In two previous posts,[1] I described the financial industry’s “single point of entry” (SPOE) strategy for resolving failed megabanks. The SPOE approach – which has been endorsed by the Federal Reserve Board (Fed) and other regulators – could be implemented under the Orderly Liquidation Authority (OLA) established by Title II of the Dodd-Frank Act or under a proposed new “Chapter 14” of the Bankruptcy Code. As I explained in my previous posts and a forthcoming law review article,[2] an SPOE resolution would involve only the parent holding company of a failed megabank and would impose losses only on that company’s shareholders and “bail-in” debtholders. The holding company’s subsidiaries (including banks and securities broker-dealers) would remain in business, and all of their creditors (including short-term Wall Street creditors) would be fully protected.
The Fed recently issued proposed rules that would establish a new “total loss-absorbing capacity” (TLAC) requirement to implement the SPOE strategy. The proposed TLAC requirement would apply to eight U.S. megabanks currently designated as global systemically important banks (G-SIBs) as well as U.S. intermediate holding companies of foreign G-SIBs.[3] Shortly after the Fed issued its proposed TLAC rules, the Financial Stability Board (FSB) released “a new international standard” that will require G-SIBs throughout the world to maintain minimum levels of TLAC.[4] The Fed’s TLAC proposal and the FSB’s TLAC standard differ in certain technical aspects, but they are aligned in their overall concept and purpose.
As explained below, the Fed’s TLAC proposal would entrench SPOE as the chosen strategy for resolving failed U.S. megabanks. Under SPOE and TLAC, only the parent holding company of a failed megabank would be placed in receivership, while its subsidiaries would be fully protected and kept in operation. All losses from the resolution would be imposed on the holding company’s shareholders and TLAC debtholders. Most of the debtholders would likely be ordinary investors in mutual funds and pension funds because regulators would discourage financial institutions from purchasing TLAC debt. If the megabank’s subsidiaries could not be recapitalized by wiping out the investments of holding company shareholders and debtholders, the Federal Deposit Insurance Corporation (FDIC) as receiver would obtain a taxpayer-financed bridge loan from the Treasury Department. Thus, SPOE and TLAC would impose the costs of resolving failed megabanks on ordinary investors and taxpayers while giving 100% protection to Wall Street creditors.[5]
SPOE and TLAC would maintain a perverse system of financial regulation that allows megabanks, their executives, and Wall Street creditors to reap massive benefits from a too-big-to-fail (TBTF) subsidy that is backstopped by ordinary citizens. We must reject this intolerable outcome, and we must require megabanks as well as their executives and Wall Street creditors to pay for the enormous risks they create.
- The Fed’s TLAC Proposal Would Ensure that Failed Megabanks Are Resolved Via the SPOE Strategy
If adopted, the Fed’s proposed TLAC requirement would be phased in between 2019 and 2022. The Fed has explained that its TLAC proposal “is primarily focused on implementing the SPOE resolution strategy” for failed megabanks.[6] In the Fed’s view, SPOE offers “substantial advantages” because it would fully protect the creditors of subsidiaries of a failed megabank and enable those subsidiaries “to continue normal operations.”[7] By preventing any failure of the subsidiaries, SPOE would “avoid the need for separate proceedings for separate legal entities run by separate authorities across multiple jurisdictions.”[8] Thus, SPOE would enable the Fed to maintain exclusive control over the resolution of the megabank’s parent holding company.[9]
The Fed clearly prefers the SPOE strategy over the alternative “multiple point of entry” (MPOE) resolution approach. Unlike SPOE, MPOE would require “separate resolutions of different legal entities within the financial firm and could potentially be executed by multiple resolution authorities across multiple jurisdictions,” a result that the Fed plainly does not want.[10] The FSB’s new international TLAC standard is more agnostic with respect to the comparative merits of SPOE and MPOE, but the FSB’s standard accommodates SPOE. [11]
The Fed’s TLAC proposal would require the parent holding company of each U.S. G-SIB to maintain “eligible external TLAC” equal to 18% of its risk-weighted assets (RWAs) or 9.5% of its total leverage exposure, whichever is greater. In addition, each U.S. G-SIB would be obliged to maintain a supplemental “external TLAC buffer” equal to 2.5% of RWAs plus the applicable surcharge under the Fed’s G-SIB surcharge rule. The Fed projects that the four largest U.S. G-SIBs would be required to satisfy minimum TLAC ratios ranging from 18.5% of RWAs for Wells Fargo to 23.5% of RWAs for JPMorgan Chase.[12]
In addition to creating “external TLAC” rules for U.S. G-SIBs, the Fed’s proposal would require each U.S. intermediate holding company of a foreign G-SIB to satisfy an “internal TLAC” requirement. The “internal TLAC” requirement would oblige each U.S. intermediate holding company to sell qualifying TLAC instruments to its parent foreign G-SIB, so that the failure of a U.S. holding company could be resolved by writing off the TLAC investments held by the foreign G-SIB. The remainder of this post will focus on the proposed “external TLAC” rules for U.S. G-SIBs, and it will not analyze the “internal TLAC” requirement for foreign G-SIBs.
Each parent holding company of a U.S. G-SIB would be required to maintain qualifying TLAC consisting of Tier 1 capital (common stock and non-cumulative perpetual preferred stock) and “eligible external long-term debt” (TLAC debt). Each G-SIB would be obliged to maintain a minimum ratio of TLAC debt equal to 6% of its RWAs plus its G-SIB surcharge or 4.5% of its leverage exposure, whichever is greater. The Fed expects that the four largest U.S. G-SIBs would need to satisfy minimum TLAC debt ratios ranging from 8% of RWAs for Wells Fargo to 10.5% of RWAs for JPMorgan Chase.[13]
Each parent holding company of a G-SIB would issue TLAC debt directly (and not through subsidiaries) to ensure that the TLAC debt could be written off in an SPOE resolution of the holding company. As the Fed’s proposal explains, “Under the SPOE approach, only the [holding company] would enter resolution. The [holding company’s] eligible [TLAC debt] would be used to absorb losses incurring throughout the banking organization, enabling the recapitalization of operating subsidiaries that had incurred losses and enabling those subsidiaries to continue operating on a going-concern basis.”[14] Thus, TLAC debt would function as bail-in debt and would be used to recapitalize operating subsidiaries following the failure of a G-SIB.
TLAC debt must be unsecured, must not be guaranteed by a G-SIB’s holding company or any of its subsidiaries, and must not have any credit enhancements that would increase its seniority. TLAC debt must be “plain-vanilla” debt with a “definite value that can be quickly determined in resolution.”[15] TLAC debt must have a remaining maturity of at least one year and would be subject to a 50% haircut if its remaining maturity were less than two years. TLAC debt must be governed by U.S. law, and it must not be convertible into equity prior to the date of the FDIC’s appointment as receiver for the holding company.
To ensure that a G-SIB’s parent holding company is relatively easy to resolve, the Fed’s proposal includes “clean holding company” provisions. Those provisions would prohibit the holding company from entering into a number of transactions, including (i) issuing non-TLAC liabilities that exceed 5% of the holding company’s total liabilities or that are pari passu or subordinated to TLAC debt, (ii) issuing any debt to non-affiliates with an original maturity of less than one year, or (iii) entering into any “qualifying financial contracts” (e.g., derivatives or repurchase agreements) with non-affiliates. The “clean holding company” prohibitions are designed to prevent G-SIB holding companies from issuing short-term liabilities or volatile exposures that would be subject to “destabilizing funding runs” by third-party creditors.[16]
- SPOE and TLAC Would Impose Losses from Megabank Failures on Ordinary Investors and Taxpayers
The SPOE resolution strategy and the Fed’s TLAC proposal would impose losses from a G-SIB’s failure first on ordinary investors in mutual funds and pension funds and ultimately on taxpayers. SPOE and TLAC would protect a failed G-SIB’s operating subsidiaries and their creditors from any losses by ensuring that “those losses would instead be borne by the external TLAC holders of the [parent] holding company,” including shareholders and bail-in debtholders.[17] This blanket protection for subsidiaries and their creditors is designed to “maintain the confidence of the operating subsidiaries’ creditors and counterparties,” thereby avoiding “destabilizing funding runs” by uninsured depositors and holders of commercial paper, securities repurchase agreements (repos), and derivatives.[18]
Who would buy the bail-in debt that would be written off to protect subsidiaries and their Wall Street creditors? The Fed’s TLAC proposal indicates that mutual fund and pension fund investors are expected to play this loss-absorbing role. The proposal states that “it is desirable that the holding company’s creditors be limited to those entities that can be exposed to losses without materially affecting financial stability.”[19] The proposal therefore strongly discourages depository institutions and their holding companies from investing in TLAC debt. Banks and thrifts would be required to deduct from their regulatory capital all of their investments in unsecured G-SIB debt. This mandatory capital deduction “would substantially reduce the incentive of a [depository] institution to invest in unsecured debt issued by a [G-SIB], thereby increasing the prospects for an orderly resolution of a [G-SIB] by reducing the risk of contagion spreading to other [depository] institutions.”[20] The FSB has mandated a similar 100% regulatory capital deduction to discourage G-SIBs from investing in TLAC debt issued by other G-SIBs.[21] Insurance regulators are likely to adopt similar capital deduction policies to deter insurance companies from investing in TLAC debt.
If depository institutions and insurance companies do not invest in TLAC debt, the most likely investors for such debt would be hedge funds, mutual funds, and pension funds. As I have previously suggested, regulators would probably discourage megabanks from selling bail-in debt to large hedge funds because those funds borrow large amounts from G-SIBs. A write-off of bail-in debt held by hedge funds could undermine financial stability by causing the failure of those funds as well as defaults on the loans they have taken from G-SIBs.[22]
In contrast, regulators and executives of megabanks appear to view mutual funds and pension funds as inviting targets for sales of bail-in debt.[23] Regulators and G-SIB leaders evidently believe that ordinary investors in mutual funds and pension funds can bear the costs of resolving failed megabanks without shaking the foundations of our financial system. HSBC chairman Douglas Flint expressed that view in very stark terms when he testified before a Parliamentary committee last year. Mr. Flint declared that society must choose between imposing the costs of resolving failed megabanks on ordinary investors or on taxpayers. As he stated, “At the end of the day, the burden of failure rests with society. Whether you take it out of society’s future income through taxation or whether you take it through their pensions or savings, society is bearing the cost.”[24]
If wiping out the investments of the parent holding company’s shareholders and bail-in debtholders would not be sufficient to recapitalize a failed G-SIB’s subsidiaries, the FDIC would call on the Treasury Department for a taxpayer-financed loan from the Orderly Liquidation Fund (OLF). The OLF has a zero balance, and the FDIC would need to borrow the necessary funds from the Treasury to complete the SPOE resolution of the G-SIB’s parent holding company.[25] Ordinarily the FDIC must repay an OLF loan within five years by imposing special assessments on large financial institutions. However, an OLF loan could be extended indefinitely “to avoid a serious adverse effect on the financial system of the United States.”[26] During a financial crisis, many large banks would probably be too weak to pay special assessments, and OLF loans would therefore be “extended far beyond the standard five-year term.”[27] Since OLF loans would represent “lengthy, taxpayer-financed bridge loans,” it is clear that ordinary citizens (either through investment losses and/or higher taxes) would ultimately bear the burden of bailing out Wall Street creditors of failed G-SIBs.[28]
- The TLAC Proposal Must Be Reformed to Compel G-SIBs, Their Executives, and Wall Street Creditors To Pay for the Risks They Create
As I have previously argued, the high-risk business model of universal banks (financial conglomerates) relies on “cheap funding from government-subsidized deposits and shadow banking liabilities to finance their speculative activities in the capital markets.”[29] The SPOE strategy and the TLAC proposal support that high-risk model by fully protecting operating subsidiaries of G-SIBs and their creditors. When a megabank fails, the costs will be borne by ordinary investors and taxpayers instead of banks, broker-dealers and their insiders and Wall Street creditors, including uninsured depositors and holders of commercial paper, repos, and derivatives.
We must reject the universal banking model with its perverse incentives for speculative risk-taking and its constant shifting of costs and burdens to ordinary citizens. Universal banks resemble giant, unsafe, high-pressure boilers whose inherent flaws cause them to blow up repeatedly and inflict terrible damage on buildings and their unfortunate residents. Instead of replacing our giant financial boilers with smaller, simpler, and safer furnaces, our policymakers continue to keep the boilers in place while tinkering with their controls. We should not be surprised if our giant financial boilers explode again in the near future. When the next explosion occurs, we will discover that we have already spent most of our available resources in repairing the injuries caused by the last explosion (which resulted in a doubling of our national debt from $9 trillion to $18 trillion, as well as a massive expansion of the Fed’s balance sheet from $900 billion to $4.4 trillion). Where will we find the necessary resources to repair the damage from the next explosion, and how can we expect Europe to survive the next crisis when it has not recovered from the last one?
The most direct way to reduce the risk of future financial explosions would be to replace the giant universal banking boilers that have proven to be unsafe under any supervisory regime. We should break up universal banks by reestablishing a regime of functional separation similar to the Glass-Steagall Act. Unfortunately, such legislation may not be politically feasible, given the formidable political clout wielded by megabanks and their determination to preserve their TBTF benefits. Last year, megabanks and their political allies succeeded in repealing Dodd-Frank’s swaps push-out rule so that financial giants could keep high-risk derivatives within their subsidiary banks and continue to benefit from their banks’ higher credit ratings and lower cost of funding.[30] Megabanks are currently lobbying Congress to weaken the Financial Stability Oversight Council’s authority to regulate systemically significant financial institutions (SIFIs).[31]
If we cannot break up universal banks, we must insist on four reforms that would reduce the TBTF benefits exploited by G-SIBs, their executives, and Wall Street creditors. First, regulators must require G-SIBs to satisfy all or most of their TLAC requirement by issuing Tier 1 equity capital. There should not be any required minimum level of TLAC debt. As federal regulators have recently acknowledged, Tier 1 equity capital provides a far superior buffer for absorbing losses. Tier 1 common stock and non-cumulative perpetual preferred stock do not have maturity dates, do not have fixed obligations to pay interest, and can suspend dividends to conserve capital.[32] The TLAC proposal is therefore plainly mistaken in arguing that G-SIBs should satisfy nearly half of their TLAC requirement by issuing bail-in debt.[33]
Second, the Fed must require all newly-issued TLAC debt to be marketed and sold as subordinated debt that is junior to the claims of all other G-SIB creditors. Requiring TLAC debt to be marketed and sold as subordinated debt would minimize the risk of misleading investors. The TLAC proposal acknowledges that a requirement of explicit subordination would “increas[e] the clarity of treatment for [TLAC debtholders] relative to other creditors.”[34] Clarity is needed because G-SIBs are already attempting to create complex forms of “senior” bail-in debt that can be sold at lower interest rates that do not fairly compensate investors for the actual risks of loss.[35] Explicit subordination would require G-SIBs to pay higher interest rates that would be commensurate with the extraordinary risks inherent in TLAC debt. If G-SIBs decide to avoid paying such interest rates by issuing larger amounts of Tier 1 capital to satisfy their TLAC requirements, that would be a highly desirable outcome.
Third, as I have previously argued, SIFIs (including G-SIBs) must pay risk-adjusted premiums to provide at least $300 billion of prefunding for the OLF. The required premiums should include fees for uninsured deposits and short-term shadow banking liabilities, including commercial paper and repos. A prefunded OLF would force SIFIs to internalize at least some of the systemic risks they create, and it would also reduce the likelihood that taxpayers would have to bear the costs of resolving failed SIFIs.[36]
Finally, SIFIs (including G-SIBs) must pay at least half of their total compensation for senior executives and other key insiders (including traders) in the form of bail-in debt. Insiders of SIFIs should not be allowed to hedge, sell, or convert their bail-in debt into stock until at least three to five years after their employment ends. Requiring insiders of SIFIs to receive much of their compensation in long-term, bail-in debt would align their interests with other long-term creditors (including the FDIC and taxpayers) and would encourage insiders to choose business strategies that are prudent and sustainable.[37] In combination, the foregoing reforms would not eliminate TBTF benefits, but they would compel megabanks and their insiders to internalize at least some of the huge risks they impose on society and ordinary citizens.
ENDNOTES
[1] “The Financial Industry’s Plan for Resolving Failed Megabanks Will Ensure Future Bailouts for Wall Street,” Columbia Blue Sky Blog (Sept. 8, 2015), available at http://clsbluesky.law.columbia.edu/2015/09/08/the-financial-industrys-plan-for-resolving-failed-megabanks-will-ensure-future-bailouts-for-wall-street/; “The Financial Industry’s Bankruptcy Plan for Resolving Failed Megabanks Would Give Unwarranted Benefits to Their Executives and Wall Street Creditors,” Columbia Blue Sky Blog (Nov. 3, 2015), available at http://clsbluesky.law.columbia.edu/2015/11/03/the-financial-industrys-bankruptcy-plan-for-resolving-failed-megabanks-would-give-unwarranted-benefits-to-their-executives-and-wall-street-creditors/.
[2] Arthur E. Wilmarth, Jr., The Financial Industry’s Plan for Resolving Failed Megabanks Will Ensure Future Bailouts for Wall Street, 50 Ga. L. Rev. (forthcoming), available at http://ssrn.com/abstract=2648572.
[3] Bd. of Governors of Fed. Res. Sys., Notice of proposed rulemaking: “Total Loss-Absorbing Capacity, Long-Term Debt, and Clean Holding Company Requirements for Systemically Important U.S. Bank Holding Companies and Intermediate Holding Companies of Systemically Important Foreign Banking Organizations,” 80 Fed. Reg. 74,926 (2015) [hereinafter Fed TLAC Proposal]. The eight U.S. banking organizations currently designated as G-SIBs are Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and Wells Fargo.
[4] Fin. Stability Bd., “Press Release: FSB issues final Total Loss-Absorbing Capacity standard for global systemically important banks” (Nov. 9, 2015), available at http://www.financialstabilityboard.org/2015/11/tlac-press-release/; Fin. Stability Bd., “Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution: Total Loss-absorbing Capacity (TLAC) Term Sheet” (Nov. 9, 2015) [hereinafter FSB TLAC Principles], available at http://www.financialstabilityboard.org/wp-content/uploads/TLAC-Principles-and-Term-Sheet-for-publication-final.pdf (stating that the FSB TLAC Principles create “a new international standard” for G-SIBs, id. at 3)
[5] Wilmarth, supra note 2, at 14-23.
[6] Fed TLAC Proposal, supra note 3, at 74,928.
[7] Id.
[8] Id.
[9] Wilmarth, supra note 2, at 10, 23.
[10] Fed TLAC Proposal, supra note 3, at 74,928.
[11] See Morrison & Foerster, Client Alert: Resolution of GSIBs – FSB Final TLAC Principles 2 (Nov. 9, 2015) (stating that the FSB TLAC standard provides “flexibility” for either an SPOE or MPOE resolution strategy), available at http://www.mofo.com/~/media/Files/ClientAlert/2015/11/151109ResolutionGSIBs.pdf.
[12] See Bd. of Governors of Fed. Res. Sys., “Depiction of Proposed LTD Requirement + Fully Phased-in Tier 1 Risk-Based Capital Requirements” (chart), available at http://www.federalreserve.gov/aboutthefed/boardmeetings/ltd-chart-20151030.pdf.
[13] Id.
[14] Fed TLAC Proposal, supra note 3, at 74,934.
[15] Id. at 74,935.
[16] Id. at 74,944; see also id. at 74,944-45 (describing the proposed “clean holding company” provisions).
[17] Id. at 74,928, 74,944 (quote).
[18] Id. at 74,928; see also id. at 74,944-45.
[19] Id. at 74,945 (emphasis added).
[20] Id. at 74,950.
[21] FSB TLAC Principles, supra note 4, at 17 (Principle 15, “Regulation of Investors”) (“In order to reduce the risk of contagion, G-SIBs must deduct from their own TLAC or regulatory capital [all] exposures to eligible external TLAC instruments and liabilities issued by other G-SIBs.”).
[22] See Wilmarth, supra note 2, at 17.
[23] See id. at 18.
[24] Id. at 18 (quoting Mr. Flint’s testimony before the U.K. House of Lords’ Select Committee on the European Union on Oct. 21, 2014) (emphasis added).
[25] Id. at 20-21.
[26] Id. at 21 (citing and quoting 12 U.S.C. §§ 5390(n)(9)(B), (o)(1)(B), (C)).
[27] Id. at 21-22.
[28] Id. at 22.
[29] Id. at 38.
[30] Id. at 2-3.
[31] See Peter Eavis, “Lew Vows to Resist Congressional Maneuvers to Weaken Dodd-Frank,” New York Times (Nov. 25, 2015), at B3.
[32] See Wilmarth, supra note 2, at 20; Dept. of Treasury (Off. of Comptroller of the Currency), Bd. of Governors of Fed. Res. Sys., and FDIC, Final rule: Regulatory Capital Rules, 79 Fed. Reg. 24,528, 24,535 (May 1, 2014) (affirming that common equity Tier 1 capital has “the highest capacity to absorb losses” while non-cumulative perpetual preferred stock “has strong loss-absorbing capacity”). For a comprehensive demonstration of the clear superiority of equity capital over debt as a loss-absorbing buffer for banks, see Anat Admati & Martin Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It (2013).
[33] See Fed TLAC Proposal, supra note 3, at 74,931-33. The TLAC proposal asserts that long-term debt “would more assuredly enhance the prospects for the successful resolution of a failed G-SIB” because, “[u]nlike common equity, [the] loss-absorbing capacity [of long-term debt] would not be at substantial risk of volatility or depletion before the [G-SIB] is placed into a resolution proceeding.” Id. at 74,931. The TLAC proposal does not present any analysis to support that remarkable assertion. If that assertion were true, the Fed should require G-SIBs to satisfy all of their TLAC requirements by issuing long-term debt rather than Tier 1 capital. Of course, neither the Fed nor anyone else (except for supporters of megabanks) believes that would be the right approach.
[34] Id. at 74,937. The TLAC proposal also recognizes the need for clear public disclosure of the risks of TLAC debt. Id. at 74,948.
[35] Wilmarth, supra note 2, at 17-20.
[36] Id. at 26-32.
[37] Id. at 35-38.
The preceding post comes to us from Arthur E. Wilmarth, Jr., Professor of Law at the George Washington University Law School.