Practitioner Insights to the Market:
Proposed Debt Rules Carry Tradeoffs
On August 29, 2023, the major three major US financial regulatory agencies proposed a rule requiring large banking organizations (LBOs, $100+ billion in assets) and certain insured depository institutions (IDIs) to maintain a minimum amount of long-term debt (LTD). This measure, calculated based on risk-weighted assets, total consolidated assets, or total leverage, aims to enhance resolvability, minimize Deposit Insurance Fund costs, and mitigate financial stability risks. However, this new regulation may lead to unintended consequences, namely:
- Financial Impact to Banks and Clients: Increased funding costs for banks due to issuing and servicing the required LTD may:
- increase borrower credit costs, and
- reduce lending activities, slowing economic growth.
Additionally, due to the higher cost of issuance, smaller institutions near the $100 billion threshold will inherently face a competitive disadvantage compared to larger institutions.
- Systemic Risks: Beyond the financial impact on individual institutions and clients, systemic challenges may materialize:
- Higher lending costs may continue the shift of banking activities to non-bank financial institutions (the shadow banking sector), increasing systemic risks in other parts of the financial system.
- Increased demand for certain types of debt instruments, to satisfy the LTD requirements, could also create unintended market volatility.
- Large amounts of new cash raised to meet a regulatory requirement will need to be deployed. Excess cash invested in long-term, interest rate sensitive assets will require appropriate risk management oversight.
- Implementation Challenges: Complexity in implementing the new requirements, particularly in determining the appropriate amount and type of LTD to issue and managing the transition period will require both time and resources.
