Federal Banking Agencies Propose Long-Term Debt Requirements for Large Banks

In Short:

The Situation: The Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation (collectively, the "Agencies") have proposed rules requiring certain large banks and their holding companies to issue long-term debt ("LTD") and to comply with other associated requirements.

The Result: If finalized, the proposals would extend and expand requirements that are already applicable to U.S. global systemically important banks ("G-SIBs") to all banking organizations with $100 billion or more in consolidated assets, with the intention of increasing orderly resolution options in the event of failure. 

Looking Ahead: The proposals specify eligible LTD, provide legacy treatment for certain types of existing LTD, and give covered entities a three-year transition period.

The Agencies have proposed rules requiring certain banks and their holding companies to maintain a minimum amount of LTD. In addition, the rules would: (i) establish "clean holding company" requirements intended to improve resolvability; and (ii) impose regulatory capital penalties (via capital deductions) on banks holding each other's debt to reduce interconnectedness and the potential for contagion.

The proposals would apply to banking organizations with $100 billion or more in consolidated assets, but not to G-SIBs, as the latter are already subject to LTD requirements at the holding company level. This extension of regulatory requirements that are currently applicable only to the G-SIBs to smaller banks is consistent with other recent proposals from the Agencies that would eliminate differential treatment among the Federal Reserve's tiered categories II, III, and IV. Unlike the G-SIB requirements, however, the Agencies propose to apply LTD requirements at the bank level in addition to the holding company level. 

The proposals would require covered holding companies and their bank subsidiaries to maintain a minimum amount of eligible LTD equal to the greater of: (i) 6% of risk weighted assets; (ii) 3.5% of average total consolidated assets; or (iii) 2.5% of total leverage exposure if subject to the supplementary leverage ratio rule. This amount is calibrated to be sufficient to capitalize a bridge bank formed to facilitate the resolution of the issuing bank. Because the Agencies have separately proposed wholesale changes to the methodologies used to calculate risk weighted assets, which may change substantially before they are finalized, or which may not be finalized at all, it may be difficult for affected banks or other market participants to predict actual LTD amounts with precision. In general terms, a bank with a holding company would issue its LTD to its holding company, while holding companies and banks without holding companies would issue debt directly to the market. 

To be eligible, the LTD must, among other things: (i) be paid in and issued directly by the issuer; (ii) be unsecured; (iii) be "plain vanilla" instruments with no "exotic" features (i.e., no structured notes, contractual provisions for conversion into or exchange for equity, credit-sensitive features, or acceleration clauses); (iv) have a maturity of greater than one year from the date of issuance; (v) be governed by U.S. law; (vi) be issued in a minimum denomination of $400,000 (for debt issued to the market rather than to a holding company); and (vii) be contractually subordinated so that the claim represented by the LTD in the receivership of the bank would be junior to deposit and general unsecured claims.

The Agencies estimate that covered firms will need to maintain approximately $250 billion of LTD under the proposals. To help close this gap, legacy LTD would count towards the required minimum, including, for example, instruments with otherwise prohibited acceleration clauses or principal denominations less than $400,000 or instruments that are not contractually subordinated to general unsecured creditors. Even with these accommodations, however, the Agencies estimate banks will need to issue an additional $70 billion in LTD to comply with the proposals. And banks will need to replace legacy LTD with eligible LTD (almost certainly at higher interest rates) as the former matures.

The proposals' clean holding company requirements would have a significant impact on the structure of a holding company's existing liabilities. Designed to promote resiliency and minimize knock-on effects of failure, the Agencies would prohibit covered holding companies from having any of the following liabilities: 

  • Third-party debt instruments with an original maturity of less than one year; 
  • Third-party qualified financial contracts; 
  • Guarantees of a subsidiary's liabilities that give counterparties cross-default rights; and 
  • Liabilities of the holding company that are guaranteed by a subsidiary or that are subject to rights that would allow a third party to offset its debt to a subsidiary upon the holding company's default on an obligation owed to the third party. 

The proposal would also limit the amount of a holding company's ineligible LTD liabilities that rank either the same priority as, or junior to, eligible LTD to 5% of 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 combined impact of these requirements will likely drive more balance sheet homogeneity, notwithstanding the very diverse business models of the banks subject to them, whether directly or indirectly. That is, the proposals will drive some banking organizations to operate with more debt funding and less deposit funding (or other funding)—or offer different types of debt—than they would otherwise, reducing diversity of approaches to liabilities and funding sources among banks. 

In altering the liability structure of banks, the Agencies also intend to alter the behavior of uninsured depositors. Specifically, requiring a "substantial layer of liabilities that absorbs losses ahead of uninsured depositors could [] reduce[] the likelihood of those depositors running" since the LTD "would be available to absorb losses that may otherwise be borne by uninsured depositors and certain other creditors of the [bank] in the event of its failure." In effect, a bank-level LTD requirement may be used to reallocate some or all losses from uninsured depositors in a failure to the LTD holders. In contrast, under the Federal Deposit Insurance Act's least-cost requirement, the Federal Deposit Insurance Corporation ("FDIC") may and often is required to impose losses on a failed bank's uninsured depositors, unless the systemic risk exception is invoked. By introducing another tranche of loss-absorbing capital in the form of bank-issued LTD, the FDIC gives itself additional flexibility to protect uninsured depositors from losses. Uninsured depositors at banks subject to the LTD requirement may conclude that their deposits will likely be protected in full by the FDIC in a failure scenario notwithstanding the explicit limitations of the current Federal deposit insurance scheme.

The public comment period closes November 30, 2023.

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