The European Commission’s new proposals on banks’ loss absorbing capacity: too big to fail?

May 2017 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

In response to the 2008 financial crisis that led to government bail-outs of banks around the world, major reforms have been undertaken, at both a European and global level, to remove the implicit state subsidy of systemic banks. Those banks were considered ‘too big to fail’, forcing states to rescue them in order to avoid a collapse of the wider economy.

In response, in May 2014, the European Union (EU) adopted the Bank Recovery and Resolution Directive (BRRD) that introduced a common resolution framework for banks. The BRRD gives authorities the power to write down a bank’s debt (a ‘bail-in tool’) and convert debt into capital instruments, imposing losses on the bank’s shareholders and creditors. The BRRD also contains mechanisms to maintain critical economical functions of failing banks, while allowing non-critical functions to be wound up. Member States had to transpose the BRRD into their national legislation by the end of 2014, with application as of January 2015. The bail-in tool came into force in January 2016. In addition, for the euro area, the EU Single Resolution Mechanism Regulation (SRMR) was adopted in July 2014. It established a separate resolution authority, the Single Resolution Board, which is in charge of significant euro area institutions and cross-border institutions. The SRMR also became fully applicable in January 2016.

To secure the effectiveness of the bail-in tool and other resolution tools, the BRRD and the SRMR require institutions meet a minimum requirement for own funds and eligible liabilities (MREL) at all times, which has to be determined by the resolution authority. The European Banking Authority (EBA) developed regulatory technical standards for MREL, which were formally adopted by the European Commission in May 2016.

At a global level, the standard developed under the aegis of the Financial Stability Board (FSB) on Total Loss Absorbing Capacity (TLAC) applicable to global systemically important banks (G-SIBs) was published in November 2015 (FSB TLAC Standard), to be applied as of January 2019. While there are certain conceptual differences between TLAC and MREL, both standards are concerned with banks holding a sufficient amount of loss absorbing liabilities to operationalise resolution tools and ensuring a credible resolution of failing institutions.

On 23 November 2016, the European Commission published several legislative proposals to amend the BRRD (BRRD 2), the SRMR (SRMR 2), the Capital Requirements Regulation (CRR 2) and the Capital Requirements Directive IV (CRD V), together ‘the legislative proposals’. The implementation of the FSB TLAC Standard into the EU legislation which includes a proposal to amend Article 108 BRRD to introduce a partial harmonisation of the insolvency creditor hierarchy, by mandating Member States implement, within their national insolvency laws, a harmonised non-preferred senior unsecured asset class to mitigate the compensation risk emanating from the principle that no creditor shall be treated worse in bail-in than in ordinary insolvency (‘no creditor worse off’ or NCWO principle) is among the core elements of the legislative proposals.

The publication of the legislative proposals by the Commission kick-started the ordinary legislative procedure in the EU that usually takes around 18 months, with the exception of the proposal to amend Article 108 BRRD, which is proposed to be implemented by Member States into their national laws by July 2017. Typically, the Council and European Parliament negotiate amendments to the Commission’s legislative proposals. Final legislation is expected to deviate to some extent from the Commission’s proposals.

The FSB TLAC Standard and the BRRD recognise both single point of entry (SPE) and multiple points of entry (MPE) resolution strategies. To implement these strategies, the concept of resolution entities and resolution groups set out in the FSB TLAC Standard is introduced by the legislative proposals. A resolution entity is an entity to which resolution tools apply. Resolution entities issue loss absorbing capacity to external third parties. A resolution entity forms a resolution group with entities owned or controlled by it but which themselves are not resolution entities. These entities may be subject to internal loss absorbing capacity issued to a resolution entity (usually the parent) of a resolution group. Internal loss absorbing capacity allows the recapitalisation of an entity with critical functions by upstreaming losses to a parent resolution entity at the point of non-viability of the entity, without placing it into resolution.

In order to avoid having two parallel regimes for G-SIBs in the EU, the aim is to integrate the FSB TLAC Standard as much as possible within the current BRRD MREL framework which applies to all EU institutions. FSB TLAC is composed of a Pillar 1 minimum standard and a firm-specific Pillar 2 add-on, whereas MREL is set on an institution-specific level with no hard minimum requirement (Pillar 2 concept). Certain key elements of the FSB TLAC Standard, such as the Pillar 1 minimum standard and the criteria for loss absorbing (eligible) liabilities, are expected to be implemented into CRR with direct effect for G-SIBs once CRR II becomes applicable.

The Commission has proposed amending CRR to implement the FSB Pillar 1 TLAC requirement (in the following P1-MREL) for G-SIBs (and subsidiaries of G-SIBs) only. The Commission has not proposed extending P1-MREL to other (non-globally) systemically important institutions. In line with the FSB TLAC Standard, G-SIBs that are resolution entities are required to hold external P1-MREL amounting to 18 percent of risk weighted assets, as of 2022 (16 percent from 2019 to 2021) and 6.75 percent of the leverage ratio exposure as of 2022 (6 percent from 2019 to 2021) at the consolidated level of the resolution group (in case of a standalone resolution entity on the solo basis of the resolution entity). Material subsidiaries of non-EU G-SIBs, which are not resolution entities, are expected to hold internal P1-MREL (on a solo basis or, if they are EU parent institutions, on the consolidated basis of the resolution group) amounting to 90 percent of external P1-MREL, which is the upper end of the internal TLAC amounting to 75-90 percent of external TLAC outlined in the FSB TLAC Standard. Internal P1-MREL is not suggested to be implemented for material subsidiaries of EU G-SIBs.

Under BRRD II, the Pillar 2 requirement (P2-MREL) will be maintained for non G-SIBs (as under current BRRD, but with amended metrics), to be extended to the institution-specific add-on for G-SIBs (if P1-MREL is not sufficient to absorb losses and recapitalise the G-SIB) and to be complemented by P2-MREL guidance on top of firm specific requirements. Currently, BRRD provides that MREL is set as a percentage of total liabilities and own funds. The metrics of P2-MREL are to be aligned with P1-MREL and expressed as a percentage of risk weighted assets and the leverage ratio exposure. There is no harmonised minimum P2-MREL. Both external P2-MREL and internal P2-MREL are set by the resolution authority on a case-by-case basis. P2-MREL may not exceed the greater of an amount equal to twice the bank’s Pillar 1 and Pillar 2 capital requirements and an amount equal to twice the bank’s leverage ratio requirement (once for loss absorption and once for recapitalisation). Depending on the chosen resolution strategy, recapitalisation of less than the whole bank’s balance sheet is conceivable.

Under CRR II and BRRD II by reference to CRR II, a largely identical catalogue of criteria applies which eligible liabilities instruments will have to fulfil in order to count toward P1-MREL and P2-MREL, with certain exceptions for P2-MREL defined in BRRD II. To count toward P1-MREL, eligible liabilities have to be subordinated to liabilities excluded from MREL (unless one of the exemptions from subordination, as set out in the FSB TLAC Standard and proposed under CRR II, applies). To count toward P2-MREL, eligible liabilities are not automatically required to be subordinated to liabilities excluded from MREL (but subordination may be required by the resolution authorities on a case-by-case basis) and certain debt instruments with derivative-linked features, such as structured notes, are not excluded, provided they have a fixed principal amount repayable at maturity.

The criteria for eligible liabilities instruments proposed under CRR II are considerably more restrictive than under the current BRRD. CRR II does not provide for any transitional provisions (grandfathering provisions) for existing instruments that do not meet the newly proposed eligibility criteria. Some newly proposed criteria, such as supervisory approval for any permission to reduce P1-MREL and P2-MREL, the prohibition of acceleration rights for holders other than in the liquidation of the issuer and the contractual recognition of statutory bail-in also for instruments governed by the law of EU Member States have been criticised by the EU credit industry as going beyond the FSB TLAC Standard.

Under the newly proposed Article 141a CRD V, breaches of P1-MREL and P2-MREL may lead to a breach of the combined buffer requirement (a gap in eligible liabilities to comply with MREL would be filled up with core equity tier 1, which counted before the MREL breach toward meeting the combined buffer requirement) and consequently trigger restrictions on discretionary payments to the holders of regulatory capital instruments and for variable remuneration purposes.

From the perspective of third country G-SIBs or third country banks with significant operations in the EU (total assets of at least €30bn), the proposed requirement for establishing an intermediate EU parent undertaking (where two or more institutions established in the EU have the same ultimate third country parent undertaking) with the aim of facilitating the resolution process within the EU has been among the most debated parts of the legislative proposals.

So far, bank resolutions in the EU have remained few and far between and have not yet had any tangible effects. It is not yet clear whether a BRRD-style resolution of a major bank would work as envisaged and spare the taxpayer from having to pick up major parts of the bill. Likely, depositors would rush to recover their funds and would leave it to the resolution authorities to deal with the rest. However, whether or not the TLAC, MREL and similar concepts will eventually have the desired effects, one thing seems already certain: they, and the EU’s collective political impetus behind them, are simply too big to fail.

Friedrich Jergitsch is a partner, and Stella Klepp is senior specialist regulatory, at Freshfields Bruckhaus Deringer LLP. Dr Jergitsch can be contacted on +43 1 515 15 ext. 218 or by email: friedrich.jergitsch@freshfields.com. Ms Klepp can be contacted on +43 1 515 15 ext. 578 or by email: stella.klepp@freshfields.com.

Friedrich Jergitsch and Stella Klepp

Freshfields Bruckhaus Deringer LLP