The Federal Reserve plans to rein in the extraordinary bank mismanagement that lead to the financial and economic collapse in 2008.
In a recent 5-0 ruling, the Fed will require 30 of the largest banks worldwide –global systemically important banks (GSIBs) – to maintain significantly more capital on their balance sheets to weather potential losses. The Fed recommends total loss absorbing capital, or TLAC, be set at or near 20 percent of assets, with half coming from equity and the other half from long-term debt provided by investors, which can then be converted to equity.
GSIBs are considered so large and interconnected that each could seriously threaten the solvency of the global financial system if it were to fail.
The thinking here: If some assets, such as loans, turn sour, and if equity capital is insufficient to cover the losses, the investor class will absorb the differential instead of the taxpayers-at-large: hence, a "bail-in" rather than a "bail-out." As compensation for this added risk, the investors will command a higher rate of interest for lending funds to these financial institutions.
The GSIBs include U.S. subsidiaries of the largest global banks and eight U.S. banks: Bank of America, Bank of New York Mellon Corp., Citigroup, Goldman Sachs, J.P. Morgan, Morgan Stanley, State Street Corp., and Wells Fargo. The Fed estimates these banks will need to issue an additional $120 billion in long-term debt to meet the new requirement. An analysis by Barclays Bank suggests Goldman Sachs and Morgan Stanley have already meet this standard, while Wells Fargo may need to issue as much as $86 billion in bonds to conform.
The ruling also requires banks to post collateral to cover losses for derivative trading that are conducted outside exchanges or clearinghouses. Many policymakers blame the $600 trillion global derivative market, which was deregulated by President Clinton in 2000, for hastening the financial implosion due to inadequate margin requirements and a high degree of speculation.
The proposed rule would also apply to the U.S. operations of foreign GSIBs. In this case, the U.S. entity would issue new long-term debt to (or borrow from) the foreign parent rather than selling bonds to external investors. Should a bank fail, the holding company would be seized by the federal authorities, but the subsidiaries would be permitted to continue operations.
If formally adopted, most of the requirements would take effect in 2019, with the remainder in 2022.
This new ruling comes on the heels of rules adopted by the Fed in July for the eight banks to increase their financial assets by about $200 billion in additional capital. This is also above and beyond the 2014 rules directing all large banks to hold adequate quantities of high-quality assets to survive a severe market fall. The banks are also required to pass “financial stress tests” and provide a "living will” that demonstrates how they could declare and proceed through a potential bankruptcy without taxpayer assistance.
The previous rulings have been characterized as the “belt” holding up the pants of the bank, while the new ruling represents the “suspenders” in the event the belt fails.
This policy is a prudent approach that should be implemented immediately.
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