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Fed's TLAC rule sparking debate about end of too big to fail

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Fed's TLAC rule sparking debate about end of too big to fail

The Federal Reserve Board believes it is poised to end too big to fail with a rule finalized Dec. 15 requiring global systemically important banks to meet a new long-term debt requirement and a new total loss-absorbing capacity, or TLAC, requirement. But industry observers are grappling with whether or not it is too early to declare an end to too big to fail.

In summary, the new rule requires banks to have total loss-absorbing capacity equal to or greater than 7.5% of total leverage exposure and 18% of risk-weighted assets. By design, the TLAC requirements are also supposed to work hand-in-hand with higher requirements for long-term debt holdings, since long-term debt's ability to be converted into equity makes it a more attractive loss-absorbing instrument in the event of failure. Long-term debt will be required in amounts equal to or greater than 6% of risk-weighted assets plus any G-SIB surcharges and at least 4.5% of total leverage exposure.

"These reforms have been guided by common sense principles: bank shareholders and debt investors place their own money at risk so depositors and taxpayers are well protected," Fed Chair Janet Yellen said during the board's Dec. 15 meeting.

Oliver Ireland, partner in the financial services practice at Morrison & Foerster, supported the main tenets of the new rule, claiming that the new requirement would have prevented the failure of Continental Illinois National Bank and Trust Co. in 1984, which at the time was the largest bank failure in U.S. history.

"I think that there's a pretty good argument that too big to fail for banking organizations has been addressed," Ireland said of the TLAC rule.

The Clearing House agreed, tweeting a statement from President Greg Baer saying "the TLAC requirement is the culmination of a legal and balance sheet revolution that has effectively ended too big to fail."

But others are not so convinced. Arthur Wilmarth, a law professor at George Washington University, said the single-point-of-entry structure of many G-SIBs makes the new TLAC rule a "nice balance sheet trick" where increased long-term debt holdings would unfairly put the responsibility of bailout on pension and mutual funds.

"I think it entrenches too big too fail and I think it continues to impose the costs of too big to fail on small individuals who don't have the ability to protect themselves," Wilmarth said.

Wilmarth argued that the Fed should have explored the question of using equity to meet TLAC standards, a point that Vice Chair Stanley Fischer raised during the meeting Thursday. Fed staff said companies, given the option, would generally elect to meet TLAC standards through debt anyway since raising equity is unfavorable to Tier 1 capital balances. Wilmarth said the Fed should have focused less on long-term debt requirements and considered similar requirements for equity.

Trade groups and organizations representing the banking industry appeared to have their own qualms about the rule, but mostly focused on how burdensome the requirements would be. In a statement, American Bankers Association President and CEO Rob Nichols said the final rule "will inevitably limit the covered banks' flexibility in managing their funding." In a statement sent by email, Executive Vice President of the U.S. Chamber of Commerce Center for Capital Markets Competitiveness Tom Quaadman said "the TLAC rule is excessive and will raise the cost of capital for businesses."