The Federal Reserve Board's newest proposal requiring minimum "total loss absorbing capacity" has yet to make the headlines it deserves. Its importance has been lost in the details, as the rule is esoteric and complex.
But the significance of the TLAC standard should not be overlooked. Although it is designed to help unwind a failing financial behemoth, the proposal confirms that the banks it applies to are actually "too big to fail."
What do I mean? Under the Fed's plan, the parent companies of the eight U.S.-based "global systemically important banks" would need to keep enough resources so that should need the need arise, the Federal Deposit Insurance Corp. could seize the parent company's resources to keep the failed corporation's subsidiaries open and operating.
The proposal states that firms must disclose the fact that their unsecured debt would be expected to absorb losses ahead of other liabilities, including the liabilities of the covered [bank holding company's] subsidiaries, in a failure scenario."
This appears to mean the company's bank subsidiary would remain open, and the bank's deposits – all of its deposits and indeed all of its liabilities – would be protected from loss. This suggests that, if your bank is owned by a GSIB, all of your accounts – insured and uninsured – would be protected by the government.
If, however, your deposits are not at a bank owned by a GSIB, you may not be so lucky. While it is true that lately the vast majority of FDIC-assisted deals following a failure involve the acquirer assuming all the deposits of the failed bank, that blanket protection is not mandated. Moreover, the bank's nondeposit creditors nearly always take losses. When a small bank fails, the FDIC guarantee only covers up to $250,000 of a depositor's money.
Extra protection for depositors in GSIB banks, but not for deposits in non-GSIB bank, is the textbook definition of "too big to fail."
But how can this be? Wasn't the Dodd-Frank Act supposed to fix too-big-to-fail? In fact, the new reality of officially designated too-big-to-fail banks could not have happened without Dodd-Frank. Dodd-Frank created the FDIC regime known as "orderly liquidation authority," or OLA. This authority allows the government to seize the assets of one corporation, and use them to keep a separate legal corporation from failing.
Before Dodd-Frank, the government had a very limited ability to seize parent bank holding company assets should a subsidiary bank fail. Dodd-Frank removed many of the normal corporate legal protections for shareholders and bondholders of a bank holding company. Under OLA, holding company investors face the possibility that the government will seize their equity – while creditors would have their debt converted to equity – all to be used to support failing businesses owned by the GSIB. The Fed's TLAC proposal operationalizes orderly liquidation authority.
So if you are the treasurer of a small business, midsize corporation, town, municipality or county, and you have payroll or other accounts above the $250,000 deposit insurance limit, where are you going to deposit your money? A bank owned by one of the eight designated GSIBs, or in a bank where your deposits are at risk?
In fact, the too-big-to-fail implications of the TLAC rule apply not only to banks, but to other critically important operating subsidiaries owned by GSIBs. The current strategy articulated by the FDIC is to seize parent GSIB assets and use them to prop up any critically important operating subsidiary.
Those subsidiaries could also include broker dealers, leasing and finance companies, insurers, asset managers, mortgage servicers and corporations involved in other specialized financial activities. The Dodd-Frank powers could be used to extend too-big-to-fail protections to any GSIB operating subsidiary that regulators deem to be too important to fail. Competing broker dealers, asset managers or other businesses that are not owned by a GSIB would fail in bankruptcy and impose losses on their uninsured creditors. Not so if the financial corporation is owned by a GSIB.
If the Fed finalizes the TLAC rule as it is currently proposed, it will use Dodd-Frank orderly liquidation authority to create a whole new class of too-big-to-fail bank and nonbank financial institutions. It is inevitable that this would reduce the appeal of doing business with financial institutions not owned by a GSIB.
The OLA was intended to be mechanism whereby a large failing financial firm could be broken up and liquidated in an orderly manner over time under the patient stewardship of the government. In a strange twist of logic, regulators have turned this authority into a mechanism for seizing the assets of one corporation and using them to recapitalize large, badly managed financial subsidiaries.
Paul H. Kupiec is a resident scholar at the American Enterprise Institute. He has also been a director of the Center for Financial Research at the Federal Deposit Insurance Corp. and chairman of the research task force of the Basel Committee on Banking Supervision