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

1.  Why a Subordinated Debt Policy?

The banking industry is undergoing profound changes, many of which tend to make the supervisor's job of protecting bank safety and soundness increasingly difficult. For example, the abolition of constraints on interstate banking has helped lead to the creation of a growing number of very large and geographically diverse banking organizations. In addition, the traditional barriers separating the financial system into different industries are breaking down as technological advances and the relaxation of legal and regulatory barriers permit firms in previously separate industries to provide a greater variety of financial services. The increasing consolidation of bank and nonbank activities, especially in ever-larger banking organizations, has further complicated bank supervision and regulation. Moreover, the expansion of nonbank firms is reducing bank supervisors' margin of error when imposing costly regulations: If bank regulators impose unnecessarily costly regulations on a particular activity, then that activity will likely shift out of the banking organization and into nonbank firms. Overlaying these trends is the fact that banks are using innovations in information processing and financial technology to create new tools for measuring, taking, and controlling risks. These new tools often greatly increase the complexity of assessing a bank's financial condition. They are also allowing banks to more effectively arbitrage differences between the risk measures used by regulators, such as those for risk-based capital, and the true riskiness of the organization.

Why subordinated debt?