A growing number of bankers, analysts, and academics think the government should buttress its supervision of large banks by requiring them to issue subordinated debt.
The price at which a bank's subordinated debt trades, advocates say, would reflect investors' perceptions of the institution's soundness-and could give regulators a heads-up on problems they might otherwise have missed.
"Requiring a minimum ratio of subordinated debt ... would ensure continuing market discipline in bad times," Columbia University professor Charles W. Calomiris wrote in a recent policy paper for the American Enterprise Institute.
"It would also help discipline the regulators," said Robert E. Litan, a member of the Shadow Financial Regulatory Committee, a group of academics and former regulators.
The concept is not new. Back in 1985, the Federal Deposit Insurance Corp. floated-and then dumped-a subordinated debt proposal.
But endorsements from the Bankers Roundtable and the Shadow Committee, as well as concerns over recently proposed megamergers, is giving the idea new cachet.
Subordinated debt holders know they are unlikely to be repaid if the bank fails because, in the liquidation pecking order, their claims are "subordinated" to depositors and most other creditors. So the more likely an institutional investor believes a bank is to fail, the bigger the yield it will demand, particularly for debt with longer maturities.
In other words, the price of a bank's subordinated debt is like a thermometer. When the temperature is high, it may be time for regulators to pay a house call.
Or, in the words of a 1997 Treasury Department report, "Subordinated debt holders act like the proverbial canary in the mine shaft."
Many large banks already issue some subordinated debt, which counts toward their Tier 2 capital requirements. The FDIC estimates that nearly $62 billion of bank subordinated debt was outstanding at the end of 1997.
Subordinated debt accounted for 5.27% of all bank debt and 14.83% of equity capital. The ratio of subdebt to risk adjusted assets of commercial banks at year end was 1.57%-up from 1.54% at the end of 1996, the agency said.
But the banks do not necessarily issue with the frequency, maturities, or amounts that advocates suggest. Several academics have suggested that a bank's subordinated debt should equal 2% or more of its risk-adjusted assets.
"The whole idea here is to instill stable market discipline," said Mr. Litan, who also is director of economic studies at the Brookings Institution.
By requiring fairly lengthy maturities-say, two or more years-the risk to investors would be higher and thus reflected in the yield. "You don't want one-day subordinated debt," said George G. Kaufman, co-chairman of the Shadow Committee, who said holders of very short-term debt would not discipline wayward banks because they could quickly cash out if trouble erupts.
Banks also could be required to issue such debt regularly. That would force them to continually "prove themselves to the debt markets," said financial services consultant Bert Ely.
Supporters also would require only banks-and not holding companies-to issue the debt. Richard M. Whiting, general counsel at the Bankers Roundtable, said the focus is on banks because only banks pose a risk to the safety net.
Enthusiasm for market supervision is based in part on the belief that investors are more sensitive to problems than regulators.
Markets are "more efficient, more targeted, and quicker to reflect the real condition of an institution," Mr. Whiting said. After all, he added, "the bond markets are repriced every day."
Advocates add that institutional investors that would buy such debt-like pension and mutual funds-have more self-interest at stake than regulators do.
Arthur J. Murton, the Federal Deposit Insurance Corp.'s director of insurance, said the agency does not have an official position on the idea. But, he added, "some type of market-guided approach may be useful, particularly for larger, more complex institutions."
Bond buyers consider a variety of factors before deciding how much they will pay for a bank's subordinated debt.
According to Eric J. Grubelich, bank bond analyst at Keefe, Bruyette & Woods Inc., institutional investors look at a bank's credit risk and ratings-current and projected-and its takeover potential.
Investors also check whether the bank is in the right lines of business, whether it is well-managed, and whether its loans are over-concentrated in a single sector, Mr. Whiting added.
Subordinated debt enthusiasts argue that market valuations of a bank's well-being will grow even more accurate-and subordinated debt an even better indicator-as banks become more transparent.
The reverse is true, too, supporters say: Due to the investment power they wield, subordinated debt buyers are in a position to demand more data from banks.
Examples of information that banks might have to make public include the results of internal risk models; bank managers' trading of their institution's stock; internal operating reports; data showing delinquent loans 30, 60, and 90 days past due; and regulatory exam reports and ratings, says an upcoming Roundtable study on market-based regulation.
But supporters of market-based discipline disagree over whether mandatory subordinated debt should lead to a reduction in government supervision.
"As the marketplace moves forward, the regulators should be prepared to move backward a bit," said Ernest Ginsberg, vice chairman of Republic National Bank of New York and an influential member of the committee that produced the Roundtable study.
For example, Mr. Ginsberg said, if the market prices a bank's subordinated debt issue relatively high, the bank should be free to either "adjust the risk profile that we present to the marketplace"-warranting a lower price-or accept the higher price as the cost of its risky activity.
"Banks are in the risk-taking business," he said.
Mr. Whiting, the Roundtable general counsel, agrees. Bank management "pays the consequences" for highly priced debt, he said.
But banks should be rewarded for fulfilling their subordinated debt mandate, he added. In addition to deducting the interest from their taxes- current tax law permits this-banks should get more breathing room from government regulators. "That's the beauty of the process," he said.
Mr. Litan, by contrast, said banks should get the tax break and nothing else. The purpose of subordinated debt, he said, is to better protect taxpayers, not reduce supervision of banks.
In fact, he added, the Shadow Committee sees subordinated debt as a way to prevent regulators from granting forbearance to banks during a future downturn.
"If the bank had to sell the subordinated debt at very high interest, that signal would embarrass the regulators" into taking action against the institution, he said.
Not everyone is enthralled by the idea of mandating subordinated debt.
"I'm not sure singling out subordinated debt holds a lot of water," said Mr. Grubelich, the bank bond analyst. He suggested regulators could track the grades assigned to banks by the rating agencies.
Mr. Ely, the consultant, said a subordinated debt mandate would put medium-size banks at a disadvantage. They would have a tougher time continually issuing such debt and would pay higher average underwriting costs, he said.
But Mr. Ely's greatest objection to the concept is more existential. "If regulators are on the job, why do we need such proposals anyway? And if you can't rely on regulators, why have them?"