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

How Should the Requirements Be Enforced and SND Information Used?

Examination and Surveillance Procedures
Data Requirements

Examination and Surveillance Procedures

A mandatory SND policy could be monitored and enforced as part of the normal examination, inspection, and overall supervisory process. As discussed in section 2, a significant source of uncertainty about a mandatory SND policy is whether it would provide new information to bank supervisors. If new and valuable information were in fact provided, examiners might be able to use that information as a factor influencing the scope of exams and special supervisory reviews. For example, if the market signal-perhaps a sharp drop in the secondary market price of a bank's SND relative to that of the bank's peers or a disruption in the bank's normal SND issuance pattern-suggested that the market perceived major problems with an institution's financial condition or market position that supervisors had not already observed, an examination or less-formal supervisory inquiry could be scheduled to evaluate the market's perception. Examiners could perhaps decide upon the breadth and depth of the examination based, in part, on their perceptions of the seriousness of the market's reactions.

More generally, information from the SND market could perhaps be used to help focus scheduled examinations or other supervisory activities. For example, if the market demand and pricing for a bank's SND were strong, examiners could possibly use this information as a factor in deciding to defer or to limit the scope of an examination. Another possibility would be for supervisors to consider SND issuance decisions and spreads as factors in assessing the amount of capital over the minimum Basel capital standards that banking organizations would be expected to hold. In a similar vein, examiners could take account of the market signals provided by SND when setting banks' CAMELS ratings and bank holding companies' BOPEC ratings. Positive or negative signals from the SND market could, for example, be explicitly used as arguments for giving a higher or lower CAMELS or BOPEC score. Such considerations could be particularly useful for institutions falling on the borderline between ratings under the BOPEC or CAMELS systems. If successful, such practices could help improve the efficiency and lower the cost of supervisory activities for all parties.

Data Requirements

Decisions regarding the potential for SND data to aid in the bank examination, surveillance, and overall supervisory process would require the collection and analysis of appropriate data. Existing data, although useful for research, would need to be augmented.  Existing research, new research conducted by the study group, and study group interviews with market participants suggested several specific useful items: transaction prices and yield spreads (both at issue and in the secondary market), bid-ask spreads, libor swap rates, and issuance history. A number of market participants suggested that the collection of such data would not be difficult for the Federal Reserve. Apparently a growing number of vendors are attempting to provide some of the needed information, and the major dealers in bank and bank holding company SND would probably be willing to provide data that could not be acquired from vendors.

Once a data collection process were in place, acquiring time series that could be analyzed and conducting the research would take some time. In this regard, historical time series going back to the implementation of FDICIA would be highly desirable.

The relation among SND policy, increased disclosure, and an improved Basel Accord