Safe to Fail?

On 10 November 2014, the Financial Stability Board (FSB) launched a consultation1 on the adequacy of the loss-absorbing capacity of global systemically important banks (G-SIBs) in resolution. The Basel III minimum capital requirements for banks have already been implemented in many jurisdictions, including in Europe by virtue of the Capital Requirements Regulation and in the United States in July 2013. These rules require banks to hold certain amounts of different types of loss-absorbing capital, expressed as a percentage of their total risk-weighted assets – common equity Tier 1 capital of at least 4.5%, total Tier 1 capital (common equity Tier 1 + additional Tier 1) of 6% and total combined Tier 1 and Tier 2 capital of 8%.

On top of these minimum capital requirements, Basel III also prescribed the maintenance of capital buffers – a capital conservation buffer and, in certain circumstances, a counter-cyclical capital buffer. Failure to maintain the required levels of buffers leads to restrictions on payments of dividends and discretionary remuneration. The capital conservation buffer must be at least 2.5% of risk-weighted assets, the counter-cyclical capital buffer can be up to 2.5% of risk-weighted assets, and both buffers must consist of common equity Tier 1 capital.

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Safe to Fail?

On 10 November 2014, the Financial Stability Board (FSB) launched a consultation1 on the adequacy of the loss-
absorbing capacity of global systemically important banks (G-SIBs) in resolution. The Basel III minimum capital
requirements for banks have already been implemented in many jurisdictions, including in Europe by virtue of the
Capital Requirements Regulation and in the United States in July 2013. These rules require banks to hold certain
amounts of different types of loss-absorbing capital, expressed as a percentage of their total risk-weighted assets –
common equity Tier 1 capital of at least 4.5%, total Tier 1 capital (common equity Tier 1 + additional Tier 1) of 6%
and total combined Tier 1 and Tier 2 capital of 8%.
On top of these minimum capital requirements, Basel III also prescribed the maintenance of capital buffers – a
capital conservation buffer and, in certain circumstances, a counter-cyclical capital buffer. Failure to maintain the
required levels of buffers leads to restrictions on payments of dividends and discretionary remuneration. The
capital conservation buffer must be at least 2.5% of risk-weighted assets, the counter-cyclical capital buffer can be
up to 2.5% of risk-weighted assets, and both buffers must consist of common equity Tier 1 capital.
In addition to the Basel III minimum capital and capital buffer requirements, the FSB has prescribed additional
common equity Tier 1 capital requirements for those banks considered to be G-SIBs in a range of between 1% and
3.5% of risk-weighted assets. In its latest list of banks considered to be G-SIBs as of November 2014,2 30 global
banks are named and assigned to various different levels (or “buckets”) of required additional capital. This
additional loss absorbency is to be implemented by way of an extension of the normal capital conservation buffer
of 2.5% that applies to all internationally active banks. In the United States, the largest banks also are subject to a
supplemental leverage ratio.
Total Loss-Absorbing Capacity (TLAC)
However, the FSB remains concerned that bank supervisors and markets need to have confidence that
systemically important banks are truly no longer “too big to fail” and are resolvable without the use of public
funds. It considers that, in order to have confidence that these firms have sufficient capacity to absorb losses,
before and during resolution, there needs to be an internationally-agreed standard on an appropriate level of total
loss absorbing capacity for G-SIBs.

1 “Adequacy of loss-absorbing capacity of global systemically important banks in resolution” – 10 November 2014
– http://www.financialstabilityboard.org/wp-content/uploads/TLAC-Condoc-6-Nov-2014-FINAL.pdf.
2 http://www.financialstabilityboard.org/wp-content/uploads/r_141106b.pdf.

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The FSB’s consultation paper contains a set of principles intended to ensure that there is sufficient loss-absorbing
capacity available in a bank’s resolution, such that the resolution authority can minimise any impact on financial
stability, ensure the continuity of critical functions and avoid exposing tax payers to loss. It also contains a term
sheet with more detailed proposals for implementing those principles in the form of an internationally-agreed
standard.
Although maintaining adequate levels of loss-absorbing capacity cannot by itself guarantee either the non-failure
of the bank or that a bank resolution would be effective, it is recognised as a vital piece of the framework for
ensuring a successful resolution of a failing bank. In Europe, the Bank Recovery and Resolution Directive (BRRD)
has now come into force and is to be implemented into national laws of EU member states by 1 January 2015,
except for the bail-in provisions which are to be implemented by 1 January 2016. The BRRD includes a
requirement for national authorities to establish minimum requirements for own funds and other liabilities that
can be “bailed in” to absorb losses. The concept is that a bank should be funded by a minimum level of liabilities
that are either designed by their terms to absorb losses, or can be made to absorb losses, in each case either by
way of conversion of the liability into an equity instrument or by the permanent writing down of the principal
amount of the liability.
In the United States, the Federal Deposit Insurance Corporation (FDIC), in December 2013, also published a
notice on its approach to single-point-of-entry (SPOE) resolution, in which it sought comments on the amount
and characteristics of loss-absorbing capacity that should be required to be held at the bank’s holding company
level in order for this approach to be successful.
Under the SPOE approach in the United States, the bank holding company of a systemically important financial
institution (SIFI) would be placed into FDIC receivership. The FDIC would then transfer the SIFI’s assets,
including any investments in its subsidiaries, to a newly formed bridge financial company. The failed holding
company’s secured liabilities and possibly limited unsecured liabilities would also be transferred to the bridge
financial company. Shareholders’ equity, senior unsecured debt and subordinated debt of the failed holding
company would not be transferred to the bridge financial company and would remain as claims of the failed bank.
In order to ensure the effectiveness of the SPOE approach, the Federal Reserve has for some time been working
with the FDIC to formulate a long-term debt requirement at the bank holding company level. Federal Reserve
Governor Tarullo has explained that, “while minimum capital requirements are designed to cover losses up to a
certain statistical probability, in the even less likely event that the equity of a financial firm is wiped out, successful
resolution without taxpayer assistance would be most effectively accomplished if a firm has sufficient long-term
unsecured debt to absorb additional losses and to recapitalize the business transferred to a bridge operating
company. The presence of a substantial tranche of long-term unsecured debt that is subject to bail-in during a
resolution and is structurally subordinated to the firm’s other creditors should reduce run risk by clarifying the
position of those other creditors in an orderly liquidation process.”
How Much Loss-Absorbing Capital?
The proposed approach of the FSB is to require a minimum level of capital that can absorb losses on both a going
concern and a gone concern basis. This will include the capital that is held to satisfy the Basel III minimum
capital requirements, but will exclude capital held as part of the Basel III capital buffers, such as the capital
conservation buffer (and the G-SIB extension of this buffer) as well as the counter-cyclical capital buffer.
The FSB proposes, firstly, that the minimum Pillar 1 TLAC requirement should be in the range of 16 to 20% of
risk-weighted assets. This would mean that a global bank that falls in the 2.5% bucket of the G-SIB buffer would
have to hold TLAC of between 21% and 25% of its risk-weighted assets, assuming no counter-cyclical buffer
applied. Authorities would also be free to set additional, institution-specific Pillar 2 requirements on top of these.

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Secondly, the Pillar 1 requirement should also be at least twice the Basel III Tier 1 leverage ratio requirement. The
Basel III leverage ratio requirement, instead of looking at a ratio of capital to risk-weighted assets, measures an
institution’s Tier 1 capital against its total (non-weighted) assets and off balance sheet exposures. As currently
proposed by Basel, between 1 January 2015 and 1 January 2017, a leverage ratio of 3% will be tested, with a view
to the final, calibrated leverage ratio being in full effect from 1 January 2018. Therefore, if the leverage ratio
remains at the proposed 3%, the FSB’s proposals will mean that, in addition to the G-SIB holding TLAC of
between 16 and 20% of its risk-weighted assets, capital would also need to be at least equal to 6% of the G-SIB’s
total non-risk-weighted exposures plus off balance sheet exposures.
The FSB intends that a breach of the minimum TLAC requirement should be dealt with by bank supervisors as
severely as a breach of minimum regulatory capital requirements.
As stated above, the required minimum levels of TLAC will include capital that already counts towards the G-SIB’s
minimum Tier 1 and Tier 2 capital requirements, but the FSB has stated that it expects that at least 1/3 of the
minimum Pillar 1 TLAC requirement will be satisfied in the form of debt capital instruments and other TLAC-
eligible liabilities that are not regulatory capital. The FSB’s reason for this specification is not immediately clear.
These kinds of liabilities are no more loss-absorbing than other TLAC. In fact those that do not constitute
regulatory capital are likely to rank senior to regulatory capital in the statutory insolvency pecking order.
Location of TLAC Within Group Structures
The financial crisis demonstrated the truth of the maxim “global in life, national in death”, when applied to
international banking groups, or in other words that, in contrast to the international nature of its operations, the
responsibility for its failure falls on the authorities in its home state. This can create an incentive for regulators in
the jurisdiction of incorporation of a material foreign bank subsidiary to require as much capital as possible to be
held locally by that foreign subsidiary, so as to be available to ensure a successful resolution of that entity in the
event of its failure.
The FSB’s consultation therefore also sets out proposals for where TLAC should be held within the group structure
of a G-SIB. Firstly, relevant authorities should determine their preferred resolution strategies and identify which
entity within the G-SIB group their resolution tools would be applied to (a “resolution entity”). This may be the
top-level parent, an intermediate holding company or a subsidiary operating company. Whichever it may be, a
resolution entity and its direct and indirect subsidiaries are considered to form a “resolution group” within the
G-SIB group. The FSB also acknowledges that within a G-SIB group there may in fact be more than one resolution
group. It therefore proposes that the minimum TLAC requirement will apply to each resolution entity within a G-
SIB group and will be set in relation to the consolidated balance sheet of each resolution group.
In terms of where within the resolution group the TLAC should be held, the FSB proposes that the foreign
subsidiaries of the resolution entity that are material (i.e., that constitute at least 5% of the G-SIB group by risk-
weighted assets, revenues or total leverage, or that are otherwise material to the group’s critical functions), but are
not themselves resolution entities, should be subject to an internal TLAC requirement in proportion to the size
and risk of their exposures. The FSB intends that this “pre-positioning” of TLAC within foreign subsidiaries
should reassure host authorities that there will be sufficient capital available to allow them to implement their
resolution strategy and allow them to ensure continuity of critical functions and maintenance of financial stability.
It therefore proposes that the amount of internal TLAC to be pre-positioned in material subsidiaries should be
equivalent to between 75% and 90% of the TLAC requirement that would apply to that material subsidiary on a
stand-alone basis. This figure, however, is a tentative figure and will be the subject of a quantative impact study in
early 2015, which is intended to assist in the calibration of the Pillar 1 minimum TLAC requirements.

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TLAC-Eligible Instruments
The FSB has not been prescriptive as to what instruments should be eligible to count towards TLAC, but has
expressly excluded certain liabilities. It expects minimum maturity restrictions to be applied, to ensure that
resolution loss absorbency will not be diminished by the withdrawal of short-term funding to an institution in the
lead-up to its failure. It therefore proposes excluding all liabilities of less than one year’s maturity or that are
callable on demand. In addition, the FSB has excluded the following from the list of eligible liabilities:
• insured deposits;
• liabilities funded directly by the issuer of the liability or a related party (unless relevant home and host
authorities waive this exclusion);
• liabilities under derivatives, including securitised derivatives such as structured notes;
• secured or insolvency-preferred liabilities;
• tax and other non-contractual liabilities; and
• any other liabilities that cannot effectively be written down or converted under the laws governing the issuing
entity.
The FSB’s proposed exclusion from TLAC of structured notes and other securitised derivatives should prove
controversial, especially for those containing a prescribed level of principal protection, and European banks would
have been expecting to be able to count such liabilities towards their minimum loss-absorbing liabilities
requirements under BRRD. Given that such securities can, in principle, be bailed-in in a resolution, it seems
difficult to justify not being allowed to count them as bail-inable for the purpose of calculating TLAC.
The FSB states that operational liabilities to providers of critical services should not be included within TLAC, and
in the EU, the BRRD also expressly excludes such liabilities from eligibility for bail-in.
Characteristics of TLAC-Eligible Liabilities
The FSB also stresses that authorities need to possess the necessary legal powers to impose losses on TLAC-
eligible liabilities, without fear of legal challenge or compensation costs. In Europe, the BRRD implements this
requirement by providing resolution authorities with a “bail-in” tool to require conversion or write-down of bail-
inable liabilities, and also enshrines in statute the power of resolution authorities to write down or convert Tier 1
or Tier 2 capital at the point of the bank’s non-viability.
In order to be eligible for TLAC, an instrument must be either:
• contractually subordinated to all excluded liabilities on the resolution entity’s balance sheet, although it may
rank senior to Tier 1 and Tier 2 capital; or
• junior in the statutory creditor hierarchy to all such excluded liabilities; or
• issued by a resolution entity that has no excluded liabilities on its balance sheet, e.g., a holding company.
However, the above does not apply for those jurisdictions in which all of the liabilities excluded from being TLAC,
as discussed above, are excluded from the scope of any bail-in tool and therefore cannot legally be written down or
converted to equity.

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In addition, where a liability eligible for TLAC is subject to set off or netting rights, the FSB states that only the net
amount of the liability should be counted towards the TLAC requirement.
In the same way as for minimum regulatory capital, the FSB states that institutions should require prior
supervisory approval before redeeming eligible TLAC instruments, unless they are being replaced with
instruments of the same or better loss-absorbing capacity and the liability replacement will not impose
unsustainable conditions on the bank.
TLAC-eligible instruments should be governed by the law of the resolution entity’s jurisdiction of incorporation,
or should contain legally enforceable contractual bail-in provisions that recognise the home state bail-in action,
unless appropriate statutory cross-border bail-in recognition provisions apply.
Transparency
The FSB also mandates adequate disclosure, for each material legal entity, on the hierarchy of its different legal
liabilities, so that creditors, investors, depositors, counterparties and customers will have as much clarity as
possible as to whom losses would be absorbed by, and in what order.
Financial Contagion
Due to the interconnectedness of the financial system, the failure of a major financial institution can cause severe
financial stress to other participants in the system and, as a result, the FSB proposes that bank supervisors should
place prudential limits on the ability of banks to invest in liabilities that are eligible for a G-SIB’s TLAC. The
BRRD in Europe similarly prescribes that resolution authorities shall have the power, as part of an EU bank’s
resolution planning, to limit that bank’s investment in liabilities eligible to be bailed-in.
Resolution Funds
The consultation proposes that, subject to certain conditions, including the agreement of the relevant authorities,
if there exist “credible ex ante commitments” from resolution funding schemes to recapitalise a G-SIB in
resolution as necessary to facilitate an orderly resolution, then such commitments may be counted towards the G-
SIB Pillar 1 TLAC. The BRRD in Europe provides for each member state to establish a national resolution fund,
funded mainly from ex ante contributions from its banks. However, the precise circumstances surrounding the
permitted use of this fund, including the minimum levels of other loss absorption that must have first been
effected, proved very controversial during the law-making stage of the BRRD, since this question is linked very
closely to the ability of EU resolution authorities to exempt, on an ad hoc basis, a class of liabilities from being
bailed-in. It remains to be seen to what extent this provision is of assistance to EU G-SIBs.
Emerging Markets
G-SIBs that are headquartered in emerging market jurisdictions are stated not to be subject, initially, to the
minimum TLAC requirements. The FSB has not offered any reasoning for this stance, but based on the most
recent list of G-SIBs, it will mean that the three largest Chinese banks will be exempt from these requirements.
United States
In the United States, as discussed above, the Federal Reserve has been studying a long-term unsecured debt
requirement for some time. In speeches and in testimony, various Federal Reserve representatives have described
it as a “requirement that large financial institutions have minimum amounts of long-term unsecured debt that
could be converted to equity” and as “gone concern” capital. Already, in public remarks, Federal Reserve
Governor Tarullo has noted that the U.S. TLAC requirements are likely to be more rigorous and may permit a

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more limited number of instruments to be issued. This would be consistent with the “super-equivalency”
approach that the U.S. banking agencies have taken in implementing Basel III requirements for U.S. banks. Also,
under the capital rules adopted in July 2013, U.S. banks have far fewer options than do their European
counterparts in terms of the types of financial instruments that are considered eligible for Additional Tier 1 (AT1)
capital.
Europe
The European Banking Authority, on 28 November 2014, released a consultation on its draft regulatory technical
standards (RTS), specifying further criteria to be applied by EU member states in determining a minimum level of
own funds and bail-inable liabilities for each institution under the BRRD. These RTS firstly consider the
relationship between the institution’s going concern capital requirements, on the one hand, and on the other hand
the resolution authority’s assessment of the amount of loss that the bank should be able to absorb (which may be
the same as the overall capital requirements, including buffers, Pillar 2 requirements and backstop capital
measures, prescribed by the bank’s supervisor).
Secondly, they go on to consider how to determine the amount of recapitalisation that would be necessary to
implement any preferred resolution strategy. This may be zero if the bank can be liquidated, or if the bank is to
continue as a going concern, it will include the minimum capital amount necessary to meet the conditions for
continuing authorisation, plus an additional amount determined by the resolution authority to be necessary to
maintain sufficient market confidence in the recapitalised institution.
Market Impact
Although it may be premature, it seems reasonable that market participants may be concerned about the potential
impact of the TLAC requirement on bank securities. For example, just as European investors in the securities of
banks reacted sharply in 2011 when the bail-in regime first took shape, one might anticipate that investors in
senior bank debt might be more focused on spreads. Perhaps the more noticeable impact may be on contingent
capital AT1 instruments given that it may be more difficult to price differences between AT1 securities in a new
capital structure that includes TLAC. Finally, if one considers that the Basel III requirements (both regulatory
capital and the liquidity requirements) are already causing banks to reconsider their capital structures, the
introduction of TLAC and possibly some new measure to reduce reliance on short-term wholesale funding will
certainly lead to a shift in funding costs and in investor behavior.
Timing
Banks would be required to comply with the minimum TLAC requirements as from 1 January 2019, and would be
subject to earlier reporting and monitoring provisions. This timing would coincide with the date on which the
minimum capital, liquidity and leverage requirements of Basel III should be fully in effect. Comments on these
policy proposals of the FSB can be made until 2 February 2015.

Authors
Jeremy Jennings-Mares
London
+44 (20) 79204072
jjenningsmares@mofo.com

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should
not be acted upon without specific legal advice based on particular situations.

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