Asymmetric finalization of capital rules creates headache for Europe’s banks

Donald Trump doesn’t need to try so hard to implement different regulation for US and EU banks: the Financial Stability Board (FSB) and Basel are doing a fine job all by themselves.

This is becoming very apparent as banks on both sides of the Atlantic scramble to meet their loss absorbing capital requirements. 

The European Commission proposed amendments to capital requirements regulation (CRR) and the bank recovery and resolution directive (BRRD) in November last year, which were swiftly followed by the FSB’s final rule on total loss-absorbing capacity (TLAC) implementation in mid-December. Banks should, therefore, know what the regulators want. Unsurprisingly, they do not.

There are now five separate pieces of European legislation in the works that deal with bank funding: two capital requirements (CRD V and CRR) and three resolution requirements (subordination, BRRD 2 and SRM 2). The core problem in Europe is the delayed implementation of Basel IV. 

TLAC applies to global systemically important banks (G-Sibs) and MREL (minimum requirement for own funds and eligible liabilities) applies to all EU banks, so if you are a European G-Sib you are subject to both. The differences between the two approaches mean that these large and complicated banks will be subject to separate, overlapping requirements from different authorities.

While both TLAC and MREL deal with loss absorbency they are different beasts. TLAC is a capital requirement that is functionally identical to tier-2 debt but has a hard minimum and is set in legislation. MREL is a resolution requirement policed by the resolution authority and will be set for each bank at a discretionary level determined by that authority.

“We are going to see the most spectacular rows between the ECB and the SRB [single resolution board] over this,” smiles one London-based lawyer, happily.

One of the key differences between TLAC and CRR terms is the restriction on acceleration rights. Many senior bonds issued by European banks or bank holdcos give bondholders the right to accelerate payments, for example if coupons are missed. 

However, under MREL, acceleration is only permitted if the bank becomes insolvent. For US banks, existing debt can be grandfathered for TLAC purposes, with only newly issued debt now having to rule out acceleration rights explicitly.

“With regard to acceleration rights for non-payment, the new proposed CRR provisions seemed to have in essence taken the equivalent tier 2 provisions, under which you can’t accelerate, and simply copied them across,” explains Simon Sinclair, head of the capital markets practice at Clifford Chance in London. 

“The TLAC rules do not seem to specifically restrict acceleration for non- payment. Banks have therefore been put in a difficult position in trying to determine which position to follow, which is creating a distinctly unhelpful position for everyone."

The expectation is that Europe will decide to permit grandfathering, but until it does, all that senior bank debt with acceleration rights may be ineligible for MREL. The asymmetric way in which TLAC and MREL terms are being finalized means that seemingly minor legal differences between the two could end up hitting European banks’ capital plans.

“We should not see wholesale sudden disqualifications of debt as MREL or as regulatory capital, but it is something worth watching, because it could affect future refinancing plans or call decisions,” note analysts at CreditSights. “These are points to be clarified as the CRR amendment proposal goes through the implementation process this year.”

They need to be clarified fast as the subordination legislation for non-preferred senior debt under BRRD 2 is due to be in place by this July – a deadline that one lawyer describes as “a farce”.

There are many other discrepancies. For example, TLAC rules exclude derivatives, while draft MREL rules look like they will allow them if they are principal protected.

It is not only the differences between TLAC and MREL in terms of eligibility that are giving European banks a headache. There are substantial differences in the extent to which banks investing in others’ capital instruments will be treated under new deduction rules.

“Deduction rules have a general policy objective of discouraging financial institutions from holding capital instruments,” explains Andrew Coats, co-head of the derivatives and financial regulation group at Clifford Chance. “Under current rules, if a bank holds someone else’s tier-2 debt that will reduce its own tier-2 debt. However, the FSB/Basel Committee says that G-Sibs must deduct any holding of another G-Sib’s TLAC from their own tier-2 capital, and not TLAC.”

These proposals are far from popular in the market.

“We believe that if regulators subtracted TLAC debt of other banks, it could have a negative impact on market liquidity, bid-ask spreads and willingness to make markets,” pointed out the CreditSights analysts when the final TLAC rules were released.

The deduction rules on the cards, however, will have very different impacts at European banks and their US counterparts. Problems arise when non-G-Sib banks invest in TLAC as they will have no TLAC debt of their own to net it off against. For US banks the rules seem clear.

“Under the FSB/Basel Committee TLAC proposals, if banks are not G-sibs and do not issue TLAC, they are still required to deduct any holding of TLAC from their own tier-2. This enables a single treatment for both G-Sibs and non-G-Sibs,” explains Coats.

Here again the differences between CRR and the FSB are creating a very bumpy playing field.

“The EU has a different logic and says that deduction should only apply at the same level – if a bank is holding tier-2, it should deduct it from its own tier-2, but if it is not a GSII and it holds TLAC, a deduction does not apply,” says Coats. “The EU rules mean that a non- GSII EU entity can invest in TLAC without limits as they won’t suffer a deduction from MREL. This is quite a divergence from the FSB approach.”