The Group of Twenty (G20) Leaders’ summit in Brisbane, Australia will meet from November 15-16 to consider a variety of issues, including a proposal released today by the Financial Stability Board (FSB)1 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. Here are several questions to consider ahead of the meeting:
- Why is an international resolution plan necessary to end to too-big-to-fail?
- How much equity and new types of debt will banks have to issue?
- How will cross-border cooperation work?
- How quickly will these reforms be implemented?
Why is an international resolution necessary to end too-big-to-fail?
The failure of a global bank will require a global response. Since the financial crisis, the United States and other nations have implemented a wide variety of enhanced measures, such as additional capital and annual stress tests, designed to reduce the likelihood that a major financial institution will fail. Regulators in these countries have also proposed new plans to ensure they have the legal tools needed to resolve a large financial institution without triggering a broader financial panic or crisis.
Broadly speaking, these plans aim to achieve two main objectives. First, they ensure continuity of a failing institution’s systemically important subsidiaries in order to avoid dangerous economic disruptions and contagion. Second, they require the company’s equity and debt holders, not taxpayers, to ultimately absorb losses, a principle often described as “bail-in” (in contrast to “bail-out” by the government).2
In the United States, the Dodd-Frank Act empowered the Federal Deposit Insurance Corporation (FDIC) with new legal authorities to wind down large, complex financial firms. This measure, known as Title II of the Act, was introduced by Senator Richard Shelby (R-AL), and enjoyed broad bipartisan support, passing the Senate by a vote of 92-5.31 While Title II should succeed in resolving major U.S. firms, there still is more work to be done by regulators to put in place the mechanisms they need to coordinate any resolution of a large, complex financial institution that operates in multiple countries.
How much equity and new types of debt will banks have to issue?
The Federal Reserve Board and other regulators across the globe have been working together, through the FSB, 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 could be used to absorb losses of a failing institution so that it could be resolved in an orderly fashion, without taxpayers having to inject money to “bail-out” the firm. Regulators refer to this new, combined standard as “total loss-absorbing capacity” (TLAC) of large financial institutions – that is equity and forms of debt that can automatically be written down and/or converted to equity in the event of stress or failure (the latter is often referred to as the “debt shield”).
Today, the FSB released a consultative document on TLAC for consideration by the G20 leaders. The FSB has proposed setting a new global minimum at 16-20 percent of risk-weighted assets and at least twice the Basel III capital leverage ratio requirement. This is a compromise between countries that had wanted the TLAC requirement to be calculated based on risk-weighted assets and those that had wanted the requirement to be based on a percentage of a bank’s total assets (i.e., a leverage ratio).4 The TLAC requirement 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 also provided criteria on the types of debt that should be counted in the TLAC buffer. Such debts must be capable of being written down or converted into equity during resolution without disrupting critical operations. Home and host countries would be free to determine additional TLAC requirements for individual firms that would apply over and above these global minimums.
How will cross-border cooperation work?
The FSB’s consultative document does not include proposals on how cross-border cooperation would work. This is an important issue: in order to successfully resolve an international banking organization, regulators across multiple countries must trust that each will do their part. Why? Although these firms are supervised by their home country regulator(s), its overseas subsidiaries are supervised by the regulator in the country where its subsidiary is based (e.g. the “host” regulator).
The “host regulator” needs to know three things. First, the “host regulator” must know, ex-ante, that the insolvency of a subsidiary in their jurisdiction will trigger an automatic transfer of losses to the parent company. Second, the “host regulator” must know that the parent company has enough capital to absorb those losses, or that the subsidiary has enough capital to absorb the losses on its own. Third, the “host regulator” must be confident that the parent company’s “home regulator” is capable of resolving the institution. If the “host regulator” has doubts, then it will be forced to resolve the subsidiary on its own – a move that would make the orderly resolution of the entire firm (the parent and any other subsidiaries) extremely challenging. Conversely, the “home regulator” must trust that the “host regulator” will not go down this path.
In order to foster trust, the FSB proposes the largest international banks hold a significant amount of capital in each of their major subsidiaries. Specifically, the proposal calls for the each major subsidiary to hold between 75 and 90 percent of the TLAC they would be expected to hold if they were a standalone company. This means that most subsidiaries would likely be able to absorb losses without support from the holding company.
However, the “home” and “host” regulators are free to enter into their own agreements to determine the exact amount of TLAC each international bank will need to hold at the parent and the subsidiary levels in various countries. In the United States, the FDIC has indicated a preference for new TLAC acceptable debt to be issued by the holding company, not the operating subsidiary. As a result, it is likely that bilateral and multilateral agreements, such as the ones the FDIC has forged with United Kingdom and Canada, will need to be hammered out between regulators in the coming years in order to determine where TLAC will be allocated within the firm. The Bipartisan Policy Center (BPC) supports the FDIC’s efforts, which have proven productive.
Finally, it is important to note that the FSB’s TLAC proposal does not immediately apply to international banks that are headquartered in emerging markets. It is unclear when this framework would be extended to those firms.
How quickly will these reforms be implemented?
The TLAC requirement is unlikely to take effect until at least 2019—and probably later. At Brisbane, the G20 leaders are expected to endorse the TLAC proposal, and the FSB will likely propose additional changes following an extensive public consultation process, quantitative impact study, and market survey. A final version of the TLAC requirement is unlikely to be approved by the G20 until late 2015.
Then, each national regulator must implement it. In the United States, the Federal Reserve Board will have to determine whether it wishes to impose additional capital requirements on top of the minimum TLAC buffer. The FDIC, which would be the resolver of such institutions, will then have to make decisions on a range of implementation issues. As the Bipartisan Policy Center’s Failure Resolution Task Force recommended, the FDIC will also have to continue its work to further expand its bilateral and multilateral agreements with foreign regulators to ensure mutual recognition of national resolution regimes.5
Finally, it is worth noting that even when these reforms do come into place, further renegotiation is likely as circumstances change. This would mirror the history of the Basel Committee on Banking Supervision, which first set global capital standards for going-concern institutions in 1988 (Basel I), revisiting them again in 2004 (Basel II), and in 2010-11 (Basel III). That means that we are likely to hear much more about this subject in the years – and potentially decades – to come.
Aaron Klein, the director of the Financial Regulatory Reform Initiative, regularly monitors and comments on the G-20, Financial System Oversight Council, and other financial stability developments. He can be reached at 202-218-6786 or at [email protected].
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 See, for example, Financial Stability Board, “Key Attributes of Effective Resolution Regimes for Financial Institutions,” October 2011.
3 U.S. Senate, “Vote Summary On the Amendment (Shelby-Dodd Amdt. No. 2827),” May 5, 2010.
4 Huw Jones, “G20 Signals Flexibility on Big Bank Failures – Sources,” Reuters, September 5, 2014.
5 John F. Bovenzi, Randall D. Guynn, and Thomas H. Jackson, “Too Big to Fail: The Path to a Solution,” Bipartisan Policy Center, May, 2013, p. 12.