Information > Manual 172 > This page

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

SND Proposals

Banking analysts have suggested several ways in which SND could be used to enhance market discipline imposed on banking organizations. A summary of these proposals is provided in table 1.

The first generation of proposals focused on the use of SND as a method of providing direct discipline by increasing the bank's cost of funding rather than by affecting its ability to obtain funds. In these proposals, the SND instrument was intended to provide gradually increasing penalties for risk-taking rather than the all-or-nothing discipline associated with runs on deposits. SND were chosen for this purpose because they would provide an additional cushion for the FDIC and possibly a margin of error in closing failing banks. Most of these proposals were made between 1983 and 1986, but the proposal by Litan and Rauch (1997) is also of this type.

The maturity of SND is generally not specified, but typically the proposals recommend requiring sufficiently frequent rollover to enhance direct discipline but not so frequent that the SND holders might escape a distressed bank before it fails.

One advantage of allowing or requiring banks to issue SND under these proposals is that regulators can effectively set higher capital requirements without imposing excessive costs on banks. The reason is that the cost of SND is typically lower than the cost of equity because the tax code permits corporations to deduct interest payments on debt but not dividend payments on equity. The FDIC may have benefited further from a requirement that banks issue SND because of the way its closure rule worked during the mid-1980s. Before FDICIA, banks were not closed until the book value of their equity reached zero, which generally implied that the value of failed banks' liabilities exceeded the market value of their assets. If the bank had outstanding SND equal to 3 to 5 percent of assets, then SND holders might have absorbed a large fraction of the losses that otherwise the FDIC would have borne.

The second generation of proposals was developed between 1988 and 1992. Proposals from this era reflect a deep dissatisfaction with the forbearance policies of the Federal Home Loan Bank Board during the thrift debacle, and they use SND to limit forbearance. This generation built on the direct discipline arising from first-generation proposals by requiring the issuance of SND and by using each bank's ability to issue SND as a trigger to force supervisory discipline. Each of the proposals required banks either to issue new debt on a frequent basis or to issue debt that contained a provision allowing the holder to ''put'' the debt back to the issuing bank. According to the proposals, each bank's ability to issue SND would then be a market signal of its viability. Banks that encountered problems would typically be given some time to persuade the market that they were solvent and to issue new obligations. However, a bank's inability to issue SND would at some point be taken as a signal that the bank was considered insolvent by the market and that it should be closed.

A weakness of the second-generation proposals is that they rely exclusively on banks' ability to issue debt as a trigger for regulatory action and fail to use the information available in the issuance or secondary market prices of SND. The proposals allowed banks to issue SND at whatever promised rate was necessary to attract willing investors. 9 Thus, banks could be operating at very high risk levels without SND's exerting indirect discipline through supervisors.  Wall (1989) would impose the strictest limits on highly risky banks by requiring that a bank be closed if it could not maintain a minimum level of SND. Although such an approach may permit supervisors to take earlier action to reduce the probability of failure, it does not guarantee supervisory intervention until the bank cannot issue debt.  Further, the market may perceive the penalty for the inability to issue SND to be so draconian as to be not credible. The severe nature of Wall's proposal may be softened by requiring frequent, partial rollovers of SND and by integrating SND requirements into prompt corrective action (see Evanoff, 1993). However, the Evanoff SND proposal could potentially allow insolvent banks to continue in operation for a long time. 10

Calomiris (1997 and 1999) provides a thirdgeneration proposal that builds on the earlier proposals by requiring monthly rollovers of SND that mature in two years but sets a cap on the rate that a bank would be permitted to pay. As with previous proposals, the focus is on direct discipline imposed in the issuance market. Banks that are unable to issue SND at rates under the rate cap would be required to shrink by approximately 1/24 per month for those months in which they are unable to issue new SND.  Calomiris's proposal is intended to provide discipline that would start taking effect before the bank was so distressed that it would be unable to issue new SND at any promised interest rate. In practice, even a distressed bank is likely to have some assets in its portfolio that it could liquidate to meet Calomiris's requirements for a few months. However, most banks would not be able to shrink 50 percent in one year, as his proposal would require in some circumstances.

Other possible weaknesses of the Calomiris-type approach are that it requires banks to be in the market very frequently to issue SND and that it allows SND levels to decline at distressed banks.  However, his recommendation that an SND proposal incorporate the rate paid on the debt combined with Evanoff's suggestion of integrating SND requirements into prompt corrective action suggests another option for generating indirect discipline: The rates paid on SND could be used to define capital adequacy for purposes of prompt corrective action.  For example, banks whose SND were issued or traded at Aaa rates could reasonably be considered to be highly capitalized regardless of their capital levels measured under existing regulatory requirements, whereas banks trading at junk bond rates could be considered to be undercapitalized (possibly severely or critically undercapitalized), again regardless of their position under the existing regulatory capital ratios. This approach provides the opportunity for progressively stricter supervisory action as a bank's financial condition deteriorates, with the potential for beginning supervisory discipline long before the bank becomes insolvent. Further, if the SND trade in active secondary markets, then such a proposal would permit almost continuous (indirect) market discipline.

  1. This is not to say that a bank could issue SND regardless of its riskiness. The supervisors could take action independent of the bank's ability to issue SND. Further, at some sufficiently high promised rate, the investors would refuse to buy a bank's SND reasoning that, if the bank is willing to promise such high interest rates, it must be planning on taking very high risks.  Thus, even though the contract interest rate would be very high, the expected return to holders of the debt would likely be very low or negative.

  2. The proposal would not prevent supervisors from closing insolvent banks. None of these proposals precludes earlier intervention by the supervisors. However, the benefit of SND from decreasing the probability of forbearance is reduced to the extent that the proposals rely on supervisors to close insolvent banks.

1.  A Summary of Various Subordinated Debt Proposals

Generation

Bibliographic citation

Required cushion

Debt characteristics

Maturity

Issuance

1st

Federal Deposit Insurance Corporation (FDIC), ''Deposit Insurance in a Changing Environment: A Study of the Current System of Deposit Insurance Pursuant to Section 712 of the Garn-St Germain Depository Institutions Act of 1982,'' A Report to Congress on Deposit Insurance, Washington, D.C.: U.S. Government Printing Office, June 1983.

Banks would be required to maintain a minimum protective cushion to support deposits (say, 10 percent), which would be met by use of a combination of equity and subordinated debt.

Maturity selection should take into consideration the desirability of frequent exposure to market judgment. The total debt perhaps should mature serially (say, one-third every two years).

As banks grow, they would be required to proportionately add to their ''capitalization.''  Those heavily dependent on debt, primarily the larger banks, would have to go to the market frequently to expand their cushion and to refinance maEagleTraders.comg issues.

1st

Benston, G., R.A. Eisenbeis, P.M. Horvitz, E. Kane, and G.C. Kaufman, Perspectives on Safe and Sound Banking, Cambridge, Mass.: MIT Press, 1986.

A significant level (say, 3 to 5 percent of deposits or a certain proportion of equity).

Short maturity, but long enough to prevent runs.

Frequent.

1st

Horvitz, P.M., ''Subordinated Debt Is Key to New Bank Capital Requirement,'' American Banker, December 31, 1986.

A minimum of 4 percent of deposits.

Not discussed.

Not discussed.

1st

Litan, R.E., and J. Rauch, American Finance for the 21st Century, U.S. Treasury, U.S. Government Printing Office: November 17, 1997.

A minimum of 1 to 2 percent of riskweighted assets.

The subordinated bonds would have maturities of at least one year.

A fraction of the subordinated debt outstanding would come due in each quarter.

NOTE.  FDICIA = Federal Deposit Insurance Corporation Improvement Act of 1991.
SND = subordinated notes and debentures.

1. Continued

Debt characteristics

Covenants

Rate cap

Putable debt

Insolvency procedures

Banks subject to proposal

Penalties would be imposed on banks that fell below minimum levels. Provisions that debt holders receive some equity interest and exercise some management control, such as in the selection of members of the board of directors, may be appropriate, as may convertibility to common stock under certain provisions.

None.

Not discussed.

FDIC assistance might still be granted and serious disruption avoided in a manner that would not benefit stockholders and subordinate creditors.  This aid could be accomplished by effecting a phantom merger transaction with a newly chartered bank that has been capitalized with FDIC financial assistance. The new bank would assume the liabilities of the closed bank and purchase its high-quality assets.

Not discussed.

Yes, to restrict the ability of the banks to engage in risky activities.

None.

Small percentage of the issue should be redeemed at the option of the holder.

Prompt closure when market value of equity is zero. To protect the FDIC, the notes would have to allow for wide discretion by the FDIC in arranging purchases and assumptions in cases of insolvency.

Large banks would be able to sell subordinated debt notes through the national financial markets, small banks might be able to sell capital notes over the counter to customers locally (or locally by other means), but medium-size banks would be too large to sell sufficient notes locally but not large enough to have access to national markets.

Not discussed.

None.

Not discussed.

FDIC would choose when to close the bank. Subordinated debt holders would provide a margin of error in the determination of when a bank should be closed and would reduce the loss to the FDIC.

Not discussed.

Not discussed.

Not discussed.

Not discussed.

Not discussed.

 Subordinated debt would be required only of banks in organizations above a certain size (say, $10 billion in total assets).

1. A Summary of Various Subordinated Debt Proposals - Continued

Generation

Bibliographic citation

Required cushion

Debt characteristics

Maturity

Issuance

1st

The Bankers Roundtable, Market-Based Incentive Regulation and Supervision: A Paradigm for the Future, Washington, D.C., April 1998.

A minimum of 2 percent of liabilities.

Not discussed.

Not discussed.

2nd

Keehn, S., Banking on the Balance: Powers and the Safety Net:  A Proposal, mimeo, Chicago, Ill.: Federal Reserve Bank of Chicago, 1988.

Ratio of a minimum of 4 percent subordinated debt to risk assets along with a 4 percent equity requirement.

The subordinated bonds would have maturities of no less than five years.

Issues would be staggered to ensure that no more than 20 percent, and no less than 10 percent, mature within any one year.

2nd

Cooper, K., and D.R. Fraser, ''The Rising Cost of Bank Failures:  A Proposed Solution.'' Journal of Retail Banking, vol. 10 (fall 1988), pp. 5-12.

A specified percentage of deposits (say, 3 percent).

The subordinate putable notes would not be long-term but would be rolled over at frequent intervals. These notes would be variable rate instruments with rate adjustments and interest payments made frequently.

Frequent.

1. Continued

Debt characteristics

Covenants

Rate cap

Putable debt

Insolvency procedures

Banks subject to proposal

Not discussed.

Not discussed.

Not discussed.

Not discussed.

Banks would have the option of complying with either a Basel-type riskbased capital standard or on approaches that rely on more market-based elements. Those banks that (1) are ''adequately capitalized'' but not subject to the leverage requirements under prompt corrective action, or (2) determine appropriate capital levels using internal management procedures would be required to issue subordinated debt.

Sanctions on bank dividend policy, payment of management fees, deposit growth, and deposit rates to be progressively increased as the bank's performance deteriorated.

None.

Not discussed.

Bank ownership would be converted to the subordinated debt holders following a judicial or regulatory determination of insolvency.  Creditors would be converted to common shareholders and would have a prescribed period to recapitalize the bank or find an acquirer; failing that, the bank would be liquidated.

Small banks could be allowed alternative means to meet the debt requirement.

Convertible to equity.

Yes, bonds would be putable at 95 percent of par value.

The notes would carry a ''put'' feature. They could be redeemed at the option of the note holders at a fixed percent of par value (say, 95 percent). The subordinated put notes would be redeemable not by the issuing bank but at the FDIC.

When a put occurred, the FDIC would be compensated for its payments on behalf of the issuing bank with nonvoting equity shares of the bank. The bank would have a prescribed period in which it could repurchase these equity shares. If it did not do so by the end of the period, revocation of the bank's charter would occur, and the FDIC would deal with the insolvent bank.

The put feature of the proposed subordinated debt would create a viable market for the instrument, no matter how small the issuing bank. If not, these banks could receive assistance from the FDIC or Federal Reserve in the placement of this debt with investors.

1.  A Summary of Various Subordinated Debt Proposals - Continued

Generation

Bibliographic citation

Required cushion

Debt characteristics

Maturity

Issuance

2nd

Wall, L.D., ''A Plan for Reducing Future Deposit Insurance Losses: Putable Subordinated Debt,'' Economic Review, Federal Reserve Bank of Atlanta (July/ August 1989), pp. 2-17.

Par value of putable subordinated debt greater than 4 to 5 percent of risk-weighted assets.

Bondholders would be allowed to request redemption in cases in which such redemption did not violate regulatory standards.

At the bank level, not the holding level.

2nd

Evanoff, D.D., ''Preferred Sources of Market Discipline,'' Yale Journal on Regulation, vol. 10 (1993), pp. 347-67.

A significant proportion of total capital would be held in subordinated debt. The 8 percent minimum capital requirement could be restructured to require a minimum of 4 percent equity and 4 percent subordinated debt.

Short enough so that the bank would have to go to the market on a regular basis, but long enough to tie debt holders to the bank and make the inability to run meaningful (e.g., five years).

Staggered so that banks would have to approach the market on a frequent basis (e.g., semiannually).

3rd

Calomiris, C.W., The Postmodern Bank Safety Net: Lessons from Developed and Developing Countries, Washington, D.C.: American Enterprise Institute, 1997.

2 percent of total nonreserve assets or 2 percent of riskweighted assets.

Not discussed.

To roll over debt and to accommodate growth in the bank's balance sheet.

1. Continued

Debt characteristics

Covenants

Rate cap

Putable debt

Insolvency procedures

Banks subject to proposal

Restrictions on the percentage of putable debt that could be owned by insiders individually and collectively.

Not discussed.

Yes. Bondholders would be allowed to request redemption in cases in which such redemption did not violate regulatory standards. With the exercise of a put, a bank would have 90 days to meet the requirements by issuing new debt or through reducing its subordinated debt requirements-say, through the sale of assets.

Any bank that could not honor the redemption requests on its putable subordinated debt at the end of 90 days without violating the regulatory requirements would be deemed insolvent and would be closed. If the proceeds of the sale or liquidation exceeded the total of deposits, that excess would first be returned to the subordinated debt holders; the remainder, if any, would be paid to equity holders.

Small banks, defined as those with less than $2 billion in assets, would be exempted because of the limited market they might face for subordinated debt instruments.  Those banks would have the option of operating under the putable subordinated debt standard.

Following the prompt corrective action (PCA) provisions of FDICIA, sanctions on bank dividend policy, payment of management fees, deposit growth, and deposit rates to be progressively increased as the bank's performance deteriorated.  Implicit in the discussion seems to be the incorporation of the SND requirements into PCA.

None.

A variant of the proposal would require the bank to issue putable subordinated debt. The bank would have 90 days to issue replacement debt. If it could not do so, it would be taken over by the regulators.

Once a bank's debt capital fell below the required level, existing subordinated debt holders would be given an equity position and would have a prescribed period to recapitalize the bank or find an acquirer; failing that, the bank would be liquidated.

Suggests that a few investment bankers had indicated some interest in establishing mutual funds for the subordinated debt instruments issued by small banks. Also, author's conversations with small bankers suggested that they could raise this type of debt relatively easily.

''Insiders'' would not be permitted to hold subordinated debt. Further, holders of subordinated debt would have no direct or indirect interest in the stock of the bank that issues the debt.  Author suggested that the ideal subordinated debt holders would be unrelated foreign financial institutions.

The subordinated debt would earn a yield no greater than 50 basis points above the riskless rate.

Not discussed.

Subordinated debt holders must have their money at stake when a bank becomes insolvent.

Yes.

1.  A Summary of Various Subordinated Debt Proposals - Continued

Generation

Bibliographic citation

Required cushion

Debt characteristics

Maturity

Issuance

3rd

Calomiris, C.W., ''Building an Incentive-Compatible Safety Net,'' Journal of Banking and Finance, forthcoming.  NOTE: This plan is labeled ''A subordinated debt plan for a developing country.''  (We understand from discussions with the author that although a plan targeted at the United States would differ in some important details [especially in terms of acceptable investors], such a plan would generally work along the lines of the developing country proposal.)

Banks must ''maintain'' a minimum fraction (say, 2 percent) of their risky (non-Treasury bill) assets in subordinated debt (sometimes called uninsured deposits).

Two years.

1/24 of the issue would mature each month.

1. Continued

Debt characteristics

Covenants

Rate cap

Putable debt

Insolvency procedures

Banks subject to proposal

Debt must be issued to large domestic banks or foreign financial institutions. (See the ''Banks subject to proposal'' column for details.)

Rates would be capped at the one-year Treasury bill rate plus a ''maximum spreadē (say, 3 percent).

Not discussed.

Banks that could not issue would be required to shrink their assets by 1/24 (4.17 percent) during the next month. If additional contraction is required (because of prior growth), then the additional shrinkage can be achieved over three months. (The author also discusses measuring assets and subordinated debt using a three-month moving average.) Presumably, this would result in the bank's liquidating all of its assets over 24 to 27 months if it could no longer issue SND.

The plan would apply to all banks. Debt issued by small banks (those that might have difficulty accessing foreign banks and international finance markets) could be held by large domestic or foreign banks. Debt issued by large banks must be held by foreign financial institutions.

Evidence on the Potential Market-Discipline Effects of Subordinated Debt