Regulators Face Challenge With Bank Debt Proposal

Banks typically rely heavily on borrowing to finance their operations. However, when loans can be withdrawn abruptly, as was seen with Silicon Valley Bank's deposits in March, both executives and regulators are left with limited options to prevent panic. A new proposal seeks to address this issue by requiring banks to secure more of their funding for at least a year, presenting a promising solution with an important caveat.

The United States already imposes a similar requirement on its largest lenders, known as globally systemically important banks. Now, regulators propose that federally insured banks with assets exceeding USD 100 billion issue long-term debt to cover a specified minimum percentage of their total funding. With a reasonable three-year compliance period, the estimated impact on net interest margins is projected to be manageable for most banks, ranging from 0.03 to 0.12 per cent points. This approach ensures that in the event of a bank failure and subsequent equity loss, bondholders would absorb additional losses, reducing the risk to uninsured depositors.

In theory, this proposal offers several advantages. Debtholders would have a vested interest in closely monitoring banks' financial health, allowing early detection of emerging concerns through fluctuations in bond prices. Consequently, depositors would be less inclined to withdraw funds during a crisis, providing regulators with valuable time to intervene. Moreover, any failures that do occur would be less financially burdensome. For instance, Washington Mutual's unwinding in 2008 incurred no cost to the FDIC's insurance fund due to its sufficient long-term debt coverage.