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DRAFT October 26, 2000 Costs and benefits of mandatory subordinated debt regulation for banks Arturo Estrella Research and Market Analysis Group Federal Reserve Bank of New York 33 Liberty Street New York, NY 10045 Phone: 1-212-720-5874 Fax: 1-212-720-1582 E-mail: [email protected] The author is grateful to Mark Flannery, Kose John, Hamid Mehran, and participants in a workshop at the Federal Reserve Bank of New York for helpful comments. The views expressed in this paper are those of the author and do not necessarily represent those of the Federal Reserve Bank of New York or the Federal Reserve System.

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Page 1: Costs and Benefits of Mandatory Subordinated Debt Regulation for … ·  · 2015-07-28Costs and benefits of mandatory subordinated debt regulation for banks ... rely on two types

DRAFTOctober 26, 2000

Costs and benefits of mandatory subordinated debt regulation for banks

Arturo EstrellaResearch and Market Analysis GroupFederal Reserve Bank of New York

33 Liberty StreetNew York, NY 10045

Phone: 1-212-720-5874Fax: 1-212-720-1582

E-mail: [email protected]

The author is grateful to Mark Flannery, Kose John, Hamid Mehran, and participants in aworkshop at the Federal Reserve Bank of New York for helpful comments. The views expressedin this paper are those of the author and do not necessarily represent those of the Federal ReserveBank of New York or the Federal Reserve System.

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Costs and benefits of mandatory subordinated debt regulation for banks

Abstract

Proposals for regulation requiring that banks maintain some minimum level of subordinated debt

have gained support recently. These proposals focus on the benefits of such regulation,

specifically, that supervisors are expected to free ride on debtholders’ monitoring efforts. But

there are also monitoring and other costs: there is no real free ride. This paper uses the theory of

capital structure to look at both costs and benefits of mandating subordinated debt for banks. The

theory encompasses the touted monitoring benefits, but also identifies potential pitfalls such as

excessive monitoring and opportunity costs, increased risk of bankruptcy, and distortion of

market signals. The analysis suggests that, to tap into the benefits of subordinated debt, it is more

sensible to eliminate disincentives from holding it than to force banks away from optimal levels.

JEL Codes: G21, G28, G32

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Costs and benefits of mandatory subordinated debt regulation for banks

Proposals for regulation requiring banks to hold certain minimum levels of subordinated

debt have been around for years, and recently seem to have been gaining broader support. For

instance, subordinated debt requirements are the centerpiece of a proposal for reforming bank

regulation from the U.S. Shadow Financial Regulatory Committee (SFRC, 2000). A

comprehensive study from staff at the Board of Governors of the Federal Reserve System (FRS,

1999) is less advocative, but seems somewhat supportive of subordinated debt requirements

within a framework of prompt corrective action.

The feature of subordinated debt that seems to attract these, as well as earlier proponents,

is the possibility of enlisting bond market participants into the effort to supervise banking

institutions. As claimants on very junior debt, subordinated debtholders stand to suffer heavy

losses in case of bank insolvency. They therefore have a strong incentive to monitor the firm

closely and continuously. Moreover, their interests are clearly aligned with those of depositors

and deposit insurers. Subordinated debt requirements thus seem to offer the promise of a free

ride for regulators and bank supervisors.

Intuitively, however, the idea of mandating the issuance of subordinated debt to obtain

information from the market seems problematic. The potential for useful monitoring is all but

undeniable.1 But surely, if banks are forced by regulation to hold more subordinated debt than

they otherwise would, the signals from the market would be at least tainted and at worst

uninformative or misleading. Advocates of the requirements present a solid case by focusing on

the substantive benefits of the proposal. The question is whether the benefits outweigh the costs

when scrutinized in detail.

Finance theory suggests that there is no real free ride. The theory of capital structure has

dealt extensively with both the benefits and the costs of debt for corporations. It thus provides a

useful setting within which the proposals may be analyzed in a more comprehensive and

balanced way, which is the main objective of this paper. Capital structure theory may be used to

address several aspects of the issue of subordinated debt requirements. First, it can provide some

notion of the potential reactions of the firm to these requirements. If an increase in subordinated

1 Levonian (2000) acknowledges that subordinated debt can be useful for monitoring and for market discipline, butquestions whether subordinated debt can outperform equity for these purposes.

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debt is mandated, what other category of funding will the additional debt crowd out? One

possible reaction is to reduce other more senior types of debt, such as deposits. Another

possibility is to substitute subordinated debt for equity, thus increasing firm leverage. These

issues are discussed in section II.

If the additional debt crowds out equity, capital structure theory provides an indication of

the likely costs incurred. We examine two approaches. In section III, we look at the implications

of agency models in which debt either improves or exacerbates various principal-agent conflicts

associated with the firm. It is interesting that these models turn the monitoring argument on its

head in the following way. As noted, proponents of subordinated debt focus primarily on the

salutary effects of the ensuing monitoring. Increased monitoring is certainly consistent with the

implications of many of the agency models, but they emphasize monitoring costs as a factor that

limits the extent of debt issuance by the firm.

We turn in section IV to signaling models of capital structure. The focus here is not

explicitly on costs and benefits, but on the signals that leverage provides to the market about

particular firms. Subordinated debt requirements have the potential to distort those signals,

reducing the value of available information and exposing the firms to various risks.

Before proceeding to the analysis of these issues, section I discusses the application of

capital structure theory to banks and summarizes the treatment of subordinated debt in current

regulation and in the proposals. After the analysis of sections II-IV, section V draws some

regulatory policy implications.

I. Bank capital structure: theory, regulation, subordinated debt proposals

A. Bank capital structure and finance theory

When compared with the universe of firms in all industries, banks tend to stand out as

highly levered institutions. Thus, when a proposal comes along that purports to induce a bank to

hold more debt, it is important to examine why banks rely so heavily on debt to begin with.

Several well-known models in corporate finance theory can help explain the reasons for this

phenomenon. This section examines a few of those models, concentrating on the aspects of the

models that explain the high leverage of banks. We come back to some of the models in greater

detail in section III.

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For reference purposes, it is useful to define a simple accounting framework for the

banking firm. This framework incorporates only the features that will be most relevant for the

subsequent analysis. Thus, suppose that the bank holds assets A and that its liabilities are

composed of deposits D and subordinated debt S. The basic accounting identity is then

A L E D S E� � � � � , (1.1)

where L represents total liabilities (=D+S) and E is equity. Because issues of leverage are

generally viewed in proportional terms, it will also be convenient to scale this equation by the

level of assets, obtaining

1 � � � � �� � � � � . (1.2)

Here each Greek letter represents the ratio of the corresponding level to assets. For example,

high leverage is represented by a value of � close to 1.

Jensen and Meckling (1976) rely on two types of agency problems to explain why firms

hold non-extreme levels of debt and equity. The relevant agency problem for the purposes of this

section involves equityholders and debtholders. Suppose the owners (and the managers) of the

firm have access to various projects of different risk levels. If they raise debt before deciding on

which projects to embark, they may later settle on the riskiest projects. Because of limited

liability of equityholders, the risk is borne disproportionately by debtholders, to the extent that

stockholders stand to gain from the switch to riskier projects. This risk-shifting or asset-

substitution problem limits the amount of debt that the firm issues, since debtholders may

demand a premium for bearing the potential risks.2

The foregoing is only part of the story, but it suffices to suggest why banks may be more

highly levered. Since banks tend to be subject to more extensive regulation and closer

supervisory scrutiny than most other industries, the danger of asset substitution is likely to be

less pronounced for banks. Thus, the limitations on debt issuance that result from the risk of asset

substitution are less important for banks, which therefore find more ready access to debt and tend

to have a higher ratio � .3 Another example is provided by the utilities industry, which is also

heavily regulated and highly levered.

A model proposed by Stulz (1990) suggests a different set of reasons why banks are

highly levered. Simply stated, managers in that model want to invest all available funds, even if

2 Mispriced deposit insurance has been blamed for risk shifting in banking. However, John, John and Senbet (1991)argue that, because of limited liability, risk shifting would exist even with properly priced deposit insurance.

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paying out cash is better for outside investors. Managers may have these preferences, for

example, if they enjoy perquisites whose value may be enhanced through greater investment or

growth in the firm. Because of the need to make interest and principal payments, debt tends to

reduce free cash flow (similar to Jensen (1986)) and limits the scope for overinvestment by

owners and managers.

Banking, at least traditional banking, may be characterized as a mature industry with

limited growth potential. This view of banking is supported, for example, by the analysis and

empirical evidence presented by Gorton and Rosen (1995). The set of possibilities in which free

cash flow may be invested are thus restricted, providing a role for debt as remedy to

overinvestment. Sources of free cash flow also tend to be relatively plentiful for banks because

of the financial focus of their activities and because of their role in the payments system. Hence,

the benefits of debt may be helpful both in terms of the sources and uses of free cash flow.

Flannery (1994) argues that liquidity has a role in determining the capital structure of

banks. The liquidity of bank loans portfolios provides numerous opportunities for asset

substitution. In the spirit of the capital structure models discussed above, Flannery concludes that

short-term debt in the form of deposits provides a form of restrictive covenant that mitigates the

asset substitution incentives. The resulting reliance on deposits as a low-cost form of financing

thus tends to increase the leverage of banks.

Taking a different approach, Diamond and Rajan (1999) argue that the role of banks as

providers of liquidity to the economy requires that banks have relatively low levels of capital. In

their model, the fragile capital structure of banks acts as a commitment device that transforms

illiquid deposits into liquidity for borrowers. Because their capital is low, banks must exercise

their skills to collect payments from borrowers; otherwise, they would be unable to raise

deposits. The Diamond-Rajan model is very specific to banks, in contrast to the models

discussed earlier, which apply to firms more generally. However, both approaches lead to similar

conclusions with regard to the leverage of banks.

To summarize, the characterization of banking as a mature, heavily regulated industry

with high levels of free cash flow and a key role as provider of liquidity helps explain why banks

are highly levered, even in the absence of mandated subordinated debt. In fact, the FRS (1999)

3 This argument is made also by Orgler and Taggart (1983).

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study indicates that large banks already have material amounts of subordinated debt on their

books.

B. Current capital regulation

Regulatory practice in the United States and abroad recognizes that banks are bound to be

highly levered institutions. It also recognizes, however, the dangers of excessive leverage in

firms whose failure may create direct costs to the public or may cause systemic disturbances.

Thus, regulation sets minimum levels of equity and other capital instruments that a bank must

meet.

In the United States, one of the requirements sets a minimum level for the ratio 1� �� �

defined above, which is somewhat confusingly known as the leverage ratio. A more complex set

of regulations is also adopted from the Basel Committee (1988), which in the context of our

model imposes minimums on both � and � �� . More specifically, the Basel accord requires that

tier 1 capital (equity + reserves) be at least 4% of “risk-weighted assets” (RWA) and that total

capital (tier 1 + subordinated debt + other capital) be at least 8% of RWA.4

The recognition of subordinated debt as part of total capital provides an incentive for the

firm to issue this type of instrument. However, the Basel accord also includes a series of

provisions that limit the recognition of subordinated debt. First, subordinated debt qualifies only

up to 50% of tier 1 capital. Second, tier 2 capital (the difference between tier 1 and total capital)

is limited to 100% of tier 1 capital. Although this restriction does not impact directly on

subordinated debt, institutions with relatively large amounts of tier 2 elements other than

subordinated debt face a reduced incentive to issue the latter. There are also restrictions on the

terms of subordinated debt that may be recognized. For example, the original maturity of the

debt must be at least five years, and the amount recognized is amortized linearly over the last

five years before maturity.

The bottom line is that capital regulation – the Basel accord in particular – recognizes

subordinated debt as an important element of regulatory capital. However, recognition is subject

to a series of limitations that may induce disincentives for banks to issue subordinated debt. For

4 RWA is the sum of assets in various categories, weighted by category weights, plus amounts representing off-balance-sheet positions. See Basel Committee (1988). For our purposes in this section, we take RWA as given, sothat the regulation implies minimums for � and � �� . Note also that our simple model does not contain reservesor the other capital instruments recognized by Basel.

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banks that find the restrictions binding, the regulation may introduce distortions relative to the

capital structure that would be optimal under unconstrained conditions.

C. Proposals for mandatory subordinated debt

Proposals for subordinated debt requirements for banks go back at least to the early

1980s. A helpful review in FRS (1999) identifies three generations of such proposals. The first

generation focuses on the direct costs that would be faced by risky banks attempting to issue

subordinated debt. The prospect of facing such costs when issuance is required is expected to

compel banks to control their riskiness.5

A second generation of proposals uses the signal provided by banks’ ability or inability to

issue subordinated debt as a trigger for supervisory action. Banks that are not able to issue or

maintain debt according to regulatory requirements would be subject to supervisory sanctions.6

The third generation builds on earlier proposals by imposing a cap on the interest rate that a bank

would be allowed to pay on subordinated debt, and by suggesting explicit sanctions that

supervisors would impose on institutions that fail to meet the issuance and pricing requirments.7

The most visible and comprehensive recent proposal for mandatory subordinated debt is

probably the monograph issued by the SFRC (2000). This document presents a range of

proposals for capital regulation, among which figure three that relate to subordinated debt. The

first of these is that the distinctions between tier 1 and tier 2 capital, as outlined above, be

removed. One effect of this move would be to eliminate restrictions and possible disincentives in

the recognition of subordinated debt as regulatory capital. It should be noted, however, that the

total removal of the distinctions between tiers 1 and 2 would have many other effects, some of

which may be unintended.

A second proposal in the document is that banks be required to issue subordinated debt

periodically. Finally, a third proposal is to incorporate the signals provided by the issuance of

subordinated debt into a system of prompt corrective action. One element of this third proposal is

the idea, mentioned earlier, of capping the rate that banks are allowed to pay on subordinated

debt, and imposing sanctions on those banks that are unable to meet the cap.

5 Examples of first generation proposals are Federal Deposit Insurance Corporation (1983), Benston et al. (1986),and Litan and Rauch (1997).6 Examples of second generation proposals are Cooper and Fraser (1988), Wall (1989), and Evanoff (1993).7 The third generation is represented by Calomiris (1997, 1999), SFRC (2000), and Evanoff and Wall (2000).

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The key idea behind all of the subordinated debt proposals is to enlist the help of bond

market participants in the continuing supervision of banks. In a sense, banks would be forced to

seek the monitoring of the bond market, and the burden on supervisors would be correspondingly

reduced by the ability to free ride on the monitoring of the market. As argued in FRS (1999),

supervisors would rely on direct market discipline by bond market participants (who decide

whether to purchase or hold the debt at any given price), and indirect market discipline by those

who monitor the pricing of the debt (including supervisors). Superficially, this reasoning is

sensible, but any promise of a free ride must be viewed with some suspicion. It behooves the

policymaker to inquire not just into the benefits of the proposed regulation, but into the costs as

well.

Subordinated debt proposals have devoted little attention to the costs of the proposed

regulation. For instance, SFRC (2000) identifies only transaction costs as a possible consequence

of the regulation. It does raise the issue of the cost of leverage more generally, but brushes it off

by asserting that subordinated debt would crowd out deposits, not equity. We return to this point

in the following section.

The FRS (1999) study identifies four types of potential costs of subordinated debt

regulation and provides a cursory discussion of each one. First, if banks encounter problems

issuing the mandatory levels of subordinated debt, the negative information may trigger bank

deposit runs. Second, banks lack the flexibility with interest rate payments that they would have

with dividends on equity. Third, debt issuance may encourage subsequent risk shifting, as

indicated above in section I.A. Finally, prompt corrective action schemes based on subordinated

debt may limit the scope for regulatory forbearance, some forms of which are seen as potentially

beneficial. Of these costs, the third is directly related to the mainstream corporate finance theory

that we consider in detail in section III. The other costs may bear further analysis, but fall outside

the scope of the present paper.

II. What would mandatory subordinated debt crowd out?

The costs and benefits of requiring banks to issue a minimum level of subordinated debt

will depend on the banks’ reaction to the requirement, and there are several possibilities. One of

these is that the requirements are not binding, in the sense that banks already issue sufficient

subordinated debt to comply with the regulation. If this is the case for some individual

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institutions, they would not need to react to the regulation. If this is the case for the whole

industry, the regulation is simply otiose. Thus, let us assume that at least for some banks, the

regulation is binding, and that they would have to increase � , as defined in section I.A.

In our simplified framework, equation (1.2) implies that

1� � �� � � , (2.1)

so that an increase in � must be accompanied by a decrease in � or � . In the first case, deposits

would be crowded out by the increase in subordinated debt and the total leverage � of the bank

would remain fixed. In the second case, deposits would stay fixed and equity would be crowded

out by the additional debt, causing leverage to rise. This section will argue that it is more likely

that equity will be crowded out and that the effect of binding regulation will be tantamount to an

increase in leverage, whose effects will be considered in the next two sections.

As noted in section I.C., the SFRC (2000) monograph claims that the additional

subordinated debt required by regulation would crowd out deposits, not equity. It gives two

reasons to support this claim:

First, total bank debt consists of deposits as well as subordinated debt. Banks

wishing to maintain any given leverage ratio could easily do so by reducing their

deposits or other debt outstanding by the amount of their new subordinated-debt

offerings. Second, because subordinated debt would create new incentives to limit

bank risk, it likely would produce both lower asset risk and lower leverage.

The first point describes something that banks could do, not necessarily what they would do if

faced with the requirements. It essentially states an accounting identity and has no behavioral

implications. The second point is clearly more substantive. It seems counterintuitive in that the

direct effect of issuance of subordinated debt is to increase leverage, everything else equal. The

statement thus must contemplate a second-round behavioral effect of the requirement, which

would more than offset the direct leverage effect. Unfortunately, the SFRC (2000) document

does not elaborate.

What does finance theory have to say about the crowding out issue? A particularly

relevant approach is provided by Myers and Majluf (1984). They suggest that corporate sources

of funds may be classified according to a natural “pecking order,” in which firms tap first

sources of funds that are less sensitive to information. The more sensitive an instrument is to

information (that is, the more its value will vary with news), the more the holders of the

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instrument will have to expend to monitor the firm. Once again we see that finance theory is

concerned with the costs of monitoring in a situation in which the proponents of subordinated

debt requirements are focused on the benefits.

The implication of the Myers-Majluf analysis for our simple prototype bank is that it will

first tap the market for deposits, which is the least information-sensitive. Then it will turn to

subordinated debt, which is the first type of liability to absorb losses. Equity will be attractive if

it comes from retained earnings. However, publicly issued equity will be the most information-

sensitive source, since it is the first line of defense against losses to the firm. Under these

circumstances, if the bank is forced to issue additional subordinated debt, the debt is likely to

crowd out publicly-issued equity, which is the most sensitive source of funds.

Another approach to the crowding-out issue is provided by research on the safety net to

which banks have access. This safety net includes deposit insurance, provision of liquidity by the

central bank, and other real or perceived benefits. In theoretical and empirical research, Kwast

and Passmore (1999) and Lehnert and Passmore (1999) have presented evidence that the safety

net provides a subsidy to banks, which takes the form of cheaper deposits. Like the pecking-

order models, this approach suggests that banks are likely to respond to binding subordinated

debt requirements by economizing on publicly-issued equity, rather that on deposits.

Are there any circumstances in which subordinated debt is likely to crowd out deposits?

One possible scenario involves the combination of minimum equity and subordinated debt

requirements, both of which are binding. In this case, it is clear that the increases must come out

of deposits in the simple model. At present, though, the banking sector holds a large equity

cushion and could in general effect an increase in subordinated debt by reducing equity.

However, a situation in which requirements are binding is at least conceivable.

Other than the foregoing scenario, it is difficult to think of cases in which reducing

deposits would be preferable for banks. In the passage quoted earlier, the SFRC (2000) document

offers the argument that banks, if required to issue subordinated debt, have an incentive to

become less risky. The details of the argument are unclear, including how the lower riskiness

leads to more equity capital. For instance, if banks reduce the riskiness of their assets in order to

contain the costs of subordinated debt issuance, both the market and regulators would be likely to

require less equity, and banks would be able to substitute debt for equity, as the earlier arguments

suggest.

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We conclude that if banks are required to increase their issuance of subordinated debt,

they are likely to increase their leverage beyond the unconstrained optimum level. The next two

sections examine the consequences of such changes in the context of capital structure models.

III. Agency models – costs and benefits

If subordinated debt requirements are binding on banks, and if banks respond by

increasing leverage as theory suggests, what are the consequences? This section turns to agency

models for the answer to this question.8 Agency models since Jensen and Meckling (1976) have

been helpful in explaining why there may be an optimal capital structure for a given firm. Earlier

approaches tended to imply that capital structure is irrelevant or that the optimal structure

consists of all debt or all equity.9 By focusing on the implications of leverage for various

principal-agent conflicts related to the firm, these models imply that there is an interior solution

to the optimal leverage problem, which is consistent with observed corporate reality.

This section uses several well-known agency models to examine the implications of

constraining the firm to have higher level that is optimal within the model. The basic principles

behind all these models may be characterized in the following way, which is admittedly

simplistic but conveys the flavor of all the models.

In each model, debt helps to reduce the magnitude of a given agency conflict. For

instance, in the Jensen and Meckling (1976) model, there is a conflict between shareholders and

managers. Managers own only a fraction of the firm, so they are not fully identified with

shareholders. Moreover, managers have access to various perquisites, ranging from “the

appointments of the office” to “the purchase of production inputs from friends.” Thus, managers

may not act fully in the interest of outside equityholders, since they have limited share of the

profits of the firm, but bear the full cost of reductions in perquisites.

Debt alleviates this situation since, with a given level of assets and outside equity, more

debt leads to an increase in the proportion of equity held by managers. More precisely, suppose

that the conflict-resolution benefits of debt are given by ( )B � , a function of firm leverage, with

( ) 0B �� � and ( ) 0B ��� � . Thus, benefits increase with leverage at a decreasing rate.

8 The next section examines signaling models, another popular approach. For an extensive review of this wholeliterature, including approaches not covered in this paper, see Harris and Raviv (1991).9 For instance, arbitrage arguments suggest that capital structure is irrelevant and tax-based arguments suggest thatdebt is more attractive and that the firm should be fully leveraged.

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The other conflict in Jensen and Meckling, between stockholders and debtholders, was

already discussed in section I.A. Here the owners of the firm have an incentive to shift to riskier

projects once debt financing has been secured. As a consequence, debtholders must engage in

active monitoring of the firm, which is costly. These monitoring costs, in turn, are passed

through to the firm in the form of more expensive debt. The larger the volume of debt, the larger

the monitoring costs. Let ( )C � represent the cost of leverage to the firm, and suppose that

( ) 0C �� � and ( ) 0C ��� � . That is, the cost increases at an increasing rate. Then there is an

optimum level of leverage *� , given implicitly by ( *) ( *)B C� �� �� . If the firm is required to

hold a level of debt above the optimum, that is, a leverage ratio ˆ *� �� , we then have that

ˆ ˆ( ) ( )B C� �� �� . The benefits of the additional leverage are positive, but the marginal benefit is

outstripped by the greater marginal cost.

The capital structure models we consider here, like the foregoing simple model, apply for

the most part to debt in general and not to subordinated debt in particular. This section, however,

focuses on the case in which mandatory subordinated debt crowds out equity, with deposits

fixed. Thus, the implications of more subordinated debt are identical to those of higher leverage.

In the notation of equation (1.2), � � �� � and � �� �� . Using the same notation as in the

foregoing paragraph, a subordinated debt requirement ˆ *� �� that exceeds the optimum level of

subordinated debt leads to ˆ( * *) ( * )B C� � � �� �� � � . Whatever the marginal benefit of the

additional subordinated debt may be, its marginal cost is greater.

Consider now the specific benefits and costs of debt in a few selected models. In general,

the benefits of debt arise from the alleviation of a conflict between managers and outside

investors. In Jensen and Meckling (1976), as we have seen, there is a conflict over manager

perquisites with outside equityholders. In Stulz (1990), the conflict also involves perquisites, but

the mechanism is somewhat different. In this case, managers want to invest all available funds,

even if paying out cash is better for outside investors. Clearly, this can lead to overinvestment

relative to the level that is optimal for the outside investors. Debt, by reducing the free cash flow

of the firm, puts a cap on the funds available for investment, thus mitigating the problem. This

feature of debt is also examined by Jensen (1986).

In Harris and Raviv (1990) and in Hart (1993), managers are reluctant to liquidate the

firm, even when it is in the interests of outside investors. The existence of debt provides

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investors with the option of forcing liquidation when it is seen as optimal. Hart (1993) stresses

the importance of short-term debt to force cash payments in the short run and of senior long-term

debt, with appropriate covenants, to prevent managers from financing the required payouts by

borrowing against future earnings.

We now turn to the cost side, which is more important for our purposes since we are

examining a case in which marginal costs exceed marginal benefits. In both Jensen and Meckling

(1976) and Harris and Raviv (1990), the key story on the cost side has to do with monitoring

costs. We have seen that Jensen and Meckling base their analysis on risk shifting. The greater the

amount of debt, the greater the potential for asset substitution and the greater the need for

monitoring by debtholders.

In Harris and Raviv (1990), the emphasis is on the collection of information that may be

used by investors to force the bankruptcy of the firm under certain circumstances. An important

purpose of this information is to determine the value of the firm at liquidation. In both Jensen-

Meckling and Harris-Raviv, the subordinated debt requirement leads to an increase in monitoring

by debtholders. However, this increase is made necessary by the issuance of the additional debt

and might not be required in the absence of the requirement, with the firm at an unconstrained

optimum level of debt.

In other models, the cost of debt is accounted, not by monitoring, but by opportunity

costs. Stulz (1990) argues that debt reduces free cash flow and prevents managers from

overinvestment. Carried to an extreme, excessive debt is too much of a good thing in that a lack

of investable funds may preclude investment in profitable opportunities. This constraint has a

negative effect on the performance of the firm as well as on economic efficiency more generally.

In Hart (1993) the emphasis is on debt as a means for outside investors to force

bankruptcy when required. The downside here is that debt overhang – a large volume of debt

outstanding – may preempt profitable opportunities. Thus, the end effect is similar to that in

Stulz (1990): the performance of the firm is adversely impacted with broader implications for

economic efficiency.

To summarize, forcing the bank to lever itself beyond the unconstrained optimum level

leads to monitoring costs that are incurred because of the problem of risk shifting, and to

opportunity costs that arise because of missed investment opportunities. Implicit in both these

types of costs is also an additional risk to the bank and to the system. In Jensen and Meckling

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13

(1976), the firm has an increased incentive to invest in risky projects. In all cases, the additional

leverage implies a greater risk of bankruptcy. In fact, for Stulz (1990) and Hart (1993) this

increased likelihood of bankruptcy is crucial even for the benefits of debt. Thus, policymakers

must ask whether these risks are consistent with their objectives.

IV. Signaling models – informational content and risk

An alternative approach to the capital structure of firms is based on the use of leverage as

a signal to the market about the quality or riskiness of the firm. In equilibrium, a high level of

debt in these models signals to the market that the quality of the firm is high, and vice versa, with

quality defined in various ways depending on the model.

For instance, Ross (1977) defines a low quality firm as one that has high bankruptcy

costs. These costs are determined by the conditional cost and by the likelihood of bankruptcy. In

the model, the returns of the firms are related by first-order stochastic dominance, and firms that

have a high likelihood of failure have higher bankruptcy costs. However, firms with greater

leverage tend to have higher value. In equilibrium, only high quality firms – those with low

bankruptcy costs – will issue larger amounts of debt, since only they can afford to take the risk of

incurring the bankruptcy costs. For low quality firms, it would be too costly ex ante to do so.

Leland and Pyle (1977) use an alternative concept of firm quality. They assume that firms

have access to a range of projects with different levels of risk. Firms that choose risky projects

are badly situated to issue large levels of debt, for reasons similar to those in Ross (1977). In

equilibrium, only firms that choose less risky projects issue large amounts of debt. Heinkel’s

(1982) model also has features similar to those of Ross (1977) and Leland and Pyle (1977), but

avoids making strong explicit stochastic assumptions in the definition of the quality of firms.

Other authors have enhanced the basic structure of these models, while retaining the

principal results regarding information transfer and risk. Poitevin (1989) presents a model in

which there is a risk of predation for new entrants into a market from incumbent firms. It is

costly for an entrant to portray itself as low cost by issuing a large amount of debt if it is really

high cost, because it can become an easy target for predation. John (1987) extends the analysis

by combining the features of agency models and signaling models. Firms are differentiated by

risk and there is asymmetric information, as in the other models discussed in this section.

However, the multi-period sequential structure of the model allows for both risk shifting – as in

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the agency models – and signaling. A high quality, or equivalently a low risk firm is signaled by

a high level of debt.

To summarize, high debt is a signal of high quality in all these models. High debt is

expensive for low quality firms because their larger risks expose them to large losses ex ante. In

most of the models, the definition of risk is standard, relying on the stochastic properties of

return. A partial exception is Heinkel (1982), in which a low quality firm is more properly

exposed to poor performance, rather than high risk, when its level of debt is too high.

Now suppose that a regulatory requirement for the firm to issue subordinated debt

increases the leverage of the firm. In the context of the signaling models, there are two important

effects. First, there is a direct effect on the riskiness of the firm. In all the models, a low quality

firm refrains from issuing a large amount of debt because its level of risk would be

unsustainable. Depending on the size of the issuance requirement, the mandatory subordinated

debt may lead to excessive risk or simply to a suboptimal level of risk. In either case, the

increase risk could be a problem for policymakers.

The second effect of the requirement is that the value of signaling would be reduced or

even lost. If a firm issues a large amount of debt, is it signaling that it is high quality or is it

compelled to do so only by virtue of the regulation? In most models, the knowledge that a high

level of debt may be the result of a regulatory constraint and that this level may be too risky

could provide an incentive for outsiders to target the firm for bankruptcy. For instance, this is a

distinct possibility in Poitevin’s (1989) model, in which high debt could prompt predatory

reactions from incumbents.

Another possible effect of subordinated debt requirements is that the signaling value of

debt may be severely curtailed. The market may shrug off the issuing of subordinated debt as

being driven strictly by regulation and may interpret that it has no other real significance. An

empirical result of this nature is obtained by Cornett, Mehran and Tehranian (1998) in the equity

market. They look at the effects of equity issuance by banks on stock prices and reported returns.

Banks that are constrained by capital regulation experience negative returns, which is consistent

with results for nonfinancial firms.10 In contrast, those that are unconstrained show no effect,

10 Theory suggests that the firms’ owners have private information and may consider equity to be overpriced at thetime of issuance.

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suggesting that the equity issuance is perceived by the market as the result of regulation and

contains no further information.

Thus, subordinated debt requirements have the potential to lead to suboptimally high

levels of risk. Moreover, they may lead to a loss in the information content of market signals,

which is ironic since the requirements are intended precisely to enhance market signals with

regard to the quality of banks.

V. Implications for regulatory policy

The analysis of this paper provides a critique of mandatory subordinated debt proposals,

but also an indication of the correct way to proceed in terms of regulatory policy. On the

negative side, the analysis suggests that subordinated debt requirements are risky in several

ways. First, they may cause the market to incur high monitoring costs. Enhanced monitoring is

certainly welcome by regulators, but what if the costs are too high? Second, the requirements

may lead to inefficiencies as a result of debt burdens that are larger than optimal. Third, forcing

banks to issue more debt increases the risk of failure and bankruptcy. Fourth, if banks are

compelled to issue more debt, some of the very signals that the regulatory proposal is intended to

tap may become less informative, or even worthless.

Viewed in this light, proposals for regulation mandating minimum levels of subordinated

debt appear ineffective and risky. This conclusion is reached even without disputing the value of

the monitoring benefits to which proponents of the regulation point. In fact, the positive aspect of

the analysis stems from the continued confidence in the value of market signals, as long as they

are not affected by regulatory or other types of distortions.

Although two of the three proposals of the SFRC (2000) monograph are seen as

potentially distortionary, the spirit of the first proposal remains compelling. Recall that this first

proposal is to eliminate distinctions between tier 1 and tier 2 regulatory capital. The intent is

most likely to eliminate disincentives for banks to issue subordinated debt capital and, in that

form, the proposal is clearly supported by the analysis of this paper. Just as it is unwise to force

banks into levels of subordinated debt that exceed the optimum, it may be problematical to

constrain banks to levels of subordinated debt below the optimum. A regulation that is neutral to

the issuance of subordinated debt would best serve the purposes of the industry and of regulators.

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Benston, G., R.A. Eisenbeis, P.M. Horvitz, E. Kane, and G.C. Kaufman (1986), Perspectives on

Safe and Sound Banking, Cambridge, MA: MIT Press.

Board of Governors of the Federal Reserve System (1999), “Using Subordinated Debt as an

Instrument of Market Discipline,” Staff Study No. 172.

Calomiris, C.W. (1997), The Postmodern Bank Safety Net: Lessons from Developed and

Developing Countries, Washington, D.C.: American Enterprise Institute.

Calomiris, C.W. (1999), “Building an Incentive-Compatible Safety Net,” Journal of Banking and

Finance 23:1499-1519

Cooper, K. and D.R. Fraser (1988), “The Rising Cost of Bank Failures: A Proposed Solution,”

Journal of Retail Banking 10:5-12.

Cornett, M.M., H. Mehran, and H. Tehranian (1998), “Are Financial Markets Overly Optimistic

about the Prospects of Firms That Issue Equity? Evidence from Voluntary versus

Involuntary Equity Issuances by Banks,” Journal of Finance 53:2139-2159.

Diamond, D.W. and R.G. Rajan (1999), “Liquidity Risk, Liquidity Creation and Financial

Fragility: A Theory of Banking,” NBER Working Paper No. 7430.

Evanoff, D.D. (1993), “Preferred Sources of Market Discipline,” Yale Journal on Regulation

10:347-367.

Evanoff, D.D. and L.D. Wall (2000), “Subordinated Debt as Bank Capital: A Proposal for

Regulatory Reform,” Federal Reserve Bank of Chicago Economic Perspectives 24:40-53.

Federal Deposit Insurance Corporation (1983), “Deposit Insurance in a Changing Environment,”

Washington, D.C.: Government Printing Office.

Flannery, M. (1994), “Debt Maturity and the Deadweight Cost of Leverage: Optimally Financing

Banking Firms,” American Economic Review 84:320-331.

Gorton, G. and R. Rosen (1995), “Corporate Control, Portfolio Choice, and the Decline of

Banking,” Journal of Finance 50:1377-1420.

Harris, M. and A. Raviv (1990), “Capital Structure and the Informational Role of Debt,” Journal

of Finance 45:321-349.

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Harris, M. and A. Raviv (1991), “The Theory of Capital Structure,” Journal of Finance 46:297-

355.

Hart, O. (1993), “Theories of Optimal Capital Structure: A Managerial Discretion Perspective,”

in M.M. Blair, ed., The Deal Decade, Washington, D.C.: The Brookings Institution.

Heinkel, R. (1982), “A Theory of Capital Structure Relevance Under Imperfect Information,”

Journal of Finance 37:1141-1150.

Jensen, M.C. (1986), “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,”

American Economic Review 76:323-339.

Jensen, M.C. and W. Meckling (1976), “Theory of the Firm: Managerial Behavior, Agency

Costs, and Capital Structure,” Journal of Financial Economics 3: 305-360.

John, K. (1987), “Risk-Shifting Incentives and Signalling Through Corporate Capital Structure,”

Journal of Finance 42:623-641.

John, K., T.S. John and L.W. Senbet (1991), “Risk-Shifting Incentives of Depository

Institutions: A New Perspective on Federal Deposit Insurance Reform,” Journal of

Banking and Finance 15: 895-915.

Kwast, M.L. and S.W. Passmore (1999), “The Subsidy Provided by the Federal Safety Net:

Theory and Evidence,” Journal of Financial Services Research 16:125-145.

Lehnert, A. and S.W. Passmore (1999), “The Banking Industry and the Safety Net Subsidy,”

Finance and Economics Discussion Series No. 1999-34, Federal Reserve Board of

Governors.

Levonian, M. (2000), “Subordinated Debt and the Quality of Market Discipline in Banking,”

Draft, Federal Reserve Bank of San Francisco, September.

Leland, H. and D. Pyle (1977), “Information Asymmetries, Financial Structure, and Financial

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Myers, S.C. and N.S. Majluf (1984), “Corporate Financing and Investment Decisions When

Firms Have Information that Investors Do Not Have,” Journal of Financial Economics

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19

Appendix. Summary Tables for Agency and Signaling Models

The tables in this appendix provide a quick summary of the models of capital structure

discussed in sections III and IV. Table 1 shows the benefits and costs of debt as identified by the

agency models considered in section III. Each row identifies the two features that give rise to the

tradeoff involving debt in a particular model.

Table 2 summarizes the structure of five different models of capital structure that rely on

signaling. Each row corresponds to a specific model and indicates the types of firms involved

(or, equivalently, the definition of firm quality in the model) and the signal provided by a high

level of debt.

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20

Tab

le 1

. Sum

mar

y of

ben

efit

s an

d co

sts

of d

ebt

in s

elec

ted

mod

els

Mod

elB

enef

its

of d

ebt

Cos

ts o

f de

btJe

nsen

and

Mec

klin

g (1

976)

Shar

ehol

ders

vs.

man

ager

s: p

erqu

isite

s.M

anag

ers

own

only

a f

ract

ion

of th

e fi

rm.

The

refo

re, t

hey

bear

ful

l cos

t of

refr

aini

ng f

rom

perq

uisi

tes,

but

cap

ture

onl

y a

frac

tion

of th

e ga

in.

Mor

e de

bt (

less

equ

ity)

mea

ns m

anag

ers

have

prop

ortio

nate

ly m

ore

of th

e eq

uity

.

Deb

thol

ders

vs.

sha

reho

lder

s: r

isk

shif

ting.

Bec

ause

of

limite

d lia

bilit

y, s

hare

hold

ers

can

incr

ease

val

ue o

f eq

uity

at e

xpen

se o

f va

lue

ofde

bt b

y ch

oosi

ng r

iski

er p

roje

cts.

The

re a

rem

onito

ring

or

bond

ing

cost

s, a

nd b

ankr

uptc

y an

dliq

uida

tion

cost

s.H

arri

s an

d R

aviv

(19

90)

Man

ager

s vs

. inv

esto

rs: m

anag

ers

neve

r w

ant t

oliq

uida

te, e

ven

whe

n op

timal

for

inve

stor

s.D

ebt p

rovi

des

inve

stor

s th

e op

tion

to f

orce

liqui

datio

n (b

ankr

uptc

y).

Man

ager

s vs

. inv

esto

rs.

Cos

ts o

f pr

oduc

ing

info

rmat

ion

in r

elat

ion

toba

nkru

ptcy

(in

vest

igat

ion

cost

s): m

onito

ring

and

valu

atio

n at

liqu

idat

ion.

Stul

z (1

990)

Man

ager

s vs

. inv

esto

rs: p

erqu

isite

s; m

anag

ers

wan

t to

inve

st a

ll av

aila

ble

fund

s, e

ven

if p

ayin

gou

t cas

h is

bet

ter

for

inve

stor

s. L

eads

to o

ver-

or

unde

rinv

estm

ent.

Deb

t red

uces

fre

e ca

sh f

low

(Jen

sen

1986

) an

d in

vest

able

fun

ds.

Man

ager

s vs

. inv

esto

rs.

Deb

t may

exh

aust

inve

stab

le f

unds

and

pre

empt

prof

itabl

e op

port

uniti

es.

Har

t (19

93)

Man

ager

s vs

. inv

esto

rs: d

ebt c

an p

ut p

ress

ure

onm

anag

emen

t to

liqui

date

the

firm

.It

is im

port

ant t

o ha

ve s

hort

-ter

m d

ebt t

o fo

rce

cash

pay

men

ts in

the

shor

t run

and

sen

ior

long

-te

rm d

ebt t

o pr

eclu

de f

inan

cing

the

shor

t-te

rmpa

yout

s by

bor

row

ing

agai

nst l

ong-

run

earn

ings

.

Man

ager

s vs

. inv

esto

rs.

Deb

t ove

rhan

g m

ay le

ad to

mis

sed

inve

stm

ent

oppo

rtun

ities

.

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21

Tab

le 2

. Ele

men

ts o

f se

lect

ed s

igna

ling

mod

els

Mod

elT

ypes

of

firm

sSi

gnal

con

veye

d by

hig

h le

vel o

f de

btR

oss

(197

7)L

ow q

ualit

y (h

igh

risk

of

failu

re a

ndba

nkru

ptcy

cos

ts)

and

high

qua

lity

(low

ris

kof

fai

lure

and

ban

krup

tcy

cost

s).

Hig

h qu

ality

fir

m.

Forc

ing

low

qua

lity

firm

to is

sue

mor

e de

bt in

crea

ses

bank

rupt

cy p

roba

bilit

y be

yond

opt

imal

leve

l.L

elan

d an

d Py

le (

1977

)D

iffe

rent

ial r

isk

of p

roje

cts

avai

labl

e to

indi

vidu

al f

irm

s.Fi

rm w

ith lo

w r

isk

proj

ects

.Fo

rcin

g fi

rm w

ith h

igh

risk

pro

ject

to is

sue

debt

incr

ease

sov

eral

l fir

m r

isk.

Hei

nkel

(19

82)

Hig

her

qual

ity f

irm

s ha

ve h

ighe

r m

arke

tva

lue

but l

ower

qua

lity

bond

s (l

ow m

arke

t-to

-fac

e va

lue

ratio

).

Hig

h qu

ality

fir

m.

Forc

ing

low

qua

lity

firm

to is

sue

debt

req

uire

s a

shif

t fro

mov

erpr

iced

equ

ity to

und

erpr

iced

deb

t.Jo

hn (

1987

)Fi

rms

choo

se le

vel o

f ri

sk in

mul

ti-pe

riod

setti

ng w

ith im

perf

ect i

nfor

mat

ion.

Com

bine

s ag

ency

pro

blem

s (r

isk

shif

ting)

with

sig

nalin

g pr

oble

ms

(asy

mm

etri

cin

form

atio

n).

Hig

h qu

ality

or

low

ris

k fi

rm.

Forc

ing

high

ris

k fi

rm to

hol

d m

ore

debt

exp

oses

it to

subo

ptim

ally

hig

h le

vel o

f ri

sk.

Poite

vin

(198

9)L

ow c

ost a

nd h

igh

cost

new

ent

rant

s.In

cum

bent

with

kno

wn

valu

e.L

ow c

ost e

ntra

nt.

Forc

ing

high

cos

t fir

m to

issu

e m

ore

debt

incr

ease

s th

e ri

skof

ban

krup

tcy.

Arg

uabl

y, it

als

o su

bjec

ts th

e ba

nk to

exc

ess

pred

atio

n (e

.g.,

pric

e w

ar to

ban

krup

t new

ent

rant

), s

ince

ther

e is

a c

hanc

e th

at th

e ba

nk is

low

qua

lity

and

that

the

high

leve

l of

debt

is d

rive

n by

reg

ulat

ion

only

.