Ending 'Too Big to Fail' at the Push of a Button

WASHINGTON — The idea that the government can seize, run and restructure a failing megabank while simultaneously avoiding giving it a bailout or causing systemic chaos has many doubters.

But global regulators are close to striking a deal meant to make resolutions near seamless, which could help rebut the skeptics.

The goal of making resolutions quick and decisive lies at the heart of an upcoming Financial Stability Board proposal to ensure failed firms are able to absorb their own losses. The plan would require a bank to hold enough capital and debt instruments to recapitalize its successor firm, but experts say no amount of loss absorbency will suffice if the process is drawn out and leads to market uncertainty.

"If you take any time at all, it can't work," said Richard Herring, a professor at the University of Pennsylvania's Wharton School. "What they're looking for is something that can be implemented over a resolution weekend."

The FSB is expected to unveil its "total loss-absorbing capacity" plan next month. U.S. regulators have discussed a similar rule for years. Large banks would essentially have to hold a minimum level of unsecured, long-term debt at the holding company, on top of regulatory capital, to internalize failure costs. According to a circulating draft summary of the FSB plan, regulators are considering minimum TLAC of between 16% and 20% of risk-weighted assets plus a bank's specific capital buffer.

But as regulators close in on a loss absorbency standard, there are still many unanswered questions. Experts say the FSB plan is somewhat in flux as some nations push for added flexibility, potentially resulting in a weaker TLAC rule. Other issues include how quickly a recapitalization can occur, whether a TLAC-like system removes the need for public financing and how banks fill any loss absorbency gaps to comply.

"It will be a business decision for each institution," said James Wigand, a partner at Millstein & Co., who formerly ran the Federal Deposit Insurance Corp.'s complex resolutions division. "But to the extent an institution's liabilities fail to satisfy the TLAC requirement, I suspect it would replace short term liabilities with long term debt obligations."

Meanwhile, the Federal Reserve Board has already signaled its loss absorbency standard for U.S. banks will be tougher than that of the FSB.

"The biggest worry for the U.S. banks is that once again the Fed is markedly more stringent than the overseas regulators," said a source at a large bank who asked not to be identified.

Loss absorbency is a key part of the resolution method favored by regulators like the FDIC, which under Dodd-Frank was granted new powers for seizing "systemically important" firms. The method, "single point of entry," involves closing the holding company and using its remaining capital and unsecured debt to operate subsidiaries under a new parent. Unsecured creditors would have their claims converted to equity to recapitalize the firm.

But a holding company must have enough stable, convertible debt to make the recapitalization work. Government liquidity would be available under certain regimes, including the FDIC's, but the idea with loss absorbency is to steer clear of public support, which might be seen as a bailout.

The FSB proposal is expected to be presented formally at the G-20 summit in Brisbane, Australia, on Nov. 15 and 16. It will be subject to public consultation and a quantitative impact study before final revisions are made.

In remarks earlier this month, Bank of England Gov. Mark Carney, who chairs the FSB, said the Brisbane summit "will be the watershed in ending 'too big to fail.'"

The TLAC plan "will establish a level playing field between global systemic banks, while taking into account differences in national resolution regimes," Carney said in an Oct. 12 speech in Washington. "It will ensure globally systemic banks finally have the quantum of total loss absorbing capacity that extensive analysis show balances the benefit of greater resilience against the higher funding costs for the banks that results from the removal of public subsidies."

But U.S. banks are already expecting the Fed to go further.

"It is quite possible that the U.S. regulators may propose and ultimately implement a TLAC-like requirement that is more stringent — or 'super-equivalent' in Federal Reserve parlance — than the internationally agreed provisions as was the case with" other global rules, said Andrew Gladin, a partner at Sullivan & Cromwell.

The FSB draft indicated that some members view an adequate TLAC level as being twice the Basel III total risk-based capital ratio of 8%. Firms can use their regulatory capital to count toward a chunk of their TLAC but debt instruments would likely make up the rest. It also appears likely that large banks subject to additional buffers and surcharges under international capital rules would have to fulfill TLAC levels beyond the 16-to-20% range, reaching as high as 25%.

"At the time of failure, an institution's capital will be essentially depleted, but not necessarily zero. The reason why going-concern capital is half the amount" to meet the TLAC requirement "is so capital can be replenished to that full level," Wigand said. "Losses will have consumed half of the TLAC amount to the point of insolvency. The institution will need to get back to the going-concern capital level as it exits the process."

But developing a common global loss absorbency standard poses challenges as domestic banking structures have key differences. Herring noted that, unlike U.S. banks, several institutions in Europe do not have an explicit holding company under which subsidiaries operate.

Loss absorbency rules "will be more of a jolt for many of the European banks than for the U.S., because they don't really have a clearly identified segment of the debt that will automatically take the hit," he said. "That's because we have a holding company structure and most of them don't."

Both the international and U.S. versions of the rules are expected to specify what debt instruments qualify to fulfill loss absorbency levels. The FSB's draft summary said eligible instruments must be unsecured and have a minimum remaining maturity of at least one year. Excluded liabilities would include insured deposits, other liabilities that can be called on demand, and structured notes, among others. In remarks earlier this month, Fed Gov. Daniel Tarullo said the central bank would likely be tougher in its rules in terms of which types of debt qualify.

Several experts say how well banks already comply with a loss absorbency standard tends to vary based on an institution's particular funding model.

"For example, institutions that rely more heavily on deposits... for their funding may need to raise additional debt as compared to banks that already rely more heavily on third party debt funding," Gladin said.

While one aim of a loss absorbency standard is to reduce the need for government funding to run a resolution — which could have political costs — some say regulators' option to utilize funding channels should not be overlooked. Under Title II of Dodd-Frank, the FDIC could borrow from the Treasury Department's "orderly liquidation fund" to help manage a resolution. That ability is somewhat similar to "debtor-in-possession" liquidity available in a traditional bankruptcy.

"By having the internal debt structure set up in a way that would allow for the recapitalization of the subsidiaries, it reduces the risk that the FDIC in a Title II resolution would have to resort to the OLF," said Michael Krimminger, a partner at Cleary Gottlieb Steen & Hamilton LLP and the FDIC's former general counsel. "But you can't ignore the importance of having access to a source of liquidity — either internally, through Bankruptcy Code debtor-in-possession liquidity, or external liquidity."

Herring said recapitalizations can work only if they are done swiftly, to avoid market confusion and potential runs following insolvency. Ideally, he said, unsecured creditors would be subject to a mandatory debt-to-equity conversion. Early conversations around "single point of entry" had suggested creditors could decide whether they wanted stock in the resolved company to satisfy their claims.

Regulators "are hoping for an unambiguous, automatic transformation of debt into equity," Herring said. "The idea is to take away from creditors the discretion to interfere and slow things down. … It would just be impossible to run these operating subs. If you dither in court for a week or so, you're lost."