Uncertainty over resolution regime may hamper loss-absorbency standard for big banks

March 18, 2015

Even as international standards slowly take shape for total loss absorbency capacity (TLAC) – key element of the regulatory effort to end the perception that major banks are “too-big-to-fail” – pe the end of a consultation period last month left uncertainty lingering over restrictions on many of its provisions, and more importantly, the context in which it would operate.

Many of comment letters on the proposal by the G-20 backed Financial Stability Boardhave argued against these elements of the plan: strict requirements over eligibility for debt instruments — and their related cost — that could be counted as TLAC, the large share attributed to long-term unsecured debt within its TLAC composition, and the authority that national regulators are accorded in issuing additional TLAC standards.

Total loss absorption capacity 

TLAC is an important cornerstone of the new resolution regime. The regime is intended to bolster confidence in the market that globally systemically important banks, or “G-SIBs,” could no longer be considered too big “too-big-to-fail” while shifting their recapitalization burden, in case of failure, from taxpayers to shareholders and creditors.

This recapitalization can be achieved through a “bail-in” scheme — while keeping the critical functions of the institution alive — where certain bank liabilities would be converted into equity in an amount that, at least, doubles the capital and leverage requirements. Since Basel III international capital rules already stipulate an 8 percent minimum capital ratio (with common equity Tier 1 capital of at least 4.5 percent and a total Tier 1 capital –common equity Tier 1 + additional Tier 1– of 6 percent) and 3 percent leverage ratio, this would take the capital and leverage tally up to a total of 16 percent of risk-weighted assets, and 6 percent respectively.

Other capital requirements– such as the capital conservation buffer and the counter-cyclical buffers of 2.5 percent each would be separate from the calculations.

The TLAC concept, therefore, provides an extra layer of capital and long-term unsecured debt in addition to the Basel III capital requirements. The buffer could then be used towards the recapitalization of the failed institution via a newly formed bridge company by its receiver FDIC.

Sometime during 2015, FSB will conduct a quantitative impact study and a market survey of investors during 2015 in order to consider its costs and benefits before proposing related metrics on TLAC later this year. The Federal Reserve Board is then expected to issue its own version.

Public pronouncements by Federal Reserve Governor Tarullo about regulators’ intent in issuing a long-term unsecured debt requirement, and the availability of only a few types of eligible financial instruments to be counted as Tier 1 capital seem to indicate that the U.S. rules on TLAC will be “super-equivalent” –that is, tougher than the set international standard, just like the U.S. rules on capital requirements.

The TLAC standards will not come into effect until January 2019.

Cost and composition 

Although the Tier I and II capital of an institution would count towards the fulfillment of the loss-absorbency requirement, FSB has stated that at least one third of the total pillar 1 TLAC should be in the form of long-term unsecured debt.

TLAC’s cost is estimated to have a wide bracket for U.S. big banks (ranging from no cost to $25 billion individually, with a higher cost for those that use relatively lower levels of long term unsecured debt), but globally add up to as much as $1.6 trillion in long-term, high-risk debt issuance.

It is not only a question of cost. It will also be difficult to sell the instruments. The type of additional unsecured debt eligible to be considered as TLAC will essentially be a new type of bank debt with a call-like feature — convertibility for bail-in purposes in case of the company’s resolution. As such, it will not be dissimilar to the one ingrained in a callable bond where the issuer reserves the right to call the security. This feature is likely to make the TLAC securities less palatable for potential investors, despite the higher yield they would carry, as compared to traditional senior debt.

Indeed, buyers of bank debt such as pension funds, mutual funds and insurance companies have so far shown little appetite for TLAC-type securities.

To make matters worse, although the FSB has not been prescriptive as to what instruments may be eligible to count as part of TLAC, it has ruled out certain liabilities, such as insured deposits, secured liabilities, structured notes, and similar securitized derivatives.

U.S. bank trade groups — the Clearing House, the American Bankers Association, the Securities Industry and Financial Markets Association, and the Financial Services Roundtable — have objected to the exclusion of the structured notes and the composition of the long term unsecured debt within the total TLAC, arguing that it is arbitrary and not supported by “sound quantitative analysis.”

Too much regulatory discretion? 

Another contested area of the FSB proposal is the discretion it allows national regulatory authorities in issuing “additional” –- pillar 2 TLAC– requirements for banks within the framework of Basel’s pillar 2 supervisory review process.

This discretion is meant to take into account the idiosyncratic risks of each institution. The regulators’ individually tailored calibration of the “GLAC” liabilities that can be easily bailed-in would be done in consultation with cross-border crisis management groups and reviewed by the FSB Resolvability Assessment Process. That is descried in the FSB key attributes resolution process. The crisis management groups bring together home and key host authorities of G-SIBs with a goal of coordinating a smooth recovery and resolution when required.

Most, if not all, the bankers base their objection to this “pillar 2″ clause on three points:

  • It represents an undue reliance on “supervisory and inherently subjective judgment” as opposed to a publicly transparent methodology in place.
  • A lack of common international standard could lead to divergent treatments of big-bank TLACs and skew the playing field.
  • It generates an adverse effect by means of “imposing two tailored G-SIB components, one established under a transparent international standard and the other entirely subjective and, by its terms, unreviewable.”

Make the TLAC requirements too prescriptive for sake of uniformity, and the outcome will be a regimen that fails to take into account the particularities of the financial system of a country, or its institutions. It is with this in mind that the FSB has urged national regulators to place prudential limits on the ability of banks to invest in liabilities that are eligible for a big-bank TLAC to keep contagion risk in check, for example – leaving to each regulator the assessment of what the “prudential limits” might be.

Similarly, there is less of a common international standard among jurisdictions than is believed. Each country seems to be busy making its own regulatory tweaks, and not even holding to a common definition on every regulatory concept. The definition of high quality liquid asset –with different treatment in the U.S. and the EU– and the treatment of contingent convertibles as regulatory capital are only a few examples.

Other areas that could be revisited 

Other areas that could be revisited before finalizing the TLAC are:

  • TLAC’s current focus on the consolidated size of the G-SIBs (as opposed to the critical functions identified to be operational during resolution)
  • Its disregard for the recovery plans developed by the big banks which include pre-resolution asset sales that alleviate the total cost
  • further liquidity considerations, such as a liquidity buffer

Endgame still far off 

The TLAC proposal is a well-intentioned response to the “too-big-to-fail” problem. It is designed to increase the credibility of a bail-in strategy for the recovery and resolution of failing financial institutions, and limit possible contagion risks.

In its final form, all of the above-mentioned hurdles -cost, type of debt securities that can be counted as TLAC, and regulators’ discretion- can be overcome through deliberation.

More challenging, however, will be its implementation within the framework of the single-point of entry resolution process, inter-jurisdictional cooperation, and prevention of large-scale dearly termination of derivative contracts.

“Without knowing how the new resolution framework would actually work, TLAC’s benefits are unknowable,” said Karen Shaw Petrou, of Federal Financial Analytics Clients.

TLAC’s success, therefore, cannot be measured, at best, before the completion of work on resolution regime, or at worst, before the next crisis.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/