This latter effect is a completely positive one. Capital in financial institutions can only be sensibly defined to include the difference between the market value of the assets and the default-free value of customer liabilities. The distinction between customer and investor liabilities is crucial. Any loss to customer liabilities can be a serious impediment to confidence in a financial firm. Customers do not wish to bear performance risk or to be paid as an investor would for doing so. Thus, it is imperative for the ongoing performance of a financial firm to assume that these customer liabilities are honored.

The treatment of investor liabilities is more complicated. Some argue (see, for example, Shepheard-Walwyn and Rohner 2 ) that for the purpose of establishing minimum capital requirements, only equity or equity-like claims that are able to sustain losses without any encumbrance ought to be counted. Thus, under such an arrangement, capital would be reduced by the default-free value of investor liabilities as well as by the default-free value of customer liabilities.

Such a definition of capital is appropriate to delineate a buffer to protect against stress losses, particularly if they are systemic in nature. Risk transfer without default is a critical aspect of the funding to withstand such shocks. In the strongest case, this would argue in favor of using the default-free value – not the market value – of investor liabilities. In stress environments when bank liquidity and funding is threatened, the likelihood of default on investor liabilities contributes to the firm’s illiquidity and stress, and therefore should reduce capital. If one were to use the market value, rather than the default-free value of investor liabilities, a firm could show considerable positive capital, yet have its capital funding in jeopardy, even if its customer liabilities were reasonably sure to be paid.

The distinction between using the default-free value versus market value of investor liabilities may seem like a small one. Default is rare enough, and in any case investor liabilities would not constitute a majority of the difference between market-value assets and book-value customer liabilities. However, this is not the case. Indeed, by subtracting the market value of investor liabilities one is essentially counting investor liabilities as capital. That is because, in increasingly severe stress scenarios, the market value of investor liabilities goes to zero before customer liabilities are affected.

This is not to say, however, that subordinated debt can’t – or shouldn’t – be used as capital for some purposes. Indeed, a different argument can be made for other prudential regulations that seek to ensure a bank is sufficiently conservatively funded to protect its customers and deposit insurers. It is potentially useful to encourage, and even require, banks to rely on subordinated debt financing. As the US Shadow Financial Regulatory Committee (SFRC) has pointed out, the required use of subordinated debt would provide valuable information to the market and to bank supervisors.3 With subordinated debt present, analysts and market participants would pay additional attention to the risks of this balance sheet tranche. The price of subordinated debt in the market place would serve as a useful objective indicator of risk individual bank risk.

This type of information is important today, and will be increasingly important in the future. Regulators and bank supervisors could benefit, as sub-debt prices would provide a tangible performance benchmark and early warning signal. Furthermore, we are rapidly moving toward a world in which deposit insurance is priced according to the risk characteristics of pools of firms, and, eventually, to individual firms. For example, the US FDIC is currently in the process of developing a plan under which it would purchase deposit insurance in the marketplace (purchased from some combination of capital markets and reinsurers). In this world, sub-debt prices would reinforce pricing of deposit insurance and vice versa, leading to better overall information accumulation and greater incentives for bank transparency.

In addition to providing information, subordinated debt could play a disciplinary role as well. The interests of subordinated debt holders and deposit insurers are closely related, and the stakes of these claimants receive more attention with management once there is a capital-markets as well as a regulatory representation.

While subordinated debt provides substantial externalities, it is important to keep these in perspective. The SFRC takes the view that some minimum amount should be required and that there should be no upper limit as to the fraction of capital provided by subordinated debt, much as with non-financial firms. Clearly this generates concerns that individual bank failures and more generalized systemic incidents could be triggered as a result of the presence of the sub-debt. To ameliorate this possibility, the SFRC suggests that the issuing bank, at the direction of its supervisor, might withhold payment of interest and principal if capital fell below a designated threshold. This is reminiscent of the way that ‘surplus notes’ work in the US insurance regulatory context.

This kind of discretionary ‘out’ substantially undermines the above information externalities that sub-debt-as-capital could otherwise bring. Rather than provide information about creditworthiness, price changes might be attributed to perceived fluctuations in supervisors’ willingness to provide relief. Moreover, once the hard penalty of default is removed, there is less incentive for management either to provide information or to tailor bank policies toward protecting sub-debt claims. As in the case of US insurance, the primary benefit of this type of arrangement would be to provide the industry with a source of tax-deductible debt service. This benefit may be substantial. But flexible sub-debt could not provide information about creditworthiness to regulators or capital markets. Nor could it align interests of debt holders with depositors. As a result, I believe sub-debt is useful only to the extent that it can remain as true, inflexible debt, and it would therefore need to play a restricted role in constituting regulatory capital.

2 Tim Shepheard-Walwyn and Marcel Rohner, “Equity at Risk: An Alternative Approach to Setting Regulatory Capital Standards for Internationally Active Financial Firms,” IFCI, April 2000.

3 “Reforming Bank Capital Regulation: A Proposal by the U.S. Shadow Financial Regulatory Committee,” George G. Kaufman, Robert E. Litan, Richard C. Aspinwall, George J. Benston, Charles W. Calomiris, Franklin R. Edwards, Scott E. Harrington, Richard J. Herring, Paul M. Horvitz, Roberta Romano, Hal S. Scott, Kenneth E. Scott, Peter J. Wallison. AEI Press, Washington, D.C., March 2000.