Proposed rule on TLAC debt investments

Proposed rule would amend regulatory capital rules to require certain LBOs to deduct certain holdings of debt.

KPMG is issuing this Regulatory Alert to highlight provisions of an interagency proposed rule covering regulatory capital and investments in TLAC-related debt.

Key points

  • The Federal banking agencies’ proposed rule would amend regulatory capital rules to require certain large banking organizations to deduct certain holdings of debt related to compliance with the Federal Reserve’s TLAC Rule.
  • The proposed rule would apply to GSIBs and “advanced approaches” banking organizations (AA Banks); a separate and outstanding proposed rule could raise the applicable total consolidated assets threshold for AA Banks from $250 billion to $700 billion.

The Federal banking agencies (Federal Reserve, OCC, FDIC) jointly proposed to amend their capital rules to require certain large banking organizations to deduct from regulatory capital certain investments in unsecured debt instruments issued by foreign or U.S. global systemically important banking organizations (GSIBs) to meet their minimum Long Term Debt (LTD) or Total Loss Absorbing Capacity (TLAC) requirements (together Covered Debt).* Such investments in GSIB debt are presently subject to a risk-weight of 100 percent and are not deducted from regulatory capital. The proposed rule is intended to reduce interconnectedness and systemic risk.

In particular, the proposed rule would:

  • Apply to GSIBs and “advanced approaches” banking organizations: Generally firms that have $250 billion or more in total consolidated assets or $10 billion or more in on-balance sheet foreign exposure – and their insured depository institution subsidiaries (together, AA Banks). However, the agencies state in the preamble that their “Interagency Tailoring NPR” (see KPMG Regulatory Alert) would amend the scope of “advanced approaches” banking organizations to include only those banking organizations subject to “Category I” or “Category II” standards, which would generally include banking organizations with $700 billion or more in total consolidated assets. The agencies state commenters should consider both proposals together when commenting on this TLAC debt proposal.
  • Treat investments in Covered Debt by an AA Bank as an investment in a Tier 2 capital instrument that is subject to deduction from the AA Bank’s own Tier 2 capital.
  • Require AA Banks to:
    • Use the “corresponding deduction approach,” where the AA Bank would deduct the Covered Debt first from Tier 2 capital, and if Tier 2 capital is insufficient to give full effect to the required deduction, deduct the remaining amount from additional Tier 1 capital and then, if needed, from common equity Tier 1 capital.
    • Fully deduct Covered Debt of “significant investments,” where the AA Bank owns more than ten (10) percent of the issuer’s common stock.
    • Aggregate Covered Debt of “non-significant investments,” where the AA Bank owns no more than ten percent of an issuer’s common stock, with other “non-significant investments” and deduct from regulatory capital any amount that exceeds ten (10) percent of the AA Bank’s common equity Tier 1 capital.
    • Fully deduct investments in its own Covered Debt.
    • Fully deduct investments in reciprocal cross-holdings of Covered Debt.
  • Exclude Covered Debt from the deduction requirement in certain circumstances:
    • Where an AA Bank holds Covered Debt for 30 business days or less and the aggregate amount of the Covered Debt is five (5) percent or less of its common equity Tier 1 capital, the AA Bank may exclude the Covered Debt from the threshold calculation and potential deduction. If the amount is over five (5) percent, different treatments would apply to AA Banks that are GSIB BHCs or subsidiaries of a GSIB and those that are not GSIB BHCs or subsidiaries of a GSIB. For GSIBs, amounts in excess of five (5) percent would be subject to deduction from Tier 2 capital, for non-GSIBs, the excess amount would be included in other non-significant investments.
    • When the Covered Debt is held for 5 or fewer business days in connection with bona fide underwriting activities.
  • Modify the Federal Reserve reporting requirements for U.S. GSIB BHCs and IHCs of a foreign GSIB to publicly disclose their outstanding LTD and TLAC, their LTD and TLAC ratios to ensure compliance with the TLAC Rule, and TLAC buffers.

Comments on the proposed rule will be accepted through June 7, 2019.

KPMG perspectives

The Federal Reserve’s TLAC regulations became effective January 1, 2019. Under these rules, a covered entity’s TLAC consists of its common equity tier 1 capital (excluding minority interest), additional tier 1 capital (excluding minority interest), and eligible LTD. Covered BHCs and Covered IHCs must meet a portion of their TLAC requirements with a minimum amount of eligible LTD.

Financial institutions should consider the impact that this proposal, in combination with their current TLAC strategy, would have on their capital ratios, and subsequent return on (i.e. dividend) and return of capital (i.e. repurchase activity), particularly under the Federal Reserve’s SA scenario. The proposal will affect dividends given that it will likely reduce available retained earnings through increased cost of capital, unless debt is raised elsewhere (though this may still be more expensive than TLAC-eligible debt). Further, the agencies indicate there could be additional costs associated with changes to internal systems or processes in order to facilitate calculation of TLAC holdings.

The agencies state they intend to give further consideration to applying the proposed approach to non-AA Banks that invest in Covered Debt. As such, non AA Banks should consider the impact this proposal would have on their approach to investing in Covered Debt from AA institutions, principally the price of such debt versus other investments against the expected return.

 “*”Covered Debt: Covered Debt subject to the deduction from regulatory capital would include eligible debt securities under the TLAC Rule that do not qualify as Tier 2 capital, and instruments that are pari passu or subordinated to such eligible securities, issued by the top-tier holding company of a U.S. GSIB or the top tier U.S. intermediate holding company (IHC) of a foreign GSIB. In addition, Covered Debt would include any unsecured debt instrument issued by a foreign GSIB or any of its subsidiaries, other than its covered IHC, for purpose of absorbing losses or recapitalizing the issuer or any of its subsidiaries in connection with a resolution, receivership, insolvency or similar proceeding of the issuer or any of its subsidiaries, and any instrument that is pari passu or subordinated to such instruments.