WASHINGTON -- U.S. banking regulators plan to issue a proposal soon that would require U.S. financial institutions to hold long-term debt to minimize risks should a firm fail, a top Federal Reserve official said on Friday.
The Fed and the Federal Deposit Insurance Corp. are expected to release a plan in the "next few months" to force the biggest banks to carry minimum amounts of long-term unsecured debt that could be easily converted to equity in the event of a resolution.
The governor, who is the point man on bank supervision and regulation at the central bank, has previously signaled plans by U.S. regulators to proceed with such an approach in order to better facilitate resolution planning.
"Absent a minimum requirement of this sort, one would expect declines in these levels as the quite flat yield curve of recent years steepens; indeed, we have recently seen some evidence of the beginnings of such declines," said Tarullo, in prepared remarks at a conference hosted by the St. Louis Fed.
New York Fed President William Dudley echoed the necessity for regulators to establish a requirement that would force parent companies to hold a sufficient amount of debt that could be converted by the FDIC into equity to ensure that a bridge company would be well-capitalized.
"We don't yet have a long term debt requirement - this is an area where we are still working out the details," said Dudley, in prepared remarks at the same conference. "My own view is that a holding company needs a substantial amount of long-term debt to ensure that the newly created bridge company is viewed fully viable by its counterparties."
Tarullo made the case that requiring "adequate loss-absorbing capacity" to those firms that went beyond minimum capital requirements would lend extra credibility and effectiveness to the FDIC's single-point-of-entry resolution strategy.
"If an extreme tail event occurs and the equity of the firm is wiped out, successful resolution without taxpayer assistance would be most effectively accomplished if a firm had sufficient long-term, unsecured debt to absorb additional losses and to recapitalize the business transferred to the bridge operating company," said Tarullo.
Such debt -- identified specifically for possible bail-in -- should "help other creditors clarify their positions in the orderly liquidation process," said Tarullo.
The requirement would also improve market discipline, since the holders of the debt would know they would face the prospect of loss if the firms enter resolution.
Still, Dudley warned that Title II of the Dodd-Frank Act alone would not entirely eliminate the advantages of being large and complex.
Advocates of resolution planning suggest that shareholders' equity should be wiped out in a failure and that some portion of the long-term debt should be converted to equity. As a result, the parent company's long-term debt holders will demand higher yields because the prospect of failure is credible, effectively eliminating the implicit subsidy of "too big to fail."
"We must recognize that Title II by itself it is not sufficient to eliminate the advantages of being perceived as too big to undergo ordinary bankruptcy at the holding company level," said Dudley, who stressed the importance of tougher capital and liquidity requirements. "Moreover, even with a viable Title II resolution regime in place, we must recognize that there still will be disruption to the financial system when a large firm fails."
Both Tarullo and Dudley also raised concerns about Title II's one-day provision with respect to over-the-counter derivatives and certain other financial contracts, which may not apply outside the United States.
While domestic governments could potentially adjust their bankruptcy and insolvency laws to recognize stays imposed in home-country resolution procedures, Tarullo noted the difficulty in making such legal changes throughout all pertinent countries.