UK: All I Want For Christmas Is An MREL

Last Updated: 23 December 2015
Article by Simon Brennan and Scott Martin

Most Read Contributor in UK, August 2017

On 11 December the Bank of England (the Bank) laid out its plans for setting the minimum requirement for own funds and eligible liabilities (MREL) – loss absorbing capacity requirements introduced in the EU by the Bank Recovery & Resolution Directive (BRRD).

The requirement sets an amount of capital and liabilities for firms to hold in order to make the 'bail-in' of creditors a credible means of absorbing losses and recapitalising failing banks. Banks, building societies and 730k investment firms in the UK come within scope of the regime.

MREL introduces an additional prudential constraint for firms, alongside risk-weighted capital and leverage requirements. It will be set at the amount the Bank judges necessary for loss absorption prior to and in resolution, and for recapitalisation post resolution via the bail-in tool.

The amount of MREL will vary firm by firm according to the resolution strategy that the Bank adopts – whether that is modified insolvency, deposit book transfer or whole-firm transfer, the decision being a function of size, complexity and systemic importance of the firm. The Bank identifies three categories of firms to guide the determination of the resolution strategy:

Scope

Resolution strategy

MREL requirement

Under 40,000 "transactional accounts"

Firms likely to undergo a modified insolvency process

Will usually require no additional loss-absorbing capacity requirement

Greater than 40,000 accounts, and balance sheet size less than £15bn to 25bn

Firms likely to need a partial transfer of assets

Some additional loss-absorbency required to effect the partial transfer, but not to support recapitalisation of the part of the business "left behind"

Greater than £15bn to 25bn assets

Firms likely to undergo a bail-in resolution

Requires loss-absorbing capacity of roughly double regulatory capital requirements in order to be able to effect recapitalisation post-resolution

Most investment firms will therefore in practice not be subject to additional loss-absorbing capacity requirements under the MREL regime, avoiding both the direct additional capital cost and the additional regulatory complexity compliance with the regime will entail. Only the smallest banks though are likely to be similarly exempt.

Around 15 of the largest UK-headquartered banks – a broader set than just the number of UK global systemically important banks (G-SIBs) and ring-fenced banks – along with some UK subsidiaries of foreign banks, will be required to hold at a minimum, capital and eligible liabilities equal to approximately two times their minimum capital requirement (the greater of Pillar 1 plus Pillar 2A, any applicable leverage ratio, and the Basel 1 floor).

The remainder of firms will have to hold a smaller amount of additional capital over and above their minimum capital requirement.

The Bank will use its MREL power to implement the international standard, Total Loss Absorbing Capacity (TLAC) set by the Financial Stability Board (FSB), and in the process be more specific than the BRRD on some topics. In particular, it will require "structural subordination" (explained below) of liabilities (or "contractual subordination" for building societies). It will also explicitly exclude structured notes and other liabilities with significant derivatives components from eligibility for MREL, a point on which the BRRD was more ambiguous.

The Bank expects to set individual MREL for UK-incorporated entities within UK headquartered groups, including ring-fenced banks, subject to the group's resolution strategy. It will set MREL for UK subsidiaries of foreign banks to reflect the agreed resolution strategy.

A breach of MREL will not automatically mean that the Prudential Regulation Authority (PRA) considers a firm to be failing or likely to fail its threshold conditions. Subject to the capital restoration plan that will need to be submitted in the event of a breach, there will be the possibility of restructuring or prohibiting dividends.

Implications for firms

The Bank has been measured and proportionate in its approach. It could have gone further, both in terms of quantum, and scope. But its requirement for structural subordination and exclusion of structured notes and some other liabilities, as well as its preference for MREL to be issued by holding companies which have 'clean' balance sheets that have no operating liabilities, will be more demanding for some firms. The Bank will doubtless be hoping to influence the EBA and the European Commission to amend the BRRD accordingly when a legislative update is proposed next year.

A key question for some firms will be what precisely the Bank means by "transactional accounts". The Bank identifies several possible definitions. It also asks whether there should also be a threshold based on the amount held in the accounts, rather than just the number (and it cites the PRA's threshold of £350mn of sight deposits for the purpose of requirements on operational continuity).

The Bank does not believe it will be necessary for a firm emerging from resolution immediately to meet all applicable capital requirements, and that in general it will be unnecessary to require an additional amount over any above minimum capital requirements for market confidence. Neither of these factors is therefore included in the amount required for recapitalisation. For G-SIBs and ring-fenced banks, however, this assumption will need to be tested. Firms subject to a bail-in resolution strategy will also want to look in more detail at the Bank's assumptions about the post-recapitalisation and understand the implications for their MREL. (And more broadly, the framework of capital requirements for UK banks is evolving – as set out in a recent statement by the Bank's Financial Policy Committee – with potential implications for MREL for some business models.)

The Bank parks the issue of disclosure until ongoing discussions by the Basel Committee on Banking Supervision have been concluded. The assumptions it does set out, however, confirm expectations that banks have significant investments to make in systems and reporting capabilities, including in detailed disclosure of creditor hierarchies on an entity by entity basis. In addition to public disclosure, the Bank will require data to enable to it to monitor and set individual MREL levels. The Bank does not, though, envisage introducing any formal reporting requirement before 2018, but may collect data as part of its ongoing data collection for resolution planning.

What comes next?

The Bank's consultation and a related consultation by the PRA close on 11 March 2016. Any revisions to the policy statements will take into account the final EU technical standard on MREL that should be adopted by the European Commission next year.

In most cases MREL will simply be set at the current minimum capital requirement between 2016 and 2019. The new framework being proposed will take effect from January 2020 (or January 2019 for G-SIBs). In 2016 the Bank will indicate where it expects MREL to be set for each firm from 2020 (2019 for G-SIBs), and confirm the resolution strategy for each firm.

Digging into the detail

Minimum requirement

For those firms likely to undergo bail-in, the Bank adopts an approach for setting MREL largely in line with the EBA's draft proposed standards on MREL, indicating an amount of effectively double a firm's minimum regulatory capital requirement (i.e. twice Pillar 1 + Pillar 2A, or the leverage ratio where appropriate).

Under the TLAC standard, G-SIBs must meet a minimum TLAC requirement of 16% of risk-weighted assets, or 6% of leverage exposures, by January 2019 and the Bank indicates it expects UK G-SIBs to meet this minimum.

Capital buffers though will sit "on top of" MREL requirements, and would need to be met using separate capital.

Eligibility of liabilities

In order to count towards MREL, liabilities will be required to have a minimum one-year residual maturity. Liabilities with significant derivative components, including structured notes, are expected not to be eligible. Liabilities subject to set-off or netting arrangements will not be eligible either. Those governed by non-EEA law will only be eligible where the Bank is satisfied that they can be bailed in.

Structural subordination

Firms will be expected to structurally subordinate liabilities in order for them to be eligible for MREL, by meeting their consolidated requirement through external issuance from their holding company, and down streaming it internally to relevant subsidiaries (building societies will be permitted to use contractual subordination). This approach effectively extends the TLAC subordination requirement to all MREL firms, which was not a requirement under the BRRD.

Internal pre-positioning

Internal MREL should be distributed appropriately – firms should "ensure that sufficient MREL resources are pre-positioned at appropriate entities within a group". The Bank does not set specific pre-positioning rules although it commits to make this pre-positioning "as consistent as possible with the TLAC standard," (75-90% of the hypothetical standalone requirement), but not for ring-fenced banks.

Minimum debt requirement

The consultation does not include rules on a minimum quantum of MREL that would have to be met with debt liabilities instead of regulatory capital (the TLAC standard introduces a one-third minimum debt requirement).

Large exposure limits

The Bank indicates it will work with the PRA to ensure that any interactions between the large exposures framework and (internal) MREL are managed appropriately.

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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