Recently, there has been a raft of regulatory consultations and standards that deal with issuance of debt that qualify as capital during stress. To understand this better from a commoner perspective, let us revisit what happened about a decade back. The financial crisis of 2007/2008 was the largest and most severe financial event since the Great Depression and reshaped the world of finance and investment banking. Post Lehman bankruptcy, the Government in many countries had to resort to extensive bail-out and rescue packages for large banks and financial institutions to restore orderly functioning of financial markets.
The magnitude of the crises prompted US Federal Reserve Chair Ben Bernanke to comment
“Governments provide support to too-big-to-fail firms in a crisis not out of favoritism or particular concern for the management, owners, or creditors of the firm, but because they recognize that the consequences for the broader economy of allowing a disorderly failure greatly outweigh the costs of avoiding the failure in some way. Common means of avoiding failure include facilitating a merger, providing credit, or injecting government capital, all of which protect at least some creditors who otherwise would have suffered losses…If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved.”
As a regulatory response to the vulnerability of the banking sector in the Financial crisis of 2007–08, and to resolve the too big to fail interdependence between large financial institutions and the economy of sovereign states, the Financial Stability Board (FSB), a global group of financial regulators, developed a method to identify the Too-Big-To-Fail Institutions in the form of Global-Systemically Important Banks (G-SIBs) to whom a set of stricter requirements would apply. G-SIBs are required to comply with Total Loss Absorbing Capacity (TLAC) capital standard in addition to the existing framework of risk based Capital adequacy ratio and non-risk based Leverage ratio. Without discussing the technical attributes of such instruments, objectives of the TLAC standard is
- Continuity of critical operations (market stability)
- Avoid exposing taxpayers (public funds) to loss
- Continuity of core business lines (preserving franchise value)
- Enable reorganization of the firm
So what does this mean for general public like you and me? Most of us would agree that we tend to have a banking relationship with the largest banks as they provide us benefits arising from economies of scale. This would translate into higher access points (branches / ATMs), multiple suite of products and generally lower transaction costs. If I was to further lay out the interaction patterns between individuals and Banks, the relationship from the individual perspective is generally towards crediting salaries, drawing cheques for settling payments, access cash through ATMs and in most cases have a long term mortgage for house property.
Does it really matter to understand the implications of TLAC? While the thought of regulators policing the large Banks to be more safer is certainly reassuring and ensuring that taxpayer’s funds are spent for better alternatives than bailing out failed risky ventures of Investment Bankers is the right step forward, there is an implicit impact to the wider society. Given the additional contingent risk of bailing out Banks in the event of stress, TLAC debt is issued at a premium to plain vanilla debt. If we were to step back and look at the Banking business model (in simplistic terms), the basic premise is Banks act as a facilitating agent for accessing cheaper funds from the market and channel them to borrowers who need money. By charging Borrowers a risk premium over and above the cost of funds, the Banks earn profits. As the cost of funds keep increasing (due to TLAC premium over other debt), the borrower will have to bear the burden assuming the risk premium remains constant. To summarise the change in framework, instead of putting large amount of capital during times of stress, the burden is shifted to a piggy bank approach spread over a larger period and built over time. In other words, it is the customer who will pay a higher transaction costs contributes implicitly to support the Bank in the event of stress.
Reading the above, one might infer that we are likely to pay more for transacting with Banks in the future. Well, the answer is Yes and No. Yes, if we believe that the benefit of Banking with large behemoths still outweighs the increasing transaction costs. No, if we bank smart and move towards the nimble and niche Banks that cater to a specific clientele or geographical reach. The optimum solution depends on individual needs. I will end the note by highlighting recent stock price movements of Banks in UK. Shares of traditional giants like RBS, Standard Chartered have all yielded negative returns in 2015 whereas new age digital Banks such as Virgin Money, Metro Banks have provided healthy double digit returns over the same period. This reflects a fundamental shift and reiterates the regulators view; Banking should not be dominated by Institutions that are Too-Big-to-Fail. Consumers should awaken to the wider possibilities, especially, in the digital space that provide similar or even enhanced products at reasonable pricing and personalized service.