Banks are going to have to stand on their own two feet. Recently, the Federal Reserve Board proposed a new rule that applies to domestic and foreign banks operating in the U.S., considered by the Board as globally systemically important banks (GSIBs) and to the U.S. operations of foreign GSIBs – translation – the big banking guns, the household names.
These institutions would be required to meet a new long-term debt requirement and a new "total loss-absorbing capacity," or TLAC, requirement. The requirements will bolster financial stability by improving the ability of banks covered by the rule to withstand financial stress and failure. Essentially the good news here is that the pressure is being taken off the government and taxpayers if they get in trouble. The phrase "too big to fail" isn’t going to cut it any more.
According to a statement from the Fed, to reduce the systemic impact of the failure of a GSIB, an orderly resolution process should allow a GSIB to fail, and its investors to suffer losses, while the critical operations of the firm continue to function. Requiring GSIBs to hold sufficient amounts of long-term debt, which can be converted to equity during resolution, would facilitate this by providing a source of private capital to support the firms’ critical operations during resolution.
"The long-term debt requirement we are proposing today, combined with our other work to improve the resolvability of systemic banking firms, would substantially reduce the risk to taxpayers and the threat to financial stability stemming from the failure of these firms," Chair Janet Yellen said in a prepared statement at the time of the announcement. "This is an important step toward ending the market perception that any banking firm is ‘too big to fail’."
According to published reports, six of eight big banks (Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and Wells Fargo), would need to raise an additional $120 billion to meet the requirements.
Dr. Oonagh McDonald, an international financial regulatory expert and author of the forthcoming book, Lehman Brothers: A Crisis of Value, sheds light on how the proposed regulations could change things.
"The banks will have to issue $120 billion in new long-term debt by January 1, 2022. Because the banks have to get at least some of the funding through long-term debt, rather than short-term debt, they will have to put up with whatever investors charge the banks to borrow, but because they are so large, it may not push up costs too much," says McDonald.
Ironically, she says, Standard & Poor’s response was that they would cut the ratings of the banks concerned because the government is less likely to bail them out in a future crisis. "They’re on credit watch negative – a 50% chance that their ratings would be cut in the next three months, that could make the cost of issuing debt more expensive."
Two of the banks concerned are so large partly because of their purchases during the crisis or in the run-up to it. "Bank of America saved Merrill Lynch from collapse during the fateful weekend when Lehman Brothers collapsed with the then-government’s knowledge," says McDonald.
JPMorgan Chase bought Bear Stearns at the government’s behest and with government support in March of 2008. "Still, all this rests on the wrong diagnosis," says McDonald.
"Government housing policy led to the financial crisis – the extent of subprime mortgages in June 2008 – over 50% of all mortgages at the time, led to many bank failures. The crisis wasn’t due to ‘casino’ banking, but to the familiar government-sponsored bad lending," says McDonald.
She explains that it wasn’t that banks were too big to fail, but that banks’ assets were concentrated in subprime mortgages and mortgage-backed securities and other derivatives.
McDonald contends that Lehman Brothers, one of the largest banks of the world, did not lead to the failure of any other bank. "Interconnectedness was not the problem. That was the sudden realization that no one knew the value of anyone else’s assets – a destruction of trust, together with the realization that the government was not going to bail out any large bank. All of Dodd-Frank and the designation of all banks and bank holding companies with more than $50 billion in assets as a systemically important institution, is based on that interpretation, but it is the wrong basis."