Abstract
A straightforward method to enhance market discipline in banking is the mandatory Sub-Debt Policy (SDP), that is a requirement by which some large banks are forced to regularly issue a minimum amount of subordinated and non-guaranteed debt. If the decision of issuing sub-debt is endogenous and/or subordinated creditors are able to influence bank managers' behaviour, then we should observe a positive correlation between the amount of sub-debt held in bank balance sheets and banking performance. By conducting statistical tests on a panel data set comprising the largest European banks, we find that (i) the sub-debt issues are made generally by the most profitable banking organizations, (ii) voluntary sub-debt issues allow banks to reduce their Tier 1 ratios, although improving their overall capitalisation (Tier 1+Tier 2 ratios) and (iii) the amount of sub-debt is negatively correlated with the quality of the credit portfolio, but positively correlated with the ratio of loan loss reserve to total loans. These results arouse several reflections about the virtues and limitations of market discipline in banking in the absence of a formal SDP.
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This study, elaborated following a fruitful collaboration between the Board of Governors of the Federal Reserve System and the US Treasury, was achieved 1 year later.2 Even though immediate implementation of an SDP is not recommended in the conclusion of this study, the interest for such a policy is plainly acknowledged: ‘The Board [of Governors of the Federal Reserve System] and the Secretary [of the Treasury] believe that existing evidence supports efforts to use subordinated debt as a way to encourage market discipline. […] A policy of mandatory subordinated debt issuance may potentially enhance market discipline and safety and soundness. Nonetheless, the Board and the Secretary believe that additional evidence must be gathered before they can support a request for legislative authority to impose a requirement that large insured depository institutions or their holding companies maintain some portion of their capital in the form of subordinated debt.’ (vide infra n. 2, pp. iv, 56–57).
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We borrowed this term from Kwan.23,24 It is worth noting that the ‘strong form’ of market discipline is a diametrically opposite concept to our ‘sine qua non’ hypothesis defined in Pop,26 in the sense that it addresses the sufficiency question.
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This fact does not mean that size effects should be completely neglected. The existence of possible threshold effects can be taken into account correctly only by leading a multivariate econometric analysis of the relationship between banking performance and the quantity of subordinated debt outstanding.
Initially, we included in the analysis of bank capitalization the two most frequently used risk based capital ratios (Tier 1 and Total or Cooke ratios). It is worth noting that these capital adequacy ratios cannot be calculated simply by looking at the balance sheet data, because of the weights that are assigned internally by each bank. Despite the fact that they are not obliged to do so, some banks voluntarily publish these ratios in their annual report. However, more than 50 per cent of the European banks included in our sample decided not to disclose this kind of information to investors.
However, it is worth emphasizing that NIRA also has its own problems. First, to the extent that banking markets are efficient, a bank can obtain a higher expected margin only by taking more risk. Second, even if banks' ability to collect and process private information allows them to earn economic rents (as is usually the case), returns are still likely to be correlated with risk. Third, NIRA does not capture the efficiency with which a bank produces its output. To be more precise, a bank could have a high NIRA but low earnings because it is simply … inefficient. In alternative specifications, we also used other measures of bank profitability (return on average assets, ROA, and especially the cost to income ratio, CIR). Unfortunately, the interpretation of the results obtained by using these alternative proxies for bank performance is less clear-cut.
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Acknowledgements
I am indebted to Michel Dietsch, Anne Lavigne, Jean-Paul Pollin, Amine Tarazi and, especially, Larry Wall for useful comments and criticism. Remarks and suggestions from participants at the 54th Annual Meetings of the French Economic Association, 23rd Symposium on Banking and Monetary Economics and 4th INFINITI Conference on International Finance – ‘Measuring and Managing Contagion’ – are gratefully acknowledged. Responsibility for possible errors is entirely mine.
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1holds a PhD from the University of Orleans, France, December 2005. In 2006, he obtained the prize for the ‘Best PhD Thesis 2006’ in Banking and Monetary Economics awarded by Banque de France. He is currently Associate Professor of Banking and Finance at the University of Nantes and consultant to the French Banking Commission (Banque de France). He is the Head of the Executive MBA Program at the Institute of Banking and Finance. His main research interests include the role of market discipline in banking regulation and supervision, Basel II, capital standards, stress testing, mandatory subordinated debt proposals, informational content of security prices, early warning systems, market efficiency, credit derivatives, Islamic banking, and too big to fail in banking.
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Pop, A. Quantity effects and the market discipline mechanism: A bivariate analysis. J Bank Regul 10, 164–175 (2009). https://doi.org/10.1057/jbr.2008.25
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DOI: https://doi.org/10.1057/jbr.2008.25