9 August 2016

EBA recommends changes to banks’ minimum loss absorbing capacity (MREL)

The European Banking Authority (EBA), on 19 July 2016, published its interim report on potential amendments to the current framework for the MREL (minimum requirement for own funds and eligible liabilities) under the EU rules on banking recovery and resolution. The interim report contains a number of provisional recommendations to amend the current MREL framework, which may be revised in the final report based on further analysis or feedback.

The EBA’s provisional recommendations aim to address several known shortcomings in the current MREL framework and further align MREL with the global TLAC (total loss-absorbing capacity) standards finalised in November 2015 by the Financial Stability Board (FSB) for all banks designated as Global Systemically Important Banks (G-SIBs). The provisional recommendations also reduce complexity in the EU rules of banking regulation by aligning the MREL framework more with the capital requirements of the Capital Requirements Directive IV (CRD IV) and the Capital Requirements Regulation (CRR).

The EBA invites interested parties to comment on a number of specific questions by 30 August 2016. The interim report is to be followed by a final report by 31 October 2016, which in turn will inform a legislative proposal of the European Commission, due 31 December 2016, to amend the current MREL framework and implement the TLAC standards.

Although the EBA’s interim report by itself will not have immediate consequences for banks, it does provide important insight into the process of revision of the MREL framework. This revision may have a significant impact on a bank’s funding structure and the pricing of debt, and may require banks to attract substantial amounts of new funds.

Background

 

The EU bank recovery and resolution framework
Over the past few years, a comprehensive EU bank recovery and resolution framework has been set up for the orderly resolution of failing banks. This should ensure that a bank’s critical functions are continued, financial stability is preserved and the burden of a bank’s losses is shifted from the taxpayer to the shareholders and creditors of banks (from “bail-out” to “bail-in”). The EU bank recovery and resolution framework is based on three main pieces of legislation: the Banking Recovery and Resolution Directive (BRRD), the Single Resolution Mechanism Regulation (SRMR) and the Intergovernmental agreement on the Single Resolution Fund (IGA).

If it becomes clear that a bank is no longer viable, the competent resolution authority has the power to apply a write-down and conversion of capital instruments (WDCI, or in Dutch: afschrijving en omzetting van kapitaalinstrumenten (AFOMKI)). If it is apparent that, even after WDCI, the bank will fail or is likely to fail (FOLF), the bank will enter into resolution under the condition that

  • no other supervisory action or private solution is available that would prevent the bank’s failure within a reasonable timeframe, and
  • resolution action is necessary in the public interest.

If the latter two conditions are not met, the bank will enter into regular bankruptcy.

In the resolution phase, four tools are available to orderly resolve a bank and ensure the continuity of its critical functions:

  • the sale of business tool
  • the bridge institution tool
  • the asset separation tool, and
  • the bail-in tool.

Similar to WDCI, the bail-in tool is used to absorb a bank’s losses and to recapitalise a bank. However, bail-in goes further than WDCI in that not only capital instruments but also (other) liabilities can be written down or converted. The Dutch Central Bank (DNB), in its capacity of national resolution authority, has recently published a consultation document, setting out the manner in which it proposes to apply the bail-in tool in the Netherlands.

The MREL requirement
Not all liabilities of a bank can be used for bail-in. The BRRD excludes some categories of liabilities, such as deposits covered by a deposit guarantee scheme and secured liabilities, and allows for the ad hoc exclusion of certain liabilities in exceptional circumstances. The exclusion of liabilities from bail-in could lead to a situation in which a failing bank may not hold a sufficient amount of bail-inable liabilities. In order to avoid this situation, the BRRD requires banks to continuously meet a minimum level of own funds and liabilities that are eligible for bail-in (the MREL). The aim of the MREL is thus to ensure that shareholders and creditors of a bank contribute to loss absorption in case of resolution. Depending on the preferred resolution strategy, sufficient MREL should also be available with a view to subsequently recapitalising and restoring a bank’s Common Equity Tier 1 (CET1) capital ratio (a CRR regulatory requirement) to a level sufficient to comply with conditions for authorisation under CRD IV. This will allow the bank to continue its business operations and to restore market confidence.

The required level of MREL is bank specific and is set by the resolution authority as a percentage of the total liabilities and own funds of a bank. There is no common minimum standard for all banks. As such, the MREL has a “Pillar 2” character. In May 2016, the European Commission adopted RTS on the methodology for setting MREL for individual banks. These RTS concern an amended version of the final draft RTS prepared by the EBA (see also the EBA’s Opinion on the European Commission’s amendments). Unless the Council of the EU or the European Parliament object (a motion to that end in the European Parliament was recently rejected), the RTS will soon be published in the Official Journal of the EU.

As it is based on an EU legal framework, the MREL framework only applies to banks in the EU. On an international level, similar standards, the minimum total loss-absorbing capacity (TLAC), have been developed by the Financial Stability Board (FSB) for all Global Systemically Important Banks (G-SIBs). Currently, the MREL framework and TLAC standards differ in some important respects, as set out below.

The TLAC standards do not have direct effect and will need to be implemented into EU law. The European Commission has committed to provide legislative proposals for the implementation of the TLAC standards for G-SIBs in the EU. In accordance with the BRRD, the European Commission is also to provide a legislative proposal for the amendment of the current MREL framework by the end of the year.


EBA interim report on MREL

 

On 19 July 2016, the EBA published an interim report, setting out preliminary recommendations on the amendment of a number of aspects of the MREL framework and asking interested parties to provide comments on a number of specific questions. The EBA is to issue a report to the European Commission by 31 October 2016 regarding various aspects of MREL. This report will inform the European Commission’s legislative proposal, due 31 December 2016, for amendment of the MREL framework and the implementation of the TLAC standards.

In short, the EBA proposes that the MREL framework is to be largely aligned with the TLAC standards, including by the setting of a specific MREL floor for banks in the scope of TLAC (G-SIBs), but is also to retain its bank-specific “Pillar 2” character and methodology, as defined in the RTS referred to above. The EBA’s interim report does not yet relate to all aspects which the EBA is to address in its final report and also does not yet cover all differences between TLAC and MREL. We have summarised the EBA’s main recommendations in the table below, followed by further detail on most topics.

Parameters MREL (currently) MREL (EBA recommendations) TLAC
Scope All banks in the EU All banks in the EU All G-SIBs worldwide
Denominator of the ratio Own funds and total liabilities Risk-weighted assets (RWA) and leverage ratio denominator Risk-weighted assets (RWA) and leverage ratio denominator
Exclusion of capital counting towards capital buffers Not excluded Excluded Excluded
Consequences of breach Not defined Additional powers for resolution authorities and further strengthening of existing powers of competent authorities To be treated as severely as a breach of capital requirements
Calibration Only individual requirement (Pillar 2 character) Individual requirement (Pillar 2 character) and possibly common floor (Pillar 1 character) for G-SIBs and potentially other types of banks Common minimum requirement (Pillar 1 character) and individual requirement (Pillar 2 character)
Subordination May be required by resolution authority on a case-by-case basis Required at least for some banks Required but exceptions apply
Disclosure to bank creditors No requirements Preliminary suggestion of introduction of disclosure of MREL instruments and creditor hierarchies TLAC instruments and creditor ranking to be included in Basel Pillar 3 disclosure framework
Intragroup distribution No detailed rules but resolution authorities can set requirements on a case-by-case basis Preliminary discussion of options for internal MREL Detailed rules on internal TLAC
Third-country recognition Broadly scoped requirement for contractual recognition clause Discussion of options to reduce the burden of compliance and narrow the scope of the requirement Enforceability on the basis of binding statutory provisions or contractual recognition clause
Timing of application By 2016, but resolution authorities can set an appropriate transition period Legislative proposal from the Commission by 31 December 2016 By 2019, with a higher calibration by 2022

Denominator of the ratio
A bank’s required MREL consists of “loss absorption” and “recapitalisation” components, which are both calculated on the basis of a bank’s regulatory requirements, and thus on the basis of its risk-weighted assets (RWA). However, MREL itself is expressed as a percentage of a bank’s total own funds and liabilities (TOFL). In line with the TLAC standards and the capital requirements of CRD IV and CRR, the EBA now recommends changing the denominator of the MREL to RWA, combined with a leverage ratio backstop.

Exclusion of capital counting towards capital buffers
Regulatory capital used to meet minimum TLAC is not allowed to be used to also meet regulatory (CRD IV) capital buffers. Currently, the MREL framework contains no similar provision. As a result, MREL eligible instruments may be double-counted towards capital buffers. This undermines the purpose of the capital buffers, which is to provide a buffer for periods of stress and to trigger certain requirements in case of a breach, such as restrictions on distributions. In line with the TLAC standards, the EBA therefore recommends that regulatory capital buffers should stack on top of MREL. However, the EBA notes that in implementing this approach, careful consideration must be given to the interaction with the rules on automatic dividend restrictions.

Consequences of breach of MREL
Under the current framework, breaches of CRD IV/CRR regulatory capital requirements lead to severe consequences and powers for the competent authorities, whereas the BRRD does not currently require immediate action to be taken after a breach of MREL. By contrast, the TLAC standards provide that a breach of TLAC must be treated as severely as a breach of regulatory capital requirements. The EBA recommends that resolution authorities be granted additional powers and a faster procedure for the use of their powers in the event of a breach of MREL and that the existing powers of competent supervisory authorities also be strengthened. More cooperation and coordination between competent supervisory authorities (involved in a breach of regulatory requirements) and resolution authorities (involved in the breach of MREL) is also recommended.

Calibration
Currently, the MREL is set on a purely bank-specific basis (Pillar 2 character). No minimum standard applies for all banks. The TLAC standards, by contrast, consist of a combination of a minimum (Pillar 1) floor for all G-SIBs and a bank-specific (Pillar 2) percentage. The EBA considers that a common minimum standard for all banks would be an excessive burden for some banks. There is greater variation between EU banks on resolution strategies than between G-SIBs, which as a rule will require recapitalisation and will not be liquidated. The EBA therefore discusses the possible introduction of a MREL (Pillar 1) floor separately for small banks, less systemic banks, systemic banks and G-SIBs. The EBA does yet make any specific recommendations except for G-SIBs, who should be subject to a floor in line with the TLAC standards. In any event, the EBA recommends that the MREL requirement also remain a “Pillar 2 type” standard, based on a bank’s resolution strategy and business model and the methodology of the current RTS. Contrary to the Pillar 2 approach under the TLAC standards, where the Pillar 2 is an add-on to the Pillar 1 common minimum, the EBA proposes that the final MREL requirement be the higher of the amount determined by the firm-specific assessment as set out in the RTS and the applicable MREL floor.

Subordination
An important principle under the BRRD is the No Creditor Worse Off (NCWO) principle, pursuant to which creditors can claim compensation from a resolution fund if it becomes apparent that they were put in a worse position under resolution than under bankruptcy. The risk of breaching NCWO can be reduced if liabilities most credibly contributable to loss absorbency are subordinated. Currently, MREL liabilities do not need to be subordinated (in contrast with the TLAC standards), although the resolution authority may require this on a case-by-case basis. The EBA recommends subordination of MREL liabilities be required for at least some banks. This approach is expected to lead to banks having to issue substantial amounts of new MREL liabilities, unless currently issued senior unsecured debt could be converted into junior debt instruments. 

Intragroup distribution
In addition to “external” MREL liabilities issued to external parties, banks should also have sufficient “internal” MREL resources: MREL instruments issued by an operating subsidiary to the top holding. This provides a mechanism to pass losses from operating subsidiaries to the top holding which facilitates orderly resolution. On the basis of the current MREL framework, resolution authorities can set internal MREL but, unlike the TLAC standards, there are no detailed rules or specific requirements. The interim report provides a preliminary discussion of the implementation of further rules on internal MREL. The EBA presents three options: one is to transpose the TLAC requirements only to EU material subgroups of third country G-SIBs, a second option would be to introduce mandatory internal MREL requirements for all or some groups subject to MREL, a third option would be to further develop the framework for resolution colleges to decide on internal MREL requirements on a case-by-case basis. The EBA also provides initial thoughts on related intragroup issues, such as the introduction of a requirement to include contractual provisions allowing write-down or conversion of internal MREL instruments at the point of non-viability of the subsidiary, without the entry of the subsidiary into formal resolution.

Third-country recognition
Under the BRRD, banks must ensure that the resolution tools, such as bail-in, can be effectively exercised. However, if a liability is governed by the law of a third country (non-EU country), bail-in of this liability may not be recognised in this third country. Article 55 BRRD therefore requires banks to include a recognition clause in its contracts governed by third-country law. This is a broader requirement, but is also specifically required for MREL liabilities. On 8 July 2016, RTS specifying the requirements of (inter alia) Article 55 BRRD were published in the Official Journal of the EU. Various market initiatives, such as the recently launched ISDA 2016 Bail-in Art 55 BRRD Protocol, are aimed at helping market participants comply with this requirement. However, including contractual recognition clauses has often proved to be difficult or not feasible. In its interim report, the EBA recognises that some reduction of the burden of compliance with contractual recognition is required, which could be accomplished inter alia by narrowing the scope of the requirement. The EBA also refers to the UK’s Prudential Regulation Authority’s new ‘impracticability’ rules which became effective in the UK on 1 August 2016.