The largest global banks will have to hold more capital and liabilities than previously reported that can automatically be written off in a crisis as much as a quarter of risk-weighted assets as regulators take on lenders deemed too big to fail.
The Financial Stability Board is developing minimum standards that will limit the double-counting of capital banks use to meet existing international rules, according to an FSB working document sent for comment to Group of 20 governments and obtained by Bloomberg News.
The restriction means that, while the basic requirement will be set at 16 percent to 20 percent of risk-weighted assets, the final number will be higher because the banks must separately meet "other regulatory capital buffers," according to the document, dated Sept. 21. The FSB in Basel, Switzerland, declined to comment on the non-public document.
"These standards are an important step in developing a strategy which will limit taxpayers' exposure to failing banks, but of course a lot of work still has to be done to determine how much flexibility national regulators will have or even need when applying the rules," said Richard Reid, a research fellow for finance and regulation at the University of Dundee in Scotland.
The FSB, which consists of regulators and central bankers from around the world, plans to present the draft rules to a G-20 summit in Brisbane, Australia, next month. The plans, which will be published for comment and completed next year, are part of a package of measures designed to make sure taxpayers are no longer on the hook when banks fail.
The FSB maintains a list of globally systemic banks that it updates each November. The latest list included 29 banks and identified HSBC Holdings Plc and JPMorgan Chase & Co. as the banks whose failure would do the most damage to the global economy.
The FSB plan would force the world's most systemically important banks to issue junior debt and other securities that could be written down in a straightforward manner and cover costs associated with winding down or restructuring. The rule would fully apply in 2019 at the earliest.
Bank of England Governor Mark Carney, the FSB's chairman, has said that the measure is needed to prevent taxpayer-funded bailouts of banks.
"It is essential that systemically important institutions can be resolved in the event of failure without the need for taxpayer support, while at the same time avoiding disruption to the wider financial system," Carney wrote in a letter to the G-20 last month.
The FSB proposals include criteria that debt and other securities have to meet to count toward a bank's minimum required "total loss absorbency capacity," or TLAC. Under the TLAC standard, lenders wouldn't be able to count the equity they use to satisfy two existing international capital buffers.
The first of these, set in 2010 by the Basel Committee on Banking Supervision, requires banks to have core capital equivalent to 2.5 percent of risk-weighted assets beyond the minimum Basel requirement to absorb losses. Failure to meet this standard can result in curbs on the bank's ability to pay bonuses and dividends.
The second buffer, set by the FSB for the world's biggest banks, can also rise to 2.5 percent of risk-weighted assets, and provides an extra safeguard in case of crisis. Both requirements must be met with the highest-quality capital, such as ordinary shares and retained earnings.
Thus the basic requirement of 16 percent to 20 percent of risk-weighted assets can swell to 21 percent to 25 percent, and could go even higher if a bank had to comply with a so-called countercyclical buffer set by its local regulator to tame credit booms.
While the FSB plan doesn't specify the instruments that count toward TLAC, it spells out liabilities that don't qualify, such as those "which are preferred to normal senior unsecured creditors under the relevant insolvency law," or which arise from derivatives.
Also excluded are liabilities that "cannot be effectively written down or converted into equity by the relevant resolution authority," according to the document.
Debt issued by the bank would also need to "have a minimum remaining maturity" of at least a year to count.
"This approach seeks to satisfy the U.S. and U.K., which want loss absorption provided by long-term, unsecured debt and at the same time cut the rest of the world some slack by allowing the buffer also to include capital," said Karen Shaw Petrou, managing partner of Washington-based research firm Financial Analytics Inc.
"This may permit G-20 finalization of the FSB consultation, but it's most unclear if it will resolve the current quandary posed by widely varying resolution protocols in key financial centers," she said.
Regulators have indicated that the bulk of instruments used to meet TLAC rules should be made up of capital and subordinated debt.
"From experience, we know that some uninsured, unsecured liabilities are not as reliably loss-absorbing in resolution as others and, in practice, it has been difficult to break into the senior class," Andrew Gracie, the Bank of England's executive director for resolution, said in July.
"In part it is because of the potential adverse consequences of taking resolution action within a class which includes liabilities that it is difficult to bail in," he said.
Under the FSB plan, instruments that could toward a bank's TLAC must normally "absorb losses prior to" liabilities that don't qualify, without "giving rise to material risk of successful legal challenge or compensation claims."
Still, there is some flexibility built into this rule to take account of European Union law, which gives regulators some discretion to decide whether or not certain liabilities should be hit with writedowns.
In such cases, banks would be given scope to count some liabilities as TLAC even if they have similar seniority to securities on the FSB's excluded list.
Banks would be able to count such securities up to an amount equivalent to 2.5 percent of their risk-weighted assets.