One approach the Federal Reserve is exploring would enhance the role of investors in bank or bank holding company subordinated debt. Unlike shareholders, who benefit from any gains from excessive risk, subordinated debt holders have only downside risk.
As a result, their incentives are similar to those of supervisors and the bank insurance fund: they lose if the bank defaults but they don’t participate in outsized gains. A difficulty, however, in creating a greater role for subordinated debt is determining how to provide investors with adequate and timely information about a bank’s risks and with sufficient leverage to affect management decisions.