Costs and benefits of mandatory subordinated debt regulation for banks

Proposals for regulation requiring that banks maintain some minimum level of subordinated debt have gained support recently. These proposals focus on the benefits of such regulation, specifically, that supervisors are expected to free ride on debtholders’ monitoring efforts. But there are also monitoring and other costs: there is no real free ride. This paper uses the theory of capital structure to look at both costs and benefits of mandating subordinated debt for banks. The theory encompasses the touted monitoring benefits, but also identifies potential pitfalls such as excessive monitoring and opportunity costs, increased risk of bankruptcy, and distortion of market signals. The analysis suggests that, to tap into the benefits of subordinated debt, it is more sensible to eliminate disincentives from holding it than to force banks away from optimal levels. JEL Codes: G21, G28, G32