United States: TLAC, And Then Some… A Preliminary Assessment Of The Federal Reserve Board's NPR

On Friday, October 30, 2015, the Federal Reserve Board ("Board") reaffirmed its commitment to both the bank holding company model and single point of entry resolution. In a departure from historical views of the purpose and function of bank capital, but building on a proposal by the Financial Stability Board ("FSB"), the Board proposed to require globally systemically important banks ("G-SIBs") to issue long-term debt for the purposes of capitalizing a bridge institution that would succeed the G-SIB in the event of the G-SIB's failure. The Board also proposed to limit the liability structure of G-SIBs and to limit other banking institutions' investments in G-SIBs in order to facilitate the resolution of G-SIBs. Specifically the Board issued a notice of Proposed Rulemaking ("Proposed Rule") seeking comment on: a proposed requirement for U.S. bank holding companies ("BHCs"), which are G-SIBs, to maintain a minimum amount of loss-absorbing instruments, including capital and a minimum amount of unsecured long-term debt. The intermediate holding companies, or IHCs, of foreign banking organizations ("FBOs"), with $50 billion or more in U.S. non-branch assets would be required to maintain a minimum amount of upstream loss-absorbing instruments, including a minimum amount of unsecured long-term debt. The Proposed Rule also introduces the concept of a "clean holding company" by imposing a number of significant restrictions on the other liabilities that a covered BHC may have outstanding.

This alert is intended to provide a brief overview, which we will supplement with a more detailed analysis in the coming days.

The Proposed Rule was issued as news circulated that the Financial Stability Board ("FSB") has come to agreement on its requirements for total loss absorbing capacity ("TLAC"). A leaked August 24, 2015 FSB TLAC term sheet published by various media outlets outlines an approach that, while theoretically consistent with the objectives underlying the Board's proposal, takes a different approach. The FSB solely sets out a TLAC requirement, not a long-term debt requirement. It is anticipated that the FSB TLAC final requirements will be released prior to or in conjunction with the mid-November G-20 meeting.

Underpinnings of the Proposed Requirements

The purpose of the Proposed Rule is to address concerns about "too-big-to-fail" and to facilitate the Dodd-Frank Act's resolution scheme under a single point of entry ("SPE") approach. The proposed SPE approach would require that the BHC of the failed G-SIB be placed in receivership while the subsidiaries would remain intact. Title II of the Dodd-Frank Act requires that the BHC be liquidated with losses imposed on the stockholders and creditors of the BHC. The stockholders of the BHC would bear the first losses and the claims of holders of the BHC's long-term debt obligations would be converted into equity that would be used to capitalize the successor entity, the bridge financial company. This approach assumes that the BHC truly functions as a holding company, that business is conducted by the entity through its operating subsidiaries, and that the holding company essentially operates as unified whole— assumptions that have been the cornerstone of the Board's approach to bank holding company supervision for decades. The bridge financial company would initially be capitalized by the bail-in of outstanding long-term debt of the failed BHC, which presumes that sufficient long-term unsecured debt would be outstanding at the holding company level in order to stabilize the bridge financial company.

External TLAC and External Long-Term Debt

The Proposed Rule would establish a two-pronged requirement—a long-term debt requirement and a separate TLAC Requirement.

A covered BHC would be required to maintain outstanding eligible external long-term debt at least equal to the greater of: (i) 6% of RWAs, plus the applicable G-SIB buffer, and (ii) 4.5% of total leverage exposure.

Eligible external long-term debt is unsecured, "plain vanilla" debt issued by the covered BHC and governed by U.S. law. Eligible external long-term debt with a remaining maturity of between one and two years is subject to a 50% haircut for purposes of the requirement. Debt with a remaining maturity of less than one year would not count toward satisfying this requirement.

A covered BHC would be required to maintain outstanding minimum levels of eligible external TLAC, or instruments issued by the BHC to third party investors, which are set in the proposal at not less than the greater of: (i) 18% of total risk-weighted assets ("RWAs") (on a fully phased-in basis), and (ii) 9.5% of the covered BHC's total leverage exposure.

Total eligible external TLAC would be the sum of the entity's Tier 1 capital issued directly by the covered BHC and the covered BHC's eligible external long-term debt. Tier 2 capital that meets the definition of eligible external long-term debt would count toward the external TLAC requirement.

An external TLAC buffer is added on top of the 18% risk-based capital component of the external TLAC requirement, which can be met only with common equity Tier 1 capital, and which equals the sum of 2.5%, any applicable countercyclical capital buffer, and the G-SIB surcharge as calculated under Method 1 of the G-SIB surcharge calculations.

The Proposed Rule solicits comment on an internal TLAC requirement for covered BHCs that would be designed to ensure that losses at holding company subsidiaries are passed upstream to the holding company where they can be absorbed by external TLAC.

"Plain Vanilla" Debt

Consistent with the FSB TLAC requirement, the Proposed Rule emphasizes the need to facilitate a quick and orderly resolution for a failed covered BHC. Valuing a complex instrument would create uncertainty during the resolution process. As a result, under the Proposed Rules, an eligible external long-term debt instrument would be prohibited from:

  • Being structured notes (as discussed below);
  • Having a credit-sensitive feature, such as a reset (similar to the regulatory capital requirements for Tier 2 instruments);
  • Including a contractual provision for conversion or exchange into the equity of the covered BHC (such as contingent capital type instruments); or
  • Including a provision that gives the holder a contractual right to accelerate payment (including automatic acceleration), other than a right that is exercisable on one or more dates specified in the instrument in the event of the covered BHC's resolution or on a payment default.

IHC Internal TLAC and Long-Term Debt

Again, to facilitate orderly liquidations in a cross-border context, a covered IHC would be subject to both an internal TLAC requirement and an internal long-term debt requirement. This would be debt, in the case of the long-term debt requirement, and capital and long-term debt in the case of the TLAC requirement issued from the covered IHC to its foreign parent so that the foreign parent (rather than another U.S. entity) bears losses in the event of a resolution.

The amount of the IHC requirements for internal TLAC depends on whether the foreign parent of the covered IHC will be separate be a resolution entity or will be resolved by the foreign home country authorities as a part of the resolution of the foreign parent.

Internal TLAC

A covered IHC that is not itself expected to enter resolution would be required to maintain internal TLAC in an amount not less than the greater of: (a) 16% of the covered IHC's RWAs, (b) for IHCs subject to the supplementary leverage ratio, 6% of the covered IHC's total leverage exposure, and (c) 8% of the covered IHC's average total consolidated assets computed for purposes of the U.S. Tier 1 leverage ratio.

An IHC that would be expected to undergo resolution would be required to maintain internal TLAC in an amount not less than the greater of: (a) 18% of the covered IHC's RWAs, (b) for IHCs subject to the supplementary leverage ratio, 6.75% of the covered IHC's total leverage exposure, and (c) 9% of the covered IHC's average total consolidated assets computed for purposes of the U.S. Tier 1 leverage ratio.

An internal TLAC buffer would apply to the RWA component of the internal TLAC requirement equal to the sum of 2.5% and any applicable countercyclical capital buffer (therefore equal to the existing capital conservation buffer applicable to covered IHCs).

Internal TLAC would be defined to include the sum of: (a) the Tier 1 regulatory capital issued by the covered IHC to its foreign parent and (b) the covered IHC's eligible internal long-term debt.

Internal Long-Term Debt

A covered IHC would be required to maintain outstanding eligible internal long-term debt in an amount not less than the greater of: (a) 7% of total RWAs; (b) 3% of the total leverage exposure, if applicable; and (c) 4% of average total consolidated assets, as computed for purposes of the U.S. Tier 1 leverage ratio. The long-term debt requirement does not depend on whether the IHC is a separate resolution entity.

An IHC's internal long-term debt is subject to requirements similar to those set forth above for external long-term debt. In addition, it must:

  • Be issued to the foreign parent entity that controls the covered IHC;
  • Be contractually subordinated to third-party liabilities of the covered IHC; and
  • Include a contractual going-concern trigger that results in conversion to common equity.

The contractual conversion feature would allow the Board to require the covered IHC to cancel the eligible internal long-term debt or convert or exchange it into Tier 1 common equity on a going-concern basis if: (a) the Board determines that the entity is in danger of default, and (b) any of the following circumstances apply: (i) the top-tier FBO or any subsidiary outside of the United States is placed in resolution proceedings; (ii) the home country authority consents to the cancellation, exchange, or conversion, or does not object to such action after 48 hours' notice; or (iii) the Board makes a written recommendation to the Secretary of the Treasury that the FDIC should be appointed as receiver under Title II of the Dodd-Frank Act.

Clean Holding Company Requirement

In order to further simplify the process of resolving a G-SIB and to reduce the potential for liquidity pressures on the holding company, the Proposed Rule introduces a new concept of a "clean holding company." As a "clean holding company" a covered BHC would be prohibited from:

  • Issuing short-term debt to third parties (including deposits) (defined as debt having maturities of less than one year);
  • Entering into qualified financial contracts ("QFCs"), such as securities contracts, commodities contracts, forward contracts, repos, swaps, and security-base swaps;
  • Having liabilities that are subject to upstream guarantees from the covered BHC's subsidiaries or that are subject to contractual offset rights for subsidiaries' creditors; or
  • Issuing guarantees of its subsidiaries' liabilities if the issuance of the guarantee would result in the covered BHC's insolvency or resolution would be an event of default on the subsidiary's part.

A covered BHC's liabilities (other than eligible external TLAC and other than eligible external long-term debt) that are pari passu with or junior to its eligible external long-term debt would be capped at a maximum of 5% of the value of the covered BHC's eligible external TLAC. This limitation would apply only at the holding company level and not to subsidiaries of the covered BHC. The cap would not apply to eligible external TLAC or to instruments that were eligible external TLAC when issued but are no longer due to an approaching maturity as long as the holder of such instrument no longer has an exercisable put right, or to payables that are not associated with such liabilities. The NPR explains that structured notes are among the types of liabilities that would be expected to be subject to this cap.

Public Disclosure Requirements

A BHC would be required to disclose publicly that its unsecured debt would be expected to absorb losses ahead of other liabilities, including liabilities of the covered BHC's subsidiaries, in a resolution.

The required disclosure could be made on the covered BHC's website or in a publicly filed financial or regulator report and in the applicable offering documents. This is similar to the current disclosure requirements regarding the possibility of "bail-in" of certain unsecured senior debt instruments issued by entities subject to the Bank Recovery and Resolution Directive in Europe. We would expect to see additions to a variety of sections of U.S. offering documents, including the "Risk Factors" section, to address these terms.

The notice explains that the Board intends to propose a requirement for regular reporting by covered BHCs of their amounts of eligible external TLAC and eligible long-term debt, as well as by IHCs of their eligible internal TLAC and eligible internal long-term debt.

Investments by Other Banks in Unsecured Debt of Covered BHCs

In order to avoid the risk that the resolution of a G-SIB cause losses to other banking institutions, banks, savings and loans and other institutions having total consolidated assets of at least $1 billion as well as IHCs formed to address the enhanced prudential standards requirements would suffer a regulatory capital reduction for any investment in unsecured debt issued by covered BHCs.

Structured Notes and Long-Term Debt and TLAC

A "structured note" is defined as a debt instrument that (a) has a principal amount, redemption amount, or stated maturity that is subject to reduction based on the performance of a reference asset or embedded derivative, (b) has an embedded derivative that is linked to one or more reference assets, (c) does not specify a minimum principal amount due upon acceleration or early termination, or (d) is not classified as debt under U.S. GAAP. The proposed prohibition, therefore, applies both to principal protected and to non-principal protected structured notes. However, the definition expressly excludes non-dollar dominated instruments as well as some rate-linked notes, such as floating rate notes linked to LIBOR.

Since the Proposed Rule applies at the covered BHC only, the Proposed Rule does not affect structured bank notes (issued by a bank subsidiary) or market-linked certificates of deposit issued by a bank subsidiary. Of course, one also could envision structured notes issued by subsidiaries of the covered BHC (not guaranteed by the covered BHC).

"Replacement" Debt

The Proposed Rule provides that outstanding debt of a covered BHC that satisfies the eligibility criteria for external TLAC and for external long-term debt would qualify to meet the two requirements. In the NPR the Board suggests transition strategies noting that covered BHCs might consider replacing "near eligible debt" with eligible external long-term debt presumably through exchange offers or similar liability management exercises prior to issuing new qualifying debt. Footnote 60 of the draft text of the Federal Register notice notes that covered BHCs could meet a substantial portion of the anticipated funding shortfall by replacing near-eligible debt with eligible external long-term debt.

Compliance Dates

Covered BHCs are required to comply with the external long-term debt and TLAC requirement as of January 1, 2019; however, the proposal contemplates phasing in the RWA component of the external TLAC requirement in two stages, such that a 16% requirement would apply as of January 1, 2019 and the 18% requirement would apply as of January 1, 2022. Covered IHCs will be required to comply on the same schedule. The clean holding company requirement would become effective as of January 1, 2019. The regulatory capital deduction would become effective as of January 1, 2019.

Comment Period

The comment period will close on February 1, 2016. We believe that the Board is committed to the resolution strategy described in the NPR and will be reluctant to make wholesale changes in the key components of the Proposed Rule. Comments that are consistent with that resolution strategy are more likely to be viewed favorably.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Anna Pinedo
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.