Bank Resolution under T-LAC: The Aftermath
Charles Goodhart 24 December 2014
The Financial Stability Board’s recent consultative document proposes dividing global systemically important banks into holding companies and operating subsidiaries to be able to insulate the latter from a significant loss. This column poses the question of exactly what will happen following the holding company is liquidated or on paper so as to recapitalise the operating subsidiary – a question up to now unanswered by the Financial Stability Board.
On 10 November 2014 the Financial Stability Board issued a consultative document on the “Adequacy of loss-absorbing capacity of globally systemic important banks in resolution”. The news release stated:
“The Financial Stability Board (FSB) has today issued for public consultation policy proposals comprising a couple of principles and an in depth term sheet on the adequacy of loss-absorbing and recapitalisation capacity of global systemically important banks (G-SIBs).
The proposals react to the decision by G20 Leaders at the 2013 St. Petersburg Summit to build up proposals by end-2014. These were produced by the FSB in consultation with the Basel Committee on Banking Supervision (BCBS) and can, once finalised, form a fresh minimum standard for “total loss-absorbing capacity” (TLAC).”
The objective of the exercise is to make sure that failing G-SIBs could be resolved without either closing down and liquidating essential banking services, or contacting taxpayers for bail-out support. It aims to get this done primarily by dividing G-SIBs right into a holding company (hold-co) and an operating subsidiary (or subsidiaries) (op-co). The hold-co is then necessary to have a sufficiency of loss-absorbing capital (LAC), in order that in case of a significant loss anywhere within the group, the external LAC of the hold-co could be on paper and the hold-co liquidated (if necessary), with the administrative centre thus released transferred, e.g. to the primary operating subsidiary (via internal LAC), to be able to recapitalize the op-co. The theory is that the op-co can soldier on after recapitalization without taxpayer support, providing necessary banking functions. Instead, the recapitalization is usually to be obtained by bailing-in the equity holders and bail-inable creditors providing eligible external T-LAC in the hold-co.
In this Consultative Paper on T-LAC you will find a clear description of the process, before the resolution of a failing bank under these new procedures. And there is absolutely no doubt that it’s a clever and subtle idea. But there is absolutely no account of what might happen following this recapitalisation (of the op-co) has been set up. In a casino game with many rounds, such as for example chess, the expert players are the ones that are trained to believe many steps ahead. Within the bail-in process, the (main) operating subsidiary (the op-co) is intended to continue, which means this is supposed to be always a multi-stage exercise. Yet there is nothing said in this paper about subsequent stages, nor the issues that may arise therein. I raise some queries in what might happen following the initial resolution is triggered.
How about liquidity?
The primary focus of the Consultative Paper is on the provision of sufficient capital by a bail-in of creditors to aid the continuing workings of the op-co. But there isn’t a word about making certain it has sufficient liquidity aswell. Sufficiency of liquidity is in no way assured.
The resolution process will be newsworthy. The entire strength of the banking group could have become undoubtedly impaired when the hold-co is liquidated or drastically on paper. The name and trustworthiness of the bank could have been brought into question. It is likely that the initial result of both informed and uninformed investors (much like Northern Rock) is to flee. In advance, no-one can guarantee that this won’t happen. Without protection from that eventuality in the guise of an associated commitment by the relevant Central Bank to supply sufficient lender of final resort (LOLR) support, the complete exercise stands vulnerable to failing disastrously at the first hurdle.
Because the op-co is solvent by design, there must be no ideological barrier to such LOLR support. Yet there are suggestions that Dodd-Frank (or other constraints) may restrict LOLR support in america. If true (and I am hoping not), this may put the complete approach at risk. If not, then what’s needed for the ultimate paper may be the addition of a sentence such as for example, “With the op-co being thus clearly solvent, its Central Bank will surely stand prepared to meet any resultant temporary liquidity requirement”. Regardless the FSB cannot burke the problem; liquidity provision should be openly discussed.
As noted earlier, with the hold-co liquidated or sharply on paper, the entire valuation and strength of the banking group could have been much impaired. The op-co could have sufficient capital of its, but it won’t have the hold-co as a buffer above it. Thus the op-co will be significantly weaker than all of the competitive banks around it. The op-co alone won’t have the T-LAC support deemed essential for everyone else. What goes on then?
Presumably the op-co cannot then spend dividends or do buy-backs until it could fully reconstitute a hold-co that meets standard requirements? Is this the intention? If so, if the paper not say so? What additional constraints on the next working of the op-co are envisaged? It’ll hardly be easy for the op-co (and/or a residual or new hold-co) to issue new equity or debt unless the constraints and terms under that your resolved entity will subsequently operate are fully and transparently spelt out. The present draft consultative paper takes us in considerable detail up to the original resolution, but is completely silent on life thereafter. What does the afterlife appear to be?
Once a failing bank is placed into resolution, a forensic auditor will without doubt be submitted to estimate the required size of the creditor haircuts necessary to recapitalise the op-co sufficiently. There can hardly be two bites as of this, only if because transactions in such assets will start again after the initial write-downs have already been established. Because of this and other reasons – such as for example uncertainty about the result of the resolution process on market values – my very own expectation is that the forensic auditor will try to err privately of austere caution in such valuations; i.e. to propose larger haircuts than subsequently result in have already been necessary.
It really is of course possible that this is simply not the case, and that the auditor underestimates the required haircuts. This might be particularly likely if the original resolution should grow to be the beginning of a systemic and major financial meltdown. What then if op-co should neglect to repair profitability, and need further recapitalisation? In the Eurozone this possibility is met within the Banking Union by the SRM and ESM. Should there be considered a similar back-stop world-wide?
I want to revert to the more probable outcome – that the proposed haircuts go well beyond what eventually actually is necessary. Will this not start the authorities to legal suit beneath the ‘no creditor worse off’ principle? This possibility could be mitigated giving the bailed-in creditors warrants against such upside recovery. However the more that the upside recovery option would head to reimburse prior creditors, the less the attraction of the equity in the op-co (or the reconstituted hold-co) to new buyers. How is, or ought to be, this balance set? Exactly what will be the proper execution and detail of such warrants?
Pro-cyclicality and contagion?
As argued earlier, the valuations of the forensic auditor will have a tendency to err on the austere side, and the haircuts will be bigger than previously expected based on the last, pre-resolution accounts. The marketplace will be shocked. The bail-inable debt will, almost by definition, have previously been bought by optimists (and the ill-informed), and their optimism will suddenly appear misguided. There should be an excellent chance that, following the first newsworthy resolution, the marketplace for such bail-inable debt will completely dry out for some time period before re-opening at a higher (also to bank CEOs unattractive) yield. What then happens as bail-inable debt rolls over? Will there not be a motivation on all the banks to deleverage sharply in order to avoid the penalties imposed on banks falling short of T-LAC? All regulation is commonly pro-cyclical. Is this not another example where in fact the T-LAC approach would reinforce the cycle and makes the financial sector a lot more susceptible to systemic crisis?
There is some (however, not much) mitigation of the danger from the one-year criterion for (eligible external) T-LAC (Box 11, p. 16). This states that
“Eligible external TLAC will need to have the very least remaining maturity of at least twelve months.
In addition, the correct authority should make sure that the maturity profile of a G-SIB’s TLAC liabilities is adequate to make certain its TLAC position could be maintained if the G-SIB’s usage of capital markets be temporarily impaired.”
This does imply that if another bank is forced into resolution through the period where refinancing roll-overs is impossible – assumed to be significantly less than one year – it’ll still have sufficient T-LAC to recapitalise the op-co. And much bail-inable debt will go through the one-year gateway as will require roll-over refinancing, so measured T-LAC it’s still falling.
You can drive back the contagion and procyclicality that regulatory procedure – alongside almost every other regulation – will probably enhance? You will want to give Central Banks the energy to alter the maturity time period limit for eligible external T-LAC, in order that in a systemic crisis (preferably with such an emergency being called based on a pre-determined metric instead of just discretion), all banks can treat all bail-inable debt right up to final maturity against the T-LAC requirement? Could or if the percentage amount of T-LAC be produced state-contingent? Has any thought been directed at the question of how exactly to counteract the pro-cyclical potentiality of T-LAC, also to the chance that the exercise might worsen instead of enhance the systemic stability of the economic climate?
I am hoping that such thought has been applied, but there is absolutely no sign of the in the consultative document. It requires us up to the occasion of the original resolution but is totally silent on what goes on afterwards. While getting the initial step right is important, if one cannot foresee the likely span of the next stages of the overall game, one will probably lose the next match, and the economic climate and the economy too.