Total Loss Absorbing Capacity: News from the Banking Capital Front
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Total Loss Absorbing Capacity: News from the Banking Capital Front

The Financial Stability Board (FSB), a group of high level officials linked to the G20, published the finalized requirements regarding TLAC (total loss absorbing capacity) on November 9, 2015, and  adopted them a week later at the G20 summit in Turkey. TLAC requires globally systemically important banks (so-called G-SIBs) to develop their ability to cope with large losses without burdening taxpayers. These banks are required to have a certain amount of loss absorbing securities outstanding, which together make up the bank's TLAC.

TLAC Requirements Finalized

The new requirements stipulate a TLAC amount of 16 percent in terms of risk-weighted assets (RWAs) or 6 percent of the leverage exposure as of January 1, 2019. This will increase to 18 percent of RWAs or 6.75 percent of leverage exposure by  January 1, 2022. However, the normal capital buffers under the global Basel 3 standards come on top of the TLAC requirements measured in RWAs, i.e. adding the capital conservation buffer, which is the same for all institutions (2.5 percent of RWA),  and other bank specific buffers (e.g. G-SIB surcharge, counter-cyclical buffer) could easily lead to total capital/TLAC needs of between 21-23 percent of RWA. The leverage exposure requirements don't need to be topped up by the various capital buffers.

National authorities can demand requirements above the minimum criteria set out by the FSB, e.g. Switzerland and the US. Furthermore, banks will also have to hold a management buffer above their total capital/TLAC needs (probably amounting to 1-2 percent of RWAs) as a breach of TLAC limits will have consequences in terms of capital distributions (similar to infringing the combined buffer requirement). Emerging market-based G-SIBs will have to fulfil the TLAC requirements by January 1, 2025 and 2028, respectively.

General Features of TLAC Securities

TLAC eligible securities include common equity (i.e. equity capital, retained earnings, reserves), subordinated debt, i.e. Tier 1 (T1) and Tier 2 (T2) securities, and certain amounts of senior unsecured debt. Specifically, TLAC securities have to be unsecured liabilities with a maturity of more than one 1 year and should not be callable without regulatory approval. The FSB also demands that at least 33 percent of TLAC to be filled with debt instruments (e.g. T1 or T2 instruments booked as liabilities or senior unsecured debt). Equity will thus amount to 67 percent of TLAC at most, i.e. it should lead to only limited additional equity capital needs. Not included in TLAC are insured deposits, both callable and on demand items, items funded directly by issuer, liabilities arising from derivatives, tax liabilities and other preferred liabilities.

Creating TLAC

Since TLAC liabilities will absorb losses prior to other liabilities, it will be crucial for investors to recognize them and to understand the various ways to create/issue such liabilities. Essentially, there are three ways to do so:

  1. Contractual subordination: TLAC liabilities can be created by contractual subordination, i.e. ranking them below all non-TLAC eligible liabilities of a bank in the terms and conditions. Thus, the respective security prospectus would include a specific clause stating the subordination. In this case, an entity could issue TLAC and non-TLAC compliant securities at the same time. Banks could opt to issue a special class of senior unsecured debt, subordinated to all TLAC excluded liabilities and "normal" senior debt, but ranking ahead of any T1 and T2 instruments, to fulfill their TLAC obligations.
  2. Statutory subordination: The applicable regulation stipulates a hierarchy of loss absorption for the liabilities in case of the resolution or liquidation of the bank, i.e. all liabilities not explicitly excluded from TLAC in the regulations would be basically eligible.
  3. Structural subordination: Banks organized as a holding company, i.e. holding level with no business activities and only ownership stakes in one or several operating entities as assets, could opt to issue out of the holding company, in which case the issued liability is structurally subordinated to debt by an operating entity and is by definition eligible as TLAC.

TLAC eligible debt therefore needs to be effectively written down or converted into equity during resolution without disrupting the provision of critical company functions. Regulators want to make sure that the loss absorption of TLAC instruments will be possible without any legal challenges. This is especially relevant for senior unsecured debt issued out of an operating entity, which is the case for most Eurozone banks, since these bonds normally rank at an equal rate with some of the excluded liabilities. Only if loss absorption in resolution is guaranteed either by statutory rules or by instrument specific provisions, would it be possible to count these liabilities as TLAC. Moreover, the maximum contribution from these liabilities would also be capped at 2.5 percent of RWAs (as long as the minimum TLAC requirement is 16 percent) and at 3.5 percent (if the minimum TLAC requirement is 18 percent).

Organizational Bank Setup Important for TLAC

The TLAC topic is closely inter-wined with bank resolution, especially with the way the resolution is actually carried out. In this regard, the organizational set-up also plays an important role, i.e. is the bank operating via a holding company (HoldCo) or is it just an operating company (OpCo)? The resolution is generally executed according to two principles: under the single point of entry (SPE) approach, one regulator takes care of the resolution process if the bank is taken under receivership. All resolution actions are applied centrally at the top parent or holding company level, where losses are absorbed. In the case of multiple point of entry (MPE), there are various regulators involved for various entities. Resolution measures are implemented at the various subsidiaries, i.e. losses are taken at the decentralized entities.

Naturally, all this will have consequences for the individual TLAC requirements as banks with MPE resolution plans may have to comply with TLAC on each subsidiary level. G-SIBs that are run as HoldCos and that thus have a single point of entry resolution mechanism applied have therefore a better starting position, in our view, as an easy way to create TLAC already exists from them. Especially Swiss, US and UK G-SIBs benefit from this point. HSBC represents an exception as it is structured as a HoldCo, but plans to implement the MPE resolution approach given its international reach in retail and corporate banking.

National Implementations – Latest Developments

The FSB standards regarding TLAC set the principles and minimal terms for the eligible instruments. However, to become effective, these more general rules need to be transferred into national laws. So far, Swiss and US regulators have put forward concrete proposals, whereas Germany has already changed its respective law.

Swiss G-SIBs (UBS, Credit Suisse) are run as HoldCos with a single point of entry mechanism applied for resolution. On October 21, the final capital requirements for the two Swiss G-SIBs were announced, stipulating the build-up of capital/loss absorbing buffers of 28.6 percent of RWAs and 10 percent of leverage exposures by 2019. These are stricter than the FSB proposals, both in terms of level as well as implementation time. Both banks have already started to issue subordinated and senior debt out of their respective HoldCo. However, both are still materially short of their leverage targets (e.g. around 70-80 billion Swiss francs according to our estimates), while the situation looks much better on RWAs calculated basis.

In the US, the Federal Reserve (FED) proposed TLAC rules for the US G-SIBS on October 30, 2015, which were largely in line with the global FSB standards. TLAC requirements in terms of RWAs are the same than proposed by the FSB. However, US institutions need to comply with a higher leverage target of 9.5 percent of total exposure. Moreover, the FED demands that banks will adhere to stricter external debt requirements (6 percent plus capital buffers in percent RWAs) in order to prevent them from filling the whole TLAC requirements with T1 securities. The eligibility criteria for senior unsecured debt are also stricter compared the FSB term sheet, e.g. only US dollar denominated debt issued under US law with a maturity longer than one year. The shortfall to the proposed target levels amount to around 120 billion dollars, according to the FED, which looks manageable.

In the EU, there hasn't so far been any common statutory approach. However, some countries have already adopted individual solutions by adapting their national laws. Germany, for example, changed its rules so that senior unsecured debt becomes in effect subordinated to liabilities originally ranking at an equal rate (i.e. corporate deposits, derivatives) with it. This solves the TLAC issue for Deutsche Bank, which is currently German only G-SIB. In Italy, the government issued a law, which gives all deposits explicit preference over senior unsecured liabilities, but it is still unclear at the moment whether this would be enough to make senior unsecured debt TLAC eligible beyond any legal doubt. In Spain, the latest changes would allow for the issuance of TLAC instruments with contractual subordination, so called Tier 3, but it has so far not got off the ground as contractual subordination could infringe the provisions of existing subordinated debt. It will thus be important to see whether there will be a common statutory approach eventually rolled in the EU, for example via an amendment of the BRRD, or whether each country will finally pursue its one way. In this regard, especially the developments in France will be important to watch.

What Is the Outlook?

The exact debt-issuing entity/modality will become an important factor in the future, in our view. This will be especially relevant for senior unsecured debt, as TLAC qualifying seniors will have a higher yield compared to non-TLAC-eligible securities given the higher associated risk, whereas T1 and T2 instruments are included in TLAC anyway. G-SIBs, which operate under a holding company organizational structure, enjoy the best starting position, in our view, since it is relatively easy and cheap for them to build up a sufficient TLAC stake, i.e. replacing most maturing senior debt from the operating company with instruments issued out of the holding company. UK and Swiss G-SIBS have already been active on primary markets in this regard year-to-date, while US banks have been issuing HoldCo senior debt for years.
Most Eurozone G-SIBs are not organized as a holding company, though, with setting up a holding company from scratch representing an expensive and time consuming exercise. Furthermore, senior unsecured bonds rank at an equal rate with other liabilities in the EU. It will therefore be crucial to view whether more countries (especially France) follow Germany's approach, i.e. legally subordinating senior unsecured debt to corporate deposits and derivative liabilities in insolvency. An EU-wide statutory solution, i.e. adjusting the BRRD (Bank Resolution and Recovery Directive), represent an alternative way out and would create a level playing field in the EU: Fulfilling the TLAC requirements by issuing more T2 debt represents an alternative, but would negatively impact earnings, is why we see this outcome as unlikely.