The answer to too big to fail, it appears, is more debt.
On Monday, global financial regulators proposed a new rule that they think will protect governments from having to bail out big banks. The rule will require the biggest banks in the world to raise $1.2 trillion in a new type of debt that can be used to cover losses or be written down or wiped out if a bank needs to be wound down. The new international rule follows a similar regulation introduced in the U.S. in late October. But the international version appears to be more strict, as it requires big banks to raise more of this new type of debt than the one proposed in the U.S.
The international rule, which was drawn up by the Financial Stability Board in Basel, Switzerland, will be applied to the world’s largest banks, which include JPMorgan Chase, Bank of America, Wells Fargo, and Citigroup, in addition to HSBC, Deutsche Bank. The largest banks in China, like the Industrial & Commercial Bank, may also need to comply with the proposed regulation.
The proposed rules, both the American and international versions, get around a sticky situation that regulators have contended with since the financial crisis. Regulators want banks to have more capital to cover bad loans and other losses they may incur. Typically, banks use equity to cover such losses. Bond holders don’t like to take losses, although that happens sometimes. But when they are forced to take losses, they tend to run in mass, causing problems.
Stock holders are looking for higher returns, and they realize that taking on the risk of losses is part of the deal. The easiest way to get more loss-absorbing capital is to sell more stock. But banks don’t like to do that, because it can hurt their stock price and it’s generally considered an expensive way to raise money.
So regulators have decided to force banks to sell a new type of debt that will explicitly cover losses in a situation where a bank’s equity is wiped out. The buyers of such debt would understand that they too are on the hook and would not run if their debt was written down. The proposed international rule requires banks to have Total Loss Absorbing Capital, or TLAC, equal to 16% of their assets, after adjusting for risk.
Will the new debt securities end big bank bailouts? Bloomberg is skeptical of the plan. It’s a workaround and, like all workarounds, it has flaws. The special debt, because it is riskier than traditional bank debt, will likely have higher interest rates and will thus be more expensive for banks to raise than traditional bank debt. Then again, it will not likely be nearly as expensive as equity. Stock holders will still have to absorb a bank’s losses first.
Regulators were smart to basically ban banks from buying up the loss-absorbing debt of other banks. (They could but it would require them to raise even more of these new securities.) During the financial crisis, banks were often the biggest bond holders of other banks. Still, someone is going to have to take on the risk of these new securities. And during a financial crisis, regulators are often loath to force anyone to take losses for fear of contagion.
Also, there is a concern that the new rules will result in less lending, though there’s not a lot of evidence for that.
Regulators have pushed banks to raise far more equity than they did before the financial crisis. And banks are now much better capitalized than they were before. But it looks like regulators have decided that they have reached their limit in how much straight equity they can get the banks to raise. So they have turned to a new type of debt to do the trick. Is it better than equity? Probably not. Is it better than doing nothing? Probably. Bank regulation, like all regulation, is a mixture of the ideal and the possible.