Board of Governors of the Federal Reserve System

A key aim of post-crisis regulatory reform has been to address the too-big-to-fail problem. An effective response requires both substantially increased resiliency of the largest, most systemically important banking organizations and a viable path to an orderly resolution should one of these firms nonetheless fail. Perhaps the most widely shared view in the aftermath of the crisis--in government and around the country--was that we must avoid having to inject taxpayer capital into a failing bank out of fear that its insolvency would bring down the whole financial system.

A great deal has been done to enhance the resiliency of these firms--a complementary set of stronger leverage and risk-based capital requirements, a credible stress testing program, the introduction of quantitative liquidity requirements, and requirements that firms have effective information and risk management systems so that they will know their own exposures and vulnerabilities. We continue to assess the efficacy and efficiency of these and other resiliency measures and, as demonstrated in our review of stress testing, are prepared to refine them as needed.

As critical as enhanced resiliency is to a safer and more stable financial system, it cannot be the only regulatory goal. No matter how much more resilient firms have become, we cannot exclude the possibility of an idiosyncratic or systemic problem that threatens the solvency of a very large financial firm. If government authorities lack confidence in the prospects for an orderly resolution of such a firm, they will be tempted to look for direct or indirect ways to bail that firm out. And if counterparties and investors believe this will happen, then no market discipline will be brought to bear upon them.

In its post-crisis legislative and oversight responses, Congress has rightly placed great emphasis on resolvability. The Federal Deposit Insurance Corporation (FDIC) has been developing strategies for the exercise of its statutory orderly liquidation authority. Jointly with our colleagues at the FDIC, the Federal Reserve has used the resolution planning process established in the Dodd-Frank Act to require large banks to modify their organizational structures and day-to-day practices, such as liquidity management, so as to facilitate orderly resolution. All major firms have made significant changes in the course of this process and, as demonstrated in our joint deficiency findings earlier this week, our two agencies are prepared to use the tools Congress gave us to achieve this goal.

The proposal before us today is another core component of a program to establish a viable resolution option. The TLAC requirement will ensure that the parent holding companies of each systemically important U.S. banking firm hold loss absorbing capital in sufficient amounts that the firm could be successfully recapitalized in bankruptcy, or in an orderly liquidation proceeding, with capital from private investors--that is, without needing to repeat the experience of 2008, when the government had to provide funds for the recapitalization of some firms.

As staff will explain, the proposal includes a requirement for each firm to maintain a minimum amount of long-term unsecured debt issued to unrelated investors. This feature of the proposal is essential to establishing a credible resolution program. While equity is far and away the best form of capital to ensure the resilience of a firm, the whole point of resolution planning is to prepare for the eventuality, no matter how unlikely, that the firm might become insolvent in some circumstances. By definition, at that point equity capital will either be totally lost, or at least below the level markets have historically required for a financial intermediary to be credible. The long-term debt required by this proposal would survive the disappearance of a bank's equity and resultant failure, and would be available for conversion into new equity. These identified debt instruments would allow the absorption of losses that the firm might continue to suffer after it fails and thus give assurance that an orderly resolution would be possible. Counterparties, customers, and depositors would have more confidence that they would not bear losses if they continued dealing with the bank.

Other benefits would come along with this proposal. One is increased market discipline of the largest banking firms. Scholars and policy analysts concerned with the too-big-to-fail problem have long called for a debt instrument of this sort. Investors holding this debt will be motivated to monitor the bank more closely precisely because they would stand to be converted into equity holders if the firm failed. The price of that debt could be both a direct source of market discipline and an indirect aid to supervisors in assessing the condition of the firm.

An additional benefit of the rule would be to help reduce run risk associated with short-term wholesale funding--whether repos, uninsured deposits, or other forms--by mandating that firms have a more substantial base of stable funding that is structurally subordinated to funding at operating subsidiaries. Though the rule is not intended to be a liquidity regulation as such, it does complement and reinforce requirements such as the Liquidity Coverage Ratio.

The proposal also applies to the U.S. intermediate holding companies (IHCs) of foreign global systemically important banks. By ensuring that U.S. subsidiaries of foreign banks will have their appropriate share of the loss-absorbing capacity of the foreign consolidated firm, the proposal will enhance prospects for orderly resolution of the foreign banks by their home jurisdiction authorities, or if necessary and appropriate, for the separate orderly resolution of an IHC by U.S. authorities.