Regulators Face Test With Bank Debt Proposal

Banks often rely heavily on borrowing to fuel their operations. However, the vulnerability arises when these loans can be withdrawn suddenly, as seen with Silicon Valley Bank's deposits in March. To mitigate this risk, a proposed solution involves mandating banks to secure more of their funding for longer terms, ideally at least one year.

In the United States, this requirement already applies to the largest lenders, known as globally systemically important banks. The proposal suggests extending this mandate to federally insured lenders with assets exceeding USD 100 billion. Regulators propose a sensible three-year timeline for compliance, estimating a manageable impact on net interest margins.

One significant benefit of this proposal is that in the event of a bank failure, bondholders would absorb additional losses, reducing the risk to uninsured depositors. Furthermore, debtholders would be incentivised to monitor banks' financial health closely, thereby providing early warning signals of potential issues. This could help prevent sudden depositor panics and give regulators vital time to intervene.

However, there are concerns regarding the proposal's potential impact on markets. Imposing losses on bondholders, even if they were aware of and compensated for the risk, can create market stress. For instance, after Switzerland wrote down some of Credit Suisse Group Inc.'s debt in March, similar securities at other institutions saw immediate price declines.

Additionally, while the proposal enhances safety, it should not breed complacency. Regulators should recognise that equity capital is the most reliable form of funding to absorb losses. Thus, more stringent requirements for equity capital should also be considered to bolster financial resilience.

In essence, while the proposed long-term debt mandate is a step towards a safer financial system, it should be accompanied by continued efforts to strengthen equity capital requirements. This proactive approach can better prepare regulators for future crises, mitigating the need for difficult choices.