US regionals need at least two years for TLAC transition

Market participants think issuance will be feasible for largest, but only in calmer conditions

US regional banks should be able to meet looming requirements to issue bail-in debt, but market participants warn it will take time, and must be part of wider efforts to restore investor confidence in the sector.

“I would have a very sceptical view about any kind of real market access today for these kinds of bonds,” says John Roddy, co-head of financial services investment banking at Raymond James.

Jacques de Saint Phalle, head of the fixed income syndicate at investment bank Piper Sandler, agrees: “Right now, market conditions are quite frankly horrible for these banks to issue debt.”

At present, only the eight US global systemically important banks (G-Sibs) are required to meet the US standard for total loss-absorbing capacity (TLAC), which includes common equity, hybrid capital and a portion of long-term debt that is legally ring-fenced so it can be bailed in.

Bank accounting right now is providing a false picture of the financial strength of a bank, because they have ways to get around the mark-to-market concept

Richard Bove, Odeon Capital

Peter Troisi, director of US credit research at Barclays, expects all the banks that are not G-Sibs but have assets of at least $100 billion could face TLAC requirements in future. There are currently 17 banks in this group, of which 11 are in Category IV (assets of between $100 billion and $250 billion), five in Category III (between $250 billion and $700 billion) and one in Category II (more than $700 billion).

Troisi thinks the group would need to raise between $40 billion and $80 billion in long-term debt to comply with any TLAC rule that is introduced. Consequently, the rule would have to include a significant transition period.

“That shortfall we would expect to be closed over a period of at least two years – and that is important because it means regional banks would not feel immediate pressure to start issuing debt later this year in an environment where spreads are very wide,” says Troisi.

Pressure building

The US Federal Reserve and the Federal Deposit Insurance Corporation issued a notice of proposed rulemaking that would require TLAC for US regional banks in October 2022, and the idea has gained considerable momentum since the failure of SVB in March this year. At a House Financial Services Committee hearing on March 29, Democrat representative Bill Foster compared the Swiss government’s swift sale of giant Credit Suisse with the difficulties the FDIC had encountered trying to sell second-tier SVB.

“When a couple of weekends back, the US banking regulators tried to find someone to buy SVB, they failed,” said Foster. “The result was potential systemic risk and emergency intervention by regulators … but when Swiss regulators tried to find a partner to buy out Credit Suisse, they succeeded.”

Foster argued the layer of bail-in debt at the Swiss bank was the key difference that had facilitated the sale process by providing extra capital for the acquiring bank, UBS. He also suggested that the investors in the layer of bail-in debt might have imposed more market discipline than the shareholders did on SVB’s poor risk management practices.

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Unlike equity, holders of bail-in debt do not participate in any upside if the bank grows quickly, but do face the potential to be wiped out if the bank needs an emergency capital injection. In response to Foster’s questioning, Fed vice-chair for supervision Michael Barr indicated that the Fed would push ahead with the October TLAC proposal.

According to Roddy at Raymond James: “There’s going to need to be some new rules written around that before you are going to see a real active market at any level, and certainly before it is something that becomes viable for US community and regional banks.”

The finalisation of the TLAC rules is also likely to form part of a wider package of reforms to address the problems thrown into such stark relief by the failure of SVB and First Republic. In particular, Richard Bove, banking analyst and chief financial strategist at Odeon Capital, says regulators will need to unravel the alarm caused by large bond portfolios held by regional banks at amortised cost, rather than fair value.

“Bank accounting right now is providing a false picture of the financial strength of a bank, because they have ways to get around the mark-to-market concept,” he tells Risk.net. “They do not show what the true assets of the bank are, and they don’t show what the true equity in the bank is.”

That’s a concern shared in Congress, with Democrat representative Brad Sherman stating at the March 29 hearing that the current rules were “absolutely perverse”. US banks with less than $700 billion in assets are exempt from marking securities to market, even if they are supposed to be available for sale. Sherman said this meant there were around $600 billion in unrecognised losses in the banking sector, “so we’re overstating the capital of our banking system by perhaps a quarter”.

Weighing the cost

Piper Sandler’s de Saint Phalle says there are signs that market conditions for regional banks are beginning to stabilise. In early June, Truist and Capital One issued senior debt deals totalling $6.75 billion in aggregate. He thinks the larger regionals – which are likely to have the highest issuance needs – will ultimately be successful in the TLAC debt market when the time is right, without paying an excessive premium over ‘money centre banks’, another term for the G-Sibs.

“The PNCs and Truists of the world, US Bank, those guys are fine,” says de Saint Phalle. “The market has a strong view of them, they are still going to be coming to market pretty close to the money centres, because of the scarcity value: they don’t come to market as frequently.”

Barclays’ Troisi adds that regional banks benefit from the possibility a significant portion of their existing debt stock could already qualify for the TLAC rule. It needs to be legally separate from the operating liabilities of the bank (such as money owed to depositors and suppliers), and must not have any features that would make it hard to value or force early redemption.

Right now, market conditions are quite frankly horrible for these banks to issue debt

Jacques de Saint Phalle, Piper Sandler

US banks typically issue long-term senior debt from their holding company, rather than their FDIC-insured operating company, and Troisi says regional issuance rarely includes exotic features: “In general, regionals issue vanilla-type senior debt.”

However, he adds that the spread relationship between regional banks and G-Sibs could be permanently changed, making the cost of debt for regionals higher in future.

Moreover, analysts are concerned that the smaller regionals currently in Category IV under the Fed’s tailoring rules (with assets between $100 billion and $250 billion) could have more difficulty issuing TLAC debt. Several regional banks, including SVB and First Republic, grew rapidly in recent years to enter Category IV for the first time, mainly driven by large deposit inflows during Covid.

“Not all of those banks have economic access today to the investment-grade corporate bond market, and that’s where there could be a higher cost to issuing incremental debt,” says Troisi.

Chris Marinac, head of equity research at Janney Montgomery Scott, estimates that if TLAC were issued now by regional banks, the yields could be as high as 9% or 10%.

Surplus funding

A further question for banks that have substantial TLAC issuance needs as a proportion of their existing balance sheet is what to do with the extra wholesale funding. One of the factors behind SVB’s downfall was its inability to put extra deposit funding to work in the loans market. Instead, the bank built up a large portfolio of mortgage-backed securities that was vulnerable to interest rate hikes by the Fed.

Chris Marinac, Janney Montgomery Scott

If regional banks cannot invest the proceeds from TLAC issuance into the floating rate loans market, then they may focus on short-term assets that will reprice quickly if rates rise, to avoid incurring interest rate risk. The alternative of trying to hedge interest rate risk through the swaps market is proving difficult for regional banks at present, due to the slow development of term secured overnight financing rate benchmark products.

“I could see them parking money at the Fed after raising the debt,” says Marinac. “It has a little bit of an interest income negative to it, because it would narrow margins and increase their interest cost.”

Odeon Capital’s Bove says this problem is less severe at the moment because the yield curve is inverted, with markets anticipating rate cuts by the Fed in the medium term. This makes it cost-effective for banks to invest in short-term money markets.

“You are making more money on the Treasury bills you buy than on the long-term debt that you raise because the yield curve is inverted,” says Bove. “So there’s no pain to the bank at the current time, but in normal times, when you have a normal yield curve, it forces the bank’s earnings lower to issue long-term debt to buy short-term securities.”

Editing by Philip Alexander