In Moody’s latest Credit Outlook, they discuss the impact of the new Total Loss Absorbing Capacity (TLAC) Standard for Global Banks.
Last Monday, the Financial Stability Board (FSB) published its standard for total loss absorbing capacity (TLAC), which sets forth the amount, composition and location of capital and debt required to meet bank recapitalization needs in a resolution. The standard prompts global systemically important banks (G-SIBs) to increase the resources available to absorb losses beyond the regulatory capital requirements and buffers embedded in the Basel III framework, a credit positive.
The TLAC framework aims to ensure that banks maintain sufficient loss-absorbing instruments (both capital and eligible long-term debt) to absorb losses and recapitalize a bank in a resolution without the use of public funds and to reduce the chance of systemic disruption. The TLAC standard applies to the 30 institutions that the FSB designated as G-SIBs, although national regulators might also require non-G-SIBs to conform with the global standard. Firms will be required to meet TLAC standards alongside regulatory capital requirements and buffers set out in the Basel III framework.
The FSB set an initial level of TLAC at 16% of risk-weighted assets (RWAs) and 6% of the leverage exposure (the denominator of the Basel III leverage ratio) starting 1 January 2019. This will rise to 18% of RWAs and 6.75% of leverage exposure starting 1 January 2022. The 1 January 2019 start date should provide banks with sufficient time to reach the required levels.
Chinese G-SIBs have been exempted from the initial TLAC deadlines given the still-low levels of demand among Chinese non-bank investors for fixed-income assets, which constrains the extent to which banks can issue substantial volumes of capital and debt instruments. Nevertheless, Chinese G-SIBs will be required to meet the first benchmark – 16% of RWAs and 6% of leverage exposure – by 1 January 2025, and the 18% of RWAs and 6.75% of leverage exposure requirement by 1 January 2028.
TLAC can comprise a range of instruments, from equity to long-term senior debt. Senior holding company debt should typically be eligible as TLAC owing to its structural subordination. The guideline contemplates the eligibility of senior unsecured bank debt normally ranking pari passu with excluded liabilities such as derivative liabilities and short-term deposits by allowing senior bank debt of up to 2.5% of RWAs in 2019 and 3.5% in 2022 issued by institutions subject to resolution regimes that provide for partial or complete exclusion of the pari passu liabilities from bail-in. However, it remains unclear how the preconditions for the eligibility of senior bank debt would be fulfilled. In particular, the inclusion of such debt must not give rise to material risk of legal challenge under the no creditor worse off principle.
The Basel Committee on Banking Supervision estimated that for a sample of 29 G-SIBs based on last year’s G-SIB list, the average eligible external TLAC ratio at the end of 2014 was 13.1% of RWAs and 7.2% of the leverage exposure. This estimate assumed no bank-issued senior debt would be eligible as TLAC, and revealed that only six banks met the 16% TLAC requirement. The aggregate shortfall to the 2022 TLAC requirements totals €1.1 trillion for all 30 G-SIBs, or €755 billion when excluding the Chinese G-SIBs. For banks subject to operational resolution regimes, which include all US and European G-SIBs, the introduction of TLAC requirements will benefit depositors and other senior unsecured creditors because of a larger cushion available to absorb losses at failure from the issuance of more subordinated securities.
Additionally, other things being equal, a larger layer of any given class of debt will benefit the ratings of that class, given that potential losses would be spread over a larger pool of investors. This could be somewhat offset by an increased reliance on wholesale funding, and a weakening of profitability should funding costs increase. However, we do not expect a material effect on those metrics.
