REFORMING BANK CAPITAL REGULATION: USING SUBORDINATED DEBT TO ENHANCE MARKET AND SUPERVISORY DISCIPLINE

In 1988 the Basel Capital Accord introduced minimum risk‐weighted capital requirements for internationally active banks. In recent years there has been a growing realization that there are significant problems with the capital guidelines. As financial firms have become more sophisticated and complex they have effectively arbitraged the requirements and have become so good at it that the regulations have essentially ceased being a safety and soundness issue for supervisors and have become more of a compliance issue. Indeed, the Basel Committee is now evaluating reforms to the capital accord and is considering various means to improve the risk‐capital relationship and to increase the role of market discipline. The authors argue that many of the problems that currently exist can be addressed, and some additional benefits not previously possible under the current capital guidelines can be realized, by increasing the role of subordinated debt in the bank capital structure. The authors discuss the potential benefits and offer a capital reform proposal that would improve both market and supervisory oversight. This should lead to more prudent risk management behavior by the larger, more complex banking organizations, resulting in a safer industry with less potential for systemic problems.