European Banks. A primer on MREL and TLAC. What are MREL and TLAC and why have them? Credit Research Credit Note

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1 Credit Research Credit Note European Banks 26 October 2016 A primer on MREL and TLAC The EBA is due to publish its report on the implementation of MREL by the end of the month and we expect it will recommend changes to the BRRD to amend and clarify important details of the framework. With the European Commission working on the introduction of TLAC and planning to make its proposal by the end of the year, we take this as an opportunity to review the current status of the two frameworks. While many understand the broad concept of MREL and TLAC, there are a lot of details that remain less than totally clear. And, although they have been around for some years, there continue to be some confusing elements. In this note, which could be sub-titled everything you sometimes need to know, but which is time consuming to source we set out a background to both TLAC and MREL. We look at their key features and differences as well as identify what remains to be decided by the authorities and what the implications for issuance are. In a subsequent piece, we intend to cover some of the more detailed elements of the frameworks such as deductions, exemptions and national creditor hierarchies. What are MREL and TLAC and why have them? Ending too big to fail has been high on the post-crisis reform agenda. Regulators and politicians have sought to create an operating and legal environment where banks can fail safely. The essence of banking is maturity transformation, taking in short-term deposits and lending for longer periods. Traditional insolvency rules mean all liabilities become immediately due; this forces an unwinding of that transformation with a substantial destruction in value. To avoid this, in a process known as resolution, regulators typically attempt to keep a bank operating rather than move it into formal insolvency and winding up. In the past, state intervention with taxpayers money was the expected outcome of bank failure in many countries although not, notably, in the US. New legislation now means shareholders and creditors should absorb whatever losses are necessary to rid the bank of its problems and recapitalise for the future as part of a resolution process. In other words, the emphasis moves from bail-out to bail-in. Regulatory capital, in the form of equity and subordinated debt is intended to cover shortfalls in most situations. However, in the event of a resolution it is recognised that this might not be sufficient as banks need to be recapitalised to continue operating. To make sure that banks have enough bail-in resources available for resolution so that formal insolvency can be avoided, value preserved and systemic risks minimised, regulators have established new rules setting a minimum amount of equity and liabilities that banks must have available. Loss absorption can be in the form of writing down a liability or can be achieved by converting a liability into equity. For now there are two principal frameworks established by regulators to deliver effective loss absorption capacity to resolution authorities. They are broadly similar principal frameworks. MREL stands for Minimum Requirement for Own Funds and Eligible Liabilities. MREL is set by the EU authorities and applies to every bank within the EU. TLAC is short for Total Loss-Absorbing Capacity. TLAC has been proposed by the Financial Stability Board (FSB); it only applies to the 30 Global Systemically Important Banks (G-SIBs). Analysts Thomas Weber thomas.j.weber@commerzbank.com Nigel Myer nigel.myer@commerzbank.com For important disclosure information please see pages 10 and 11. research.commerzbank.com / Bloomberg: CBKR / Research APP available Juliane Rack juliane.rack@commerzbank.com

2 How does a bank achieve this loss-absorbing capacity? MREL and TLAC require banks to have a minimum level of loss-absorbing resources. Equity and subordinated debt already have the capacity to do this while the bank remains in business. Senior obligations have historically only defaulted on insolvency or winding-up. A key element of the resolution process is to ensure that these situations are avoided. Hence, to the extent that the MREL/TLAC requirements are not met with equity and subordinated debt, ways had to be found to enable losses to be absorbed by other liabilities without triggering cross-defaults or accelerations of other liabilities. This essentially requires some form of effective subordination of those liabilities in order to ensure resolution authorities can fulfil their function without material risk of investors triggering the No Creditor Worse Off (NCWO) protection. NCWO holds that a creditor should be no worse off in resolution than in a winding up. In theory this should be straightforward since the concept of resolution is to preserve value within the institution that would be destroyed in a winding up. However, the principal has to be respected at the individual liability level as well as for the whole bank. Since some liabilities that are currently pari passu are likely to be simpler to assign losses to than others and some have greater significance for stability, respecting NCWO and effective loss absorption is more complicated than it may initially seem. There are three approaches that banks can use to create securities that meet MREL/TLAC needs: 1) Statute: new legislation is passed that changes the status of existing liabilities. This overrides the terms and conditions of outstanding debt. It can take the form of making some liabilities more senior than they have been or by making others more junior and able to absorb losses without affecting other liabilities. An example of the former is Italian deposit seniority from 2019, while in Germany certain senior liabilities will become more junior from ) Structure: a bank s corporate structure is such that liabilities are issued out of a nonoperating holding company that is designed to absorb losses leaving the operating business intact. Although losses will occur at the operating company, intercompany loans from the holding company designed to absorb losses allow the losses to be passed on to the holding company, which in turn has raised external funds meeting MREL/TLAC needs. This is the route favoured by the UK, Swiss and US authorities and it is also used in Belgium. 3) Contract: liabilities are issued with terms and conditions specifically designed to meet the requirements of MREL and TLAC. An example is the French authorities plan to allow banks to meet these needs through the issuance of a new class of debt, so-called non-preferred senior. We note that some form of legislation to enable both the structural and contractual options is typically needed. In particular for contractual subordination, legislation permitting previously equivalent liabilities to be treated differently in resolution or over-riding other commercial arrangements is normally necessary. What is the legal basis for MREL and TLAC? The MREL requirement originates from the Bank Recovery and Resolution Directive (BRRD), the EU s framework for handling bank failures, which had to be implemented into national law since The implementation of the bail-in tool, which is part of the BRRD, had an optional implementation deadline later than the rest of the directive and was due to be effective no later than January The European Banking Authority (EBA) was assigned the task of developing Regulatory Technical Standards (RTS) specifying key elements of MREL including guidelines on how to determine the amount banks would be required to hold. The final RTS on MREL were eventually adopted by the European Commission (EC) on 23 May 2016, which thus became a delegated regulation. TLAC is a standard set by the Financial Stability Board (FSB) and is part of the post-crisis agenda to end too big to fail. G20 countries have committed themselves to implement the standards, but the term-sheet itself is not legally binding. TLAC is designed to apply only to the 2 do not delete 26 October 2016

3 30 G-SIB banks designated by FSB at the end of It needs to be transposed into national or European law. As of today, only MREL is a binding requirement for banks. Who sets and supervises MREL and TLAC? FSB proposals have no legislative or regulatory status, they are merely advisory and require individual countries to adopt the necessary proposals at a national level. But, like the Basel Committee on Banking Supervision (BCBS), the FSB is made up of representatives of the most important countries so the adoption process is not normally controversial even though variations do occur between countries. In the case of TLAC, the proposals are theoretically only relevant to those countries that are home to G-SIBs although the concept is expected to be applied more broadly as all BCBS countries are signed up to the idea of resolution. MREL, as the EU-wide equivalent of TLAC, is part of the BRRD and therefore exists by law, which is proposed by the European Commission, as a minimum standard throughout the union. As with all Directives, the BRRD had to be implemented by means of national legislation. The details of implementation are established by means of RTS that are proposed by the EBA which then, unless objected to by the Commission, pass into law and become delegated acts. TLAC levels and compliance are set and supervised by the home authorities of G-SIBs. The term sheet does not specify a particular breakdown of responsibilities between the regulatory and resolution authorities. For MREL, resolution authorities have the responsibility to set the requirement and enforce it although we expect the regulator to be closely involved on an ongoing basis. For ECB supervised banks, the Single Resolution Board (SRB) acts as the resolution authority. What is the timeline for MREL and TLAC implementation? Timeline for MREL and TLAC 22 Feb 16 SRM starts data collection for MREL determination Banks are given indicative MREL requirements Expected time for final MREL requirements 1 Jan 16 Deadline for implementation of bail-in MREL becomes effective 23 May 16 Delegated regulation on MREL published 31 Oct16 EBA due to release implementation report on MREL Source: Commerzbank Research, SRB, FSB 31 Dec16 EC due to publish legislative proposal on MREL and TLAC 1 Jan 19 First stage of TLAC implementation Minimum of 16% of RWA or 6% of leverage exposure 1 Jan 22 Second stage of TLAC implementation Minimum of 18% of RWA or 6.75% of leverage exposure The FSB term sheet proposes the implementation of TLAC in two steps. By January 2019, G-SIBs must maintain TLAC eligible liabilities of at least 16% of RWA or 6% of the Basel leverage denominator. The minimum rises to 18% and 6.75%, respectively, by January The combined buffer requirement comes on top of this. Emerging markets G-SIBs have an additional six years to meet the requirements. Regulators of G-SIBs thus have a clear timeline by which they should adopt TLAC for those banks. The timeline for MREL is less clear. While MREL came into force at the start of 2016, there were no specific technical standards relating to implementation or eligibility. Unlike TLAC, there is no minimum level of MREL as each bank will have an individually set requirement. So, in practice, for 2016 EU banks have not had an MREL requirement. The authorities have stated they intended to communicate group-level requirements for large banks in 2017 towards the end of 26 October 2016o not delete 3

4 2016, with subsidiary level and smaller banks needs to follow in due course. However, it looks increasingly likely to us that the regulators will miss this window and that banks may only get their first indications in Q A report on the implementation of MREL and the potential need for legislative changes will be published by the EBA by 31 October Furthermore, the European Commission promised to bring forward a legislative proposal on the implementation of TLAC by the end of 2016, which we expect to reflect the comments from the EBA on MREL. We expect that some aspects of MREL will change in the future. Not only is the European Commission working on its proposal as to how TLAC and MREL can be combined and what changes to the existing framework could be necessary, it is also planning to propose more general changes to the CRR/CRD IV regulatory framework that may affect MREL. Furthermore, as there is still no uniform approach for setting Pillar 2 capital requirements within the EU, this feeds through to the amount of MREL banks are required to hold. It therefore seems likely to us that EU banks will not have meaningful clarity about the amount of MREL they need until well into Elke Koenig, head of the Single Resolution Mechanism (SRM), the Banking Union s resolution authority, has said three to four years is a realistic assumption for the implementation. Alongside final MREL targets, banks are likely to be given interim targets that reflect the starting point in terms of each bank s liabilities structure and the availability of MREL eligible funding instruments and which tie-in with TLAC needs and timing for G-SIBs as appropriate. What are the consequences of a breach of the requirements? A breach of TLAC is designed to be as serious as a breach of minimum capital requirements. The term sheet mandates that authorities should require a firm to take prompt action to address a breach or likely breach. The relevant part of the TLAC term sheet preamble then notes that authorities must intervene and place a firm in resolution if it is failing or likely to fail with no reasonable prospect of recovery. There is no direct link established between a failure to take prompt action and failure that requires resolution. While the BRRD is clear that banks must meet their MREL requirements at all times, it does not set out specific actions following a breach, although there are some indirect powers a resolution authority could use to require a plan to restore compliance. There are also early intervention powers if the authority identifies a significant deterioration in MREL and powers to impose measures and penalties for breaches of any requirements. In its interim report on the implementation of MREL in July the EBA discussed this shortcoming. The absence of specific consequences for a breach of MREL/TLAC is surprising. The remedies are more implied than explicit. However, we think the clear intention for both TLAC and MREL is that it is to be seen as a very serious breach that would require a capital improvement plan and if that is not credible or followed then the likelihood is that the authorities would regard the bank as failing or likely to fail and hence implement resolution plans. By the end of this year, we also expect the EBA to make legislative proposals to provide more certainty over actions following a breach. What s in and what s out? For both TLAC and MREL, the relevant rules not only set out what features a liability must fulfil to be eligible; they also establish what obligations are excluded. For example, while TLAC explicitly requires eligible instruments to be subordinated to excluded items, the BRRD is silent on the matter. We expect more detailed guidance from the EBA in coming months as the NCWO principal is an important constraint. The delegated regulation provides some constraints, as we note below. 4 do not delete 26 October 2016

5 What are the criteria for debt to be TLAC eligible? The key criteria for TLAC are: Unsecured Not subject to set off or netting rights Minimum remaining maturity of at least one year (or perpetual) Must absorb losses prior to excluded liabilities in insolvency or resolution without giving rise to material risk of successful legal challenge or compensation claims Must be subordinated to excluded liabilities (contractually, statutorily or structurally) Issued directly by resolution entities (with certain exceptions and grandfathering rules) Furthermore, the TLAC term sheet also provides a negative list. The following must not be included in TLAC: Insured deposits, sight deposits and short term deposits Derivative liabilities Debt instruments with derivative-linked features (structured notes) Tax liabilities Liabilities preferred to senior unsecured in insolvency Any liability that cannot be bailed-in without giving rise to material risk of legal challenge or compensation claims What are the criteria for debt to be MREL eligible? The eligibility criteria for MREL liabilities are defined in Article 45 of the BRRD. The main conditions are: Unsecured, not guaranteed Remaining maturity of at least one year Liability does not arise from a derivative Liability does not arise from a deposit which benefits from preference in insolvency The delegated regulation on MREL requires resolution authorities to identify any liabilities that are excluded or are reasonably likely to be excluded from bail-in, which then needs to be considered when setting MREL. One of the powers given to resolution authorities by the BRRD is the right to treat equally ranking creditors differently if this is necessary to achieve the resolution objectives. This option is however subject to the NCWO creditor safeguard. According to the BRRD, liabilities that by definition are excluded from bail-in are: Covered deposits (i.e. retail and corporate deposits below 100k) Secured liabilities incl. covered bonds (up to the value of the collateral) Liabilities arising by virtue of the holding of client assets or fiduciary relationship Liabilities to institutions or system operators with an original maturity of less than seven days Liabilities to employees, creditors that provide goods or services that are critical to the daily functioning of operations, tax and social security authorities and deposit guarantee schemes Will MREL eligible debt need to be subordinated to excluded items? A difference between TLAC and MREL is that subordination to excluded liabilities is not an explicit requirement for MREL eligibility according to the BRRD. In fact, resolution authorities can decide on a case by case basis which liabilities they accept for meeting the MREL requirement and that may be different from one bank to another subject to each bank s individual liabilities structure. In order for the bail-in tool to be feasible in resolution, we think however, that for MREL some form of subordination will eventually be needed. 26 October 2016o not delete 5

6 How does a resolution vs insolvency affect losses for bondholders? Assuming that a resolution preserves value compared to insolvency by avoiding a fire sale of assets, there is room for a certain degree of unequal investor treatment without breaching the NCWO principle. The following example illustrates the logic behind this concept: Consider a bank with 200 of assets which are funded with 20 of capital, 80 of bail-in senior debt (e.g. bonds), 20 of non-bail-in senior debt (e.g. non-preferred deposits, structured notes) and 80 of preferred deposits. If the bank is put into insolvency, we assume higher losses than in resolution of say 40 as all assets need to be liquidated in a fire sale. As bail-in debt and non-bailin debt share losses equally in insolvency, the haircut on senior debt is 20%, which is the part of the loss exceeding capital divided by all senior liabilities. If the bank is put into resolution instead, it can be assumed that losses will be lower than in liquidation as a sale at discount prices can be avoided and the viable business of the bank continues to operate. If we assume losses in this scenario are only 30, the haircut on bail-in debt is only 12.5%, although non-bail-in debt does not share any of the losses. Illustration of the No Creditor Worse Off principle Insolvency Resolution Capital Bail-in senior debt Non-bail-in senior debt Total senior debt Preferred deposits Total liabilities and capital Loss Haircut on bail-in senior debt 20% 12.5% Haircut on non-bail-in senior debt 20% 0% Source: Commerzbank Research In this example, bail-in senior creditors are better off in resolution than insolvency, although some equally ranking creditors get preferential treatment by being excluded from bail-in. The greater the amount of senior liabilities that is excluded from bail-in though, the higher the chances that bail-in senior creditors will be worse off in resolution compared to insolvency. What risks are there to bailing-in non-mrel liabilities? While there are few reasons to exclude long-term senior bonds from a bail-in, the situation is different for structured notes, derivative liabilities and corporate deposits. The bail-in of corporate deposits in our view could destabilise the funding structure of the bank because depositors are more likely to withdraw their funds when they know they are first in line of bail-in if the bank fails. Excluding or preferring depositors can therefore have a stabilising effect on a bank s viability as an important source of liquidity is more likely to be preserved. Furthermore, imposing losses on core clients of the bank has the potential to fundamentally damage the franchise of the bank, which would reduce the chances of the systemic part of the bank being able to operate as a going concern. The concerns about bailing in structured notes and derivative liabilities are primarily complexity and contagion. As resolution measures will need to be taken quickly potentially just over the weekend when markets are closed the bail-in of structured notes represents an operational obstacle as a large number of instruments would need to be identified and valued before a haircut or conversion rate can be applied. Furthermore, many structured notes are sold to retail investors where there may be resistance to impose losses, an issue that was highlighted in Portugal and Italy recently. Besides their complexity, derivatives are a major source of contagion risk as large global financial institutions have substantial exposure towards each other through the derivatives market. We would therefore expect that regulators will exempt derivative liabilities from a bail-in. In addition, a large part of derivative liabilities is typically collateralised and netting agreements exist, therefore limiting the amount available for bail-in. 6 do not delete 26 October 2016

7 Considering the likely exclusion of deposits, derivatives and structured notes, the risk of a breach of the NCWO principle becomes significant, because a large proportion of senior debt will not share losses in resolution. This gives rise to the risk of legal challenges by investors that are treated less favourably. The delegated regulation on MREL therefore defines a de minimis rule according to which the resolution authority needs to consider excluding otherwise MREL eligible liabilities when more than 10% of a class of liabilities ranking junior or pari passu has been identified as being likely to be excluded from bail-in. Therefore, unless a bank has only a very small proportion of its senior liabilities in the form of corporate deposits, structured notes or derivatives, we think subordination of senior bonds will effectively be required. What is the difference between a liability being bail-inable and being MREL/TLAC eligible? A liability may be bail-inable, but not MREL eligible while all MREL eligible debt needs to be bailinable. Bail-inable liabilities are simply those which are able to absorb losses in resolution whether on a statutory or contractual basis. MREL is then the subset of all bail-inable liabilities that fulfil the appropriate definition and count towards the MREL ratios. In resolution therefore a bank s actual loss absorption capacity should be greater than that suggested by its MREL ratio. The order in which losses are assigned to bail-inable resources will depend on statutory, contractual and structural subordination provisions as already discussed. For example, a senior unsecured bond, which fulfils all the criteria for MREL eligibility, will cease to count towards MREL as soon as its remaining maturity falls below one year. This concept is similar to Tier 2 capital, where the nominal amount amortises gradually over the last five years before maturity for regulatory purposes. Given the higher cost of Tier 2 compared to other sources of funding, many banks have issued Tier 2 in callable format allowing the issuer to redeem the bond when regulatory amortisation kicks in. We think the senior unsecured market or the MREL eligible part of the senior unsecured market might see the emergence of a similar feature giving issuers a call right one year before maturity. This would ensure cost efficiency for banks issuing debt to meet MREL maturity requirements. Indeed this structure is starting to be used by US banks. Illustration of the difference of bail-inable and MREL eligible debt Liabilities (non-bail-inable) Covered deposits Secured liabilities (e.g. covered bonds) Interbank liabilities < 7 days Liabilities to employees, tax and social security authorities or deposit guarantee schemes Bail-inable debt Derivatives Derivative-linked notes Preferred deposits MREL debt Remaining maturity > 1 year Own funds Source: Commerzbank Research 26 October 2016o not delete 7

8 How much TLAC do banks need? The final TLAC proposal states that banks have to hold a TLAC ratio of 16% of risk-weighted assets plus combined buffer requirements by January 2019, which rises to 18% plus combined buffer requirement by Additionally, there is a TLAC leverage ratio, which is set at 6% of leverage exposure as of 2019 and 6.75% from 2022 onwards. TLAC is the standard for G-SIBs and hence only applies to a handful of European banks. However, we think that MREL requirements, as presented below, should in most cases exceed the TLAC requirement. The TLAC term sheet only sets a minimum requirement, individual regulators are free to require higher levels, as the US has chosen to do. Also, G-SIBs are required to have at least 33% of their minimum TLAC amount in the form of non-equity capital or eligible debt instruments. This is to ensure they have enough debt available to absorb losses and/or recapitalise the bank at the point of resolution. MREL does not have the same minimum debt requirement. How much MREL do banks need? The amount which banks have to hold for MREL purposes is not finally clarified. We expect the MREL requirement will not be set as a percent of own funds and total liabilities as initially planned, but either as a percentage of risk-weighted assets as shown below or based on the leverage ratio exposure. Different regulators have suggested different approaches. We expect more clarity on the denominator and numerator in coming months. Some banks have previously stated that they have no intention of publishing their MREL requirement as this is closely tied to the bank s resolution plan. We think that the MREL requirement, in particular for larger institutions, will be published, but we do see some risk that smaller banks might refrain from the disclosure. The EBA s interim implementation report suggests various approaches of how much MREL banks have to hold. In our view, the most likely approach is that EU banks have to hold a total capital amount of 8% plus the Pillar 2 requirement to absorb losses, while the same amount is required for recapitalisation. The combined buffer requirement would then come on top. The Bank of England has suggested a similar MREL requirement. They propose to hold 8% total capital plus Pillar 2A for each, loss absorption and recapitalisation. The combined buffer requirement will come on top of this. Swedish banks may be subject to an even higher MREL requirement. This mainly relates to the fact that Pillar 2 requirements as well as the combined buffer requirement are much higher there as compared to other countries. Our table below shows our estimated MREL requirements for selected European banks under the various approaches. However, it is yet unclear whether the newly introduced Pillar 2 guidance will be included in a bank s MREL requirement. If not, our estimates shown below could be too conservative for ECB supervised banks. 8 do not delete 26 October 2016

9 Estimated MREL requirements for selected European banks in % of RWAs Country MREL requirement assuming transitional capital requirements MREL requirement assuming fullyloaded capital requirements Swedbank SE Handelsbanken SE SEB SE Nordea SE Barclays UK Lloyds UK DB DE ING NL ABN NL Rabo NL HSBC UK Erste AT KBC BE RBS UK BNP FR Unicredit IT Popular ES ES Santander ES BPCE FR BBVA ES SocGen FR CA FR Intesa IT StanChart UK UBI IT Source: Commerzbank Research, company data Glossary Abbreviation Meaning BRRD Bank Recovery and Resolution Directive BCBS Basel Committee on Banking Supervision EBA European Banking Authority FSB Financial Stability Board G-SIB Global Systemically Important Bank MREL Minimum Requirement for Own Funds and Eligible Liabilities NCWO No Creditor Worse Off SRB Single Resolution Board SRM Single Resolution Mechanism TLAC Total Loss-Absorbing Capacity Source: Commerzbank Research 26 October 2016o not delete 9

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