floating-rate payments tied to libor to better match the flows of interest on their assets. The relative homogeneity of the SND instrument makes comparisons of prices in the bank and bank holding company SND market relatively straightforward and is an important, indeed perhaps the single most critical, reason for the depth and efficiency of the market. The overwhelming impression given by interviewees is that the market for the SND of the largest banks and bank holding companies is, in the context of corporate bond markets, quite liquid, to the point that it provides a useful vehicle for trading and hedging. 25
Market participants generally felt that, subject to a number of important caveats, existing market prices of SND reflect risk differences across firms. 26 Indeed, SND spreads (over comparable-maturity Treasuries or the swapped libor rate) appear to be followed closely, sometimes daily, by market participants. Because changes in spreads tend to be positively correlated across banks and bank holding companies, changes in an institution's relative position within its peer group of institutions is viewed by some as the most important signal of a change in the perceived credit quality of an institution. While SND and equity prices were viewed as normally tending to move together, SND price movements were generally deemed to have value added relative to stock price movements.
Having said this, all interviewees felt that spreads need to be interpreted with great care. For example, the general level of spreads is quite sensitive to cyclical fluctuations. In good times, spreads tend to be rather narrow, reflecting the view that all banks and bank holding companies are in good shape. In bad times, spreads balloon, reflecting broad skepticism regarding the financial health of banking institutions. Indeed, the August-October 1998 market turmoil was widely considered a prime example of what market stress can do to spreads. Interviewees also tended to feel that daily fluctuations in spreads were overly sensitive to news and rumors. Particularly troublesome were so-called technical factors, which include idiosyncracies such as news or rumors about mergers and supply shortages or surpluses in particular issues or maturities.
Secondary market prices were viewed as being quite efficient, at least in normal times, and as tending to reveal changes in market sentiment ahead of rating agency actions. 27 New issue prices were thought to have significant value added. New issues were seen as focusing investors' attention on the financial condition of a firm and as requiring a firm to disclose its most recent and complete information. Moreover, new issue prices reflect actual transactions, not hypothetical (for example, model-based) prices that have been posted by a market-making firm.
These evaluations by market participants are consistent with the view that SND have the potential to impose both direct and indirect market discipline on issuing institutions, and that indeed they do so today. As discussed in section 1, direct discipline is exerted if issue prices are sensitive to risk, a condition that market participants clearly believe to hold. Moreover, a number of interviewees argued that new issuance particularly encourages new disclosure. Indirect (and to some extent direct) discipline can be exerted if secondary market prices are sensitive to risk changes, and this condition was also supported by study group interviewees. However, interviewees argued that prices can be subject to a fair amount of noise, particularly on a daily basis, and can be quite misleading in times of systemwide financial distress. Thus, interpretation of SND price movements would have to be done with much care and might require considerable practical experience before being done with an acceptable degree of reliability.