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

Could an SND Policy Be Expected to Improve Market Discipline?

As discussed earlier, direct discipline is exerted through a risk-sensitive debt instrument when a banking organization's expected cost of issuing the instrument increases with its risk profile. This form of market discipline may induce the bank to lower its riskiness and even not to issue SND when the expected cost is relatively high. In contrast, indirect market discipline is exerted through a debt instrument when private parties and possibly government supervisors monitor secondary market prices of the instrument to determine the risk exposure (or default probability) of the banking organization. Although direct discipline generally operates through the SND issuance market and indirect discipline operates through the secondary market, indirect discipline could be enhanced by SND issuance if such issuance affected the information that is contained in secondary market SND spreads.

Overall, there is fairly strong evidence that market discipline, both direct and indirect, is exerted on banking organizations that issue SND. The extent to which direct market discipline is imposed on banking organizations appears to depend on (1) whether SND market participants perceive that there are government guarantees and (2) what banking market conditions are. The larger the perceived guarantee, the smaller the amount of direct SND market discipline that is exerted. Thus, for an SND policy to enhance direct market discipline, bondholders would have to believe that they would not be bailed out when the bank became insolvent or financially distressed. During periods of financial difficulty, the SND market appears to impose rather strong direct discipline on banks: The evidence indicates that in such periods some of the riskier banking organizations do not issue SND. Therefore, an SND policy with mandatory issuance would likely impose greater market discipline on riskier banking organizations during periods of financial stress, when such discipline would presumably be most beneficial.  In more quiescent periods, SND spreads over comparable Treasuries may be less reflective of banking organization risk (that is, direct market discipline appears to be weaker), but nonetheless, some direct market discipline still seems to be imposed on the relatively risky banking organizations. 43

With respect to indirect market discipline, academic studies that use readily available historical time-series information on SND secondary market spreads found that it would have been useful after 1988 for private parties to have monitored such information to assess the relative riskiness of banking organizations. 44 Given this finding, it is not surprising that, in many cases, study group interviewees indicated that market participants monitor SND spreads for peer groups of banks. Indeed, some of these participants indicated that they viewed relative changes in SND spreads as the most important signal of a change in the perceived credit quality of a banking organization. SND market participants also suggested that different information was contained in SND spreads than was contained in stock price movements. Therefore, an SND policy that would make information on SND secondary prices less costly to obtain would likely increase the extent of indirect market discipline provided by the SND market. 45

The evidence also supports the view that an SND policy that requires regular issuance would enhance indirect market discipline. SND market participants interviewed by the study group claimed that substantially more information is revealed to the SND market at issuance. Therefore, issuance appears to compel disclosure to the market of information about a banking organization's current condition and prospects, and such disclosure would refresh secondary market prices and enhance indirect market discipline. This observation, together with the finding that some riskier banking organizations choose not to issue during periods of financial strain, implies that an SND policy that would require banking organizations to issue SND in shorter time intervals would improve the information content of SND spreads and therefore presumably increase their use by private parties that monitor the condition of banking organizations.

Also important is whether supervisors could use SND market information to monitor the condition or perceived credit quality of a banking organization.  Empirical evidence suggests that assessments about a banking organization's risks are reflected in its supervisory opinions, its decision to issue SND, and its secondary market SND spreads over comparable Treasuries. Supervisory opinions are refreshed by conducting bank examinations. Market assessments are refreshed by new issuances that compel disclosure to the market about an organization's current condition and prospects or by other events that provide information to the market. Therefore, if bank examinations and new SND issues occur at different times, then these assessments likely reflect different information about a banking organization's risks.  Further, markets probably would focus on different aspects of a banking organization than would supervisors.  The few empirical studies that consider whether market assessments about banking organization risks would be valuable information to supervisors, although simplistic in their measurement of supervisory opinions, suggest that such assessments would be useful supervisory tools, despite the fact that existing studies do not consider whether market information had been refreshed by new issuance.  On the whole, it seems likely that information contained in the SND market would supplement supervisory assessments of banking organizations.

In sum, academic studies, SND market participant interviews, and research undertaken by study group members suggest fairly strongly that an SND policy would be likely to improve both direct and indirect market discipline on the institutions subject to the policy. The next section considers a number of key design features of an SND policy likely to affect the expected improvement in direct and indirect market discipline.

  1. Studies of secondary market SND spreads during the mid-1990s have found these spreads to be risk-sensitive. Because issuance prices are likely to be correlated with secondary prices, direct market discipline was probably imposed during this period.

  2. In many cases, the authors adjusted the secondary market spreads over comparable Treasury securities for non-credit-related factors that affect bond yields. The most important of such adjustments is for the value of call options, which can be embedded in many of the bank SNDs. See Flannery and Sorescu (1996).

  3. SND market participants that monitor prices daily said that they feel calling at least five dealers for their quotes is necessary (see appendix B). Interestingly, in the interviews conducted by study group members, SND market participants did not indicate that a lack of standardization across SND instruments made it difficult to compare the credit quality of banking organizations within a peer group.

Analysis of the Key Characteristics of a Subordinated Debt Policy