Introduction
The first article in this series of articles looked at changes made to banking regulation by the Basel III framework, in particular changes to the capital adequacy requirements. It also briefly discussed bank balance sheets.
This article looks at new regulations specifically targeted at big banks with the aim of preventing taxpayer bailouts in future crashes. These are ‘bail ins‘.
The new bail in regulations have predictably led to a forest of acronyms. The most important is ‘TLAC’ (total loss absorbing capacity’) for big banks. The requirements on ‘TLAC Holdings’ ultimately again came from the Basel Committee on Banking Supervision, via a separate standard published in 2016. TLAC, and the roughly equivalent European acronym, MREL (minimum requirement for eligible liabilities), are also discussed in this article.
What is a Bail In?
Bail ins were an idea put forward during the financial crisis as an alternative to bailouts. The idea is to get the shareholders and bondholders to pay for the bank to continue operating, rather than taxpayers. Here ‘bondholders’ means people who have bought bonds issued by the bank: that is, people who have lent the bank money.
The shareholders and bondholders will pay by having the money they’ve given to the bank written off, or in the case of bondholders, possibly converted into shares. More on this later. To do this the bank’s regulator will step in in what is known as a ‘bank resolution’. This only happens when the alternative is that the bank goes bust, or has to take taxpayer’s money to survive.
How Do Bail Ins Help?
One obvious question with this is how a bail in actually helps a bank that’s in trouble. A bank that’s in bad trouble is going to have problems paying its bills. This applies both in the short term because they don’t have enough current available cash, and in the long term as obligations fall due and they no longer have enough assets to generate enough cash to pay. Ultimately it’s lack of cash that causes companies to fail.
A bank can remove all rights for shares currently in issue, but that doesn’t generate any cash. It means the bank won’t have to pay any dividends, but these aren’t mandatory in any case.
Of course, the situation is slightly different with bondholders. The bondholders have lent money to the bank, which they expect to be repaid at the maturity of the bond. They also expect interest payments. If the bank voids the bonds then that does save the bank cash: it won’t have to pay interest payments or repay at maturity.
So why doesn’t our regulator ‘bail in’ by just voiding the bonds and stopping paying the bondholders? The answer is related to what happens if the bank actually goes bankrupt, which is an alternative to this ‘resolution’.
Creditors’ Hierarchy in Bankruptcy
In bankruptcy the people who are owed money are paid in a specific order. In this order the stockholders are close to the bottom, and any bondholder is above them.
This is because of the essential nature of what a stockholder is: they are (usually) the owners of the company, and get a share of all gains or losses after everyone else has been paid. This can either be via a dividend or an increase in value of their stock.
No Creditor Worse Off
So there’s a problem if the regulator just wipes out the bondholders and leaves the stockholders in place. The bondholders have been disadvantaged relative to the stockholders. Buying a bond is a legal contract, so the bondholders can theoretically sue the company for breach of contract in this case. If you’re thinking ‘no bondholder’s going to sue a company that’s nearly bust’ you need to read about vulture funds.
As a result there’s a concept in a resolution called ‘no creditor worse off than in liquidation’, snappily shortened to ‘NCWOL’, or ‘NCWO’. Broadly this means the regulator cannot screw the bondholders without screwing the stockholders first.
Potential Problems with Bail Ins
So for a bail-in to work we need to work out how much debt (the bank’s own bonds) needs to be written off in order for the company to survive, and then first write off all the stockholders and then write off the calculated amount of debt. There are now two further problems.
- Too much debt may be written off
- There may not be enough debt that can be written off
1. Writing Off Too Much Debt
We have to ensure that ‘no creditor is worse off than in liquidation’ (NCWOL, see above). If the bank goes bust then the liquidator sells the bank’s assets and pays off the creditors in order. The unsecured bondholders might not get much, but might get something. If a regulator steps in and voids their bonds completely they may sue the company: the bond contract says that they are entitled to a share of the assets of the company, and that’s a legal contract. Even if the regulator reduces the value of their debt in accordance with some calculation they may sue.
Now, what we want is for the debtholders whose debt we’re writing down to have a claim over their share of the assets of the company. However, we want to stop paying them interest, and don’t want to have to repay the capital. Fortunately there’s something we can give them that reflects this situation: stock.
This is a longwinded way of saying that in a bail-in the regulator usually won’t just void the bondholders’ bonds. Instead the bonds will be swapped for equity. We’ll swap the bonds for shares in the company. Remember we’re writing off the existing stockholders as part of this process. So the bondholders become the new stockholders.
This has the additional advantage that we have recreated an equity ‘cushion’ as described above in the Capital Adequacy section. If we do this right we can create enough of a cushion so that the bank is still compliant with the capital adequacy rules. We can ‘recapitalize’ the bank.
2. Not Enough Debt
Not having enough debt is a genuine problem with bail-ins. As discussed, the intention of a bail-in is to avoid using taxpayer money to save a bank by instead screwing the bondholders and stockholders of the bank. However, for most banks until recently there just weren’t enough bondholders that could be screwed.
Even if bonds had been issued they often had features that meant it was hard to to save money by voiding them. For example, they might be secured against specific assets of the company. This meant that the bondholders would expect the assets to be sold to reimburse them fully in bankruptcy, and no creditor worse off rules would apply again. Or the bonds might have complicated features that made them hard to value and hence more likely to lead to a lawsuit.
The global banking regulators had an easy answer for this though. This was to force the big banks to hold more simple unsecured bonds that can be restructured in a resolution or ‘bailed in’.
Total Loss Absorbing Capacity (TLAC)
New Ratio: the ‘TLAC Ratio’
The regulators wanted to ensure that banks were carrying enough debt that could be voided or converted to equity in a bail in (‘bailed in’). So they created a new ratio like the capital adequacy ratio that banks had to comply with. This says:
Total loss absorbing capacity (TLAC) must be at least a set percentage of risk-weighted assets, where the set percentage is currently (2019) 16% + an amount that varies by bank
Note that the regulators used the same denominator as in the capital adequacy ratio above: risk-weighted assets. Remember that risk-weighted assets largely reflect risky loans that the bank has made.
Lets look in more detail at the numerator of the ratio: total loss absorbing capacity.
Definition of Total Loss Absorbing Capacity
Total loss absorbing capacity, or TLAC, starts with broadly the same capital definition as in the capital adequacy ratio, that is equity plus reserves. To calculate total loss absorbing capacity we then add in bonds that have the characteristics we’ve already described: simple unsecured bonds that the bank has issued, and that could be converted to equity. The regulators specifically excluded regular deposits in bank accounts, and anything complicated or short-dated.
Total loss absorbing capacity is then, sort of, a measure of the total losses a bank can suffer if it’s being bailed in. If it’s lost more than this then theoretically it won’t be able to repay its secured bonds, or its deposits, and a bail in probably won’t work.
Interpretation
The rule in the ‘New Ratio’ section above thus says roughly that the bank must have a fairly large amount of capacity to absorb losses if being bailed in, relative to the amount of loans it has made. Looked at another way, a bank shouldn’t be making more loans it might lose money on if it doesn’t have enough capacity to absorb any losses on them.
For most banks this new ratio has meant they have needed to restructure the bonds they have issued. In particular they’ve had to ensure that enough of their bonds can be included in the total loss absorbing capacity number.
Scope of the Rules: Too Big to Fail
One thing to note here is that these total loss absorbing capacity (TLAC) ratio only applies to the biggest global banks. In fact, in 2018 it only applies to 29 banks. These banks have their own acronym: they are ‘G-SIBs’, which stands for ‘global systemically important bank’.
These are the banks that the regulators think are too big to fail, and hence would need to be bailed out or bailed in if they got into trouble.
Other Additional Regulatory Requirements for Big Banks
Obviously the aim of the TLAC ratio above is to allow a bail in of these big banks. However, note that as well as needing to comply with the TLAC ratio these banks are forced to have higher basic capital adequacy ratios than smaller banks.
Furthermore, there’s also a TLAC leverage ratio with which they have to comply. This ensures they have enough total loss absorbing capacity relative to the usual ‘leverage ratio exposure’ (LRE) definition. This is as before, broadly, the bank’s assets, unadjusted for risk weighting, but adjusted for some off balance-sheet items and derivatives.
In short, overall these requirements are more complicated than just the one TLAC ratio presented above.
Europe
Minimum Requirements for Eligible Liabilities (MREL)
The total loss absorbing capacity (TLAC) requirements only formally came into force at the start of 2019. Initial discussions took place some time ago. In Europe the regulators, notably the Bank of England, jumped the gun and created their own similar requirements. These came into force in 2016.
These are pithily called ‘minimum requirement for own funds and eligible liabilities’ or ‘MREL’. The ‘own funds and eligible liabilities’ part is very similar to the ‘total loss absorbing capacity’ from above. It is equity and reserves (‘own funds’) plus unsecured borrowing/bonds issued (‘eligible liabilities’). The ‘minimum requirement’ is very similar to the TLAC requirement: it is often expressed as a minimum percentage of risk-weighted assets that the own funds and eligible liabilities must represent. There are helpful articles on the internet that discuss the exact differences between TLAC and MREL.
The Key Difference: All European Banks are Affected
Whilst the MREL requirements for banks are very similar to the TLAC requirements there is one crucial difference. The MREL requirements apply to ALL banks in the EU, not just the few big banks that the TLAC requirement applies to. Also regulators in European countries have discretion to vary the requirements based on an individual bank’s circumstances.
In Europe these two overlapping sets of similar requirements are a little confusing. As a result, the regulators are harmonizing them.
Conclusion
This series of articles has briefly examined some of the changes to banking regulation since the financial crisis of 2008. One of the aims of these changes has been to prevent the need for large taxpayer bailouts in future crashes.
As a result of these changes banks are much better capitalized than they were before the crash, do less risky lending relative to their ability to absorb losses, hold more cash and liquid assets, and have issued bonds that can be converted to equity or even voided rather than the taxpayer having to bail out the bank. All of these measures reduce the profitability of banks, and in particular reduce the amount of lending that they are able to do. As with all regulation there is an associated cost.
However, these measures certainly should reduce the need for, or at least the size of, taxpayer bailouts in future banking crises.
Rich Newman 