Federal Reserve proposes rule to require largest banks to hold minimum amounts of unsecured long-term debt

Federal Reserve proposes rule to require largest banks to hold minimum amounts of unsecured long-term debt
Posted by David Wright on November 5, 2015.

On October 30, 2015, the Board of Governors of the Federal Reserve System (Federal Reserve) unanimously approved an important proposed rule that seeks to improve the likelihood that the largest banking organizations can fail without the use of taxpayer funds or destabilizing the financial system. The proposal would establish new Total Loss-Absorbing Capacity (TLAC) and related Long-Term Debt (LTD) requirements for US banking organizations deemed to be “global systemically important banks” (GSIBs) as well as US Intermediate Holding Companies (IHCs) of foreign GSIBs. In her prepared remarks for the Federal Reserve’s open meeting on the proposal, Chair Janet Yellen argued that the new rules, in conjunction with other regulatory efforts to improve the resolvability of GSIBs, would “substantially reduce the risk to taxpayers and the threat to financial stability stemming from the failure of these firms.”

TLAC is perhaps the most significant remaining piece of the regulatory reform puzzle. It is the third line of defense after capital and liquidity to ensure that government funds are not used for bailouts and that systemically important firms can be resolved without disrupting the financial system. The basic idea is to make institutions hold standby funds that allow for an orderly resolution—specifically through the “single-point-of-entry” (SPE) resolution strategy—if they fail. The so-called “bail-in” funds that banks would need to hold would take the place of government bail-out funds, so that taxpayers are not on the hook, and so that systemic firms can be resolved while continuing to provide critical operations to the marketplace. A bail-in and orderly resolution also reduces the risk that a failing firm will transmit losses to other systemic firms.

In November 2014, the international Financial Stability Board (FSB) released its proposed TLAC standard, which suggested that the TLAC requirement be set within the range of 16-20% of risk-weighted assets (RWAs) and at least double the Basel III Tier 1 leverage ratio requirement of 3%. The Federal Reserve’s proposal would set an external TLAC requirement for US GSIBs right in the middle of that range: 18% of RWAs. The Federal Reserve estimates that six of the eight covered US GSIBs would currently have external TLAC shortfalls, and that the aggregate shortfall for the external TLAC and LTD requirements would be approximately $120 billion. Further, the Federal Reserve estimates that the aggregate increase in funding cost for these banks ranges from approximately $680 million to $1.5 billion annually.

For IHCs of foreign GSIBs, the proposal differentiates between “resolution entity” IHCs (i.e., IHCs expected themselves to enter resolution in the event of failure of the parent foreign GSIB) and “non-resolution entity” IHCs (i.e., IHCs not expected themselves to enter resolution in the event of failure of the parent foreign GSIB), setting forth slightly more stringent requirements for the former: internal TLAC of 18% of RWAs vs. 16% of RWAs. Importantly, whether an IHC is designated as a resolution or non-resolution entity is outside of the IHC’s control; to receive the lower requirements of a non-resolution entity, the home country’s resolution authority must certify that its resolution strategy for the parent foreign GSIB does not involve the IHC.

Under the proposal, the eligible external TLAC for US GSIBs would be generally defined as the sum of (1) common equity tier 1 (CET1) capital and additional tier 1 capital issued directly by the holding company and (2) eligible external LTD. Similarly, the eligible internal TLAC for IHCs would generally be defined as the sums of (1) the CET1 and additional tier 1 capital issued from the IHC to the foreign entity that directly or indirectly controls it and (2) eligible external LTD.

The Federal Reserve’s proposal also includes two key requirements not contained in the FSB’s original 2014 TLAC proposal.

  • First, it would require that US GSIBs maintain external LTD, a subcategory of external TLAC, at least equal to the greater of (1) 6% of RWAs, plus the applicable G-SIB buffer or (2) 4.5% of total leverage exposure (the denominator of the supplementary leverage ratio (SLR)). For IHCs, regardless of resolution entity status, the proposed rule sets forth a minimum internal LTD requirement at least equal to the greater of (1) 7% of RWAs, (2) 3% of total leverage exposure (if the institution is subject to the SLR), or (3) 4% of average total consolidated assets (in cases where the SLR does not apply). For both US GSIBs and IHCs, eligible LTD would generally be defined to be debt that is:
    • Issued directly by the US GSIB or IHC;
    • Unsecured;
    • “Plain vanilla,” which excluded structured notes and most instruments that contain derivative-linked features;
    • Governed by US law; and
    • Two years or greater to fully qualify (with a 50% discount for 1-2 years maturity; less than a year does not qualify).

However, external LTD of US GSIBs would differ from internal LTD of IHCs in several ways. Specifically, internal LTD would be required to (1) be issued to a parent foreign GSIB that controls the IHC, (2) be contractually subordinated to all third-party liabilities of the IHC, and (3) include a contractual trigger pursuant to which the Federal Reserve could require the IHC to cancel the eligible internal LTD of convert or exchange it into tier 1 common equity on a going-concern basis (i.e., without the IHC entering resolution) under certain circumstances.

  • Second, the proposal, in a departure from the FSB’s version, would establish so-called “clean holding company” requirements that prohibit US GSIBs and IHCs of foreign GSIBs from entering into certain financial arrangements in order to facilitate a SPE resolution. Specifically, these institutions would be prohibited from engaging in short-term borrowings from third parties, entering into qualified financial contracts with external counterparties, issuing guarantees of subsidiary liabilities that could create cross-default rights or set-off and netting rights for its subsidiaries’ creditors, or having liabilities subject to a guarantee from a subsidiary. The Federal Reserve believes that this clean holding company requirement would facilitate a SPE resolution by avoiding holding company creditor and other third-party legal challenges that might hinder the movement of bail-in funds to where they are need in the organization or create losses for subsidiaries.

Despite the great level of detail in the Federal Reserve’s proposed rule, certain issues remain unresolved, including the amount of TLAC that must be distributed (i.e., “prepositioned”) internally to material entities. The FSB proposed that 75-90% of the TLAC requirement that would apply to a material entity subsidiary on a standalone basis should be prepositioned to these entities, but that the specific internal TLAC requirement be defined by the relevant host authority in consultation with the home authority. Importantly, the Federal Reserve’s proposal did not include specific requirements regarding prepositioning of TLAC to lower-level material entities. However, during the question-and-answer portion of the open meeting, Chair Yellen asked staff if the SPE resolution strategy requires debt to be prepositioned in the holding company’s material subsidiaries and if further rulemaking would be appropriate related to prepositioning. Staff noted that, conceptually, the internal TLAC could be “in the form of either prepositioned resources such as the parent’s equity or long-term debt investments in its subsidiaries, or in the form of contributable resources, which would be assets held at the company and could be flexibly contributed to any subsidiary that needs to be recapitalized.” The proposal seeks comment on this question.

Implications of the proposal for US GSIBs and IHCs are significant. Several US GSIBs will need to issue new qualifying LTD to meet the requirements, and both US GSIBs and IHCs may need to restructure their holding companies to meet the clean holding company requirement.

Comments on the Federal Reserve’s proposed rule, which seeks feedback on 72 separate questions, are due by Feb. 1, 2016. As the comment period begins, Deloitte will continue to monitor and report on it.

In addition, the FSB will hold a briefing on Monday, November 9 at which it is expected to release its final TLAC term sheet. We will continue to monitor developments at the international level and update our analysis as appropriate.

For more information regarding the Federal Reserve’s proposed rule, refer to our analysis here.

David Wright
Managing Director
Banking and Securities

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