The world's biggest banks should hold a buffer of bonds in case of a collapse so that government bailouts are avoided, a global regulatory body proposed on Monday.
The draft rule is the last major piece of banking reform put forward by world leaders since the 2007-09 financial crisis forced taxpayers to shore up undercapitalized lenders.
The Financial Stability Board (FSB), made up of regulators from the Group of 20 economies (G20), said global banks like Goldman Sachs (GS.N) and HSBC (HSBA.L) should have a buffer of bonds or equity equivalent to 16 to 20 percent of their risk-weighted assets from January 2019.
The bonds would be converted to equity to "bail in" a stricken bank. The total buffer would include the minimum mandatory core capital requirements banks must already hold.
The proposal is set to be endorsed by G2O leaders later this week in Australia. It is being put out to public consultation until Feb. 2, 2015.
FSB Chairman and Bank of England Governor Mark Carney said the buffer would be finalised next year, marking a watershed in ending banks that are too big to be allowed to fail.
The new rule will apply to 30 banks the FSB has deemed to be globally systemically important, though initially those from emerging markets would be exempt.
"Once implemented, these agreements will play important roles in enabling globally systemic banks to be resolved (wound down) without recourse to public subsidy and without disruption to the wider financial system," Carney said in a statement.
Most of the banks would need to expand their issuance of debt to comply, the FSB said. Some senior debt already issued would will also need restructuring.
To avoid banks downplaying the riskiness of their assets to meet the new rule, the buffer, formally known as total loss absorbing capacity or TLAC, must also be at least twice their leverage ratio, a separate measure of capital to total assets regardless of the level of risk.
Globally, this yardstick has been set provisionally at 3 percent but it could be higher when finalised in 2015.
Parts of the buffer would be held at major overseas subsidiaries to reassure regulators outside a bank's home country.
"We believe TLAC will be a more material challenge in Europe than in the U.S.," Fitch ratings agency said ahead of the announcement. Extra requirements from national supervisors could swell the buffer to 25 percent of risk weighted assets, it added.
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