Total Loss Absorbing Capacity: the end of the bail-out?

Total Loss Absorbing Capacity: the end of the bail-out?

Billions of euros of public funds were invested in systemically important institutions in order to sustain them at the height of the crisis. This was deemed an absolute one-off bail-out and the Financial Stability Board (FSB) introduced a proposal to end ‘too-big-to-fail’. Does this proposal effectively protect the tax payer or are we simply paying the burden in advance?

At the peak of the crisis, many financial institutions had to be rescued from the abyss by sovereign governments. This was met with heavy protest from society. In the summer of 2013 the leaders at the G20 summit in Saint Petersburg tasked the FSB with formulating a sustainable solution to tackle the problem of institutions that are ‘too big to fail’ (TBTF), so that national governments will never again have to jump to their rescue.

The FSB published a proposal in the shape of a consultation paper. The primary goal of its requirements is to provide a framework for dismantling a distressed financial institution in an orderly fashion. In addition, the proposal aims to eliminate the funding advantages that systemically relevant banks have through implicit state guarantees, thus ensuring a (more) level playing field.

The proposal is part of an effort by regulators and government to make the financial sector more resilient. With the introduction of the Basel III requirements and the Bank Recovery and Resolution Directive (BRRD) to be implemented by EU member states, steps have been taken to both increase the banks’ resilience and to provide governments the right to perform a ‘bail-in’. For this to be possible, sufficient bail-in capacity must be available. For this purpose, the FSB is introducing Total Loss-Absorbing Capacity (TLAC) as a metric. Instruments on the credit side of a bank’s balance sheet qualify as TLAC if they can credibly be used to cover losses in a crisis scenario. Besides own equity this covers subordinated loans and convertible debt. Insured retail deposits are specifically excluded and senior debt can only be used to a limited extent.

Although the eligibility criteria – all long-term, Basel III eligible tier-1 and tier-2 instruments plus additional hybrid instruments qualify – are flexible, the TLAC Pillar 1 requirement is impressive: a minimum between 16% and 20% in RWA terms (versus Basel III’s 8%) and a minimum leverage ratio of 6%. On top of this the Basel III capital buffer requirements1 are added, as well as an additional TLAC Pillar 2 requirement2 , which depend on the individual bank’s characteristics such as legal structure and services offered.

For most EU banks, so far only facing the Basel III rules as implemented in regulation through CRR and CRD IV, this constitutes a steep increase in the requirements. For Swiss banks, the change is smaller as the national regulator FINMA already imposed more stringent requirements – see box below.

In 2011, the Swiss financial regulator, FINMA, incorporated capital requirements in addition to those of Basel III. These apply to all but the smallest Swiss banks. For moderately large banks, on top of the Basel III minimum requirement, up to 3.9% of RWA needs to be held in CET1 and other instruments, bringing Swiss maximum capital requirements to 14.4%. A special TBTF regime applies to its globally active banks, Credit Suisse and UBS. This involves a requirement to hold between 3% and 9% of RWA in CoCos, depending on institution-specific characteristics3. The combined current capital requirements are set to 19.2% and 16.7% of RWA for UBS and Credit Suisse respectively4. These requirements will come fully into force from 2019, and a phase-in scheme is in place.


The overall requirements are summarized in the figure below:

The proposed Pillar 1 required minimum of 16%-20% of RWA is preliminary. A quantitative impact study (QIS) will be held in 2015 to determine an optimum which significantly facilitates smooth resolution while not disproportionately increasing funding costs. A final proposal is expected at the end of 2015; these requirements will come into effect in 2019 at the earliest.

The financial sector will undoubtedly communicate that these high capital requirements will unduly increase financing costs. According to a study by the Bank of England these effects are likely to be limited5. However, a radical change in funding strategy is required, as banks need to be less reliant on ‘typical’ debt financing.

Flexible financing is important for the loss-absorbing capacity of a bank. Although the BRRD contains provisions allowing authorities to bail-in debt instruments, a discretionary power of the government will diminish their attractiveness to investors. Contingent financing, allowing a bail-in or write-off under contractually specified conditions, are likely to be given preference. However, if the systemically relevant institutions around the globe aim to eliminate the new capital gap by means of these instruments, the market will be flooded with billions of hybrid instruments and other forms of ‘creative’ financing. It remains to be seen whether investors will embrace these products on such a scale. After all, investors are still averse to complex products.

Whether these new rules will create a more level playing field is in doubt. Especially because it is the simple retail banking model that will be most affected, as insured retail deposits do not qualify as TLAC. This appears to be at odds with the general trend to simplify bank balance sheets and to deter wholesale business models. The risk that banks will adjust their product offerings at the expense of clients cannot be ignored.

Problems are envisaged in particular with the Pillar 2 requirements. The translation of specific business characteristics into capital requirements has plenty of potential to result in an endless discussion between banks and regulators, and among the national regulators themselves. In the longer term, the risk of regulatory competition emerges. One possibility is that Pillar 2 requirements will eventually become so standardized, effectively reducing them to a simple, fixed Pillar 1 add-on.

Lastly, it remains doubtful whether small banks will be able to catch up with their larger peers as a consequence of the proposal. It is very likely that once TLAC capital levels above 20% become the norm for systemic banks, these also become the norm for smaller banks. As a consequence, the entire system will be more robust, but systemically relevant banks at best only give up part of their advantage.

All in all, the FSB proposal definitely contributes to the smoother unwinding of systemically relevant banks. It remains to be seen, however, whether its other consequences are desirable. If capital requirements become excessively high and there is no sufficient supply from market investors, banks will reduce the amount of credit available to the economy. The upcoming QIS will reveal to what extent this will be the case. Finally, one must avoid focusing too strongly on capital and ease of resolution. Supervision of business models and management effectiveness is at least as important. After all, it is better to prevent a disease rather than cure it.

These consist of the anti-cyclical, capital conservation and systemic buffers.
2 Not to be confused with Pillar 2 of the Basel requirements.
3 A fixed requirement of 3% of RWA in CoCos converting at 7% RWA, and a flexible, bank-specific requirement of up to 6% of RWA in CoCos converting at 5% RWA. 
4 The minimum leverage ratio is 4.6% for UBS and 4.0% for Credit Suisse.
5 “Optimal Bank Capital”, Bank of England discussion paper, 2011.