Implementation and timeline

The requirements of Basel III concerning quality and quantity of capital, discussed in chapter 2, will be gradually phased in until 2019. Moreover, financial intuitions will be obligated to satisfy the MREL by 2022 (SEB, 2017). Complying with the

likely be difficult and incur certain additional costs. Because the difficulties and costs MREL-eligible debt issuance can be substantial for some banks, resolution authorities are given discretion to require banks to meet the MREL on a gradual basis to prevent undesirable effects on the banks’ activities and the economy (Com-mission Delegated Regulation 2016/1450, Article 8).

Issues have been raised regarding the issuance of instruments in the transitional period (SEB, 2017). The EU directive that allows banks to issue T3 debt is expected to be finalized in July 2017. After this is passed, most EU member states will begin the process of changing their insolvency laws to allow for the T3 debt. This is expected to take up to 18 months to finalize. Therefore, banks will only have few years to refinance their outstanding senior preferred debt to T3 or to amend their balance sheets. The maturity profile of most banks’ outstanding debt might lead to some time-related concerns.

One solution could be to begin issuing debt that should count as T3 before the MREL is adopted into national law, as seen in the UK, France, and Spain. The problem for some banks, however, is that they have provisions for existing T2 debt that do not allow a debt layer between senior and T2 debt. Therefore, these banks cannot use this approach. Another solution is for national regulators to “front-run”

the EU in implementing the legislation into law, thereby allowing banks to start issuing T3 debt.

Shortfall of MREL-Eligible Debt

Considering that much of the MREL will be met with T3 debt, the aggregate shortfall of T3 debt might be highly significant. To comply with the MREL, many institutions will likely amend their balance sheets to increase the amount of T3. In its final report on MREL, the EBA estimates, based on two MREL scenarios, how banks are currently complying with the MREL, as well as how much bail-in-eligible debt banks need to have to comply with the requirements (EBA, 2016).

The investigation reveals that banks are in massive shortfall of bail-in debt. Under the fully loaded requirements, the estimated shortfall for the mild and strict sce-nario is between EUR 66.6bn and EUR 220.5bn, respectively. In both cases, the shortfall would increase significantly if MREL-eligible deposits were excluded from the MREL stack (EBA, 2016). This is shown in Figure 6 below.

Figure 6: Estimated Financing Needs

Source: EBA, 2016

Similarly, Natixis, a French corporate and investment bank, estimates the MREL shortfall to be more than EUR 400bn in the worst-case scenario for Europe’s main banks (Natixis, 2016).

These reports focus on total need for bail-in debt, but it should be noted that the T3 will not all be additional debt in the market, as most is expected to be covered by either statutory subordination or refinancing of existing senior bonds into T3 debt (CS Pres., 2016). However, a net incremental supply of debt instruments is expected. This is primarily due to the actual shortfall that banks will face.

Motivation for Price Investigation

Previous regulation gave rise to the AT1 debt class, which was a relatively cheap source of funding to fulfil capital requirements, but had a degree of complexity.

Pricing these instruments therefore required a great amount of work. The new reg-ulation gives rise to yet another debt class: the T3. This class might share many characteristics with the regular senior unsecured bonds, but there are still addi-tional complexities that investors will have to consider when pricing the new in-struments. In particular, the event of resolution and the consequences for the T3 instruments are surrounded by a high degree of uncertainty, as are the actual re-quirements for many banks.

Some banks have started to issue new MREL-eligible debt. However, these

instru-0 50 100 150 200 250 300 350

LA buffer - MREL LA buffer - MREL ex

dep Buffer/8% - MREL Buffer/8% - MREL ex dep

Financing need (in€ bn)

Other O-SIIs G-SIBs

mentioned above motivate us to investigate how these instruments are currently priced relative to the bank’s other well-known debt instruments, such as regular senior debt and T2. Therefore, the next section will investigate and present empir-ical observations of how the market prices the new T3 tranche.

Summary

Under the BRRD and the MREL, banks will be required to hold a significant por-tion of capital to ensure that they at all times have sufficient funds available for bail-in if they should end up in resolution and have to be recapitalized. A bank can use any of the regulatory capital instruments to satisfy the current capital require-ments, but is expected to meet a significant portion of the MREL using the new T3 instruments. This is a senior debt class that can be used for bail-in because of its subordination to other senior claims, which ensures that it does not violate the NCWO principle if used for bail-in. Hence, the new regulation and the introduction of a new liability class contribute yet another degree of complexity to the capital structure of banks, which makes debt instruments difficult to price.

Considering the objective of this thesis, namely, to investigate the pricing of the new T3 instruments, a first important step has been to obtain a deep understanding of the current regularity environment and how the new T3 instruments fits into the MREL. This is what we have done in the previous chapters. To analyze the pricing of the T3, the next step is to investigate how bonds are valued currently.

Therefore, the following chapter will present empirical market observations on T3 prices.