Mandatory Sub-Debt Policy as an Alternative to the Third Pillar of Basel II: Is It Feasible?[La Politique de Dette Subordonnée comme alternative au IIIe Pilier de Bâle II : est-elle faisable ?]

Yes and no. The recent proposals of reform put forward by the Bank for International Settlements and the Federal Reserve System include specific elements of market discipline that are naturally added to the traditional tools of banking regulation and supervision. More precisely, a mandatory Sub-Debt Policy by which certain large and sophisticated banking organizations are forced to issue some minimum amount of subordinated debt on a regular basis, can prove itself effective in mitigating moral hazard and regulatory forbearance in banking industry. In this article, we provide some interesting and useful insights into the incentives structure of sub-debt holders by using a standard framework for option pricing applied to the banking firm. In particular, under ‘normal' conditions of bank solvability the subordinated creditors act indeed as natural ‘allies' of regulators, mitigating the risk taking incentives of bank shareholders. On the contrary, as the bank approaches its default point, they may exacerbate the moral hazard problems and complicate the tasks of supervisory authorities. In this second case, the sub-debt holders behave in fact as ‘enemies' of the government supervisor. Finally, we derive some major policy implications in terms of market discipline and optimal bank regulation design.