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

Implications for Direct and Indirect Market Discipline

Our analysis of the SND issuance decision has several implications for the potential extent of direct market discipline imposed by a mandatory SND requirement. First, during periods of financial stress or uncertain bond market conditions, the SND market appears to impose rather strong direct discipline on banking organizations. Earlier research established that SND spreads are related to a banking organization's risk. Our finding that some banking organizations during 1989-92 revealed a preference for not issuing SND when they became riskier clearly indicates that mandatory issuance would impose a penalty for risk-taking beyond the penalty associated with not issuing SND. The result that some banking organizations during the current regime do not issue when bond markets are volatile suggests that mandatory issuance would impose additional costs during such conditions. However, the fact that some banking organizations continue to issue SND during such times possibly suggests that these banking organizations are able to convey their soundness to the market. Therefore, mandatory SND issuance might increase disclosure by banking organizations during periods of bond market turbulence and enhance safety and soundness.

Second, direct discipline may vary with banking market conditions. Issuance was statistically sensitive and positively related to accounting-based risk measures during 1993-97. This finding suggests that SND prices did not fully reflect banking organization risk because, if they did, the riskiest banking organizations would not have had an incentive to issue SND.  Therefore, market discipline appears to have been relatively weak during this period of favorable banking market conditions.

Third, mandatory issuance may enhance indirect market discipline during periods of financial stress.  This inference follows because (1) relatively riskier banking organizations choose not to issue during periods of banking industry distress and (2) issuance prices may refresh secondary prices because disclosure generally increases at issuance. The results also suggest that, in the absence of mandatory issuance, information exists in the decision to issue itself, particularly in periods of financial stress. Therefore, our results suggest that a systematic analysis of banking organizations' decisions to issue SND could be used to enhance supervision during or after such periods.

Could and SND policy be expected to improve market discipline