By Charles W. Calomiris
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Extra info for The Postmodern Bank Safety Net: Lessons from Developed and Developing Economies (AEI Studies on Financial Market Deregulation)
As much of the recent research on the operation of banks before the era of deposit insurance has emphasized, holders of large amounts of bank debt (often other banks) helped to ensure the proper mixture of assistance and discipline within the banking system (Gorton 1985; Calomiris 1989, 1990, 1993b; Calomiris and Gorton 1991; Calomiris and Schweikart 1991; Calomiris and Mason 1997). They provided mutual assistance to solvent banks during times of illiquidity because they were knowledgeable about the banks’ prospects and because debt holders faced strong incentives to help solvent banks.
It has the advantage of ensuring incentive compatibility with a minimal set of regulatory guidelines and no reliance on government supervisors to analyze and disclose the condition of bank loan portfolios. 3 That rule would force banks to operate below the fifty-basis-point risk schedule. If the most junior 2 percent of debt bears a premium of fifty basis points, then overall the fairly priced risk premium for all debt (including the 98 percent of debt that is insured) must be lower. To be willing to hold the bank’s debt, private subordinateddebt holders would have to be satisfied that the leverage and the portfolio risk of the bank were sufficiently low to warrant that low (fifty-basis-point) yield spread on debt.
If subordinated debt is not really junior to 28 POSTMODERN SAFETY NET the government insurer, then it serves no purpose. It is widely believed that many governments provide implicit insurance for some or all uninsured debts in their banking systems. That raises the question of whether government is willing or able to allow private market discipline to take place. In previous work (Calomiris 1997), I have argued that there are ways to limit the likelihood of a bailout of subordinated debt by restricting the identities of the holders of subordinated debt to those that the government would be unlikely to bail out (for example, foreign-based banks) and by providing other systemic protections to the financial system that limit the incentive to provide bailouts.