Total Loss-Absorbing Capacity (TLAC) – FSB and US Federal Reserve developments

Two major developments concerning the regulatory requirements for loss-absorbing and recapitalisation capacity applicable to global systemically important banks (GSIBs) have recently been seen.

On 9 November 2015, the international Financial Stability Board (the FSB), in line with its mandate to promote global financial stability, published its final Principles on Loss-absorbing and RecapitalisationCapacity of G-SIBs in Resolution and a related term sheet (the Term Sheet) setting out internationally agreed standards on TLAC for G-SIBs (the FSB Guidelines).

In a related development, on 30 October 2015, the Board of Governors of the US Federal Reserve System (the Federal Reserve) issued a notice of proposed rulemaking (the US Proposed Rules) in parallel with the development of the FSB Guidelines.

This client publication sets out a brief description of the FSB Guidelines and the US Proposed Rules.

To whom does this apply?

• The FSB Guidelines apply to G-SIBs.
• The US Proposed Rules will affect holding companies of US G-SIBs and US intermediate holding companies of foreign G-SIBs with substantial US operations.

What are the key FSB requirements?

• From 1 January 2019, common minimum TLAC requirements will apply to all G-SIBs except for those headquartered in an emerging market economy.
• Authorities may specify additional firm-specific requirements above the common minimum TLAC.
• In order to be eligible to count towards the requirements, instruments must meet certain criteria. Structured notes and liabilities arising from derivatives are not eligible.
• Additional regulatory capital (e.g. Basel III) requirements must be met on top of minimum TLAC requirements.
• Disclosure requirements also apply.

What are the key US requirements?

• If the proposals are adopted, from 1 January 2019, minimum external TLAC requirements will apply to covered entities.
• Additional buffers would also apply, which must be met with common equity tier 1 capital.
• Long-term debt requirements would also need to be met.
• "Clean holding company" restrictions would apply to covered entities (including, among others, a prohibition on the guarantee by the covered entity of the liabilities of a subsidiary where the insolvency or resolution of the covered entity would trigger a default).

Next steps

• The comment period for the US Proposed Rules ends on 1 February 2016.

FSB Guidelines

Minimum external TLAC requirement
Under the FSB Guidelines, G-SIBs must meet a new minimum TLAC requirement. This is additional to the minimum regulatory capital requirements set out in the Basel III framework and will apply to each "resolution entity" within a G-SIB. Depending on the G-SIB's resolution strategy, a resolution entity may be a parent company, an intermediate or ultimate holding company, or an operating subsidiary. There may be more than one resolution entity in a G-SIB.

The minimum TLAC requirement for each resolution entity will be determined based on the consolidated balance sheet of each "resolution group" (broadly, the resolution entity and its direct and indirect subsidiaries).

The requirements will be phased in as follows:

• from 1 January 2019, at least 16 per cent of the resolution group's risk weighted assets (RWAs) and at least six per cent of the applicable Basel III leverage ratio denominator; and
• from 1 January 2022, at least 18 per cent of the resolution group's RWAs and at least 6.75 per cent of the applicable Basel III leverage ratio denominator.

In addition to the minimum TLAC requirements, home authorities may also apply additional firm-specific requirements.

G-SIBs are expected to meet at least one-third of their requirements with eligible long-term debt (LTD), rather than equity.

TLAC eligibility criteria
In order for an instrument to be eligible for application towards TLAC, it must:

• be issued and maintained directly by a resolution entity (subject to certain exceptions);
• be paid in;
• be unsecured;
• not be subject to set-off or netting rights;
• have a minimum remaining contractual maturity of at least one year or be perpetual;
• not be redeemable by the holder prior to maturity;
• not be redeemable by the issuing G-SIB prior to maturity without supervisory approval if the redemption would lead to a breach of that G-SIB's TLAC requirements;
• be subject to the law of the jurisdiction in which the relevant resolution entity is incorporated or be otherwise subject to the laws of another jurisdiction if the application of resolution tools by the relevant resolution authority is effective and enforceable in respect of those liabilities;
• contain a contractual trigger or be subject to a statutory mechanism permitting the relevant resolution authority to write it down or convert it to equity in resolution;
• not be funded directly or indirectly by the resolution entity or a related party of the resolution entity, except where permitted by the relevant authorities; and
• be subordinated to excluded liabilities by way of contractual, statutory or structural subordination (subject to certain exceptions).

Where an instrument is not TLAC-eligible, it may nevertheless be subject to other bail-in powers under applicable laws (see Relationship to EU Bank Recovery and Resolution Directive below).

Excluded liabilities
Certain liabilities are specifically excluded from TLAC eligibility, including deposits with an original maturity of less than one year, liabilities arising from derivatives, and liabilities arising from debt instruments with derivative-linked features (such as structured notes).

Internal TLAC requirements
Under the FSB Guidelines, "material sub-groups" of a resolution entity (broadly, the direct and indirect subsidiaries of that resolution entity) must maintain TLAC (internal TLAC) of 75 per cent to 90 per cent of the external minimum TLAC requirement that would apply to the material sub-group if it were a resolution group. The actual percentage will be determined by the applicable authority. The liabilities that are excluded from eligible external TLAC (see Excluded liabilities above) are also excluded from internal TLAC, and internal TLAC instruments must be statutorily or contractually subordinated to these.

Emerging market economies
The FSB Guidelines will not apply to G-SIBs headquartered in an emerging market economy until 1 January 2025 (for the initial 16 per cent RWAs/six per cent requirements) and 1 January 2028 (for the higher 18 per cent/6.75 per cent requirement). However, compliance may be required sooner if, in the five years after the publication of the FSB Guidelines, the aggregate amount of the emerging market economy's financial and non-financial corporate debt securities or bonds outstanding (as measured using BIS statistics, excluding issuance by policy banks) exceeds 55 per cent of its GDP, as reported by the relevant national authorities.

Disclosure
The Term Sheet imposes general disclosure requirements on G-SIBs regarding the amount of internal and external TLAC maintained and details of its composition. These disclosure requirements are to be developed by the Basel Committee on Banking Supervision.

Relationship to EU Bank Recovery and Resolution Directive
The EU Bank Recovery and Resolution Directive (the BRRD) entered into force on 2 July 2014 and established a recovery and resolution framework for EU credit institutions, certain investment firms and particular related entities.

The BRRD contains a bail-in tool which EU member states must implement by 1 January 2016. A key element of the bail-in tool is a requirement that inscope entities must maintain at all times a minimum level of own funds (i.e. the sum of tier 1 and tier 2 capital) and eligible liabilities (together known as the minimum requirement for own funds and eligible liabilities (the MREL)).

The aim of the FSB Guidelines is broadly the same as that of the MREL, however there are differences between the two:

• application – the FSB Guidelines only apply to GSIBs but the MREL will apply to all institutions which fall within the scope of the BRRD;
• calibration – the FSB Guidelines provide for a common minimum TLAC, applicable to all G-SIBs, and an additional discretionary firm-specific element, whereas the MREL will be calibrated entirely on a firm-specific basis;
• calculation – minimum TLAC is expressed as a percentage of the resolution entity's RWAs, whereas the MREL is calculated as a percentage of the institution's own funds and total liabilities; and
• eligibility – the eligibility criteria are similar but not the same. For example, liabilities arising from derivatives are not eligible for application for either TLAC or the MREL, but structured notes, while specifically excluded from being TLAC-eligible, are not excluded from application towards MREL.

This, and the subordination requirements, could give rise to a complex internal hierarchy of instruments for G-SIBs, some of which will be either TLAC-eligible or MREL-eligible, and some which could be subject to both regimes.

The European Banking Authority is required to submit a report on the MREL and its implementation across member states to the European Commission by the end of October 2016. One of the issues that the report is required to cover is the consistency of the MREL with similar international standards, which presumably would include the FSB Guidelines. Depending on the content of the report, this may lead to amendments to the MREL provisions of the BRRD to align the two regimes.

US Proposed Rules

Applicability
The US Proposed Rules distinguish between holding companies of US G-SIBs (covered BHCs) and US intermediate holding companies of foreign G-SIBs with substantial US operations (covered IHCs). The lossabsorbing requirement for each comprises a TLAC component and a LTD component. The US Proposed Rules also impose "clean holding" limitations on these entities by restricting the other liabilities that they may have outstanding.

Covered BHC requirements – LTD
Under the US Proposed Rules, a covered BHC would be required to maintain outstanding eligible external LTD in an amount not less than the higher of:

• six per cent plus the applicable percentage surcharge of total RWAs; and
• 4.5 per cent of total leverage exposure.

In order to be eligible, external LTD must:

• be issued by the covered BHC (not a subsidiary);
• not be guaranteed by the covered BHC or a subsidiary and not be otherwise credit-enhanced;
• not be convertible or exchangeable for equity in the covered BHC;
• be unsecured;
• have a maturity of at least one year from the date of issuance;
• not provide for acceleration except on receivership or insolvency, or any failure to pay principal or interest;
• not contain credit-sensitive features such as interest rates that adjust in relation to the covered BHC's credit quality;
• not be a structured note; and
• be governed by US (or applicable US state) law.

Covered BHCs would not be permitted to redeem any such LTD prior to its maturity date without prior approval if the redemption would jeopardise compliance with the LTD requirement.

In determining whether the LTD requirements are met, LTD having a remaining maturity of at least one but less than two years is haircut by 50 per cent and no credit is given for outstanding LTD having a remaining maturity of less than one year.

Covered BHC requirements – TLAC
Under the US Proposed Rules, each covered BHC would be required to maintain outstanding eligible external (i.e. issued to third-party investors) TLAC of not less than the higher of:

• from 1 January 2019, 16 per cent (rising to 18 per cent as of January 2022) of its RWAs, plus an external buffer (which must be met with common equity tier capital); and
• 9.5 per cent of its total leverage exposure under the supplementary leverage ratio rule.

Covered IHC requirements – LTD
Under the US Proposed Rules, a covered IHC would be required to maintain outstanding eligible internal LTD in an amount not less than the highest of:

• seven per cent of total RWAs;
• three per cent of the total leverage exposure (if applicable); and
• four per cent of its average total consolidated assets.

In order to be eligible, internal LTD must:

• be issued by the covered IHC to, and remain held by, a company organised outside the US which controls, directly or indirectly, the covered IHC;
• represent the most subordinated debt claim in a receivership or insolvency of the covered IHC;
• be unsecured;
• have a maturity of at least one year from the date of issuance;
• not provide for acceleration in any circumstances;
• contain a contractual provision, approved by the Federal Reserve, providing for either (i) the immediate conversion or exchange of the instrument into common equity tier 1 of the covered IHC, or (ii) the cancellation of the instrument, upon issuance by the Federal Reserve of an internal debt conversion order;
• not be a structured note; and
• be governed by US (or applicable US state) law.

Covered IHCs would not be permitted to redeem any such LTD prior to its maturity date without prior approval if the redemption would jeopardise compliance with the LTD requirement.

In determining whether the LTD requirements are met, LTD having a remaining maturity of at least one but less than two years is haircut by 50 per cent and no credit is given for outstanding LTD having a remaining maturity of less than one year.

Covered IHC requirements – TLAC
Covered IHCs would be subject to different TLAC requirements depending on whether they were expected to enter into resolution themselves or whether they would be retained as a going concern while a parent was resolved. This would largely depend on where the covered IHC sat in the group structure. Those expected to become subject to resolution would be subject to higher requirements, as detailed below.

A covered IHC would be required to maintain eligible internal TLAC (i.e. internally issued TLAC used to upstream losses) in an amount not less than the highest of:

• 16 per cent or 18 per cent (depending on the status of the covered IHC) of its total RWAs (on a fully phased-in basis);
• six per cent or 6.75 per cent (depending on the status of the covered IHC) of its total leverage exposure; and
• eight per cent or nine per cent (depending on the status of the covered IHC) of its average total consolidated assets.

As with covered BHCs, a TLAC buffer also applies here.

Clean Holding Company Requirements
Under the US Proposed Rules, both covered BHCs and covered IHCs would be prohibited from:

• issuing short-term debt instruments to third parties (including deposits);
• entering into "qualified financial contracts" (e.g. securities contracts, commodities contracts, repurchase agreements) with third parties;
• having liabilities that are subject to "upstream guarantees" from the covered entity's subsidiaries or that are subject to contractual offset rights for its subsidiaries' creditors; and
• guaranteeing their subsidiaries' liabilities if the covered entity's insolvency or entry into resolution would trigger default rights for a counterparty of the subsidiary.

In addition, each covered BHC would be subject to a cap on the value of its liabilities (other than those related to eligible external TLAC or eligible external LTD) that can be pari passu with or junior to its eligible external LTD at five per cent of the value of its eligible external TLAC.

Further developments

On 3 November 2015, the FSB published its Principlesfor Cross-Border Effectiveness of Resolution Action, which set out statutory and contractual mechanisms that jurisdictions should consider, including in their legal frameworks, to give cross-border effect to resolution actions in accordance with the FSB Key Attributes.

Additional information

See the current list of FSB-specified G-SIBs here.