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To TLAC or Not to TLAC?

It’s been over a year since we first commented in our article Will we see Tier 3 in Australia? about whether APRA could be contemplating a new Tier-3 capital class for the domestic big 4 banks. This would form the Australian response to the “Total Loss-Absorbing Capacity (TLAC)” regime being imposed on the world’s largest banks by international regulators.

As a quick recap, TLAC aims to define a total amount within a bank’s capital structure that is available to be converted into equity capital should this be necessary in stressed situations. This also reduces the need for public money to bail out a “too big to fail” bank, a politically controversial and expensive experience for many governments during and following the GFC.

Table 1: Global Systemically Important Banks

Source: BondAdviser, FSB

Strictly speaking, APRA has no need to create a TLAC regime since none of Australia’s banks are Global Systemically Important Banks (G-SIBs, see table 1 above), for whom the TLAC requirements were written. Nevertheless, the Financial System Inquiry (FSI) back in 2014 stated that “when seeking funding in wholesale markets, the internationally active Australian banks must compete against banks that meet these global requirements” and called for a similar measure in Australia.

For the past few years, TLAC has been steadily rolled out internationally with exact requirements being optimised and tweaked. The Financial Stability Board (of which Australia is a member) finalised European TLAC requirements in December 2017, the same month the US Federal Reserve formally adopted a TLAC rule for US banks, to be formally implemented in 2019. “Brexited” UK followed suit in May 2018 when the Bank of England published targets for the UK’s version of TLAC – known as Minimum Requirement for own funds and Eligible Liabilities (MREL), to be applied from 2020. Once established, non-compliance could impede a bank’s ability to make discretionary distributions such as dividend payments or additional tier-1 coupons, as TLAC is part of the Pillar 1 Basel requirements.

APRA on the other hand, has not yet commenced consulting with the banking sector, nor does it seem likely it will start to in the near future after a few false starts. It is understood the regulator is considering TLAC separately to its assessment of “unquestionably strong”, even though TLAC forms part of the capital buffer available to soak up losses.

Should Australia really adopt TLAC? Whilst the benefits are obvious, the potential costs are less so. As the major four banks frequently tap the international capital markets (and Australia as a whole is a net-importer of capital), a lack of visible compliance with a TLAC regime could prejudice Australian banks with offshore investors as it would be relatively difficult for international investors to assess capital ratios uniformly, making it possible for a “TLAC discount” on Australian bank debt, forcing up borrowing costs. Moreover, endorsing a bail-in regime under TLAC too strongly could lead ratings agencies to reduce assumptions that big banks will receive implicit government support in a crisis, given the bigger buffer reduces the need for such support. This could lead to an outright ratings cut, which would also put upward pressure on funding costs. Whatever the argument, what’s for certain is that TLAC imposes extra costs on banks in non-crisis times, one way or another. In an attempt to quantify the cost, CBA recently published a rough 13 bps cost for the banking sector if the sector is to replace about $135 billion of existing debt with TLAC-compliant instruments.

So what is the right conclusion? Is TLAC the next thing for Australia? Our “unquestionably strong” capital requirements are generally high for international standards. Coupled with a broadly conservative banking culture this helped to insulate Australia from the worst effects of the GFC. The country needs to maintain strong links to the world growth engines of America and the Asia-Pacific. If doing so necessitates TLAC, we are sure that the regulators can eventually strike a good cost-benefit balance which continues to safeguard the country’s financial reputations.