The Impossibility of TLAC

TLAC (“tea-lack”) stands for Total Loss Absorbing Capacity. TLAC sits as the very center of the post-Lehman financial system. Key financial institutions are still quite large, but the financial community aims to make bankruptcy somewhat tidier, and thus more likely to actually happen, than it was before 2010. “Resolution” is the preferred term here for failure, even though most normal Americans would call it “bankruptcy.” TLAC provides the foundation for all of the post-Lehman resolution plans. But what is TLAC? TLAC are a set of regulations that require some equity in place to help in resolution. But the more curious part of TLAC is the long-term debt requirement, which necessitates the creation of a squad of bondholders who stand ready to endure substantial pain upon financial distress. These requirements work hand-in-hand with requirements that the bank’s holding company have a “clean” balance sheet, such that these TLAC bondholders and the shareholders are all alone on the right-hand side, waiting to incur losses – or, more elusively, “haircuts” – in times of stress. Most often, this will mean that bondholders will be involuntarily converted into the new bank shareholders – either in a chapter 11 bankruptcy proceeding or a similar “OLA” (you knew there’d be more acronyms) proceeding under the Dodd-Frank Act. And those shares will be worth the bondholders’ old par value, less the losses the bank has suffered and will suffer during the course of its “resolution.” To put it mildly, bondholders will not be paid in full. The public stockholders of the holding company would bear the first losses, likely exiting the scene quite swiftly, and the bank’s long-term debt obligations would be converted into equity that would be used to capitalize the successor entity. That is, if all goes according to plan. In my paper, I report the results of a simple empirical study. In early March 2019, I attempted to obtain quotes for every domestic bond or note on Citigroup’s list of TLAC debt. For those issues with available information – even if no currently active quote was available – I recorded the disclosures provided to investors. Not one mentioned TLAC, or the role that the debt would play in the resolution of Citigroup. I argue that TLAC largely depends on the ability to disguise equity as debt, and further pretend that financial institution equity is just like other “blue chip” corporate equity. This obfuscation facilitates the adoption of a new resolution model in the short term, but presents long-term risks. In particular, investors may be slow to appreciate the risks that TLAC presents, but once they do, what price will large financial institutions pay to support their present capital structure? A sudden investor move out of TLAC debt, or the equity of large banks, would present obvious problems. A gradual yield (or cost) increase might be less problematic, and indeed might ultimately suggest a kind of “soft” breakup of the larger banks. But it seems strange and even reckless to leave such an important policy aim to chance. The paper thus concludes by observing that the efforts to fit the existing banking system, largely unchanged, within a “new and improved” resolution structure is a task that will only succeed if we close our eyes to the serious problems such a move presents.