Using Subordinated Debt as
an Instrument of Market Discipline
The Argentine Experience with Mandatory Bank SND
Argentina appears to be the only country that has required banks to issue subordinated debt. Because the rule has just begun to be implemented, only limited lessons can be drawn from the Argentine experiment at present, but greater perspective ought to be possible in the foreseeable future because the government appears to be firmly committed to continuing with the policy. The market discipline that subordinated debt is intended to elicit is viewed by the Argentine central bank as a complement to supervision rather than as a substitute.
In late 1996, Argentina announced, as part of a five-point regulatory initiative, that banks would be required to carry liabilities in the form of subordinated debt in an amount equaling at least 2 percent of deposits. The other components included enhanced supervisory powers; a measure for financial accountability (that is, risking their own money) on the part of external auditors; a requirement that all banks obtain a credit rating; and efforts to increase the public availability of information about individual banks, including fairly detailed monthly accounting information that is now accessible through the central bank's web site. Because deposit insurance is capped at a fairly low level per account holder (10,000 pesos on short-term deposits and 20,000 pesos on time deposits over ninety days), better information about a bank's condition might induce further market discipline from depositors.
The subordinated debt rule had originally been scheduled to take full effect at the beginning of 1998, but enforcement was delayed until July 1998 because the Argentine central bank decided that persistently high domestic interest rates associated with apparent spillover from the Asian financial crisis had made timely compliance too costly. However, by late 1998, most privately owned banks had satisfied the requirement. The exceptions were approximately twenty of the smaller banks, collectively accounting for only about 1 or 2 percent of Argentine banking assets, which were permitted further extensions.
The subordinated debt, which must have a maturity of at least two years, may take one of three forms. First, a bank may issue bonds that are registered for public trading. A number of the larger banks had tradable debt securities outstanding before the policy was announced, in both the euro market and the domestic bond market. Second, a bank may accept an uninsured deposit from a foreign bank that has a credit rating of at least A. Such a deposit would be more likely to be forthcoming from the foreign entity when the two banks are otherwise affiliated. Slightly more than half of Argentine banking assets are held by subsidiaries or branches of foreign banks. Some of the smaller, domestically owned banks had been expected to make use of the third alternative, by which they take a deposit from another domestic bank that has otherwise satisfied the requirement. It is not clear whether any banks have used this route to compliance.
In evaluating the Argentine situation, one should keep in mind that about 30 percent of bank assets are held by banks controlled by the national or provincial governments, which may not be subject to central bank regulation in any meaningful way. The industry has become highly concentrated as well, with the ten largest private banks, which are mostly foreign branches or subsidiaries, holding 40 percent of system assets and the two largest government banks holding another 20 percent. Although a majority (by number) of Argentina's 120-odd banks are domestically owned and privatesector, these account for less than 20 percent of bank assets. At the end of 1998, the median Argentine bank held assets of about $250 million, and a quarter of the banks had $50 million or less. Many of these smaller banks may disappear as industry consolidation continues. Only ten banks are traded on the Buenos Aires stock exchange.
About twenty of the banks in Argentina have become first-time issuers of publicly traded bonds since the subordinated debt requirement was announced. Most of these bonds were issued in the domestic bond market, with maturities typically between two and six years, and are denominated in dollars rather than in Argentine pesos.1 Generally, they were placed at yields to maturity at least 100 basis point higher than where BB-rated dollar bonds of the Republic of Argentina were then trading, suggesting that investors were not regarding these bank obligations as sovereign-backed. Nevertheless, the issue yields may include a premium to compensate buyers for liquidity. Many of the bonds have less than $10 million in face value outstanding (still enough to cover 2 percent of the deposit base of all but the twenty-five largest banks in Argentina), and they do not appear to be heavily traded. However, on March 30, 1999, Bloomberg L.P. had bond prices for fourteen Argentine banks-four banks that had issued securities only in domestic markets and ten more that are large enough to sell debt in international markets.
The lack of secondary market prices for the other banks limits the extent to which the central bank can rely on external warning signals that supervisory action may be needed. This shortcoming is exacerbated somewhat by the minimum debt maturity of two years, which reduces the frequency at which banks are subject to primary market discipline. The minimum maturity was motivated by the notion that investors would convey a stronger signal about a bank by committing funds for a longer period-thus, it meant stiffer discipline imposed less often. A compromise would have been to require staggered two-year issues at, say, a quarterly frequency, but this alternative might entail prohibitively higher costs for the typical Argentine bank.
Discipline will be forthcoming from the subordinated debt market, of course, only if investors believe that their money is at risk. A closely related question-whether bank SND in Argentina are fully at risk-has already been tested once, by the failure in late 1998 of Banco Mayo, Argentina's twenty-ninth largest bank, a credit cooperative with about $1 billion in total assets. The answer to that question thus appears to be ''yes.'' Banco Mayo had been in compliance with the subordinated debt requirement, with two euro medium-term notes outstanding, as well as a sinking floater that was listed in Buenos Aires, with the three instruments having an aggregate face value of $124 million. The bank had received emergency lending from the Argentine central bank and the deposit insurance fund in the midst of a run on deposits during the third quarter. In October, Banco Mayo's operations were suspended, and its deposit liabilities and about half of its branches were assumed by Citibank in an agreement reached with the Argentine central bank in November. The remaining assets of Banco Mayo were to be liquidated, with Citibank to receive the first 400 million pesos in proceeds, and the loans from the Argentine central bank (328 million pesos) and from the deposit insurance fund to be repaid ahead of other creditors' claims. Thus, bondholders stand to lose unless the bank turns out, ex post, to have been solvent, and bond creditors may well lose their entire stake.
NOTE. John Ammer, Economist, Division of International Finance, Board of Governors of the Federal Reserve System, Washington, D.C., prepared this appendix. The author thanks Jennifer Crystal for helpful conversations. Opinions expressed herein should not be construed to represent those of the Board of Governors or any other employees of the Federal Reserve System.