Total loss absorbing capacity

What Is Total Loss Absorbing Capacity?

Total loss absorbing capacity (TLAC) is an international regulatory standard designed to ensure that global systemically important banks (G-SIBs) possess enough equity and bail-in debt to absorb losses and facilitate an orderly resolution in the event of failure. This standard falls under the umbrella of regulatory finance, aiming to prevent a financial crisis and minimize the need for taxpayer-funded bailouts. By requiring large banks to maintain a minimum amount of loss-absorbing capacity, TLAC aims to protect financial stability by shifting the burden of a bank's failure from taxpayers to its investors.¹⁹

TLAC instruments are those that can be written down or converted into equity to recapitalize the failing institution. This includes Common Equity Tier 1 capital, additional Tier 1 capital, Tier 2 capital, and certain unsecured debt instruments with a maturity of at least one year.¹⁸,¹⁷ The framework enhances the ability of a resolution authority to manage the failure of a G-SIB without severe disruption to the broader financial system.

History and Origin

The concept of Total Loss Absorbing Capacity emerged as a direct response to the 2008 global financial crisis. The crisis highlighted a significant problem: several large financial institutions were deemed "too big to fail" because their collapse would have catastrophic ripple effects throughout the global economy. This perception often led to government bailouts, shifting the financial burden to taxpayers.¹⁶

To address this, the G20 leaders called for an end to "too big to fail" and mandated the Financial Stability Board (FSB) to develop a standard for the loss-absorbing and recapitalization capacity of G-SIBs. In November 2014, the FSB, in consultation with the Basel Committee on Banking Supervision (BCBS), published a consultative document on an international standard for TLAC.¹⁵ The final TLAC standard was issued by the FSB in November 2015, establishing minimum requirements for the instruments and liabilities that should be readily available for bail-in within resolution at G-SIBs.¹⁴ This landmark initiative aimed to ensure that shareholders and creditors, rather than taxpayers, would bear the losses of a failing systemically important financial institutions.¹³

Key Takeaways

Total loss absorbing capacity (TLAC) is a post-2008 financial crisis regulatory standard.
It ensures that global systemically important banks (G-SIBs) can absorb losses and recapitalize themselves without taxpayer funds during a bank failure.
TLAC consists of eligible equity and long-term debt instruments that can be written down or converted into equity.
The standard is set by the Financial Stability Board (FSB) and implemented by national regulators.
Its primary goal is to enhance financial stability and facilitate orderly resolution.

Interpreting Total Loss Absorbing Capacity

Interpreting Total Loss Absorbing Capacity involves understanding its purpose: to ensure that a failing G-SIB can be resolved without resorting to public funds. A higher TLAC ratio indicates a greater capacity for a bank to absorb losses internally before external support or a disorderly liquidation becomes necessary. Regulators monitor banks' adherence to the TLAC requirements, which are typically expressed as a percentage of a bank's risk-weighted assets (RWA) and its leverage ratio exposure (LRE).¹²

For instance, as of January 1, 2022, G-SIBs are generally required to hold TLAC equal to at least 18% of their RWA and 6.75% of their LRE.¹¹,¹⁰ This means that a significant portion of a G-SIB's funding structure must consist of liabilities that can be "bailed in," transforming them from debt to equity, thereby recapitalizing the bank and allowing it to continue its critical functions even in a gone concern scenario. This mechanism contrasts with a going concern where a firm operates normally.

Hypothetical Example

Imagine "Global MegaBank Inc." (GMB), a designated Global Systemically Important Bank. GMB has €1 trillion in risk-weighted assets and €500 billion in leverage ratio exposure. According to the current TLAC requirements, GMB must hold TLAC equal to at least 18% of its RWA and 6.75% of its LRE.

To meet these requirements, GMB would need:

TLAC (RWA basis) = 18% of €1,000 billion = €180 billion
TLAC (LRE basis) = 6.75% of €500 billion = €33.75 billion

GMB has already issued €100 billion in Common Equity Tier 1 capital. To fulfill the remaining TLAC requirement, GMB issues an additional €80 billion in long-term unsecured subordinated debt and contingent convertible bonds that are eligible to be written down or converted into equity in a resolution. This ensures GMB has a robust buffer, allowing a resolution authority to intervene and recapitalize the bank using these instruments, minimizing disruption to the financial system and avoiding taxpayer exposure.

Practical Applications

Total loss absorbing capacity is primarily applied within the framework of international banking regulation, particularly for global systemically important banks (G-SIBs). Its practical applications include:

Enhancing Bank Resiliency: TLAC requirements compel G-SIBs to maintain a substantial buffer of capital and eligible debt, which can be used to absorb losses and recapitalize the institution in a crisis. This directly improves the bank's resilience and reduces the likelihood of systemic contagion.
Facilitating Orderly Resolution: By pre-positioning loss-absorbing capacity, TLAC simplifies the process for resolution authorities to implement an orderly wind-down or restructuring of a failing G-SIB. This minimizes market disruption and ensures the continuity of critical financial services. The Federal Reserve Board, for example, adopted a final rule to strengthen the ability of government authorities to resolve the largest domestic and foreign banks operating in the United States without taxpayer support.
Shifting ⁹Burden from Taxpayers: One of the core aims of TLAC is to ensure that the costs of a bank failure are borne by its shareholders and creditors through mechanisms like bail-ins, rather than by taxpayers.
Market Discipline: The existence of TLAC requirements encourages greater market discipline as investors in TLAC-eligible instruments are aware their investments are at risk in a resolution scenario. This provides incentives for investors to monitor banks more closely.
Stress Testing: TLAC requirements are often integrated into stress testing scenarios, where regulators assess if banks have sufficient TLAC to withstand severe adverse economic conditions.

Limitations and Criticisms

While Total Loss Absorbing Capacity is a critical component of the post-crisis regulatory framework, it faces certain limitations and criticisms:

Complexity: The TLAC framework, especially its interaction with existing regulatory capital requirements like Basel III, can be highly complex. This complexity can make implementation challenging for banks and oversight difficult for regulators.
Market Ca⁸pacity for Issuance: There have been concerns about the capacity of markets to absorb the large volumes of TLAC-eligible debt that G-SIBs need to issue, particularly in certain currencies or jurisdictions. This could potentially increase funding costs for banks.
Cross-Border Resolution Challenges: Despite TLAC's international nature, challenges can arise in cross-border resolutions, especially concerning the allocation of losses and the recognition of bail-in powers across different legal jurisdictions. This complexity was highlighted by the 2023 banking crises, where authorities faced challenges in bank resolution.
Potential⁷ for Contagion: While TLAC aims to reduce contagion, some critics argue that the bail-in mechanism, if not carefully managed, could still trigger market instability or affect investor confidence in a broader range of bank liabilities. The Basel Committee on Banking Supervision (BCBS) has published standards to limit contagion within the financial system from TLAC holdings.
Impact on⁶ Emerging Markets: Implementing TLAC requirements in emerging markets may pose unique challenges due to differences in financial market depth, investor bases, and legal frameworks. The International Monetary Fund (IMF) has discussed the challenges for emerging market and developing economies related to financial stability and debt vulnerabilities.

Total Loss ⁵Absorbing Capacity vs. Regulatory Capital

Total Loss Absorbing Capacity (TLAC) and regulatory capital are both crucial elements of a bank's financial strength, but they serve distinct yet complementary purposes. Regulatory capital, often defined by the Basel Accords, primarily focuses on a bank's capacity to absorb losses on a "going concern" basis—meaning while the bank is still operating normally. It ensures that a bank has sufficient capital to cover unexpected losses from its daily activities and business risks, preventing it from becoming insolvent in the first place.

In contrast, TLAC is designed for a "gone concern" scenario—when a global systemically important bank (G-SIB) is no longer viable and needs to be resolved. While TLAC includes regulatory capital (such as Common Equity Tier 1, Additional Tier 1, and Tier 2 capital), it also mandates a minimum amount of external long-term debt that can be written down or converted into equity during a resolution. This additional layer of loss-absorbing capacity ensures that a failing G-SIB can be recapitalized and restructured without requiring a government bailout, transferring losses to private investors rather than taxpayers. The core distinction lies in their primary application: regulatory capital keeps banks afloat, while TLAC ensures an orderly wind-down if they cannot be kept afloat.

FAQs

What types of instruments qualify as TLAC?

Instruments that qualify as Total Loss Absorbing Capacity generally include Common Equity Tier 1 (CET1) capital, Additional Tier 1 (AT1) capital, Tier 2 (T2) capital, and certain unsecured senior and subordinated debt instruments. These debt instruments must typically have a residual maturity of more than one year and be capable of being written down or converted into equity in a resolution scenario.

How is TLAC di⁴fferent from Basel III capital requirements?

TLAC builds upon and complements Basel III capital requirements. While Basel III establishes minimum capital ratios for banks to operate on a "going concern" basis (i.e., while financially healthy), TLAC focuses specifically on Global Systemically Important Banks (G-SIBs) and their capacity to absorb losses and be recapitalized during a "gone concern" scenario (i.e., when facing insolvency). TLAC ensures that beyond the minimum capital, there's enough loss absorption capacity for an orderly resolution without public funds.

Why was TLAC introduced?

TLAC was introduced by the Financial Stability Board (FSB) following the 2008 global financial crisis. Its primary goal was to address the "too big to fail" problem, ensuring that the failure of large, interconnected banks would not destabilize the global financial system or necessitate taxpayer-funded bailouts. It aims to ensure that private investors bear the costs of a bank's failure.,

Do all banks ³n²eed to comply with TLAC requirements?

No, TLAC requirements primarily apply to Global Systemically Important Banks (G-SIBs). These are the largest and most interconnected financial institutions whose failure could pose a significant risk to the global financial system. However, some national authorities may impose similar loss-absorbing capacity requirements on their domestic systemically important banks (D-SIBs).

What happens i¹f a bank does not meet its TLAC requirement?

If a bank fails to meet its Total Loss Absorbing Capacity requirement, it could face various regulatory consequences. Regulators may impose restrictions on the bank's operations, such as limits on dividend payments, share buybacks, or bonus payments. Ultimately, persistent non-compliance could lead to more severe supervisory actions aimed at restoring the bank's capital adequacy and loss-absorbing capacity.