UK: Bank Resolution - The Alphabet Soup Of Loss Absorbency

Last Updated: 23 October 2013
Article by David Strachan and John Andrews

Most Read Contributor in UK, August 2017

Bank resolution is central to regulatory efforts to overcome 'too big to fail'. Within this, proposals for a bail-in tool, and requirements for additional loss absorbing capacity (LAC) beyond minimum regulatory capital requirements, have the potential to constrain further the flexibility banks have to manage their balance sheets.

The challenges of dealing with new resolution frameworks are compounded by an alphabet soup of acronyms in a minefield of jargon, which is not always consistent across borders. It can be difficult to keep track of the evolving policy agenda, and so here we attempt to shed some light.

Spelling it out

PLAC, SLAC, GLAC, GCLAC, and MREL – all refer to the same general idea of loss absorbency  beyond minimum regulatory capital requirements. None of them is yet finalised, and how far they will be harmonised in the future is unclear. But while the specifics of the proposals vary, the concepts have much in common.

  • Draft proposals in the UK on ring fencing require banks to hold Primary Loss absorbing Capacity (PLAC). PLAC will comprise regulatory capital and an additional buffer of bail-in-able long-term debt (although banks will be able to meet their PLAC requirement entirely with equity, at their discretion). The largest UK-headquartered banks will need to have PLAC of 17% of risk-weighted assets (RWAs). (UK regulators also refer to secondary LAC (SLAC), other liabilities that could be written down but would not be first in the firing line).
  • The Financial Stability Board (FSB) is developing proposals on gone-concern loss absorbing capacity(GLAC or GCLAC). The key difference between PLAC and GLAC is the focus on gone-concern: since equity should be wiped out as a firm moves into resolution,
    financial resources required to be available to replenish the bank's equity capital in resolution would take the form of a buffer of long-term bail-in-able debt.
  • US regulators have also used the language of 'gone concern' loss absorbency, and a regulatory proposal is expected imminently. Daniel Tarullo, Governor at the Federal Reserve, is due to speak on Friday 18 October at a conference on resolution, and his speech will be watched keenly for possible further details. Martin Gruenberg, Chairman of the FDIC, also
    recently signalled that the FDIC will publish a detailed description of its proposed resolution process for public comment before the end of 2013.
  • The EU's draft Recovery and Resolution Directive (RRD) refers to a minimum requirement for own funds and eligible liabilities (MREL). Interpreting the EU's approach is complicated by the fact that the RRD is still being negotiated. MREL is likely to be set as a proportion of total liabilities, rather than RWAs, but beyond this it is unclear how it will be calculated or applied to individual banks. It is also unclear whether it will be more like PLAC (i.e. could be met with equity) or like GLAC (to be met with debt).

Key questions

The final design of the bail-in tool and its consequences for banks' liability structures is not yet clear, and nor is it (yet) consistent between countries. The key open questions are:

  • How much? Loss absorbency requirements will go beyond minimum regulatory capital requirements, but we don't yet know by how much. One approach to gauging the scale of the requirement is to think about the impact of a catastrophic loss scenario that wiped out regulatory capital – not only would losses have to be absorbed, but the bank would need to be recapitalised. Moreover, to ensure credibility of bail-ins, regulators are likely to adopt a cautious approach ('over bail-in'), aiming for capital ratios comfortably above the regulatory minima.
  • What form - debtor equity? Discussions around recapitalisation imply that banks will be expected to maintain non-equity buffers of bail-in-able liabilities. But if a minimum loss absorbency requirement of (for example) 20% of RWAs specified that (say) 8% could be met only with some form of debt, this may in fact disincentivise banks from holding more equity. It will be important to understand how regulators intend to apply these requirements depending on the business model of the bank in question.
  • Where in the structure? Paul Tucker, outgoing Chair of the FSB Steering Group on Resolution, recently indicated that he expects the RRD to have far-reaching structural implications for many EU banks, emphasising that the choice between resolution strategies will require some banking groups to make significant changes to their legal, operational, and financial structures. A key component of this will be the location of bail-in-able debt, and its legal form between entities within groups, and it will be important to understand which arrangements will be acceptable to resolution authorities.
  • When? Timelines are currently fluid and out of line across borders. UK banks are expected to implement ring-fencing requirements by 2019. In the EU, bail-in is due to come into force by 2018 at the latest, but possibly earlier. The FSB is due to set out proposals for GLAC by the end of 2014. The US is expected to bring forward its proposals shortly. That is to say nothing of what the market will expect.

The importance of the answers to these questions to the regulatory drive to solve 'too big to fail' puts them firmly in the 'too big to ignore' box for all concerned.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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