Basel Committee Issues Final Standard on Capital Treatment of TLAC Holdings

On October 12, 2016, the Basel Committee on Banking Supervision published a final standard (the "Final Standard") on the regulatory capital treatment of holdings by banking organizations--both G-SIBs and non-G-SIBs--of total loss-absorbing capacity ("TLAC") instruments issued by G-SIBs, implementing a provision of the Financial Stability Board's November 2015 TLAC Term Sheet (the "FSB TLAC Term Sheet"). The Final Standard is generally consistent with the Basel Committee's November 2015 consultative document (the "Proposal"). Both address TLAC holdings by building upon the Basel III capital framework's provisions addressing deductions by banking organizations of their holdings of regulatory capital instruments issued by other banking organizations. Those provisions apply a "corresponding deduction approach," generally requiring that holdings of regulatory capital instruments be deducted from the corresponding regulatory capital component of the holder. The Final Standard, like the Proposal, deviates from that approach by requiring that a banking organization's holdings of TLAC instruments that do not otherwise qualify as regulatory capital (for example, senior debt) be deducted from the banking organization's Tier 2 capital.

The Final Standard includes certain modifications from the Proposal in response to industry comments-- most notably to facilitate market-making activities in non-regulatory capital TLAC instruments by introducing an additional threshold below which holdings of those instruments need not be deducted from Tier 2 capital.

The Final Standard will take effect at the same time as the minimum TLAC requirements for each GSIB--that is, January 1, 2019 for investments in G-SIBs other than those headquartered in emerging market economies. Key aspects of the Final Standard are discussed in greater detail below.

  • The Final Standard retains the Proposal's asymmetric approach requiring deductions from Tier 2 capital.
    • The Final Standard requires banking organizations to deduct holdings of TLAC instruments that do not otherwise qualify as regulatory capital and certain pari passu instruments ("TLAC liabilities") from Tier 2 capital--a category of regulatory capital. As noted above, this approach departs from Basel III's symmetric "like-for-like" corresponding deduction approach for regulatory capital instruments, in which an investing banking organization deducts covered investments in capital securities of an issuing banking organization from the corresponding components of the investing banking organization's own capital stack.
    • The Basel Committee explained that the asymmetric approach to deductions allows for the same treatment for both G-SIBs and non-GIBs (which are not subject to TLAC requirements) and "provid[es] sufficient disincentives for banks to invest in TLAC."
    • In contrast, a G-SIB's holdings of its own TLAC liabilities (including certain liabilities that are not eligible to be recognized as TLAC) must be deducted from the G-SIB's TLAC resources but need not be deducted from its Tier 2 capital.

 

  • The Final Standard includes TLAC liabilities within the 10% threshold under which nonsignificant investments in unconsolidated financial institutions may be risk-weighted (rather than deducted).
    • The current Basel III deduction approach allows a banking organization to risk-weight (rather than deduct) non-significant investments in the capital of unconsolidated financial institutions, up to 10% of the banking organization's common equity. The Final Standard, like the Proposal, includes TLAC liabilities within this 10% threshold, such that the deduction requirement applies both to holdings of TLAC liabilities and to holdings of regulatory capital instruments that, taken together and on a net long basis, exceed 10% of the banking organization's common equity (after applying all other adjustments). Below this 10% threshold, a banking organization may risk-weight (rather than deduct) its holdings of regulatory capital instruments and TLAC liabilities.

 

  • The Final Standard introduces an additional 5% threshold for holdings of TLAC liabilities to facilitate market making.
    • This additional threshold--which was not included in the Proposal--allows a banking organization to risk-weight (rather than deduct from its Tier 2 capital) non-significant investments in TLAC liabilities of unconsolidated financial institutions, up to 5% of the investing banking organization's common equity (after applying all other adjustments), with holdings measured on a gross long basis.
    • For a G-SIB, the 5% threshold is subject to additional conditions. It may be used only for TLAC liabilities in the G-SIB's trading book that are sold within 30 business days. Once a GSIB has designated a holding as falling within this 5% threshold category, the holding may not subsequently be included within the general 10% threshold described above. In addition, notwithstanding either threshold, reciprocal cross-holdings of TLAC liabilities between G-SIBs must be fully deducted.

 

  • TLAC liabilities include liabilities that qualify as TLAC (but not as regulatory capital) and certain pari passu instruments.
    • TLAC liabilities include (i) direct, indirect, and synthetic holdings of instruments eligible to be recognized as TLAC that do not otherwise qualify as regulatory capital, and (ii) instruments that are not eligible to be recognized as TLAC and are pari passu with TLAC liabilities that meet requirements for contractual, statutory or structural subordination.
    • The Basel Committee included such pari passu instruments in order to "better meet the objective of limiting contagion," and to "help to avoid the development of mistaken market expectations that only liabilities which qualify for TLAC, or are actively serving to meet TLAC requirements, will normally be exposed to loss in resolution, even where this involves a departure from the insolvency creditor hierarchy."
    • For liabilities recognized as TLAC due to the capped exemption from the subordination requirements generally applicable to TLAC instruments, a proportion of the investing banking organization's holdings of such liabilities are treated as TLAC liabilities, and subject to potential deduction, based on the amount of such liabilities that the issuing G-SIB uses to satisfy its TLAC requirements. In order to facilitate compliance, the Basel Committee will introduce disclosure requirements for G-SIBs so that investing banking organizations will have sufficient information to apply the proportional approach.

 

  • Common Equity Tier 1 used to meet TLAC requirements cannot be used to meet regulatory capital buffers.
    • Consistent with the FSB TLAC Term Sheet, the Final Standard revises the calculation of regulatory capital buffers to reflect that banking organizations must meet regulatory capital buffers in addition to minimum TLAC requirements.

The Basel Committee's approach to the regulatory capital deductions for TLAC liabilities is similar to the U.S. approach in the Federal Reserve's October 2015 proposed TLAC rules in several respects, including by requiring institutions to make deductions from Tier 2 capital, requiring deductions for holdings of liabilities that do not qualify as TLAC, and requiring both G-SIBs and non-G-SIB institutions to make these deductions. However, certain aspects of the Federal Reserve's proposed TLAC rules are more stringent than the Final Standard--for example, consistent with the Basel Committee's Proposal, the Federal Reserve's proposed TLAC rules did not include an additional 5% deduction threshold to facilitate market-making activities in TLAC instruments. It remains to be seen whether the Federal Reserve will conform its final TLAC rules to the modifications reflected in the Basel Committee's Final Standard.