Federal Reserve looks at way to shift big-bank losses to investors
Washington, October 31
In their latest bid to reduce the chances of future taxpayer bailouts, federal regulators are proposing that the eight biggest US banks build new cushions against losses that would shift the burden to investors.
The Federal Reserve’s proposal put forward on Friday means the mega-banks would have to bulk up their capacity to absorb financial shocks by issuing equity or long-term debt equal to prescribed portions of total bank assets.
The idea is that the cost of a huge bank’s failure would fall on investors in the bank’s equity or debt, not on taxpayers.
The Fed governors led by Chair Janet Yellen voted 5-0 at a public meeting to propose the so-called ‘loss-absorbing capacity’ requirements for the banks, which include JPMorgan Chase, Citigroup and Bank of America.
The eight banks would have to issue a total of about $120 billion in new long-term debt to meet the requirements of the proposal, the Fed staff estimates.
If formally adopted, most of the requirements wouldn’t take effect until 2019, and the remainder not until 2022.
The new cushions would come atop rules adopted by the Fed in July for the eight banks to shore up their financial bases with about $200 billion in additional capital — over and above capital requirements for the industry. And they would be in addition to 2014 rules directing all large US banks to keep enough high-quality assets on hand to survive during a severe downturn.
Combined with the regulators’ previous actions, the new proposal ‘would substantially reduce the risk to taxpayers and the threat to financial stability stemming from the failure of these (banks)’, Yellen said at the start of the meeting.
Stricter capital requirements for banks were mandated by Congress after the financial crisis, which struck in 2008 and set off the worst economic downturn since the Great Depression. Hundreds of US banks received taxpayer bailouts totalling hundreds of billions of dollars during the crisis, including the eight Wall Street mega-banks that became known as ‘too big to fail’ in Washington.
The previously adopted capital and liquidity rules are the ‘belt’ designed to reduce the likelihood of big banks failing, while the new proposal for transferring potential losses to investors is the ‘suspenders’ in case banks do fail, said Oliver Ireland, an attorney specialising in banking law at Morrison & Foerster who was an associate general counsel at the Fed.
Investors will know that if a bank fails, ‘they will be on the hook’ and likely won’t recover the full amount they put in, Ireland said. Higher interest rates paid by banks on the debt they issued beforehand would compensate for the investors’ risk.
The other banks subject to the requirements are Goldman Sachs, Wells Fargo, Morgan Stanley, Bank of New York Mellon and State Street Bank.
In its action on Friday, the Fed was putting forward its piece of a plan proposed by international regulators in November 2014 for ‘loss-absorbing capacity’ for the world’s 30 largest banks. Including the eight US banks, they are considered so big and interconnected that each could threaten the financial system if they collapsed.
US regulators won the power under the 2010 financial overhaul law to seize and dismantle big banks and financial firms that could topple and jeopardise the broader system. The Fed sees a mandate for loss-absorbing capacity as a key to enabling that process. It would put long-term debt into a bank’s holding company that could be converted to stock as an injection of capital — instead of taxpayer funds. If a bank failed under the regulators’ scenario, the holding company would be seized but subsidiaries would be allowed to continue to operate.
Also at their meeting on Friday, the Fed governors set requirements for collateral to cover possible losses that banks have to post for trades in derivatives that are made outside of clearing houses. The Fed joined other US regulators who adopted the requirements last week.
The aim is to cut down on the kind of risky trades that contributed to the 2008 financial crisis. Policymakers have blamed the $600 trillion global derivatives market, which was unregulated before the crisis, for hastening the financial meltdown.
Derivatives are transactions whose value comes from an underlying investment — oil, for example, or currencies, interest rates or stocks. Farmers, airlines and industrial companies use derivatives to hedge against risks. But derivatives have also been used — sometimes recklessly — by financial firms to speculate.