TLAC spells the end of too big to fail

As it turned out we did not have to wait for the G20 Leaders Summit on the weekend to find out what the Financial Stability Board would propose to address the problem of banks that are too big to fail. The FSB released a consultation paper on Monday setting out its proposals to ensure G-SIBs will never be bailed out with taxpayer funds.

In fact, the FSB's proposals should ensure that failure is simply not possible.

The proposals have been developed in consultation with the Basel Committee on Banking Supervision but are in addition to Basel III, and go beyond its minimum capital requirements. For starters, the FSB wants the minimum leverage ratio for G-SIBs set at twice that proposed under Basel III.

This means a minimum leverage ratio of six per cent, rather than three per cent. This is line with the proposal of US bank regulators and goes well beyond the UK's Financial Policy Committee recommendation of 4.75 per cent, made two weeks ago.

Under the Basel III definition of the leverage ratio, a G-SIB's assets, including off-balance sheet exposures, cannot be more than 16.7 times its common equity tier one capital. This will require a massive de-gearing of G-SIB balance sheets.
      
In going beyond Basel III, the FSB introduces the concept of Total Loss-Absorbing Capacity (TLAC). This has been hinted at for some time but now we have the reality.

The FSB is seeking the implementation of a minimum level of TLAC (Pillar 1), but allows for individual regulator discretion to impose additional TLAC requirements (Pillar 2).

The one surprising aspect of the TLAC proposal is the use of risk-weighted assets as the ratio denominator. The use of risk-weighted assets has become increasingly controversial because of the black box approach used by G-SIBs and D-SIBs to determine risk weightings, with the result that two banks can have different weightings for the same risk.

The FSB seems to have ignored this controversy, and perhaps it doesn't matter given the amount of loss absorbing capacity that G-SIBs will need to offset against their risky assets and other exposures.
 
For Pillar 1 requirements the FSB wants to see minimum TLAC levels of 16 per cent to 20 per cent of risk-weighted assets. But if a G-SIB is subject to a one per cent G-SIB capital buffer (under Basel III) then the TLAC minimum increases to 19.5 per cent to 23.5 per cent, and if the G-SIB buffer is set at 2.5 per cent, then the minimum TLAC requirement is 21 per cent to 25 per cent.
 
Then, as previously noted, regulators can set any Pillar 2 requirement they consider appropriate. The regulators that can impose Pillar 2 TLAC requirements include regulators in host countries, such that the impost applies to the G-SIBs operations in the host country.

There is great potential here for a new form of tariff barrier.

So what constitutes TLAC? Regulatory capital as defined under Basel III will provide the base for TLAC but it is expected that at least a third of a G-SIB's TLAC will come from debt that does not constitute regulatory capital.

In other words, this will be senior debt - but senior debt that contains a non-viability clause (contractual non-viability). Thus, there will be two classes of G-SIB senior debt: one that will convert to equity or be written-off in the event of non-viability; and another that will just be simple senior debt.

However, the simple senior debt holders will still be exposed to loss if it occurs in the "normal" course of resolving a failing G-SIB. This however, seems to be contrary to the notion that a G-SIB will have sufficient TLAC to ensure that it cannot fail.

Given the FSB proposals, there may be some of the 30 designated G-SIBs that decide they no longer wish to be a G-SIB and set about breaking themselves up.

As for the remainder, this brave new world of G-SIB banking is not imminent.

The FSB will assess the responses to its consultation paper and the likely economic impact of its proposals, and will make its final recommendations to the 2015 G20 Leaders Summit. Assuming that no significant change results from the consultation process, the TLAC and leverage requirements for G-SIBs will come into effect from 1 January 2019.

In the meantime, David Murray may have had his job done for him, in terms of any additional capital recommendations he wants to make for Australia's D-SIBs.