One of the most outrageous legacies of the financial crisis remains the use of Main Street taxpayer money to bail out Wall Street’s biggest banks that engaged in reckless risk taking and illegal activities in the blind pursuit of profits and bonuses.  Those bailouts were justified as necessary to prevent a systemwide financial collapse and economic catastrophe like a second Great Depression. 

The purpose of the Dodd-Frank financial reform law was to make sure that didn’t happen again, including, in particular, preventing the need for hardworking Americans on Main Street to bailout bankers on Wall Street.  While regulators have made a number of strides towards this goal, the current system, although improved from the pre-crisis years, is far from perfect and will still result in indefensible bailouts. 

One example is the Federal Reserve’s 2016 rule on “total loss absorbing capacity” (“TLAC”) requirements for the largest Wall Street banks.  The TLAC requirement was intended to ensure that if these banks suffered financial stress, they would have sufficient capital to stay afloat, or undergo resolution, without threatening financial stability and without needing a taxpayer bailout.  Unfortunately, instead of simply requiring that banks maintain more capital—the simplest and most effective way to ensure banks have sufficient loss absorbing capacity—the Fed opted for an inferior solution, a complicated and untested regime in which banks could meet some of their TLAC requirements by issuing long-term convertible debt.  In the event a large bank undergoes serious financial distress, that debt can theoretically be “bailed in,” i.e. turned into equity, thus sustaining the bank, foisting any losses onto those who bought the debt, and supposedly sparing the U.S. taxpayer.  However, as we detailed in the past here, that is not likely to be the way things turn out in the midst of a crisis. 

Recently, the banking agencies proposed a rule to address one potential flaw in this regime, which might increase the risk of contagion and the spread of a financial crisis: If large banks hold the TLAC debt of other large banks, then trouble at the bank that issued the TLAC debt can spread through the banking system when the banks holding that debt have to take losses on it.  Again, rather than choosing the more straightforward option of simply prohibiting large banks from owning directly or indirectly the TLAC of other banks, the proposal seeks to prevent the risk of contagion by making it more expensive for large banks to hold the TLAC debt of other large banks through complicated capital deductions. 

On June 7, 2019, Better Markets filed a comment letter [link] on the proposal.  We argued that while the proposal is one way to help limit contagion in the banking system, the TLAC regime still suffers from other fundamental weaknesses that, if not addressed, could increase the risk of Main Street and taxpayer bailouts of big banks in the future.

THREATS TO FINANCIAL STABILITY CAN FLOW THROUGH THE SYSTEM REGARDLESS OF WHO HOLDS TLAC DEBT.

• Contagion can spread through non-bank holders of TLAC debt:  Banks are not the only entities that might present systemic risk if forced to take large losses on TLAC debt.  Recall that after Lehman failed in 2008, a money market fund, which held debt issued by Lehman, faced a run that resulted in its “breaking the buck.”  That triggered a run on other money market funds, even those that had no exposure to Lehman.  As a result, the government quickly de facto nationalized the entire $3.7 trillion money market fund industry, an unprecedented action. 
• Retail investors are likely to be the holders of TLAC debt:  It is likely that the holders of TLAC debt will be largely retail investors through their brokerage accounts, mutual funds, or pension funds.  In fact, by making it more costly for big banks to hold the TLAC debt, the proposal would ensure that TLAC debt would be steered towards these investors.  Thus, if a big bank runs into trouble and its TLAC debt is “bailed in,” resulting in losses for the holders of that debt, it will be the savings and retirement accounts of Main Street investors that ultimately take the hit.
• Contagion can spread to other large banks with outstanding TLAC debt:  The failure of a large bank is unlikely to occur in a vacuum.  In fact, no matter who holds TLAC debt, if one large bank encounters trouble and TLAC debt holders are forced to take large losses, there will likely be spillover effects in the form of capital runs on other large banks with TLAC debt that are also seen as vulnerable.   This, itself, can imperil the stability of the financial system.

THE RESULTING PRESSURE ON POLICYMAKERS WILL BE IRRESISTIBLE. 

• During a period of financial stress or crisis, these circumstances will increase political pressure on policymakers to use taxpayer funds to bailout large banks to prevent the potentially catastrophic results of imposing large losses on TLAC debt holders.  And indeed, this scenario has recently played out in countries with similar regimes—in crafting a rescue of its third-largest bank, Italy specifically avoided imposing losses on holders of subordinated debt, many of them retail investors, despite the fact that this debt was supposed to be “bailed in” to absorb losses.  It was, frankly, politically impossible to make Italy’s Main Street investors suffer losses to bail out its banks.  There is no reason to think that a similar situation would play out any differently here.

AT A MINIMUM, MORE TRANSPARENCY IS ESSENTIAL TO ENSURE THAT THE RISKS ASSOCIATED WITH TLAC DEBT ARE REFLECTED IN ITS COST.

• If regulators are unwilling to simply require that large banks have adequate loss-absorbing capital, one step they can and should take now is to improve the disclosure regime.  Currently, issuers of TLAC debt are subject to a vague disclosure standard that could be misunderstood, misapplied, or gamed.  Regulators should impose a much more robust regime that requires issuers of TLAC debt, and mutual and pension funds that invest in TLAC debt, to clearly explain the significant risks involved in buying that debt.  A more robust regime would likely increase the cost of TLAC debt, ensuring that investors are adequately compensated for the added risk of investing in TLAC debt, and also likely causing issuers to choose to satisfy more of their TLAC requirements with equity.