US Federal Reserve proposals for total loss-absorbing capacity go well beyond the Financial Stability Board standards in some areas. 

What’s happening?

In October 2015, the US Federal Reserve published a consultation on requirements for total loss-absorbing capacity (TLAC). This is the combination of equity and debt that could be written off or bailed in to recapitalise a systemic bank in resolution. The TLAC standards would apply to the bank holding companies of US global systemically important banks (GSIBs) and also to large intermediate holding companies (IHCs) owned by foreign banks.

The US proposal was published several days before the Financial Stability Board’s (FSB’s) final international TLAC standard, although with prior knowledge of what the FSB term sheet contained. The consultation period for the US TLAC rules was extended by more than two weeks to mid-February 2016, reflecting the importance of the proposals.

What’s the difference?

The FSB required banks to hold TLAC equivalent to 18% of risk-weighted assets, or 6.75% of leverage ratio assets, by 2022. The Fed has proposed a higher leverage ratio standard for TLAC – 9.5% instead of 6.75% – and has introduced a minimum long-term debt (LTD) requirement that is absent from the FSB term sheet. The minimum LTD ratio must be the higher of 6% of risk-weighted assets (RWAs) plus the GSIB buffer, or 4.5% of total leverage exposure.

“The standalone LTD requirement was not part of the FSB term sheet or process, and does not make sense given that equity is both a going-concern and a gone-concern loss absorber, whereas debt is only loss absorbent in a gone concern,” says Greg Baer, president of the Clearing House Association, which represents US clearing banks including many of the affected GSIBs.

What do other countries say?

For foreign-owned bank subsidiaries that would be resolved by the home supervisor using a single point of entry resolution strategy, the FSB term sheet contained an internal TLAC requirement equivalent to between 75% and 90% of what the entity’s standalone requirement would be. The exact level for each material subsidiary should be decided after consultations with each cross-border bank’s crisis management group (CMG) of home and host supervisors.

By contrast, the Fed has requested that foreign-owned IHCs hold whichever is higher of 16% of RWAs or 6% of the total leverage assets. This equates to internal TLAC of almost 90% compared with the standalone requirement. The Fed has also gone beyond FSB standards in requiring internal TLAC to be issued only to the parent company, not to third-party investors. The Fed has apparently not consulted CMGs before issuing its proposal, irritating foreign parent banks and their home supervisors.

“At that [90%] level, we believe the internal TLAC requirement constitutes ex-ante ring fencing, which is precisely what the single-point-of-entry resolution regime was designed to avoid and is effectively a vote of no confidence in the home country supervisor. We also do not see any rational basis why the TLAC should only be issued to the parent rather than to the market; debt issued to third parties by a US IHC is just as loss absorbing as debt issued to the parent,” says Mr Baer.

Reg Rage - Reg Rage

He believes the IHC TLAC requirement could make it difficult for foreign banks to compete in the US. The leverage ratio TLAC requirement also represents a level that is almost 50% higher for US-headquartered banks than the international standard.

“In the current economic and financial situation, it is hard to tell if that will place US banks at a competitive disadvantage to their peers in Europe and Asia, but it could do in the long term,” says Mr Baer.

What can be done?

The Fed is unlikely to make major modifications to its proposed TLAC rules. But the industry is pushing for alterations to the eligibility of debt for inclusion in the LTD requirement. The Fed has ruled out debt-containing acceleration clauses (because this could effectively become short-term debt if accelerated) and debt issued under foreign law. The Clearing House Association has estimated that, unless ineligible debt is grandfathered, the GSIBs would need to issue $363bn to meet the TLAC rule, compared with the Fed’s own estimate of $120bn.

Many acceleration clauses concern technical changes such as the sale of a bank operating company or the change of a paying agent. These changes remain under the control of the bank, and the sale of an operating company needs regulatory approval. Neither would happen when a bank is in danger of entering resolution, so the industry views disqualification of debt containing these clauses as disproportionate. For similar reasons, Mr Baer says foreign law bonds should also qualify as TLAC.

“The law governing issuance in major foreign currencies such as sterling and yen does not impede the federal authorities from making this debt loss-absorbing if a bank holding company fails, and these jurisdictions have sophisticated legal systems where we have a high degree of confidence that they would respect the bail-in of debt in the US,” says Mr Baer.


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