Although Paul Kupiec's recent BankThink post is right to point out the significance and importance of the Federal Reserve's recent proposal requiring the largest banks to hold a minimum amount of "total loss-absorbing capacity," the author is wholly wrong that the proposal perpetuates "too big to fail." Indeed, it is just the opposite.
The Fed proposal bolsters the government's resolution regime, which already provides a legal framework to safely and cleanly inflict the losses of a large bank's failure in an orderly way on the equity and debt holders of its holding company, and not taxpayers. This includes the Federal Deposit Insurance Corp.'s "single point of entry" approach, under which failing holding companies would be placed in resolution, and the recent International Swaps and Derivatives Association protocol staying termination of financial contracts in a resolution.
The TLAC proposal complements this framework by ensuring that the largest and most complex banks hold sufficient capital and unsecured long-term debt — enough to absorb even historically unprecedented levels of loss — so that critical operating subsidiaries can be recapitalized and remain in operation. Kupiec criticizes this aspect of the proposal, but it is an accomplishment, not a flaw. It will ultimately be the banks' shareholders and long-term creditors that take the hit, not the taxpayer. This is certainly "extra protection," as Kupiec notes, but that protection is wholly bought and paid for by the bank's shareholders and creditors. This, again, is the point.
Kupiec seems especially worried that all this "extra protection" puts smaller banks and their depositors at a disadvantage — "a textbook example of 'too big to fail.' " That is tough to understand, since we've yet to see banks clamoring for regulators to let them into the TLAC club. This is probably because the TLAC requirement will increase the funding costs of the firms that must meet it — after all, TLAC's protections come at a cost, which will be absorbed by the affected banks.
TLAC represents a final linchpin in a carefully constructed set of postcrisis reforms intended to ensure that in the next crisis, government officials are not faced with a terrible choice between rescuing a large financial firm from failure with taxpayer money or allowing it to fail and destabilize the rest of the financial system. TLAC mitigates that terrible choice by providing a third way, one in which the resources of shareholders and long-term creditors, and not taxpayers, are deployed to recapitalize key operations and prevent destabilizing contagion. TLAC doesn't perpetuate TBTF. It helps to end it.
Jeremy Newell is executive managing director, head of regulatory affairs and general counsel of The Clearing House Association.