Using Subordinated Debt as
an Instrument of Market Discipline
Since the mid-1980s a growing number of observers, both within and outside the bank regulatory agencies, have proposed using subordinated notes and debentures (SND) to increase market discipline on banks and banking organizations. The perceived need for more-effective market discipline has continued to receive attention, even after implementation of the reforms contained in the FDIC Improvement Act (FDICIA) of 1991, in part because of the increasing size and complexity of banking organizations and in part because of the desire to lower the potential vulnerability of the banking and financial system to systemic risk. Indeed, market discipline has become one of the three ''pillars''-along with improved capital standards and more risk-based supervision-of the Federal Reserve's approach to bank supervision and regulation. In light of the ongoing interest in using SND as an instrument to augment market discipline, staff of the Federal Reserve System undertook a study of the issues surrounding an SND policy. 1 This study presents the results of the staff's work.
The study proceeds as follows. Section 1 defines market discipline, discusses the motivation for and theory behind an SND policy, and summarizes existing policy proposals. Section 2 summarizes and reviews the economic literature on the potential for SND to exert market discipline on banks. It also presents a wide range of new evidence acquired by the study group. Section 3 analyzes many characteristics that an SND policy could have, in terms both of their contribution to market discipline and of their operational feasibility. The final section provides a brief conclusion.
During its work, the study group acquired and analyzed a large amount of information and assessed a broad range of ideas. In many cases, these activities resulted in written products, and these are provided in the appendixes. In an effort to keep the body of the study to manageable proportions, the text often refers to material in an appendix. Thus, although the study attempts to present the group's findings fully, we have tried not to repeat many details that can be found in the appendixes.
NOTE. This study was completed in May 1999, before enactment of the Gramm-Leach-Bliley Act (Public Law 106-102) on November 12. The act requires that the Federal Reserve Board and the U.S. Department of the Treasury conduct a joint study of the feasibility and appropriateness of requiring large insured depository institutions and depository institution holding companies to hold a portion of their capital in subordinated debt. The joint study must be submitted to the Congress within eighteen months of the date of the enactment.