Karen Shaw Petrou’s memorandum to the Federal Financial Analytics clients on a cautionary TLAC slap.
TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: November 20, 2015
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The House yesterday voted on strictly-partisan lines in favor of sweeping FRB-reform legislation that in a largely-unnoticed provision subjects the central bank to extensive cost-benefit analysis (CBA) standards. These are meant mostly to throw the Board rulemakings down so deep an analytical hole that they never come out. Chair Yellen thus protested the CBA provisions, but the FRB could bolster its justifiable case by making it far more clear that its rules would work in practice, not just theory. For an example of CBA built to suit, not to measure realistic costs, look no farther than the Board’s proposal for total loss-absorption capacity (TLAC). It justifies the proposal on so many assumptions premised on so much hope as to make it certain that TLAC will have consequences far afield from the FRB’s vaunted benefits. As detailed in our in-depth analysis, the TLAC proposal imposes a series of major demands on U.S. GSIBs and foreign GSIBs rash enough still to do business in these parts. The U.S. approach differs materially from the final FSB TLAC standards, most importantly in the FRB’s decision to demand large amounts of unsecured, long-term debt (LTD) as its buffer against run-risk. The FSB, in sharp contrast, wants TLAC to be equity capital and sees this as a solvency – not liquidity – buffer. Thus, even global regulators are far from united on how TLAC should work even as they all hope it will do the trick when it comes to TBTF.
Although this dissent is an important early warning signal, I will save for another day the debate over whether LTD or equity capital is a robust buffer and what buffers should stand where when GSIBs go bad. The FRB may or may not be right about its approach to TLAC as a run-risk remedy. Take it as a given that TLAC could well be a valuable buffer against bail-out even if it isn’t a cure-all. But, even so, it’s critical to know how much it costs because cost – even if thoroughly warranted by anticipated policy benefit – has real market impact. Without knowing what it is, the FRB runs grave risk that even it isn’t smart enough to know from the start without benefit of rigorous, forward-looking CBA.
In the proposal, there are just a few paragraphs laying out the CBA on which the Board put so much faith at its TLAC meeting. The FRB’s CBA finds that TLAC won’t cost GSIBs all that much because it assumes that most already have lots of equity and lots of eligible LTD. Is this right? The FRB justifies this assumption on grounds that TLAC’s cost has to come from TLAC’s requirements and capital compliance isn’t one of them. However, TLAC’s costs are built on the fundamental FRB structure and thus add to it. If by 2019 one or another GSIB isn’t in full capital compliance – hard for the FRB to contemplate, but almost surely true given the exigencies of the next three years – then TLAC will cost more – and maybe a lot more because a capital-challenged GSIB that has to raise both equity and LTD will be paying a lot for both.
Maybe market-risk premiums warrant these higher costs – capitalism red in tooth and claw says so – but it could well prove that the TLAC requirements for a weaker bank translate into higher funding costs for stronger GSIBs. Think brokered deposits and be afraid.
A second assumption the FRB included in its not-to-worry CBA is that most unsecured GSIB long-term debt is eligible LTD. It readily acknowledges that this isn’t true, but then says that the cost of issuing new LTD to conform existing LTD will be “relatively minor.” How it knows this is not revealed, although perhaps the FRB knows just what interest rates will be in effect when GSIBs need to transform old debt at low rates into eligible LTD at the new ones. If rates are about the same, maybe costs are relatively minor; if old debt turns into eligible LTD at higher rates – the FRB is supposed to be normalizing away between now and 2019 – then relatively minor may well seem relatively minor only to a central bank flush with trillions on its balance sheet.
The FRB’s CBA goes on to numerous other readily-acknowledged assumptions based on seemingly constant interest rates and insatiable market appetite for big-bank LTD. The one big assumption not specified but clearly underlying the FRB’s devil-may-care TLAC conclusion is that higher-cost TLAC – it just has to be higher-cost because of all the conditions that make it eligible – can somehow be used to fund old-fashioned, lower-cost assets.
But, at the end of the day, TLAC is a funding source that GSIBs have to intermediate in just the same way they put all their other deposits and debt to work. Unless TLAC is put in a vault – not proposed – or pre-positioned – suggested but not demanded – it can go for any purpose any GSIB hopes will help it clear the higher net-interest margin hurdle the costly TLAC surely constructs.
Maybe the market will love TLAC – the FRB clearly thinks investors will fork over large amounts of long-term, unsecured debt ready for conversion into equity in a GSIB’s surviving bits and pieces because the surviving bits and pieces will ensure these creditors are no worse off than they would have been in bankruptcy. However, investors have a lot of ways to fund GSIBs – deposits, secured debt, repos, and the like. Since GSIBs have a limited number of assets they can book because of leverage and related capital requirements, they will have to substitute these liabilities with TLAC to meet the FRB’s demands unless they can find more equity capital – see above for how hard this may prove for all GSIBs by 2019. The more TLAC banks issue, the greater the supply and, presumably, the less the demand absent price compensation in the form of higher-interest LTD, compounding overall funding costs as low-cost liabilities are supplanted by TLAC.
If unsecured LTD investors demand a lot more for their money than insured depositors – and I sure would – then higher cost funds have to go either into higher-risk assets or still lower-profit GSIBs. The latter might make some folks happy, but it doesn’t make U.S. finance any safer or U.S. GSIBs any more resilient – quite the contrary, in fact.
FRB stress tests demand that GSIBs put themselves through three wringers: baseline, adverse, and severely-adverse scenarios. The FRB should be as disciplined with itself – running CBA only on happy thinking validates its tough rules but it overlooks real risks under real-world conditions. Secure in its marble bunker, the FRB may think its dissertation-long models take all unforeseen events so fully into account that nothing can go wrong. Without sharing what’s really in the CBA and how its assumptions work under stress, no one else can be so sanguine.