Speed read
On 9 November 2015, the Financial Stability Board (FSB) issued its Principles establishing a new international standard for “total loss absorbing capacity” (TLAC) for global systemically important banks (G-SIBs). According to Mark Carney, FSB Chair, “(t)he FSB has agreed a robust global standard so that G-SIBs can fail without placing the rest of the financial system or public funds at risk of loss. This new standard (…) is an essential element for ending too-big-to-fail for banks.” This briefing summarises the Principles and discusses the standard’s implementation.
Why is TLAC needed and how does it work?
Purpose
TLAC expands the concept of “gone-concern loss-absorbing capacity” (GLAC) as the proposed method of “topping off” the capital structure that G-SIBs are required to maintain as part of the Basel III framework. At the same time, TLAC is conceptually distinct from traditional “going concern” capital, which is designed to absorb losses and protect an institution against insolvency. Instead, TLAC is intended to ensure that a banking group maintains sufficient consolidated resources to allow for orderly resolution and robust recapitalisation of non-viable operating subsidiaries in the event of a banking group’s failure without recourse to public funds and direct taxpayer “bailouts”. Ultimately, regulators hope that TLAC will help to demonstrate that national regulators have the ability to resolve G-SIBs without triggering any systemic disruption, and thus contribute to eliminating the so-called “too-big-to-fail” problem.
Quantum
TLAC is set as a minimum requirement, in addition to regulatory capital requirements under Basel III. From 2019, each resolution entity of a G-SIB will be required to maintain minimum TLAC issued to non-affiliates (External TLAC) that is equal, on a consolidated basis, to the greater of (i) 16% of risk weighted assets (RWA) (increasing to 18% from 2022), (ii) 6% of the leverage ratio denominator (6.75% from 2022), or (iii) the sum of Internal TLAC requirements. The quantum of the TLAC requirement is roughly twice the size of the Basel III capital requirements: the guiding principle is that a G-SIB should hold adequate bail-inable items to ensure that following resolution, the G-SIB will not only be solvent, but also meet Basel III regulatory capital requirements.
Composition of External TLAC
In broad terms, External TLAC will comprise certain externally issued regulatory capital instruments and qualifying debt. At least 33% of a resolution entity’s TLAC must be in the form of debt liabilities.
Instruments that count towards regulatory capital may count towards External TLAC, provided that they meet certain conditions intended to ensure that there are no obstacles to these instruments being written down or converted to equity during a period of financial distress. However, Core Tier 1 (CET1) instruments used to meet TLAC requirements may not be counted towards meeting any regulatory capital buffers, in order to ensure that these buffers sit “on top of” the minimum CET1 requirements.
Instruments and liabilities that do not count towards regulatory capital can count towards TLAC if they meet certain eligibility criteria and are not excluded liabilities (which include insured deposits, derivatives and non-bail-inable liabilities). The rationale here is that eligible TLAC must absorb losses prior to excluded liabilities and without giving rise to material risk of successful legal challenge or valid compensation claims.
There are two classes of additional instrument which may, exceptionally, count towards External TLAC. In broad terms these are (i) commitments of qualifying pre-funded resolution funds and (ii) senior debt ranking alongside excluded liabilities which may be bailed in without triggering compensation claims. Each counts towards up to 2.5% of External TLAC (increasing to 3.5% from 1 January 2022).
SPE v MPE resolution strategies
Banking groups will have single point of entry (SPE) or multiple point of entry (MPE) strategies, dependent on their structure. MPE strategies involve multiple resolution entities and hence multiple external TLAC requirements. Because MPE strategies do not benefit from consolidation effects, a concern was raised in consultation that MPE G-SIBs would be disadvantaged. The TLAC standard makes two allowances to address level playing field concerns and give some flexibility to G-SIBs with an MPE resolution strategy. The first allowance concerns TLAC deductions. Normally, as TLAC is calculated on a consolidated basis, TLAC exposures of one resolution group to another resolution group and TLAC issued by a resolution entity to its parent which is also a resolution entity, must be deducted from TLAC resources. However, the TLAC standard allows limited flexibility as to the allocation of the deduction, so that the deduction could be made at the level of the subsidiary resolution entity instead of the parent, subject to a cap. The second allowance is that, in cases where the sum of TLAC requirements for MPE resolution entities is greater than the (hypothetical) TLAC requirement which would apply on SPE basis, an adjustment may be made to minimise or eliminate the difference. This adjustment can be made in respect of differences which arise from the calculation of RWA between home and host jurisdictions, but not for differences arising from exposures between resolution groups, as this would be inconsistent with the objectives of an MPE resolution strategy.
Internal TLAC
To ensure that loss-absorbing and recapitalisation capacity is appropriately distributed within a resolution group, each material sub-group of a resolution entity may be required to commit a proportional amount of loss-absorbing capacity to each material sub-group (Internal TLAC). Each material sub-group must maintain Internal TLAC equal to 75% to 90% of the minimum TLAC it would be required to maintain if it were a resolution group. The eligibility criteria and excluded liabilities for Internal TLAC are the same as for External TLAC.
The TLAC standard provides that G-SIBs must disclose the amount, maturity and composition of External and Internal TLAC that is maintained by each resolution entity and at each material sub-group respectively.
Capital treatment
The BIS has consulted on the regulatory capital treatment of TLAC instruments. It proposes deducting such instruments from Tier 2 capital.
Technical issues
i. Eligibility of non-Basel III compliant capital instruments
The interaction of regulatory capital and the TLAC eligibility rules is somewhat confused in the paper. Section 6 of the paper indicates that only Basel III compliant capital instruments are to be included within TLAC, which implies that other capital instruments should not. However, non-Basel III compliant capital instruments will generally satisfy the conditions necessary to be qualifying debt, and should therefore also count towards External TLAC.
ii. Internal TLAC
In practice there is a widespread expectation that Internal TLAC will be structured as regulatory capital.
Implementation around the world
United States
In the United States, the Board of Governors of the Federal Reserve System (Federal Reserve) has issued a proposed rule (US Rule) that would apply to U.S. G-SIBs and to any intermediate holding company (IHC) that is established by a non-U.S. banking organisation to hold U.S. total consolidated non-branch assets of USD 50 billion or more (see our client alert discussing the Federal Reserve's IHC requirements here). The US Rule is generally consistent with the final TLAC rules, but in some respects is more stringent. Consistent with the BHC structure commonly used by banking organisations in the United States and the SPE resolution strategy favoured by the Federal Reserve and the U.S. Federal Deposit Insurance Corporation to resolve large BHCs, the US Rule requires that all TLAC be maintained by a “clean” top-tier holding company. All TLAC issued by IHCs must be Internal TLAC issued to their non-U.S. parent and must be in approximately the same amount as Minimum TLAC for U.S. G-SIBs. Specific requirements are set forth for eligible long-term debt (LTD) as a component of Minimum TLAC, which requirements are more restrictive for IHCs than they are for U.S. G-SIBs. U.S. banking organisations are discouraged from holding external TLAC issued by U.S. G-SIBs. The Minimum TLAC would be phased-in, the same as is provided for by the TLAC Term Sheet, but the LTD requirements would take full effect from 1 January 2019.
i. Minimum TLAC
Under the existing Basel III capital requirements, a U.S. G-SIB must currently maintain CET1 in a minimum amount that is between 8% and 11.5% of RWA. It also must maintain a combination of CET1 and other Tier 1 capital (T1) in a minimum amount that is between 9.5% and 13% of RWA and, to meet leverage ratio requirements, its T1 must be not less than approximately 7% of its total leverage exposure. Its T1 and Tier 2 capital (Total Capital) must be in a minimum amount between 11.5% and 15% of RWA.
The U.S. Rule would require U.S. G-SIBs to maintain Minimum TLAC of 18% of RWA (Minimum RWA TLAC) and Minimum TLAC of 9.5% of the Basel III leverage ratio denominator (Minimum LRE TLAC) at its top-tier company. The LTD component must be not less than 6% of RWA plus the percentage amount of the organisation’s G-SIB surcharge (i.e., 1% to 4.5% of RWA) and not less than 4.5% of the G-SIB’s total leverage exposure. On top of these amounts, the top-tier company would maintain a buffer of CET1 equal to the sum of its capital conservation buffer, countercyclical capital buffer, and G-SIB surcharge as calculated using the FSB’s methodology.
IHCs would be subject to similar requirements. If an IHC was expected by the home country supervisor of its non-U.S. parent to enter into resolution proceedings in the event of the parent’s failure, then the IHC would maintain Minimum RWA TLAC of 18%, Minimum LRE TLAC of 6.75%, and TLAC equal to not less than 9% of average total consolidated assets if the IHC did not use advanced approaches to calculate its leverage exposure. The LTD component must be not less than 7% of RWA (equal to the basic 6% requirement plus the requirement for U.S. G-SIBs subject to the lowest G-SIB surcharge), 3% of total leverage exposure, and 4% of average total consolidated assets. On top of these amounts, the IHC would maintain a buffer of CET1 equal to the sum of its capital conservation buffer and the countercyclical capital buffer that would apply to the IHC if it was a large BHC. If an IHC was not expected to enter into resolution proceedings in the event of its parent’s failure, then its TLAC requirement would be reduced to a Minimum RWA TLAC of 16%, a Minimum LRE TLAC of 6%, and 8% of average total consolidated assets. The LTD requirements, however, would not be reduced.
ii. Qualifications of Long-Term Debt
To qualify as LTD, a debt instrument would be required to meet several conditions intended to reduce uncertainty arising from its write-down or conversion, avoid the infection of other financial institutions, and maximize the effectiveness of the debt instrument to recapitalize the issuer’s subsidiaries. LTD must be issued by the top tier company of the G-SIB or IHC, must be unsecured, and must not be subject to a guarantee by the issuer or any of its subsidiaries or to any credit enhancement that would increase its seniority. LTD must not contain any derivative-linked or other exotic features that would make it unduly difficult to value the instrument during a period of economic distress: structured notes, credit sensitive features, contractual rights to convert prior to resolution, and acceleration rights (except upon payment default, insolvency of the issuer, or at a stated put date) would not qualify. LTD must have a remaining maturity of at least one year, and it would be subject to a 50% haircut if it had a maturity of less than two years and more than one year.
If the issuer was an IHC, additional conditions would apply. All LTD must be Internal LTD held by its non-U.S. parent, in order to avoid legal challenges to conversion and the possibility that cancellation or conversion might cause a change of control of the IHC. All LTD also must be contractually subordinated to all third-party liabilities of the IHC. The LTD also must contractually provide for the ability of the Federal Reserve to cancel or convert the instrument in certain circumstances without the IHC entering into insolvency proceedings. In order to cancel or convert, the Federal Reserve would be required to determine that the IHC is in default or in danger of default and, if the non-U.S. parent had not been placed into resolution proceedings, the non-U.S. parent’s home country supervisor would have an opportunity to object. However, the Federal Reserve would have the sole authority to decide whether to cancel or convert, unlike its shared authority to place a financial company into receivership pursuant to Title II of the Dodd-Frank Act.
iii. “Clean” Holding Company Requirements
Similar in effect to the requirements above that LTD must be “plain vanilla,” a G-SIB issuer would be subject to a number of restrictions on its activities that are intended to simplify the company’s operations, reduce the risk of a run or a fire sale of its liabilities, and ensure that its subsidiaries would not incur losses as a result of its insolvency. The issuer would be prohibited from engaging in short-term borrowing from third parties, entering into qualified financial contracts except with affiliates, guaranteeing the liabilities of a subsidiary where the guarantee could provide creditors with cross-default rights or netting rights, or issuing liabilities subject to an upstream guarantee by a subsidiary. The issuer would be permitted to have a de minimis amount (i.e., equal in the aggregate to not more than 5% of the value of its LTD) of non-contingent liabilities outstanding that were junior to or pari passu with its LTD (except other LTD).
An IHC would be subject to the same restrictions. However, because its LTD would be contractually subordinated to all liabilities of the IHC to third parties, an IHC would be unable to have any amount of junior or pari passu liabilities.
iv. Cross-Holding Restrictions
Any financial institution subject to supervision by the Federal Reserve and with total consolidated assets of USD 1 billion or more that invested in unsecured debt issued by the top-tier company of a G-SIB or IHC above certain thresholds would be required to deduct the amount of its investment from its regulatory capital. The Federal Reserve has stated that it intends to seek the same treatment by other U.S. banking regulatory authorities of financial institutions under their supervision.
v. Implementation
The U.S. Rule, if finalized, would take effect from 1 January 2019. However, the TLAC requirements would be phased-in. The Minimum RWA TLAC for G-SIBs and for IHCs that were expected to enter into insolvency proceedings in the event of their parent’s failure would initially be 16% and would increase to 18% from 1 January 2022. The Minimum RWA TLAC for IHCs that were not expected to enter into insolvency proceedings would initially be 14% and would increase to 16%. However, Minimum LRE TLAC and the minimum LTD requirements would not be phased-in.
vi. Impact on U.S. G-SIBs’ Funding
The Federal Reserve has stated that a U.S. G-SIB that meets all of its existing Basel III capital requirements would only need to issue the minimum required amount of qualifying debt to meet all of its TLAC requirements. It has also noted that six of the eight U.S. G-SIBs would be required to raise additional equity or long-term debt in the aggregate amount of approximately USD 120 billion, at an additional funding cost between approximately USD 680 million and USD 1.5 billion. Some initial estimates of compliance costs, however, suggest a higher cost.
European Union
The European Bank Recovery and Resolution Directive (BRRD),in the context of its provision for bail-in powers, requires member states to impose on European banks a minimum requirement for eligible liabilities (MREL). The BRRD states that MREL is to be calculated as the sum of a firm’s own funds (i.e., its capital) and liabilities that are eligible for bail-in (subject to certain conditions), expressed as a percentage of the firm’s total liabilities and own funds. In addition, the European Banking Authority (EBA) has published draft regulatory technical standards specifying the criteria by which the amount of MREL to be required of each firm is to be assessed. Appendix 1 compares the two concepts.
While the conditions that must be satisfied for instruments to count as MREL overlap with the FSB’s proposed conditions for TLAC, the difference in the denominator (i.e. total liabilities as opposed to RWA) gives rise to a number of uncertainties for European G-SIBs and European subsidiaries of non-European G-SIBs. Other key differences are that the BRRD does not explicitly require that any portion of MREL be met by subordinated debt, nor does it treat Basel III capital buffers as separate and additional requirements. It is understood that the European authorities do not intend for MREL and TLAC requirements to be imposed simultaneously, and, indeed, the EBA has expressed the view that the FSB’s TLAC requirements should be capable of being implemented in Europe via MREL.
Notably, there is not a pan-European approach to resolution strategies for banking groups. While the Bank of England believes that SPE represents the optimal structure to achieve resolution with minimal financial and operational disruption to operating banks, authorities elsewhere in Europe have been less vocal on the topic. European banks, unlike U.S. and UK G-SIBs, generally do not employ a bank holding company (BHC) structure in which the top-tier company of a banking organisation serves primarily as a holding company. The move to a BHC-style structure to facilitate an SPE strategy would represent a fundamental change to funding, and in some cases corporate, structures for a number of banks, imposing considerable transitional costs. In addition, a number of non-U.S. banks operate along nationally subsidiarised lines, with more-or-less independent subsidiaries. Such banks are expected to be resolved along national lines under a MPE resolution strategy.
i. United Kingdom
The Bank of England has expressed its firm view that “TLAC can and will be applied for G-SIBs through the setting of MREL requirements”, and that TLAC is just one particular expression of how MREL will be set.
The Bank of England also emphasised that the resolution strategy will govern decisions on MREL. As mentioned above, the Bank of England supports SPE as the optimal resolution strategy, however it recognises that in practice SPE may incorporate elements of an MPE strategy for certain parts of the group.
ii. Germany
Germany has put forward a legislative proposal which provides that certain senior unsecured debt instruments will be statutorily subordinated, and thus eligible to count towards TLAC requirements.
iii. Italy
Italy has followed a different approach: the legislation which implemented the BRRD modifies creditor hierarchy in insolvency, and provides that “other deposits” (i.e. deposits that are not protected under article 108 of the BRRD) will rank senior to other unsecured debt. The result of this change to the creditor hierarchy is that senior unsecured bonds are statutorily subordinated to deposits. This makes it easier for Italian banks’ senior unsecured debt to be TLAC eligible, as such debt is subordinated to deposits.
iv. France
It is reported that France may follow with similar legislative proposals to Italy or Germany.
v. Netherlands
No proposals have been made on implementation in the Netherlands.
Asia-Pacific
No proposals have been made on implementation in Hong Kong although the authorities have expressed commitment to convergence with the TLAC standards. In Singapore, the authorities have raised proposals to limit the statutory bail-in framework to subordinated debt.
Conclusion
The FSB’s final standard represents a critical step on the path to credible and consistent regulation of systemic banks’ resolvability. It is perhaps unfortunate that its implementation will be made more difficult by the fundamental differences in approach between the US and Europe, (and further differences between European Member States), which risk undermining the clarity of the regime. Until investors have a clear and predictable view of the resolution process and their place in the hierarchy of loss absorbency within it, pricing will reflect their uncertainty – impeding the efficiency of the funding process and ultimately impairing economic recovery. The new rules form an important step toward resolving that uncertainty. A consistent approach in the EU to loss-absorbency would further aid the process. In the United States, the FRB proposed rule sets somewhat higher requirements for External TLAC than the FSB standard, but most noteworthy is its treatments of IHCs. The size threshold for requiring TLAC is lower; the amount of TLAC required to be maintained in the United States is higher; the qualifications for Internal TLAC, which IHCs would issue, as compared to External TLAC, are more prescriptive; and the requirement that IHCs issue only Internal TLAC is more rigid than the FSB standard for G-SIBs applying an MPE resolution strategy to allocate capital, and strikes an unwelcome protectionist note, which may have knock-on consequences for non-UK G-SIBs.
Further information
FSB TLAC Principles and Term Sheet
FSB press release
Andrew Gracie, "TLAC and MREL: from design to implementation" (Speech to the BBA loss absorbing capacity forum, London, 17 July 2015)
Allen & Overy client alert, November 2014: Global banks face higher capital requirements in FSB "TLAC" proposal
Allen & Overy client alert, October 2014: https://www.aohub.com/aohub/publications/fsb-publishes-final-tlac-standard?nav=FRbANEucS95NMLRN47z%2BeeOgEFCt8EGQ71hKXzqW2Ec%3D&key=BcJlhLtdCv6/JTDZxvL23TQa3JHL2AIGr93BnQjo2SkGJpG9xDX7S2thDpAQsCconWHAwe6cJTmY5zp3jUS0lWxaD%2BHibKrZ
