On April 2, 2019, the federal banking agencies proposed a rule that would require large banking organizations to deduct from their regulatory capital certain investments in total loss-absorbing capacity (“TLAC”) debt issued by global systemically important banking organizations (“G-SIBs”) rather than to risk-weight such investments as is currently done. The rule is intended to reduce interconnectedness in the financial system by discouraging (but not prohibiting) banking organizations from investing in G-SIBs’ debt, and therefore has important implications for the marketability and liquidity of debt instruments that G-SIBs are required to issue under the Federal Reserve’s TLAC requirements.

In a chart accompanying this blog post, we have compared the key parameters of the interagency proposal to the deduction requirements included in the Federal Reserve’s 2015 TLAC proposal and the Basel Committee’s 2016 final standard. Comments on the interagency proposal are due June 7, 2019.

Applicability of the Deduction

The interagency proposal would apply to any advanced approaches banking organization, i.e., any insured depository institution holding company that has at least $250 billion in total consolidated assets or consolidated on-balance sheet foreign exposures of at least $10 billion, and any insured depository institution subsidiary of such a company. The preamble to the proposal suggests that the final deduction requirements may ultimately apply only to “Category I” and “Category II” institutions as defined in the federal banking agencies’ 2018 tailoring proposal, which would generally be banking organizations with $700 billion or more in total consolidated assets. However, the preamble also cautions that the agencies will consider ways to “strongly discourage” smaller banking organizations from investing in TLAC debt.

Instruments that would be subject to the deduction include eligible debt securities under the TLAC rule that do not qualify as Tier 2 capital, and instruments pari passu with or subordinated to such securities, in either case issued by the top-tier bank holding company of a U.S. G-SIB or the top-tier U.S. intermediate holding company of a foreign G-SIB. Instruments issued by other foreign G-SIB entities that have the purpose of absorbing losses or recapitalizing the issuer or any of its subsidiaries in connection with the resolution of the issuer or any of its subsidiaries, and instruments pari passu with or subordinated to such instruments, would also be subject to the deduction.

Operation of the Deduction

The deduction would work similarly to the deductions for holding Tier 2 capital of unconsolidated financial institutions under the existing regulatory capital rules. Any required deduction would be made using the “corresponding deduction approach,” by which the investor would deduct TLAC debt holdings first from Tier 2 capital and, if it had insufficient Tier 2 capital to make the full requisite deduction, deduct the remaining amount from additional Tier 1 capital and then from common equity Tier 1 capital.

The deduction would be required in the following circumstances:

  • Non-Significant Investments.
    • Generally, if the investor has a “non-significant investment” in the issuer (e., the investor owns no more than 10 percent of the issuer’s outstanding common stock), the aggregate amount of the investor’s non-significant investments in the capital of unconsolidated financial institutions and the TLAC debt of G-SIBs exceeds 10 percent of the investor’s common equity Tier 1 capital, and the value of the investor’s aggregate non-significant investments in TLAC debt that does not qualify as regulatory capital exceeds 5 percent of the investor’s own common equity Tier 1 capital, then the amount above 10 percent of the investor’s common equity Tier 1 capital would be deducted using the “corresponding deduction approach.” The TLAC-specific 5 percent threshold, first introduced in the Basel Committee’s 2016 standard, would afford investor banking organizations greater latitude to invest in TLAC debt without being required to deduct such holdings from their own regulatory capital than would have been the case under the Federal Reserve’s 2015 proposal.
    • However, where the investor is itself a G-SIB, the 5 percent threshold would apply only to holdings of TLAC debt that are made for the purpose of short-term resale or with the intent of benefiting from actual or expected short-term price movements, or to lock in arbitrage profits, and sold within 30 business days.
  • Significant Investments. If the investor has a “significant investment” in the issuer (i.e., the investor owns more than 10 percent of the issuer’s common stock), deductions of TLAC debt holdings would be required in full, using the corresponding deduction approach.
  • Investment in Own TLAC Debt. If an issuer holds any of its own TLAC debt, the issuer would be required to deduct such investment in full, using the corresponding deduction approach.
  • Reciprocal Cross-Holdings. If the investor holds any TLAC debt reciprocally with another financial institution – meaning that the investor and the financial institution have a formal or informal arrangement to swap, exchange, or otherwise intend to hold each other’s capital or TLAC – then the investor would be required to deduct such reciprocal cross-holdings in full, using the corresponding deduction approach.

The deduction would not, however, apply to underwriting positions held for five or fewer business days. Additionally, with approval of the investor’s primary federal regulator, holdings resulting from a failed underwriting could be exempt from the deduction for longer.

Any amount of an investor’s holdings of G-SIB unsecured debt that is not required to be deducted would be risk-weighted as it normally would, generally at 100 percent.

The proposal does not include a proposed effective date for when the deductions would begin.

Reporting Requirements

The proposal would modify the Consolidated Financial Statements for Holding Companies (FR Y-9C), Schedule HC-R, to require the investor to report its deductions of TLAC debt. The preamble to the proposal states that the agencies would in the future also modify Call Reports to effectuate similar reporting at the bank level.

Additionally, the proposal would modify Schedule HC-R of the FR Y-9C to require top-tier bank holding companies of U.S G-SIBs and top-tier U.S. intermediate holding companies of foreign G-SIBs to report their outstanding TLAC and TLAC debt and related ratios.