Anticipated TLAC Proposal:  Impact on Banks’ Balance Sheet Structures and Resolution Plans

SUMMARY

It appears increasingly likely that the Financial Stability Board (the “FSB”), followed by the Board of Governors of the Federal Reserve System (the “Federal Reserve”) (and other national regulators, possibly including other U.S. banking agencies), will soon issue proposals establishing Total Loss Absorbing Capacity (“TLAC”) requirements (the “TLAC Proposal”).  TLAC consists of regulatory capital and long-term debt that in the context of a resolution (or possibly in anticipation of a resolution) is designed to absorb losses through write-downs, forgiveness or conversion into common equity and thereby avoid the need to use taxpayer funds to prevent systemic disruption.  The TLAC Proposal would apparently apply to the 29 banks (including eight U.S. banks) identified by the FSB as Global Systemically Important Banks (“G-SIBs”).

Although specific details of the TLAC Proposal are not publicly available, and are presumably still being formulated, it could have a significant impact on G-SIBs’ balance sheet structures and resolution plans.  Accordingly, this memorandum outlines some of the likely issues to be presented by the TLAC Proposal.

DISCUSSION

The TLAC Proposal will likely have two basic components―(i) “External TLAC” and (ii) “Internal TLAC” (sometimes referred to as “pre-positioning”). External TLAC would be required at the parent holding company level and would be issued to third parties. Internal TLAC would be required for each material subsidiary, and would be issued to the parent company (or perhaps to another affiliate that is not itself subject to an Internal TLAC requirement).

Both External TLAC and Internal TLAC would consist of a required ratio of (i) regulatory capital and long- term debt (perhaps defined as debt having a remaining duration to maturity of at least one year) (numerator) to (ii) assets and exposures (denominator). The denominator could be risked-weighted or leverage-based (that is, on-balance sheet assets plus some measure of off-balance sheet exposures, perhaps based on the Basel III supplementary leverage ratio) or very possibly there could be both risk- weighted and leverage-based tests.

  1. Required Ratios

There has been substantial speculation about the required ratios for External TLAC and Internal TLAC. Suggestions for External TLAC have spanned a wide range, from as low as 15%-16% to as high as 25% (on a risk-weighted basis). It is widely anticipated that Internal TLAC required ratios will be less than External  TLAC  required  ratios, but will nonetheless  represent a  very substantial percentage  of  the External TLAC required ratios.1

Beyond the percentage itself, there are a number of other questions regarding the required ratios. First and foremost is the calculation methodology for both the numerator and denominator. For example:

  • Will all regulatory capital be included in the numerator, or, as some have suggested, will the portion of Tier 1 common equity constituting the capital conservation, G-SIB and, if ever invoked, the countercyclical capital buffers be excluded and, in effect, “sit on top” of the TLAC requirement?
  • Will some portion of TLAC be required to be in the form of long-term debt?
  • Will a parent company be able to meet any portion of its External TLAC requirement through the issuance by material subsidiaries to unaffiliated third parties of regulatory capital instruments or long-term debt and, if so, would those issuances offset not only the External TLAC requirement but also the Internal TLAC requirement at the issuing subsidiaries?

Another key question is whether the External TLAC requirement will be the same for all G-SIBs. We believe it is likely that a differential will be imposed, either directly or indirectly by excluding the capital necessary for the G-SIB buffer. A related question is whether the Internal TLAC requirement will be the same among G-SIBs and even among the subsidiaries of the same G-SIB.

G-SIBs have substantial operations outside their home countries―they are “global” as reflected in the name. The TLAC Proposal’s treatment of cross-border considerations—particularly the interplay between cross-border withholding and other tax consequences and the different currencies in which G- SIBs conduct operations in host countries—could have a significant impact and make particularly important the permissibility of crediting capital and long-term debt issued by material subsidiaries to third parties against the Internal and External TLAC requirements.

Whatever the regulatory-required TLAC ratios may be, it is likely that G-SIBs and their material subsidiaries will need to maintain a meaningful cushion to protect against a significant unanticipated decline in the entity’s TLAC. It remains to be seen what sanction(s) a bank that fails  its  TLAC requirement would be subject to and how much latitude the regulators will give G-SIBs to address a deficient TLAC ratio. Regardless, the G-SIBs will presumably be concerned by the impact of disclosure of a TLAC breach.

  1. Impact on Balance Sheet Structure

The answers to these questions about the required ratios (and others) will determine what changes will need to be made to the balance sheets of G-SIBs and their material subsidiaries. Some G-SIBs may need to raise long-term debt, and some G-SIBs may need to replace part of their assets with assets representing Internal TLAC issued by their subsidiaries. Likewise, G-SIB subsidiaries may need to replace some of their current deposits and other liabilities with TLAC debt to the parent or possibly to third parties.

It appears that the External TLAC debt issued by a parent company will not need to be contractually, as well as structurally, subordinated. This may help somewhat in pricing, although the benefit may prove limited, or non-existent, if there is a regulatory or supervisory prohibition or severe limit on short-term debt at the parent level. The market for these instruments may be restricted, and pricing adversely affected, if, as appears likely, G-SIBs are prohibited from purchasing TLAC debt of other G-SIBs.

  1. Regulatory Decision-Making

In addition to the required ratios, a number of regulatory decisions will need to be made unless the answers are prescribed by the TLAC Proposal. At this point, it is unclear which regulator will make the decisions.

  1. Material Subsidiary

A key issue is which subsidiaries will be deemed “material” and therefore subject to an Internal TLAC requirement.2 In a home-host country situation, it will need to be determined whether the decision will be made by the host or home country, or whether either could designate a subsidiary as “material.” Considering the United States alone, there are multiple permutations for the designation authority: the Federal Reserve, FDIC (at least in the case of state non-member banks and possibly for all insured banks), OCC (in the case of national banks and federal savings and loan associations), the SEC (in the case of broker-dealers) or some combination of the foregoing.

  1. Conversion

Another key question will be which government authorities will make the decisions to convert TLAC debt into equity (or forgive the obligation), as well as what standards (if any) will apply to those decisions. In the United States, for example, will the decision be made by the Federal Reserve or FDIC, or both, with respect to External TLAC at the holding company level? At the subsidiary level, will the decision be made by the host country in the case of a foreign subsidiary or by the primary federal regulator in the case of a domestic subsidiary? If there are to be standards, will they be prescriptive or more flexible and general?

  1. Impact on Resolution Plans

The TLAC requirement, particularly Internal TLAC, could represent significant support for the credibility of resolution plans. The substantial additional equity resulting from conversion would not directly enhance liquidity, but should do so indirectly by providing a much more significant equity cushion.

A key issue is timing. The TLAC requirements will apparently not be implemented, at least globally, until near the end of this decade. They, therefore, will not be directly applicable to the resolution plans that must be submitted in the intervening years unless the Federal Reserve accelerates the implementation or a banking organization “voluntarily” implements TLAC at an earlier time.

CONCLUSION

Although it is difficult to plan for a regulation that has not even been formally proposed, the potential importance of TLAC requirements suggests careful consideration by G-SIBs even now. These requirements could have a material impact on the balance sheets of both the parent companies and material subsidiaries and ultimately play an important role in resolution plans. Moreover, although the TLAC requirements currently under consideration apply only to G-SIBs, there is some potential that TLAC-like requirements will eventually be applied to a wider range of banks.