TLAC for G-SIBs: The first step

Transcription

1 November Evaluate the risk in regulatory capital TLAC for G-SIBs: The first step By Mark J. Welshimer, partner at Sullivan & Cromwell in London and New York The concept behind the FSB paper appears simple and intuitively correct, but national regulators face significant challenges in converting it into a concrete framework that works for complex corporate structures Internal TLAC addresses host country concerns, but too much prepositioning may trap holding company resources. This could impede the holdco s ability to tackle problems by depriving it of additional resources for contribution to a subsidiary in distress The proposal is not specific on triggers, notably who pulls it on internal TLAC and when Worries about an intra-g-sib contagion effect following a trigger being pulled on internal TLAC by a material subsidiary will need to be addressed G-SIBs might be forced to change their corporate structure, including the possibility of having multiple issuing entities that must follow disclosure rules Earlier this month and in anticipation of the Brisbane G-20 summit, the Financial Stability Board (FSB) released for comment its proposed framework for total loss absorbing capacity (TLAC) that would apply to global systemically-important banks (G-SIBs). The core of the proposal would require G-SIBs to fund themselves with equity and debt instruments that, were the G-SIB to fail, could be written down or converted into common stock in a manner and through a process that would both ensure the continuity of critical functions and avoid exposing taxpayers to loss. A credible TLAC framework is widely viewed by the regulatory community and most industry participants as an essential tool to address too big to fail. Any resolution-related framework for international application must be general in some respects in order to accommodate different laws and other circumstances among jurisdictions, irrespective of the complexity of the subject matter. Implementation of TLAC in a particular jurisdiction, requiring actions by national regulators and in some cases legislators, by its nature cannot be general. The FSB proposal raises many topics for discussion that illustrate the challenges and complexities of moving from a general international framework to specific national implementation. This article discusses three of them: the challenge of converting an intuitively simple and correct concept into a concrete framework that works for entities that invariably have complex corporate structures with international footprints, characteristic of G-SIBs; particular challenges with respect to cross-border implementation specifically, the trigger and who pulls it; and implications for all G-SIBs corporate structures and treasury functions, perhaps requiring significant changes going forward. First, and for context, the core components of the FSB s TLAC framework, developed in consultation with the Basel Committee, include the following: G-SIBs would be subject to two TLAC requirements an external TLAC requirement applicable to each resolution entity within the G-SIB and an internal TLAC requirement applicable to each material subsidiary of a resolution entity incorporated in a different

2 national jurisdiction from the resolution entity that is, cross-border from the G-SIB resolution entity. For purposes of the external TLAC requirement, the term resolution entity is not defined with specificity. In most cases it will include the parent G-SIB and each subsidiary which, under national standards, would be expected to go through a resolution proceeding in a failure. The external TLAC requirement will consist both of a pillar 1 minimum requirement applicable to all G-SIBs and a pillar 2 requirement tailored to the relevant G-SIB s specific circumstances. Pending the outcome of a quantitative impact study (QIS) that the FSB is about to commence, the FSB proposes that the pillar 1 minimum requirement be 16% to 20% of riskweighted assets, but not less than twice the applicable leverage requirement. The pillar 2 firm-specific requirement is to be determined in accordance with enumerated principles that include, among others, that the amount and distribution of [TLAC] within a G-SIB should be sufficient to facilitate an orderly resolution and incentivise home-host co-operation. Instruments eligible for inclusion in external TLAC, subject to the requirement that they may be written down or converted into common shares in a failure, include regulatory capital instruments, equity and subordinated debt that does not qualify as regulatory capital, and senior debt. All TLAC instruments that are not perpetual must have a remaining maturity of at least one year, and at least 33% of external TLAC is to be debt or other instruments that are not regulatory capital. Eligible external TLAC would not include common equity tier 1 buffer amounts for example, the capital conservation buffer, the applicable G-SIB buffer, or the countercyclical capital buffer if invoked; buffer amounts sit on top of external TLAC. Eligible external TLAC may not include insured deposits, short-term liabilities such as commercial paper, secured debt, some types of structured notes, or instruments that rank on a parity with such excluded liabilities. Internal TLAC is in substance pre-positioned cross-border capital. Pending the outcome of its QIS, the FSB proposes internal TLAC for each material subsidiary of a G-SIB resolution entity between 75% and 90% of the amount of external TLAC the material subsidiary would be required to maintain if it were a resolution entity, with the amount for any particular material subsidiary determined by the relevant host authority in consultation with the home authority. The purpose of internal TLAC is to facilitate co-operation between home and host authorities and implementation of cross-border resolutions strategies that are feasible and credible. A material subsidiary is defined as a subsidiary accounting for more than 5% of the consolidated risk-weighted assets, revenues or Basel III-based total leverage exposure of the G-SIB group or that has been identified by the G-SIB s crisis management group as material to the exercise of its critical functions. Instruments that qualify for external TLAC will also generally qualify as internal TLAC. A pre-programmed solution The concept behind TLAC is simple and intuitively correct. Imagine a universal bank that conducts all of its operations in a single entity no parent-subsidiary or cross-border complexities. The capital stack on the right side of the balance sheet from the bottom up consists of common stock, non-cumulative perpetual preferred stock, perhaps cumulative or term preferred stock, subordinated debt and senior debt. If the universal bank suffers losses and the assets on the left-side of the balance sheet are written down or written off, then absent a TLAC regime common equity (and perhaps preferred equity) on the right side of the balance sheet will shrink or be eliminated depending on the magnitude of the losses, eventually resulting in the exercise by debtholders of creditors rights, loss of confidence by market participants (with the universal bank not being able to roll over maturing debt, whether long-term or shortterm), and ultimately bankruptcy or receivership of the universal bank. Absent a pre-programmed solution like TLAC, if the universal bank s role in the financial system is sufficiently important, the pressures for government support to assure the universal bank s continued provision of critical services and functions are overwhelming. Hence the bail-outs during the financial crisis.

3 TLAC addresses this with a pre-programmed solution by creating a regime where, at some level of distress (whether defined as failure or reaching a point of non-viability where, absent a restructuring, failure is inevitable the FSB proposal is not specific on the trigger), the right side of the balance sheet restructures to implement a recapitalisation that will assure the continued operation of the universal bank and avoid the need for government support at taxpayers expense. The old common stockholders interest is eliminated and, working from the bottom to the top of the capital stack as necessary, some amount of preferred equity, subordinated debt and/or senior debt is written down or converted into equity as necessary to result in a capital structure that is sustainable on a going concern basis. The challenge is that no G-SIB is a simple universal bank of the type described above. Instead of a single entity, the number of entities in a G-SIB group may number in the 100s or even 1,000s; with few exceptions they include more than one entity the failure of which could have systemic importance; and all G-SIBs have meaningful cross-border operations, in some cases in dozens of countries. Hence the magnitude of the challenge the FSB faced in fashioning its TLAC proposal and national regulators (and perhaps legislators) will face in implementing it. Three specific interrelated aspects of the challenge are noteworthy. First, because many (actually most) G-SIBs operate through a holding company structure where the operating losses that could result in failure would occur in operating subsidiaries, TLAC is only in part a right-side-of-the-balance sheet issue. Yes, it is certainly the case that, because the treasury function is normally conducted at the holding company, an effective framework requires a mechanic to recapitalise the holding company and force its securityholders, including debtholders, to participate in the recapitalisation. With limited exceptions, that is where external securityholders are positioned they own debt and equity of the holding company. But it is equally an asset issue that is, a left-side-of-the-balance sheet issue. Operating subsidiaries at which losses occur will benefit from TLAC, and customers and market participants dealing with those operating subsidiaries will have confidence in their continued viability only if the operating subsidiaries losses can be pushed up to the holding company and its securityholders. Or, put another way, if the holding company s resources, which functionally means its assets, can be pushed down to the troubled operating subsidiaries as capital contributions and if that pushup/push-down can occur quickly, likely over a resolution weekend. Second, the FSB s TLAC proposal recognises the asset-side issue but does so explicitly only in one context resolution of cross-border material subsidiaries. Internal TLAC is essentially a forced contribution of assets by a holding company that is a resolution entity to a material subsidiary in another jurisdiction. The internal TLAC instrument is simply an asset to the holding company that, when the subsidiary faces distress, is written off or converted into equity of the subsidiary effectively contributed to the subsidiary s capital. In theory, instead of a pre-positioned internal TLAC requirement, a TLAC regime could obligate the holding company to contribute capital to the material subsidiary when the subsidiary is in distress. That, of course, would require a high degree of cooperation and trust between regulators in host and home countries. The internal TLAC requirement documents the reality that practical experience during the financial crisis eroded the level of trust that would be necessary to support a cross-border proposal that did not include prepositioning. Third, and related to the foregoing, the FSB s internal TLAC prepositioning requirement likely does not address the outer parameters of prepositioning. Although the FSB proposal only requires prepositioning for cross-border material subsidiaries, home country regulators may require prepositioning by holding companies with respect to the lead subsidiary or other significant subsidiaries within the home jurisdiction. Why is that bad more generally, why is prepositioning bad? At its most basic level, the industry concern, shared by many in the regulatory community, is that too much prepositioning will trap holding company resources in some subsidiaries in a way that actually impedes the holding company s ability to address a problem. It does that by depriving the holding company of additional resources for contribution to the subsidiary that is in distress because available assets and resources are pre-positioned in other subsidiaries that are not in distress. In a more trusting and cooperative environment,

4 holding companies would maintain a stock of transferable assets with ascertainable value that could be contributed in a targeted way to the subsidiary where the distress is occurring. No clarity on trigger rules As noted above, the internal TLAC prepositioning requirement addresses one cross-border concern by giving comfort to host country regulators that home country resources of the G-SIB resolution entity are available to address distress at a material subsidiary in the host country. But it also raises an issue that should be a concern to G-SIBs home country regulators as well as G-SIBs themselves. Specifically, who pulls the trigger for the conversion or write-down of internal TLAC and when? And is it possible for the trigger to be pulled on internal TLAC issued by one material subsidiary without setting off an intra-g-sib contagion effect resulting in the trigger being pulled (and write-down and conversion occurring) on the G-SIB s external TLAC and internal TLAC of its other subsidiaries, forcing a crisis in other parts of the G-SIB, including possibly a failure of the parent holding company itself? The FSB framework does not attempt to address either component of this issue that is, what is the trigger event for a write-down or conversion and may a host country regulator force the write-down or conversion acting alone. This issue will almost certainly be a subject of comment on the proposed FSB framework and, if the final FSB framework is silent on these issues, will ultimately need to be addressed in national implementation. Adjusting to TLAC Implementation of an FSB-like TLAC framework will inevitably mean changes for G-SIBs. The changes for any particular G-SIB will depend upon the interplay between its existing structure and capitalisation, on the one hand, and the precise terms and manner of implementation of TLAC in the G-SIB s home country and host countries where it operates, on the other hand. This includes new rules and possible statutory changes as well as how a bankruptcy or resolution would be addressed under existing statutes and rules. Items of focus in this regard include the following. Will the G-SIB be able to implement TLAC within its existing corporate structure or will it need to change its structure for example, by creating a new holding company that issues external TLAC or by creating a new subsidiary that issues securities that do not qualify as external TLAC? There are aspects of the FSB s TLAC framework that could force G-SIBs to restructure. On the one hand, clarity and transparency with respect to the ordering of loss absorbency among different classes of instruments may push some to form a new holding company and eventually migrate the treasury function to that new holding company. Similarly, if the final TLAC framework like the FSB s proposal requires that qualifying external TLAC be subordinated to ineligible debt instruments for example, commercial paper and structured notes, unless the G-SIB is prepared to stop issuing such instruments through the entity that conducts its treasury function, one way to address the subordination requirement is to form a new holding company that issues external TLAC and keep the existing holding company in place for issuance of ineligible instruments. Alternatively, a G-SIB that wishes to issue commercial paper or structured notes could, depending on the conformancy and compliance periods and the terms of the ineligible instruments, terminate the issuance of ineligible instruments out of the existing holding company and form a new subsidiary for issuance of those instruments. Either of these steps raises a variety of considerations, including the possibility of having multiple issuing entities that face the public and must prepare disclosure documents. It also raises the fundamental issue of whether the requirement that eligible external TLAC be subordinate to ineligible instruments is necessary. It may not be in some circumstances, for example in a jurisdiction where the relevant bankruptcy and insolvency laws implement the assignation of

5 losses to eligible TLAC instruments by leaving those instruments in a bankrupt entity that ultimately is liquidated, with the transfer of assets and TLAC ineligible liabilities such as commercial paper to a bridge company. Will the G-SIB have to raise substantial additional amounts of debt or equity in order to satisfy the TLAC requirement? That question, of course, cannot be answered until the FSB s TLAC framework is further calibrated, taking into account the results of the QIS that the FSB is undertaking, and home jurisdictions implement their own versions of TLAC. Preliminary feedback from a number of G-SIBs indicates that, depending upon where the FSB ends up in its indicated pillar 1 range of 16% to 20% of risk-weighted assets but not less than twice leverage, some G-SIBs will have to raise substantial amounts of eligible TLAC. Will outstanding instruments that look plain vanilla qualify as external TLAC? The proposed FSB framework raises some questions in this regard. For example, it requires that external TLAC instruments may be redeemed only with regulatory approval. No outstanding G-SIB long-term senior debt is likely to include a regulatory approval requirements for redemption. Comments on the FSB s proposal are due on February The FSB proposes to conduct a QIS to assist it in sizing the amount of TLAC required of G-SIBs and to finalise its TLAC framework before the 2015 G-20 summit. Although the FSB has not yet established an implementation date for performance, its recently released consultation document indicates that implementation by national regulators will not be before January All rights in and to the content of this report ( Content ) belong to Reg Cap Analytics, a business of Euromoney Institutional Investor PLC ( us/our or Euromoney ), our group companies or our third party content providers and are protected by the intellectual property laws of the UK, US and other countries. All use of the Content is subject to our standard Terms and Conditions of service (the Standard Terms ) which are available at Without prejudice to the foregoing: 1. You may use the Content solely for your own personal use and benefit and not for resale or other transfer or disposition to any other person or entity. You may not reproduce, modify, transfer, exploit, distribute or dispose of any Content without our express written permission. 2. You agree that your use of the Content is at your sole risk and acknowledge that the content is not comprehensive and is made available for your general information. Any opinion, statement or other information forming part of the content is not intended for trading or to address your particular requirements. The Content does not constitute any form of advice, recommendation or arrangement by us (including, without limitation, investment advice or an offer or solicitation to buy or sell any security, financial product or other investment) and is not intended to be relied upon by users in making (or refraining from making) any specific investment or other decisions. Appropriate independent advice should be obtained before making any such decision. 3. Euromoney did not originate the offering document, prospectus or other information referred to in the Content ( Original Document ) and does not accept any form of liability in relation to either the Content or the Original Document. The Content may include inaccuracies or typographical errors, and the final interpretation of the Original Document by a court or issuer may differ from that set out in the Content. The Original Document may be a draft or preliminary prospectus which may differ from the final offering. All liability for the Content or the Original Document is hereby excluded to the fullest extent permitted by applicable law.