Banks & Subordinated Debt

I ran across an interesting story today on the Cleveland Fed website: Credit Spreads and Subordinated Debt by by Joseph G. Haubrich and James B. Thomson.

Subordinated debt may be counted as part of Tier 2 capital by the banks, where it is senior to preferred shares (and everything else that’s in Tier 1) but junior to deposits.

One proposed means of injecting more market discipline into the banking sector is a subordinated debt requirement. It would compel banks to issue some debt that the government does not guarantee and that is paid off only after all depositors have been satisfied. A mandatory subordinated debt requirement was one of the reforms recommended in a 1986 study commissioned by the American Bankers Association. In addition, the Financial Modernization Act of 1999 requires that large banking companies have outstanding, at all times, at least one (though not necessarily a subordinated) debt issue rated by a commercial credit-rating agency.

Some experts argue that subordinated debt is unnecessary because equity capital already gives depositors and other bank creditors a layer of protection. But banks’ equity—that is, their stock—rises when their profits increase, so the prospect of higher equity can encourage them to take greater risks. Debt is more sensitive than equity to the loss aspect of risk because it lacks the upside inducement of higher profits. Subordinated debt thus gives a bank’s depositors and general creditors the same protection from losses as equity does, without creating the incentive to assume more risk.

Evidence on credit spreads and credit spread curves suggests that these sources of information could one day become useful to bank regulatory agencies. At this time, however, the evidence is too weak to justify imposing a mandatory subordinated debt requirement, especially if its purpose is to increase market discipline on banking companies and give bank supervisors better information about banks’ changing conditions. Before supervisors add credit spreads from subordinated debt to their dashboard of early warning signals of deteriorating bank conditions, much more work must be done on extracting useful, reliable risk indicators. So, despite some encouraging results, we need considerably more evidence on the value of credit spread information to regulators and markets before deciding to impose any new rule on how banks fund themselves.

By way of example, Royal Bank’s 2006 Annual Report shows $21.5-billion in Tier 1 Capital and $8.6-billion in Tier 2 Capital; the latter figure includes $7.1-billion in sub-debt.

Update, 2007-11-22: OFHEO is attempting to use sub-debt as a control feature on the GSEs, but it isn’t working out very well:

Those tests show that the market behavior of sub debt yields has changed as negative information has emerged about the Enterprises’ management and risks. However, the nature of the change has been to link sub debt yields more closely to Treasuries. That paradoxical development is consistent with investors having greater confidence that Fannie Mae and Freddie Mac or their federal regulator would reduce the Enterprises’ default risks, with greater liquidity in the Enterprise sub debt market in recent years, or with greater confidence in the value of the implicit federal guarantee associated with Enterprise debt.

8 Responses to “Banks & Subordinated Debt”

  1. […] Note that while the Equity/RWA ratio and Tier 1 Ratio have both deteriorated over the year, BMO’s Total Capital Ratio has remained constant. This is due to issuance of about $1-billion in Subordinated Debt, which is junior to deposits, but senior to Tier 1 Capital. […]

  2. […] Note that, as with BMO and TD, the Equity/RWA ratio and Tier 1 Ratio have both deteriorated over the year, but for NA the Total Capital Ratio has also declined. Subordinated Debt outstanding has declined over the past year. […]

  3. […] Note that, as with all banks examined thus far, the Equity/RWA ratio and Tier 1 Ratio have both deteriorated over the year; for CM, NA and RY the Total Capital Ratio has also declined. CM’s Subordinated Debt outstanding has actually declined over the past year. […]

  4. […] Assiduous Readers will be familiar with Banks Subordinated Debt, but perhaps not so much with the difference betwee Tier 2A and Tier 2B Capital. 2.2.1. Hybrid capital instruments (Tier 2A) Hybrid capital includes instruments that are essentially permanent in nature and that have certain characteristics of both equity and debt, including: • Cumulative perpetual preferred shares • Qualifying 99-year debentures • Qualifying non-controlling interests arising on consolidation from tier 2 hybrid capital instruments • General allowances (see section 2.2.2.) Hybrid capital instruments must, at a minimum, have the following characteristics: • unsecured, subordinated and fully paid up • not redeemable at the initiative of the holder • may be redeemable by the issuer after an initial term of five years with the prior consent of the Superintendent • available to participate in losses without triggering a cessation of ongoing operations or the start of insolvency proceedings • allow service obligations to be deferred (as with cumulative preferred shares) where the profitability of the institution would not support payment Limited life instruments (Tier 2B) […]

  5. […] Update, 2008-2-8: Further discussion and thought! The idea that yield spreads are well-correlated with credit risk has been examined by the Cleveland Fed, with the idea that bank supervision would be improved if every bank had at least one sub-debt issue that would trade in the market, providing information to the Fed. According to the Cleveland Fed, this is not yet a reliable measure. […]

  6. […] All that’s reasonable enough; the uncertain desirability of mandatory sub-debt has been previously discussed. […]

  7. […] never been a fan of Banks’ subordinated debt, on the grounds that, while you get paid for term of T, you are taking the risk of a term of T+5 […]

  8. […] sub-debt has been discussed on PrefBlog before, as have Credit Default Swaps. The place of sub-debt in a bank’s capital structure has been […]

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