On November 10, 2014 the Financial Stability Board (FSB) issued a long-awaited Consultative Document “Adequacy of loss-absorbing capacity of global systemically important banks in resolution” that defined a global standard for minimum amounts of Total Loss Absorbing Capacity (TLAC) to be held by Global Systemically Important Banks (G-SIBs). TLAC is meant to ensure that G-SIBs have the loss absorbing and recapitalization capacity so that, in and immediately following resolution, critical functions can continue without requiring taxpayer support or threatening financial stability.
The TLAC proposal is one of the final components of a long-standing reform effort laid out in 2010 by the FSB to limit the probability and impact of the failure of large global systemically important financial institutions, i.e., ending the too-big-to-fail (TBTF) phenomenon. At its core, TLAC bolsters capital and leverage ratios, thereby creating a greater capital cushion intended to further pre-empt any need for a taxpayer-funded bail-out.
At the global level, the G20 have agreed to a proposal that G-SIBs will have to fulfill in future regarding their capital structure. In particular, these banks will need to ensure a minimum amount of TLAC, which may be as high as 20 percent including the minimum capital requirements and the G-SIB buffer. This will make global banks more resilient, and it will allow for their orderly resolution.
TLAC will apply in addition to the capital requirements set out in the Basel III framework, including the countercyclical, G-SIB and other capital buffers. The measure appears challenging but manageable for most G-SIBs who will have until 2019 to meet the minimum Pillar 1 requirements.
As per the Consultative Document, the minimum TLAC requirement will be within the range of 16-20 percent of the group’s risk-weighted assets (RWA) and at least twice the fully loaded Basel III leverage ratio requirement. This is considered the “Pillar 1” requirement according to the FSB. Regulatory authorities may set additional requirements above their so-called minima, also known as the “Pillar 2” component of TLAC.
The interest at this stage from traditional consumers of bank paper, such as pension funds and insurers, is lukewarm at best. While the securities, designed to be written down in a crisis, would offer higher yields than senior debt, the risk of bail-in may be more than some buyers can tolerate. That could leave the banks struggling to meet regulatory requirements.
Banks already issue dated subordinated debt with mandatory coupons that banks can count toward some existing loss-absorbency requirements. Those notes, which have an established investor base, potentially could also be used to meet TLAC. That would be expensive: average yields on Tier 2 debt are 1.53 percent, more than double the 0.70 percent yield on banks’ senior bonds in euros, according to Bank of America Merrill Lynch index data.
On February 2, 2015 the Institute of International Finance (IIF) and the Global Financial Markets Association (GFMA) jointly submitted a letter to FSB on the Consultative Document. In general, the industry supports the concept that the FSB has developed. Assuring that loss-absorbing capacity is available if a G-SIB needs to be resolved is something the industry agrees to be essential. Nevertheless, a reform of this magnitude naturally raises many practical issues that have to be considered during the implementation of the new TLAC concept. Thematically, the most important areas include:
- Historical evidence suggests that 16% of risk-weighted assets will be a sufficient level of TLAC to absorb potential losses for G-SIBs in the future.
- The current drafting of TLAC subordination requirements raises important implementation difficulties, both for groups funded via holding company structures and for groups funded at the operating parent company or bank level.
- The disposition of Internal TLAC will involve a delicate balancing of home and host regulatory interests, ideally aligning these interests to support cross-border cooperation.
- Upon implementation, it’s estimated that the new framework would govern about US$4 trillion in TLAC-eligible securities. For issuance at this scale to be effective, it will need to be supported by broad, deep, liquid and diverse markets.
Last month a slew of European banks issued 10-year bullet maturity Basel III-compliant, tier-2 (B3T2) subordinated bond deals, as they sought to grow a new market for these lower cost TLAC-eligible instruments. Deutsche Bank attracted a €4.4 billion order book for its €1.25 billion deal priced at 210 basis points over mid-swaps. BNP Paribas drew €5.5 billion of demand for its €1.5 billion offering at 170 basis points over, while Société Générale took €3.8 billion of orders for a €1.25 billion transaction at 190 basis points over.