Investing

The Fed’s Loss-Absorbing Capacity Threatens Big Banks

In October 2015 the Fed governors unanimously voted to pursue a “loss-absorbing capacity” measure requiring the largest eight banks, including “JP Morgan, Chase, Citigroup and Bank of America,” to issue hundreds of billions in new equity and debt to insulate the economy from the crippling effects of future financial shocks. The key focus of this proposal is to transfer the risk of failure back to the financial sector, specifically investors, by ensuring an adequate supply of high-quality assets are easily accessible to convert to stock for capital injection purposes instead of relying on tax-payer bailouts.

Oliver Ireland, former associate general counsel at the Fed, offered this analogy to best describe the justification for such action: “The previously adopted capital and liquidity rules are the ‘belt’ designed to reduce the likelihood of big banks failing, while the new proposal for transferring potential losses to investors is the ‘suspenders’ in case banks do fail.” If adopted the regulations governing the new equity and long-term debt issues would mandate the formation of a holding company which, in the case of a bank’s failure, the assets “would be seized but subsidiaries would be allowed to continue to operate.”

Consequently it is reasonable to assume the largest eight “too big to fail” banks will offer investors greater interest rates to compensate for such added risk. Unfortunately it is not clear how current stakeholders will be rewarded should they hold on to their portfolio if and when the loss-absorbing capacity rule becomes effective. Presently the word on the street is “if formally adopted, most of the requirements wouldn’t take effect until 2019, and the remainder not until 2022.” Thus, between now and sometime in the not too distant future it is likely the market will witness a potentially volatile disruption in the market caps of these eight banks.

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