Federal Reserve policymakers have primarily focused on subordinated notes
and debentures (SND) when discussing potential sources of market data.
SND are fixed-income bank liabilities that are uninsured and unsecured.
Rather than examining the yield on SND directly, analysts track the difference
between the SND yield and yield on a security of a comparable maturity
that has very little chance of default, such as a U.S. Treasury bond.
Focusing on this "spread" should help highlight that part of
the SND yield reflecting the chance that the issuer will default.
Supporters offer two reasons to focus on SND as a source of market
data. First, the incentives facing SND holders are believed to be
closely aligned with regulatory objectives. A recent Federal Reserve
publication explained the point as follows:
Subordinated debt holders have an interest in discouraging excessive
risk taking because their claims are both long-term and junior
to all depositors and to any senior debt holders. Subordinated
debt holders share in very limited ways in potential gains made
by a company but are exposed to considerable risk if it encounters
financial difficulty. In this respect, their risk preferences
can resemble those of bank supervisors.1
SND supporters usually contrast the incentives of SND holders
with those of equity holders who can benefit from the upside potential
of bank risk taking (equity holders also have long-term, junior
claims). Seeming ease of calculation and interpretation offers a
second reason to focus on SND spreads.
In truth, use of SND signals faces many complications because of
the limited number of issuers, the diversity of SND issues by banking
institutions and the availability of reliable real-time data for
supervisors. The choice of the risk-free benchmark rate has also
become more problematic due to changes in the market for U.S. Treasury
securities. These factors make it difficult to isolate that portion
of the spread that reflects the riskiness of the institution.
Concerns about SND data led analysts to re-examine the ability
of supervisors to harness equity data. Equity market instruments
are issued by more firms. In addition, we have more confidence in
the prices of equity securities because they are traded in more
liquid and transparent markets compared to SND. But concerns about
equity holders' ability to benefit from risk taking remained. Moreover,
raw stock prices do not facilitate cross-institution comparisons
nor do economists look to stock prices as direct measures of risk.
So-called Merton models (named after the Nobel Prize-winning economist
who first devised them) offer one method for addressing these concerns
in a theoretically sound manner. Merton recognized that information
embedded in equity prices, as well as in the movement of those prices,
can allow valuation of the assets of the firm and the riskiness
of those assets. More precisely, he observed that equity holders
can be viewed as owning a call option that allows them to purchase
the assets of the firm from other creditors. The models then use
a very standard formula to value the option and determine the asset
value and the volatility of assets. By comparing the value of assets
to the value of liabilities and figuring out the chance that assets
will fall below liabilities based on their volatility, analysts
can determine the probability of a firm failing.
While computationally complex, this approach has become fairly
standard among financial economists and policy analysts. Indeed,
Federal Reserve economists have cited the output from such models
to argue that deposit insurance provides a subsidy to banks.2
Certainly, questions about model assumptions and equity holder
incentives remain. But, similar questions have also been raised
about SND, particularly the degree to which supervisors and SND
holders view the world similarly. After all, for the proper compensation
an SND holder might be willing to finance bank risk taking that
a supervisor would oppose.
Uninsured deposits offer another potential source of market data.3 These deposits take the form of certificates of deposit (CDs)
with a principal of over $100,000. The basic research on jumbo CDs
shows that their spreads also vary with the riskiness of the bank.
Jumbo CDs of the vast majority of banks never trade in secondary
markets, although the biggest banks issue jumbo CDs in very large
amounts that do trade regularly. Rates on jumbo CDs of either type
might be valuable market-based information, but the Federal Reserve
does not have routine access to such data at the individual bank
Senior bonds also are a potential source of price signals. Prices
paid for senior debt should reflect market perceptions of institutional
risk taking. But use of senior debt prices would present a trade-off.
Reviewing these prices would significantly expand the amount of
bond market data available to supervisors. On the other hand, senior
bond holders may not be as sensitive to risk as SND holders, due
to their more protected position; this could reduce the information
value of senior debt.
Supervisors could also review nonprice market data. Data on shifts
in the composition of a bank's funding may be valuable. Banks appear
to decrease their use of uninsured deposits and increase their use
of insured funding as they approach failure. Likewise, the decision
of a bank to abstain from issuing SND appears to provide information
on its riskiness. In the equity markets, share purchases and sales
by insiders may be informative. As is the case with jumbo CDs, these
types of potential signals have received little attention to date,
primarily because the Federal Reserve has not developed the apparatus
to collect and distribute such nonprice data for use in banking