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

What Amount of SND Should Be Required?

Existing proposals for mandatory SND vary considerably with respect to the amount that should be required. When proponents view SND as a supplement to existing capital regulations, or when a cap on the rate that banks can pay on their SND is proposed, the minimum percentage is typically in the range of 2 percent to 3 percent of riskweighted assets. Calomiris (forthcoming), for example, would require banks to issue at least 2 percent of risk-weighted assets in the particular form of SND that he proposes. When authors view SND as a substitute for equity or regulatory capital, the minimum percentage required is typically boosted to the 4 percent to 5 percent range.

None of the existing SND proposals attempt to derive the appropriate amount of SND from an optimizing model of, say, the desired level of bank safety and soundness. Indeed, when stated this way, the task seems problematic at best. Also, because under the Basel Accord a limited amount of SND is considered part of tier 2 capital, the issue of how much SND a bank should issue is inevitably part of the broader question of how much capital a bank should maintain.51 The answer to this question is highly complex, as we know from the ongoing work both domestically and internationally relating to revising the Basel Accord. Indeed, some observers may question whether bank safety and soundness would be improved if an SND policy encouraged banks to substitute SND for common stock.

A lower bound on an SND requirement is the amount of SND needed to provide a liquid and efficient market in an institution's SND. But this question is also complicated, and the answer is unclear. The answer depends primarily upon the minimum efficient size of an offering (currently around $150 million and apparently rising), the size of the bank or bank holding company, and the required frequency of issuance. The larger the bank, the smaller the required percentage of, say, riskweighted assets can be for the purpose of establishing a liquid and efficient market. More-frequent issuance may also allow the minimum percentage to be smaller for a given size of banking organization because the greater disclosure required by issuance means that the market is more likely to have the information it needs to assess a firm's financial condition. All that can be said with certainty is that the current level of SND outstanding at the very largest bank holding companies, in most cases from 1.7 percent to 4.0 percent of risk-weighted assets, has been sufficient to provide a liquid and efficient market for the SND of these firms.

In light of these considerations, the study group has not attempted to develop an optimizing model of the amount of SND a bank should be required to hold under an SND policy. Rather, we have considered the more straightforward issue of whether an SND minimum should deviate substantially from the existing Basel Accord guidelines.

As indicated, the Basel Accord limits the amount of SND that qualifies as tier 2 capital to 50 percent of a bank's or a BHC's tier 1 capital. Thus, a bank or BHC with tier 1 capital equal to 4 percent of risk-weighted assets could include SND in tier 2 capital in an amount up to 2 percent of its riskweighted assets. Moreover, because currently virtually all U.S. banks are considerably above the wellcapitalized minimum of a 6 percent tier 1 ratio, for such firms the maximum allowed ratio for SND is 3 percent or more. 52

If an SND policy sought to stay within the context of current market conventions, then setting the SND minimum close to the current Basel Accord maximum standards would have considerable appeal.  From this point of view, a required minimum ratio of 2 percent or 3 percent of risk-weighted assets is probably reasonable. Such amounts are within the current outstandings for forty-eight of the top fifty bank holding companies that had SND outstanding at the end of 1998 (see the ''top 50'' column of the bottom panel of table 5, which gives the equally weighted and weighted [by risk-weighted assets] averages of SND to risk-weighted assets, respectively, for those bank holding companies that issued SND). As of the end of 1998, the average ratio was 2.5 percent, and the weighted average ratio was 2.9 percent. Moreover, these ratios had been rather stable since 1995.

However, once again a more disaggregated analysis of the 1998 data suggests a more complex story and further supports the view that an SND policy should probably be focused, at least initially, on the very largest organizations. As shown in the SND/RWA column of table 7, at the end of 1998, fifteen of the top twenty bank holding companies had a ratio of SND to risk-weighted assets greater than or equal to 2.5 percent, but only five of the next thirty bank holding companies had ratios this high.  Indeed, eighteeen of the next thirty bank holding companies had ratios below 2 percent. In addition, as may be seen in the tier 1/RWA column of the table, all of the top fifty bank holding companies had tier 1 ratios over 6 percent.

The implications of a 2 percent to 3 percent standard for banks are more uncertain. On the one hand, the data in table 4 indicate that, as of the end of 1998, the top fifty banks that issued SND had outstandings slightly in excess of 2 percent of their risk-weighted assets. On the other hand, and as indicated earlier, most bank SND, even those of the major banks, appear to be held by the holding company parent and not traded. Thus, a requirement that banks issue tradable SND, even if it were limited to only the very largest banks, would likely cause some disruption in current market arrangements.  It seems reasonable to assume, however, that an appropriate phase-in period could reduce any problems to minimal proportions (see the later discussion in the section regarding a transition peiod).

From the point of view of the effectiveness of market discipline, a 2 percent to 3 percent requirement would, at least for the largest banks, likely be sufficient to provide a clear signal regarding the market's evaluation of a bank's financial condition. Indeed, there is substantial evidence that this is currently the case for the SND of the largest bank holding companies. Thus, indirect market discipline would almost surely be enhanced at the largest banks. With respect to direct discipline, 2 percent or 3 percent of a bank's risk-weighted assets is clearly a small portion of its total portfolio, and thus the direct effect on a bank's average cost of funds and the resulting direct market discipline could be small. However, the arguments and evidence presented in sections 1 and 2 suggest that a 2 percent or 3 percent requirement may well exert substantial direct market discipline, especially if the policy includes a minimum frequency of issuance. Moreover, raising the minimum amount of SND to a level high enough to significantly and directly affect the bank's average cost of funds would likely require levels of SND substantially above those that exist today. The competitive implications of such an increase and other key aspects of the way the market would react to such an increase in the supply of bank SND are unknown.

  1. Under the Basel Accord, the amount of SND that may be included in tier 2 capital is limited to a maximum of 50 percent of the issuing bank's or BHC's tier 1 capital. For more on this point, see appendix E.

  2. The ''well-capitalized'' minimum tier 1 ratio was defined in the implementation of prompt corrective action.

What characteristics should the required SND have?