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

Why Subordinated Debt?

In such a complex and changing environment, one way to encourage safety and soundness is to enhance the ''market discipline'' imposed on banking organizations.  In this study, we distinguish between direct and indirect market discipline. Direct market discipline is exerted through a risk-sensitive debt instrument when a banking organization's expected cost of issuing that instrument increases substantially with an increase in the organization's risk profile. For such discipline to occur, investors must gather and collect information about the banking organization's risks and prospects and then incorporate that information into the decisions to buy and sell the organization's debt. The anticipation of higher funding costs provides an incentive ex ante for the banking organization to refrain from augmenting its risk.²

Indirect market discipline is exerted through a risk-sensitive debt instrument when private parties and possibly government supervisors monitor secondary market prices of that instrument to assist in determining the risk exposure (or default probability) of the banking organization. In response to a perceived increase in bank risk, such parties could then take various actions that increase the cost of the bank's operations. For example, private parties could increase the banking organization's cost of funds, limit its supply of credit, or reduce its ability to engage in certain types of contracts, such as counterparty positions on derivative contracts, long-term commitments, or syndication agreements. Government supervisors could conduct examinations, limit a bank's activities, or raise capital requirements. The anticipation of these types of penalties, from either private parties or government supervisors, provides banking organizations with additional incentives to refrain from augmenting their risk.

Direct and indirect market discipline could, at least in principle, complement supervisory discipline and provide some advantages over it. Advantages of market discipline include (1) the aggregation of information from numerous market participants, (2) a clear focus on the goals of reducing failures or losses, and (3) the ability to shift the burden of proof from supervisors, who need to show that a bank is unsafe, to bank managers, who need to demonstrate to the market that their banking organization is not excessively risky. Market information could also be used to allocate scarce supervisory resources: Secondary prices on risk-sensitive debt instruments could be considered in establishing CAMELS and BOPEC ratings, in setting deposit insurance premiums, in triggering prompt corrective action, and in deciding when an on-site examination or supervisory action is warranted. ³

Although direct and indirect market discipline may be imposed on banks whenever they choose to issue risk-sensitive debt instruments, a policy that requires regular issuance of homogeneous instruments would, in principle, enhance both types of market discipline.  Required issuance ensures that a banking organization incurs a higher cost of funds if it chooses to increase its risk, an outcome that enhances direct market discipline. Further, issuance compels disclosure to the market about the firm's current condition and prospects, which refreshes secondary market prices and thereby enhances indirect market discipline.  A policy that requires relatively homogeneous debt instruments across banking organizations further augments indirect discipline by facilitating market and supervisory interpretations of the signals about banking organization risk contained in secondary market prices.

SND are clearly not the only bank liability capable of providing market discipline. Indeed, a considerable economic literature, summarized in the beginning of section 2, indicates that holders of uninsured certificates of deposit (CDs) and other uninsured liabilities impose market discipline on banks. This econometric result is, in addition, consistent with supervisory experience. However, SND issues have several characteristics that make them particularly attractive for providing increased market discipline.

For the price of a bank debt instrument to be risk-sensitive, investors must perceive that they will not be bailed out by the government should the banking organization fail. Among bank liabilities, SND are uninsured and among the first (after equity) to lose value in the event of bank failure. SND holders likely view a bailout in the event of bank failure as highly improbable. Depositor preference laws reinforce this view. Hence, the issuance price of SND should be particularly sensitive to the risks of a banking organization, making SND an especially strong instrument of direct market discipline. ⁴ Further, SND holders would have a greater incentive to demand disclosure of the banking organization's risk than would other bank liability holders.⁵ The subordinated status of SND relative to other liabilities (especially deposits) provides another important benefit-SND that are issued in place of insured deposits are an extra ''cushion'' for the Federal Deposit Insurance Corporation (FDIC) in the event of bank failure.

Another important characteristic of SND is the incentive that their holders have to monitor risk.  Investors in SND are exposed to loss, but they do not benefit from any upside gains that accrue to excessive risk-taking. Thus, the incentive of SND investors to monitor and limit bank risk-taking is similar to that of bank supervisors and in stark contrast to that of equity holders. Equity holders, while exposed to loss, can also reap gains from risk and thus have a much stronger preference for risk than SND investors have. ⁶ Indeed, standard optionpricing theory suggests that, all else being equal, the value of equity increases with the risk of a banking organization's assets.

A final advantage of SND is their relatively long maturity. Thus, while SND have the potential to provide effective market discipline, SND investors are not able to ''run,'' possibly mitigating a systemic risk situation. The long maturity also magnifies the risk sensitivity of SND investors.

A policy that would require regular issuance of fairly homogeneous SND might also impose little regulatory burden on large banking organizations.  As discussed below, the market for SND appears to be well established (that is, many large banking organizations currently issue SND frequently), and the maturity and option characteristics of recent issues do not differ markedly across banking organizations.  Therefore, an SND policy that is based on current market conventions may not impose a substantial regulatory burden.

The benefits of enhancing market discipline do not come without potential costs. First, although SND holders cannot run, market discipline provided by SND may encourage ''deposit runs'' with potential systemic risk implications. For example, if uninsured creditors (such as uninsured depositors and sellers of federal funds) witness a dramatic decrease in the secondary market price of a banking organization's SND, then they may withdraw their funds. Such actions would increase the liquidity pressure on the banking organization and could bring about or hasten bank insolvency. If a very large bank were to fail, or more generally if there were a period of financial crisis, some instability in the SND market could arise, and other (safely managed) banking organizations could potentially be affected.

Second, when a banking organization is experiencing difficulty, or in a time of financial stress, bank equity has an advantage over SND in that dividends on common stock do not have to be paid. Although it is unlikely that the interest expenditure on SND would cause a bank to fail, in some instances such expenditures would limit the ability of a banking organization to build capital through retained earnings.  For these reasons, supervisors have the right to suspend interest payments on SND as part of the policy for prompt corrective action.

Third, enhancing market discipline through mandatory issuance of SND could increase a banking organization's moral hazard incentive to augment its risk (at the expense of the SND debt holders) following shocks to the organization's condition. This moral hazard incentive always exists after an organization issues debt, and it increases with the spread on the debt. ⁷ Therefore, if a shock increases the required spread of an organization's SND by a sizable amount, then mandatory issuance might increase its moral hazard incentive. ⁸

Finally, a cost of all forms of market discipline is that they reduce the flexibility of supervisors and may force the supervisor's hand. The limit on forebearance is one reason to use market discipline. But policymakers should recognize that at times it may at least seem that reduced flexibility is a significant problem. Indeed, all of these potential costs highlight the importance of supervisory discretion in the implementation of any policy designed to enhance market discipline. They do not, however, narrow the set of risk-sensitive debt instruments that might be viable candidates for such a policy.

In sum, although any policy designed to enhance market discipline would have some potential costs, an SND policy appears, at least in theory, to be viable and effective. SND have a number of advantages over other instruments that could be used.  The advantages generally derive from their very junior status and long maturity. Moreover, the current, relatively frequent issuance of homogeneous SND instruments suggests that a policy based on SND issuance would likely impose minimal regulatory burden on banking organizations.

2. These higher funding costs are imposed over the entire life of the debt.

3. The federal banking agencies summarize the composite financial condition of banks and bank holding companies according to the CAMELS and BOPEC scales respectively. Each letter in the CAMELS stands for a key element of bank financial condition-capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risks. Similarly, the components of BOPEC stand for bank subsidiaries, other (nonbank) subsidiaries, the parent company, consolidated earnings, and consolidated holding company capital adequacy.
   
   For supervisors to benefit from using market data, the market does not need to be generally more informed than supervisors about the banking organization's risks and prospects. Rather, it is necessary only that the market and supervisors respond to different information. If such is the case, supervisors may expand their information about a banking organization's risks and prospects by incorporating information contained in secondary markets.

4. Early in its deliberations, the study group sought to identify hybrid capital instruments (for example, preferred stock and trust preferred stock) that could substitute for SND. Preferred stock seemed like the most attractive candidate. However, study group interviews with market participants indicated that preferred stock was not as homogeneous and liquid as SND. For a discussion of this point, see appendix B.

5. One reason that current disclosures may be inadequate is that the federal safety net, including the ''certification of soundness'' provided by federal supervision of banks and bank holding companies, leads market participants to demand less disclosure than they would in the absence of the safety net.

6. An important caveat is that, as a bank approaches insolvency, the risk preferences of SND holders become more like those of stockholders. The reason for this development is that, if a bank becomes insolvent, the only way that SND investors will be paid in full, or possibly at all, is for the bank to save itself by winning a large and risky bet. Thus, SND are probably best thought of as providing ''supervisor-compatible'' market discipline only on banks that are clearly going concerns.

7. Suppose that a bank has had a negative shock that has depleted its capital. Suppose further that this shock has also raised the cost of issuing the bank's risk-sensitive debt. A safer banking organization that has issued debt at the higher cost has a higher probability of actually having to pay the higher cost than does a riskier bank. This fact implies that riskier organizations have a relatively lower expected cost of debt payment, and this benefit increases with the interest rate on the debt issued.

8. This augmented incentive to increase risk occurs only at the margin. Banks may still choose to refrain from increasing their risks to avoid even more direct market discipline.

SND Proposals