New TLAC Guidance Could Have Positive Implications for US Banking Sector
The Financial Stability Board (FSB), an international body of banking regulators founded to promote global financial stability, on Sept. 25 confirmed that it would release its final proposal for minimum levels of “total loss absorbing capacity” (TLAC) required for globally systemically important financial institutions, or G-SIFIs, by the G20 Summit this November.1
Under the new rule, TLAC, comprised primarily of common equity, preferred equity, subordinated bonds and senior unsecured bonds, would be called upon in the event of severe financial stress rather than relying on extraordinary government support to help absorb losses and prevent a collapse of the banking system.
Higher standards for common and preferred equity were established many years ago to build larger firewalls to prevent another financial meltdown, and most banks are already in compliance with the new capital requirements. But this new rule is the first to target the amount of bonds that banks must issue, and is considered the most important new rule in regulators’ efforts to end the moral hazard of “too big to fail” banks.
The FSB’s initial proposal, released in November 2014, outlined a potential range of 16%-20% minimum TLAC to risk-weighted assets required by Jan. 1, 2019. Given the past precedent of US regulators enforcing tougher standards than global peers, most experts following the US banking sector were expecting a 20% minimum to be applied to all eight US G-SIFI banks, including JPMorgan Chase, Bank of America and Citigroup.
This outcome would have forced these banks to issue roughly $280 billion of new senior unsecured bonds before the Jan. 1, 2019 deadline, which is over and above refinancing any bonds scheduled to mature over that time frame. Concern over this potential new bond issuance has weighed on bank credit spreads over the past 12 months, despite continued improvement in the underlying credit fundamentals for US banks.
However, according to an article published by Bloomberg on Oct. 2, the FSB will propose only a 16% minimum for TLAC by 2019, rising to 18% by 2022. Additionally, according to the FSB, all members will support “consistent implementation over the appropriate timelines of this new standard.”2
This language is critical as it implies that US banking regulators will not enforce a shorter timeline or higher standards than what is being proposed by the FSB. Assuming this outcome proves correct, new senior bond issuance demands of US banks to comply with the 16% TLAC target by 2019 drops dramatically to only $58 billion, with an additional $120 billion needed to comply with the 18% TLAC target by 2022. This reduction in the supply overhang through Jan. 1, 2019 is substantial, and the longer timeline gives banks more flexibility to take other actions (i.e. reducing risk-weighted assets) to reduce their bond issuance needs.
Key takeaway
This is unquestionably positive for spreads on US bank senior unsecured bonds. We still see the most attractive relative value in preferred securities, followed by subordinated bonds from the US banks. However, with current bond spread levels near the widest levels over the past three years, combined with the outlook for less TLAC-related issuance needs, we have now become more positive on senior unsecured bonds from banks as well.
Overall, we believe the US banking sector is relatively attractive amidst the recent market turmoil, with potentially strong fundamentals that are anchored by the current regulatory environment and stable US economic backdrop. With valuations now at their cheapest levels in years, and potentially a much less onerous outlook for bond issuance, the investment proposition in US bank credit is very compelling.
1 Source: The Financial Stability Board, “Meeting of the Financial Stability Board in London on 25 September,” Sept. 25, 2015
2 Source: Bloomberg, “FSB Said to Phase in TLAC Bank-Failure Rule at Low End of Range,” Oct. 2, 2015
Read more fixed income investment views by Invesco’s experts.
Important information
Preferred equity is a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock.
Subordinated bonds are bonds that rank below other bonds with regard to claims on assets.
Senior unsecured bonds are bonds that are not backed by an asset of any kind. If bankruptcy occurs, repayment is not guaranteed by a future revenue stream, equipment, or property.
Credit spreads are the difference in yield between bonds of similar maturity but with different credit quality.
Spreads represents the difference between two values.
Valuation is how the market measures the worth of a company or investment.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The Financial and Banking industry can be affected by changes in government regulation, interest rates, economic downturns, and risks of insolvency or bankruptcy. Performance of investments from these industries will depend on the overall conditions of the companies in the industry as well as the industry as a whole.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
All data provided by Invesco unless otherwise noted.
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New TLAC guidance could have positive implications for US banking sector by Invesco Blog
