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TLAC/MREL: making failure possible?

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The Finance Watch policy brief is a valuable in-depth description and analysis of TLAC/MREL, pointing to some substantial deficiencies. It provides an update on recent developments in the area of bank recovery and resolution, and contains a brief primer of the current EU bank resolution regime, in particular the “bail-in” tool, as well as an introduction to the capital standards TLAC and MREL.

Policy brief
1 March 2016
Finance Watch

>  FW policy brief March 2016
>  FSB TLAC standard

Summary

This note provides an update on recent developments in the area of bank recovery and resolution. It contains a brief primer of the current EU bank resolution regime, in particular the “bail-in” tool, an introduction to the recently published capital standards, TLAC and MREL, and Finance Watch’s assessment of the potential benefits and shortcomings of these initiatives.

TLAC (Total Loss Absorbing Capacity) and MREL (Minimum Requirement for own funds and Eligible Liabilities) are regulatory standards which define a minimum amount of own funds and certain debt obligations that must be held by banks to allow them to be restructured or wound up in an orderly fashion in the event of a crisis.

TLAC is a global standard issued by the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) in November 2015. It covers only the 30 largest global banks which have been designated “Global Systemically Important Banks” (G-SIBs) by the FSB. Thirteen of these banks are domiciled in the EU.

It is not legally binding by itself but G-20 member states which are home to G SIBs are bound to adopt its rules into domestic legislation. From 2019 onwards, G-SIBs will be required to hold mandatory minimum TLAC levels equivalent to 16% of risk-weighted assets (RWA) or 6% of total exposure, rising to 18% and 6.75% in 2022. In addition to regulatory capital (min. 8% of RWA), TLAC may include subordinated or unsecured senior debt (8 10% of RWA). Capital buffers, which typically range from 2.5 to 6.0% of RWA, are not included and must be covered by additional equity (CET1) capital. TLAC is a mandatory “Pillar 1” requirement under Basel III and will apply to all G-SIBs globally.

MREL, on the other hand, is based on the EU’s Bank Recovery and Resolution Directive (BRRD) and legally binding for all banks domiciled in the EU including, but not limited to, G SIBs. MREL does not impose any mandatory minimum levels over and above the minimum regulatory capital requirement of 8% of RWA, which is already enshrined in CRR/CRD IV6, but delegates to the relevant resolution authorities the power to set MREL individually for each bank on a case-by-case basis (“Pillar 2”). Capital buffers are not additive, i.e. CET1 capital used to cover capital buffers may also be counted towards MREL. As a result, the current rules might well justify MREL levels as high as 16-20% of RWA, notably for larger banks, but the baseline for any such exercise effectively remains at a lowly 8% of RWA.

The BRRD framework contains a so called “burden sharing” clause, which requires shareholders and other investors of an EU-based bank to contribute at least 8% of all liabilities, including own funds, to the cost of its resolution before any external funding can be accessed, e.g. from the Single Resolution Fund. There is disagreement between the European Commission and EBA currently whether this threshold should be incorporated into MREL as a formal requirement for large banks.

As a result, the current MREL rules are not sufficient to guarantee that EU-domiciled G SIBs will satisfy the FSB’s TLAC benchmarks. MREL rules for European G-SIBs – and, arguably, other banks which are systemically relevant at the national level – therefore need to be amended in 2016 to ensure compliance with the FSB’s TLAC requirements.

A recent European Commission proposal suggests that the regulatory capital regime for European banks in CRR/CRD IV should be amended to increase the regulatory capital for EU-domiciled G SIBs to 16-18% of RWAs, in line with the TLAC requirements. This could be achieved by aligning the definition of Tier 2 capital in CRR/CRD IV with the FSB’s eligibility criteria to create a single new category of TLAC-compliant Tier 2 debt. The minimum Tier 1 capital level would not be altered, so that European G-SIBs would be in a position to satisfy the new requirements by refinancing a part of their current outstanding debt in the course of the next three to seven years with new issues of TLAC-compliant Tier 2 debt.

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