Finalizing one of its last remaining post-financial crisis efforts to improve bank resiliency and avoid tax-payer funded bailouts, the Federal Reserve has approved new capitalization requirements for the largest domestic and foreign banks operating in the United States.

These institutions will be required to meet a new long-term debt mandate and a new “total loss-absorbing capacity” (TLAC) requirement. The final rule applies to domestic firms identified as global systemically important banks and to the U.S. operations of foreign GSIBs.

To reduce the systemic impact of the failure of a GSIB, a bankruptcy or statutory orderly resolution process imposes the losses of a failed GSIB on investors rather than taxpayers as the critical operations of the firm continue to function. Requiring a GSIB to maintain sufficient amounts of long-term debt, which can be converted to equity during resolution, would” help achieve this objective by providing a source of private capital to support the firm's critical operations during resolution,” the Board said in a statement.

“We are putting into place one of the last critical safeguards that make up the core of our post-financial crisis reform efforts,” Chairman Janet Yellen said. “These reforms have been guided by common sense principles: bank shareholders and debt investors place their own money at risk so depositors and taxpayers are well protected, and the biggest banks must bear the costs that come with their size. Specifically, these banks must bear the costs their failure would impose on the financial system and the economy.”

The final rule we are about to consider advances both principles, because it requires systemically important domestic bank holding companies and the U.S. operations of systemically important foreign banks to issue a minimum amount of long-term debt that could be converted into equity to recapitalize a failed institution. Simply put, this requirement means taxpayers will be better protected because the largest banks will be required to pre-fund the costs of their own failure.

Like the proposal issued in October 2015, the final rule establishes a minimum level of long-term debt for domestic GSIBs and the U.S. operations of foreign GSIBs that could be used to recapitalize the critical operations of the firms upon failure. The complementary TLAC requirement will set a new minimum level of total loss-absorbing capacity, which can be met with both regulatory capital and long-term debt.  These requirements will improve the prospects for the orderly resolution of a failed GSIB and will strengthen the resiliency of all GSIBs.

The final rule also will require the parent holding company of a domestic GSIB to avoid entering into certain financial arrangements that would create obstacles to an orderly resolution. These "clean holding company" requirements will include bans on issuance of short-term debt to external investors and on entering into derivatives and certain other types of financial contracts with external counterparties.

In response to comments received on the proposed rule, the Board made several notable changes. The final rule will grandfather long-term debt issued on or before Dec. 31, 2016, by allowing it to count toward a firm's long-term debt requirement even if the debt has certain contractual clauses not allowed by the rule. To count toward a firm's long-term debt requirements, debt issued after that date will need to fully comply with the rule;

While foreign firms' U.S. operations will generally be required to issue long-term debt to their foreign parent, the U.S. operations of certain foreign firms will be permitted to issue long-term debt to external parties, rather than solely to their parent companies, consistent with their resolution strategy.

The long-term debt requirements of foreign firms were slightly reduced from what was provided in the original proposal to be consistent with the treatment of domestic firms, reflecting the expectation that the losses of those firms would slightly reduce their balance sheets and the capital needed for recapitalization.

“Perhaps the most widely shared view in the aftermath of the crisis—in government and around the country—was that we must avoid having to inject taxpayer capital into a failing bank out of fear that its insolvency would bring down the whole financial system,” Fed Governor Daniel Tarullo said.

The requirement for each firm to maintain a minimum amount of long-term unsecured debt issued to unrelated investors “is essential to establishing a credible resolution program,” he added. “The long-term debt required by this proposal would survive the disappearance of a bank's equity and resultant failure, and would be available for conversion into new equity. These identified debt instruments would allow the absorption of losses that the firm might continue to suffer after it fails and thus give assurance that an orderly resolution would be possible. Counterparties, customers, and depositors would have more confidence that they would not bear losses if they continued dealing with the bank.”

Other benefits, he said, include “increased market discipline of the largest banking firms” and helping to reduce run risk associated with short-term wholesale funding.

“Our rule is risk-sensitive so that the amount of long-term debt required will increase with the size and complexity of the banking institution's activities,” Fed Governor Lael Brainard said. “More systemically important financial institutions will be required to hold more long-term debt, thus reinforcing incentives to reduce their systemic footprints.”

“Today's long-term debt requirement, together with rigorous resolution planning and preparedness, the GSIB surcharge, capital stress tests, and liquidity requirements, will decrease substantially the risk that a large financial institution's distress could pose to the broader financial system and help ensure that no banking institution is too large and too complex to fail,” she added. [The new] rule moves us closer to our goal of a safer, more responsible, and more resilient financial system.”

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