By John Manning – john.manning@internationalbanker.com
The concept of a “bail-in” policy first reached the discussion table as a consequence of the fallout of the global financial crisis. The policy outlines a plan for banks to call on their bondholders to cover a banking institution’s financial shortfalls in the case of a financial crisis, such as that of 2008, before calling on the government for help. In the UK, Bank of England Governor Mark Carney has indicated that G20 policymakers are moving forward with plans to force the world’s “too-big-to-fail” banks to call on bondholders rather than governments to bail them out during financial crises. The world’s top banks would have to hold safety buffers of “bail-in” bonds and capital equivalent to 16 to 20 percent of their risk-weighted assets, a plan of global regulators outlined in announcements made through September 2014. The plan is part of wider efforts to insulate the global financial system from being held hostage by ailing financial institutions in the future. The new measures are key to global efforts aimed at ending the “too-big-to-fail” operational models of many of the largest banks across the globe. More importantly, the regulations are intended to protect taxpayers worldwide from having to direct their tax dollars towards rescuing lenders again. The finer details of the regulation are still under discussion and have been under particular scrutiny by G20 finance ministers as they plan their next discussion agenda.
The initial rules suggested that banks create a separate facility for dedicated bail-in bonds to be written down in cases of financial collapse and bank failures. However, amendments to the regulation now allow for a wider range of instruments to be included in the bail-in buffer in the eventuality of a bank failure. The current form of the plan has outlined a parameter of minimum total loss absorption capacity (or TLAC) for big banks worldwide of 16 to 20 percent of risk-weighted assets and at least twice the Basel III Tier 1 leverage-ratio requirement. This plan signals a diversion in approach from having an entirely separate facility only made up of dedicated bail-in bonds to including a broader range of assets and liquidity.
Cyprus may seem like a one-off case, where depositor funds were seized as part of providing stability to the banking sector. However, similar bail-in policies are now appearing in other nations as a last-resort measure. These rules were pushed into the spotlight when Iceland refused to bail out its banks and depositors several years ago. Additionally, many banks have been found to have been commingling risky derivatives business operations with their depository divisions, despite the objections of the FDIC (Federal Deposit Insurance Corporation), with Bank of America being a prominent example. Many banks are also now insolvent, and this has pushed this piece of regulation to the top of the agenda to prevent such crucially important mistakes from occurring again in the future. Were a crisis to occur in a major European nation, such as Italy or Spain, this would have the potential to lead to a chain of defaults beyond any nation’s control—and far beyond the ability of federal deposit-insurance schemes to reimburse depositors. This regulation is designed to prevent this kind of dramatic shortcoming and the subsequent potential damage to the global financial system.
The new rules essentially restructure the banking system so that creditor funds will be used to support the business of a bank in default, and this will now include using uninsured deposits to recapitalise banks when they are collapsing. Sceptics of this policy suggest that this is not fair to depositors. However, unsecured creditors in all areas of business, both within banking and otherwise, face similar claim structures should the business fail—those funds become the property of the business in question. The FDIC was set up in 1934; before this time, US depositors would lose their funds if and when a bank went bankrupt. Currently deposits are protected only up to a $250,000 insurance limit, and only to the extent that the FDIC has the money to cover the deposit claims or can source appropriate funds. For secured depositors the question of concern then becomes one of whether and to what extent the FDIC is secure, rather than the bank with which the customer is depositing funds. In 2009, the FDIC fund had to pay out $8.2 billion in payments. At this time Chairwoman Sheila Bair assured depositors that their funds would be protected by a substantial credit line backed by the Treasury. However, the FDIC is backed by premiums paid by member banks. These banks are responsible for topping up funds held by the FDIC, and a special assessment was carried out to recover the $8.2 billion, which ended up severely damaging some smaller banks’ balance sheets.
Meanwhile, bulge-bracket banks, such as Bank of America and JPMorgan Chase, have been accused of commingling their risky derivatives portfolios with their depositary holdings; question marks remain as to whether insurance funds should be diverted towards derivatives gambles that have left some banks on the brink of bankruptcy. These two US banks have deposits exceeding $1 trillion, and they both have derivatives holdings with notional values greater than the world GDP. Were these large banks to call on the FDIC, they would risk wiping out the FDIC altogether. This type of banking structure exposes the wider financial system to serious risks. This is because under the Bankruptcy Reform Act of 2005, derivatives counterparties are given preference over all other creditors and customers of the bankrupt financial institution in question—and this even includes preference over FDIC-insured depositors. In 2011 Bank of America Corp transferred trillions of dollars in derivatives-asset holdings (mostly credit-default swaps) from its Merrill Lynch unit to its banking subsidiary. This action was undertaken without regulatory approval and was stimulated by the fear of counterparties, exacerbated by a Moody’s downgrade of the bank. The FDIC opposed the move, making clear that it would be subjected to the risk of insolvency if the BofA in this structure were to later file for bankruptcy. The Federal Reserve approved the move, based on the priority of providing some support and relief for the bank. The Fed was more concerned at the time about a “too-big-to-fail” scenario—concerned that the focus should be on supporting a big bank rather than risk a financial institution going under and setting off a wider financial collapse across the globe.
The FDIC has only approximately $25 billion in its deposit-insurance fund, which is forced by law to maintain a balance equivalent to only 1.15 percent of insured deposits. The Dodd-Frank Act (Section 716) now bans taxpayer bailouts of most speculative derivatives activities. Drawing on the FDIC’s credit line with the Treasury to cover a bulge-bracket bank’s derivatives losses would be equivalent to a taxpayer bailout, which the FDIC’s member banks cannot afford to service. Many EU and US banks threaten to wipe out federal deposit-insurance funds, and this risk is driving the impetus for these “bail-in” policies and rules, which places the burden on the institutions’ unsecured creditors, including depositors, instead of taxpayers.
Under the new bail-in banking rules, 29 major banks that have been judged to be systemically important on a worldwide basis will be forced to issue “bail-inable” bonds, which will convert to equity should a bank get into financial difficulty. This will include global banks such as HSBC, Citigroup, Barclays, JPMorgan Chase, BNP Paribas and Deutsche Bank. A number of bankers are concerned that forcing senior bondholders to cover part of the cost of future bank rescues may stifle investor demand for bank bonds and lead to increases in bank-funding costs as liquidity sourcing dries up. If a bank makes a financial mistake then bondholders will essentially become equity holders and be exposed to that risk of liability for recapitalisation. This plan has been put in place to build buffers into the financial system and is also designed to draw the attention and consciousness of bondholders when making their investment choices. Certain advocates of the policy have argued that following the global financial crisis of 2008, bondholders were let off lightly from the creditor burden as these parties essentially ended up owning government-backed debt securities. Policymakers want to ensure that taxpayers are not liable for this financial-risk exposure going forward.
Mark Carney, who chairs the Financial Stability Board (FSB), has indicated that the specific amount of bail-inable bonds that banks will be required to issue would be outlined more specifically at the G20 Leaders’ Summit scheduled for November in Brisbane. Under current definitions, no Australian banks are classified to be systemically important on a world platform, and it will be up to individual nations and their leaders to decide whether they want to apply a similar approach with their smaller-sized local banks. Putting an end to the “too-big-to-fail” policy that came out of the global financial crisis is one of the key financial reforms on the G20 discussion agenda in Australia alongside key issues of shadow-banking and derivatives-market risks. The central goal is to put in place stabilisers to provide a loss-absorbing capacity within the banking sector. Whether there is a need to have specific bail-inable bonds or a new legal structure to permit a bail-in element of debt structuring will be discussed, while leaders put together a bail-in operation designed to bring stability and economic freedom to the global financial system. Regulators have been reaching agreements towards creating a more flexible approach so as to cater to differences in banking-structure models from nations across the globe, and the proposed new rules for the world’s largest banks is part of a broad plan for improving bank safety after governments had to rescue lenders during the 2008 credit crisis.
The largest banks across the globe are facing consideration by regulators of amendments to regulatory policies regarding capital holdings. These big banks may be able to count surplus capital towards the new buffers of special bonds being imposed by regulators. For the moment the rule has been amended so that regulators have agreed that capital banks holding above-minimum global requirements could be counted toward the Gone-concern Loss Absorbing Capacity (GCLAC or simply GLAC) figure. This is a major difference from the original version, which suggested that GLAC be made up of a separate standalone buffer of only subordinated debt that would not be combined or mixed with other bank safety cushions or funds. Should the buffer minimum level be breached then regulators will be notified through a trigger system. The regulator will then intervene into bank operations so as to ensure that the lender restores buffer-holding levels. The measure will for now apply to the 29 big banks that the FSB has assessed as applicable and who already have been forced to hold more capital than their smaller banking peers by a 2019 deadline. After the November G20 meeting, there will be a further stage of public consultation to help set a range for the GLAC figure, and the suggested range is expected to cover either side of 10 percent or equivalent to the core capital buffer the banks typically already hold. In particular regulators believe that this amount of GLAC would be the minimum needed to rebuild market confidence following a bank collapse.
There is still uncertainty as to how the GLAC requirement will be calculated, with banks being tasked with applying two alternative methods; they will then have to comply with the higher figure. The first method of calculation, which is currently the preferred choice in Europe, calculates GLAC as a percentage of risk-weighted assets—similar to how a bank’s core capital buffer is calculated. The second method of calculation, for which American market participants have shown preference, calculates GLAC as a percentage of a bank’s total assets, similar to the leverage ratio. The majority of bank depositors assume that their deposits are 100-percent safe in their bank accounts and trust bank-operational structures to protect their savings. However, under the new rules, all lenders (including depositors) to the bank have the potential to be forced to “bail in” their respective banks. Under particular risk are pension funds and public revenues. In particular “unsecured creditors” who would take more of a financial hit under the new regulation if a financial failure were to occur will expose pensioners to greater risk. For example, pensioners drawing their pensions from pension funds that have been heavily invested in unsecured bank debt and owners of insurance policies with insurance companies holding unsecured bank debt will be exposed to greater risk.
A further key issue to finalizing the regulation will be the primary goal of restoring and safeguarding trust between parties at home and abroad. Relations between domestic and overseas banking participants need protecting and rebuilding, and the regulation may help. Elements of trust were lost between these parties during the global financial crisis—especially as host regulators put pressure on foreign banks to hold capital locally to protect taxpayers. This action led to increased fragmentation in global capital markets. These kinds of agreements will have positive “knock-on” effects on banking business models over the longer term and will hopefully bring about an end to “too-big-to-fail” approaches. This would prevent further fragmentation of the global financial system for the future. For now, the final date for compliance with GLAC is uncertain all the way through to 2019, which is when other capital requirements come fully into effect. Until then the policy debate and finalisation of regulatory details remains under discussion.
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