Academic journal article Economic Perspectives

Subordinated Debt as Bank Capital: A Proposal for Regulatory Reform

Academic journal article Economic Perspectives

Subordinated Debt as Bank Capital: A Proposal for Regulatory Reform

Article excerpt

Introduction and summary

Last year, a Federal Reserve Study Group, in which we participated, examined the use of subordinated debt as a tool for disciplining bank risk taking. The study was completed prior to the passage of the 1999 U.S. Financial Services Modernization Act and the results are reported in Kwast et al. (1999). The report provides a broad survey of the academic literature on subordinated debt and of prevailing practices within the current market for subordinated debt issued by banking organizations. Although the report discusses a number of the issues to be considered in developing a policy proposal, providing an explicit proposal was not the purpose of the report. Instead, it concludes with a call for additional research into a number of related topics.

In this article, we present a proposal for the use of subordinated debt in bank capital regulation. Briefly, our proposal would require that banks hold a minimum level of subordinated debt and be required to approach the marketplace on a somewhat regular basis to roll over that debt. We believe the proposal is particularly timely for a variety of reasons, one of which is that Congress recently demonstrated its interest in the topic when it passed the U.S. Financial Services Modernization Act (Gramm-Leach-Bliley Act). The act instructs the Board of Governors of the Federal Reserve and the Secretary of the Treasury to conduct a joint study of the potential use of subordinated debt to bring market forces to bear on the operations of large financial institutions and to protect the deposit insurance funds. [1] The act also requires large U.S. national banks to have outstanding (but not necessarily subordinated) debt that is highly rated by independent agencies in order to engage in certain types of financial acti vities. Another reason to consider alternatives now is that banks in most developed countries, including the U.S., are relatively healthy. This reduces the probability that a greater reliance on market discipline will cause a temporary market disruption. Additionally, history shows that introducing reforms during relatively tranquil times is preferable to being forced to act during a crisis. [2]

Perhaps the most important reason that now may be a good time to consider greater reliance on subordinated debt is that international efforts to reform existing capital standards are highlighting the weaknesses of the alternatives. In 1988, the Basel Committee on Banking Supervision published the International Convergence of Capital Measurement and Capital Standards, which established international agreement on minimum risk-based capital adequacy ratios. [3] The paper, often referred to as the Basel Capital Accord, relied on very rough measures of a bank's credit risk exposure, however, and banks have increasingly engaged in regulatory arbitrage to reduce the cost of complying with the requirements (Jones, 2000). The result is that by the end of the 1990s, the risk-based capital requirements had become more of a compliance issue than a safety and soundness issue for the largest and most sophisticated banks.

Bank supervisors have recognized the problems associated with the 1988 accord, and the Basel Committee recently proposed two possible alternatives: a standardized approach that uses credit rating agencies to evaluate individual loans in banks' portfolios and an internal ratings approach that uses the ratings of individual loans that are assigned by banks' internal ratings procedures. An important element of both of these proposals is that they rely on risk measures obtained from private sector participants rather than formulas devised by supervisors. [4] The use of market risk measures has the potential to provide substantially more accurate risk measurement than would any supervisory formula. Market participants have the flexibility to evaluate all aspects of a position and assign higher risk weights where appropriate.

Whether either of these approaches would result in a significant improvement, however, is questionable. …

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