The devil’s not just in the detail. It’s in the interpretation of the detail. US legislation aiming to end “too big to fail” on Wednesday passed the House Financial Services Committee and drew fire from securities industry bodies over one particular amendment. Critics argue that introducing the possibility of losses for secured creditors when systemically significant institutions fail could push up funding costs and potentially disrupt the repo market that banks use for short-term loans secured against assets.
Any losses on secured creditors would be determined by the regulatory body handling the resolution – which admittedly introduces ample uncertainty into pricing that risk. The amendment allows that a collateralised creditor’s claim be split into a 80 per cent secured claim and a 20 per cent unsecured claim. The latter might then be subject to haircuts, once shareholders and other unsecured creditors, such as bondholders, have suffered total losses. That is an extreme scenario. And the newly created unsecured loan should maintain a preferential position to general unsecured creditors.
Pushing up the cost of funding for overly large institutions, in reality, underpins various reform efforts, including imposing higher capital requirements. This is intended to be a deterrent. True, introducing the prospect of loss into repo could mean funding for troubled banks dries up faster. But forcing earlier regulatory intervention could avoid counterparties grabbing additional collateral as a bank heads for the wall.
Regardless, loud opposition means the amendment now looks set to be amended. It would be helpful to clarify its application, for example by carving out longer-term loans such as those from Federal Home Loan Banks. Even then the knock-on effects might reduce liquidity in repo markets, possibly meaning more carve-outs for Treasuries, say, to keep yields down. But repo was already set for an overhaul after 2008’s upheaval and banks should not overly rely on short-term, secured borrowing. Sometimes details aren’t so devilish after all.