Why It Matters. A key objective of the DFA was to end too-big-to-fail (“TBTF”) and eliminate the potential need for future taxpayer-funded bailouts. A large part of this is preparing large banks to be resolved in the event of failure in a way that limits contagion and losses to the deposit insurance fund as well as to taxpayers. This has not been achieved in large part because regulatory agencies have not required banks to have enough capital or, worse, rely on the fallacy of convertible long-term debt (so-called TLAC Debt). Such debt rather than capital has proven over and over to be a mirage and only push losses away from the banks to other parts of financial markets that the government inevitably would bail out. This advance notice of proposed rulemaking suggests applying some form of TLAC Debt requirement that currently applies to GSIBs to other large banks.
What We Said. Given the continuing and tremendous uncertainty about the possibility of a successful non-disruptive resolution, the Agencies should ensure that for large banking organizations both the consolidated enterprise and its material subsidiaries are capitalized and have sufficient funding to withstand severe stress and continue to operate. Losses that TLAC Debt theoretically is supposed to absorb after failure of the holding company should be covered upfront through higher equity capital requirements. Only such real, high-quality capital will also create much greater confidence about these banks’ resilience in times of stress. In a bank failure scenario, the use of higher regulatory capital requirements upfront would help ensure losses are absorbed by shareholders without the significant complications and uncertainty that come from resolving a large bank and the associated conversion of TLAC Debt. Additionally, separate capital requirements should be in place for material subsidiaries.
Bottom Line. There are several enhancements that must be made to the resolution process to make it more effective in limiting contagion, losses to the deposit insurance fund, and losses to taxpayers. The agencies are right to bring all large banking organizations up to a standard that actually protects the American public from the catastrophic fallout that results from their failure, but they must do it in the right way. TLAC is the wrong way; upfront capital is the right way for the banks, the financial system and the economy.