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Thursday, 24 April 2014

Bond math

New U.S. TBTF plan is too big to succeed

A U.S. lawmaker’s new idea to fix too-big-to-fail looks too big to succeed. In theory, Republican Representative John Campbell’s proposal for a new capital cushion at the largest banks could minimize the likelihood of bailouts and justify the lighter regulation he desires. But do the math, and the proposal would mean big U.S. banks issuing more than $2 trillion of junior debt. Other flaws aside, that just doesn’t square with today’s markets.

The plan’s intent, to protect senior creditors by making banks issue a layer of long-term subordinated debt, seems on the right track. Requiring at least five years to maturity could help to keep banks’ funding more stable in a credit crunch. That ought to make government intervention less necessary and protect the economy from systemic risk.

That said, the protection would be stronger if the proposal involved banks holding more equity rather than debt, or at least a “bail-in” idea whereby the subordinated debt would convert to equity if a bank ran short of capital. The details of the new legislation, however, leave room for graver criticism.

The idea is that banks with assets of $50 billion or more would have to issue junior debt equal to at least 15 percent of their total assets. The 38 U.S. banks to which that would apply would, as a result, have to issue more than $2 trillion of the new paper. That’s already a quarter of the size of the entire corporate bond market - something that’s simply not achievable from scratch, even if investors turn out to like the instruments. JPMorgan alone would need to issue nearly $350 billion of the new debt - which would also logically cost more than whatever funding it replaced, setting back banks’ recovering profitability.

The bill would also create market triggers to compel regulators to resolve troubled institutions if their credit deteriorates sharply enough. This is also a fine concept in principle, but the proposal relies on often-volatile credit-default swap prices.

A well-structured additional capital requirement would legitimately support the idea of cutting back other regulation, as Campbell proposes, on the grounds that the largest banks would be safer in the first place. Unfortunately, his plan looks too out of whack with financial market reality to pass the test.

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U.S. Republican Representative John Campbell, who chairs the House Financial Services Subcommittee on Monetary Policy and Trade, introduced a bill on Feb. 11 that seeks to reduce the risk that big banks pose to the economy. The Systemic Risk Mitigation Act would require banks with total consolidated assets of $50 billion or more to hold another layer of protection. That would consist of long-term subordinated debt equal to at least 15 percent of a bank’s total consolidated assets.

The legislation also requires regulators to rely on market-based triggers to take remedial actions on a troubled institution. Those triggers depend on the average credit-default swap prices of the new subordinated debt. For example, if the CDS price rose by more than 100 basis points, the bank would have to be placed into receivership.

Alongside these additional safety measures, the proposal seeks to eliminate a few of the Dodd-Frank Act’s provisions. It would nullify the so-called “Volcker Rule,” which bars banks from proprietary trading. It would also strike out much of the prudential regulation required of large institutions, such as their 15 to 1 maximum leverage ratio.

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