The role of an explicit subordinated debt policy in the smooth transition to Basel II: Developing economy perspective

Abstract

The major concern for the banking sector of developing economies is that implementation of Basel II will cause banks to raise capital appreciably, and thus undermine their existing capital position. In such a situation, subordinated debt can play a complementary role in enhancing bank capital. Pillar II of Basel Accord II emphasises supervisory review process. To this end, subordinated debt can provide quality market signals, which can be used by the supervisors to identify distress in bank management. Pillar III of Basel Accord II argues that the financial market would discipline banks. As investors in subordinated debt face maximum potential financial loss, they have the incentive to closely monitor bank activities, and may react promptly through the financial market. Therefore, an explicit subordinated debt policy mandating the banks to issue subordinate debt seems to be an immediate necessity for a smooth transition to Basel II, and to mitigate banks' excessive risk-taking behaviour in South Central Asian countries, although similar analogies can also be applicable for other comparable developing countries.