QuickTake: What next for Minimum Requirement for Own Funds and Eligible Liabilities (MREL)?
European credit institutions i.e. banks have been required to comply with the EU's MREL requirement, which was introduced in 2014 and substantially updated in 2017. MREL consists of own funds and part of the institutions' liabilities. If an institution fails and goes into a regulatory led resolution process, the MREL acts as a buffer to absorb losses and provide new regulatory capital to the institution as well as being capable of becoming subordinated (despite some on-going disagreement on how/when that is possible). The recapitalization also assists with providing stability for the firm to perform its "critical functions" and fulfil obligations with creating (further) additional systemic risk.
Shares, other capital instruments and certain debt instruments can be MREL eligible, thus allowing issuers to be compliant with "their" MREL requirements. MREL, which is an EU-wide regime, is set by the Member State resolution authority (NRAs) on an institution-by-institution basis, depending on preferred resolution strategy. Whilst there is no minimum level of MREL, the BRRD sets out criteria which the resolution authority must consider when setting it. In the Eurozone, the relevant authority is the Single Resolution Board (SRB) that leads the NRAs to make up the Single Resolution Mechanism (SRM) as the second pillar to the Banking Union.
Globally systemically important banks (G-SIBs)1 are required to comply with the Total Loss Absorbing Capacity (TLAC) standard as of January 1, 2019. MREL and TLAC share the same supervisory aims with TLAC being more detailed in what is permitted. With recovery and resolution as well as the EU policy to harmonize national insolvency laws, and with creditor hierarchy2 very much back in the focus at the outset of 2019, notably in the Eurozone following some worrying outlook for certain Banking Union Supervised Institutions (BUSIs), the SRB MREL policy matters and so does compliance in order to remain resolvable both for BUSIs and non-Banking Union credit institutions given the cascade effects.
This SRB policy represents a common approach to ensure consistency and a level playing field within the Banking Union and takes into account where necessary any bank-specific features. The publication of the SRB's 2018 MREL Policy3 marks a key update to existing SRB guidance from 2017, and with the SRB looking to complete the setting of binding individual and group MREL targets for relevant BUSIs by 2020, this Client Alert assesses some of the key specifics that firms might want to consider ahead of SRB communicating MREL Decisions throughout 2019. Some market commentators have become warned that MREL-deficit amongst BUSIs could occur. Others have expressed concern that while MREL is EU-wide, there are some very different conditions for issuers and funding conditions between the core and periphery EU Member States. This fragmentation is a barrier in terms of issuance costs and ease of issuance. Equally, MREL Decisions and the transition to 2022 comes at a busy time of the ECB, in its supervisory Single Supervisory Mechanism (SSM), publishing further supervisory expectations in respect of ILAAP and ICAAP as well as taking supervisory actions.4 This will matter equally to those issuers of MRELs inasmuch as holders i.e., investors.5
MREL corresponds conceptually to the minimum amount of loss-absorbing capacity that is also covered by the international standard of TLAC developed by the Financial Stability Board. It was enacted in the BRRD in May 2014 for all banks. The SRB foresees a transitional two-step approach to the MREL-setting process for the 2018 planning cycle. This year's cycle is split into two waves—the first one started in January 2018 and allowed for banks that did not have binding targets in 2017 to be addressed first based on an MREL Policy. This document acts as a point of reference for the determination of SRB Decisions on MREL for these BUSIs during 2019.
The SRB 2018 MREL Policy updates the general MREL approach finalized in 2017, by adding a few additional features. First, the MREL policy now caters for all resolution tools, and not only for strategies based on an open-bank bail-in. Second, the MREL policy removes the reference to the Basel I floor in the MREL formula.
While the SRB 2018 MREL Policy does not specifically mention Brexit, the SRB has communicated its concerns that the size of outstanding MREL eligible issuances with a nexus to the UK and/or English law of the law of a third-country may mean that UK courts or a third-country court may cease to recognize the resolution actions of EU authorities such as bail-in.6 While the SRB considers that the issuance of liabilities under the laws of one of the Member States of the EU-27 might alleviate such concerns, it is equally important that the place of performance/issuance or dispute resolution venue is the law of a Member State of the EU-27. At the time of writing of this Client Alert, it remained unclear whether any fully binding transitional arrangement or other form of regulatory relief would be introduced (possibly out to 2024) to account fully for recognition issues.
Moreover, as the European Banking Authority (EBA) has announced that in its 2019 Work Programme it will focus on MREL quality and supervision, given that it—like the SRB—has found poor data quality, including in respect of the Liability Data Report (LDR) exercises. Equally, the EBA and SRB are both monitoring and preparing for the impact of Brexit on MREL, while concurrently forward-planning for the range of technical delivery on the EU's "Banking Package," i.e. the reforms known as CRR 2/CRD V, SRMR 2 and BRRD 2. Agreement on the Banking Package presented a relief for a range of BUSIs that are comparably "less risky" and brought convergence on how to comply closer with TLAC and MREL. As part of the SRB's data quality improvement efforts, there is an expectation, especially due to the Banking Package, that various divergences and differences stemming from national options and discretions will be streamlined by the SRB much in the same way as the SSM undertook a similar exercise in 2016 and 2017 in terms of how the CRR/CRD IV regime is applied within the Banking Union. The SRB has also announced its focus on operationalizing "internal MREL," which like TLAC permits a subsidiary in a banking group to be recapitalized by the parent company without subjecting the company to a formal resolution procedure.
January 1, 2019 also marked the start of G-SIBs needing to meet a weighted TLAC requirement of at least 16% in risk-weighted assets and an unweighted requirement of at least 6% expressed in the same denominator as the leverage ratio. From January 1, 2022 these levels increase to 18% and 6.75%. With the former EBA Chairman, now the Supervisory Chair at the ECB's Single Supervisory Mechanism, having called for the SRB to publish MREL requirements, this sharpens the tone even further.
SRB 2018 MREL Policy Methodology
A – Targets and Location
The MREL policy builds upon the delegated regulation (DR)7 default formula which consists of two components: (i) a default loss-absorbing amount (LAA), which reflects the losses that a bank will incur in resolution, and (ii) a recapitalization amount (RCA), which reflects the capital needed to meet ongoing prudential requirements after resolution. MREL targets are based on fully-loaded risk weighted assets (RWAs) and fully loaded capital requirements.
The leverage ratio remains excluded from the MREL formula, and now the Basel I floor has also been removed from the MREL requirements. MREL targets will be set using supervisory and resolution reporting data from the previous year.
The SRB does not adjust the default LAA. In accordance with the DR, the SRB considers the default LAA the sum of a bank's minimum capital requirement (Pillar 1 requirement), its Pillar 2 requirement (P2R), and its fully loaded combined buffer requirement (CBR).
The default RCA is the starting point for a MREL determination. Under the DR, the RCA is composed of: the minimum requirement for authorization (P1 and P2R) and an amount intended to regain market confidence, the MCC.
Banking groups which prefer liquidation as a resolution strategy have no RCA. Where the preferred strategy at the level of the group is liquidation, MREL will be set at the level of the LAA, with no RCA and no MCC. Bank-specific adjustments are considered on the basis of the DR. The DR enables resolution authorities to make bank-specific adjustments to three components of the RCA, including the MCC.
The SRB may allow, on a bank-by-bank basis, three adjustments to the RWA basis. These adjustments relate to:
- The effect of balance sheet depletion: "The failure of a banking group may result in the banking group having a smaller balance sheet directly following resolution, particularly if the failure was due to credit risk losses. The SRB considers that, on a group-by-group basis, a maximum balance sheet depletion of up to 10% of total assets may be used to adjust the RWA basis."
- The use of recovery options: "The SRB will consider only those limited recovery options that can be implemented swiftly as a resolution action, assuming that the bank was unable to use them in the early intervention or recovery phase."
- Restructuring plan divestments and sales: "If actions as formulated, and restructuring plans are legally binding and time-bound, the SRB may take into account the possible impact on the bank's RWA basis. These plans aim to restore the long-term viability of the bank by achieving sustainable profitability and reducing risk, among other goals. This includes the removal from the balance sheet of riskier assets with associated higher risk weighting through mandatory deleveraging actions embedded in the restructuring plan."
No further adjustments to the default RCA and MCC are foreseen.
Other bank-specific adjustments are taken into account for the overall MREL target
The SRB maintains the reference to an 8% total liabilities and own funds benchmark. No adjustments to MREL targets for the first wave of resolution plans are foreseen. "This relates in particular to (i) liabilities mandatorily excluded from bail-in under Article 44(2) of the BRRD, for which preliminary assessments are conducted in resolution plans to assess the possible risk of breaching the no creditor worse off (NCWO) principle when applying the bail-in tool; (ii) liabilities that are likely to be excluded in exceptional circumstances under Article 44(3) of the BRRD and (iii) deposit guarantee scheme (DGS) contributions. The SRB considers that taking into account DGS contributions would not be consistent with the preferred resolution strategy for most of the banking groups under its direct responsibility."
Specificities of multiple points of entry strategies are addressed
The SRB MREL policy addresses multiple points of entry (MPE) strategies. The aim is to limit contagion risk. The SRB MREL policy identifies the requirement for a consolidated MREL target at the level of the resolution entity, within the MPE group.
Calibration for transfer strategies
To use transfer strategies, resolution plans need to make sure banks meet the standards in terms of seperability and data availability and analyse the market.
The SRB keeps the LAA consistent with its approach to bail-in. The RCA is adjusted downwards to reflect the transfer of assets. This MREL approach to transfer strategies is an interim step towards a more tailored approach.
B - Quality, Subordination and Eligibility Criteria
Subordination improves resolvability. It also reduces the risk of breaching the NCWO principle. Subordination policy consists of two elements: (i) a general level depending on the systemic importance of banks and (ii) a potential bank-specific add-on to address NCWO risks based on mandatory exclusions. This (ii) is used for monitoring purposes only. The assessment of compliance with the relevant subordination levels takes into account all forms of subordination, including 'senior non-preferred' instruments, subject to analysis in line with national laws. The SRB is keen to stress that it reserves the right to adjust this policy at a later stage in light of the future design of the BRRD and further development of the MREL policy.
Banks are expected to have a minimum level of subordinated instruments, depending on their size and systemic importance. "The SRB also monitors an NCWO add-on related to mandatory exclusions from bail-in. In the next wave of resolution plans, the SRB has committed to refine further its subordination policy and the approach to NCWO issues."
Eligible liabilities and own funds are taken at consolidated level
Compliance with binding targets is assessed against eligible liabilities and own funds at consolidated resolution group level. The SRB considers a hybrid approach to assessing banks' future compliance with MREL targets for the next cycle.
Structured notes are mostly excluded
In line with the 2017 SRB policy, structured notes remain excluded in the 2018 SRB MREL Policy. However, the SRB will assess on a case-by-case basis the eligibility of such liabilities:
- when a given amount of the liability arising from the instrument is known in advance at the time of issuance, is fixed (i.e. the amount cannot go below a minimum floor) and is not affected by a derivative feature;
- if the instrument, including its derivative feature, is not subject to any netting agreement and its valuation is not subject to Article 49(3) of the BRRD;
- only up to the amount of the liability that complies with point 1 (i.e. for the fixed floor of the liability that would have to be paid)."
Non-covered non-preferred deposits breakable below one year are excluded
Non-covered (i.e. non-DGS) non-preferred deposits will continue to be excluded if they can be withdrawn within a one-year horizon. "Some term deposits may have an early redemption clause that would have to be taken into account in the maturity assessment (Article 45(4) of the BRRD)."
Liabilities held by retail investors are MREL-eligible
The SRB does not see any legal basis for resolution authorities to exclude ex ante and uniformly eligible liabilities held by natural persons or small- and medium-sized enterprises from MREL or from bail-in. However, holdings of subordinated or senior instruments by retail customers might be an impediment to resolution. These statements build upon—but should also be read in conjunction with—the EBA's own supervisory Statement on the treatment of retail investors holding MREL eligible instruments in the context of resolution as well as how issuers may want to approach issuance of MREL eligible instruments to ensure compliance with MiFID II/MiFIR obligations including avoiding conflicts of interest.8
Liabilities issued under third country law or by entities outside the EU are mostly excluded
Liabilities issued by banks located outside the EU are not recognized as MREL eligible and Banks are expected to be proactive with regards to the impact of Brexit.
C - Transition Period
Bank-specific transition periods will support banks' efforts to reach MREL targets and binding MREL targets are set with a bank-specific transition period.
Conclusion and next steps
The SRB's first wave of resolution plans updates the 2017 MREL approach and introduces new elements. For example, the applicable policy for banks subject to transfer strategies is an additional step to tailoring MREL targets to bank-specific features. The overall degree of resolvability within the Banking Union is also likely to be strengthened via the SRB setting binding decisions for a much wider scope of banking groups. The development of the MREL policy will continue in 2019 for the second wave of resolution plans affecting those BUSIs with "Resolution Colleges." The SRB aims to update its general MREL policy, paying particular attention to subordination, eligible instruments and individual MREL targets.
MREL decisions are reviewed annually. Thus, the SRB will continue its review practice and will also take into consideration changes stemming from supervisory decisions or linked to the evolution of banks' risk profiles and overall structures during the course of 2019 and its overall goal to get MREL fully embedded by 2020.
For affected BUSIs, in addition to building upon their MREL readiness projects and reviewing contractual terms for legacy and existing issuances, may wish to consider the following questions, given the SRB's own supervisory priorities through to 2020 and those of the ECB-SSM.9 Part of this is also accentuated by the ECB's announced 2019 Liquidity Stress Test10 and greater use of on-site inspections, plus a more intensive application of the SSM run SREP as well as the SRB and SSM both pushing to improve better data quality, specifically for recovery and resolution planning and its operationalization.
- Are systems and controls in place to proactively designate and monitor financial instruments as MREL-eligible?
- Is there a sufficient periodic and documented understanding amongst stakeholders of the scope, breadth and cost of "critical functions" within a firm?
- Is there sufficient investor facing disclosure to flag risks of holding MREL-eligible instruments; are sufficient measures in place to prevent conflicts of interest in relation to self-placement of instruments?
- Are there sufficient systems and controls in place to be able to own one's exposure and that of key counterparties to MREL eligible instruments whether as holder and/or as a collateral asset?
- What fallbacks are in place, both in terms of timing and location of issuance, to avoid herd behavior, being left behind the crowd and/or due to uncertain macroeconomic pressures potentially impacting issuance of a certain class or blend of types of MREL eligible financial instruments, which themselves may price more expensively in terms of wide spreads compared to say senior debt?
- How agile are BUSIs and other credit institutions placed to respond to changing circumstances caused by actions of the SRB in respect of non-Banking Union MREL requirements and issuances?
- Can legacy MREL eligible instruments be amended to become Brexit-proofed?
All of these questions may require fast-paced action during what is set to be an eventful 2019 and road to 2022.
2 Directive (EU) 2017/2399 requires Member States to create a new class of 'non-preferred' senior debt, eligible to meet the subordination requirement of the TLAC standard and had a transposition deadline of 29 December 2018.
3 Read more here
4 See also our Eurozone Hub coverage on the operationalization of Recovery and Resolution Plans
5 The EBA has already published its supervisory expectations on how to deal with retail investor holdings in MREL-eligible instruments. Click here for more details.
6 This interpretation may be a narrow reading of Art. 45 BRRD, but one where both the EBA and SRB have made their supervisory concerns and expectations clear, and done so since 2017 including in the publication of their Supervisory Principles on Relocations (SPoRs) – See our dedicated coverage on this.
10 Which is, besides not only being a SSM supervisory tool, a development that might support Elke König, Chair of the SRB's calls for a specific liquidity resource to add to the existing Recovery and Resolution Toolkit at the disposal of the SRB but EU NRAs more generally.
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