Total loss-absorbing capacity (TLAC) considers the scope for a bank to absorb losses.
It thus adds two types of debt to the amount of common equity: subordinated debt and contingent convertible debt (CoCos). In the case of CoCos, conversion of debt to equity (or simply the sacrifice of principal) would occur before bankruptcy upon reaching a specified trigger.
In the case of subordinated debt, there is also loss-absorbing capacity because in bankruptcy this debt can in principle be extinguished in the queue of claims following the wiping out of shareholders but before touching senior debt.For global systemically important banks (G-SIBs), the Basel III reforms include the requirement that TLAC reach 18 percent of risk-weighted assets by the beginning of 2022 (FSB 2015c). Considering that the benchmark Basel III requirement for common equity for G-SIBs is 9.5 percent of risk- weighted assets, in effect the TLAC requirement approximately doubles the absorptive capacity of equity alone.[153]
There has long been a literature on how subordinated debt can act as a salutary discipline on bank risk taking; recently, studies on the incentive benefits of CoCos have proliferated. Despite the emphasis in the literature on incentive effects, in practice much of the motivation for the adoption of TLAC requirements seems to have come from the political imperative to limit taxpayer costs of future bank bailouts, as opposed to pursuit of effective system incentives. Regardless of the motivation, the central policy question is whether the TLAC requirement, taken together with Basel III requirements for equity capital, is sufficient to ensure that banks are adequately capitalized in some broad meaningful sense. This question is equivalent to asking whether subordinated and CoCo debt are reasonable substitutes for capital and, if so, at what rates of equivalence.
At an important level, simple subordinated debt cannot be a substitute at all for equity capital.
This level pertains to the key objective of avoiding bankruptcy. By definition subordinated debt only helps the balance sheet once a bankruptcy takes place and certain asset classes are ruled to have lost their claim. Subordinated debt may thus serve an important function in terms of monitoring and disciplining risk by sending market signals of rising spreads, but its relief cannot be mobilized without entering into what is dangerous for the system if even a few G-SIBs are involved at the same time: a financial sector crisis.[154] At the outset, then, it seems useful to rule out subordinated debt as an effective substitute for equity capital with respect to systemic risk. Subordinated debt may be more useful as a vehicle to limit taxpayer losses, but if that is the objective, it is important that TLAC not be conflated with equity as insurance against financial crisis.CoCos might be seen as closer substitutes for equity if in practice they could be mobilized without contributing to a deterioration in market confidence and escalation of incipient crisis conditions. Importantly, in the case of the United States, tax authorities have not permitted CoCos to enjoy deductibility of interest expense, essentially ruling out their use by banks. CoCos have been more widely used in Europe, but they were the subject of new doubts in early 2016, when fears that Deutsche Bank issues might reach conversion triggers caused a sharp decline in equity prices for European banks.
Survey of the Literature on Total Loss-Absorbing Capacity
This chapter is based primarily on a survey of the literature on the role of subordinated debt and CoCos in providing greater systemic stability. It then examines the experience of large banks in the United States during the Great Recession as an event study of whether the larger banks took risks that revealed too big to fail (TBTF) behavior. It then draws policy implications for the role of TLAC in the overall regime of capital requirements.