The Fall and Rise of Debt in Bank Capital Structures

Debt has undergone a remarkable resurrection in relation to banks’ capital structures. In the immediate aftermath of the crisis it was uncertain whether debt would survive at all in the Basel Committee’s minimum capital requirements for internationally active banks. Today, however, debt is heavily promoted by bank regulators as an essential ingredient in the resolution arrangements for global systemically important banks (GSIFIs). In my article, The Fall and Rise of Debt in Bank Capital Structures, I chart how this remarkable change came about.

In the aftermath of the financial crisis of 2007-9 much criticism was directed at the low level of equity in banks’ capital structures and, by implication, the high level of debt funding (leading to a high debt to equity or leverage ratio). The rules of the Basel Committee on Banking Supervision (BCBS), the international standard setter, required that only 2% of banks’ risk-weighted assets (RWA) be financed by shareholders’ equity. It was clear that only a relatively modest decline in the valuation of banks’ assets would push the bank into bankruptcy.

Not surprisingly, the immediate post-crisis focus was on increasing the amount of equity in banks’ capital. The equity requirement (CET1 – ‘core equity tier 1’ – in Basel terms) was raised from 2% to 4.5% of risk-weighted assets and various ‘buffers’ were added on top, which had to be met via equity alone. All internationally active banks were required to hold a capital conservation buffer of 2.5% CET1 (though this could be reduced in the down-turn of the economic cycle) and systemically important banks were require to hold a further 2.5% CET1 in the case of the largest ones. National regulators have made greater use of their powers to move the minimum numbers upwards.

More surprising was that debt survived as a permitted ingredient in the international minimum requirements, but only in a reduced role. Pre-crisis, bank regulators accepted that subordinated debt could be permitted to count towards capital, on the grounds that the primary purpose of capital was to protect bank depositors and so reduce the probability of a bank run. Debt lower in the hierarchy than deposits could perform this role, as well as equity. And debt was more attractive to banks than equity because of the tax shield for debt interest which many jurisdictions provide (i.e., interest comes out of pre-tax revenues whilst dividends come from taxed income). What this argument ignored was the fact that debt absorbs losses only once the bank is placed into insolvency. Then subordinated debt will be written off before deposits, but until insolvency the debt-holders’ claim against the bank is legally intact.

In the crisis, all governments concluded (at least, based on their actions) that in nearly all cases (Lehman being the big exception – though it certainly proved the rule) the damage caused to the real economy through the loss of lending and other financial capacities following financial instability was likely to be more than the damage done to the public finances through a bail-out. So, most banks were bailed out rather than put into insolvency, with the result that the loss-absorbing capacity of subordinated debt was not triggered. Taxpayers bailed out subordinated debt-holders as well as depositors.

The response of the Basel authorities was not to take subordinated debt out of the permitted categories of capital but to reduce its role. The increased role for equity meant that the role of debt in bank capital structures was downgraded significantly. For a large GSIFI the permitted role of debt was reduced from approximately 75% of the capital requirements to 25%. As important the definition of eligible subordinated debt was made more demanding. To count now the subordinated debt must be capable of being written off or converted into equity by the public authorities when breach of the minimum capital requirements was likely but before bankruptcy was reached. Writing down or converting subordinated debt at this earlier point would mean that it absorbed losses before the taxpayer injected funds into the bank.

There is, therefore, a distinct sense of reluctance in the post-crisis treatment of debt in the Basel rules. Banks are not required to use debt at all in their capital structures. Only debt convertible into equity will count. And the maximum amount of permitted debt is heavily reduced.

So matters might have remained. The debt/equity dichotomy (good equity, bad debt) might have continued to frame the discussion, but for developments in another part of the field of banking regulation. In a second reform phase attention moved from increasing capital requirements (designed to reduce the probability of bank failure) to designing bank resolution procedures capable of handling failing banks without putting them into a standard bankruptcy procedure. Bailing-out is one such resolution procedure but its dependence on taxpayer funding makes it deeply unpopular. In the hunt for an alternative, the notion of restructuring the capital of a failing bank moved centre stage – the so-called bail-in. In this mechanism a bank which is in financial distress has its liabilities reduced by the write-off of its debt and, its equity position restored by the conversion of that debt into equity. This mechanism has the potential to restore a failing bank to viability through a restructuring of its capital.

With bail-in came the rehabilitation of debt. Bail-in has a chance of working only if the bank carries a substantial amount of debt; writing off trivial amounts of debt is unlikely to produce viability. Ironically, the more highly leveraged a bank is, the more likely bail-in is to work. Necessarily, the bail-in debt must be long-term. The prospect of bailing in depositors is virtually a guarantee that they will run at the first hint of trouble, thus increasing the chances of a bail-out. And the bail-in debt should be held outside the banking sector, so that losses are not just shifted among banks.

But the most remarkable thing about bail-in debt is that the very feature that makes it suspect as a technique for reducing the probability of bank failure makes it desirable as a technique for increase the probability of successful resolution. Unlike equity, whose book value reduces as the bank’s economic success declines, the formal value of the debt-holder’s claim on the bank remains intact. When the public authorities intervene to write off and convert the debt in resolution, that debt is fully available as a fresh source of capital at the point of failure.

Those concerned with resolution thus talk, not about capital, but ‘total loss absorbing capacity’ (TLAC) in which long-term debt is a vital element. The Financial Stability Board (FSB) proposes GSIFIs should have a TLAC of (eventually) 18% RWA, with an ‘expectation’ that one third of that be provided via bail-in debt. (See FSB, Overview of the post-consultation revisions to the TLAC Principles and Term Sheet, 9 November, 2015.) The Federal Reserve Board in its proposals of October 28, 2015 is even more firm on debt within TLAC. Long-term debt would be a mandatory element of TLAC, and at a level somewhat above one third.

If readers will forgive the pun, it’s obviously too early for those interested in banking regulation to write off debt.

The preceding post comes to us from Paul L. Davies, Senior Research Fellow, Harris Manchester College, Oxford and formerly Allen & Overy Professor of Corporate Law at Oxford University. The post is based on his article, which is entitled “The Fall and Rise of Debt: Bank Capital Regulation after the Crisis” and available here.