OREANDA-NEWS. The Federal Reserve Board's total loss absorbing capital (TLAC) proposals outline important additional capital requirements for US-based banking subsidiaries of large foreign banking organizations (FBOs). The new requirements would stem cross-border contagion by implementing parent-funded capital that would absorb the losses of their US-domiciled subsidiaries, says Fitch Ratings.

The focus of the proposals released at the end of September define the amounts and general terms of additional internal long-term debt (internal LTD) that US intermediate holding companies (IHCs) of FBOs would be required to maintain. Internal LTD would be issued from the IHC to the foreign parent, who would be its sole holder. Theoretically, such capital absorbs the losses of the failing IHC by channeling the losses to the parent bank.

The rules would benefit bank counterparties because the internal LTD would be contractually subordinated to all third-party liabilities of the covered US subsidiary. Subordinating the FBO's debt held in its US subsidiary reduces the risk of third-party creditor challenges to recapitalizations and the risk that such recapitalizations could cause a change-in-control event. Avoiding such scenarios improves the potential for orderly resolutions.

Another feature of the internal LTD is that it would include a contractual trigger. The Fed could require the IHC to cancel the internal LTD, convert it, or exchange it into equity on a going-concern basis, meaning the IHC could avoid resolution. To enact the trigger, the Fed would have to first determine that the IHC was in default or at high risk of insolvency. Secondly, one of the following must be true: the foreign parent must be in resolution; the foreign parent's regulator must consent or fail to object within 48 hours; or the Fed must recommend that the Treasury appoint the FDIC as receiver, as contemplated under Dodd-Frank. This process arguably gives the foreign regulator an opportunity to participate in the proceedings.

The internal LTD requirement, when combined with regulatory equity capital requirements (internal TLAC), would also be theoretically sufficient to keep the IHC operating under a parent resolution occurring in the home country. The Fed anticipates that US IHCs generally could be allowed to continue as a going concern through a home resolution of the parent. In such an event, internal TLAC requirements would be marginally lower for the IHC. The TLAC level proposed is the greater of 16% of RWA, plus an additional capital conservation buffer, or 6% of total leverage exposures, or 8% of average total assets, as determined for the US Tier 1 ratio. Otherwise, the Fed proposes the same requirements as imposed on US G-SIBs.

The Fed proposals will be further clarified through the comment period. Further guidance from the Financial Stability Board, released this week, will be presented to global leaders at the G-20 summit this weekend.

A separate Fitch comment regarding the FSB's TLAC proposals and the rating implications for G-SIBs is available in the report dated Nov. 9, "TLAC for Banks - Sovereign Support's Heir (Positive Rating Implications for Major Global Banks, but not Universally)."