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The 2023 Banking Crisis: Lessons about Bail-in

The FDIC could have saved $13.6 billion in the recent failures of three large banks if regulators had earlier held the banks to the total loss-absorbing capacity (TLAC) standard, based on reasonable assumptions.

The FDIC could have saved $13.6 billion in the recent failures of three large banks if regulators had earlier held the banks to the total loss-absorbing capacity (TLAC) standard, based on reasonable assumptions.

Over the past few months, US regulators resolved three large, failed banks: Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank. The FDIC estimated that coverage of uninsured depositors, discounts on the purchase price of the banks, and potential losses on the assets it assumed would cost its Deposit Insurance Fund (DIF) a total of $31.5 billion, roughly half of which it will recoup later from other large banks.

We estimate that the FDIC could have saved $13.6 billion by imposing losses on other creditors of the failed banks if US regulators had held the banks to a modified version of an existing international standard known as total loss-absorbing capacity, or “TLAC,” based on reasonable assumptions (Figure 1).

Under the 2016 TLAC standard agreed by the Basel Committee on Banking Supervision, regulators began requiring the world’s largest banks to maintain a minimum level of long-term, unsecured debt to complement their regulatory capital. Together, this debt and regulatory capital (equity) represent a bank’s TLAC. If a bank’s losses exhaust its capital, the additional layer of debt can be “bailed-in,” that is, converted to equity, providing an additional cushion against the bank’s insolvency.

The presence of TLAC facilitates the open-bank resolution of bank holding companies. Regulators now expect the largest bank holding companies to have resolution plans under which they can enter bankruptcy without shutting their banking and investment banking subsidiaries. TLAC complements these plans because it recapitalizes these subsidiaries and keep them open.

Currently, US regulators require all banks to meet minimum capital requirements. But they only require eight global systemically important banks (G-SIBs) to meet the TLAC requirement, which includes the layer of long-term debt on top of capital. In late 2022, US regulators proposed extending the rule to the five or so additional domestic banks with greater than $250 billion in assets.

In the wake of recent bank failures—all three of which were below this $250 billion threshold—the Biden Administration renewed calls to apply the long-term debt requirement to more US banks. On a recent earnings call, PNC Financial CEO Bill Demchak said, “TLAC, I think, is a certainty at this point” for his $550 billion bank, yet uncertainty remains about “how much it will be and whether it’s varied as a function of size and complexity of a bank.” Although regulators have not yet proposed a new threshold, FDIC Chair Martin Gruenberg noted at the time of the 2022 proposal that the agency was considering the challenges posed by banks with $50 to $100 billion in assets. In 2019, Paul Tucker, former Deputy Governor of the Bank of England, and former FDIC Chair Sheila Bair submitted a letter to Jerome Powell and FDIC Chair Jelena McWilliams, encouraging them to impose long-term debt (LTD) requirements on all US regional banks. There is now growing speculation that regulators could seek to apply the rule to the 20 or so domestic banks with more than $100 billion in assets.

The regulators’ proposal last year did not provide details about how they might adjust the TLAC rule to smaller banks. The recent bank resolutions offer an opportunity to study how a revised rule might have worked if it were already in place.

Background: Basel standards, international variations, and size-based tailoring

Under the Basel TLAC standard, G-SIBs are required to hold an additional cushion on top of their minimum regulatory capital requirements. In addition to common equity, TLAC includes unsecured debt with a remaining maturity of more than one year, so long as that debt is subordinated to deposits and other excluded liabilities. As of 2022, a G-SIB’s total TLAC under the Basel standard should be the greater of (1) 18% of its risk-weighted assets (RWAs)—that is, the bank’s loans, securities, and other assets, weighted to reflect the risk of loss to the bank—or (2) 6.75% of its leverage exposures—that is, the bank’s total assets and off-balance sheet exposures.

Beyond these minimum standards, implementation varies by country. The US applies a minimum 18% of RWA and 7.5% of leverage exposures—again, though, only to G-SIBs. The Basel standard also sets an expectation that LTD will form at least one-third of the TLAC requirement (see page 3 of the standard). Following Basel, the US requires its G-SIBs to have 6% of RWA in LTD, or one-third of the 18% requirement.

Unlike the US, the EU requires all banks to meet a minimum requirement for their own funds and eligible liabilities, or “MREL,” and regulators vary this requirement by the size of the bank. With some minor exceptions, liabilities qualifying for MREL are the same as TLAC: long-term, unsecured debt with at least a year of residual maturity. The primary difference is where those liabilities fall in the creditor hierarchy. For example, unlike TLAC, MREL includes some liabilities, such as senior preferred bonds, that rank pari passu with protected liabilities, such as common claims.[1]