Too-big-to-fail after FDICIA

This reprint of a 1993 article outlines what Congress intended the Federal Deposit Insurance Corporation Improvement Act of 1991 to accomplish. A new preface discusses FDICIA's successes and failures as well as research calling for clearer policies to deal with the problem of "too big to fail" banks.Federal Deposit Insurance Corporation Improvement Act of 1991 ; Deposit insurance

Determinants of the loan loss allowance: some cross-country comparisons

This paper analyses the determinants of banks’ loan loss allowances for samples of US banks and three non-US samples: a group of 21 countries, Canada and Japan. The model includes fundamental (or non-discretionary) determinants of the allowance such as non-performing loans, and discretionary determinants such as income before the loan loss provision. The results suggest that the loan loss allowance is sensitive to pre-provision income in almost all samples. However, the results also suggest that some variables thought to reflect fundamental factors in US analysis, such as net chargeoffs, are not significant factors for non-US banks.loan loss allowance; accounting standards; international banking; nonperforming loan; discretionary accruals

Subordinated debt and prompt corrective regulatory action

Several recent studies have recommended greater reliance on subordinated debt as a tool to discipline bank risk taking. Some of these proposals recommend using subordinated debt yield spreads as additional triggers for supervisory discipline under prompt corrective action (PCA), action that is currently prompted by capital adequacy measures. This paper provides a theoretical model describing how use of a second market-measure of bank risk, in addition to the supervisors’ own internalized information, could improve bank discipline. The authors then empirically evaluate the implications of the model. The evidence suggests that subordinated debt spreads dominate the current capital measures used to trigger PCA and consideration should be given to using spreads to complement supervisory discipline. The evidence also suggests that spreads over corporate bonds may be preferred to using spreads over U.S. Treasuries.Bank supervision ; Debt

Debt, hedging, and human capital

This paper provides a theory of debt and hedging based on human capital. We distinguish human capital from physical capital in two ways: (1) human capital is inalienable and can exercise a one-sided option to leave the firm, and (2) human capital is not perfectly replaceable. We show that a firm may reach the first best solution while issuing debt or equity to outsiders provided that either the insiders receive a senior claim or that the firm hedges. We then show that, given asymmetric information concerning costs, the only viable solution has the firm issuing debt to outsiders and hedging.

Subordinated debt and prompt corrective regulatory action

Several recent studies have recommended greater reliance on subordinated debt as a tool to discipline bank risk taking. Some of these proposals recommend using subordinated debt yield spreads as additional triggers for supervisory discipline under prompt corrective action (PCA); action that is currently prompted by capital adequacy measures. This paper provides a theoretical model describing how use of a second market-measure of bank risk, in addition to the supervisors own internalized information, could improve bank discipline. We then empirically evaluate the implications of the model. The evidence suggests that subordinated debt spreads dominate the current capital measures used to trigger PCA and consideration should be given to using spreads to complement supervisory discipline. The evidence also suggests that spreads over corporate bonds may be preferred to using spreads over U.S. Treasuries. *The authors wish to thank Mark Flannery, Xavier Freixas, Ben Gup, Alan Hess, George Kaufman, Joe Haubrich, William Perraudin and Mark Vaughan for constructive comments and suggestions on earlier drafts. The authors also acknowledge the support of Nancy Andrews, Mark Murawski and George Simler in developing the database used in the study, and Andy Meyer, Alton Gilbert, and Mark Vaughan for graciously providing detailed information about their 'early warning model. The opinions expressed, however, are those of the authors and not necessarily those of the people mentioned above, the Federal Reserve Bank of Chicago, Federal Reserve Bank of Atlanta or the Federal Reserve System.Debt ; Bank supervision

Subordinated debt as bank capital: a proposal for regulatory reform

Industry observes have proposed increasing the role of subordinated debt in bank capital requirements as a means to increase market discipline. A recent Federal Reserve System Task Force evaluated the characteristics of such proposals. Here, the authors take the next step and offer a specific sub-debt proposal. They describe how it would operate and what changes it would require in the regulatory framework.Bank capital ; Debt ; Bank supervision

Measures of the riskiness of banking organizations: Subordinated debt yields, risk-based capital, and examination ratings

Recently there have been a number of recommendations to increase the role of subordinated debt (SND) in satisfying bank capital requirements as a preferred means to discipline the risk-taking behavior of systemically important banks. One such proposal recommended using SND yield spreads as the triggers for mandatory supervisory action under prompt corrective action guidelines introduced in U.S. banking legislation in the early 1990s. Currently such action is prompted by bank capital ratios. Evidence from previous research suggests that yield information may be a better predictor of bank problems. This paper empirically analyzes potential costs and benefits of using SND signals to trigger prompt corrective action.Risk ; Debt ; Banks and banking ; Bank supervision ; Bank examination

Measuring capital adequacy supervisory stress tests in a Basel world

The United States is now committed to using two relatively sophisticated approaches to measuring capital adequacy: Basel III and stress tests. This paper shows how stress testing could mitigate weaknesses in the way Basel III measures credit and interest rate risk, the way it measures bank capital, and the way it creates countercyclical capital buffers. However, this paper also emphasizes the extent to which stress tests add value will depend upon the exercise of supervisor discretion in the design of stress scenarios. Whether supervisors will use this discretion more effectively than they have used other tools in the past remains to be seen

Preconditions for a successful implementation of supervisors' prompt corrective action: Is there a case for a banking standard in the European Union?

Over the past years, several countries around the world have adopted a system of prudential prompt corrective action (PCA). The European Union countries are being encouraged to adopt PCA by policy analysts who explicitly call for its adoption. To date, most of the discussion on PCA has focused on its overall merits. This paper focuses on the preconditions needed for the adoption of an effective PCA. These preconditions include conceptual elements such as a prudential supervisory focus on minimizing deposit insurance losses and mandating supervisory action as capital declines. These preconditions also include institutional aspects such as greater supervisory independence and authority, more effective resolution mechanisms, and better methods of measuring capital.

The adoption of stress testing: Why the Basel capital measures were not enough

The Basel capital adequacy ratios lost credibility with financial markets during the crisis. This paper argues that failure was the result of the reliance of the Basel standards on overstated asset values in reported equity capital. The United States' stress tests were able to assist in restoring credibility, in part because they could capture deterioration in asset values. However, whether stress tests will prove equally valuable in the next crisis is not clear. Some of the weaknesses in the Basel ratios are being addressed. Moreover, the U.S. tests' success was the result of a combination of circumstances that may not exist next time