Hoenig on Resolvability and Resilience of Large Banks

Peterson
Institute for International Economics

Resolvability
and Resilience of Large, Interconnected Banking Firms

Wednesday,
January 20, 2016

Key
Topics & Takeaways

    Financial Stability and Total Loss Absorbing Capacity:
    The FDIC’s Vice Chairman, Hoenig, argued that the Federal Reserve’s proposal
    for TLAC may paradoxically undermine financial stability by creating incentives
    for firms to increase leverage and invest in higher risk assets. 

     

  • Title 1 Approach: Hoenig argued that Title 1
    should be the “sole means” to ensure there is sufficient capital to resolve a
    financial firm, claiming that little reliance is given to the amount of equity
    on the balance sheet in the TLAC calculation.  He explained that the
    living will process – which is based on firms’ individual business models and
    the bankruptcy strategy that is best tailored to that firm – is ideal rather
    than using a one-size-fits-all approach through TLAC.

Opening
Remarks

In his speech, the Federal Deposit
Insurance Corporation’s (FDIC’s) Vice Chairman Thomas Hoenig expressed concern
that the Federal Reserve’s (Fed’s) proposed rules for Total Loss Absorbing
Capacity (TLAC) may “paradoxically undermine” financial stability, even though
the rules are designed to improve resolvability of significantly important
banks.  Hoenig explained that the Fed’s TLAC proposal mandates that the
largest banks maintain certain levels of long-term debt, which will require
many firms to issue more debt to meet those requirements.  Hoenig
cautioned against the one-size-fits-all approach underpinning TLAC and
suggested that it be “used in a more limited and discretionary manner.” 
For instance, he argued that the resolution plans mandated under Title I of the
Dodd-Frank Act acknowledge that not all business models are the same and that
different resolution strategies may work better than TLAC for individual firms
and for financial stability, overall. 

Hoenig
summarized the main features of the Fed’s TLAC proposal, which requires banks
to hold long-term debt to facilitate resolution and recapitalization, and noted
that the estimated shortfall of the requirement is approximately $100 billion.
Still, Hoenig argued that the proposal affects firms in other ways as
well.  For instance, he maintained that TLAC would increase firms’
leverage, pressure firms to change their business models, and encourage them to
add risk that may be inconsistent with prudential goals.  He explained
that TLAC will induce firms to increase debt and leverage, which will require
them to earn higher returns by expanding into non-bank activities or generating
revenues through higher risk assets.   

To
illustrate his point, Hoenig recalled that similar debt instruments –
trust-preferred securities (TruPS) – did not perform well during the financial
crisis and undermined firms’ resolvability.  He argued that weaknesses of
TruPS “revealed themselves” during the crisis because firms were pressured to
continue making interest payments which he claimed “certainly exacerbated” the
crisis.  Further, Hoenig warned that the TLAC proposal neither offers
assurances that the amount of debt is sufficient to absorb losses after equity
is extinguished (in a crisis) nor ensures that operating subsidiaries are
well-capitalized. 

Hoenig
also argued that Title I should be the “sole means” to
ensure there is sufficient capital to resolve a financial firm, claiming that
little reliance is given to the amount of equity on the balance sheet in the
TLAC calculation.  He explained that the living will process, which is
based on firms’ individual business models and the bankruptcy strategy that is
best tailored to that firm, is ideal, rather than using a one-size-fits-all
approach through TLAC.

Hoenig
argued that a “guiding principle” for TLAC should be for it to have “at least a
neutral” effect on the leverage position of firms in the industry.  Further,
he offered other policy strategies that would be less reliant on debt, such as
allowing certain firms to serve as a bridge bank while the FDIC acts as a
receiver. 

Question
and Answer

When
asked what the optimal balance is between debt and equity to ensure
resolvability, Hoenig explained that it depends on the bank’s business model,
as well as the supervisor’s perspective.  He explained that a specific
amount of both debt and equity is not defined, and emphasized the importance of
making these determinations on a case-by-case basis rather than through a
formulaic approach. 

In
response to a question, Hoenig explained that regulators are still making
refinements to the prudential reforms and that there is still more work to do
to ensure resolvability and resilience of banks.  He emphasized the
importance of having sufficient equity levels, getting the Volcker Rule in
place, and ensuring supervisors continue “swimming against the current” to
ensure risks are appropriately addressed. 

When
asked about the role of the macroprudential framework and monetary policy in
ensuring financial stability, Hoenig explained that monetary policy should
maintain a long-run perspective to ensure economic stability and that the
macroprudential framework should focus on whether banks have enough capital and
supervision. 

More
information about this event can be accessed here.