Using Subordinated Debt as
an Instrument of Market Discipline
Frequency of Issuance
Besides requiring banks or bank holding companies to fund a portion of their assets with SND, one might require that institutions issue SND regularly. Regular issuance would force banks to pay a wider spread on at least a small additional portion of their liabilities if their risk profile had deteriorated since their last issue. Thus, more-regular issuance would bolster direct market discipline. More-regular issues would also impose indirect market discipline because yields on new issues reflect actual transaction prices rather than brokers' ''indicative'' prices, which likely provide a less-accurate measure of the market's view of a banking organization. Several market participants noted that new issues focused investors' attention on the issuer, thereby encouraging issuer disclosure, and thus the pricing on a new issue would likely reflect a more up-to-date evaluation of the borrower.
Requiring highly frequent issuance could, however, raise borrowing costs for reasons unrelated to risk-perhaps because issues would either have to be smaller or have shorter maturities than they would otherwise. For example, if the requirement were for banks to have SND outstanding equal to 2 percent of risk-weighted assets and issues had to be made twice a year, then each issue for a bank with risk-weighted assets of $100 billion, issuing standard ten-year noncallable subordinated debt, would be about $100 million. 59 Because $100 million would be a fairly small issue in the current market for bank SND, the debt would likely carry a higher yield than a larger issue would. It also would be less likely to trade actively in the secondary market, and so it would provide supervisors with less timely and precise information on secondary market spreads. In other words, indirect market discipline would be impaired.
Financial innovations could, of course, change these tradeoffs over time. For example, if investment banks began to issue collateralized bond obligations (CBOs) backed by smaller banks' subordinated debt, then smaller issue sizes might become cost-effective. Because secondary market price information for a particular bank would not be available from the secondary market price of the CBO, however, it is not clear that such an innovation would be desirable from a supervisory point of view. Indeed, such a development would likely require even more-frequent issuance so that prices in the primary market-when the debt was sold to the CBO-could be observed on a more timely basis. In essence, the decline in indirect market discipline caused by the CBO would need to be offset by an increase in direct discipline. More generally, that changes in financial markets and practices might affect SND markets in unforeseen ways suggests that the Federal Reserve and the other banking agencies would need to retain the flexibility to alter the terms of an SND requirement.
Another consideration is that strict requirements about the timing of SND issues could considerably raise the costs of SND without materially improving information gathering and market discipline. Market participants noted that an SND issue by one bank could cause a temporary fall in the price of other, similar banks' subordinated debt as the market absorbed the new issue. Restrictive rules on the timing of issuance could also force banks to sell SND when financial markets were temporarily unsettled. Also, as the previously discussed empirical results indicate, there is useful information in a bank's or bank holding company's voluntary decision to issue (or not to issue) SND. Thus, it would seem desirable for an SND policy that required a minimum frequency of issuance to set the minimum low enough so that institutions would also have a realistic opportunity to issue voluntarily. In this way, some market information could continue to be provided by the pattern of voluntary issues.