The popular press is perpetuating misconceptions regarding the Federal Reserve's proposed TLAC requirements. The TLAC proposal is leading some bank holding companies to move the issuance of structured notes from the bank holding company to a finance subsidiary. Although this move has been characterized in the press as exploiting a loophole, it is not. Rather, the move is designed to restructure the bank holding company in order to make it easier for regulators to resolve in the event of another financial crisis. The issue is not that it is unsafe for the bank holding company to issue structured notes; rather the issue is that valuing structured notes quickly to facilitate an over-the-weekend resolution of a bank holding company using a single-point of entry resolution approach may be difficult. Moving the notes to a finance subsidiary avoids the weekend valuation problem.
Bank Holding Company Debt and Structured Notes
Since the Financial Stability Board first released its consultative document regarding the TLAC requirement for G-SIBs, it became clear that regulators were concerned about the difficulties associated with valuing, in the context of a resolution of a bank holding company, any structured products that had been issued. The Federal Reserve's notice of proposed rulemaking ("Fed NPR") noted that structured notes "contain features that could make their valuation uncertain, volatile, or unduly complex," and the difficulty associated with valuing structured notes would, in the Federal Reserve's view, make more challenging the orderly resolution of a failed bank holding company. The Fed NPR noted further that securities issued by bank holding companies ought to have easily ascertainable values. Perhaps to a lesser extent, the Fed NPR also expresses a concern that the purchasers of structured notes are interested principally in exposure to the underlying reference assets and less interested in being exposed to the credit of the bank holding company issuer.
Absence of Restrictions on Financings Undertaken by Subsidiaries
As a result of these views, the Fed NPR excludes structured notes from qualifying as eligible long-term debt for TLAC purposes. However, contrary to press reports, there is no "loophole" or "exemption" that would expressly permit the issuance of structured products by G-SIB subsidiaries--none is needed. The Fed NPR does not address and therefore does not purport to limit the types of securities that may be issued by a subsidiary of a G-SIB bank holding company. The eligible long-term debt and TLAC requirement is imposed as a means of promoting the feasibility of the single-point of entry resolution ("SPOE") approach outlined in the Dodd-Frank Act and by the FDIC. The Fed NPR also does not limit issuances of structured notes by bank subsidiaries (bank notes).
Single-Point of Entry Resolution
In various presentations, we have used the below FDIC diagram to illustrate the operation of the SPOE resolution approach:
To see the diagram click here to view the original page.
As illustrated by the diagram, the SPOE resolution scheme is focused principally on the liabilities of the parent G-SIB bank holding company and the orderly resolution of the bank holding company. If one were to posit that the views expressed in the Fed NPR are true, and that structured notes issued by the bank holding company are difficult to value (which is not a statement with which we would agree), it still would not lead to any need to any regulatory imperative to limit the issuance of structured notes at the subsidiary level.
Finance Subsidiary Issuance: an Illustration
Many U.S. G-SIB issuers of structured notes have established finance subsidiaries that issue, or that will issue, structured notes. There is no subterfuge involved in doing so. As explained above, the issuance of structured notes by a subsidiary of a G-SIB is not a scheme to evade the TLAC requirements. Also, the use of a finance subsidiary for funding purposes is not a new development or a new idea. Financial institutions and operating companies with frequent capital-raising needs have employed finance subsidiaries for decades in an open and transparent manner, both for structured products as well as plain vanilla notes.
The finance subsidiary approach can be illustrated by the following simplified diagram:
To see the diagram click here to view the original page.
The finance subsidiary will be the issuer of the structured notes. The U.S. Securities and Exchange Commission definition (see Rule 3a-5 of the Investment Company Act) of a "finance subsidiary" is an entity whose primary purpose is to finance the business operations of its parent company or companies controlled by its parent company. As a result, the finance subsidiary will not have any operations other than issuing structured notes or other securities, on-lending the proceeds of such offerings, and entering into related hedging transactions with affiliates. The parent BHC will provide an unconditional guarantee; however, in order to comply with the "clean holding company" requirement set forth in the Fed NPR, the occurrence of a bankruptcy event relating to the parent BHC will not cause an event of default that would accelerate payments under finance subsidiary-issued structured notes.
Upon a failure of the parent BHC, the finance subsidiary-issued notes are not expected to convert into equity of the parent BHC or of a new bridge holding company. As contemplated by the SPOE resolution process, it is anticipated that the finance subsidiary-issued structured notes would remain outstanding. The guarantee would remain in effect, but it may not be assumed by the bridge holding company. The Federal Reserve Board has indicated that one of the many purposes of the new proposed regulations is to maintain market confidence and stability by keeping subsidiaries of a bank holding company operating after a failure of that bank holding company. However, because of the untested nature of the new regulatory regime, and the fact that bank regulators may exercise equitable and other discretionary powers, it is not possible to know in advance how, or whether, this goal will be met. As is the case with a structured note issued directly by a bank holding company, with structured notes issued by a finance subsidiary, in the event of a failure of the bank holding company, an investor is subject to the possibility of a complete loss of his or her investment.
Disclosure and Suitability Requirements
The finance subsidiary-issued securities are offered pursuant to a registration statement declared effective by the SEC. The same disclosure and liability standards that would apply to SEC-registered securities of the parent bank holding company are applicable to these securities. Similarly, for broker-dealers that participate in the distribution of the finance subsidiary-issued securities, the same standards relating to the suitability of recommendations remain applicable. Unfortunately, articles have suggested that offerings of finance subsidiary-issued securities would be subject to less onerous standards or to different or fewer regulatory requirements, which is simply not the case. Finally, although it should be apparent, the requirements related to eligible long-term debt and TLAC are not intended to address disclosure or suitability considerations. Disclosure issues would, in any event, be addressed by the SEC, and suitability or misselling concerns would be addressed by FINRA.