Preparing for the Proposed Long-Term Debt Rule: Part II (Compliance and Optimization)

A new rule requiring large banks to issue long-term debt (LTD) to boost their resilience and resolvability is on the way. The final rule has not been issued, so we don’t know when the clock starts ticking on compliance. But it’s not too soon to plan for a requirement likely to increase banks’ marginal cost of funding, impact strategic decisions, and demand more capabilities and resources.

Part I of this series introduced the rule, covering why it was proposed, what it will require, and potential industry impact (even for institutions not in scope). This article revisits elements from Part I and delves deeper into how practitioners and institutions can achieve effective and efficient compliance.

Background and Basics

The long-term debt requirement proposed last year by the Federal Reserve, FDIC, and OCC extends the scope of some of the total loss absorbing capacity (TLAC) 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 to allocate losses from a failed bank to investors.

The rule covers U.S. banks larger than $100 billion, foreign non-GSIB intermediate holding companies, and all insured depository institutions over $100 billion in assets. To comply, banks will raise qualifying external debt from third parties and loan the proceeds to subsidiaries to cover potential losses in resolution. Clean holding company provisions will reduce the opportunities for non-loss absorbing claimants to interfere with a bankruptcy.

Calibration, Eligible Instruments, and Timing

In-scope companies are generally 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.

For U.S. bank holding companies, eligible debt generally includes parent company “benchmark” debt issued to unaffiliated investors. Debt with less than two years remaining to maturity is subject to a 50% haircut, and debt with less than a year to maturity does not count toward the requirement. More details on eligible and ineligible debt are included in Part I of this article.

The LTD requirements generally have a three-year transition period, beginning with the rule’s finalization, or upon crossing the threshold to become a covered firm. The requirements phase in 25% in year one, 50% in year two, and fully by year three.

Interaction With Other Regulations

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

As a complement to capital requirements, LTD is intended to refill the fully depleted capital base of a failed institution, but 6% of RWA is enough to replace common equity tier one funds as well as the capital conservation buffer. The rule also ignores the excess capital most covered banks currently hold, adding to the incentive to reduce excess capital. Further, the need for buffers to reduce the risk of falling below required LTD levels increases LTD needs well beyond the stated requirements. The risk that new issuance is either very expensive or unavailable as needs increase or as LTD becomes inapplicable to the rule requirement may lead to substantial buffers, on top of what banks already hold against their capital requirements.

The proposed Basel III Endgame further compounds the challenges around calibration. The Endgame proposal notes that Endgame will increase RWA 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 deposit insurance fund (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.

Implementation Planning and Optimization

Compliance will often be the treasurer’s responsibility, but the rule will affect decisions beyond treasury. Banks need to adapt governance structures and practices, pricing frameworks, and capital markets capabilities. Longer term, these updates will illuminate optimization opportunities, as businesses and markets adapt to a new reality. As with any new compliance initiative, implementation will focus first on compliance, then on hardening the capabilities required to maintain compliance, then on optimizing business decisions around the new parameters introduced by the rule.

Ideas to consider along this journey follow.

Incorporating LTD Into Planning

Treasurers will consider outstanding current eligible debt, the effect of planned issuance, forecasted changes in RWA, and the forecasted “decay” of the eligible LTD balance when developing the path to compliance.

The decay of rule-eligible debt as it nears maturity will affect funding strategies by raising the effective cost of meeting the bank’s needs and pulling forward required funding transactions.

When developing the path to compliance, treasurers will consider:

• Outstanding current eligible debt.
• The effect of planned issuance.
• The timeline to target for compliance.
• The amount of issuance required.
• Forecasted changes in RWA, including as a result of Basel III Endgame.

This analytical baseline will allow capital markets teams to plan their issuance and communicate those plans to the market. It will also allow greater insight into the term structure/cost trade-off inherent in supporting an increased aggregation of long-term debt.

Risk managers will want to understand the market’s ability to absorb issuance as well as the increased maturity risk concentrations that may arise. Regulators will be keen to understand the timeline until compliance. And investors will want to understand the volume of issuance to come. All these considerations feed back into the bank’s profitability.

Debt Market Disruption and Financial Costs

The LTD rule will increase the absolute amount of debt outstanding in the markets, presenting several risks and costs:

• More volume, even during market calm, may widen spreads, raising the cost of all issuance.
• During market turmoil, markets may be either much more expensive or unavailable to meet issuance requirements. That could result in higher interest expense on debt, or higher debt outstanding at most points in the cycle to fund management buffers.

Compliance could be further challenged because some funds that reliably invest in banks have industry concentration limits that could prevent them from buying more. The Bloomberg Investment Grade Credit Index, for example, caps financial industry debt at 25% of its total assets. It was recently in the 23% range. Banks are concerned that such caps could limit the demand for additional debt and serve to increase the spreads needed to attract buyers. They are also concerned about operational challenges imposed by the proposed rule’s $400,000 minimum denomination restriction, which is meant to protect “retail” investors from bearing the cost of bank failures, but imposes operational challenges to asset managers who manage separate accounts. Opportunistic issuance approaches and market engagement could mitigate the worst of the feared effects, as could longer-term optimization initiatives.

For their part, investors are concerned that the wider spreads on regulatory long-term debt could drive mark-to-market losses on the “legacy” bank debt they hold at lower rates. Regulators have estimated that in-scope institutions will need to raise $70 billion of LTD to comply with the rule, while other estimates have ranged much higher than this.

Strategic Impacts

Longer term, the economic effects of the rule will inform changes in the bank’s business model. This may lead to strategies that result in reductions of RWA—whether prospectively as new business is subjected to higher hurdle rates, or through the sale of assets or business lines that are no longer attractive. This will compound the effects of the Basel III Endgame’s increased RWA density of many businesses. Strategic decisions must consider the fully loaded costs of new business.

Enhancing and Enabling Capabilities

Because the LTD rule requires more issuance of eligible debt, complying will likely reduce other funding sources. Adapting to new balance sheet management strategies and deepening capital markets engagement will enable strategies to offset the costs imposed by the rule.

Balance Sheet Funding and Investment Strategies

Balance sheet management is the first function treasurers will need to address, given the potential for wide-reaching effects on a risk profile. As LTD compliance shifts funding from bank to parent, there is a need for new systems and governance capabilities to manage the delivery of bond proceeds to the bank. This rerouting of funding strategies will require decisions that address:

• How to manage the funding cost differential between bank and parent company.
• Whether to manage any differences between the target term structure at the bank and the effect of back-to-back lending from the parent.
• Governance structures that ensure that bank funding and parent funding decisions meet requirements at each entity.

Given the increase in the cost and average life of borrowings to meet the LTD rule, bank management will need to revise their approaches to interest-rate risk, portfolio management, and derivatives usage. Over time, as the disciplines of managing debt at the parent company become standard procedure, optimization will become more natural. But in the short run treasurers will need to make sure debt and liquidity find their way to the most appropriate vehicle, minimizing frictions.

Adapting Issuance Plans to Mitigate LTD Decay

Treasurers should evaluate their issuance plans and overall program structure to mitigate the effects of decaying eligible debt. Debt that has funding and liquidity value but doesn’t satisfy the rule raises compliance costs by increasing issuance volumes.

Issuance plans should therefore explore the costs and benefits of changing the term structure of new debt. Extending the average life of outstanding debt can reduce the portion of LTD that is no longer eligible. While this may carry a term premium, that may be partly offset by the benefits of lower annual issuance needs.

Additionally, issuers may want to include an early redemption option allowing debt to be redeemed at par prior to maturity so the bond can be redeemed prior to losing all LTD eligibility. Shortly after the TLAC requirements were finalized, GSIBs began to issue TLAC debt with this feature, typically with a limited—or no—premium for the redemption option.

Adapting Funding Sources

Meanwhile, treasurers may be able to mitigate the costs of on-lending debt raised by the parent firm to subsidiaries by reducing other marginal sources of funding, so long as liquidity and funding metrics remain in line. While LTD will often have a higher cost than other marginal sources, the ability to reduce reliance on other funding sources, such as brokered CDs or Federal Home Loan Bank advances, can offset the new funding costs while managing interest-rate risk and liquidity metrics. Depending on the reliance on non-core funding, the excess liquidity generated by issuing LTD can be managed down, albeit likely at higher cost given the longer-term nature of LTD.

Capital Markets Capabilities

Increased issuance of LTD may tax the capital markets capabilities of banks that have not been regular issuers. Enhancing capital markets teams will allow more strategic management of debt issuance based on changes in pricing, competing supply, and investor sentiment.

A willingness to issue debt when conditions are favorable can counteract pressures. Treasurers will consider questions such as:

• “Should I issue now despite wider spreads, locking in those costs for the next several years?”
• “Can I mitigate the effects of spread widening by delaying issuance or drawing down buffers?”

Investor Engagement

Because ongoing debt issuance will lock credit market spreads into earnings over time, addressing investor concerns in a way that leads to more favorable financing rates can improve earnings—and enhance market liquidity. As issuance programs evolve, speaking directly to credit investors is likely to pay off.

Three years before the TLAC rule proposal, credit investors trying to understand the implications for their portfolios engaged directly with GSIBs, getting insight into the rule’s likely requirements and impact on issuance. This helped investors conduct a more informed analysis, and improved understanding among investors and issuers as they prepared for the rule. Despite concerns, the markets effectively absorbed increased issuance volumes.

For the long-term debt rule, investors are also likely to seek information on sector-wide supply dynamics and issuers’ strategies for achieving compliance, including issuance volumes, term structures, and other structural features such as redemption options. For well-established issuers, additional investor engagement may be relatively low-key. Issuers facing substantial increases in volume may benefit from more active outreach. Ways to engage include:

• Provide supplementary commentary and data with an earnings release or other public forums.
• Hold targeted investor interactions like roadshows.
• Engage with rating agencies.

Policy Updates

Heightened compliance requirements beget heightened governance requirements. The LTD requirements necessitate updates of contingency planning and capital forecasting capabilities at a minimum.

The LTD rule will likely require updates to the governance mechanisms for all aspects of balance sheet management, including much of the asset-liability committee policy suite (such as capital, liquidity, interest rates, and risk management). Many updates will reflect the shifts in balance sheet management. Of note is the need for a management buffer to reduce the risk of falling below the required amount of LTD, as acknowledged in the LTD proposal preamble. The buffer would inform early warning triggers, and prompt action as breach risk increases. Buffer methodologies would address the following drivers of uncertainty:

• Variability in RWA: Greater confidence in the quarter-end RWA calculation would reduce buffer needs.
• Forecasted Debt Outstanding: The decay of LTD eligibility as instruments near maturity can be known with certainty. Meanwhile, issuance plans are subject to market conditions and management decisions. A management buffer must address the likelihood that issuing eligible debt will be impossible or unduly expensive at a targeted point on the curve.
• Breach Consequences: Penalties for falling below the long-term debt requirement have not been specified. That uncertainty creates an incentive for a larger management buffer, all else being equal.  

Closing Thoughts

While there is some uncertainty regarding when a final rule will be issued, and it’s possible the proposed requirements could be modified, anticipating and planning for the rule is worthwhile. Exploring how it will affect the strategy and operations of an institution now, and beginning to plan for how to optimize compliance, will pay dividends.

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