Earlier this week, FedFin sent clients an in-depth analysis of a little-noticed Financial Stability Board proposal with far-reaching potential to rewrite the structure of global finance companies.  As is often the case with reform proposals, the FSB’s big idea here – internal total loss-absorbing capacity (I-TLAC) – makes a lot of sense in one context but wreaks havoc when one steps back to consider it in the broader framework of the way cross-border finance actually works.  Someday someone will do the cross-sectoral, cumulative impact study I have been calling for since 2011, but until then we’re in a world of one-off wonders strongly supported by the regulatory working groups that draft them and ill-understood by the senior regulators who  then approve them.  No wonder GOP law-makers plan to blow up Dodd-Frank – they can’t tell the good from the bad so want it all gone.  And, as another new FedFin report laid out, Senate Democrats are of a mind to join them, at least when it comes to the post-crisis resolution framework.

I-TLAC is part of TLAC – sounds like a Schwarzenegger movie, come to think of it.  The FSB TLAC requirements — adopted in a 2015 “term sheet” — are meant over time to apply for all SIFIs but, as usual, for now and likely forever, actually apply only to GSIBs.  These unhappy banking behemoths are required to hold a buffer of loss-absorbing capacity – equity capital for the FSB and largely long-term debt for the FRB – so that a lot of money stands ahead of taxpayers or financial catastrophe if a big bank falters.

I-TLAC takes TLAC down into the bowels of a GSIB by allowing host-country regulators to isolate loss-absorbing capacity within their borders.  As a result, I-TLAC essentially turns GSIBs into great big eggs.  The yolk – i.e., the home country bank and subs under host I-TLAC – survive when the shell is cracked, but everything else in it along with the newly-weakened shell becomes an awful mess. 

Thus, under I-TLAC, the parts are stronger than the whole.  Ring-fencing capital makes some parts of a GSIB safer but weakens the whole because it cannot easily or quickly funnel resources across the company in response to changing market or stress conditions.  Many GSIBs are thus likely to be forced to hold more parent TLAC, further building their buffers but reducing their balance-sheet capacity to gather deposits and weakening their ability to channel funds to productive financial intermediation.

In the name of a resilient global financial system, I-TLAC essentially turns that global system into one of big and little fiefdoms.  Each of the little ones is safer, but the sum total of global finance is more fragile and still less able to support economic growth.