WASHINGTON — A proposal that would require the biggest banks to issue long-term debt as a backstop to prevent another government bailout could instead instigate one, Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig said Thursday.
The Federal Reserve Board released its long-awaited plan on Oct. 30 to require globally systemically important banks to hold a combination of debt and equity known as "total loss absorbing capacity" that would act as a buffer to prevent another bailout if the bank were to become insolvent. The proposal also would require that the banks issue a minimum amount of unsecured long-term debt that could be converted to equity as part of the TLAC calculation.
But Hoenig argued at an international bank conference hosted by the Federal Reserve Bank of Chicago that requiring a firm to issue more debt helps in the resolution process, but could make a failure more likely.
"It is costly to service this debt, putting earnings pressure on firms and their units that – all else being equal – could accelerate failure should an institution run into financial trouble," Hoenig said in prepared remarks.
"A question we must ask, then, is whether the effect of such a requirement that is designed to make a firm more resolvable once that firm has failed, could -- prior to failure -- increase the firm's leverage and thereby its likelihood to default. Our goal to prevent failure should be every bit as important as resolving failed firms."
The proposal would also influence bank activities by risk-weighting assets to help determine how much debt would need to be issued.
The debt measure "would require regulators to predict what activities and investments might cause future crises… which as you know could arise from a number of activities, but mostly likely will come from something we fail to predict," Hoenig said.
On the other hand, using a higher equity requirement and "simple leverage measures instead of risk-based capital measures eliminates relying on the best guesses of financial regulators to guide decisions," and would be not require "extraordinary insight" into future risks, Hoenig said.
He also addressed recent calls by banks, clearing houses, exchanges and other stakeholders to ease up on the leverage ratio treatment of trades that members of clearing houses guarantee for their clients. The stakeholders want margin held on those trades to count against the leverage ratio's charge on that exposure.
"The Basel leverage ratio, which has been adopted for the largest firms in the U.S., requires banks to hold a small amount of capital against the potentially unlimited guarantee they provide to the [central clearing party]," Hoenig said.
"Nevertheless, efforts continue to try to reduce or eliminate the capital they hold against this guarantee. If this were to be allowed, large amounts of economic exposure to derivatives -- significant financial leverage and risk -- would vanish from the regulatory capital radar screen, encouraging even larger volumes of interlinked and opaque derivatives activity."