What’s the Best Way to Resolve a Global Bank? A Review of Comment Letters on Total Loss Absorbing Capacity (TLAC)

Last November, the Financial Stability Board (FSB)¹ released a proposal to put in place a new international failure resolution regime designed to address the too-big-to-fail challenge posed by the largest global banks. The FSB’s consultative document, which was endorsed by the United States and others at the Group of Twenty (G20) Leaders’ summit in Brisbane, Australia, proposes the creation of a new set of international capital buffers, over-and-above those currently prescribed through the Basel III agreement. These capital buffers ? known as total loss-absorbing capacity, or TLAC?would serve to absorb losses of a failing global systemically important bank (G-SIB) so that it can be resolved in an orderly fashion without posing a threat to systemic stability or requiring taxpayers to “bailout” the firm (read our earlier blog post on the proposal).

Since the fall, the FSB received comment letters from at least 50 stakeholders – ranging from industry representatives to financial reform advocates – on the TLAC plan. The responses largely welcomed the TLAC proposal as a key piece of the puzzle in ending the “too-big-to-fail” problem. However, many stakeholders expressed concerns that parts of the proposed TLAC framework could undermine effective cross-border resolution, lead to competitive inequities, were insufficiently transparent to investors and could have adverse impacts on the real-economy. Below is a brief summary of many of the key comment letters² grouped by their responses to several high profile issues. You may find areas of expected disagreement, expected agreement, and some unexpected agreement.

External TLAC

The FSB has been working for several years to establish an additional buffer for the largest global banks beyond the current minimum capital requirements contained in the Basel III accord. This additional cushion, now known as TLAC, is designed to impose losses on the holders of the institution’s equity and debt so that a G-SIB can be resolved in an orderly fashion without taxpayers having to inject money to “bail-out” the firm (hence this approach is often described as “bail in”).

The FSB has proposed that G-SIBs hold External (that is group-wide) TLAC equivalent to 16-20 percent of their risk-weighted assets and at least twice the capital leverage ratio required under the Basel III accord (6 percent). This proposed minimum TLAC requirement (also known as “Pillar 1” TLAC) incorporates the existing Basel III capital requirements but does not include either the capital buffers that international banks are required to hold or surcharges that have been placed on them. When those are included, the largest global banks may have to hold between 20 and 25 percent of their risk-weighted assets in equity and debt instruments that can be “bailed in” in times of crisis. The FSB proposal also includes an additional potential “Pillar 2” TLAC requirement for individual firms that would apply over and above the Pillar 1 minimum standards. This additional requirement would be determined on a case-by-case basis by the firm’s home country supervisors and regulators of its key subsidiaries in other countries.

The Systemic Risk Council’s comments articulate that the level of TLAC should be of “sufficient ?thickness’ ? to reassure financial markets, regulators and the public ? that resolution mechanisms for G-SIBs are credible.” The bulk of the industry response letters advocate for the FSB to adopt an External TLAC requirement at the low end of the 16-20 percent range, arguing that a higher requirement would be both unnecessary to ensure the orderly resolution of a G-SIB and result in economic inefficiencies. The U.S. trade associations’ joint letter cite research showing that a 16 percent External TLAC requirement would be capable of absorbing losses under the severely adverse scenario used in the Federal Reserve’s stress tests when both the Basel III capital conservation buffer and the new U.S. G-SIB surcharge are included in the calculation.

The U.S. trade associations, the Institute for International Finance (IIF) and Global Financial Markets Association (GIFMA), and individual institutions, such as Credit Suisse, advocate for a clear, straightforward Pillar 1 requirement. Some of the responses felt that the proposed Pillar 2 add-on requirement would lead to inconsistent and ad-hoc treatment of different firms, undermining a level-playing field. IIF and GIFMA note that existing regulatory and supervisory framework already addresses many of the issues ? such as resolution planning ? that would be required under Pillar 2.

The proposed leverage ratio also attracted attention in the submitted responses. The Systemic Risk Council urges the FSB to “base the TLAC requirement primarily on a substantial leverage ratio” given their concerns about the shortcomings of risk-weighted metrics. Standard and Poor’s (S&P) also raises concerns about over-reliance on existing RWA approaches to calculating capital standards. However, both S&P and the IIF- GIFMA responses warn that the proposed leverage ratio could supersede the 16-20 percent RWA requirement for low-risk retail banks, thus inadvertently penalizing institutions that are less systemically risky.

Internal TLAC

One of the centerpieces of the FSB’s TLAC framework is a proposed prepositioning of capital in the major or “material” subsidiaries of the G-SIB. This is a requirement that the FSB refers to as “Internal TLAC” as it would reside internally in the country of operation for that subsidiary. The FSB believes that this additional Internal TLAC requirement is critical in order to provide confidence to regulators in “host” jurisdictions that the G-SIB’s operations in those countries will maintain sufficient local resources should they run into difficulty. The FSB has proposed that material subsidies hold 75-90 percent of the External TLAC level that would apply to that subsidiary if it were a standalone entity.

This requirement has the potential to reshape the internal structure of many global banks, a marked departure from prior international agreements that did not proscribe how capital was distributed within firms. S&P raises the concern that Internal TLAC will lead to further “fragmentation of the banking system, leading to trapped capital and liquidity for global banks.” The Institute of International Bankers (IIB), Credit Suisse and the U.S. trade associations all raise the concern that Internal TLAC could lead to the balkanization of capital among the major subsidiaries of the group, making it difficult to quickly redeploy resources to other parts of the group that may be experiencing financial difficulties. This problem could be exacerbated if the international trend toward “ring-fencing” ? legal restrictions that make it difficult to reallocate local subsidiary capital to foreign entities ? continues. In the view of many commentators this could ironically undermine the ability to resolve the parent company or another major subsidiary, which is the very purpose of the TLAC framework.

The S&P and industry responses suggest that firms should have more flexibility in distributing TLAC across the group (notably neither Better Markets nor The Systemic Risk Council focus on the specific level and distribution of Internal TLAC in their responses). In this context, most of the industry letters argue that the Internal TLAC requirement should be revised down to 65-75 percent, with a presumption that the figure for most subsidiaries should be at the lower end of the range. IIB recommends that Internal TLAC not be automatically applied, but rather be determined following discussions with the G-SIB’s home regulator and input from Crisis Management Groups (CMGs) of key regulators of the G-SIB. The S&P, IIB and IIF-GIFMA responses also note that the aggregate of the group’s Internal TLAC requirements in its material subsidiaries could in some cases exceed its consolidated External TLAC requirement, undermining the objective of having flexible group-wide resources and imposing competitive disadvantages on some firms.

International Cooperation

Another concern that is widely expressed across both industry and non-industry letters is that the internal TLAC requirement should not act as a substitute for international cooperation on resolution issues. That is, the “host” and “home” regulators should agree ex ante on procedures for resolving the group and its subsidiaries so that they avoid engaging in ring-fencing activities that could result in the failure of the group or a major entity within it. Better Markets suggests reform of CMGs, which are a key forum for such cooperation. Currently, membership in these groups is restricted to authorities that are material to the effective resolution of the firm, meaning ? by the FSB’s own admission – that “host jurisdictions where a G-SIB has a systemic presence” could be excluded.³ Better Markets advocates that the FSB adopt a more inclusive approach to membership in these groups in order to avoid “domestic ring fencing, collateral seizure and similar activities” in a crisis.

Transparency

In its consultative document, the FSB stated investors should have a clear understanding of “how losses are absorbed and by whom and in which order”; in short, investors should know if and under what circumstances they will bear the firm’s losses. This transparency would, in the FSB’s view, “enhance the credibility and feasibility of resolution and strengthen market discipline.” While welcoming this commitment to disclosure, The Systemic Risk Council, S&P, and Better Markets all call on the FSB to ensure increased transparency and accessibility of TLAC instruments. S&P and Better Markets suggest that there should be common standards for the disclosure of the “pecking order” of various types of liabilities included in TLAC; i.e., what classes of liabilities are liable for losses first. Better Markets would also like full disclosure of the entire corporate structure of the group so that “investors and regulators can see the ownership, control, and inter-relationships of each entity” within it.

Composition of TLAC

What counts as TLAC ? and what doesn’t ? is at the core of a lot of the responses to the consultative document. Two specific issues have attracted significant attention. First, the consultative document makes it clear that TLAC-eligible debt will contractually absorb losses before all other holders of bank liabilities. This is necessary to ensure that holders of TLAC debt are the first to absorb losses from the failure of the firm. However, as both the IIF-GIFMA letter and the U.S. trade associations note, this creates problems for bank holding companies ? the form of bank structure most common in the United States. These holding companies sometimes have liabilities arising from taxes and hedging transactions, amongst others, that would not be permitted under this rule. Ironically then, this provision could discourage G-SIBs from forming a holding company structure, which in turn could undermine the “single-point-of-entry” strategy for resolving large global banks currently being developed by the Federal Deposit Insurance Corporation (FDIC).⁴

Second, the maturity duration of TLAC instruments is raised in many of the response letters. The FSB’s consultative document makes clear that to be TLAC-eligible, liabilities must have a minimum remaining maturity (repayment date) of at least one year. S&P expresses the concern that this short time-frame will result in large-scale redemptions of TLAC liabilities during periods of stress. It therefore proposes capping the contribution of instruments with a maturity date of 12 to 24 months to reduce the danger that the TLAC buffer will be rapidly depleted during such a period. The U.S. trade associations’ letter, by contrast, notes that “even during the financial crisis, the period between an institution’s distress becoming apparent and its collapse was generally less than six months.” As such, they suggest reducing the proposed minimum remaining maturity requirement to six months, providing it had an original maturity of at least one year. In their view, this would make TLAC more manageable from a corporate finance perspective and also make it consistent with Basel III’s existing liquidity rules.

Cross-Ownership of TLAC

Since G-SIBS can hold each other’s TLAC instruments, another potential concern is that the extensive cross-ownership of such debt could create a contagion effect in the event of a bank failure, leading to losses across the financial sector. Several of the industry letters acknowledge this risk but also highlight a problem: those same banks play an important role in ensuring liquidity in the financial markets by underwriting sales of debt or equity and purchasing debt or equity for short-periods for their clients (a role known as “market making”). Prohibiting them from conducting these activities could reduce liquidity in the market for TLAC instruments, making it difficult to raise funds. The industry recommends that the revised FSB proposal permit G-SIBs to hold each other’s TLAC instruments for bona fide underwriting and market making purposes.

Domestic Flexibility vs. Global Requirements

The potential adoption of more stringent rules by national regulators attracted attention in the response letters. The Systemic Risk Council is clear that the TLAC requirements proposed by the FSB “should be a floor and not a ceiling for the TLAC requirements that national regulatory authorities around the world ultimately set.” Moreover, they explicitly urge U.S. regulators “to consider imposing minimum leverage and risk-based capital requirements above and beyond the levels set forth by the FSB.” By contrast, the IIF and GIFMA urge the FSB to discourage the practice of what they view as potential “goldplating” by domestic regulators, arguing that it would undermine “the level playing field and efficient international markets” and “compound the existing “goldplating” of Basel III in some jurisdictions.” The IIB is particularly concerned that Internal TLAC could be subject to “goldplating,” thereby increasing the likelihood of the firm’s aggregate Internal TLAC exceeding the G-SIB’s External TLAC requirement.

Economic Impact

The IIF-GIFMA response notes that “the new requirements will almost certainly raise bank funding costs ? probably not just for G-SIBs ? and such [an] increase can be expected to have fallout effects on real-economy financing costs.” Their response along with other industry letters welcome the FSB’s decision to conduct a macro-economic quantitative impact study and market-impact analysis over the course of this year. S&P examined the potential impacts for the FSB to consider as it conducts its impact studies. They note that a key consideration is whether capital markets will be able to absorb bank’s TLAC needs, noting ? on a global basis ? that banks would have to raise $500 billion in TLAC instruments, assuming the lower end of the proposed range. They further note that those additional costs could double to $1 trillion if the FSB settles on a level toward the upper part of its proposed range. Much will depend not only on the range, but the composition of TLAC. In addition, individual country regulators may exceed these criteria, or apply them more widely to non-G-SIB institutions, which could increase the overall cost of the proposal.

What’s Next

The FSB’s consultative effort is part of a year-long review process that will also include a range of impact assessment studies examining the effects of the new rules on the broader economy, financial markets, and the banking sector. The FSB will almost certainly release a significantly revised version of its loss-absorbing capacity proposal prior to the next G20 Leaders’ Summit in Antalya, Turkey, which will likely be held in the fall of 2015. At that point, it is probable that national regulators will begin their consultation process with stakeholders ahead of the proposed conformance date of January 1, 2019. The Federal Reserve Board, which will set these standards domestically, will have to determine whether it wishes to impose additional requirements on top of the minimum TLAC buffer. Meanwhile, the FDIC, which would be the resolver of such institutions, will have to make decisions on a range of implementation issues and continue to forge cross-border resolution agreements with foreign regulators, a key recommendation of the Bipartisan Policy Center’s Failure Resolution Task Force.

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¹ The Financial Stability Board is an international body established by the G20 to coordinate the work of national financial regulatory bodies and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory, and other financial sector policies.

² For the purposes of this blog, comment letters from the following organizations’ letters were reviewed: Better Markets; a joint U.S. trade associations letter submitted by The Clearing House Association, SIFMA, American Bankers Association (ABA), and the Financial Services Roundtable (FSR); Credit Suisse; Institute of International Bankers (IIB); a joint letter submitted by the Institute of International Finance (IIF) and the Global Financial Markets Association (GIFMA); Standard and Poor’s (S&P); and The Systemic Risk Council.

³ Financial Stability Board, Progress and Next Steps Towards Ending Too-Big-To-Fail, September 2, 2013.

⁴
For more on the single-point-of-entry strategy, see John F. Bovenzi, Randall D. Guynn, and Thomas H. Jackson, “Too Big to Fail: The Path to a Solution,” Bipartisan Policy Center, May, 2013 and BPC’s Financial Regulatory Reform Initiative’s Failure Resolution Task Force, “Comment on the Notice on the Resolution of Systemically Important Institutions: The Single Point of Entry (SPOE) Strategy,” March 2014.