Loss Absorbency Requirements: Federal Reserve Proposes Loss Absorbency Requirements for U.S. G-SIBs and U.S. Intermediate Holding Company Subsidiaries of Non-U.S. G-SIBs, Projects $120 Billion Shortfall for Covered U.S. G-SIBs

Sullivan & Cromwell LLP - November 4, 2015
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On October 30, 2015, the Federal Reserve approved for publication and comment Proposed Rules that would impose loss absorbency requirements on U.S. G-SIBs (“Covered BHCs”) and U.S. intermediate holding company subsidiaries (“Covered IHCs”) of global systemically important foreign banking organizations.  The Proposed Rules are among the most potentially significant and impactful regulations that have been issued by the U.S. Federal banking regulators in response to the popular narrative regarding the causes and consequences of the financial crisis of 2008. The Proposed Rules, alongside related measures taken by regulators in other jurisdictions, are widely viewed as a major step in addressing the concern that certain large financial institutions would need to be resolved with extraordinary government support and taxpayer expense—that they are “too big to fail”.

The Proposed Rules’ key components include:

  • For both Covered BHCs and Covered IHCs, two separate but related requirements, described in the Preamble to the Proposed Rules as “complementary”:
     
    • A long-term debt (“LTD”) requirement, which requires Covered BHCs and Covered IHCs to maintain an outstanding amount of eligible LTD that is not less than an amount equal to an applicable designated percentage of:
       
      • for all Covered BHCs and Covered IHCs, RWAs,
      • for all Covered BHCs and for Covered IHCs that are subject to the Federal Reserve’s supplementary leverage ratio (“SLR”), total leverage exposure, and
      • for all Covered IHCs only, average total consolidated assets,
with the LTD requirement being the highest amount produced by those calculations; and
  • A total loss absorbing capacity requirement, which requires Covered BHCs and Covered IHCs to maintain an outstanding aggregate amount of common equity Tier 1 capital (“CET1”), additional Tier 1 capital, and eligible LTD (together, “TLAC”) that is not less than an amount equal to an applicable designated percentage of:
     
    • for all Covered BHCs and Covered IHCs, RWAs,
    • for all Covered BHCs and for Covered IHCs that are subject to the SLR, total leverage exposure, and
    • for Covered IHCs only, average total consolidated assets,
with the TLAC requirement being the highest amount produced by those calculations, plus, in each case, buffers equal to:
  • for all Covered BHCs and Covered IHCs, 2.5%, plus
  • for all Covered BHCs and Covered IHCs, any applicable countercyclical capital buffer, plus
  • for Covered BHCs only, the G-SIB surcharge applicable to the Covered BHC under method 1 of the G-SIB surcharge rule.
These buffers must consist only of CET1 effectively excluded from eligible TLAC and “sitting on top”.  Breaching these buffers would result in graduated restrictions on the Covered BHC’s or Covered IHC’s ability to make distributions (including dividends and share repurchases) and discretionary bonus payments.   
  • “Clean holding company” requirements, that, among other things, would:
     
  • prohibit the issuance of third-party short-term debt by Covered BHCs and Covered IHCs,
  • impose a cap—at 5% of the Covered BHC’s TLAC—on the amount of a Covered BHC’s liabilities (including operating liabilities but not including secured liabilities and liabilities ranking senior to eligible LTD) that do not qualify as eligible LTD for purposes of the TLAC requirement, unless those liabilities are senior to the eligible LTD or fall into other specified categories,
  • prohibit both Covered BHCs and Covered IHCs from entering into derivatives or other qualified financial contracts with unaffiliated third parties, and
  • prohibit both Covered BHCs and Covered IHCs from guaranteeing their subsidiaries’ obligations if the beneficiary of the guarantee would have any default right arising from the insolvency of such guarantor.
     
  • A Covered BHC cross-holding deduction requirement, that would require bank holding companies (“BHCs”), state member banks, and savings and loan holding companies with $1 billion or more in total consolidated assets to deduct from their own Tier 2 capital, investments in all unsecured debt securities of Covered BHCs (not just unsecured debt securities that are eligible LTD for purposes of the LTD requirement), subject to (i) the thresholds in the Federal Reserve’s capital rules for significant and non-significant investments in unconsolidated financial institutions that need not be deducted, and (ii) a limited exception for securities held as part of underwriting, but not market-making, activities.
The calibrations for the LTD and TLAC requirements differ between Covered BHCs and Covered IHCs as well as  between Covered IHCs that may be resolution entities and those that may not. 

The Proposal differs in important respects from the Financial Stability Board’s (the “FSB”) TLAC proposal, initially released in November 2014 and expected to be released in final form on November 9, 2015 (the “FSB TLAC Proposal”) as well as predictions by various commentators.  Moreover, the Proposal rejects a number of recommendations advocated by industry participants when commenting on the FSB TLAC Proposal.  Among other things:
  • The FSB TLAC Proposal does not include a separate LTD requirement but, instead, requires that at least 33% of eligible TLAC be long-term debt or other non-capital instruments.The Federal Reserve’s separate LTD requirement is likely to increase the shortfall, compared to the shortfall that would arise under the FSB’s 33% test.
     
  • The Proposal’s definitions of eligible LTD for the LTD differ in certain important respects from those advocated by industry participants. Significantly:
     
    • Eligible LTD of both Covered BHCs and Covered IHCs excludes structured notes, notes not governed by U.S. law, and any Tier 2 debt that does not meet the other eligibility criteria (for example, Tier 2 debt not governed by U.S. law).
       
    • Eligible LTD of Covered BHCs also:
      • excludes (but also subject to the 5% exceptions bucket referenced above) convertible securities (irrespective of whether they otherwise qualify as Tier 2 capital) and any debt that permits acceleration other than upon non-payment or a receivership or insolvency, and debt with a step-up feature, and
      • for purposes of the LTD requirement but not the TLAC requirement, applies a 50% haircut to otherwise eligible LTD that has a remaining maturity of less than two years but more than one year.
         
    • Eligible LTD of Covered IHCs also:
       
      • excludes any instrument that permits acceleration on any event (even in the event of non-payment or a receivership or insolvency),
      • must include a contractual provision providing for cancellation of the instrument or conversion into CET1 upon the Federal Reserve’s determination (and issuance of a related order) that, among other things, the Covered IHC is in default or in danger of default or the FBO parent of the Covered IHC has been placed into a resolution proceeding in its home country, and
      • must be held by the top-tier FBO parent or an intermediate non-U.S. entity that directly or indirectly controls the Covered IHC.
      • Eligible internal LTD of Covered IHCs must represent the most subordinate debt claim in a receivership or insolvency, whereas eligible LTD issued by Covered BHCs could be senior or subordinate debt.
  • Although the FSB TLAC Proposal states that G-SIBs’ holdings of eligible external TLAC of other G-SIBs must be deducted from the investing G-SIBs’ own TLAC or regulatory capital in a manner “generally parallel” to the Basel III requirements addressing cross-holdings of capital instruments, the FSB assigned the Basel Committee the task of developing detailed provisions.The Proposed Rules move ahead of any Basel Committee proposal with detailed provisions that take an approach that is different from that advocated in comments to the FSB in several important respects, including:
     
    • not providing an exception for holdings arising out of market-making activities,
    • making the cross-holding capital deduction applicable to BHCs, state member banks and large savings and loan holding companies (and not just G-SIBs as contemplated by the FSB TLAC Proposal), and
    • bringing within the scope of deductible instruments all non-Tier 2 unsecured debt securities of Covered BHCs, irrespective of maturity or ranking, and not just debt securities included within eligible TLAC as in the FSB TLAC Proposal.
       
In addition to applying the TLAC buffers set forth above, the Proposed Rules also include for both Covered BHCs and Covered IHCs a restriction on dividends and discretionary bonus payments not contemplated by the FSB TLAC Proposal.This additional restriction would prohibit a Covered BHC or Covered IHC from making distributions and discretionary bonus payments in an amount exceeding retained earnings for the previous four quarters unless the entity’s applicable TLAC buffers have not declined as compared to its buffers at the end of the preceding quarter.This could create serious issues for organizations confronting one-time extraordinary charges.

Of particular importance for Covered BHCs, the Proposal does not grandfather outstanding instruments that would not qualify as eligible LTD.  Nor does the Proposal address the consequences for a Covered BHC that is not able to comply with the 5% exceptions bucket because, for example, it has outstanding long-term ineligible debt that does not include redemption provisions exercisable prior to the Proposed Rules coming into effect.

Furthermore, a significant immediate concern is that much of the debt that is currently on the books of Covered BHCs would not constitute eligible LTD if the Proposed Rules are adopted in their current form.  In addition to the securities noted above, even plain vanilla senior debt would be ineligible if it could be accelerated for reasons other than insolvency proceedings or payment default — for example, if the securities provided for an acceleration right upon the issuer’s violation of covenants contained in the securities’ governing instruments.  This restriction, combined with the 5% limitation on non-eligible liabilities, may force a massive restructuring of G-SIBs’ outstanding debt financing in order to achieve compliance.  Starting immediately, Covered BHCs must consider whether to modify the standard terms for new issuances of senior debt to address the status of those securities under the Proposed Rules, particularly if outstanding senior debt securities are not ultimately grandfathered.  Modifications could involve making such new issuances “senior subordinated” (meaning senior to Tier 2 subordinated debt but subordinated to existing and future senior debt, potentially including structured notes, that are not subordinated by contract) or including an early redemption right if under the final version of the Federal Reserve’s rules the new issuances do not qualify as eligible LTD.  Those modifications also will have associated costs.

The Federal Reserve estimates that the eight U.S. G-SIBs that are Covered BHCs would have shortfalls relative to the Proposal’s LTD and TLAC requirements totaling approximately $120 billion and that the increase in their annual funding costs would be in the range of $680 million to $1.5 billion.  It is not clear whether these estimates take into account the actual eligibility of the outstanding LTD of those entities, the just-mentioned balance sheet restructurings, or the loss of liquidity that would result from the lack of an exemption for market-making activities.  In any event, other factors that will affect the ultimate shortfall include the separate LTD requirement, the addition of buffers to the TLAC requirement, and the strict limitations on eligible LTD.  The Preamble also states that the Federal Reserve is assuming those costs will be passed on to consumers in the pricing of products offered by the entities subject to the Proposed Rules.

The Proposed Rules would become effective January 1, 2019, except for increases in the RWA components of the TLAC requirement, which would not apply until January 1, 2022.  The Proposed Rules do not provide for any “grandfathering” of existing debt.

The Proposed Rules and the Preamble are available here, and a memorandum of the Federal Reserve’s staff, including a useful executive summary of the Proposal at pages 2 to 4, is available here.

The Federal Reserve requests comments on the Proposal by February 1, 2016.