On August 29, 2023, the Board of Governors of the Federal Reserve System (Fed), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (collectively the “agencies”) published a Notice of Proposed Rulemaking (NPR or the “Proposal”) seeking public comment on a new requirement that large banking organizations issue minimum levels of long-term unsecured debt (LTD). The Proposal “piggybacks” off the Basel III Endgame capital rules proposed on July 27, 2023.

As described below, the Proposal would require covered entities and covered Insured Depository Institutions (IDIs) to issue and hold minimum amounts of LTD as a component of their funding base. The Proposal is intended to promote safety and soundness and avoid situations that the industry experienced during the Spring 2023 bank failures, namely a contagion of bank runs and a severe hit to the FDIC Deposit Insurance Fund (DIF). The FDIC Board believes that the Proposal, if finalized, will reduce the risk of bank liquidity runs, limit costs to the FDIC DIF, reduce the need to enact extreme regulatory actions (i.e., the Systemic Risk Exception), and create additional resolution options as a bank or banking organization moves toward failure.

While in theory these objectives are likely outcomes, the Proposal fails to fully consider the additional regulatory stress placed on regional banks that is piling up in the wake of regulators’ own admittedly weak supervision of flawed business strategies earlier this year. In public statements announcing the rule, regulators repeatedly referenced the failures of three banks as the catalyst for this rule: Silicon Valley Bank, Signature Bank, and First Republic. However, the causes of those bank failures were quite simple and based in fudamentally risky funding and interest rate strategies, coupled with bank supervision and regulatory oversight that can be described as weak.

Ironically, with implementation of this Proposal, the Basel III Endgame proposed rule, and other Resolution and Recovery-related rules already proposed, regional banks that may have sound business plans and diversified funding structures will incur additional direct and indirect costs because of the failures of those three banks. Additionally, this Proposal would force some institutions to access a narrow market for unsecured long-term regional bank debt that is not well tested, lacks depth, and could pose costly market and liquidity risks to in-scope banks and their holding companies, especially in the current interest rate and economic environment. When viewed collectively, these proposals would raise the regulatory, operational, compliance, and reputation costs for regional banks, and could further complicate the viability of their business models. The knock-on implications for small businesses could also be felt via the cost and availability of credit for an important segment of the economy for which regional banks are a vital source.

Scope of the Proposed Rule

The NPR applies to “covered entities,” which the Proposal defines as (1) Category II, III, and IV bank holding companies and savings and loan holding companies and (2) Category II, III, and IV U.S. intermediate holding companies (IHCs) of foreign banking organizations (FBOs) that are not U.S. Global Systemically Important Banks (GSIBs). The NPR also applies to “covered IDIs,” which the Proposal defines as IDIs that are not consolidated subsidiaries of U.S. GSIBs and either have at least $100 billion in consolidated assets or are affiliated with IDIs that have at least $100 billion in consolidated assets. The proposed rule would require such banking organizations to hold minimum eligible outstanding LTD equal to the greater of: (1) 6 percent of their risk-weighted assets; (2) 2.5 percent of total leverage exposure; or (3) 3.5 percent of average total consolidated assets.

Key Elements of the Proposal

The 221-page proposal focuses on enhanced LTD requirements for banks with $100 billion or more in total assets. The proposal distinguishes between the LTD requirements applied to covered entities and covered IDIs and specifies the features of eligible LTD. It also would subject covered entities to clean holding company requirements and make technical changes to the Total Loss Absorbing Capital (TLAC) rule.

The NPR includes 66 prepared questions, grouped by topic risk area, on which the regulators are soliciting feedback. The questions cover all aspects of the rule. There are 16 questions posed regarding LTD requirements for covered IDIs, 12 of which address the scope of application. Six questions are asked regarding LTD requirements for covered entities, only 2 of which address the scope of application. There are also 15 questions presented regarding the features of eligible LTD.

Features of Eligible LTD

The proposal stipulates the features of eligible LTD including that it be unsecured, “plain vanilla” in structure, and issued in a minimum denomination of $400,000. The proposal notes that LTD must have a maturity of greater than 1 year in order to be considered eligible, but goes on to specify that “principal due to be paid on eligible external LTD in 1 year or more and less than 2 years would be subject to a 50 percent haircut for purposes of the external LTD requirement.” The haircut in conjunction with the maturity requirement effectively means that LTD must have a maturity of over 2 years in order to be eligible and not subject to a haircut within six months of issuance.

Regarding eligible internal LTD, the proposal stipulates that such debt issued by an IDI must be issued to and remain held by a company that consolidates the IDI, likely an upstream parent. Internal LTD would not be subject to the minimum principal denomination requirement.

Additionally, the proposal sets forth certain requirements specific to covered IHCs regarding eligible internal LTD including that, regardless of an IHC’s structure (resolution or non-resolution), internal LTD must contain a contractual conversion trigger. The contractual trigger would require the IHC to convert or exchange all or some of the eligible internal LTD into common equity tier 1 capital on a going concern basis under certain circumstances. The circumstances identified include (1) the Fed determining the IHC is in default or danger of default and the top-tier FBO or its subsidiary being placed into resolution proceedings, (2) the home country supervisory authority consenting or not objecting to the exchange or conversion, or (3) the Fed recommending that the FDIC be appointed receiver of the covered IHC.

Clean Holding Company Requirements

The NPR proposes to impose “clean holding company” requirements on covered entities, essentially subjecting such organizations to requirements very similar to those imposed on U.S. GSIBs and imposing two notable prohibitions on the categories of outstanding liabilities they are permitted to maintain. Covered entities would be prohibited from having third-party debt instruments with an original maturity of less than 1 year, though, as discussed above, the maturity requirement is effectively over 2 years and would be prohibited from having third-party qualified financial contracts (QFCs). Additional prohibited categories are noted in the proposal.

The clean holding company requirements would also implement a cap on the value of a covered entity’s non-eligible LTD liabilities that would rank at either the same priority as or junior relative to eligible LTD in a bankruptcy or resolution proceeding. Such liabilities would be capped at 5 percent of the sum of the entity’s common equity tier 1 capital and eligible LTD amount.

Transition Period

The agencies propose a transition period of three years for covered entities and IDIs that would be subject to the final rule to become compliant with the rule. The transition period includes a phase in schedule that would require covered entities and covered IDIs to meet 25 percent of their LTD requirements by year one, 50 percent after year two, and 100 percent after year three. The transition period and phase in schedule would also apply to a firm becoming subject to the rule sometime after it is finalized.

Consequences and Impact of Implementation

Market and Operational Impacts

The LTD requirement, if implemented, could place significant market, earnings, and operational burdens on regional banks. By essentially applying Total Loss Absorbing Capital (TLAC) standards, previously required only for Category I GSIBs, toward Categories II, III, and IV bank entities, many of these regional banks would be forced to access unsecured bank debt markets that they have not previously entered, at least not materially. The unsecured regional bank debt markets may lack the liquidity depth and ability to absorb a significant level of new entrants without blowing out spreads in an environment where intermediate debt costs are already near their highest levels in 20 years.

The Proposal does not seem to accurately consider market factors in the impact analysis. For example, the Proposal indicates that the net interest margin (NIM) impact would be “moderate” at just three basis points, which would seem fairly nominal. But the analysis does not fully consider the additional earnings impact related to market spread widening from the estimated $70 billion shortfall (or as high as $250 billion) in what Category II – IV entities would need to issue in order to comply. According to the Proposal, of that $70 billion new LTD shortfall, $50 billion would be needed at Category IV firms, the thinnest of the markets. Excluding Category I firms, the market presently has only $70 billion outstanding. Thus, presuming a nominal NIM impact for those issuing new debt under these rules does not seem fair, given that the market would need to grow by 100 percent for Category II – IV firms alone.

Additionally, the costs for covered IDIs to enter or expand, operationalize, and maintain compliance as an issuer of LTD can constitute material expenses, particularly for a new issuer. The NPR does not highlight common debt issuance expenses such as:

• Legal filing expenses;
• Accounting costs to comply with financial reporting;
• Underwriting fees that enable payments in exchange for their agreement to purchase any unsold amounts;
• Regulatory costs including fees paid to regulatory authorities for debt security issuance approval; or
• Direct costs including credit rating agency fees and listing fees.

Bank Customer Consequences

All told, the cumulative effect of Basel III Endgame proposals, this Proposal, proposed Resolution and Recovery planning rules, and the reality of heightened regulatory scrutiny has the potential to impact the business models of regional banks and their customers adversely and materially.

Bank customers would bear the brunt of this regulation as regional banks pass costs on to customers, both commercial and consumer. Even the NPR acknowledges this, stating: “Covered entities and covered IDIs could seek to offset the higher funding costs from an LTD requirement by lowering deposit rates or increasing interest rates on new loans.”

The risk of banks cutting back on business volumes or activities is a potential real consequence, and could further encourage movement of activities from the already highly-regulated regional bank space to smaller community banks or nonbanks. The NPR acknowledges this: “Alternatively, the higher funding costs could indirectly affect covered entities and covered IDIs’ loan growth, or result in some migration of banking activity from covered entities and covered IDIs to other banks or nonbanks.” Smaller community banks could be well positioned to absorb some spillover, but may not be well equipped to absorb the size of some commercial relationships or the nature of some loan portfolios that regional banks manage, potentially leaving a sizable gap in an important market.

As noted above, depositors could face a significant downside as banks would have to attend to alternative sources of funding. This could be influenced by market rates and costs of entering into the capital markets, or by maintaining lower interest yields on deposit accounts.

Put Patomak’s Expertise to Work

Patomak has deep experience in advising clients on liquidity risk management and governance, as well as strategic decision making. Patomak has worked to assist firms in managing market risk and operational risk. Patomak has deep experience in helping financial institutions draft and submit comment letters to the OCC, Federal Reserve, SEC, CFTC, and FINRA related to rule proposals.

If you would like to learn more about how Patomak can partner with you, please reach out to John Vivian, Senior Director, at jvivian@patomak.com or Laura Magyar, Managing Director, at lmagyar@patomak.com