The 2007-2009 financial crisis was a watershed event that shook the confidence of people around the globe in the stability of the international financial system. The crisis demonstrated a failure of market discipline and the government responses only exacerbated this problem by confirming the long-standing expectation that some firms – particularly globally active financial companies – were too big or interconnected to fail.

In response, international standard setters and national authorities have sought to create a more resilient financial system while fashioning statutory frameworks and strategies to make the resolution of so-called systemically important financial institutions (“SIFIs”) possible.

The U.S. Response.

In the wake of the financial crisis, the U.S. created a special insolvency regime for a failing SIFI under the Orderly Liquidation Authority (“OLA”) provisions of Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). OLA is designed exclusively to address the failure of SIFIs in cases where such an insolvency would have serious adverse effects on the U.S. economy.^[1] It is important to note that OLA supplements—rather than replaces—existing insolvency regimes. Unless a decision is made to place a SIFI into OLA resolution, the normal insolvency laws – such as the Bankruptcy Code – continue to apply. Of course, FDIC-insured banks remain subject exclusively to resolution under the Federal Deposit Insurance Act.

The U.K. and European Response.

The United Kingdom’s Response. In the Financial Services Act 2012, the U.K. restructured its financial services regulatory framework to give the Bank of England responsibility for macro-prudential oversight for the financial system, supervisory authority for systemically important financial services companies, and resolution authority for SIFIs. The UK adopted a further reform through the Banking Reform Act 2013 to provide for a bail-in tool, which is designed to recapitalize a failing or failed financial company and restore its ability to meet regulatory and market requirements.

In a paper entitled “The Bank of England’s Approach to Resolution” (“BoE Resolution Paper”), released on October 23, 2014, the Bank of England described at a high level how it anticipates using its authority under U.K. law in a resolution of a systemically important financial company in the future.[2]

The European Response. At the time of the financial crisis there was no harmonization of the insolvency regimes for resolving banks or other financial institutions in the EU. The 2014 Bank Recovery and Resolution Directive (“BRRD”), lays out a harmonized toolbox of resolution powers that will be available to national authorities in each member state.^[3] While the BRRD authorizes a set of resolution tools, for purposes of the present discussion the most important tool is the bail-in tool.

The Role of Bail-in under the Resolution Authorities.

Although it may not be suitable for some financial companies, the international debate about the best resolution strategies to apply to complex, global financial companies has been dominated since 2011 by the single point of entry strategy (“SPE”). While SPE was developed to implement OLA under the Dodd-Frank Act it has come to be viewed as the most promising approach for the resolution of SIFIs from other jurisdictions as well.

Under the SPE strategy, only the top-level holding or operating company of a financial group would be resolved, and recapitalized. The goal is to focus the resolution on the top-level owner of the operating subsidiaries so that those subsidiaries conducting the systemically important functions of the group would be able to remain open and operating.^[4] Once the top-level holding company is placed into receivership, its operations and assets – principally its ownership of the subsidiaries – are transferred to a bridge financial company.

In Europe (including the U.K. and Switzerland), the SPE strategy is expected to rely more heavily on the use of bail-in authority to allow recapitalization either with or without the initiation of formal insolvency proceedings. In these approaches, the bail-in authority would be used to recapitalize the top-level company by writing down existing equity and converting certain debt obligations into new equity. This open institution approach has been favored by many in Europe because the top-level company for many of the European SIFIs are themselves operating companies and there is concern that putting these operating companies into insolvency proceedings, even if for a moment, could lead to greater disruptions to their operations. In contrast, the top-level companies for U.S. SIFIs are holding companies with virtually no operating businesses.

In the BoE Resolution Paper, the Bank of England describes bail-in as a preferred resolution strategy for global SIFIs compared to use of its transfer powers, which include the power to transfer operations of the failing SIFI to a bridge.   The reason lies in the Bank of England’s concern that it will be exceedingly difficult to separate the critical economic functions of the SIFI from those that are less critical in making the transfer.[5] This is viewed better facilitating continuity in critical operations. To the extent it is effective at recapitalizing the SIFI and achieving renewed market confidence, this could prove an advantage. However, as noted above, if the transfer to the bridge involves all key operations of the SIFI or if the ‘point of entry’ is at a holding company level where there are few, if any, operating facilities, this may not be a significant difference. Finally, bail-in is viewed as presenting an advantage because it can potentially operate before insolvency as well as after initiation of resolution actions.[6]

The BoE Resolution Paper does discuss an issue that continues to create challenges. If the bail-in occurs before resolution, the reliability of valuations of the assets becomes more difficult.[7] The Bank of England, and the FDIC, have noted that this issue may be addressed by issuing new equity based on an estimated valuation while providing “warrants” or “certificates of entitlement” to creditors so that a true-up of the value of their claims can be completed when more complete market valuations are available.

The principal distinction between the US OLA approach and bail-in in the UK and under BRRD is that the latter approach authorizes bail-in before the financial company has been placed into an insolvency proceeding. There, the purpose of the bail-in tool is to restore an institution’s ability to comply with the conditions for authorization, to carry on its authorized activities, and to sustain sufficient market confidence in the institution.^[8]

While the bail-in tool may also be used in an insolvency proceeding, the focus in the UK and in the EU is clearly on pre-failure bail-in.

Total Loss Absorbing Capacity and Bail-in

On November 10, 2014, the Financial Stability Board (“FSB”) released a consultative document entitled “Adequacy of loss-absorbing capacity of global systemically important banks in resolution” (the “Proposal”). The stated objective of the Proposal is to ensure that the SIFIs maintain sufficient loss absorbing and recapitalization capacity so that, during and after a resolution, “critical functions can be continued without taxpayers’ funds (public funds) or financial stability being put at risk.”

To achieve this objective, the Proposal recommends requiring all SIFIs to maintain levels of equity capital and debt as Total Loss Absorbing Capacity (“TLAC”) to serve as a going concern and gone concern cushion so that, once the Basel III minimum required capital is eroded, there remains sufficient TLAC that can be written down or converted into equity to recapitalize the SIFI.

Now that comments have been received, the FSB will conduct additional analysis, including a quantitative impact study (“QIS”) and a market survey. The FSB has stated that it plans to issue the final standards at the next G-20 Summit in November 2015. Although the FSB does not anticipate global implementation until January 2019, certain jurisdictions, including the United States, may seek to implement the requirements more rapidly.

Implications of TLAC and the Future of Finance.

A Focus on SPE Strategies and Non-operating Holding Company Structures

The Proposal has clear implications for which entities will be issuers of debt. While the Proposal accommodates MPE strategies by allowing for multiple “resolution entities” that must hold TLAC and can issue external TLAC, the Proposal was developed in the context of an SPE strategy designed to maintain systemically important operations in subsidiaries and favors holding companies with no or very limited operations. While this is the structure used by the U.S. SIFIs and some others, there are a considerable number of SIFIs, particularly in Europe and Asia, that have operating banks as the topmost parent. If the TLAC requirement is interpreted by regulators as implying a need for the reorientation of SIFI organizations towards a U.S.-style holding company model, it would have significant consequences on the diversity of available business models and the flexibility previously allowed in financing business operations.

Internal TLAC – Rigidity and Scaling

The requirement of internal TLAC for material subsidiaries located outside the home country raises significant questions. While such an approach “pre-positions” recapitalization resources in host countries, it also creates a risk of trapping those resources in multiple host country silos. This could limit the ability of SIFIs to redeploy resources to threatened subsidiaries by reducing the available and easily deployable resources to head off failure, which, on a global scale, raises concerns about systemic stability in future crises.

However, if properly structured, internal TLAC could provide an effective avenue for financial companies to recapitalize their foreign operations and avoid a potentially disorderly break-up along national lines. This could be a significant step towards more effective international resolution strategies.

New Relationship Between Equity Capital and Debt

If adopted as proposed, the Proposal would impose more specific requirements on the composition of SIFI balance sheets by mandating specific minimum proportions of instruments that are Tier 1 or Tier 2 capital instruments in the form of debt plus other eligible TLAC that is not regulatory capital. In essence, the Proposal represents an historic realignment of the traditional relationship between equity capital and debt. Traditionally, common equity capital (often referred to as Tier 1 common) has served as a shock absorber for unanticipated losses to prevent insolvency. In that role, it provides going-concern loss absorbency. Debt issued by a banking institution has been conceived as providing a more secure investment for a more limited return.

This change in the relationship between equity capital and debt is reflected in the Proposal’s recommendation of a Pillar 1 minimum external TLAC requirement that is double the Basel III minimum capital standard as a percentage of RWAs, while requiring that at least 33% of the TLAC must be in Tier 1 or Tier 2 capital instruments in the form of debt plus other eligible TLAC that is not regulatory capital. This approach is designed to provide assurance that there will be a sufficient buffer of loss absorbing equity and debt to permit recapitalization after regulatory capital has absorbed losses prior to insolvency. This relationship assumes that resolution occurs while sufficient TLAC remains to recapitalize the SIFI. Under the Proposal, this action can occur either before or after initiation of insolvency proceedings. In either event, while the Proposal does not address this question, it is essential that action must be taken before the exhaustion of the Basel III minimum capital requirement so that the remaining TLAC can serve to recapitalize the SIFI. While the Proposal does not count the additional Basel III capital buffers as part of TLAC, this additional cushion would still serve to absorb losses before the TLAC cushion. In effect, the Proposal recommends a significant extension of the current regulatory capital framework.

Interplay with Resolution Regimes

As discussed above, although certain aspects of the Proposal, such as the concept of “resolution entities,” appear designed to accommodate MPE resolution, the Proposal as a whole still generally presumes an SPE-resolution approach and contains provisions that may not be consistent with the corporate and debt structures of many SIFIs headquartered outside the United States. The FSB may need to reconsider how the proposal defines the types of instruments eligible for inclusion as TLAC to permit firms with different corporate and debt structures to compete with their foreign counterparts on a level playing field. Alternatively, some European jurisdictions may need to change their laws regarding priority so that senior unsecured debt is subordinated to liabilities, such as insured deposits or liabilities arising from derivatives, that are excluded from qualifying as TLAC. .

Other elements of the Proposal may also frustrate fair competition between SIFIs. For instance, the blanket exemption for SIFIs from developing countries may make it very difficult for firms with headquarters in developed nations to compete in developing countries where local banking organizations would not have to bear the costs of meeting the TLAC requirements. Likewise, the provision allowing SIFIs with uncapped resolution funds to count those funds towards 2.5% of RWAs fails to account for the fact that firms in other countries also contribute to resolution funds. While this provision may have been a political compromise, it creates a potential mismatch in TLAC requirements that could impose differential costs on SIFIs competing in the same markets and for the same customers.

Calibration of the Total TLAC Requirement

The projected calibration of the Pillar 1 external TLAC requirement at 16% – 20% of RWAs also raises some questions. Although this range represents approximately twice the Basel III regulatory capital requirements, it is not clear that this is the appropriate figure. It presumes that regulatory capital would be depleted in its entirety before resolution occurs. However, if regulators apply prompt corrective action strategies and seek resolution before capital insolvency, or if the company cannot access market-based funding and becomes illiquid before capital insolvency (as happened during the recent financial crisis), resolution should occur before capital insolvency. If so, TLAC calibrated around double the Basel III regulatory capital requirements (while excluding regulatory capital buffers) may impose higher total TLAC requirements than necessary.

Triggers

Greater clarity is likely necessary with respect to the triggers applicable to TLAC instruments. The Proposal provides that such instruments would need to “contain a contractual trigger or be subject to a statutory mechanism” that permits the resolution authority to expose the instrument to losses in resolution. Investors, however, will likely need greater certainty as to when this trigger event is likely to occur, i.e. what standards regulators will use to determine when a SIFI has reached the “point of non-viability.”

Cost-Benefit Analysis

This is, in some ways, the ultimate question that is inherent within the preceding issues. What are the costs and benefits to economic development and financial resiliency of a defined level of TLAC for SIFIs? The FSB directly poses this question in the Proposal. The FSB notes that “the added funding costs associated with a TLAC requirement will lead to a reduction of the implicit public subsidy for SIFIs.” However, in assessing this effect, it presumptively adopts a relatively simple binary understanding of the potential relationships by concluding that “SIFIs may pass on a share of their higher funding costs to their clients, prompting a shift of banking activities to other banks without necessarily reducing the amount of activity.” While this may be true for many activities, it appears to assume the answer and, at least, presents some questions about whether it is inevitably true about certain financial functions performed by SIFIS, such as global capital formation, funding and certain more complex derivatives activities.

Final Thoughts

The answers to the foundational questions posed above are critical to answer the underlying and more technical questions for every level of the TLAC Proposal. We must assume that international and national regulators will be open to a transparent discussion about these issues. They are too important to resolve without bringing the best analytics together in an open dialogue.

ENDNOTES

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Title II—Orderly Liquidation Authority, codified at 12 U.S.C. §§5381-5397.

[2] Bank of England, “The Bank of England’s Approach to Resolution” (Oct. 2014), available at www.bankofengland.co.uk/financialstability/Documents/resolution/apr231014.pdf, which will be updated periodically.

[3] As a practical matter, national authorities will be replaced by the single resolution board under the single resolution mechanism in certain cases.

[4] Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy, 78 Fed. Reg. 76614 (Dec. 18, 2013); Swiss Financial Market Supervisory Authority, “Resolution of Global Systemically Important Banks,” August 7, 2012, available at http://www.finma.ch/e/finma/publikationen/Documents/pos-sanierung-abwicklung-20130807-e.pdf; Bank of England & Federal Deposit Insurance Corporation, “Resolving Globally Active, Systemically Important, Financial Institutions,” December 10, 2012, available at https://www.fdic.gov/about/srac/2012/gsifi.pdf.

[5] See BoE Resolution Paper at 18.

[6] See BoE Resolution Paper at 9-10.

[7] See BoE Resolution Paper at 18-19.

[8] BRRD art. 43.

This post comes to us from Michael Krimminger, who is a Partner with Cleary Gottlieb Steen & Hamilton, and former General Counsel and Deputy to the Chairman for Policy at the U.S. Federal Deposit Insurance Corporation.   The views expressed in this post are solely those of the author and do not necessarily represent the policies or views of Cleary Gottlieb or any of its partners. This post is based on a paper by Michael Krimminger, which is entitled “Shadows and Mirrors: The Role of Debt in the Developing Resolution Strategies in the U.S., U.K., and European Union” and available here. © 2014 Cleary Gottlieb Steen & Hamilton.