As clients will recall, FedFin last year studied the panoply of financial rules to identify unintended consequences, most of them caused not by each rule on its own, but rather by unanticipated interactions among them. These studies, funded by SIFMA but representing FedFin’s views, can be found at http://www.fedfin.com/images/stories/client_reports/Regulatory%20Landscape.pdf. Since we finished the work in October, regulators of course haven’t been idle. New ideas, many of them designed to tame TBTF, are racing forward with scant regard to the next round of bumper-car collisions between all of these careening concepts. One to take carefully: the difficulty mandating new “bail-in” capital for big banks given the FDIC’s asset-based premium scheme. We can have one – large up-front holdings of unsecured debt at BHCs – or the other – standards that force funding through deposits, not debt – but it’s darn hard to do both at the same time.
First, a quick walk-through each of these complex proposals. The “bail-in” debt idea is under rapid development at the Federal Reserve following the U.S.-U.K. agreement on a single-point-of-entry (SPE) resolution framework late last year. As we noted in our daily briefings earlier this week, the Financial Stability Board is also building bail-in, coming out with its standards in early summer. If the FRB follows the FSB – and I think it will – bail-in will cost a bundle. As outlined by the U.K.’s Paul Tucker, bail-in holdings would need to be equivalent to Basel III capital plus a buffer – say at least ten percent of risk-adjusted assets. The idea is that all of this debt – unsecured and long-term – would sit at the top tier of the BHC so that, in an emergency resolution under the SPE, creditors would insulate the FDIC from anything but a short-term risk as even the most complex SIFI’s affairs are settled.
The idea here is based on bankruptcy, although no rules now require non-banks to hold specific amounts of debt to ensure orderly operations while in bankruptcy because none of these firms has any statutory claim on support from the U.S. Government. Big banks around the world have supported SPE as the best way to keep a firm operational under even acute stress without a bail-out, but the industry strongly disputes the need for so large a buffer of such expensive debt.
Now, to the second policy: the FDIC’s assessments, mandated by Dodd-Frank, that charge deposit-insurance premiums based on assets, not on insured deposits. I have argued that this is perverse because, the more premiums are levied against an institution, the greater the protection apparently provided to it, not to the limited class of insured depositors actually covered by the FDIC. And, because deposits no longer pack a premium, they have become cheaper for big banks to use as a funding source, driving up the FDIC’s real risk even though no premiums are charged against it.
A Bank for International Settlements study earlier this week (http://www.bis.org/publ/work413.htm) analyzed the actual market impact of the asset-based premium scheme and in fact found it worked as I anticipated: the biggest banks have bulked up on deposits and need no longer rely on funding through wholesale debt. The study thinks this makes each bank safer because deposits are less prone to run-off than short-term debt, which is true. Or, it’s true as far as it goes – the study also found that the overall U.S. financial system is more prone to run risk because foreign banks aren’t covered by the new premiums and thus have sharply altered their funding patterns. The BIS study views the FDIC’s asset-based premiums as a tax and, thus, took a hard look at tax-avoidance strategies by the biggest banks to see how this redeployed funding strategies in otherwise-uneconomic ways.
Where do the bail-in debt requirements and the FDIC’s premium standards collide? One might think not at all – the premiums do come only out of an insured depository and thus do not necessarily affect the cost of debt issued by a parent holding company. However, in practice, insured depositories and their parent holding companies are inextricably combined at virtually all of the nation’s biggest BHCs. Funding from the top-tier parent is used to fund lending in the bank subsidiaries as well as other BHC operations (most of which are far less liability-intensive than traditional banking). Thus, the more debt the BHC issues, the less the need for deposits and – at least from a liquidity perspective – the riskier the insured depositories become (albeit with the side effect of lowering FDIC pay-outs on insured deposits when the storm hits).
The presumed cure to this conundrum is that the top-tier debt is to be long-term and the bulk of funding drawn upon by insured depositories is short-term (checking accounts and the like). The thinking is that the long-term wholesale debt will stay long so that the BHC can’t downstream it to the subsidiary insured depository to fund intermediation. But, how true is this?
First, derivatives these days can make long-term debt turn short into a nanosecond. Thus, the top-tier BHC’s debt funding could still be readily deployed to support down-stream bank lending. Will new premiums charged on these assets make up the difference and constrain this bit of regulatory arbitrage? This seems unlikely because, costly as FDIC premiums are, that of huge volumes of parent-company debt is still more punitive. In short, the costs have to go somewhere, and my bet is that it’s into the insured depository.
The higher the bail-in debt requirement, the greater the incentive to put it to work even if down streamed debt in a bank costs a bit more in FDIC premiums than deposit-derived funding. Is there a policy priority – protecting the parent company’s counterparties through bail-in debt or the FDIC through the asset-based premium scheme? Regulators want to do both at the same time, but like so much else on the regulatory to-do list, it’s one or the other. Both at the same time collide with a hard, costly bang.