The paper presents a model of a bank with endogenous risk choices, where delegated monitoring by subordinate debt helps to contain risk shifting by banks in the presence of deposit insurance. While there are individual shortcomings in these instruments, their joint featuring to stabilise banks is deemed complementary in this paper. While deposit insurance can increase welfare for uninformed depositors and helps in averting information based bank runs, active monitoring by subordinate debt can counter moral hazard associated with deposit insurance. The model developed here explores conditions which can lead banks to choose the risk consistent with the risk chosen by a social planner as first best.
The model builds on previous studies and envisages an active market for subordinate debt which can continuously impart signals to the regulators and other at-risk stakeholders. This provides the necessary discipline for banks so that they may conform to solvency consistent behaviour. While active monitoring is a precondition to achieve the first best, it can be ensured by inducing stronger interest on part of subordinate debt holders to monitor bank risk. A market in these securities, therefore, is deemed vital which further enables the incorporation of the risk assessment by subordinate debt into the objective functions of banks.
The model also depicts the relevance of subordinate debt in eliminating the distortions in deposit insurance pricing. Specifically, subordinate debt helps in checking the risk shifting incentives even when the insurer charges a premium other than the first best, while completely eliminating these incentives where optimal quantities of subordinate debt are chosen. Importantly, the paper also argues that subordinate debt can induce incentives for counter-cyclical asset allocation by banks for their risky portfolios.
