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The Fed Rule That Could Hammer Bank Profits

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Several weeks ago, I wrote about a new plan put forward in a paper jointly authored by the Federal Deposit Insurance Corporation and the Bank of England that looks to solve the problem of too "big to fail," i.e., when globally active, systemically important financial institutions -- or G-Sifis -- get into trouble and have to be bailed out at taxpayer expense.

My focus then was, per the proposed plan shareholders would be first in line to absorb any costs related to winding up a failing institution. Today I'm going to look at how something called "subordinated debt" may work to absorb bank profits but ultimately help shareholders, along with the financial system at large.

The strategic debt reserve
More than four years after the financial crash, too big to fail is still with us. Can anyone doubt that if Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , Citigroup (NYSE: C  ) , or Wells Fargo (NYSE: WFC  ) were facing insolvency that the federal government wouldn't again have to step in with a capital injection? And that's just in the U.S. Britain has its share of G-Sifis, as well, including Barclays, HSBC, and Standard Chartered. This proposed U.S./U.K. plan proposes standardized measures to wind these G-Sifis up in the case of trouble.  

In the latest related development, Financial Times is reporting that Capital Group, an asset manager with $1.1 trillion under management and a top-ten shareholder in both JPMorgan and Citi, is lobbying the Federal Reserve to reconsider requiring banks to hold increased levels of subordinated debt. Subordinated debt is "junior-level" debt and would therefore be the first level of debt tapped in a crisis. As such, it's seen as more risky, which means it's costlier for the bank to issue because you have to pay bondholders a higher rate of return.

This subordinated debt would be held in a kind of strategic reserve at the holding company level, to be used if the bank found itself facing a run, like Lehman Brothers did in September 2008, or some similarly catastrophic financial event. The idea is, this kind of debt could more quickly and easily be made liquid to meet emergency capital requirements. If this proposed rule goes through as written, the banks would have to issue "hundreds of billions of dollars in subordinated debt," according to one Morgan Stanley analyst.

Too big to fail -- too awful to reexperience
Here in the U.S., the Dodd-Frank financial reform act of 2010 is slowly but surely wending its way into effect, with the Volcker Rule nearing completion and changes in the way derivatives are traded being finalized, too . Across the pond, British regulators are also hard at work with their own Vickers Commission proposals getting nearer and nearer implementation.  The global financial system is being reorganized, whether it wants to be or not.

And as you can expect, it doesn't want to be, hence the lobbying by Capital Group and almost certainly other companies like it, as well as by the banks themselves. You can't blame a company for not wanting increased regulation -- and working like the devil to slow it, stop it, or change it -- but you also can't let that keep it from happening, so long as the regulation is well thought out and smart.

The stakes are too high: Too big to fail is too awful to reexperience. As a stakeholder in a major bank (Goldman Sachs), one that will likely be affected by this rule if enacted, I don't necessarily like the idea that increased subordinated-debt requirements may make my investment less profitable, but if it makes the bank -- and the financial system -- more stable in the long run, count me in. 

To learn more about the most-talked-about bank out there, check out our in-depth company report on Bank of America. The report details Bank of America's prospects, including three reasons to buy and three reasons to sell. Just click here to get access.

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