The FDIC Board is considering today a Notice of Proposed Rulemaking (NPR) jointly with the Board of Governors of the Federal Reserve System and the Office of the Comptroller of Currency to require insured depository institutions with more than $100 billion in assets to maintain a minimum amount of long term debt.
This proposed rulemaking is the product of an extensive deliberative process. In October of last year, the FDIC and the Federal Reserve published an Advance Notice of Proposed Rulemaking (ANPR) seeking public comment on whether a layer of loss-absorbing debt held at the bank would be effective in facilitating the orderly resolution of large insured depository institutions.1 In the ANPR, the agencies sought input on how to structure such a proposal to facilitate resolution across a range of scenarios in a manner that is least costly to the Deposit Insurance Fund, and also minimizes contagion risk and impact to the financial system and local communities. In particular, the agencies sought comment on how to expand the options for resolution without resorting to the sale of the failed institution to another large banking organization or a Global Systemically Important Bank (GSIB).
The failure earlier this year of three large regional banks only underscored the agencies’ urgency in considering whether to put forward such a proposal. While the FDIC resolved all three institutions in a manner that mitigated systemic risk, that outcome was by no means certain. In particular, the resolution of Silicon Valley Bank and Signature Bank required the use of extraordinary authority by the FDIC, the Federal Reserve, and the Secretary of the Treasury -- the systemic risk exception under the Federal Deposit Insurance Act (FDI Act) -- to protect uninsured depositors at those institutions, setting aside the least cost requirement to the Deposit Insurance Fund.2
In making the proposal that is before the FDIC Board today, the agencies considered the comments received on the ANPR and their experience, both recent and long-term, in the resolution of large banks.
This proposal would establish a requirement that all covered banks issue qualifying long-term debt that would be available to absorb losses in the event of the failure of the bank, thereby protecting depositors and reducing the cost to the Deposit Insurance Fund.
Under the proposal, covered banks would include insured depository institutions with at least $100 billion in total assets and their affiliated banks. The proposal is designed to address the risks specific to these institutions.
The proposed rule would provide for eligible debt instruments to incorporate features, such as subordinating this debt to all other creditors, including depositors, and a simple “plain vanilla” structure - not a complex financial instrument - that makes them best suited to the goal of supporting resolution.
The requirement has been calibrated to support the stabilization and recapitalization of a bridge depository institution, and to facilitate a wider range of acquisition options. It would provide for a three-year transition period, which appropriately recognizes that banks may need time to issue debt that meets the requirements.
The proposal is coordinated with proposals by the Federal Reserve and the OCC, to assure that these requirements apply in the same manner to the institutions they supervise.
In crafting this proposal, the agencies carefully considered projected costs covered institutions might incur to meet and maintain the proposed long-term debt requirement. The costs associated with both the full estimated amount of long-term debt, as well as the amount needed to supplement the current volume of eligible long-term debt already issued by covered institutions were considered.
It is anticipated that as banks come into compliance over a transition period of several years they will replace existing funding sources, such as uninsured deposits, with long-term debt. Thus, the funding costs will be the difference between the cost of their existing funding sources and interest paid on long-term debt issued to meet the requirement. Taking this dynamic into account, and factoring in the existing long-term debt already issued by many covered institutions, the agencies concluded that the incremental long-term debt required under the proposal would marginally increase funding costs and may result in a decline of net interest margins of about 3 basis points.3
These relatively modest estimated compliance costs should be considered in the context of the potential benefits that may result from the requirement. For example, the FDIC currently estimates total losses to the Deposit Insurance Fund of over $30 billion from the recent failures of Silicon Valley Bank, Signature Bank, and First Republic Bank associated with coverage of insured deposits at all three banks and uninsured deposits at Silicon Valley Bank and Signature Bank. These costs – a major portion of which would have been borne by long-term debt holders if this proposal had been in place – will instead be passed on to the banking industry through assessments.4
This long-term debt requirement could have also made a wider range of resolution strategies and transactions available to the FDIC, which would have further reduced losses, potentially avoiding the necessity of a systemic risk exception, and possibly avoiding the costs that resulted from these failures altogether.
These are direct benefits that might have resulted from this requirement. We should keep in mind the benefit to the wider financial system that would result from less disruptive, and possibly fewer, large bank failures over time, and from limiting the ensuing contagion that such failures can cause. That is harder to quantify, but nonetheless may be consequential.
In summary, a long-term debt requirement such as the one being proposed today can mitigate the resolution challenges encountered in the failure of large regional banks and bolster financial stability. First, the long-term debt absorbs losses before the depositor class – uninsured depositors and the FDIC – take losses. This lowers the incentive for uninsured depositors to run. Second, even if the institution fails, the buffer of long-term debt reduces cost to the Deposit Insurance Fund and makes it more likely that a closing weekend sale could comply with the statutory least-cost test and avoid the need for a systemic risk exception. Third, it creates additional options in resolution, such as recapitalizing the failed bank under new ownership or breaking up the bank and selling portions of it to different acquirers, as an alternative to a merger with another large institution.
Since this debt is long-term, it will not be a source of liquidity pressure when problems become apparent. Unlike uninsured depositors, investors in this debt know that they will not be able to run when problems arise. This gives them a greater incentive to monitor risk in these banks and exert pressure on management to better manage risk. Finally, because these instruments are publicly traded, their prices serve as a signal of the market’s view of risk in these banks.
In conclusion, the experience of the three large bank failures this spring should focus our attention on the need for meaningful action to improve the likelihood of an orderly resolution of large banks under the Federal Deposit Insurance Act, without the expectation of invoking the systemic risk exception. The long-term debt requirement put forward in this NPR would be a meaningful step in that direction. I am pleased to support this Notice of Proposed Rulemaking. I look forward to reviewing the comments we receive.
Finally, I would like to thank the staff of the FDIC, as well as the Federal Reserve and the OCC, for their diligent and thoughtful work in developing this proposal.
1 ANPR: Resolution-Related Resource Requirements for Large Banking Organization, 87 FR 64170 (Oct. 24, 2022).
2 Joint Statement of the Department of the Treasury, Federal Reserve, and FDIC, March 12, 2023, available at FDIC: PR-17-2023 3/12/2023. As a general rule, section 13(c)(4) of the FDI Act requires the FDIC to resolve failed insured depository institutions at the least cost to the Deposit Insurance Fund, but provides an exception for instances where the failure will have would have serious adverse effects on economic conditions or financial stability, and any action to be taken would avoid or mitigate such adverse effects. 12 U.S.C. 1823(c)(4).
3 Notice of Proposed Rulemaking: Long-term Debt Requirements for Large Bank Holding Companies, Certain Intermediate Holding Companies of Foreign Banking Organizations, and Large Insured Depository Institutions at 111-112 [footnotes omitted].
4 As required by the Federal Deposit Insurance Act, the FDIC will impose special assessments to recover losses attributable to the two systemic risk determinations and the coverage for uninsured deposits. 12 USC 1823(c)(4)(G)(ii); see also FDIC Notice of Proposed Rulemaking: Special Assessment Pursuant to Systemic Risk Determination, 88 FR 32694 (May 22, 2023). Ordinary risk-based deposit insurance assessments will cover the rest.12 USC 1817(b).