Does More Debt Mean Fewer Problems? WSJ Renewal Wondered

WSJ Renewal reported that a proposal to expand the requirement to issue long-term debt is the requirement for megabanks that is part of what is known as the Total Loss-Absorbing Capacity, or TLAC, standard. This helps regulators with the job of resolving a troubled bank by providing an extra, cushioning layer of debt that can be wiped out and converted into equity in the event that the government needs to recapitalize a failing bank. The hope is that with a “bail-in” from such debt, the government can avoid funding a bailout with money from taxpayers or the deposit-insurance fund.

In a situation such as the one for Silicon Valley Bank, it might have helped to have funded more of its business with unsecured debt. Back in 2019, Martin Gruenberg, who was then a board member at the Federal Deposit Insurance Corp. and is now chairman, highlighted that, for resolving a bank with no acquirer and “little or no unsecured debt to absorb losses,” it is likely that it “would require that uninsured depositors take losses.” WSJ Renewal said.

That said, the current market environment might be a tough one for banks to be issuing more loss-absorbing debt. For one, debt investors are now hyperaware of the risks of instruments with some of these features after holders of Credit Suisse Additional Tier 1, or AT1, bonds were wiped out to help facilitate its acquisition by UBS. Plus, banks are already going to be facing a squeeze on their earnings going forward from higher interest costs as depositors demand higher rates on their cash. Long-term debt such as unsecured bonds are usually an even more expensive source of funding.

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But unless banks can show investors that they have a better handle on interest-rate risk, they might trade at lower multiples in the future to reflect this now front-of-mind concern. One key way they can do so is to improve the matchup between their assets and liabilities. Replacing some deposit funding with long-term debt can help reduce banks’ liquidity risk. A bank that buys a five-year bond paid for with on-demand deposits might make more money than one that pays for it by issuing bonds of its own, but it runs the risk that those deposits leave before the bond pays off, forcing it to scramble for other ways to repay them.

That is what has happened to SVB and others that bought ultrasafe longer-term investment assets but did a poor job matching them with what proved to be the ultrashort duration of their deposit liabilities. SVB’s parent company, for example, had just over $3 billion of unsecured long-term debt, or about 2% of what it had in uninsured deposits at the end of last year.

Adding more debt wouldn’t eliminate mismatches between banks’ assets and liabilities. Nor should it, since banks’ ability to “transform” maturities—taking short-term money and turning it into long-term financing—is a vital part of their job in the economy. But it might help mitigate extreme imbalances such as at SVB.

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In general, banks have relied more heavily on deposit funding in recent years, even with the megabanks having debt requirements. A group of the 11 largest U.S. banks had deposits making up about two-thirds of total liabilities as of the end of last year, compared with around 40% 15 years ago, according to figures compiled by analysts at Barclays. Informed WSJ Renewal.

Also, though TLAC-eligible long-term debt in the U.S. has some commonalities with the Credit Suisse’s AT1 bonds that were wiped out, it isn’t exactly the same. AT1s were thought by many buyers to be triggerable only under certain conditions before the bank reached the point of failure. There is now vigorous debate on whether those conditions were met. But TLAC-eligible debt is typically more clear about what happens when the bank has essentially already failed.

Megabanks that have already been subject to long-term debt requirements are arguably now enjoying some of the stability resulting from these and many other more-stringent rules. Leveling the regulatory playing field somewhat might help with the fear that deposits will simply keep flowing to the biggest, most-regulated banks.

Banks made plenty of mistakes in what they bought. They also made mistakes in how they paid for it.