The Federal Reserve fell short in compelling the SVB Financial Group to contribute its $4 billion in assets to Silicon Valley Bank under Regulation Y and the Dodd-Frank Act. This failure resulted in a $4 billion loss for the FDIC in SVBFG’s Chapter 11 case, a loss that could have been avoided. A proposed rule was announced last August by the FDIC and the Fed as a response; however, this rule appears to be insufficient and costly, leading to discussions on the need for a more effective solution.
The proposed rule, ostensibly aiming to curtail future FDIC losses, enforces the “source of strength” doctrine against large bank holding companies – even those without sufficient strength on their own. This principle seeks to oblige every large holding company— i.e. those with an asset portfolio betwixt $100 and $700 billion — to release and maintain long-term unsecured debt (LTD) equal to 3.5% of total assets or 6% of “risk-weighted” assets, whichever is higher.
In practice, this means that if we consider construction loans – which carry a “risk weight” of 150% – the 6% capital requirement scales to 9%. However, assets like US Treasuries and agency-backed mortgages, gain a zero-risk weight, causing their 6% requirement to effectively reduce to zero. This new rule necessitates each large holding company to invest cash equal to the LTD amount in its bank, albeit on a deeply subordinated basis. This condition effectively doubles the minimum capital a large holding company is required to commit to its bank.
The requirement for stocks of LTD is to be phased in over three years, starting from the year after the rule is adopted. The impact of this proposed rule varies between different holding companies. Companies like Capital One, which reported over $31 billion in LTD and over $27 billion in bank deposits, are in a favourable position and can use their existing debt to comply with the proposed rule rather well. In contrast, Northern Trust, which reports less than $600 million in cash and almost no non-bank assets, could face difficulties in meeting the terms of the rule due to its financial profile.
A better approach to this issue may lie in a properly written “source of strength” rule, requiring each holding company to execute a capital adequacy and liquidity maintenance agreement with the Federal Reserve, the FDIC, and the regulator of the holding company’s bank. This agreement should include several terms such as the commitment to buy bank equity in the amount specified by the banking authorities pertinent to a bank receivership or by the FDIC during receivership. Furthermore, the rule should mandate holding companies to bank all their deposits at their bank and subordinate their deposit claims to the prior payment of all other liabilities of the bank to comply with the Bankruptcy Code’s requirements for immediate enforcement in bankruptcy.
This expert opinion of Kramer Levin’s partner, Thomas Moers Mayer, published on Bloomberg Law suggests an alternative strategy to address future regulation [read more]. A solution that not only prevents imposing high interest rates on holding companies with insufficient assets but also adequately obligates asset-rich holding companies to contribute assets they do have.