WASHINGTON — With the Federal Reserve's finalization of a rule designed to quickly recapitalize a failed megabank, some large institution representatives are saying the era of "too big to fail" is effectively over.
Greg Baer, president of the Clearing House Association — which represents many of the largest U.S. banks — said the rule was the "final piece of the regulatory puzzle" to ensure that taxpayer bailouts are a thing of the past. He cited previous efforts, as well as regulators' decision to approve four of five big banks resolution plans this week, as proof regulators had taken the steps they needed to.
"The TLAC requirement is the culmination of a legal and balance sheet revolution that has effectively ended 'too big to fail,' " said Baer, a former executive at Bank of America and JPMorgan Chase. "As reflected in this week's living wills announcements, this rule protects taxpayers by requiring U.S. GSIBs to maintain enough loss-absorbing resources to be recapitalized during a resolution and ensure that any and all losses are borne by creditors and shareholders, and not the taxpayer."
Rob Nichols, president and CEO of the American Bankers Association, was similarly emphatic that the final rule was a finale to the post-crisis regulatory regime.
"Today's final rule caps the dramatic regulatory changes that have been made to reinforce our nation's policy that no bank should be too big to fail," Nichols said. "The TLAC resources — combined with higher capital and liquidity requirements, stress testing, recovery and resolution planning — ensure that the system is better prepared to withstand shocks and has a viable framework in place to handle them."
To be sure, that did not mean the industry didn't have problems with the final rule. Nichols said that its constraint of banks' funding strategies would require further examination to balance prudential standards with "the need to ensure that banks can effectively support economic growth and opportunity."
But not everyone is convinced "too big to fail" is truly over. And some raise concerns with the TLAC rule itself, questioning whether it is workable in practice.
The rule was among the most important post-crisis reforms that was still unfinished, and complements other capital and liquidity rules that had been put in place. The rule essentially requires the largest global systemically important banks to hold a certain ratio of debt and capital that can be converted into equity in a successor firm should the bank fail. In this way, the banks would have bailed themselves out in advance via convertible debt, obviating the need for a taxpayer bailout.
Of the eight U.S.-based GSIBs, only four would have to raise additional unsecured debt to come into line with the rule, according to Fed estimates. The central bank would not specify which four institutions were not already in compliance, but since insured deposits do not qualify and Wells Fargo is well known to acquire its funding via that method, it is reasonable to conclude that it is one of them. The Fed said in its staff memo that the shortfall amounted to $70 billion across the four banks — down from an estimated $120 billion when the rule was first proposed in October 2015.
Yet the rule faces criticism from fellow regulators. Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., has criticized the idea, saying that it would encourage banks to take on additional leverage, and as a secondary effect, would push them to seek greater returns through riskier behaviors to make up for the additional costs of complying with the rule.
Federal Reserve Bank of Minneapolis President Neel Kashkari has similarly said he thinks that the TLAC and other post-crisis reforms will not prevent another taxpayer bailout, and recently unveiled a competing vision for ensuring enhanced safety at the banks — one that relies more heavily on equity capital at a much higher level.
Fed Gov. Daniel Tarullo, reflecting the doubters' concerns about the efficacy of TLAC in recapitalizing a failed bank without creating excess risk, asked staff members whether there was any concern that requiring a certain level of unsecured debt might mandate that banks take on additional leverage.
Mark Van Der Weide, deputy director of the Fed's division of banking supervision and regulation, said that if banks simply take debt they already have outstanding and move it from a subsidiary to the bank holding company level — or make similar adjustments — the four noncompliant banks can align themselves with the rule without taking on any additional leverage. And even if a bank were to take on more debt, they would have to comply with the leverage-based capital requirements, he said.
"All, or nearly all, of the shortfall can be met with that sort of rearrangement of liabilities on their balance sheet," Van Der Wiede said. "Firms may increase their balance sheets, but we also have a set of capital requirements that do constrain leverage, and those are … pretty strong constraints on leverage."
Baer, when asked whether the banking industry's support for the final TLAC rule would translate into a willingness to defend it against efforts to dismantle it or replace it with some other regime, said whatever comes next can't be pitched as a way to end "too big to fail." This rule, combined with other steps, resolves that issue, he said.
"This moots the need for any solutions that are premised on large banks being 'too big to fail,' " Baer said. "In effect, the largest banks have already paid a very high cost for this solution."
Art Angulo, managing director at Promontory Financial Group and a former New York Fed official, said the Fed's decision to grandfather in existing debt that might not have met the rule's requirements was a positive choice because it reduces the costs associated with the rule and thus makes it a less attractive target for the incoming administration.
"It was a smart move to allow the grandfathering," Angulo said. "This is a large-bank issue, and one thing that Republicans and Democrats generally seem to agree on is that it's OK to come down hard on big banks. There are bigger fish to fry, and the banking industry's political capital would be better spent on other issues."
John Simonson, a partner with PricewaterhouseCoopers and former deputy director of the FDIC, agreed that the rule would probably stand the test of time precisely because it made itself palatable without being a total giveaway. What is more, most of the other competing plans for ending "too big to fail" essentially rely on higher levels of capital — particularly leverage-based capital — and those plans just won't have the kind of popularity necessary to knock off TLAC entirely.
"At the end of the day, I wouldn't expect a wholesale change," Simonson said. "It's unclear whether there is widespread support to implement capital levels that people like Hoenig, Kashkari and others have been talking about."
There are still some unresolved issues with TLAC. A major one is that the Fed sidestepped for the moment the question of what institutions would be allowed to hold the debt. A major concern is that GSIBs or other banks might simply hold one another's debt, thus creating a closed feedback loop and, perversely, an additional source of contagion risk in the financial system.
Dennis Kelleher, president of the Wall Street watchdog Better Markets, said that, while the implementation of the final TLAC rule is a welcome step, "careful monitoring of loss absorbing debt will be necessary," particularly as it relates to "trigger mechanisms, the pricing, the trading and the composition of the purchasers and holders of the convertible debt."
Tarullo asked staff about this issue, and Van Der Weide noted that the current market reality is that "the bulk of the long term debt of the U.S. GSIBs is held by nonbank institutional investors, such as pension funds, insurance companies, and bond mutual funds."
The draft proposal included a capital charge that would "disincent quite strongly" banks from participating in the TLAC market, he said. That portion of the proposal was not finalized in the rule, however, but Van Der Weide said it will be developed next year with the Office of the Comptroller of the Currency and the FDIC.
"We are attentive to that potential risk," Van Der Weide said. "Though we are not finalizing that today, we are going to work actively with the OCC and FDIC in 2017 to get that rule finalized, and that is an important part of the program to make sure that, though there is not a lot of interbank holdings of this instrument today, that it doesn't develop in the future."
Jacques Schillaci, financial regulation counsel at Linklaters, noted that during the meeting, Tarullo said that one of the important innovations of TLAC was that it would reinforce market discipline by incentivizing holders of that long-term debt to ask questions of the banks and hold them accountable for their actions. But he said the specifics for exactly how that accountability would occur have not yet been spelled out, and it is, at least for now, a theoretical benefit, not a real one.
"Market discipline is something that the Fed has been trying to figure out a way to implement for a long time," Schillaci said. "I think TLAC is probably more likely to do it, but it leads to the question of, Will it work? We'll have to see."