Fed Makes Bid to Simplify the Megabanks

WASHINGTON — The Federal Reserve Board released a proposal Friday to require the largest and most systemically risky banks to issue additional capital and unsecured debt to absorb losses in a failure, a move that experts say could ultimately make the banks less complex and easier to resolve in a crisis.

The central bank's plan would establish a standard for "total loss absorbing capacity." It would require global systemically important banks to issue enough TLAC that could be used to absorb losses and ultimately recapitalize a temporary or successor institution. A sufficient amount of TLAC is seen as crucial in the effectiveness of a new Federal Deposit Insurance Corp. regime to seize and unwind failed behemoths.

Speaking at a board meeting ahead of the rule's release, Fed Gov. Daniel Tarullo said the proposal would prevent taxpayer bailouts by effectively requiring banks to have the means of bailing themselves out.

"The principal effect of the long-term debt requirement will be to increase the loss-absorbing capacity of a GSIB even after it has failed," Tarullo said. "By making the failure of even the largest banks more manageable, the proposed regulation will be another important step in solving the too-big-to-fail problem."

The impact of the plan could be significant. David Wright, managing director of banking and securities at Deloitte, pointed to the proposal's requirement that debt issued emanate from "clean" bank holding companies. That could have a broad effect on some institutions, potentially forcing them to reorganize.

"It prohibits short-term debt from third parties, derivatives, other qualifying contracts with external parties, guarantees of subsidiary liabilities, anything that would create a set off or netting rights for subsidiaries," Wright said. "So that's a pretty big deal, because some parent companies have a mix of operations in them, so this might require … some degree of reorganization."

The clean holding company portion of the plan would prohibit the overall parent entity of a GSIB or the U.S. subsidiary of a foreign GSIB from issuing short-term debt to third parties, holding derivatives or other contracts with external counterparties, holding liabilities guaranteed by its subsidiaries or guaranteeing its subsidiaries in such a way that creates "disruptive default, set-off, or netting rights for subsidiaries creditors." Other non-contingent junior liabilities unrelated to TLAC or long-term debt are capped at 5% of the holding company's TLAC under the proposal.

John Simonson, a partner with PricewaterhouseCoopers and former deputy director of the FDIC, said the requirement in many ways resembles guidance from the Fed and FDIC sent to the GSIBs in response to their 2014 living will submissions. That guidance suggested that banks should have clean holding companies, but the TLAC rule effectively makes that guidance mandatory.

"I think the clean holding company requirement took [the 2014 guidance] and made it a rule, rather than just guidance for resolution planning, and it looks like it took it a step further than the requirements they laid out in that other context," Simonson said.

The TLAC concept works by requiring banks to hold a certain amount of unsecured debt and a certain ratio of capital relative to risk-weighted assets. If a bank fails, the TLAC unsecured debt is converted into a stake in the successor bank, while the capital would be used to jump-start the successor bank's balance sheet.

The proposal focuses on two separate but related components for achieving adequate TLAC: long-term debt and Tier I capital. For the debt requirement, "plain-vanilla" instruments would qualify, therefore excluding things like structured notes. The debt would also have to be issued by the bank holding company directly rather than by a subsidiary in order to be consistent with the FDIC's "single-point-of-entry" approach for resolving failed firms. The proposal notably does not include any restrictions on what kinds of entities would be eligible to buy that long-term debt.

For the capital requirement, banks would have to maintain 18% of total risk-weighted assets or 9.5% of total leverage exposure, whichever is larger. Common equity Tier 1 capital and Tier 1 capital issued by the bank holding company, as well as eligible external LTD, would qualify toward that total. But the GSIB surcharge would have to be applied on top of the capital requirement, not as part of it. The proposal details that the Fed could take actions to restrict dividend payments or curb "discretionary bonus payments" if covered banks fail to meet the capital requirements.

The Fed's policy memo on the proposal said "any covered [bank holding company] that already meets the existing capital requirements and capital buffers would be able to come into compliance with the proposal solely by issuing additional long-term debt." The memo said that six of the eight covered GSIBs have external TLAC shortfalls. The aggregate increased funding cost of the proposal is between $680 million and $1.5 billion, the memo said.

But some observers are concerned that the proposal's call for banks to take on more debt is short-sighted and doesn't adequately take into consideration the historically low cost of funds

Karen Shaw Petrou, managing partner of Federal Financial Analytics, said that as interest rates rise, compliance with the debt requirement will inevitably go up as well, thus driving up the cost of lending market-wide. Smaller banks not subject to the requirement could potentially compete in that environment, but a more likely scenario is that nonbanks will see an opportunity and swoop in.

"Big banks have issued a lot of debt under current rates that, when re-issued to comply with TLAC and meet market demands, will cost considerably more," Petrou said. "As a result, it will be more difficult for these banks to offer competitive loan products."

The plan also lays out internal TLAC rules for U.S.-based subsidiaries of foreign GSIBs, which effectively requires the subsidiary to hold similar ratios of capital and debt issued exclusively in a relationship with the parent firm overseas. Tarullo said during the board meeting that he expected that a similar arrangement would be passed by foreign regulators for foreign subsidiaries of U.S. GSIBs.

The proposal includes a phase-in period, with certain aspects taking effect on Jan. 1, 2019, and the full requirement taking effect on Jan. 1, 2022. The Fed will take comment on the plan through Feb. 1, 2016.

The Fed's proposal comes as the international Financial Stability Board issued a framework rule last November that laid out a minimum TLAC that would amount to between 16-20% of a bank's total risk-weighted assets. The TLAC plan, along with two separate liquidity rules and new capital rules, constitute the sweeping post-regulatory environment envisioned by Basel III.