Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Subordinated Debt and Prompt Corrective Regulatory Action

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Subordinated Debt and Prompt Corrective Regulatory Action

Article excerpt

Abstract: Several recent studies have recommended greater reliance on subordinated debt as a tool to discipline bank risk taking. Some of these proposals recommend using subordinated debt yield spreads as additional triggers for supervisory discipline under prompt corrective action (PCA), action that is currently prompted by capital adequacy measures. This paper provides a theoretical model describing how use of a second market-measure of bank risk, in addition to the supervisors' own internalized information, could improve bank discipline. The authors then empirically evaluate the implications of the model. The evidence suggests that subordinated debt spreads dominate the current capital measures used to trigger PCA and consideration should be given to using spreads to complement supervisory discipline. The evidence also suggests that spreads over corporate bonds may be preferred to using spreads over U.S. Treasuries.

JEL classification: G2, G3, L5

Key words: bank regulation, subordinated debt, capital adequacy, prompt corrective action

1. Introduction and overview

Prompt corrective action is based on a simple mandate directed toward bank supervisors: "resolve the problems of insured depository institutions at the least possible long-term cost to the deposit insurance fund." (1) The central provisions of prompt corrective action (PCA) aim to provide a series of interventions as a bank's financial condition deteriorates. Moreover, rather than relying solely on supervisory judgment about a troubled bank's financial condition, PCA focuses on quantifiable measures of a bank's financial condition. In particular, supervisory intervention is currently triggered by bank capital adequacy ratios.

Although quantifiable measures have a variety of advantages, probably the most important advantage in the context of PCA is that their use reduces the scope for supervisors to exercise forbearance. The measure used, however, needs to be closely associated with the financial condition of the bank if it is to effectively achieve this purpose. A limitation of focusing almost exclusively on capital adequacy ratios is that banks and supervisors have substantial influence over the calculation of the numerator (capital) and denominator (a proxy for risk) of these ratios. The Basel Bank Supervisors Committee is currently trying to address problems in the calculation of the denominator, [see BIS (2001)]. Yet the more serious problem lies with the measurement of capital. Whether capital is measured using historical cost accounting (as is currently the case) or economic value accounting, a bank's capital will reflect declines only if the bank voluntarily recognizes the losses or the supervisors force recognition. Given that banks usually resist recognition of losses that would result in their being undercapitalized under PCA, responsibility for accurate capital measurement rests with the supervisors. This is to say, if the supervisors want to exercise forbearance, all they need do is acquiesce to a bank's refusal to recognize losses. Prominent examples of such acquiescence by supervisors include recognition of losses at U.S. banks due to loans to less-developed-countries (mostly in Latin America) in the 1980s and recognition of domestic loan losses by Japanese regulators throughout the later 1990s.

An alternative to exclusive reliance on capital adequacy ratios would be to use some market-based risk measure as a trigger for supervisory action. Examples of such measures would include the spread of subordinated debt obligations over comparable maturity Treasury obligations as proposed by Evanoff and Wall (2000a) and probabilities of default calculated using stock returns, such as is done by KMV [see Gunther, Levonian and Moore (2001)]. (2) The advantage of using a market-based risk measure is that market participants have a strong incentive to base their valuations on the expected payouts for their claim, whether or not a particular price is the one desired by banks and their regulators. …

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