(Bloomberg) -- A rule designed to reduce risk in the financial system could end up punishing the wrong banks.
That’s what analysts, economists and some banks say will happen if regulators adopt guidelines proposed last year by the Financial Stability Board, which coordinates banking policy for the biggest economies. The rule, which would require banks to hold a minimum level of long-term debt that can be converted to equity if they fail, benefits lenders with big securities-trading businesses, the kind that led to the 2008 credit crisis.
The quirk is the result of risk weighting, the mathematical models that treat trading assets as safer than corporate or consumer lending. It will force banks such as Wells Fargo & Co. and Banco Bilbao Vizcaya Argentaria SA, which depend mostly on deposits for funding, to replace them with costlier bonds.
“The rule is distorted because it favors large trading banks,” said Alberto Gallo, head of European macro-credit research at Royal Bank of Scotland Group Plc. “The problem is using risk-weighted assets. Lending banks have higher RWAs, while trading banks have lower RWAs. The trading banks with a much more volatile business model will end up having half as much debt requirement as the more stable lending banks.”
The U.S. probably will be the first adopter of the FSB guidelines, which require the world’s 30 largest banks to have capital and debt equal to 20 percent to 25 percent of their risk-weighted assets. Most of that requirement -- what the FSB calls total loss absorbing capacity, or TLAC -- is already covered by minimum capital rules agreed to globally, including surcharges for the most systemically important firms.
The minimum capital level can reach 15 percent for the biggest U.S. banks, which face even higher surcharges. That leaves between 8 percent and 12 percent that can be met with debt maturing at least one year later, a cheaper source of funding than equity. The debt would be used to recapitalize whatever new entity rises from a failed bank’s ashes, avoiding the need for a government bailout.
The Federal Reserve is expected to propose its version of the rule as early as next month. The FSB is scheduled to decide where to set the required level by November.
Of the six biggest U.S. banks, only Wells Fargo would fall below the 20 percent threshold, according to estimates by analysts at Citigroup Inc. and Keefe, Bruyette & Woods. In Europe, Spain’s BBVA and Banco Santander SA are among lenders facing the greatest shortfall.
Trading revenue accounts for 3 percent of the total at San Francisco-based Wells Fargo, which gets about 70 percent of its funding from deposits. At Santander, trading revenue makes up 7 percent of the total, and at BBVA it’s 10 percent.
Replacing some deposits with debt could reduce profit at these banks by 2 percent to 4 percent a year, Citigroup and KBW estimate. The hit to income would be greater if banks have to pay more for long-term debt than they do now because of the premium investors might demand for the risk of becoming shareholders one day.
Banks with large securities businesses, such as Morgan Stanley, Goldman Sachs Group Inc. and Deutsche Bank AG, already have twice as much debt as required, Citigroup and KBW estimates show. Trading accounts for about a third of revenue at the three firms, which also underwrite securities, offer merger advice and manage money for wealthy clients. Loans made up about 10 percent of the balance sheets last year at New York-based Morgan Stanley and Goldman Sachs and 23 percent at Deutsche Bank.
The German lender doesn’t benefit as much as U.S. counterparts under the FSB rule because most European banks aren’t organized as holding companies and less of the debt held at operating subsidiaries counts toward the requirement. That might change if Germany adopts proposed legislation allowing senior bondholders of operating companies to face losses when a bank fails, making more of the bank’s existing debt eligible.
Wells Fargo said in a letter to the FSB last month that the debt requirement has no correlation to risk, pointing out that by various measures it’s the safest of the six big U.S. banks.
“Those companies that fund most of their operations with debt are less impacted,” Wells Fargo Chief Executive Officer John Stumpf said of the proposed debt rule in an interview in December. “We fund substantially all of our balance sheet with retail funds. Wouldn’t it be an oddity to have the most conservative funding and yet be asked to go raise more debt?”
It makes sense to require deposit-reliant banks to issue some debt so depositors don’t end up being on the hook in the event of a failure, RBS’s Gallo said. Still, the rule is too onerous on them and too easy on the market-funded trading firms.
“Depositors don’t put their money in a bank thinking they’d be bailed in,” said Barney Reynolds, head of the financial regulatory practice at Shearman & Sterling LLP in London. “If they did, then there’d be run on the bank.”
Investment banks benefit because they’re allowed to use their own models to predict trading risk, reducing the weighting of complex securitizations and other assets. Plain-vanilla lending gets a full weighting in the calculations. That results in Deutsche Bank’s risk-weighted assets being less than 25 percent of its total, while Wells Fargo’s are about 70 percent. It can also result in JPMorgan Chase & Co. losing more than $6 billion on positions that had zero risk for regulatory purposes.
The FSB rule requires a minimum $95 billion of capital plus debt from Morgan Stanley while demanding $287 billion from Wells Fargo, according to KBW estimates. That makes Wells Fargo’s burden twice Morgan Stanley’s based on total assets. While the risk of losses on loans that make up most of Wells Fargo’s balance sheet is easier to predict, the specter of losses on Morgan Stanley’s $39 trillion derivatives portfolio is harder to gauge. Wells Fargo has about $5 trillion of such contracts.
U.S. and European lenders would face a shortfall of about $500 billion, more than half of which would be borne by five deposit-heavy banks -- Wells Fargo, Santander, BBVA, UniCredit SpA and HSBC Holdings Plc -- according to KBW estimates. The use of risk-weighted ratios “severely penalizes retail oriented banks and does not allow a level playing field,” UniCredit wrote in its comment letter to the FSB.
The debt requirement was born out of a U.S. need to comply with a section of the 2010 Dodd-Frank Act that calls for the Federal Deposit Insurance Corp. to seize big banks when they get in trouble and restructure them without using taxpayer funds.
The FDIC created a model to facilitate this, which it calls single point of entry: The parent company is taken over, while the operating entities keep functioning with Fed support. The parent needs to have enough debt to allow it to be recapitalized and to push capital down to the subsidiaries if necessary.
FDIC officials led by Jim Wigand, head of complex institution supervision at the time, discussed the model with counterparts in the U.K. in 2011 because the broker-dealer operations of the largest U.S. banks in London would be involved in any resolution strategy.
Paul Tucker, then-deputy governor of the Bank of England, embraced the idea, which fit in with the top-down resolution model already being discussed by an FSB committee he led. The two came up with the loss-absorption concept. Other European countries signed on.
China’s largest banks, which also rely on deposits and have higher risk weightings than investment banks, won’t have to comply with the rule when it goes into effect as early as 2019. The exemption was granted to get the country on board, according to people with knowledge of the discussions. The FSB hasn’t said when the exception will end.
Wigand and his allies aimed to reduce the so-called too-big-to-fail subsidy the largest banks get when they borrow. If investors know in advance that part of the debt will be convertible, they’ll demand a premium for the risk of becoming shareholders one day. In theory, they would no longer lend as cheaply to the largest banks in the belief that the government would bail them out.
“TLAC will cause borrowing costs to rise, but that’s necessary if the too-big-to-fail discount is to be eliminated for good,” said Wigand, now a partner at Washington-based financial-advisory firm Millstein & Co.
That goal may now be in jeopardy. U.S. investment banks can reduce the debt of their holding companies to the required minimum, shifting the rest to operating subsidiaries. That almost guarantees they will keep their too-big-to-fail discount because only parent-company debt would be converted to equity.
Instead of a flat rate for the biggest banks, the debt rule should have used a sliding scale based on the riskiness of the business model, according to former Fed Governor Jeremy Stein.
“You really need a formula that distinguishes between wholesale funding and deposits, or it could look at the size of broker-dealer operations,” Stein said, referring to short-term borrowing from institutional investors that investment banks rely on to finance their business. “It will defeat the purpose of the rule if the investment banks downstream the debt because they exceed the minimum requirements by a lot.”
The Fed used the wholesale-funding distinction last year when it proposed gold-plating the FSB’s capital surcharges for the most systemically important firms. U.S. banks that rely more on short-term funding from institutional investors, such as through repurchase agreements, could see the surcharge double.
There’s no sign the Fed will take a similar approach with the debt rule, according to three people with knowledge of the discussions about the forthcoming proposal who asked not to be identified because the talks are private. Spokesmen for the Fed and the FSB declined to comment.
“The most interesting aspect of this new rule is that banks with the most stable source of funding, that’s deposits, are the ones most adversely impacted,” said Alok Sinha, a principal at Deloitte & Touche LLP in San Francisco. “That’s the irony of this rule.”
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