Bank Resilience: Equity Capital versus Long-Term Debt

The Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Comptroller of the Currency (Agencies) have released a joint proposed rule to impose long-term debt requirements for firms with $100 billion or more in total assets that are not currently subject to such requirements. The Agencies assert that increasing the debt of these banking firms would improve financial stability by increasing the resolvability and resiliency of such institutions.  Such long-term debt would absorb bank losses and would increase the options available to resolve these banks in case of failure. They also claim that requiring this long-term debt would reduce the risk that uninsured depositors would face losses and reduce the speed and severity of bank runs, while limiting the risk of contagion when a bank is under stress.

These are lofty goals.  Who could object to increasing bank resiliency of an industry. Thus, it is surprising that the Agencies are proposing debt as a means to resiliency, especially as both Michael Barr, the Vice Chair of the Federal Reserve and Martin Gruenberg, the Chair of the FDIC highlight the importance of strong capital in assuring the resilience of the industry.  The Federal Reserve’s Vice Chair noted:

Banks rely on both debt and capital to fund loans and other assets, but capital is what allows the bank to take a loss and keep on operating. The beauty of capital is that it doesn't care about the source of the loss. Whatever the vulnerability or the shock, capital is able to help absorb the resulting loss and, if sufficient, allow the bank to keep serving its critical role in the economy. Higher levels of capital also provide incentives to a bank's managers and shareholders to prudently manage the bank's risk, since they bear more of the risk of the bank's activities.

Similarly, the FDIC’s Chair noted:

Maintaining a strong leverage capital requirement as improvements are made to the risk weighted capital requirements is an important principle to insure continued resilience in the U.S. banking system.

Both individuals promote the value of having greater equity in a bank’s capital stack to promote financial stability and resiliency.  That is why their proposal to impose a long-term debt requirement on banks greater than $100 billion is at odds with these statements.  Simply put, increased debt to solve a leverage problem is contradictory to the goal of greater financial stability. 

In rationalizing their position, the agencies cite examples in which banking firms that failed, which issued long-term debt, reduced FDIC losses.  The investors holding the long-term debt absorbed losses that otherwise would have fallen to the FDIC.  Maybe that’s true, but that begs the question, had there been more common equity in those instances would the bank have failed in the first place, and if it had failed with more equity in place, would the losses to the FDIC been greater?  The answer is probably not.  While bank losses at failure can vary widely, they historically average between 15 and 20 percent of assets.   If a bank is required to fund itself with equity equal to its current equity plus the proposed long-term debt amount, FDIC losses would be approximately the same in either case.  For example, U.S. GSIBs fund their total assets with 7 percent equity and approximately the same percent of total loss absorbing long-term debt.  If a GSIB fails, equity plus debt would absorb the same 14 percent of the bank’s losses and the FDIC would absorb the remainder.  However, if the bank relied on 14 percent equity rather than the 7 percent figure, it is less likely to fail which saves the FDIC from taking any losses, and should it fail, the FDIC is no worse off.  Moreover, bank resiliency is not about the FDIC, it is about avoiding failure.  Equity not long-term debt serves that goal best.   

In the recent failure of Silicon Valley Bank, had the capital rules required 15 percent common equity of assets, the bank would have been less likely to grow at a 60 percent annual rate, which contributed to its failure. The bank might also have had less need to raise capital as it announced losses from its government guaranteed bond portfolio, which triggered a bank panic.  To blame the FDIC’s losses on too little debt versus too little equity is simply wrong.  

Another shortcoming of the proposal is its assumption that long term debt is as stable as equity capital within the bank’s capital structure. When a bank or a bank holding company has a significant amount of debt on its balance sheet, that debt must be serviced from bank earnings.  During a recession, for example, even though earnings may be substantially reduced, the interest on the debt must be serviced to avoid default and likely failure.  In contrast, dividends on equity can end and no default is triggered.  Thus, the presence of long-term debt will be destabilizing in comparison to equity.

The disadvantages of long-term debt were described in a 2010 FDIC publication released just after the great financial crisis (GFC).  The FDIC noted that banks had come to include long-term debt, in the form of Trust Preferred Securities (TruPS), within their capital structures.   It emphasized that TruPS were a major source of instability within banking during the GFC, accelerating the pace of bank failures.  It also emphasized that it is equity capital that mitigates the moral hazard risk within the banking industry by ensuring that owners, who reap the rewards when a bank’s risk-taking is successful, also have a meaningful stake at risk should it fail.   And finally, it emphasized that the effect of accumulated interest owed on debt in default interfered with a bank holding company’s ability to raise capital when needed and weakens the institution’s resilience when it is most needed.

Thus, while the FDIC is correct in its efforts to reduce its exposure to losses should a bank fail, it should consider the unintended consequences of policies that mandate leverage to address a problem of a bank carrying too much leverage. 

Finally, the banking industry opposes most efforts to require equity over debt as a source of funding.  GSIBs and the banking industry argue that requiring banks to have more equity funding puts them at a competitive disadvantage with other international banks. But the data fail to support this claim.  For example, as of year-end 2022, European/Canadian and Asian GSIBs were required to have tier I capital which averaged only between 4 and 5 percent of total assets.  U.S. GSIB were less leveraged with tier I capital that averaged 7 percent of total assets.  However, in terms of the market’s reaction to this difference, U.S. banks were the winner.  U.S. GSIBs’ price to book value ratios at that time averaged 1.08, while Europeans/Canadian GSIBs ratios averaged .53 and Asian GSIBs ratio average .4. Moreover, the respective price to tangible book values averaged 1.78 versus .69 and .51.  Investors prefer stronger to weaker institutions and the U.S. continues to dominant the global financial industry.

The industry also insists that to require greater equity as a funding source would significantly raise borrowing costs within the economy.  While there is evidence that borrowing cost would increase, studies also show that the increases are marginal and under a cost-benefit test, the benefit of equity overshadows its cost to the economy. Also, over the economic cycle, banks that are more strongly capitalized are better able to support their lending activities through the entire cycle.

Banking regulators should abandon the mistaken view that requiring banks, either GSIBs or banks over $100 billion dollars, to increase their leverage to reduce FDIC losses when a bank fails is sound policy.  They should do what the market does when the safety net is unavailable to bailout creditors.  They should demand more equity capital, which increases industry resilience and reduces creditor losses if an institution fails.