Automated Bail-In: Enhancing TLAC Instruments with a Penny Stock Trigger

Background: Evolution of Bank Resolution Mechanisms

The 2023 banking turmoil exposed significant flaws in the resolution framework for global systemically important banks (G-SIBs), as highlighted in the “Christmas Report” of the Parliamentary Investigation Commission on the Management of the Authorities — Credit Suisse (CS) Emergency Merger (December 2024).This merger reignited concerns regarding regulatory capital requirements for UBS, especially given its “too big to save” status and the Swiss Government’s limited negotiating power compared to host countries where the bank operates. While discussions on the quantity of capital remain critical, equal attention should be given to capital quality. Additional Tier 1 (AT1) instruments face increasing scrutiny, with the Netherlands considering reforms and Australia already implementing changes. This blog contribution proposes enhancements to the Total Loss-Absorbing Capacity (TLAC) standard to improve its automatic loss absorbency.

After the Global Financial Crisis (GFC), policymakers and the financial industry needed a credible solution to the “too big to fail” (TBTF) problem that minimized resistance from banks and political fallout. Representatives of CS successfully lobbied for the bail-in mechanism, avoiding more radical solutions such as breaking up banks, separating business lines, imposing stringent equity capital requirements, or capping bank size.

The bail-in concept gained traction based on its promise as an effective resolution tool, making alternative proposals seem obsolete. Regulatory discussions then shifted toward balancing risk tolerance, credit supply, and the cost of regulatory capital. The debate involves multiple stakeholders: G-SIBs seeking low financing costs, debt investors demanding risk-adjusted pricing, competitors pushing for a level playing field, and taxpayers seeking compensation for implicit state guarantees. Regulators, however, remain uncertain whether reducing banks' funding cost advantages should outweigh concerns about profitability and the market for regulatory capital.

TLAC and Its Shortcomings

To complement the bail-in mechanism, the TLAC standard was introduced as a buffer to absorb losses. However, TLAC requirements led to the issuance of opaque bail-in bonds, which are marketed as loss-absorbing instruments to regulators but as debt instruments to investors. These instruments continue to benefit from lower funding costs compared to regulatory capital, with minimal reduction in implicit state guarantees.

The bail-in mechanism ultimately became a euphemism for public bailouts. The discretionary nature of bail-in trigger events and the blurred distinction between recovery and resolution create pre-insolvency uncertainty, leading to delays in regulatory action. Existing triggers, such as those for AT1 instruments, are difficult to assess and often too late to be effective. The discretion involved in identifying resolution triggers introduces time inconsistency—politicians may delay activating resolution mechanisms due to short-term costs, undermining financial stability.

Legal scholar Katharina Pistor’s Legal Theory of Finance supports this observation, noting that the legal enforcement of financial contracts is often suspended during crises to protect systemic stability. However, it is paradoxical for a crisis management framework to be abandoned precisely when it is most needed. It follows, that the bail-in mechanism only benefits the industry as long as it remains unused.

A Market-Driven, Automatic Loss Absorption Mechanism

To address these flaws, this article proposes a streamlined approach: TLAC-eligible instruments should be structured as mandatory contingent convertible (CoCo) bonds with a penny stock trigger (USD 5 or higher). This solution builds on ideas from Flannery, Pennacchi, Vermaelen and Wolff, and Sundaresan and Wang. The proposed trigger is simple, contractual, and transparent, ensuring compliance with solvency requirements for Emergency Liquidity Assistance (ELA).

One concern about activating TLAC instruments is the potential for market destabilization. Critics argue that a share price-based triggers could initiate a “death spiral,” but this concern might be overstated. Converting TLAC debt into equity at a predetermined share price threshold would simply flood the bank with equity capital, stabilizing its balance sheet. The proposed mechanism ensures automatic recapitalization, reducing reliance on government intervention.

Aligning Management Incentives with Stability

Linking TLAC conversion to a share price threshold incentivizes bank management to maintain strong stock valuations. While short-term measures like dividend payouts and share buybacks could artificially boost stock prices, they remain regulated and monitored. More importantly, the risk of losing control due to forced TLAC conversion aligns management incentives with long-term financial stability. 

Preventing Opportunistic Behaviors

An automatic TLAC trigger prevents creditors and potential acquirers from exploiting regulatory delays or negotiating preferential outcomes during crises. By eliminating discretionary interventions, the framework discourages holdout strategies and reduces legal disputes. Markets would price risks upfront, fostering discipline among banks and their stakeholders.

International Crisis Management Challenges

Cross-border resolution is complicated by fragmented capital and funding structures. In case of CS, capital at the solo-entity level was insufficient due to internal funding structures resembling a carry trade and involving double leverage through intermediate holding companies. CS parent bank in Switzerland raised funds at low costs and downstreamed them to foreign subsidiaries, where local regulations restricted their recoverability. Ringfencing issues make a Single Point of Entry (SPE) resolution strategy unrealistic. Given that a bank’s assets are often located abroad, a Multiple Point of Entry (MPE) strategy is the only feasible option, requiring a horizontal holding structure.

The proposed automatic conversion mechanism reduces reliance on prolonged negotiations, enabling smoother coordination among international crisis management groups.

Emergency Liquidity Assistance (ELA) and Market Confidence

The CS crisis underscored how fragile market confidence can lead to liquidity crises and bank runs. Public announcements of ELA can exacerbate panic, as market participants may interpret them as signs of distress. The proposed automatic TLAC conversion mechanism stabilizes a bank’s balance sheet before liquidity issues escalate, while ensuring that solvency criteria are met for coordinated liquidity support among central banks.

Transparency and Regulatory Adjustments

To enhance transparency, TLAC-eligible liabilities should be ranked equally with Tier 2 capital instruments and include clear subordination language and Basel II Pillar 3 disclosures at the solo-entity level. The distinction between going-concern (Tier 1) and gone-concern (Tier 2 and TLAC) capital appears artificial unless G-SIBs can demonstrate orderly resolution. TLAC triggers should not be treated as events of default or trigger early termination rights. Instead, Basel III standards for Tier 1 capital—where discretionary payments do not constitute a default—should be extended to TLAC instruments. This adjustment would curb speculative behaviors like shorting bank stocks to trigger TLAC instruments to gain Credit Default Swap (CDS) payouts.

Regulatory disparities in tax treatment should also be addressed to maintain an international level playing field.

A Market-Driven Solution Without Public Intervention

This proposal does not involve central banks, regulators, or resolution authorities. There is no need for statutory amendments, debates over intervention appropriateness, or concerns about state liability. The automatic TLAC conversion mechanism operates purely within the market framework, enhancing loss absorption without requiring formal resolution proceedings.

Lessons from the CS collapse highlight the need for a more effective TLAC framework. If TLAC cannot be entirely backed by equity, incorporating equity-like mechanisms through automatic triggers is the best alternative.

For further analysis on bail-in regulations and an in-depth discussion of this proposal, see my recent article in the Journal of Banking Regulation.

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By Urs Benedikt Lendermann (Deutsche Bundesbank University of Applied Sciences)

Views expressed are personal and cannot be attributed to Deutsche Bundesbank or its staff.

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