Subordinated debt and bank capital reform

In recent years there has been a growing realization that there are significant problems with the current bank risk-based capital guidelines. As financial firms have become more sophisticated and complex they have effectively arbitraged the existing capital requirements. They have become so good at avoiding the intent of capital regulation that the regulations have essentially ceased being a safety and soundness issue for supervisors and have become more a compliance issue. There is also a growing realization that bank regulation must more effectively incorporate market discipline to encourage prudent risk management. One means recommended to accomplish this is to increase the role of subordinated debt in the bank capital requirement. Arguments have been made that this could lead to improvements in both market and supervisory discipline. Although a number of such proposals have been made, there appears to be significant misunderstanding of how bank capital requirements would be modified and what might be accomplished by the modification The goal of this article is to provide a comprehensive review and evaluation of subordinated debt proposals, and to present a regulatory reform proposal that incorporates the most desirable characteristics of subordinated debt.