Total Loss-Absorbing Capacity: More Leverage Is No Solution

Following the recent failures of Silicon Valley Bank and Signature Bank, U.S. bank regulators are being encouraged to require that regional bank holding companies (BHCs) issue added debt, which is one component of total loss-absorbing capacity (TLAC), to facilitate the resolution of a bank when it fails. In the original vision for TLAC, if a bank and its parent BHC were to fail, the Federal Deposit Insurance Corporation (FDIC) would take the BHC into receivership and reconstitute it as a new company with its bank subsidiaries remaining in place and operating normally. To facilitate this process, the BHC would be required to have long-term debt available to absorb losses after its equity is extinguished and to recapitalize the subsidiaries sufficiently to continue under a new holding company. The presumption is that such a transition could be accomplished without financial panic or significant government funding and could reduce losses to the FDIC’s deposit insurance fund.

While elegant in theory, in practice TLAC introduces its own brand of instability. Adding long-term debt to the balance sheet will most likely increase a BHC’s leverage and, therefore, its risk. For example, a BHC that has a subsidiary bank capitalized at the relevant regulatory agency’s accepted level could issue debt and downstream the proceeds to the bank as equity. This would raise the bank’s capital above the required minimum. The bank could then upstream the newly created excess capital to the BHC to be paid out in dividends or stock buybacks—a simple means to pay out equity capital. Such an outcome can be anticipated by comparing the average leverage ratio of 6.7 percent at June 30, 2022, for the largest eight U.S. global systemically important banks (G-SIBs) with the average leverage ratio of 9.2 percent for U.S. regional banks. The G-SIBs are required to issue debt, whereas the regionals are not. If neither group is too big to fail, it is worth asking which group is sounder.

No matter a BHC’s financial situation, it must pay interest on that debt component of TLAC or go into default and risk bankruptcy. Thus, when an economic recession occurs and bank earnings are under pressure, the BHC will face the prospect of either having the bank transfer scarce earnings to it and avoid default or retain earnings in the bank to build capital. Unlike dividends, there can be no unilateral suspension of debt interest payments. This outcome is in stark contrast to the notion of the BHC being a source of strength to the insured bank. The irony of such a result should not be lost on policymakers. Rather than encouraging regional banks to add leverage, the financial system would be best served by encouraging BHCs to moderate their consolidated leverage.

There is the possibility that a BHC issuing debt might choose to reduce other liabilities, including deposits, to keep the overall leverage position of the BHC constant. However, this is unlikely, given that subordinated debt is more costly than deposits, requiring greater earnings to service. Thus, the move to long-term debt for TLAC, on net, is most likely to increase BHC leverage, require more bank earnings for debt service, and, therefore, increase the risk profile of the industry.

Also, requiring regional BHCs to carry greater amounts of debt offers no assurance that such debt would prove sufficient to avoid failure at the bank level or avoid financial panic. There is no certainty regarding how much long-term debt is enough to both absorb losses after equity is extinguished and adequately recapitalize the operating subsidiaries. Once losses absorb the subordinated debt, the FDIC or Treasury will find it necessary to provide for any capital shortfall in the subsidiaries. Finally, touting the ability of debt to reduce losses that would otherwise fall to the FDIC fund is misleading. Requiring a comparable amount of equity capital in place of debt would lessen the likelihood of the bank’s failure in the first place, and should it fail, the greater equity position would absorb the same volume of losses as debt. Also, the bank could cease paying dividends on equity to strengthen bank capital without triggering default, but it cannot cease paying interest on its debt without doing so.

To appreciate the potential adverse effects of added debt for TLAC, it is useful to look at the history of trust-preferred securities (TruPS). Before the Global Financial Crisis, regulators permitted firms to issue these instruments at the holding company and to include them as part of the firms’ capital. Although TruPS are essentially long-term debt instruments, it was argued that they would be available to help absorb losses in a crisis, relieving the firms from having to hold equity. As the crisis unfolded, the weaknesses of TruPS revealed themselves as banking firms moved cash from the operating banks to the holding company to avoid default. TruPS placed significant pressures on insured banks to continue making large debt-service payments, which ultimately exacerbated losses to the banking system. As it turns out, Congress eliminated the use of these instruments as part of industry capital when it passed Dodd-Frank.

As an alternative to requiring that BHCs issue debt for TLAC, Congress should insist that the industry, including the largest banks, strengthen equity capital standards. Such a shift in emphasis would raise equity capital levels and better assure the public that banks are safe and sound and that the industry is financially resilient. Regulatory agencies repeatedly give too little weight to the importance of tangible equity held on balance sheets. It is well understood among investors that although leverage may boost short-term returns, it is equity that provides reliable long-term performance and industry resiliency.

Finally, it is often suggested that requiring higher bank capital raises the banking industry’s cost of funding and reduces lending. However, there is competing evidence that shows current risk-based capital standards may do more to discourage bank lending than a higher level of capital. Debt funding is an essential input to economic growth. However, mandating debt over equity as a regulatory tool to enhance banking stability is not good finance and even less useful bank regulation.