Mr Meyer's remarks on market discipline as a component of banking supervision and
regulation
Speech by Mr Laurence H Meyer, a member of the Board of Governors of the US Federal
Reserve System, at the conference on Reforming Bank Capital Standards in New York on 14
June 1999.
Good afternoon. The topic of this conference - reforming bank capital standards - could not
be more timely. Reform is very much an issue on the minds of all supervisors and market
participants. But regulatory capital standards are only one component of the overall
framework for maintaining bank safety and soundness. This overall framework can be
described, as in the consultative paper recently released by the Basle Supervisors Committee,
in terms of "three pillars" - bank supervision, market discipline, and regulatory capital
standards.
There are two approaches to assessing the adequacy of the overall framework. First, we could
consider merely rebalancing the existing components, in search of the most efficient
combination. Some have argued, for example, that enhancing market discipline could permit
reduced reliance on the more intrusive and burdensome regulatory and supervisory
components. Second, to the extent that recent changes in banking and financial markets have
made bank regulation and supervision more difficult, we may also need to incrementally
improve capital standards and supervisory practices as well as enhance market discipline.
My remarks today will focus on the market-discipline component of the three-pillars
framework, specifically on how we might enhance market discipline in banking as we adapt to
changes in banking and financial markets that have made bank supervision and regulation
more difficult. There is an irony here in that it might take additional regulation - for example,
increased disclosures and/or a mandatory subordinated debt requirement - to enhance market
discipline. I will also discuss practical issues that must be considered and questions that must
be answered if we are to move in this direction.
Adapting to change
As we all know, financial markets and institutions are evolving at a rapid and unprecedented
pace. This evolution has been driven in part by statutory reforms and dramatic regulatory
changes. The abolition of interstate banking constraints has allowed for the creation of a
growing number of very large banking organizations. The erosion of legal and regulatory
barriers has permitted banking organizations to expand their scope of activities. And both the
relaxation of trade barriers and the freer flow of capital have facilitated the operation of banks
across national boundaries.
Financial and technological innovations have had an equally dramatic effect on financial
markets and institutions. As a result of technological innovations, the increased speed and
reduced cost of transacting have improved the depth and liquidity of financial markets. These
improvements, together with advances in financial theory, have led to the adoption of new and
arguably more complex tools for measuring, taking, and controlling risks.
The growing size and complexity of banking organizations make the supervisor's job of
protecting bank safety and soundness increasingly difficult. Size, scope, and complexity
simply make it more difficult for supervisors to understand and evaluate bank positions and
operations. In response, heightened supervisory focus on risk-management procedures and
policies has been under way for some time. This focus recognizes that a bank's own
riskmanagement process is the linchpin for controlling risks. However, while new procedures,
policies, and tools for risk management may ultimately buttress supervision and regulation,
these tools are based on relatively recent financial theories that have yet to be tested under the
full range of market conditions. Moreover, the sophistication and complexity of these new
tools often make it more difficult, not less, for supervisors to assess the true risk of a banking
organization and to assign appropriate capital requirements. Adding to these difficulties,
supervisors must account for risk exposures that are altered at an ever faster pace.
We have often said that, in this environment, we want supervision and regulation to simulate
or mimic market discipline in the sense of creating the proper incentives, costs, and rewards. I
also believe that we ought - where we can - to skip the middlemen and go right to our first
line of defense: market discipline. By aligning market incentives with regulatory incentives,
policies designed to harness market forces could complement bank supervision by
encouraging banks to refrain from excessive risk-taking.
Indeed, I believe that market discipline is a particularly attractive tool for encouraging safety
and soundness in a rapidly evolving environment. Market discipline is inherently flexible and
adaptive with respect to innovations, since market participants have incentives to change the
ways that they evaluate risks as innovations are adopted.
Market discipline as a complement to supervision and regulation
Before discussing how market discipline might complement bank supervision and regulation,
it is useful to discuss how market discipline works. It seems to operate through two channels.
"Direct" market discipline is exerted through risk-sensitive debt instruments when a banking
organization's expected cost of issuing those instruments increases substantially with an
increase in its risk profile. For this to occur, investors must gather and collect information
about the banking organization's risks and prospects, and then incorporate that information
into their decisions to buy the organization's debt. The anticipation of higher funding costs
provides an incentive for the banking organization to refrain from excessive risk-taking.
"Indirect" market discipline is exerted through risk-sensitive debt and equity instruments
when private parties, and possibly government supervisors, monitor secondary market prices
of those instruments in order to help determine the risk exposure (or default probability) of a
banking organization. In response to perceived increases in bank risk, such parties could then
take a variety of actions that increase bank operating costs. For example, purchasers of bank
claims could increase the bank's cost of funds and limit its supply of credit, and both private
counterparties and supervisors could reduce the bank's ability to engage in certain types of
contracts. The anticipation of these actions, which are essentially various types of penalties,
provides banking organizations with incentives to refrain from excessive risk-taking.
Market discipline does not come naturally to banking. The federal safety net limits direct
market discipline because it reduces the demand for disclosure and the risk-sensitivity of debt
holders. Clearly, insured depositors have almost no incentive to penalize banks for excessive
risk-taking. And, uninsured depositors, because of depositor preference laws, may also
perceive relatively little need to impose higher costs on banks for excessive risk-taking. Given
these incentives, secondary market rates and spreads on these debt instruments would be
inadequate - if not irrelevant - barometers of a bank's risks and would therefore generate little
indirect market discipline. Further, the real and perceived certification of soundness provided
by supervisory authorities may also reduce the demand for disclosures and the risk-sensitivity
of debt holders. Compounding these disincentives for investors to evaluate bank risks, the
raison d'être of banks is that these institutions provide credit in environments characterized by
asymmetric information. Therefore, banks are inherently opaque and difficult to assess.
Nevertheless, there seems to be fairly strong statistical and anecdotal evidence supporting the
view that both direct and indirect market discipline currently are exerted on large banking
organizations. With respect to direct market discipline, econometric studies of the relationship
between deposit growth and portfolio risk have generally found that uninsured depositor
holdings decline with increases in the depository institution's risk. And, other econometric
studies have found that rates on uninsured certificates of deposit are sensitive to measures of
risk. Supervisory experience is consistent with both of these observations.
Other types of bank liabilities also appear to be sensitive to risk. For example, during periods
of financial stress, riskier banking organizations tend voluntarily not to issue subordinated
debt. This is precisely what would be expected if the subordinated debt market imposed risk
premiums on banking organizations. Above and beyond this implication that issuance costs
are risk sensitive, this empirical evidence suggests that direct market discipline is substantial
enough in the subordinated debt market to affect actual decisions made by banking
organizations.
The evidence with respect to indirect market discipline is also encouraging. Studies that have
considered recent secondary market spreads on subordinated debt have found them to be
statistically sensitive to various measures of risk. Importantly, while risk-sensitivity of
subordinated debt spreads is necessary for market participants to exert indirect market
discipline on banking organizations, it is not sufficient. Market participants outside of the
subordinated debt market also must monitor these spreads to assess the condition of the
banking organization. Indeed, market participants confirm that the "Street," not just the bond
market, appears to pay considerable attention to such spreads. On balance, the empirical
evidence together with anecdotal evidence from the market indicates that secondary market
subordinated debt spreads are generating indirect market discipline on banking organizations.
While market discipline is currently exerted directly and indirectly on large U.S. banking
organizations, the strength of this discipline could be enhanced by policymakers in a number
of promising ways. For example, a policy improving disclosures of bank risk exposures and
internal capital assessments could potentially improve the market's ability to assess risks.
Another option is for supervisory policy to enhance indirect market discipline by linking
supervisory actions to secondary market information. For example, secondary market
information could be used to help time bank examinations, to possibly limit bank activities, or
to potentially raise bank capital requirements. In this way, market discipline might strengthen
bank supervision. While the evidence is not yet clear whether secondary market indicators
provide information that the supervisor does not yet have, at worst such indicators could
confirm supervisory views or could prompt supervisors to reassess their appraisals of banks.
Using subordinated debt to enhance market discipline
A promising approach to enhance market discipline, which has received considerable renewed
attention of late, is to adopt a subordinated debt policy. There are a number of features of
subordinated debt that make it particularly attractive for providing increased market
discipline. First of all, subordinated debt is the most junior of all bank liabilities. Therefore,
these bondholders are the least likely to be bailed out in the event of bank failure, and the
most likely to demand disclosures of a bank's condition. Second, subordinated debt holders
do not partake in the upside gains associated with risk-taking. Hence, at least in principle, the
issuance and secondary market spreads on subordinated debt should be particularly sensitive
to banking organization risk. In contrast, since equity holders may also benefit from the upside
gains associated with risk-taking, equity issuance may provide inadequate direct market
discipline, and the signals of bank risk derived from secondary market prices may be blurred
and difficult to interpret.
In addition, subordinated debt has a relatively long maturity. This feature magnifies the
risksensitivity of the debt and reduces the probability of a "silent run" on the bank occurring when
the debt becomes due. Subordinated debt issued in place of insured deposits also provides an
extra "cushion" for the deposit insurance fund in the event of bank failure. Subordinated debt
is also attractive from a market discipline perspective because there exists a well-established,
deep, and fairly liquid market for such instruments. Market participants claim that bond issues
of $150 million or more are traded in liquid markets - a requirement satisfied by very large
bank holding companies and a much smaller number of very large banks. The standardization
of publicly traded subordinated debt of banking organizations is also striking and desirable
from a market discipline perspective. The majority of U.S. bank or (more commonly) holding
company subordinated debt instruments being issued today are fixed-rate, noncallable, 10-year
maturity bonds with few bells and whistles. These two features of the market, liquidity and
standardization, facilitate the comparison by market participants of secondary market
subordinated debt spreads. The finding in recent empirical research that spreads are sensitive
to banking organization risks further supports the depth of the secondary market. Not
surprisingly, market participants claim routinely to monitor such spreads for various peer
groups, which is consistent with the imposition of indirect market discipline on these banking
organizations, and some of this discipline is no doubt passed through to banks, particularly if
the bank makes up a sizable fraction of the bank holding company.
Existing proposals
Based on the appealing characteristics of subordinated debt, many observers have called for
requiring banking organizations to issue subordinated debt and some have also called for
frequent issuance of such debt. Requiring banking organizations to issue subordinated debt
frequently would force them to issue risk-sensitive debt, rather than insured deposits, when
the bank's risk has increased. Without such a requirement, there is empirical evidence that
risky banks tend to shift their funding sources toward insured deposits and away from
risksensitive securities. This evidence provides important motivation for a policy that would
require a banking organization to regularly issue subordinated debt. In short, mandatory and
regular subordinated debt issuance would weaken a banking organization's ability to shield
itself from direct market discipline.
Existing proposals for mandatory subordinated debt typically share three common elements:
first, that organizations be required to issue subordinated debt; second, that the subordinated
debt be held by independent third parties; and third, that the bank have total subordinated debt
outstanding in excess of 2 percent of its risk-weighted assets. There are, however, a number of
other practical issues that have to be considered in designing an operational mandatory
subordinated debt policy and many of these involve important tradeoffs that have to be
weighed in deciding how to proceed.
Practical considerations and details of a mandatory subordinated debt proposal
Only large banks? Some proposals would only require large banks to issue subordinated debt.
This approach is consistent with a theme I have been emphasizing, the importance of
differentiation in regulatory standards and supervisory practice between the largest, most
complex and internationally active banks and all others. As we begin to think of reform of the
capital standards, for example, I expect we will move to a bifurcated approach in the United
States, applying the revised Basle Accord only to large, complex, and internationally active
banks and designing a simpler, less burdensome approach for the overwhelming majority of
U.S. banks. In our supervisory program, the Federal Reserve is already focusing increased
attention on a small number of large, complex domestic and foreign-owned banking
organizations. It is sensible that any effort to enhance market discipline should also be focused
on those banks.
Several arguments can be advanced that suggest that a policy focused on large banks would
get the most bang for the regulatory buck. Such banks hold the most significant systemic risk
potential, and most of the banking system's assets are in such organizations. These are the
institutions that have become larger, more varied in their services and practices, and are more
complex and, as a result, are more difficult to supervise. It is also the case that subordinated
debt issues of the largest banks are more likely to be large enough to ensure a liquid market
for the instrument. Finally, large banking organizations are already voluntarily issuing a
significant amount of subordinated debt, so that a mandatory policy could be introduced with
minimal transition costs.
Bank or bank holding company? Interestingly, the top fifty U.S. insured commercial banks on
average already finance in excess of 2 percent of their risk weighted assets with subordinated
debt. Thus, many large banks already issue subordinated debt in the amounts stipulated in
many of the existing subordinated debt proposals. This is not to say, however, that a 2 percent
subordinated debt requirement would have no bite. Currently, most bank subordinated debt is
held by the parent holding company and hence is not traded. Thus requiring a bank to issue
tradable debt would likely increase both direct and indirect discipline. Moreover, in the
absence of such a requirement, risky banking organizations could shift into risk-insensitive
deposits and, in effect, avoid market discipline. With the requirement, this option would be
closed and riskier banks would have higher funding costs.
Most of the largest bank holding companies already have 2 percent or more of their
riskweighted assets in subordinated debt, and, in this case, the debt is publicly traded. While such
debt issue is voluntary, these organizations typically come to the market to issue subordinated
debt at least once or twice a year.
Most subordinated debt proposals focus on banks, however, and there are strong public policy
reasons for doing so. Insured commercial banks have direct access to the federal safety net,
and thus, banks are where the dangers of moral hazard and the consequent risks to the
taxpayer are concentrated. The commercial bank is the primary concern of supervision and
regulation, and where the supervisors most need the market's help. It follows that a
subordinated debt policy should be focused on banks and not on their parent or affiliate
organizations. In addition, subordinated debt issued at the bank level can provide increased
protection for the deposit insurance fund. And, a policy focused on banks would reinforce the
regulatory philosophy that the safety net and associated policies are limited to just commercial
banks.
How frequently should debt issuance be required? In the design of a subordinated debt policy,
one also needs to analyze what frequency of issuance would be required. On the one hand,
frequent issuance could improve the quality of the signals provided by spreads of
subordinated debt in the secondary market, because the issuance process generally involves
increased disclosure. This boost in the information content of secondary prices may be
particularly important during periods of financial stress. More generally, frequent renewal of
the information content of secondary prices may be highly beneficial as financial and
technological innovations allow banking organizations to change their financial condition
rapidly. Frequent issuance may also result in lower spreads as the market's familiarity with the
issuers increases. This would, of course, reduce the cost of a subordinated debt requirement.
On the other hand, a lower required frequency of issuance may allow banks to signal their
financial condition through their timing of issuance. Flexibility with respect to issuance may
also allow banks to avoid the unnecessary cost of issuing subordinated debt during periods in
which the bond market is turbulent. On balance, a mandated frequency of once or twice a year
would seem reasonable, and would be in line with current practice for larger banking
organizations.
Should subordinated debt with standardized characteristics be required? There are also
tradeoffs associated with requiring banking organizations to issue a standardized debt
instrument with the same maturity, option characteristics, and covenants. The benefit of
standardized debt is fairly obvious. It makes it easier for market participants to decipher the
signals of a banking organization's condition. The costs are also pretty clear. A standardized
debt instrument could be more costly for some banks to issue than for others because bank
capital structures differ across organizations. And, a standardized debt instrument may be very
costly during certain market conditions. For example, in periods of actual or expected interest
rate volatility, spreads on debt without put options may be relatively high. I would expect that
the benefits of standardization in ensuring a purer signal about the relative risk of different
banking institutions would outweigh the costs associated with such a restriction.
Should put options be required? Some proposals have advocated that the required
subordinated debt have put options. These options have been suggested for two reasons. First,
they would provide debt holders with a powerful tool for increasing the cost of bank
risktaking. With a put option, debt holders would be able to force early repayment of debt when a
bank changed its risk profile. Second, under some proposals, put options take the closure
decision out of the hands of the regulators and place it in the hands of the debt holders. Not
coincidentally, these proposals arose in the wake of the savings and loan crisis during which
regulators were criticized for their forbearance. Put options may also increase indirect
discipline if they trigger supervisory actions.
As disciplinary as they may be, there are strong arguments against the inclusion of put
options. First, the exercise of put options can be extremely Draconian, inducing liquidations
and possibly premature closures. Second, the high correlation of risks across banks may
induce a simultaneous exercise of put options, which could exacerbate or even trigger a
systemic crisis.
Should there be a cap on the rate paid at issuance for subordinated debt? Other proposals
have advocated that a subordinated debt policy should impose maximum caps on rates or
spreads over Treasuries with comparable maturities. The primary appeal of such an approach
is that direct market discipline would be relatively strong under a rate cap. Banking
organizations unable to issue under such a cap would be forced to lower their riskiness by
shrinking their assets or by changing their asset mix. A cap could also be used to strengthen
indirect discipline. A banking organization's inability to issue subordinated debt under the cap
would send a "red flag" to the market. Alternatively, the cap could be used to trigger
supervisory action in the same way that a banking organization's capital ratios currently
trigger prompt corrective action.
The downside of a cap is that it would be difficult, perhaps in practice impossible, to
determine the optimal rate or spread that should serve as a cap, particularly since the optimal
cap would vary with bond market and macroeconomic conditions. A fixed cap might harshly
punish all banking organizations unnecessarily when the bond market is highly illiquid. A
fixed cap might also be highly procyclical. Banking organizations would be forced to shrink,
change their asset mix, or face supervisory discipline during downturns because spreads
would be more likely to run into a fixed cap at such times. While some procyclical effects of
market discipline are unavoidable, a fixed rate cap may make a market discipline policy so
severely procyclical as to be undesirable from a macroeconomic perspective.
As one considers the various features that have been recommended in the existing
subordinated debt proposals, it is important to keep in mind that there are strong reasons to
stay closely aligned with current market practices and conventions. Capitalizing on such
conventions could, of course, reduce the potential costs of a subordinated debt policy. And, at
the same time, a subordinated debt policy aligned with such conventions could be very
effective. Given the current deep and liquid markets for subordinated debt, such a policy
would likely improve the information content of secondary market debt spreads. These
spreads would facilitate an increase in indirect market discipline.
Questions about the value of a subordinated debt requirement
It is important to recognize that the costs and benefits of a subordinated debt policy - even
one tailored to current market conventions - would vary over time.
Subordinated debt in times of stress. A mandatory subordinated debt requirement would likely
be most costly to banking organizations when either the markets are under stress, the economy
is deteriorating, or the bank itself is in financial difficulty. During these periods, the cost of
issuing risk-sensitive securities would likely increase, and, at such times, forced issuance of
subordinated debt would be particularly costly.
I believe proposals that increase market discipline inevitably risk aggravating instability in
times of overall stress. Eliminating deposit insurance, for example, would have the same
qualitative outcome. The key in designing approaches to enhance market discipline is
therefore to ensure a favorable tradeoff - sufficiently better controlled risk-taking in good
times and bad times relative to somewhat aggravated risks during periods of overall stress.
Subordinated debt, with its relatively long maturities and therefore limited ability to "run,"
appears to offer such a favorable tradeoff..
The cost of reduced funding flexibility. Another major cost of a subordinated debt proposal
would be the reduced flexibility in financing, resulting in a somewhat higher cost of financing
than would otherwise be available. These higher costs may also vary with business conditions,
market conditions, and banking conditions.
One of the ironies of a subordinated debt proposal is that it suggests that additional regulation
is required to induce additional market discipline. Regulations are never costless, so we must,
therefore, ask what additional costs might be imposed as a consequence of the mandate.
Of course, to the extent that the proposal follows existing market conventions - in terms of
the amount, frequency, etc. - the incremental costs are limited, though, of course, so are the
benefits. It is therefore important to be satisfied that the benefits outweigh the costs.
More research is important
A subordinated debt proposal is, in my judgment, promising and intriguing. Still, there remain
questions to be answered. To move in the direction of answers, the Federal Reserve is
working to improve the data it has available on the market price of subordinated debt issued
by banks and bank holding companies, as well as other market data that could be useful in
signaling changes in the risk profiles of banking organizations. We will be evaluating the
degree to which prices of market instruments track the changing risk profiles of banking
organizations, assessing the usefulness of such market signals in the surveillance of the
financial conditions of large, complex banking organizations, and evaluating the potential
usefulness of such data in the supervisory process. We believe that before we seriously
consider imposing a mandate related to subordinated debt, we should carefully study how the
existing market functions and the degree to which current practices may already be fulfilling
many of the objectives of a mandatory system.
In addition, we will be focusing increased research effort on topics related to market discipline
in general and subordinated debt in particular. We must get a reasonable estimate of how
much additional market discipline would be imposed by forced issuance of risk-sensitive debt.
How much more effective would subordinated debt holders be than uninsured deposit holders
when they raise funding costs for a risky bank? Does the strength of penalties associated with
bank debt issuance vary systematically across bank liabilities or with the business cycle? This
research may also help us understand how to strike a balance between supervision, regulation,
and market discipline in order to most effectively achieve the safety and soundness of our
financial system.
Conclusion
I hope my review of the difficulties and challenges associated with developing an
operationally feasible market discipline policy has not been disheartening. Such has not been
my intention. Rather, I have sought to realistically review the practical issues and tradeoffs
that need to be resolved. When all is said and done, however, it seems clear that market
discipline remains our first line of defense. It is perhaps the most flexible option for
maintaining bank safety and soundness in a rapidly evolving environment and has the
potential to strengthen and complement bank supervision and regulation, particularly on the
outside chance that the market knows best. While I believe that more research is needed to
make the case for a policy to enhance market discipline through subordinated debt, and to pin
down the design features of a specific policy for such instruments, we should not ignore the
abundant evidence that highlights the promise of market discipline in general and - perhaps -
subordinated debt in particular.