Fed's Final TLAC Rule Will Affect 4 Of 8 Big Banks

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Includes: BAC, BK, C, GS, JPM, MS, STT, WFC
by: Long/Short Investments

Summary

The Federal Reserve Board rolled out its final total loss absorbing capacity (“TLAC”) rule last week, with compliance among global systematically important banks (“GSIBs”) required by January 1, 2019.

Four of the eight GSIBs will require further capitalization under the new rule.

This will dilute existing stakeholders to an extent, but is generally a positive event for senior debtholders through the capital buffer the regulation is designed to provide.

Thesis

The Federal Reserve Board's finalization of its total loss absorbing capacity ("TLAC") rule will require four of the eight global systematically important banks ("GSIBs") to increase their capitalization ratios to ensure compliance. Although the Fed did not public release the names of the institutions, Wells Fargo (NYSE:WFC) is believed to be among the four and take up approximately half of the cumulative shortfall. If Wells Fargo and the other three banks issue securities to meet the stipulations (with compliance required by January 1, 2019), this will be dilutive to existing stakeholders. Nonetheless, the compliance costs relative to earnings are expected to be relatively small.

This is also positive for senior creditors generally, given the capital buffer the regulation works to create will enhance the resolvability of GSIBs and reduce the risk associated with the most senior parts of each bank's capital structure.

Overview

Last week, the Federal Reserve Board announced it had established an official TLAC requirement to regulate US GSIBs. In the field of bank resolution and recovery, TLAC refers to the maximum losses a bank could take without falling below regulatory capital stipulations that would necessitate recapitalization or resolution. TLAC can refer to equity or longer-term subordinated/mezzanine debt, senior unsecured debt, and other unsecured liabilities that must be held against a bank's assets.

Both equity and specific forms of eligible long-term debt that can be written off or converted into equity to allow for a successful recapitalization or resolution process and ensure the firm's critical operations remain functional upon failure. The rule applied to US and foreign banks with US operations without the necessity of taxpayer-provided funds.

Equity is naturally the preferred form of capital given it denotes the value of the firm to its owners. However, given that in certain circumstances equity gets zeroed or close to it, the long-duration debt will serve as a capital source that can absorb losses, withstand a bank's failure, avoid depletion, and convert into new equity to help restore the institution's equity capital base.

Naturally the goal is to mitigate the chance of a broader systemic failure by ensuring a sizable capital buffer. In the event a failure does occur - as the probability can never be technically reduced to zero (nor would it be healthy for the institution to excessively rein in its risk-taking) - the burden will fall on investors rather than depositors and taxpayers.

The Fed's new TLAC standards will help establish a clearer bank resolution process, which helps to prevent losses and thereby preserve value. The biggest beneficiaries of the new guidelines are systematically important banks'* senior creditors due to the higher capital requirements that have been instituted.

*(The eight systematically important banks include Bank of America (NYSE:BAC), BNY Mellon (NYSE:BK), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), Morgan Stanley (NYSE:MS), State Street (NYSE:STT), and Wells Fargo.)

The TLAC and long-term debt ("LTD") requirements are calculated in two forms - one relative to the GSIBs risk-weighted assets and one according to a bank's leverage exposure as defined by Basel III regulatory framework (which takes into account on-balance sheet assets and off-balance sheet arrangements such as over-the-counter derivatives, cleared derivatives, repo-style transactions, and other forms of off-balance sheet exposures).

Also, in order to qualify for TLAC or LTD, the security cannot possess any attached acceleration covenants, or clauses that demand full loan repayment if certain conditions are not met. Exceptions apply in the event these covenants relate to payment failure or insolvency of the firm or holding company.

The rule also stipulates that the LTD must be issued under US law. Given that most of the debt in GSIBs would be in violation of this requirement, any and all debt that was issued before December 31, 2016 will be grandfathered in, as will any debt with acceleration covenant attachments that are not allowed under the final rule. This is also a positive development for GSIB senior creditors, as it reduces the vast complications that would occur had the new issuance stipulations required immediate compliance.

The proposal mandates that US GSIBs comply with both TLAC and LTD rule by January 1, 2019. Initial full TLAC compliance was slated for January 1, 2022 based on the original proposal, but was expedited up to the same date as the LTD requirement due to the exemptions negotiated with respect to acceleration clauses and foreign-issued debt. Moreover, the Fed Board also declared that principal-protected structured notes and trust preferred securities do not qualify under the new rule, given trust preferreds are not issued by the holding company and contain a level of sophistication beyond what is desired by regulators.

Despite these added regulatory requirements, the Fed has estimated that by the end of Q3 2016, four of the eight GSIBs would need to raise additional equity or long-term debt before the January 1, 2019 deadline to ensure compliance with the final rule. The Fed has not publicly specified which firms will need to raise capital. However, it's likely that BNY Mellon, Citigroup, Goldman Sachs, and Morgan Stanley are in the clear based on their current capitalization ratios, likely leaving Bank of America, JPMorgan, State Street, and Wells Fargo subject to additional issuance of long-term debt.

The Fed estimates this figure at about $70 billion, which is just 7.4% of the $951.4 billion in outstanding debt currently on the balance sheets of these firms as of the end of Q3 2016 (source: company filings). Accordingly, complying with the TLAC and LTD requirements in just over two years' time shouldn't represent a major inconvenience for the firm's believed to be affected. At this time last year, the capital shortfall was estimated at about $120 million, which demonstrates meaningful progress.

The improvement can largely be attributed to year-over-year declines in risk-weighted assets and leverage exposures as well as additional issuances of debt and preferred stock that fit the TLAC and LTD stipulations. As a result it's likely that the current $70 billion can be fulfilled with a relatively low cost burden. Stakeholders in Bank of America, JPMorgan, State Street, and Wells Fargo - if they are indeed the four banks in need of capital raising - may see some level of dilution to comply with the requirements. Wells Fargo likely has the largest degree of capital shortfall among the four on the basis of its risk-weighted assets and leverage exposure, consuming an estimated $35 billion of the $70 billion cumulative deficiency.

But all in all, final compliance costs by January 2019 will likely be fairly small relative to aggregate earnings. The Fed provided a fairly broad compliance cost estimate of $0.7-$2.0 billion per year. According to the financial statements of the four institutions believed to be in shortfall, these firms had a trailing-twelve-months' net income available to common shareholders of $58.8 billion. This would put compliance costs at an estimated range of 1.2%-3.4%.

Potential Concerns

The main concern regarding TLAC is the pro-cyclicality of the regulation. When banks suffer losses, the TLAC works to increase capital ratios during a downturn, which could cause banks to lend less and exacerbate an economic slowdown. Contrarily, capital ratios are generally relaxed during an upturn, causing too much lending and overextension of leverage.

But for investors' sake, the more senior the stakeholder, the more robust the benefit.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.