Wednesday, February 3, 2016

Will the Fed’s TLAC requirement be a cure all?

By John M. Pachkowski, J.D.

Although the time to provide comments was extended by the Federal Reserve Board, a number of stakeholders have weighed in on a November 2015 proposed rulemaking by the Fed that would require a small number of bank holding companies (BHCs), considered to be global systemically important banking organizations (GSIBs) to take a number of steps to enhance their resolvability under the U.S. Bankruptcy Code.

Specifically, the Fed’s proposal would:

  • require covered BHCs to establish an external long-term debt requirement (external LTD requirement), an external total loss-absorbing capacity requirement (external TLAC requirement), and a related external TLAC buffer;
  • impose restrictions on the operations of covered BHCs to be known as “clean holding company requirements”; and
  • impose regulatory deductions for investments in the unsecured debt of covered BHCs by requiring an institution with a non-significant investment in a covered BHC to deduct any investment in unsecured debt issued by the covered BHC in the same manner as if the unsecured debt were tier 2 capital using the “corresponding deduction approach.”

To meet the external TLAC requirement, covered BHCs would be required to maintain outstanding eligible external TLAC equal to the greater of: 18 percent of risk-weighted assets (RWAs) and 9.5 percent of total leverage exposure. The external LTD requirement would be met if a covered BHC maintains outstanding eligible external LTD equal to the greater of: 6 percent of RWAs, plus the applicable GSIB capital surcharge, and 4.5 percent of total leverage exposure. Finally, the external TLAC buffer would equal the sum of 2.5 percent, any applicable countercyclical capital buffer, and the GSIB surcharge applicable under method 1 of the Fed’s GSIB surcharge rule.

Right direction. Stephen Matteo Miller, PhD, a Senior Research Fellow at the Mercatus Center, called the proposed rule’s emphasis on higher capital, using debt and equity, as a “step in the right direction” for mitigating future crises, but the holding company is not necessarily the correct entity to rely on to mitigate future crises. He also noted that it was “unclear” as to whether the continued use of risk-based capital could create problems in the future.

Benefit-cost analysis. Miller also raised concerns regarding the Fed’s benefit-cost analysis for the proposed rule. He noted that although the Fed chose a “detailed and well-reasoned framework to estimate the inputs used to conduct the benefit-cost analysis,” one aim of economic analysis “should be to justify a new rulemaking compared to alternatives, not merely to examine whether the proposed rule’s estimated benefits exceed its costs.”

No end to TBTF. In his analysis of the TLAC proposal, Paul Kupiec, Resident Scholar at the American Enterprise Institute, suggested that the proposal will not remove the risk of “too big to fail” and that the largest financial institutions may require future taxpayer assistance should the country face another financial crisis. He added, “the uncertainties associated with using TLAC in a Dodd-Frank Title II resolution are likely to create a new important source of systemic risk—uncertainty about which investors bear losses in a GSIB resolution—a risk that did not exist in the prior financial crisis.”

Kupiec also raised a number of concerns associated with the proposal. These concerns were:

  1. The alleged benefits of TLAC are only available in a Dodd-Frank Title II Resolution. If the GSIB parent holding company is not eligible for a Title II resolution, TLAC investors will not be required to bear the loss of a failing bank subsidiary.
  2. The “clean” parent holding company provisions of the proposed TLAC rule will make it more difficult to use a Title II resolution.
  3. The proposed TLAC rule extends trillions of dollars in new implied government guarantees for the liabilities issued by GSIB subsidiaries.
  4. Requiring TLAC debt at the parent holding company does not necessarily remove large institution TBTF interest rate subsidies.
  5. The proposed TLAC regulation adds complexity to a regulatory system already plagued by overly complex capital and other prudential regulations. There is a simpler, more transparent way to satisfy TLAC regulatory goals.

Addresses TBTF. The Independent Community Bankers of America generally supported the proposal to impose an external TLAC requirement and an external LTD requirement on covered BHCs and agreed with the Fed that “there is a need for both requirements and that the LTD requirement will specifically help address the too-big-to-fail problem.”

TLAC and LTD requirements. As for the external TLAC and LTD requirements, the ICBA noted that the proposed TLAC capital measure closely reflects the “historical loss experience of major financial institutions during the recent financial crisis.” It added that the proposed LTD requirement was “vital if the single point of entry (SPOE) resolution process is to work.”

Capital deduction. Commenting on the proposed requirement that there be a regulatory capital deduction for investments in the unsecured debt of covered BHCs, the ICBA noted that the deduction was necessary to address the potential contagion stemming from the failure of a GSIB.

Although the ICBA agreed that the capital deduction was necessary, it raised concerns regarding the effects that “corresponding deduction approach” would have on community banks. It recommended that the banking agencies issue specific guidance to community banks on this issue prior to the TLAC rules becoming effective in 2019. The ICBA noted, “The guidance should explain how the ‘corresponding deduction’ rules work under Basel III and the consequences to an institution’s regulatory capital if covered BHC debt is purchased.”

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