Loss Absorbing CapacityEdit
Loss Absorbing Capacity
Loss Absorbing Capacity (LAC) refers to the ability of a bank to absorb losses using its own resources in a crisis, rather than relying on public bailouts. In practice, LAC blends high-quality capital with sophisticated liability structures that can be converted into equity or written down in an orderly resolution. The aim is to keep essential banking functions running, protect financial stability, and shield taxpayers from bearing the costs of bank failures. The concept gained prominence after the global financial crisis of the late 2000s, when policymakers sought credible private-sector buffers to fund a bank’s wind-down without disorderly disruption to credit markets.
A formal implementation has come in through international and regional standards. The Global framework for big banks emphasizes Total Loss-Absorbing Capacity (Total Loss-Absorbing Capacity), which requires large, globally active banks to hold sufficient loss-absorbing resources to cover a stressed wind-down. In the European Union, the equivalent national and supranational rules are known as the Minimum Requirements for Own Funds and Eligible Liabilities (MREL). Taken together, TLAC and MREL are meant to align the incentives of banks, regulators, and taxpayers toward a more market-oriented resolution framework. They are closely related to the broader capital standards being implemented under Basel III and its emphasis on high-quality capital.
From a policy standpoint, LAC is a market discipline device that reduces the expectation of taxpayer-funded bailouts and reinforces responsible risk-taking. By ensuring that a portion of a bank’s losses can be absorbed by private investors, LAC helps maintain the continuity of critical financial services, preserves confidence, and prevents the systemic spillovers that accompany large bank failures. The idea is to keep the system solvent by asking the right players to bear the costs, rather than calling on the government to pick up the bill. The concept is also linked to the broader debate about whether certain institutions are “too big to fail” and how to prevent such institutions from crowding out private capital and competition. See Too big to fail.
Core concepts
Capital and loss-absorbing instruments
A core element of LAC is the mix of capital buffers that remain in the bank (chief among them common equity) and the set of liabilities that can be bailed-in or converted into equity in a resolution. High-quality equity—often referred to in policy discussions as CET1 (common equity tier 1)—acts as a straightforward absorber of losses. In addition, there are instruments designed to absorb losses more aggressively when trouble hits, such as Additional Tier 1 (AT1) capital and various forms of bail-in eligible liabilities. In many regimes, banks also issue contingent convertible instruments (CoCo) and other long-dated debt that can be written down or converted to maintain continuity of banking services. See Common equity tier 1, Additional Tier 1, Contingent convertible, Basel III.
Resolution frameworks and bail-in
LAC is realized through a resolution regime that can write down or convert eligible liabilities to preserve critical functions and avoid a chaotic collapse of the institution. In practice this means a well-defined sequence of actions by resolution authorities, protected by clear statutory powers and credible private buffers. Bail-in mechanisms complement traditional capital buffers by distributing the costs of distress to bank creditors before public funds are invoked. See Bail-in and Bank resolution.
Cross-border considerations
Because large banks operate across multiple jurisdictions, LAC frameworks must be credible across borders to prevent regulatory arbitrage and ensure smooth resolution. TLAC provides a global baseline, while national regimes like MREL embed the same logic within local legal systems. Effective cross-border coordination helps avoid the emergence of stranded liabilities and fragmented creditor expectations at times of stress. See TLAC and MREL.
Debates and controversies
Taxpayer protection vs private discipline
Proponents argue that robust LAC reduces the likelihood and cost of government bailouts and thus protects taxpayers. Critics from the other side of the policy spectrum worry that excessive loss-absorbing requirements can raise funding costs for banks, potentially restraining credit and harming investment. The core rebuttal reflects the balance: the aim is to convert private losses into private costs at the onset of distress, not to eliminate all risk or to throttle productive lending. See Too big to fail.
Lending impact and economic growth
Some observers contend that higher capital and loss-absorbing requirements can tighten credit conditions, especially for smaller banks that rely more on wholesale funding. Advocates counter that better risk management and resolvability ultimately support sustainable lending by reducing the chances of disruptive bailouts that distort incentives and distort the risk-reward calculus for all lenders. The focus remains on achieving a credible wind-down framework without endangering the supply of credit to households and firms. See Basel III.
Regulatory burden and competitiveness
There is concern that stringent LAC rules could impede a bank’s ability to compete internationally or domestically, particularly for smaller institutions facing higher relative costs. Defenders of the approach point to the necessity of credible resolution mechanics and to the efficiency gains from a level playing field where the market expects losses to be borne privately, not by government balance sheets. See Basel III and MREL.
Cross-border resolution risks
Despite TLAC’s broad aim, cross-border wind-downs raise complex questions about jurisdiction, creditor rights, and timing. Critics worry about fragmentation or inconsistent application across different legal systems. Proponents argue that a common objective—private loss absorption ahead of public funds—helps align incentives even across borders; effective cooperation among resolution authorities remains essential. See TLAC and Bank resolution.
Woke criticism and its rebuttal
Some critics contend that LAC rules create rigidity, limit lending, or blunt the growth of financial markets. Supporters respond that the goal is not to choke credit but to eliminate moral hazard—ensuring that the costs of distress lie with private investors rather than with taxpayers. The counterargument is that well-calibrated LAC supports financial stability and long-run growth by preventing expensive bailouts and preserving confidence in the financial system during crises. See Bail-in.