The Federal Reserve Board, led by Chairperson Janet Yellen, proposed a new long-term debt and capital requirement level for the "too big to fail" banks at a meeting held on Friday, Oct 30. The board aims to shift the burden of any probable default by big banks to the companies' debt and equity investors, thereby safeguarding taxpayer money from another bailout.
Under the proposed rule, selected banks will be required to include the long-term debt in their respective holding companies' balance sheets. Notably, such debt can be converted into equity in the event of a failure, as this would help infuse the capital required to support critical operations during a crisis.
Target banks include domestic global systematically important banks ("GSIB") as well as foreign GSIBs operating within the U.S.
Notably, Citigroup Inc. C , JPMorgan Chase & Co. JPM , Wells Fargo & Co. WFC , Bank of America Corp. BAC , Morgan Stanley MS , State Street Corp. STT and The Bank of New York Mellon Corp. BK are subject to the new proposal.
Further, while the actual amount required to be raised by such banks remains undisclosed, sources anticipate the debt amount to reach $120 billion.
Per the proposal, domestic GSIBs will be required to maintain a long-term debt balance of 6% of their respective GSIB surcharge of risk-weighted assets ("RWA") or 4.5% of total leverage exposure, whichever is greater.
Additionally, it requires banks to maintain a Total Loss Absorbing Capacity amount of 18% of RWAs or 9.5% of total leverage exposure, whichever is greater.
For U.S.-based operations of foreign GSIBs, long-term debt amount is required to be maintained at 7% of RWAs or 3% of leverage exposure or 4% of average consolidated assets, whichever is greater. Also, required TLAC amount will stand at 16% of RWAs or 6% of leverage or 8% of average consolidated assets, whichever is greater.
Overall, the proposed level of capital requirement will likely increase the loss-absorbing capacity of target banks by 60%. Based on a Reuters report, the set requirements were at par with the banks' expectations.
More importantly, the new requirement comes on top of the need for maintaining sufficient high-quality assets (proposed in 2014) as well as a cushion to raise capital levels by an additional $200 billion, over and above the industry requirements.
According to Yellen, the proposed rule "would substantially reduce the risk for taxpayers and the threat to financial stability stemming from the failure of these banks. This is an important step toward ending the market perception that any banking firm is 'too big to fail.'"
However, given that Federal officials indicated a possible hike in benchmark interest rates in December, raising debt is going to be a major headwind for target GSIBs. Notably, a Bloomberg report quotes Karen Shaw Petrou, managing director at Federal Financial Analytics, as saying, "Big banks have issued a lot of debt under current rates that, when re-issued to comply with TLAC and meet market demands, will cost considerably more."
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