MREL will be a challenge for banks and regulators

MREL is a key instrument enabling the liquidation of banks without threatening the stability of the financial system, are now close to conclusion. The work on regulations is now close to the end.

The minimum requirement for own funds and eligible liabilities (MREL) is a new minimum requirement that each bank has to meet. When it comes to own funds, their amount in relation to risk-weighted assets (RWAs) is determined by the CRR Regulation, in accordance with the rules introduced by Basel III. There are no changes in this regard. As for eligible liabilities, significant changes are on the horizon.

Let us recall, that a certain type of “eligible” liabilities is used, so that they can be converted into capital in the event of an orderly liquidation of a bank, also known as a resolution. This mechanism was introduced in the European Union by the BRR Directive in 2014. If a bank was subjected to resolution, such liabilities would be used to cover its losses, if own funds are not enough for this, or to “recapitalize” the institution if it was necessary to create a bridge bank, use the bail-in mechanism, or so that it could be taken over by another institution.

The MREL is a prerequisite for the success of the resolution process, which is clearly emphasized by the Single Resolution Board, i.e. the body responsible for conducting the orderly liquidation of banks in the European Union. In 2017, this institution carried out its first successful resolution of the Spanish Banco Popular. This bank did not have any MREL eligible liabilities, and Santander decided to cover the losses. It is doubtful, however, that in other cases a potential acquirer would be inclined to take similar steps.

UniCredit expects that the largest quantities of “MREL-eligible” bonds will be issued by French, Spanish and Scandinavian banks. It is estimated that in the case of four French G-SIBs (that is, entities obliged to fulfill the TLAC requirement), their value will reach EUR93bn until 2022. The six largest Spanish banks will issue bonds worth EUR91bn (half of which will fall to Santander, which is also a G-SIB), and bonds worth EUR48bn will be issued by Swedish banks. In total, this gives us over EUR200bn, and this is only a portion, albeit sizable, of the issues that have already begun on the EU market.

The lack of MREL eligible liabilities has already prevented the application of the resolution procedure in several other situations. The failed Italian banks, Veneto Banca and Banca Popolare di Vicenza, had losses that exceeded their capitals by EUR5.2bn. They were taken over by the largest Italian institution Intesa Sanpaolo, but the latter received public funds to cover the losses. Meanwhile, resolution has been introduced specifically to ensure that taxpayers’ money isn’t used to save banks.

The situation in which capital was not enough to cover losses and banks reached into the pocket of the taxpayers was repeated many times following the outbreak of the recent global crisis. In order to prevent such a situation, higher capital requirements were introduced in accordance with the principles of Basel III.

As it turns out, even such requirements, along with supervisory haircuts and buffers, can be insufficient. And it is difficult to raise them even higher (although this happens in several countries, such as Switzerland or Sweden) because the profitability of banks in most European countries is lower than the cost of capital. Therefore, eligible liabilities were introduced, which can be written down and converted into capital in the case of a bank liquidation. They are also known as Tier 3.

When a bank is subjected to resolution, after covering the losses, there should be some reserve left to recapitalize the institution. This is supposed to ensure that it is able – while under orderly liquidation – to perform critical functions and fulfill obligations resulting from them without creating systemic risk. And that’s precisely why MREL was introduced. At the end of 2017, the European Commission agreed on the changes concerning this instrument with the European Parliament and the European Council.

Various concepts of requirements

The MREL was introduced by the BRR directive adopted in 2014. Why was it therefore necessary to change the rules before the requirement practically entered into force? Already after the adoption of the BRRD, towards the end of 2015, the Financial Stability Board (which is a body established by the G20), introduced a new prudential standard known as the TLAC. This stands for the total loss-absorbing capacity which applies to the thirty largest banks in the world, or so-called G-SIBs (global systemically important banks). Thirteen of them are headquartered in the European Union.

The idea behind TLAC is very similar to MREL. In addition to total capital (i.e. Pillar I plus Pillar II plus buffers), the banks must have a certain portion of liabilities that in the case of resolution would be converted into capital and used for covering losses and for the recapitalization of the institution created from the liquidated bank. Starting from 2019, the thirty largest banks in the world will have to have capital and debt instruments to cover losses in an amount higher than 16 per cent of risk-weighted assets or 6 per cent of the leverage ratio. Starting from 2022, these figures will be increased to 18 per cent and 6.75 per cent, respectively.

In the case of MREL, the debate on the determination of the requirement levels is still in the initial phase, but Article 45 of BRRD had to be amended to ensure that the MREL rules are consistent with those regulating TLAC. The point was that the largest banks shouldn’t have to fulfill a European prudential requirement in one way, and another global prudential requirement in another way, or shouldn’t have to simultaneously fulfill two similar, but slightly different requirements.

The MREL is the quotient of own funds and eligible liabilities and the balance sheet total, while the TLAC had the same elements in the numerator, but it had total risk exposure in the denominator. After the changes the MREL will be a percentage of risk exposure, like the TLAC. In addition, the changes introduce an internal MREL requirement, which – like TLAC – allows a subsidiary in a banking group to be recapitalized by the parent company without subjecting the company to a formal resolution procedure.

Environment of multiple legal systems

The adaptation of the MREL to the TLAC is a very important, albeit not the most important, reason for the changes. Let us recall, that the MREL is a prudential requirement that will apply to all banks in the European Union. Although – it should be added – this will depend on the adopted resolution strategy, and whether the bank will be considered as one for which a resolution would be planned or one where an ordinary bankruptcy could take place.

For example, in Poland, the Bank Guarantee Fund, which created resolution plans and handed them out to all the banks in October 2017, concluded that the basic way of dealing with banks for which there is no hope, would be ordinary bankruptcy. Typical resolution strategies, such as a bridge bank, takeover or bail-in are the basic strategies only for banks fulfilling critical functions. The Bank Guarantee Fund does not disclose the strategies prepared for banks, but they can disclose them to the public themselves.

Meanwhile, even before the adoption of the BRRD, several countries in the European Union introduced into their national legislations at least a part of the resolution provisions, such as the most important mechanism, i.e. the bail-in, allowing for covering losses not only from shareholders’ money, but also from banks’ liabilities. By introducing these provisions, various definitions have been adopted for liabilities which can be written down in the case of resolution (bail-inable liabilities). And this is where previously unforeseen problems emerged.

It’s well known that the EU law protects certain bank liabilities and they cannot be written down. The BRRD lists them in detail. These are guaranteed deposits up to EUR100,000, liabilities arising from derivatives, or, for example, liabilities towards employees. But corporate deposits or deposits of natural persons exceeding EUR100,000 could be used to cover losses.

The BRRD did not specify this clearly, although it established certain hierarchies. It is known that subordinated debt is lower in the hierarchy than senior debt, and that it should be written down first. But what will happen when it runs out? What will happen if it cannot be written down, as was the case in Italy? Should senior debt be then written down, and if so, in what order?

The case of the Italian banks has proven not only the necessity of having MREL liabilities in the balance sheet, but also the fact that these should in fact be entirely new liabilities. And that additionally they have to be precisely defined. In the case of Italian banks, including Banca Monte dei Paschi di Siena, no resolution could be carried out, because a significant part of their subordinated bonds (just like the senior debt) was held by retail investors.

These investors were treated as depositors whose savings are protected. The conclusion was that the MREL should generally include new liabilities specified in the amendment to the BRRD and treated equally in the entire European legal system.

New hierarchy of obligations

The need for a more precise definition of the MREL and the unambiguous positioning of “MREL-eligible” instruments in the hierarchy of liabilities also resulted from the fact that in the various legal orders of EU Member States, these liabilities were defined in various ways or were not defined at all. In general, the fact that some liabilities may be subjected to write downs may have three different grounds.

The first of them – contractual – is based on the fact that the issuing bank reserves in the securities issue agreement that the debt may be written down in certain circumstances. The second – structural – is used, for example, in the United States. It is based on the fact that the parent company issues debt which is subject to write downs, but the issues of subsidiaries are “safe” from this point of view.

Finally, there is the third option – a statutory one. It was introduced in France a few years ago on the occasion of the bail-in mechanism. But in the various legal orders of the EU Member States, these three foundations were taken into account in varying degrees. In the case of resolution of a group operating in several countries, this would cause very serious complications and legal uncertainty. That is why the amendment introduces a special category of non-preferred-senior debt and determines its place in the hierarchy of liabilities.

It is supposed to look as follows:

  • secured liabilities (e.g. guaranteed deposits, covered bonds);
  • deposits of small and medium-sized enterprises as well as individual deposits exceeding the guaranteed amount;
  • senior debt;
  • non-preferred-senior debt, issued specifically to fulfill the MREL;
  • subordinated debt;
  • regulatory capital.

These changes will create a necessity for the introduction of changes in the bankruptcy law in many EU countries, including Poland.

“Currently, eligible liabilities are classified in the third category of satisfaction, while the European Commission is working on the definition of non-preferred senior debt, which would be placed between the current fifth and sixth categories. France has already implemented such a solution. If this were to happen in Poland, the Bankruptcy Law would have to be changed and such a category would have to be introduced,” says the President of the Bank Guarantee Fund Zdzisław Sokal.

The amendment of the BRRD will therefore end a period of legal uncertainty both inside and outside the European Union. Let us recall, that all the previous resolution procedures carried out by local authorities (as in the case of Hypo Alpe Adria Bank), as well as by the Single Resolution Board (Banco Popular) caused a plethora of legal conflicts. The Single Resolution Board has already announced, that as a principle only liabilities issued on the EU market will be counted towards the MREL, so that when a decision on resolution has to be made, there will be no risk of a conflict with the legal systems of third countries.

“(…) The EU’s recent agreement to introduce a new debt class, non-preferred senior, is an important step towards clarity on how troubled EU banks will be resolved,” Fitch Ratings said in a statement published shortly after the European Commission’s decision.

Huge debt issues are coming

The fact that it will not be possible to include in the MREL any given liabilities issued thus far, including subordinated debts (although some will probably be eligible), puts banks in a completely new situation. They have to place their new “MREL-eligible” debt on the market, which will basically be limited to the EU.

Some of them are already doing that, like the French giants or Santander, which owns BZ WBK. Analysts at UniCredit have calculated that on March 2017 the non-preferred-senior debt of French banks was more expensive by 35 to 63 basis points than senior debt. The January valuation of Santander’s debt, specified in the terms of issue as non-preferred-senior debt, started with a spread exceeding 60 bps, after which it decreased to 54 bps.

“In our opinion, the spreads of non-preferred bonds will probably be more volatile than in the case of senior bonds,” the analysts said in the aforementioned comment.

They added that the expected loss from holding such securities in the portfolio will be diminishing over time, because their volumes in the market will be increasing, and therefore the risk will be distributed. This, in turn, should cause the tightening of the spreads, and perhaps also hikes in ratings. Currently, the ratings of these securities are one-two notches lower than those of unsecured senior debt.

What MREL will the Polish banks need to have? In October 2017, along with the resolution plans the Bank Guarantee Fund also conveyed to the banks the expectations regarding the MREL, although it did not determine amounts. The volumes will surely continue to evolve when the changes in the MREL enter into force and when the Single Resolution Board “allocates” the MREL requirements to banking groups in 2018.

Therefore, it is difficult to clearly determine what will be the volume of issue of Polish banks, which are supposed to reach the full MREL threshold by 2023. Zdzisław Sokal says that this will be a “significant level”. The Bank of England has already announced the MREL levels publicly. They were set at 21-24 percent of the RWA.

Analysts at the consulting company EY have estimated that PKO BP should have MREL in the amount of 19.3 per cent of RWAs, Pekao – 17.9 per cent, BZ WBK – 18.6 per cent, mBank – 23.22 per cent, and ING – 17.4 per cent. At the end of the third quarter of 2017, PKO BP had a total capital ratio of 17.7 per cent,  Pekao – 16.5 per cent. BZ WBK – 16.9 per cent, mBank – 24.16 per cent, ING – 15.1 per cent. We can see that four of the five largest Polish banks are somewhat lacking.

“This isn’t really a small amount,” said Paweł Flak, an EY manager, during that company’s December conference on banking regulations.

The questions regarding the MREL structure remain open

It’s still difficult to predict the size of issues of Polish banks also because of the fact that on the one hand, they have relatively high own funds, and their capital is of good quality. But this should not be equivalent with the conclusion that the MREL will have a marginal size in their balance sheets. On the other hand, it would be unwise to replace capital with liabilities. All of this will have to be balanced, both in Poland and throughout the European Union.

“The European Commission is working on determining the size of eligible liabilities and their minimum size will be established. There is also a discussion about the MREL structure: what should be the ratio of own funds to eligible liabilities,” says Zdzisław Sokal.

In 2017, the Bank Guarantee Fund adopted a methodology in which it clearly states that subordinated debt held by retail investors will not be included in the MREL. It also believes that Polish banks, and especially the weaker ones, should not wait with their issues until the European market gets crowded.

The  Single Resolution Board announced that the review of recommendations concerning the MREL will be carried out every year. The requirements may vary depending on the assessment of the possibility of subjecting a bank to resolution. They will be adapted to the bank’s balance sheet structure and risk profile. However, if the minimum MREL requirements (and such apply in the case of TLAC) are introduced, they will also apply to Poland.

In 2018, the Single Resolution Board also intends to determine where and in what proportions should the MREL be “located” within a group – how much in the parent company (internal MREL), and how much in its subsidiaries (individual MREL). The next most important issue will be the policy towards MREL transfers. The point is to ensure, without any doubt, that it will go to the company within a group which is in trouble. All these areas of activity of the Single Resolution Board are of key importance to the Polish financial sector.

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