Global financial regulators have taken a fresh gambit at avoiding future bank bailouts with a recently announced proposal for total loss-absorbing capacity requirements. The Financial Stability Board's plan would require banks to accumulate enough combined capital and long-term unsecured debt to go through a resolution process without relying on taxpayer dollars.
But while some people view the TLAC proposal as a practical alternative to government support, my colleagues at Kroll Bond Rating Agency and I respectfully disagree. While well intended, the plan will not preclude future bank failures or the tendency of governments to rescue large financial institutions. Indeed, even if TLAC requirements are fully implemented, they will only go part of the way in keeping a failed institutions liabilities from translating to a liability for the sponsoring government.
The FSB's plan supports a bail-in strategy, whereby shareholders and even debt holders would responsible for sharing the losses in the event of a bank downturn. Therefore in combination with other regulatory initiatives, it aims to promote greater market discipline, incentivizing creditors to enhance their monitoring of global systemically important banks' risk-taking.
But the proposal does not address the political issues and real-world concerns at the heart of the TBTF issue, such as over-the-counter derivatives and related counterparty risk. Nor does increased capital address the core issues behind the 2008 market breakdown, including liquidity risk, a lack of adequate public disclosure and securities fraud related to off-balance-sheet financing.
The OTC derivatives market has been one of the primary reasons that global regulators have been reluctant to liquidate G-SIBs and remains so today. U.S. law provides for the continued payment of OTC derivatives contract even after a depository is declared insolvent, owing to concerns about systemic risk. Over the past two decades, OTC derivatives have been given priority over other creditors to ensure that the failure of one institution does not create a chain of defaults affecting entire markets.
But this provision assumes that the failed bank has the resources and intention to make payments. If this is not the case, it appears the responsible governments would be forced to subsidize payments to the derivatives counterparties in order to avoid financial Armageddon.
Under the Dodd-Frank resolution authority, the FDIC has just 24 hours to reaffirm the OTC derivatives contracts of a failed bank or financial institution. If the FDIC uses its receivership power to repudiate the OTC contracts, however, then the OTC counterparties of the insolvent bank may then declare an event of default and can seize any available collateral behind these contracts, triggering a systemic run on liquidity a la Lehman Brothers.
One of the chief questions that regulators have yet to answer is how to impose losses on a major bank without triggering an event of default affecting the banks OTC derivatives book. The increased capital envisioned by TLAC does not address how to resolve the huge OTC derivatives positions of a major bank. The OTC derivatives books of JPMorgan or Citigroup, for example, are orders of magnitude larger than the banks themselves.
Moreover, if TLAC is adopted, the cost of complying with the new capital-raising requirements will be substantial. The long-term debt called for under TLAC will carry terms that are decidedly unattractive to traditional investors in investment-grade debt. Holders of TLAC debt will effectively be required to convert their investment into equity when regulators so require. Just who, precisely, will buy such a debt instrument? And at what yield? Regulators have not thought through how to convince investors to buy debt that has characteristics of equity.
And although the FSB hopes to encourage an equitable and standardized TLAC approach across international borders, the standards would surely vary across countries. There remains a basic lack of coordination among the industrial nations when it comes to prudential supervision of banks and markets. Unless all international banks face the same capital requirements, regulators risk making the competitive landscape even more uneven than it is today.
Regulators are taking steps in the right direction as they work to avert future bailouts. But one of the key factors behind the continuation of TBTF is a bilateral OTC derivatives market that places derivatives counterparties ahead of the other creditors of large banks. Until regulators and elected officials recognize this, the problem of how to liquidate insolvent banks will remain.
Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency, where he is responsible for financial institutions and corporate ratings. He is co-author of the new book Financial Stability: Fraud, Confidence & the Wealth of Nations. Follow him on Twitter at @rcwhalen.