Can Feedback from the Jumbo-CD Market Improve Bank Surveillance?

Abstract

In recent years, policymakers in the Basel countries have begun exploring strategies for harnessing financial markets to contain bank risk. Indeed, the new Accord counts market discipline, along with supervisory review and capital requirements, as an explicit pillar of bank supervision.1 A popular proposal for implementing market discipline in the United States would require large banks to issue a standardized form of subordinated debt (Board of Governors 1999; Board of Governors 2000; Meyer 2001). Advocates of this proposal argue that high-powered performance incentives in the subordinated debt (sub-debt) market will produce accurate risk assessments. And, in turn, these assessments-expressed for risky institutions through rising yields or difficulties rolling over maturing debt-will pressure bank managers to maintain safety and soundness (Calomiris 1999; Lang and Robertson 2002). Even if financial markets apply little direct pressure to curb risk taking, market data could still enhance supervisory review by improving offsite surveillance.2 Off-site surveillance involves the use of accounting data and anecdotal evidence to monitor the condition of supervised institutions between scheduled exams.3 Market assessments could enhance surveillance in three ways: (1) by flagging banks missed by conventional off-site tools, (2) by reducing uncertainty about banks flagged by other tools, or (3) by providing earlier warning about developing problems in banks flagged by these tools (Flannery 2001). Such enhancements would reduce failures over time by enabling supervisors to take action earlier to address safety-and-soundness problems. One concern about attempts to incorporate market data into surveillance is regulatory burden-current proposals would require large banking organizations to float a standardized issue of sub-debt. That most large banks currently issue sub-debt does not imply the burden is negligible.4 Voluntary issuance varies considerably over time with market conditions. For example, the number of sub-debt issues by the top-50 banking organizations rose from 3 in 1988 to 108 in 1995, only to fall to 42 in 1999 (Covitz, Hancock, and Kwast 2002). Moreover, banks currently issuing sub-debt may be choosing maturities unlikely to produce valuable risk signals, so a mandated maturity would still impose a regulatory burden. Before placing additional burden on the banking sector, particularly at a time when other sizable regulatory changes (Basel II) are in the offing, supervisors should first assess the power of risk signals from existing securities. One potential source of risk assessments that can be mined without increasing regulatory burden is the market for jumbo certificates of deposit (CDs). Jumbo CDs are time with balances exceeding $100,000. The typical bank relies on a mix of to fund assets-checkable deposits, passbook savings accounts, retail CDs, and jumbo CDs. Both retail and jumbo CDs have fixed maturities (as opposed to checkable which are payable on demand); they differ by Federal Deposit Insurance Corporation (FDlC) coverage. Only the first $100,000 of is eligible for insurance, so the entire retail CD (which is less than $100,000) is insured while only the first $100,000 of a jumbo CD is covered. Checkable deposits, passbook savings, and retail CDs are often collectively referred to as deposits because balances respond little to changes in bank condition and market rates. Full FDIC coverage makes these a stable and cheap source of funding. At year-end 2005, U.S. banks funded on average 67.1 percent of assets with core and 14.4 percent with jumbo CDs. The average jumbo CD balance in the fourth quarter of 2005 was $330,886; the average balance in 95 percent of the U.S. banks exceeded $152,115. The average maturity was just over one year. Jumbo CDs are considered a volatile liability because relatively large uninsured balances and short maturities force issuing banks to match yields (risk-free rates plus default premiums) available in the money market or lose the funding. …