For years, academics have claimed that requiring banks to issue subordinated debt would strengthen banking regulation. Many regulators are beginning to agree.
The argument is that holders of such debt - who stand little or no chance of being repaid in the event of a bank failure - would want as much information as possible about the institution, to measure its risk.
Banks, therefore, would be required to disclose more about their operations. In addition to making banks' inner workings more transparent, supporters say, a subordinated debt requirement would have two other benefits: First, regulators could refer to the market's assessment of a bank's riskiness in making decisions about its safety and soundness. Second, banks would respond by reducing their risk to merit lower interest rates on their debt - an effect known as market discipline.
The idea of strengthening market discipline of banks through increased disclosure has strong support at the Federal Reserve Board, having been publicly touted in speeches by Chairman Alan Greenspan and Vice Chairman Roger W. Ferguson Jr. Gary H. Stern, president of the Federal Reserve Bank of Minneapolis, is a vocal advocate of requiring banks to issue subordinated debt.
A presentation by the Shadow Financial Regulatory Committee, an independent group that analyzes and critiques regulatory policy, last week suggested that years of give-and-take between academics and interested regulators is beginning to shape a subordinated debt requirement that regulatory agencies could endorse.
As part of its critique of a proposed revision of the way the Basel Committee on Banking Supervision sets capital standards for large banks, the shadow committee proposed an alternative based on a requirement that banks issue subordinated debt.
After listening to the presentation, Myron L. Kwast, associate director of the Fed's research and statistics division, said he felt "cautiously optimistic" about the use of subordinated debt to augment the work of bank examiners.
He said advocates of the policy may be moving "toward something that might just work - and be politically and operationally feasible. I'm not sure we're there yet, but I think we're much closer than we were even six months ago."
Comptroller of the Currency John D. Hawke Jr., though not completely supportive, also saw some benefits. "The real value of subordinated debt is the way it confronts the management of the bank with what the consequences will be of taking on greater risk. For that reason and others, I think it is a concept that really ought to be pursued," he said.
Persuading the regulators is seen as a vital first step toward adopting a subordinated debt requirement.
"Regulators could probably require banks to issue [subordinated debt] without a statutory change," said Robert E. Litan, co-chairman of the shadow committee. But its other suggestions, such as linking market signals to specific regulatory action, would probably require congressional action.