The European Commission’s efforts to ensure that there is an immediate resolution on the bankruptcy of financial institutions are expected to influence an initiative detailed last November by the Financial Supervisory Board (FSB), according to structured product professionals. The European legislation is included in its Bank Recovery and Resolution Directive (BRRD), which member states are due to implement in national law by January 1, 2016. The FSB’s consultation on Total Loss-Absorbing Capacity (Tlac), which was opened on November 10, 2014, has closed with a final statement of its intent expected by November this year.
For structured products, there is a fundamental difference between the two pieces of rule-making and the way in which they treat securities in the event of a ‘bail-in’, the mechanism by which assets and liabilities are ring-fenced should a bankruptcy happen. “There are discussions between European regulators and the FSB to make sure that there is a convergence eventually between the two ratios,” says Pierre Lescourret, head of cross structuring, Europe, Middle East & Africa at Societe Generale. “They are not computed the same way and the eligible liabilities that you need to count are not the same.”
The UK, Germany and Austria have at least partially implemented the new European rules. “The European Union has been first out of the blocks with very specific bail-in provisions,” says Peter Green (pictured), partner at Morrison & Foerster in London.
The EC has introduced a broad power for the relevant resolution authorities in member states – in the UK, this means the Bank of England – within the single supervisory mechanism, under the auspices of the European Central Bank. “The power contained in the BRRD means that when an institution fails and becomes subject to resolution, the relevant authority can impose a bail-in on eligible liabilities, of which the definition is very wide,” said Green. “It would potentially cover structured products and derivatives: there are specific provisions as to how derivatives would be bailed in.”
The minimum requirement for own funds and eligible liabilities (Mrel), which is included in the BRRD, makes no specific statement about structured notes, stating only that anything not excluded is included, while the list of excluded liabilities is very narrow and would not cover structured notes. Although there is little detail about how the authorities will implement the rules, they have a limited ability to add to the excluded list.
The directive does state that the debt needs to have a maturity of more than one year and must be unsecured, as opposed to secured or covered bonds and “structured notes will be eligible for the purpose of determining the Mrel ratio for all European banks,” says Lescourret.
“For the Mrel, structured notes are eligible, while for the Tlac, at the moment, structured notes, whether junior or senior, are excluded,” says Lescourret. “We are discussing (through professional associations) with the regulators that excluding structures notes makes no sense as they have the same seniority as vanilla notes. If you look at fixed-rate vanilla notes, the most simple note you can find, at the end of the day the bank will have to trade a derivative to swap the fixed rate into a floating rate: the switch is made in order to hedge interest-rate risk. So nearly all notes use swaps (including cross-currency swaps) or cross guarantee swaps to hedge their liabilities – there are swaps everywhere. So you would have to exclude all of these notes from the bail-in.”
Within the EC, the BRRD also contains provisions relating to Mrel. “National resolution authorities must require banks to hold a minimum amount of loss-absorbing liabilities as a percentage of total assets – not risk weighted – and that will be set on a jurisdiction-by-jurisdiction basis,” says Green.
“It is envisaged that the liabilities treated as loss absorbing under Mrel will include regulatory capital instruments, so additional tier 1 and tier 2, but also Cocos not qualifying as regulatory capital and other liabilities eligible for bail-in, which will include a whole range of unsecured liabilities, such as, potentially, structured notes,” says Green.
“On top of that, there is Tlac, the FSB’s proposed requirement for Globally Systemically Important Banks (GSibs), which is very similar to Mrel, and which requires GSibs to have a minimum amount of total loss-absorbing instruments,” says Green. Under the current Tlac proposals, this is set at 16-20% of risk-weighted assets, a significant difference to Mrel, which is based on total assets and liabilities.
“The FSB’s Tlac proposals contain a definition of eligible securities that can be counted as loss-absorbing for this purpose and at the moment this does not include structured notes or derivatives,” says Green. “We believe this exclusion is due to a concern about how easy it would be in practice to value and bail-in those liabilities. A similar issue could arise in the European Union under the BRRD, as to whether, in a bank resolution, authorities would bail-in difficult-to-value liabilities. However, for relatively simple principal-protected notes, there should be no reason in principle why they could not be subject to a bail-in. Valuation would be more challenging for more esoteric non-principal protected notes and it may be the case that authorities may not seek to make these subject to bail-in in practice, even though the power is there. They would probably be dealt with on a case-by-case basis.”
“For instruments for which a mark-to-market value could be readily obtained, why would they not be included?” says Green. “A further concern under the current Tlac requirements is that, to qualify as an eligible liability, it must be subordinate to every other liability of the institution that is not eligible. Normally, structured notes and derivatives are ranked pari passu to other unsecured instruments. Therefore, under the current proposals, if structured notes and derivatives are excluded, other unsecured instruments would not be able to be included. There is a big question mark over this logic.”
The Bank of England’s main concern is operational: if a bank is put in resolution, over 48 hours during the weekend, there needs to be the possibility of firing the management, creating a bad bank and calculating the write-off that will be applied to liabilities in order to reduce them so new capital can be raised.
“You need to do that in a very short space of time,” says Lescourret. “The central bank’s concerns are, how do you do that while you have hundreds if not thousands of structured notes in your liabilities: you need to look at each note to see how you will apply the write-off, the conversion to equity, and so on.
“Our answer is simple: the resolution directive includes a requirement to create a resolution plan,” says Lescourret. “What we need to do is to identify and flag the structured notes as eligible debt for the bail-in to be able to evaluate those notes daily, and to have a predefined mechanism which can quickly apply the conversion to equity through structuring and systems. This is more or less what we have submitted to the regulators within the consultation.”
The other concern is, although Tlac and Mrel are similar, it means that GSibs would potentially have to comply with two different sets of loss-absorbing requirements. “The two regimes are similar, but do not sit happily together, not least the fact that Tlac is based on risk-weighted assets and Mrel is based on a gross assets,” says Green. “Of course, Tlac would not be directly applicable in the EU and would need to be included in specific EU regulation. The EU authorities have been prepared to make some amendments to the Basel III requirements in CRD IV (capital requirements directive), so it is not certain that they would apply Tlac exactly as the FSB prescribes.”
The Tlac consultation was completed on February 2, and the FSB is due to publish revised requirements ahead of this year’s G-20 Summit on November 15-16, with the earliest implementation date set at January 1, 2019. The FSB is chaired by Mark Carney, governor of the Bank of England, one of the institutions that has already embarked on implementing the European rules included in the Mrel Directive.
From a European perspective, it is likely to be helpful that the EU is already well down the road in implementing minimum loss-absorbing capital requirements under the BRRD. “It is possible that the FSB could refine its views on the inclusion of structured notes to reflect the European position,” says Green. “Tlac is very much still in the consultation phase, whereas the BRRD is now into the implementation stage. European banks in particular are likely to be pushing the FSB to amend the Tlac requirements to more closely reflect where we are on Mrel.”