Paul Kupiec of the American Enterprise Institute has submitted a comment letter to the Federal Reserve detailing his criticisms of the Fed’s recent proposed rule imposing long-term unsecured debt and “total loss-absorbing capacity” (“TLAC”) requirements for global systemically important banks (“GSIBs”):
My analysis of the proposal suggests that TLAC will not remove the risk that the largest financial institutions may require future taxpayer assistance should the country face another financial crisis. Indeed 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. Moreover, the language of the proposed TLAC rule promises new protections to a huge volume of outstanding GSIB operating subsidiary liabilities. These new protections will provide tangible too-big-to-fail (TBTF) benefits to eight GSIBs that are not accessible to smaller institutions that are not eligible for a TLAC-Title II resolution. As a result, TLAC will not end TBTF, but instead will ensure that the largest financial institutions continue to benefit from a funding cost advantage created by their GSIB status as the TLAC plan makes it clear that regulators intend to preserve GSIB subsidiary institutions intact while smaller institutions will continue to fail and be liquidated under deposit insurance resolution rules.
Title II of the Dodd-Frank Act gave the Federal Deposit Insurance Corporation (“FDIC”)—the agency generally responsible for the resolution or liquidation of insolvent banks—expanded powers to resolve certain designated financial institutions. Federal regulators’ hope is that exercise of this “orderly liquidation authority” will reduce the systemic risks attendant on bank failures and spare taxpayers the costs of future “bailouts.”
The FDIC’s preferred approach to resolving such banking groups is the so-called “single-point-of-entry” strategy, as detailed in a December 2013 policy release. “Single-point-of-entry” relies on the typical structure of U.S. banking groups in which various operating subsidiaries (e.g., insured depository institutions, broker-dealers, etc.) are positioned under a top-tier bank holding company, whose operating activities are more or less limited to holding its subsidiaries’ shares. A feature of this system is “structural subordination,” which essentially means that customers and creditors of the operating subsidiaries do not face losses until the debt and equity claims of the bank holding company against its subsidiaries are exhausted. Thus, in this respect, the parent bank holding company acts as a buffer against losses at the operating subsidiary level, simply as a function of the group's structure.
The Federal Reserve proposes to strengthen this buffer by requiring GSIBs to maintain a minimum amount of “total loss-absorbing capacity,” which may be satisfied with both “regulatory” (primarily equity) capital and long-term unsecured debt. The proposal would require maintenance of a minimum amount of such long-term unsecured debt, which must be explicitly subject to a “bail-in” (i.e., convertible into equity in extremis). The proposal would also ban bank holding companies from issuing short-term debt and certain other “runnable” financial instruments to external counterparties. According to the Fed, these “clean bank holding company” requirements are intended to “reduce the risk of destabilizing funding runs at the holding company, reduce holding company complexity, and enhance the resiliency of operating subsidiaries during an orderly resolution.” The proposed rule further includes provisions that would create a disincentive for regulated banking institutions to hold the TLAC instruments of other banking groups, in hopes of containing any contagion effects in the event of a future financial crisis.
Putting it all together—and eliding a significant amount of technical and operational detail—if an insolvent GSIB bank holding company were to be placed into resolution proceedings, (i) losses at the operating company level would be “passed up” to the bank holding company, to be borne by its equity holders, thus recapitalizing the failing subsidiaries and allowing them to live to fight another day; and (ii) long-term debt holders would be “bailed in,” meaning that they would join equity-holders of the holding company in bearing the brunt of the losses.
The Federal Reserve explains as follows:
To reduce the systemic impact of the failure of a GSIB, an orderly resolution process should allow a GSIB to fail, and its investors to suffer losses, while the critical operations of the firm continue to function. Requiring GSIBs to hold sufficient amounts of long-term debt, which can be converted to equity during resolution, would facilitate this by providing a source of private capital to support the firms’ critical operations during resolution.
The regulators’ objective, in other words, is to create a system in which a systemic bank holding company may fail and be resolved in an orderly manner without (i) jeopardizing continuation of the critical functions performed by its bank and non-bank subsidiaries and (ii) forcing such subsidiaries into panicked fire-sales of assets.
Dr. Kupiec’s letter advances five principal criticisms of the proposed rule:
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 [Too-Big-to-Fail] 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.
- The Federal Reserve’s press release announcing issuance of the Notice of Proposed Rulemaking is available here. The full text of the Federal Register notice of the rule release is available here.
- A Wall Street Journal’s article discussing the proposed rule and analyzing its potential effects on GSIBs is available here.
- For a detailed discussion of the TLAC and long-term debt requirements, see this visual memorandum prepared by Davis Polk & Wardwell LLP.
- A joint comment letter of The Clearing House Association, the Securities Industry and Financial Markets Association, the American Bankers Association, and the Financial Services Roundtable filed on February 2, 2015 with respect to the Financial Stability Board’s TLAC proposal is available here. The letter expresses the trade associations’ “continued support for a well-structured and appropriately-applied TLAC requirement.” The final TLAC standard of the Financial Stability Board, issued on November 9, 2015, is available here.
* C. Wallace DeWitt is a financial regulatory lawyer based in Washington, D.C. He is a graduate of Yale College, Harvard Law School, and King's College, University of Cambridge.