Academic journal article Economic Commentary (Cleveland)

Subordinated Debt: Tougher Love for Banks?

Academic journal article Economic Commentary (Cleveland)

Subordinated Debt: Tougher Love for Banks?

Article excerpt

People who think banks could use some market discipline have proposed that subordinated debt could provide it. Are their proposals likely to succeed?

Good parents understand the perils of overprotection. They know that letting their children grow up often means letting them take their lumps. The past two decades have reinforced a similar principle with respect to the safety and soundness of banks. Government protection sometimes does as much to create the problem as to solve it. Here is the economics of moral hazard: Banks, secure in the safety net offered by the government, feel free to take increasingly risky positions. Depositors, knowing their deposits are safe, don't care and will neither withdraw their funds nor demand a higher interest rate. The deposit insurance system then effectively insulates the bank from market discipline.

One proposed solution. or rather set of solutions, to this problem aims at restoring a measure of market discipline to the banking sector-the regulatory equivalent of cutting the apron strings. Several recent proposals hope to restore discipline by forcing banks to issue debt that is not guaranteed by the government-- what they term subordinated debt.1 This Economic Commentary examines the reasoning behind such mandatory subordinated-debt proposals and assesses the evidence on their possible success.

Incentives and Information

Subordinated-debt proposals would require, indeed force, banks or bank holding companies to issue some amount (usually 2 percent to 5 percent of total assets) of debt that is junior to deposits. In case of failure, the bank would be barred from making any payments on the subordinated debt until all depositors (and any other senior debt holders) were paid off in full. Currently, many banks do issue some amount of subordinated debt, but there is no requirement to, and not all banks (or even all large banks) do so. The actual sub-debt proposals also specify further details, such as the debt's maturity, how much banks should issue, and so forth, but it's not worth examining those details without a clearer idea of how, in general, subordinated debt would increase market discipline. It does so by creating better incentives and providing better information.

The key incentive problem that regulators face in banking crises is the tendency to "go for broke." When a bank gets into trouble, often its best strategy for returning to health and profitability is to take big bets that might pay off. If that new shopping mall in the desert doesn't catch on, well, you were going to get closed down anyway. If it does succeed, you're back in business. In a phrase, the managers and owners (the stockholders) get all the upside gain from the risky loan, without bearing any downside risk. They're like a football team losing late in the fourth quarter: Time to try a "Hail Mary" pass that might win the game. Ordinarily, such a pass would be too risky, but now it gives the team a chance, whereas three yards in a cloud of dust up the middle certainly won't win.

What's wrong with a bank trying to return to profitability? The trouble is that when it goes for broke and ends up deeper in the hole than before, the FDICand ultimately other banks or the taxpayer-must pick up the bill.2

Subordinated debt is a way to change the incentives. It has some maximum payoff-the promised principal and interest payments. This means that it does not share in the upside potential of equity. If the bank generates high profits, it doesn't give debt holders any more money. If a bank's income is low, all of it is used to pay depositors (or the FDIC). If income is somewhat higher. the bank can pay the holders of subordinated debt. Above that, when sub-debt holders are paid in full, stockholders get whatever remains. Stockholders like increased risk, because they get the upside gains but don't share in the downside losses. Depositors don't care. because they are insured. …

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