The federal bank regulatory agencies have proposed a rule requiring issuance of long-term debt by U.S. banking organizations with assets exceeding $100 billion that are not deemed global systemically important banks (GSIBs). In this post, we identify two significant problems with the proposed rule that may have been unintended, and in any event were not considered by the agencies in assessing its cost.
As background, the proposed rule applies to both banks and their bank holding companies. Parent companies must downstream the proceeds of externally raised debt to their subsidiary banks, which then issue internal long-term debt back to their parent entities. Although a bank’s externally issued outstanding debt could cover both the requirements for the bank holding company and the subsidiary bank itself, only internally issued debt would satisfy the proposed bank level requirements. Ultimately, all mandatory external long-term debt would have to be raised by the parent company under the proposal, with the proceeds channeled to its subsidiary banks as internal long-term debt.
The banking agencies estimate that a total shortfall of existing long-term debt versus required debt of about $70 billion: $20 billion at Category II and III banks, and $50 billion at Category IV banks covered by the proposal.[1] However, the proposal’s shortfall is underestimated for two reasons. First, the proposed rule does not examine a quite realistic scenario where the holding company meets the debt requirement but does not have liquid assets to downstream to its subsidiary bank. Second, the proposed rule does not consider the effects of downstreaming debt from the parent to its subsidiary banks on the bank holding company’s liquidity coverage ratio (LCR). Some banks may need to issue additional debt because they cannot maintain the required LCR at the holding company level while changing the liability composition of the balance sheet at the bank level. Our analysis shows these two factors increase the shortfall of banks subject to the LCR to nearly $65 billion, about 2.3 times higher than the banking agencies’ projections.
Explaining the Effect of the Long-term Debt Requirement Using Simplified Bank Balance Sheets
In this post, we use simplified balance sheets to explain the transactions between the bank, the parent only, and the bank holding company. We only show the balance sheet items essential for understanding the mechanics related to issuance of internal long-term debt by the bank to its parent entity.
- On a bank’s balance sheet, the asset side contains liquid assets like reserve balances and Treasury securities. Note that the LCR framework caps the amount of a bank’s high-quality liquid assets (HQLA) that can count toward the bank holding company’s LCR. The bank’s HQLA can only contribute to the bank holding company’s LCR up to the value of the bank’s projected net cash outflows. On the liability side, there are overnight deposits from the parent only and internally issued long-term debt at the bank level.
- On the parent-only balance sheet, the asset side contains liquid assets, including overnight deposits and investments (equity) in the bank; on the liability side, there is long-term debt issued externally.
- On the bank holding company’s balance sheet, the asset side contains liquid assets, with some qualifying as HQLA to satisfy the LCR. Note that the HQLA amount excludes trapped liquidity, defined as the HQLA held at the bank in excess of its total net cash outflows that cannot be transferred to nonbank affiliates. The liability side contains externally issued long-term debt.
Why the LTD Shortfalls are Underestimated
The examples assume that for each $1 of long-term debt the bank holding company is funded with, externally issued by the parent, the parent has $1 in overnight deposits or equity investments in its bank on the asset side. We also assume that the bank currently meets the LCR at both the bank and the bank holding company levels and aims to maintain the current LCR level at the bank holding company (the level disclosed to market participants). Let us illustrate how Category II and III banks manage the transfer of asset/debt proceeds between the bank and its parent company and discuss why the proposal significantly underestimates the long-term debt shortfalls of these banks.
Case 1: Subsidiary Banks Do Not Have Long-term Debt
In Table 1, we present a bank holding company with externally issued long-term debt (LTD) by the parent but does not have any debt at the bank subsidiary level. Normally, the parent would infuse capital while downstreaming the funds in a deposit account or term deposits. However, for ease of exposition, we present a case where the parent only makes equity investment in its bank subsidiary. In such a scenario, the bank’s ability to meet the long-term debt requirements hinges on the parent company’s ability to buy the bank subsidiary’s long-term debt. Note that if the parent company lacks enough liquid assets to purchase the bank’s long-term debt, it will need to issue more debt to cover the bank’s long-term debt shortfall.
Table 1: Before Introduction of Long-Term Debt Requirements
Before implementation of the long-term debt requirement, the parent company would transfer funds to its bank as equity after issuing external long-term debt. But with the long-term debt proposal, the parent company would need to redirect funds initially intended for equity investments to downstream externally raised debt proceeds to its bank subsidiary. In turn, the bank would issue internal long-term debt back to its parent to meet the long-term debt requirement. However, the parent company cannot convert its existing equity in the bank into internally issued debt that aligns with the bank level requirements under the long-term debt proposal. To bridge the gap at the bank level, the parent company would have to issue securities, such as long-term debt, preferred stock or common stock, enabling it to finance the internally issued long-term debt to the bank (in our example, valued at $1).
In Table 2, let us assume the bank is issuing long-term debt. We show the balance-sheet adjustments for both the bank and the parent company when the latter issues more debt to meet the bank’s long-term debt requirement. The bank’s balance sheet expands, because the parent company issues an extra $1 in long-term debt. On the asset side, the parent company will hold the $1 of long-term debt issued to its bank. The boost in funding to the bank in the form of long-term debt will increase treasuries by $1 on the asset side of the bank.
Table 2: After Introduction of Long-Term Debt Requirements
Case 2: Subsidiary Banks Receive Overnight Deposits from the Parent Company
Next, we examine a scenario where the subsidiary bank receives overnight deposits from the parent company. In such a case, the parent company’s need to issue additional debt is contingent on its ability to meet the LCR at the bank holding company level. Currently, some parent companies maintain overnight deposits at the bank to meet liquidity requirements and other regulatory needs and to offer a source of strength to the subsidiary bank. This arrangement also optimizes the amount of excess HQLA at the bank, which can be upstreamed to the bank holding company to meet the LCR requirements. In Table 3’s scenario, the parent company issues $2 of external long-term debt and channels it to its bank subsidiary as an overnight deposit. When the overnight deposits are received from the parent company, the bank then possesses HQLA assets valued at $2.
Table 3: Before Introduction of Long-Term Debt Requirements
The bank holding company can count the subsidiary’s HQLA only up to the amount of the subsidiary’s projected net cash outflow. In this case, the net cash outflows attributed to the parent company would be $2, because deposits of financial institutions have an outflow rate of 100 percent, so only $2 of HQLA would count. Since the parent company’s sole liability is long-term debt, it would not have any other liabilities.
In Table 4, we show the parent company placing $1 of long-term debt with its bank after the implementation of the long-term debt requirement. This means $1 of overnight deposits in the bank is replaced by $1 of internal long-term debt issued by the bank. After this transaction, the parent company’s balance sheet remains unchanged, but its asset composition shifts from overnight deposits to long-term debt at the bank level. Likewise, the bank’s balance sheet remains the same, but there is a shift in the composition of liabilities from overnight deposits from the parent company to internal long-term debt. This shift reduces the HQLA amount that can be counted toward the LCR of the bank holding company.
In scenarios driven by the long-term debt requirement, the net cash outflows assigned to the holding company is $1, so only $1 of HQLA would be eligible to be upstreamed to the bank holding company. Consequently, the bank has $1 of “Excess HQLA,” representing HQLA beyond the projected net cash outflows. The bank holding company’s balance sheet size remains constant: $2 in liquid assets, and $1 in long-term debt as liabilities. Yet, the substitution from overnight deposits to long-term debt reduces the HQLA that can be counted at the bank holding company by $1 and increases trapped liquidity in the bank subsidiary by the same amount.
Table 4: After Introduction of Long-Term Debt Requirements
If banks must hold long-term debt instead of overnight deposits, this could require the parent company to issue more term debt to restore the level of the bank holding company’s LCR. Currently, the overnight deposits boost the bank’s net cash outflows and maximize the amount of HQLA at the bank level that can be upstreamed to the bank holding company, helping it satisfy its own LCR. To restore the LCR to its initial level before the long-term debt requirement’s introduction at the bank, the parent company would need to issue securities that would not increase net cash outflows at the parent level (for example, long-term debt, preferred stock or common stock). These raised funds would then be used to transfer the proceeds to the bank in the form of an overnight deposit.
In Table 5, we illustrate a scenario where the parent company issues more long-term debt to restore its LCR to account for the proposal’s effects. The parent company issues an extra $1 of long-term debt and channels these funds to its bank as overnight deposits. This action increases the amount of HQLA at the bank that can be upstreamed to the bank holding company, due to the increase in net cash outflows. As a result, the bank holding company restores its $2 of HQLA and its LCR.[2]
Table 5: After Introduction of Long-Term Debt Requirements and Restore LCR
Banks need to decide whether to issue the additional debt and bear the subsequent interest expenses or to adapt to lower publicly reported LCRs as the standard. Redistributing liquidity from the parent to the bank will also lead to considerably higher bank level LCRs. The LCR rule mandates public LCR disclosure at the bank holding company level. As a result, the LCR at this level may not fully represent the bank’s liquidity. By establishing a significantly larger buffer at the bank, the publicly reported LCR will be less effective at conveying the strength of the banks’ liquidity profile.
Shortfall Estimates for LTD Requirements Based on These Scenarios
This section revises the shortfall estimates based on the two scenarios we highlighted, and in which the bank also needs to meet an internal long-term debt requirement. Based on the proposal’s assumptions, we estimate a shortfall of $9.1 billion for Category II and III banks. This estimate is lower than the proposal’s shortfall estimates of $20 billion, since we use the most recent balance sheet information (from 2023 Q2) and current long-term debt outstanding to construct our estimates. Although our initial shortfall estimate is lower than that in the proposal, it significantly increases when we account for the two factors we previously discussed.
As shown in Figure 1, the bank level shortfall for Category II and III banks increases by an estimated $15.7 billion. This shortfall increases by another $40 billion when we consider the need to restore the LCR at the bank holding company level. After adjusting for these two factors in the long-term debt proposal’s cost estimates, the total shortfall for Category II and III reaches $64.9 billion. This is about seven times our initial shortfall estimates of $9.1 billion and nearly $45 billion more than the proposal’s estimate.
Since March 2023, regional banks across the United States have faced increased pressure from rising funding costs. Forcing these banks to issue a substantial amount of long-term debt would exacerbate the pressure on their profitability. With many regional banks currently facing a marginal cost of funding ranging from 4 to 5 percent, making profitable loans with reasonable credit risk has become more challenging. The new requirement will likely prompt banks to issue most of their external debt from the parent company, which usually results in higher credit spreads than their banking subsidiaries. This could also lead to higher debt spreads, because the market would need to absorb a much larger amount of long-term debt.
The banking agencies could alleviate the burden of more issuance to meet the LCR at the holding company level by offering flexibility to satisfy the bank requirement. For instance, they could permit long-term debt to be excluded from trapped liquidity or allow banks to issue a support agreement from the parent company that promises overnight deposit funds to the bank in case of deterioration. Furthermore, the banking agencies could also offer flexibility in satisfying long-term requirements through existing debt, intercompany deposit liabilities or new debt issuances at the bank level.[3] Lastly, the banking agencies could lower the calibration of subsidiary bank requirements given the amount of debt banks would have to issue to meet the requirements.
Conclusion
Our analysis reveals that the long-term debt proposal considerably underestimates the long-term debt shortfalls banks are facing. One major reason for this shortfall is that banks are unable to substitute the parent’s overnight deposits at the bank with internal long-term debt without notably affecting the liquidity coverage ratio of the bank holding company. To maintain their LCR levels, holding companies would need to issue a substantial amount of long-term debt.
Although our discussion focused on the long-term debt shortfall adjustments for banks subject to the LCR, banking agencies are expected to apply both the LCR and NSFR on Category IV firms. We will evaluate the shortfalls for these banks in a forthcoming post.
[1] These estimates were calculated based on the averages of balance-sheet information between 2021Q4 and 2022Q3.
[2] Alternatively, the holding company could hold liquid assets that could be counted toward HQLA instead of placing deposits in the IDI. However, regulators like to have more resources at the IDI for resolution purposes.
[3] The decision to meet long-term debt requirements through bank-level or holding company issuance would depend on the bank holding company’s resolution strategy and relative funding costs.
