Dealing with banks that are "too big to fail"
Over the past few years, major strides forward have already been taken by raising the requirements governing capital buffers under the new Basel III framework, such as the new conservation buffer, the countercyclical buffer and the capital buffer for systemically important banks. Those requirements explicitly prescribe that capital of the highest quality be put aside, such as share capital and reserves, whereas the rules recently proposed create additional flexibility, for example in the form of specific types of debt securities.
The new framework is designed to reduce the likelihood and impact of the collapse of a bank considered too big to fail. For instance, capital requirements have been tightened in terms of volume and quality under Basel III to minimise the likelihood of a bank's collapse. In addition, resolution plans are being drafted and authorities will have new instruments to wind down banks, such as the bail-in instrument.
Towards credible resolution
The new TLAC standard is needed to ensure that systemic banks have sufficient capacity to absorb losses should they run into financial trouble. The financial crisis brought to light that such capacity was sorely needed as governments were forced to foot the bill.
The latest proposals provide for a dedicated loss absorbing capacity reserved for winding down banks that fail. This will help make resolution after a bank's collapse more credible, as shareholders and creditors pick up the bill, for example using the bail-in instrument. Moreover, the TLAC requirements seek to ensure that a bank's critical activities, while in the process of resolution, maintain sufficient capital to continue.
As a further consequence, the playing field for systemic and non-systemic banks will become more equal, as global systemic banks are to lose their funding advantage on the back of implied government support. Likewise, creditors will exert more discipline as the implied safety net spread by the government disappears. As a result, banks will be less keen on taking excessive risks.