Preparing for the Long-Term Debt Rule ​(Part I: The Requirements)

In August 2023 the Federal Reserve, OCC, and FDIC jointly proposed long-term debt (LTD) requirements for large banks. The proposal extends the scope of some of the rules currently applicable to global systemically important banks (GSIBs) and is informed by the regional bank failures in 2023. These failures demonstrated the risk of a deposit run and the value of having resources available to allocate losses from a failed bank to investors.  

The rule is designed to improve the resolvability of failed institutions by mitigating impediments to an orderly resolution. It covers U.S. banks larger than $100 billion, foreign non-GSIB intermediate holding companies, and all insured depository institutions with more than $100 billion in assets. It does not apply to U.S.-based GSIBs, which are already covered by the existing total loss absorbing capacity (TLAC) rule and resolution planning requirements. 

The LTD rule has three primary elements for the in-scope U.S. banks:  

Policy Priorities 

The LTD requirements are designed strictly to increase the resources available to regulators in case a bank fails. Unlike the capital regulations, they don’t support going-concern risk-taking, and are not intended to reduce the likelihood of failure. Regulators say that these requirements will:  

• Improve the likelihood of an orderly and cost-effective resolution that minimizes costs to the deposit insurance fund (DIF). 
• Increase the range of options available to the receiver. 
• Enhance the stability of funding profiles. 
• Involve credit markets in enforcing market discipline related to the operations of covered firms. 

Internal LTD requirements would allow losses at an insured depository institution (IDI) to be passed on to the parent company, which would likely be bankrupt. Meanwhile, clean holding company provisions​     ​similar to those applicable to GSIBs are intended to slimit conflicting claims in bankruptcy, facilitating a wind-down.  

Calibration and Eligible Instruments

In-scope banks would be required to hold eligible long-term debt no less than the greatest of:  

• 6% of risk weighted assets, 
• 2.5% of total leverage exposure, or  
• 3.5% of average total consolidated assets.  

These requirements were derived based on the capital refill principle, and would conceptually allow regulators to restore Common Equity Tier 1 (CET1) capital depleted by losses, including required buffers. 

Covered institutions that face markets (typically domestic bank holding companies) would have to issue debt to unaffiliated investors, while other covered firms (including most banks as well as foreign intermediate holding companies) would have to issue debt to an affiliate of their parents. This internal long-term debt would allow parent companies to recapitalize operating subsidiaries and absorb the losses themselves in the event of a resolution. 

The proposal specifies criteria for eligible debt, summarized in the Figure. These criteria aim to reduce the risk that creditors slow down the resolution of a failed bank, whether due to conflicting claim priority, conflicts of law, or other considerations.  

Figure: Eligible and Ineligible Debt  

In practice, most debt issued by banks in “benchmark” format (see Figure) is eligible. Standard benchmark structures have evolved to align with LTD requirements, including features such as early redemption options that reduce compliance costs and legal terms that confirm the risks associated with bail-in debt.  

Implementation Timeline  

The LTD requirements generally have a three-year transition period, beginning upon the finalization of the rule—the comment period ended on January 16—or upon crossing the threshold to become a covered company. The requirements phase in 25% in year 1, 50% in year 2, and fully by year 3.  

Comparison to GSIB Rules 

While the LTD requirements are modeled after the rules applicable to GSIBs, there are some important differences.  

• GSIBs are subject to TLAC requirements, in addition to LTD requirements. TLAC includes regulatory capital as well as debt, allowing excess capital to offset the LTD required.  
• GSIB requirements for internal TLAC are determined individually according to the Resolution Capital Adequacy and Positioning (RCAP) methodology that forms a key part of the 165(d) resolution planning requirements, rather than having generic requirements.  
• The requirements also include GSIB surcharges, increasing the ratios GSIBs must maintain.   

LTD Rule Implications and Concerns  

Debt Market Disruption and Financial Costs 

The LTD rule will increase the absolute amount of debt outstanding in the markets, which presents several risks and costs.  

• Even in periods of calm, more volume in the market may widen new issuance credit spreads, raising the cost of all issuance, and potentially driving mark-to-market losses on investors holding “legacy” debt. 
• In periods of turmoil, markets may be either much more expensive or unavailable to meet issuance requirements. Market turmoil could impose higher interest expense on debt issued at inopportune times, or increase debt outstanding at most points in the cycle to fund management buffers. 

Wider spreads on existing debt outstanding would be negative for investors. Separately, investors are concerned about operational challenges imposed by the $400,000 minimum denomination restriction. The minimum is intended to protect “retail” investors from bearing the cost of bank failures, but imposes operational challenges to asset managers who manage separate accounts. 

Banks are concerned about the burden of complying with requirements that were originally intended for larger and more complex institutions. The costs associated with higher debt are substantial, and could impact net interest margin and earnings in addition to increasing  compliance and operating costs.  

Transition periods may ease the shock as markets adapt to the new, elevated levels of issuance. Opportunistic issuance approaches and market engagement may mitigate the worst of feared effects, as will longer-term optimization initiatives. For more on this, Part II of this article will suggest ideas for optimizing compliance with the LTD rule.  

Changing Funding and Liquidity Structures 

The LTD rule will force banks to reevaluate their funding structures and adapt interest-rate risk and liquidity positions. LTD requires different term structures and rate characteristics than current marginal funding, and will be issued at the more costly parent company level. Proceeds raised at the parent must be invested in the bank to satisfy internal LTD requirements, requiring new funding patterns. The new debt will likely be longer-term, fixed-rate funding, potentially requiring more derivatives activity to rebalance rate risk. While the longer-term funding may help liquidity profiles, the additional cost due to term, structure, and issuing entity must be allocated thoughtfully to business activities to assess their profitability.  

Interaction With Other Regulations 

The LTD rule interacts with other current and proposed rules, complicating implementation and compliance.  

For example: As a complement to capital requirements, it aims to refill the fully depleted capital base of a failed institution, but 6% of RWA is enough to replace minimum CET1 as well as the capital conservation buffer.​     ​The rule also ignores the excess capital most covered banks currently hold, adding to the cost of excess capital. Further, the need for management buffers increases actual LTD needs well beyond the regulatory requirements. So does the risk that, when new issuance is needed, it will be either very expensive or unavailable.  

The proposed Basel III Endgame further compounds the challenges regarding calibration. The Endgame proposal notes that Endgame will increase risk-weighted asset calculations for most institutions, increasing LTD requirements along with capital requirements. 

The LTD requirements share a lineage with resolution planning rules. The availability of recapitalization resources or “gone concern” capital is central to the FDIC’s ability to protect the DIF. The LTD rule sets a floor under those resources and creates a path to transmit losses from the bank to the parent company. As resolution planning requirements take hold, the amount and positioning of LTD to mitigate losses borne by the DIF may affect resolution strategy.  

It seems likely that these consequences will be felt by banks not yet categorized under the rule as well. For example, banks that wish to issue debt for corporate finance reasons, rather than compliance reasons, may find that compliance-driven issuance crowds out demand for their offerings, raising the cost of that debt. Further, as banks grow and evaluate strategic opportunities, the LTD requirements add to the cost and time horizon for banks that may cross the $100 billion threshold.  

The Big Picture  

The LTD rule requires more issuance of eligible long-term debt, which will likely replace other funding sources. The regulatory agencies have estimated that in-scope institutions will need to raise $70 billion of LTD to comply with the rule, while others have estimated much higher numbers.  

Adapting to new balance sheet management demands and deepening capital markets engagement will enable many strategies to offset the costs imposed by the LTD rule. Part II of this article will offer ideas on those and other ideas regarding effective and efficient compliance.  

Peter Kapp is an independent advisor with Forty4Advisors. Peter can be reached at gpkapp@gmail.com.