U.S. Federal Banking Regulators Release Proposed Long-Term Debt Requirements for Large Regionals

Twelve Quick Observations

The FDIC met today to discuss proposed long-term debt requirements for firms with $100 billion or more in total assets that are not currently subject to such requirements. The Federal Reserve Board and OCC are also today expected to endorse the same proposal.

In no particular order, and with no claims to being comprehensive (especially with respect to foreign banks, which I am leaving for a later post), this post highlights things I thought were interesting on a first read through of the proposed rule.

1. As Expected, the Proposal Would Apply to All Non-GSIB U.S. Firms with $100 Billion or More in Total Assets

As proposed, the rule would apply to all Category II, III and IV U.S. BHCs and SLHCs, meaning that all firms with $100 billion or more in total assets will be subject to an LTD requirement.

The proposal would also apply to an insured depository institution that has at least $100 billion in total assets and is not controlled by a holding company. (Thus had the rule been in place at the time, it would have covered firms like Signature Bank and First Republic, which operated without holding companies.)

2. Less Expectedly, Firms Subject to the Rule Would be Required to Comply with LTD Requirements at Both the Holding Company and IDI Level.

Last year when the Federal Reserve Board and FDIC requested comment on a potential long-term debt requirement a key question on which they sought input was whether the requirement should apply at the holding company level (such that the holding company would issue debt externally to the market), at the insured depository institution level (conceivably, either through external issuance or issuance to the holding company), or whether any eventual LTD requirement should provide for flexibility by remaining open to both approaches.

In today’s release, the agencies have decided to propose requiring long-term debt issuance at both the holding company (HC) and the IDI level. Furthermore, an IDI that is an affiliate of an IDI subject to an LTD requirement would itself be subject to its own LTD requirement, if the IDI itself would not be subject to the rule on a standalone basis.¹

HC-level LTD would need to be issued externally. IDI-level LTD, for IDIs that are subsidiaries of covered HC, would be issued internally to a holding company. IDI-level LTD for banks not subsidiaries of a covered HC would need to be issued externally to non-affiliates.

3. U.S. GSIBs, For Now, Would Not Be Subject to an IDI-Level LTD Requirement

U.S. GSIBs, though currently subject to an LTD requirement at the holding company level, are not currently subject to an IDI-level LTD issuance requirement, and this proposal would not subject them to one. In this sense, the proposal would subject IDI subsidiaries of Category II, III and IV firms to a rule to which U.S. GSIBs are not currently subject. The agencies include a question in the proposal asking: “What would be the advantages and disadvantages of requiring IDI subsidiaries of U.S. GSIBs to issue specified minimum amounts internal LTD? Should the agencies propose applying the same IDI-level requirements to these entities?”

4. Proposed Requirements Would be Calibrated to be Slightly Less than Those Applicable to U.S. GSIBs

Under the current HC-level LTD rule applicable to U.S. GSIBs, U.S. GSIBs must maintain LTD equal to (i) a percentage of RWAs equal to 6% plus the firm’s applicable GSIB surcharge and (ii) 4.5% of total leverage exposure.

Under today’s proposal, the new HC-level LTD requirement for U.S. Category II, Category III and Category IV firms would be equal to: (i) 6% of RWAs, (ii) 3.5% of average total consolidated assets and (iii) 2.5% of total leverage exposure (if subject to the SLR rule²).

The IDI-level LTD requirement for covered IDIs would be the higher of (i) 6% of the IDIs RWAs, (ii) 3.5% of average total consolidated assets and (iii) 2.5% of total leverage exposure (if subject to the SLR rule).

In comments on last year’s ANPR, banks and their trade associations argued that, if an LTD requirement is going to be imposed, it should be “significantly lower” than that applicable to GSIBs³ because the GSIB LTD rule has been “calibrated based on a capital refill framework designed and applied in the context of the GSIB SPOE resolution strategy.” Oversimplifying slightly, the industry’s argument is that the GSIB LTD requirements were set at a level intended to ensure that the GSIB has enough loss-absorbing capacity to recapitalize all its material entities as contemplated by a single-point-of-entry resolution strategy. U.S. firms in Category II, III and IV have not adopted SPOE strategies, and so, they contend, the amount of loss-absorbing capacity necessary to provide the FDIC with its desired flexibility in pursuing a least-cost resolution should be lower.

In the proposal the agencies disagree, saying that the capital refill framework remains appropriate for calibrating the HC-level LTD requirement, even for firms in Categories II, III and IV:

The proposed eligible LTD requirement was calibrated primarily on the basis of a “capital refill” framework. Under that framework, the objective of the LTD requirement is to ensure that each covered entity has a minimum amount of eligible LTD such that, if the covered entity’s going-concern capital is fully depleted and the covered entity fails and enters resolution, the eligible LTD would be sufficient to fully recapitalize the covered entity by replenishing its going-concern capital to at least the amount required to meet minimum leverage capital requirements and common equity tier 1 risk-based capital requirements plus the capital conservation buffer applicable to covered entities.

With respect to the calibration of the IDI-level LTD requirement, the agencies similarly say:

The proposed IDI LTD requirement has been calibrated so that, assuming a failed covered IDI’s equity capital is significantly or completely depleted, the eligible LTD outstanding would be sufficient to capitalize a newly-formed bridge depository institution with an amount necessary to comply with the minimum leverage capital requirements and common equity tier 1 risk-based capital requirements plus buffers applicable to ordinary non-bridge IDIs after accounting for some balance sheet depletion.

5. The Rule Would Not Tailor the Calibration of Its Requirements for Category II, III or IV Firms

Consistent with the Basel Endgame proposal from a few weeks ago that would apply the same capital requirements to firms with $100 billion across the board (plus, for U.S. GSIBs, a few additional requirements), the LTD proposal would set the same regulatory minimum amount of LTD for U.S. Category II, III and IV firms (and their IDIs), without differentiation across categories.

For whatever it’s worth, the agencies do include a few questions intended to signal they have not completely foreclosed the possibility of additional tailoring. For example:

• Question 4: Are there elements of the rule that should be applied differently to Category IV organizations as compared to Category II and III organizations, and what would be the advantages and disadvantages of such differences in requirements? […]

• Question 6: Should the Board consider increasing or decreasing the calibration of the eligible external LTD requirement applicable to covered entities based on any other factors, such as the level of uninsured deposits at their IDI subsidiaries?

6. Eligible LTD Requirements Would Mostly Track Those Under the Existing TLAC Rule, With Grandfathering of Certain Legacy Instruments

Eligible LTD Requirements

Consistent with the current LTD rule for U.S. GSIBs, eligible external LTD must be unsecured, must have a maturity greater than one year (with LTD with between 1 and 2 years remaining maturity subject to a 50% haircut), must have plain vanilla features, and must be governed by U.S. law.

In addition, in a difference from the current LTD requirement applicable to GSIBs, eligible LTD would need to be issued in a minimum denomination of $400,000. (As discussed below, the proposal also would add this as a new requirement to the existing LTD rule applicable to GSIBs.)

This new minimum denomination criteria is intended to address a question some have raised about long-term debt requirements: if the idea is that LTD holders must be made to bear losses in a resolution, will the government truly have the appetite to take that step if that means imposing losses on ordinary folks?⁴ The agencies explain:

Significant holdings of LTD by retail investors may create a disincentive to impose losses on LTD holders, which runs contrary to the agencies’ intention that LTD holders expect to absorb losses in resolution after equity shareholders. Imposing requirements that will tend to limit investments in LTD to more sophisticated investors will help ensure that LTD holders will monitor the performance of the issuer and thus support market discipline.

The discussion in the proposal as to how the agencies got to the $400,000 number is sort of funny,⁵ but overall this seems unlikely to cause many headaches. Of course, that is a separate question from whether it actually addresses the underlying concern. Sure, this minimum denomination requirement could spare the government from having to impose losses on direct individual retail holders, but what about other politically sympathetic groups who wind up (directly or indirectly) holding TLAC debt?

Legacy Instruments

The proposal would allow certain debt instruments that would not otherwise qualify as LTD to nonetheless qualify, provided that the instrument was issued before the publication of the final rule in the Federal Register. Specifically:

• External LTD issued before that date can qualify as eligible LTD even if it contains otherwise impermissible acceleration clauses or if it is issued with principal denomination that are less than the $400,000 proposed minimum.⁶

• Eligible legacy LTD issued by a consolidated subsidiary IDI of a covered holding company may be used to satisfy the minimum internal LTD requirement applicable to the IDI, as well as to satisfy the minimum external LTD requirement applicable to its parent holding company.

The agencies say this grandfathering is “consistent with the intent of the legacy exceptions that were made available” under the 2016 TLAC rule.

7. SLHCs Would be Subject to the Rule, Including the LTD Requirement

As noted above, the proposed rule would apply to all Category II, III and IV banking organizations, including savings and loan holding companies. The agencies included a specific section of the preamble to the proposal addressing arguments that SLHCs cannot under current law be subjected to an LTD requirement. The agencies believe that they have this authority under HOLA, and conclude that the fact that Section 165 of the Dodd-Frank Act does not mention SLHCs is not an obstacle to imposing an LTD requirement on them.⁷

Section 10(g) of the Home Owners’ Loan Act (HOLA)22 authorizes the Board to issue such regulations and orders regarding SLHCs, including regulations relating to capital requirements, as the Board deems necessary or appropriate to administer and carry out the purposes of section 10 of HOLA. As the primary federal regulator and supervisor of SLHCs, one of the Board’s objectives is to ensure that SLHCs operate in a safe-and-sound manner and in compliance with applicable law. Like BHCs, SLHCs must serve as a source of strength to their subsidiary savings associations and may not conduct operations in an unsafe and unsound manner.

Section 165 of the Dodd-Frank Act directs the Board to establish specific enhanced prudential standards for large BHCs and companies designated by the Financial Stability Oversight Council to prevent or mitigate risks to the financial stability of the United States. Section 165 does not prohibit the application of standards to SLHCs and BHCs pursuant to other statutory authorities.

8. The Rule Also Includes Clean Holding Company Requirements Like Those That Apply to GSIBs Under the Existing TLAC Rule

The proposed rule includes prohibitions on certain corporate practices (clean holding company requirements) similar to those imposed on U.S. GSIBs and certain U.S. IHCs under the 2016 TLAC rule.

Specifically, the proposal would prohibit covered entities from having the following categories of outstanding liabilities: third-party debt instruments with an original maturity of less than one year (short-term debt); QFCs with a third party (third-party QFCs); guarantees of a subsidiary’s liabilities if the covered entity’s insolvency or entry into a resolution proceeding (other than resolution under Title II of the Dodd-Frank Act) would create default rights for a counterparty of the subsidiary (subsidiary guarantees with cross-default rights); and liabilities that are guaranteed by a subsidiary of the covered entity (upstream guarantees) or that are subject to rights that would allow a third party to offset its debt to a subsidiary upon the covered entity’s default on an obligation owed to the third party.

Additionally, the proposal would limit the total value of a covered entity’s (i.e., parent-only, on an unconsolidated basis) non-eligible LTD liabilities owed to nonaffiliates that would rank at either the same priority as or junior relative to eligible LTD to 5 percent of the value of the covered entity’s common equity tier 1 capital (excluding common equity tier 1 minority interest), additional tier 1 capital (excluding tier 1 minority interest), and eligible LTD amount. The proposed prohibitions and cap would apply only to the corporate practices and liabilities of the covered entity itself.

The agencies say these requirements “provide benefits independent of the resolution strategy of a covered entity” and so make sense to apply to Category II, III and IV firms as they do currently to GSIBs.

9. The Rule Would Phase In Over Three Years

The requirements discussed above would be phased in over a period of three years. Holding companies and their IDIs would need to meet 25 percent of their LTD requirements after one year, 50 percent after two years, and 100 percent after three years.

10. The Agencies Say the Rule Could Have “Substantial” Benefits; Also Acknowledge Potential for “Moderate” Increases in Costs

The agencies include a cost-benefit analysis section in which they conclude that the proposal is “likely to moderately increase funding costs.” The agencies also believe, however, that the increase in loss absorbing capacity that would result from the rule would reduce costs to the DIF and increase the likelihood of least-cost resolutions in which all deposits are transferred to an acquiring entity. The agencies argue that “experience in recent bank failures suggests that these benefits could be substantial.”

LTD Shortfalls

In their approach to quantifying the potential need for firms to raise additional long-term debt, the agencies use two different approaches. One looks at the current⁸ reported principal amount of LTD issuance and takes that as a reasonable proxy for baseline levels of LTD that covered firms would maintain even in the absence of a final rule (“incremental shortfall approach”). The other assumes that covered firms would, without the proposed rule, not maintain any eligible LTD at all (“zero baseline approach”).

The agencies estimate that, in total, covered firms will need $250 billion of external LTD to meet the requirements of the rule ($130 billion for Category II and Category III firms and $120 billion for Category IV firms).

Under the incremental shortfall approach, the agencies estimate that banking organizations are currently around $70 billion short (Category II and Category III firms have a $20 billion shortfall; Category IV firms have a $50 billion shortfall).

As for whether the market will be able to easily absorb this new debt, the agencies estimate that the annual issuance market for LTD, including that issued by GSIBs, would need to increase by five to seven percent. If you exclude GSIBs from that calculation, then non-GSIB annual issuances will need to increase anywhere from 16 to 24 percent.⁹

Funding Costs

Based on the above analysis, and again using the incremental shortfall approach, the agencies estimate Category II and III firms will experience an estimated pre-tax annual funding cost increase of approximately $460 million, “representing a two-basis point permanent decline” in net interest margins. Category IV firms would incur additional funding costs of approximately $1.1 billion, “representing a five-basis point permanent decline” in net interest margins.

Estimated increases in funding costs are a bit higher under the zero baseline approach, and the agencies say that the expected funding cost is likely to fall in between the two.

As for who will bear this “moderate range of funding cost impacts,” the agencies sort of shrug, but believe the effects will be similarly limited.

An increase in funding costs associated with the rule may be absorbed to varying degrees by stakeholders of covered entities and covered IDIs, including equity holders, depositors, borrowers, employees, or other stakeholders. Covered entities and covered IDIs could seek to offset the higher funding costs from an LTD requirement by lowering deposit rates or increasing interest rates on new loans. Alternatively, the higher funding costs could indirectly affect covered entities and covered IDIs’ loan growth, or result in some migration of banking activity from covered entities and covered IDIs to other banks or nonbanks. The modest to moderate range of funding cost impacts presented above suggests a similarly limited scope for these types of indirect effects.

Reduced Deposit Assessments (In Theory…)

One possible small upside for banks newly subject to a long-term debt requirement would be a slight decrease in deposit insurance assessments - “the FDIC estimates that the proposed rule could result in reductions in deposit insurance assessments for the covered IDIs of approximately $800 million per year, in aggregate.”

But banks should not get their hopes up. The FDIC says in the very next sentence that it intends to “consider revisions to its large bank pricing methodology, including the treatment of unsecured debt and concentrations of uninsured deposits.”

11. The Proposal Also Would Make Changes to the Existing TLAC Rule

The proposal includes changes to the TLAC rule adopted by the Federal Reserve Board in 2016 that are intended to “harmonize provisions” and “address items that have been identified through the Board’s administration of the rule.”

Some of these changes are likely to be welcomed by GSIBs or are unlikely to have much practical impact. For example, the Board says it now has “gained experience with agreements that may constitute QFCs” and has concluded that some of these agreements “may not present the risks intended to be addressed by the clean holding company requirements.” So holding companies will now be able to enter into underwriting agreements, fully paid structured share repurchases, and certain employee and director compensation arrangements, subject to the conditions described in the rule. In addition, as noted above, the $400,000 minimum denomination requirement for LTD that has been proposed for Category II, III and IV firms would also under the proposal apply to LTD that a GSIB seeks to use LTD to meet TLAC requirements.

Other changes, however, might be at least slightly more annoying.¹⁰ Most notably, the proposal would modify the treatment of eligible LTD under the TLAC requirement such that eligible LTD for TLAC purposes would (as it currently is for LTD purposes) be subject to a 50% haircut when it has a remaining maturity of between one and two years. The proposal estimates that this would result in a reduction of $65 billion (or 2.7%) in overall aggregate TLAC currently held by firms subject to the 2016 TLAC rule. Even after this change, though, the staff believes that all firms subject to the 2016 rule would “meet or nearly meet” their TLAC requirements.

12. There Is A Relatively Short Turnaround Period for Comments

Comments on the LTD proposal are due by November 30, 2023. This is the same comment deadline as the deadline for the Basel Endgame proposals released last month, which the agencies described at the time as “more than 120 days for public comment.”

On the subject of comments, the agencies acknowledge that the nearly 80 comments they received on the LTD ANPR were mostly opposed to, or at least raised concerns about, the proposal. The agencies note rather pointedly, however, that “most of the comments were received prior to the recent bank stress events involving SVB, SBNY, and First Republic and therefore did not take those events into consideration.”

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Thanks for reading! A post later today will discuss the other proposals released this morning. In the meantime, please feel free to send any comments to bankregblog@gmail.com

1. So for example if you imagine a company that has two IDI subsidiaries, one with $125 billion in total assets and the other with $30 billion in total assets, that second smaller IDI would also be subject to the rule.

2. Currently Category IV firms are not subject to the SLR, but the agencies’ Basel Endgame proposal would change this and apply the 3% SLR requirement to all firms with $100 billion or more in total assets.

3. That quote is from a BPI comment letter; see also for example U.S. Bancorp’s comment letter on the proposal: “If a long-term debt requirement is adopted for regional banking organizations, the calibration for regional banking organizations without significant nonbank assets should be no more than 2.5 percent of risk-weighted assets”.

4. See, e.g., comments from Better Markets on the ANPR, opposing LTD requirements for this (and several other) reasons:

TLAC holders that are not large, interconnected financial institutions may be individual retail investors (directly or indirectly through brokerage accounts, mutual funds, and pension funds). Rather than having their debt investments converted to potentially worthless equity as a bank fails, there would be intense political pressure to not saddle these investors with losses, increasing the chance the failing bank would be bailed out.

5. The agencies explain that $400,000 is the “median value of the total portfolio of directly-held bonds for households that had at least one bond and had household incomes in the 90th to 100th percentiles.”

The agencies also say that they thought about setting the minimum denomination at $100,000, which would “likely result in well over half of retail investors not participating in the market for direct purchases of eligible LTD.” The agencies note that “the median value of the total portfolio of directly-held bonds for households that had at least one bond in 2019 was $121,000” and thus the agencies believe it is “possible but unlikely that a household that directly holds an aggregate amount of individual bonds equal to this $121,000 figure would include within such holdings any eligible LTD instruments because, in that case, the minimum denomination associated with the eligible LTD instrument would cause such instrument to represent nearly the entirety of such bond holdings.”

6. For the few IDIs that will need to issue debt externally, instruments that are not contractually subordinated to general unsecured creditors will also be grandfathered in.

7. The footnote here referring to Section 401(b) of the EGRRCPA is a provocative choice. See FN 24 on page 23 of the PDF of the proposal.

8. To avoid distortions that could have been driven by the Q4 2022 release of the ANPR or the spring 2023 banking stress, the agencies use time series averages from Q4 2021 to Q3 2022.

9. Later on, the agencies say that “there is a risk that efforts by covered entities and covered IDIs to issue a large volume of LTD over a limited period could strain the market capacity to absorb the full amount of such issuance if issuance volume exceeds debt market appetite for LTD instruments.” They then say in a footnote, however, that “the agencies’ estimated eligible external LTD shortfall is a small to moderate fraction of the average total annual bank LTD issuance.”

10. In addition to what is discussed in the text, there are also new proposed disclosure templates that are intended to help “market participants fully understand the creditor hierarchy.” Holding companies subject to the TLAC rule would need to “disclose information regarding the TLAC HC’s creditor ranking individually and in aggregate at the TLAC HC’s resolution entity” by identifying and quantifying “liabilities and outstanding equity instruments that have the same or a junior ranking compared to all of the TLAC HC’s eligible LTD, ranked by seniority in the event of resolution and by remaining maturity for instruments that mature.”