Calls to break up big banks could complicate efforts by large institutions to raise sizable cushions of capital that can absorb losses in the event of a failure.

Under the Federal Reserve Board's "total loss absorbing capacity" proposal, banks deemed systemically important must issue additional debt that could be written down or converted into equity in a successor bank — essentially acting like a built-in bailout.

This debt, which must be raised over the next 21 months, is designed to avoid the need for a taxpayer-financed bailout.

Big banks are also under pressure to shed operations and assets; this month, Minneapolis Federal Reserve President Neel Kashkari added his voice to calls for more steps to force banks to rethink their size and complexity. The Minneapolis Fed is expected to produce a white paper of recommendations to the Federal Reserve Board by year-end.

But potential investors are uneasy about putting money to work at the holding company of a bank that could be broken up, either abruptly or over time, leaving it in a weaker position to pay interest and principal. Normally, the sale of a major business line would trigger the requirement for a company to immediately repay all of its unsecured debt. But bank regulators have determined that debt with this type of covenant, known as an acceleration remedy, is not be eligible to be counted toward the TLAC requirement.

As a result, the Credit Roundtable, which represents fixed-income managers at investment advisory firms, insurance companies, pension funds and mutual fund firms, has been lobbying for an alternative form of protection. Working with the research firm Covenant Review, it has produced model covenants it would like to see in TLAC-eligible debt that require a bank to offer to repay the securities, but not compel it to repay them, in the event of a breakup or major disposition.

David Knutson, a senior research analyst at Legal & General Investment Management America and a Credit Roundtable co-leader, said the big concern is that investors who purchased bonds from a diversified financial conglomerate will get stuck with debt that is backed solely by the riskiest business: the investment bank.

"If we lent money to a big bank at, say, 5% annually, the part of that integrated conglomerate that really needs debt capital is not the commercial bank; it's the investment bank," Knutson said. "So if management decides to sell the investment bank or split it off, it's logical that investors like me will probably end up as creditors of the investment bank by itself. But investment banking is a volatile business and generally would require more risk premium [or a higher yield] compared to a commercial or integrated bank to compensate for the increased volatility."

Most existing unsecured debt issued by these banks has an acceleration remedy. That theoretically makes it ineligible for TLAC, but investors are working on the assumption that existing debt will be grandfathered for at least a few years. If existing debt isn't eligible, banks would need to issue much, much more — potentially more than $500 billion — than what regulators have publicly stated, according to CreditSights. The Fed has said it only expects the proposal to force banks to raise $120 billion in incremental issuance.

While the acceleration remedy for a covenant breach is valuable to investors, it is troublesome for regulators and TLAC eligibility. 

In the absence of an acceleration remedy triggering the repayment of the debt, the value of the bonds would decline, meaning holders will lose money if they need to sell them.

Instead, the Credit Roundtable is pushing for covenants that will require banks that sell or dispose of a major business line to offer to repurchase existing debt, either at face value or somewhere in the neighborhood of where it's trading in the secondary market.

Importantly, Knutson said, the Credit Roundtable's suggestion requires banks to make an offer to purchase, it doe s not compel investors to redeem their bonds; investors with no intention of selling the debt may not want to have to find a place to put their money back to work. This flexibility also reduces the onus on banks if they don't have to refinance all of their debt at once.

All three proposed covenants governing asset sales are adopted from various corporate bond indentures existing in the market, according to Adam Cohen, founder and manager of Covenant Review. "Nothing here should be viewed as revolutionary," he said.

The first covenant limits the sale of stock or assets of a holding company's principal subsidiaries. According to Cohen, it is already part of some existing bank holding company indentures, including the indenture for debt that State Street issued in 2009.

A second covenant limits asset sales if the net book value of all asset sales completed during the four prior calendar quarters exceeds 15% of the company's total assets at the beginning of the quarter. Although this language doesn't appear in existing bank holding company debt, the idea does exist in investment-grade bond indentures such as those for bonds issued by PPL Energy Supply and Talen Energy, two independent power producers spun off from parent company PPL Corp. in 2015.

A third covenant, which is found universally in bank holding company debt, requires that if the holding company is transferring "substantially all," then the bonds must travel with those assets.

The Credit Roundtable is also calling for improved disclosure, for all stakeholders, of information about a bank holding company's TLAC requirement. Additionally, the investors want banks to provide accelerated reporting in the event that they are subject to resolution, in order to allow bondholders a seat at the table as the process plays out.

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