Last November, the Financial Stability Board (FSB) presented its consultation document on Total Loss Absorbency Capacity (TLAC). The document is a response to the request of G20 leaders to enhance the loss-absorbing capacity of global systemically important banks (G-SIBs) in resolution. It presents a term-sheet with requirements for TLAC.

The document looks heavy-handed because of its tough capital requirements. It is also complex, because it needs to fit many jurisdictions. As a result, it may crumble under its ambitions.

I am therefore skeptical: the consultation document on TLAC looks unfinished and compromised by political interests, the term sheet contains features that look odd, the hard 20% TLAC requirement seems a bit Gung-ho. As a result, the document raises some important questions, which I decided to split into three: good questions, bad questions, and ugly questions.

Good questions.

These questions are about the calibration of the TLAC requirements. The minimum TLAC requirement is currently set at 16-20% of Risk-Weighted Assets. This in addition to Basel III buffers and surcharges. The problem with this minimum requirement is the lack of rigorous empirical support. Why 16-20%, why Risk-Weighted Assets instead of total assets or the leverage ratio exposure measure?

This lack of empirical support has important consequences. Firstly, it will spook banks, who will now hurriedly seek to issue TLAC. This is disruptive, and may lead to inefficient and costly TLAC issuances. The high costs may deplete cash and equity, which is actually not what a prudential supervisor wants. Banks should preserve cash and aim to increase equity.

Secondly, the lack of empirical support for the calibration weakens the authority of the FSB proposal. Consequently, countries may decide to ignore the proposal. For example, countries that cleaned up their banking sectors after previous crises, e.g. many countries in the Asia Pacific region, may choose to lower their commitment to the TLAC proposal. Australia, for example, has recently shown its appetite for bail-in is nil.

Another good question is about the buyers of TLAC. The FSB proposal bans global systemically important banks from holding TLAC, this to minimise the risk of bank failure contagion. Fair enough. However, who else should buy? Some market regulators may ban retail investors from holding TLAC, like the FCA did in August last year with CoCos. As result, TLAC may end up being issued to a small group of investors. This of course increases the cost of TLAC for issuers. Again, these costs are a drain on bank capital and liquidity.

To gain credibility on TLAC, the FSB should prioritise addressing these questions.

Bad questions.

These questions are about the technical specifications of the TLAC proposal. For example, why does the TLAC proposal exclude senior unsecured debt, where the European resolution directive includes them (see Article 45.2 of the BRRD)? Why does the proposal require TLAC to be subordinated to items excluded from TLAC? Why the expectation that the minimum Pillar 1 TLAC requirement shall be met with at least 33% debt?

These questions can be very distracting. Addressing them may be very time-consuming and wasteful. However, if not properly addressed, they may force banks to engage in all sorts of costly activities, like setting up holding companies, even though more efficient solutions for the resolution of global systemically important banks may exist.

Where relevant, the FSB should step back and think again: do we really need this rule to make orderly resolution of G-SIBs work?

Ugly questions.

These are the questions about the practical application of TLAC: what if push comes to shove? We cannot know the answers now, but prior experience and the responses of authorities to recent bank failures in Europe make me worry. Prior experience with writing down CoCos tells me that regulators (and academics) pay far too little attention to what actually happens after resolution actions happen. In practice, resolution is not the end of trouble, it is the beginning of it. It always ends in tears. Legal action will follow, and this will only get worse if the rules are complex and ambiguous.*

The idea of TLAC is to bail-in the holders of bank equity and bank debt instruments, i.e. to stop bailing out failing banks. However, over the last couple of years, some investors were bailed in (those of SNS, Bank of Cyprus), some were bailed out (those of Banco Espirito Santo, Düsseldorfer Hypothekenbank). The direction therefore is mixed – the application of the bail-in powers may depend on the country, politics, it may vary over time. In addition, the European resolution framework (BRRD) offers countries discretion regarding the implementation of the BRRD in national legislation, which leads to inconsistencies, and may therefore undermine the authority of the European resolution framework. If a framework cannot be relied on, then we are back to square one, and bail-out will be on the menu as ever before.

Answering these questions may reveal the Emperor’s new clothes. Nevertheless, if addressed properly, TLAC may stand a chance.

*My post on CoCos documents many issues that limit the effectiveness of conversion or write-down.