The Capital Market Effects of the Minimum Requirements for Own Funds and Eligible Liabilities.

(1)

The Capital Market Effects of the Minimum Requirements for Own Funds and Eligible Liabilities.

Master’s Thesis Cand.Oecon

Copenhagen Business School

Authors:

Jacob Hvidberg Jensen Christian Skovsgaard

Supervisor:

David Lando

Date: May 15, 2017

Number of Characters: 230,667 Pages: 119

(2)

(3)

Abstract

In this thesis, we examine the capital market effects of the new minimum requirements for own funds and eligible liabilities (MREL). Specifically, we investigate the pricing of the new liability class that banks can use to comply with the MREL.

The MREL was introduced by the European Union under the Bank Recovery and Resolution Directive to ensure that financial institutions have sufficient funds available for bail-in if they should end up in resolution and have to be recapitalized.

This should guarantee that losses of a failing bank are borne by shareholders and creditors instead of taxpayers. For banks to comply with these requirements, a new liability class has emerged: the Tier 3 bond. We investigate how these instruments should be valued relative to banks’ other well-known instruments, and how the uncertainty related to bank capital and regulation affects prices.

To do this, we develop a model to value bank debt instruments. The key distin- guishing feature of our model is that it incorporates the cash flow waterfall of a bank into a simple and intuitive framework that is able to capture some of the complexities of bank capital regulation, such as the MREL, discretionary coupon payments, mandatory payout restrictions, and conversion of contingent capital.

In our waterfall model, the return of the bank’s assets follows a jump-diffusion process. This incorporates a realistic feature of bank asset returns: namely, that they sometimes experience sudden, discrete jumps, for example during a financial crisis. The cash flow waterfall approach is found to be useful in a valuation setting for banks because it clearly defines the priority of payments according to the tranche hierarchy. This results in a model that can be used to make quantitative and qualitative predictions about the price mechanisms of bank bonds.

We apply our model to numerically analyze how certain factors affect credit spreads, and investigate how the Tier 3 instruments should be valued relative to the senior and Tier 2 bonds. An important finding is that certain parameters have a significant effect on the absolute credit spreads, but not on the relative spreads between Tier 2 and Tier 3; these are the volatility of assets and the initial CET1 ratio. On the other hand, we find that parameters such as the costs of the resolution process, the location of the point of non-viability, and the balance sheet composition have a large impact on the relative spreads between the bank’s bonds.

(4)

The considerable sensitivity of credit spreads to the volatility of assets, the costs of resolution, and the point of non-viability in particular, which are not directly ob- servable in the market, presents significant challenges for investors to accurately assess the prices and risks of the new instruments. An important contribution of this thesis is therefore that we develop a tool to quantify these uncertainties.

(5)

Abbreviation sheet

AT1 Additional Tier 1

BRRD Bank Recovery and Resolution Directive CBR Combined Buffer requirement

CCB Capital Conservation buffer CCyB Counter-cyclical buffer CDO Collateralized debt obligation CLO Collateralized loan obligation CET1 Common Equity Tier 1

CRD IV Capital Requirement Directive IV CRR Capital Requirement Regulation DGS Depositor Guarantee Scheme EBA European Banking Authority EBIT Earnings Before Interest and Taxes EBU European Banking Union

ECB European Central Bank

G-SIBs Globally Systemically Important Banks HoldCo Holding company

LAA Loss Absorption Amount LGD Loss given default

MDA Maximum Distributable Amount

MREL Minimum requirement for own funds and eligible liabilities NCWO No creditor worse off principle

O-SII Other systemically important institution PONV Point of Non Viability

PD Probability of default P2G Pillar 2 Guidance P2R Pillar 2 Requirement RA Recapitalization Amount RWA Risk weighted Assets SNP Senior Non Preferred debt SRB Single Resolution Board

SREP Supervisory Review and evaluation Process SRM Single resolution mechanism

SSM Single Supervisory Mechanism TC Total Capital

TLAC Total loss absorption capacity

T2 Tier 2

T3 Tier 3

(10)

“I can´t help smiling at complaints from bankers about their capital requirements, knowing that they always imposed even stronger requirements on people in debt to them”

- Merton Miller (1994)

(11)

1. Introduction

The financial crisis of 2008-09 had enormous ramifications for financial institutions.

Some were considered too-big-to-fail and were bailed out using public funds, whereas other institutions, such as Lehman Brothers, were allowed to fail. With around €600 billion paid out in government bank support in the EU between 2008 and 2012 (EU BRRD MEMO, 2016), the level of state aid during the crisis was the highest ever seen. While there were no other real alternatives than to bail out the distressed banks to prevent a far-reaching collapse of the financial system and the real economy, the substantial capital injections of taxpayers’ money led to both fiscal deficits and public debt (Hull, 2015). The lessons learned from the financial crisis motivated regulatory initiatives to ensure that taxpayer funds would not be used to bail out financial institutions. Therefore, a more comprehensive recovery and resolution framework was needed.

The Bank Recovery and Resolution Directive (henceforth BRRD) has been the regulatory response in the EU. The Directive is the legislative framework for harmonizing the recovery and resolution approach for banks; it offers regulatory and resolution authorities a set of comprehensive and efficient tools to handle bank failures at the national level, as well as cooperation tools to prevent cross-border banking failures. The bail-in tool is the cornerstone of the Directive: it is a vital tool given to resolution authorities. Instead of relying on public bailout, the bail-in tool imposes losses on the shareholders and creditors of a failing bank. The loss absorption mechanism is achieved by either converting liabilities of the failing bank into equity capital, or by writing down the principal amount, thereby shielding taxpayers from bailing out financial institutions.

For the bail-in tool to be effective, sufficient liabilities need to be available to absorb losses. To ensure this, banks are subject to a minimum requirement for own funds and eligible liabilities (henceforth MREL) that they must meet at all times. The MREL ensures that the bail-in tool can efficiently be applied if a bank enters the resolution process. In response to these capital requirements, a new capital instrument has been introduced that can be used to comply with the MREL. This debt class is known as Tier 3 bonds.

The Tier 3 instruments have characteristics similar to those of regular senior unsecured bonds, but include subordination clauses such that they can be used to bail-

(12)

in and recapitalize the bank, if needed. Thus, the instruments come with complexities that investors will have to consider when pricing them. In particular, the event of resolution and following consequences for the Tier 3 instruments are surrounded by a high degree of uncertainty, as are the requirements themselves for many banks.

To comply with the MREL, many institutions will likely amend their balance sheets to increase the amount of bail-in-eligible debt instruments. However, given its rank in the capital structure, there has been much debate about how Tier 3 bonds should be priced relative to the other classes of debt. In its final report on MREL, the European Banking Authority estimates the shortfall of bail-in debt to be between

€66.6bn and €220.5bn, depending on its exact implementation (EBA, 2016). Some banks have started to issue new MREL-eligible debt. However, these instruments are still a scarcity across Europe.

A significant amount of Tier 3 debt will need to be issued throughout Europe over the coming years. The demand for pricing these instruments is therefore significant.

However, this task is complicated by the uncertainties mentioned above, and the fact that the MREL increases the complexity of banks’ capital structure even further. These complexities and the novelty of the Tier 3 instrument have motivated us to investigate how these new instruments should be priced. We aim to investigate what drives the spreads on Tier 3, and how they should be priced relative to the bank’s other well-known debt instruments, such as regular senior debt and Tier 2. The objective of this thesis is therefore to develop an understanding of the pricing of the new Tier 3 instruments.

Research Question

In this thesis, we investigate the capital market effects of the new minimum requirements for own funds and eligible liabilities for banks in the EU. Specifically, our aim is to develop an understanding of the pricing of the new Tier 3 instruments that can be used to comply with the MREL. To do that, this thesis seek to answer the following research question:

How can the new Tier 3 instruments be priced and what are the drivers of their credit spreads?

This question will make it necessary to understand the MREL and analyze the most important aspects of bond pricing. To answer the research question, the thesis will

(13)

• Describe the current bank capital regulation

• Investigate how the new MREL will affect banks’ capital structure

• Develop a model that can be used to analyze bank bonds and price the new Tier 3 instruments

• Analyze and discuss how spreads are affected by different factors using the model developed

These objectives will assist in answering the overall research question.

Delimitation

At the time of writing, the MREL is still a proposal that has to be adopted into the EU countries’ national law. Therefore, we have had to approach the analysis by relying on sources such as the European Banking Authority to explain what will likely be the final proposal. The reader should be aware that certain parts of the thesis describe regulatory areas that are subject to changes. Therefore, the analysis on the new requirements has been limited to general aspects that can provide in- sight into the new T3 instrument. Furthermore, throughout the writing of this thesis, there have been several developments regarding the MREL regulation, such as national regulators’ proposals for it. We have had to limit the analysis to not consider these proposals in great specificity.

Bank regulation is a complicated and technical field of study. As the current Basel III, BRRD, and the new MREL include many aspects and technicalities, the analysis of the regulation is centered around the aspects that impact the pricing of the new Tier 3 instruments. Therefore, we leave out certain aspects that could potentially have some consequences for investors and banks, such as the impact of the internal allocation of MREL.

Several research articles have discussed the economic impact of the BRRD and the MREL. As the goal of the BRRD is to avoid taxpayer bailouts and contribute to a more stable financial system, there could potentially be positive spillovers to the overall pricing of bank bonds. As this is an area of research in itself, we will not address the potential impact of these factors on prices, but instead acknowledge that there could be lasting spread impact once the MREL has been fully phased in.

Furthermore, research articles on the MREL have also discussed the transitional period to comply with MREL, and how this period could have temporary effects on the T3 prices. As these are only temporary, however, we have chosen not to

(14)

focus on them in detail, and will only focus on effects that could have potential long-term effects.

As the MREL applies to most financial institutions across Europe, there are an endless amount of cases of banks that we could consider in our investigation. For this reason and because there is a greater uncertainty regarding the resolution strategy chosen for smaller banks, we will base our analysis on the largest banks in the EU that are expected to be recapitalized in full. However, we will not include the banks that are classified as globally systemically important banks. This is because the latter will also have to comply with a proposal similar to the MREL from the Financial Stability Board, called the TLAC. As these banks will have to comply with both requirements, including them would require an extensive analysis of the interaction between the two proposals, which has not yet been set. Given the purpose of this thesis, we therefore do not consider the requirements of bail-in debt for globally systemically important banks.

As our aim is to develop a pricing model that can analyze T3 prices, we focus only on calculating spreads on senior debt, T3, and T2, which are the debt tranches that are useful for the discussion of the spreads on T3. Thus, we have chosen not to focus on pricing bank equity and the AT1 instruments.

Finally, as our focus is on testing our model and examining how spreads are im- pacted, we have to make use of a great degree of mathematical concepts and tools.

As our model is used for more practical and applied purposes, a mathematical derivation and understanding is outside the scope of this thesis. Derivations will only be presented in certain cases where it is necessary to justify certain choices and findings.

Structure of the Thesis

This thesis is structured as follows. Chapter 2 will introduce the current capital requirements under the Basel framework, and explain the new bank recovery and resolution directive. Chapter 3 will go over the MREL by investigating how banks can comply with it and explain the new Tier 3 instrument. Market observations of the Tier 3 instruments are subsequently presented in chapter 4.

Chapter 5 will examine current literature on bond pricing, and chapter 6 will review important theoretical concepts needed for developing a bond pricing model. In

(15)

Chapter 8 will give an overview of the benchmark scenario and parameters used in the numerical analysis. The model is implemented in chapter 9, where spreads are obtained for the Tier 3 instruments, as well as senior and Tier 2 debt. Chapter 10 will check the robustness of our results, and chapter 11 will compare the results obtained from the model to the observed market spreads, and discuss the factors that drive the spreads on the T3 instruments.

The thesis ends with a discussion in chapter 12 on the lessons learned from the model, and a conclusion in chapter 13.

(16)

2. Basel III and Current Regulatory Re- quirements

Bank capital is a complicated subject due to the ever-changing nature of regulation.

As our goal in this thesis is to investigate the price of the new T3 instrument of banks, a natural starting point for our analysis is to study the current regulatory environment, as it explains much of the influence on price. In this chapter, we will therefore explore the current regulations on bank capital, and analyze how the new common regulatory framework for resolution in the EU impacts the capital structure of banks.

Capital Definition and Requirements

The current capital requirements are based on the Basel Accords. The Basel Ac- cords refer to the banking supervision Accords, i.e. Basel I, Basel II, and Basel III, which are recommendations on banking regulations developed by the Basel Com- mittee on Banking Supervision (henceforth the Basel Committee). The first set of minimum capital requirements was published in 1988 and, since then, bank capital regulation has been an evolutionary and continuous process.

The global banking system experienced an inadequate level of high-quality capital during the financial crisis of 2008-09 (Hull, 2015). Therefore, the Basel III capital requirements emphasize common equity, which has the highest-loss absorbing quality (BIS, 2010). Under Basel III, the components of capital are:

1. Tier 1 (going-concern capital) a. Common equity Tier 1 b. Additional Tier 1 2. Tier 2 (gone-concern capital)

Going-concern capital is capital that can be depleted or take losses without placing the bank in insolvency, whereas gone-concern is meant to take losses in insolvency.

These minimum requirements are also referred to as the Pillar 1 requirement. Com- mon Equity Tier 1 (henceforth CET1) capital consists primarily of common shares issued by the bank and retained earnings, whereas Additional Tier 1 (henceforth AT1) capital are primarily convertible debt securities. Tier 2 (henceforth T2) cap-

(17)

In addition to the regulatory capital in Basel III, a bank’s total capital consists of other classes as well. Table 1 illustrates the typical capital classes.

Table 1: Tiers of Capital Table XX Tiers of Capital

Deposits covered by the DGS, i.e. deposits < €100K Liabilities secured against a pool of assets

Deposits from SME > €100K Deposits from households > €100K Second most senior liability class

Senior debt

Corporate deposits > €100K

Derivatives and other senior liabilities New liability class to comply with the MREL Senior non-preferred, Tier 3, HoldCo Senior Subordinated debt

Undisclosed and asset revaluation reserves General provisions/general loan-loss reserves Hybrid (debt/equity) capital instruments

Equity capital (paid-up share capital/common stock) Disclosed reserves

Additional Tier 1 capital (CoCos) Guaranteed deposits, covered

bonds and secured liabilities Junior deposits (SME and households) > €100K

Tier 3

Tier 1 Tier 2

Senior preferred debt / Derivatives / Corporate deposits > €100K

Source: Bank of America Merrill Lynch, 2015

The AT1 capital class is a distinct class of capital for banks, and requires some attention. AT1 instruments are contingent convertible capital instruments (henceforth CoCos), which are hybrid capital securities that absorb losses either by (i) conversion to equity or (ii) write-down of the principal at a pre-specified trigger point defined in the contractual terms. The issuance of CoCos is mainly motivated by their ability to satisfy regulatory capital requirements (Avdjiev, et al., 2013), and the instruments were originally invented as a going-concern loss absorbing cushion.

AT1 capital consists of junior subordinated debt instruments. The criteria for instruments to be included in the AT1 capital are specified by the Basel Committee in the Basel III publication, and some of the main characteristics of AT1 instruments are the following. Instruments must be perpetual, i.e. with no maturity date.

The issuing bank is allowed to call the instrument, but the call provision cannot

(18)

contain step-ups or other incentives to redeem. Regulators must approve any re- payment of the principal, e.g. through repurchase or redemption, and the amount of capital that is redeemed early must be replaced with capital of the same quality or better. The instruments have discretionary payments of coupons, and the bank has full discretion at all times to cancel or defer payments. Cancellation of payments is not an event of default, and it does not impose restrictions on the bank except in relation to distributions to common stockholders. In addition to the discretion in coupon payments, there are also contractual provisions that can prevent a bank from paying coupons on AT1. This happens when a bank breaches its maximum distributable amount trigger, or if the availability of distributable items prevents the bank from payout. This will be described later.

Risk-Weighted Assets

Most bank capital regulation is based on having an adequate amount of capital available to match the riskiness of the bank’s assets. To estimate this amount, the concept of risk-weighted assets (henceforth RWA) has been developed to quantify the bank’s total risk exposure (Hull, 2015). Simply stated, RWA is calculated by attaching a specified weight on an asset of the bank according to its expected degree of credit risk (BIS, 1988).

In the simple setting, a bank’s credit exposure can arise either from on-balance sheet assets (excluding derivatives), off-balance sheet items (excluding derivatives), or from over-the-counter derivatives (Hull, 2015). As an example, a simple calculation for a bank’s total RWA, for n items with principal P and risk weight w, is given by

𝑅𝑊𝐴= ^𝑛 𝑤_𝑖𝑃_𝑖

𝑖=1

The RWA is therefore determined by the number and amount of assets, and the risk weight assigned to a particular asset. This was the original approach proposed in the first Basel accord; the calculation has since then become more advanced in its estimation approach to address several initial shortcomings. The current calculation of RWA includes measures that take into account the correlation of default among the bank’s assets, how much is at exposure when default occurs, and the probability of default (Hull, 2015).

The exact calculation of RWA is highly complicated, and is beyond the purpose of

(19)

to understand, as most of the capital requirements are expressed as a percentage of the RWA.

Minimum Capital Requirements

The calculated RWA is used as a reference for the capital requirements of a bank.

In Basel III, the minimum capital requirements are as follows:

- Tier 1 capital must be at least 6.0% of RWA at all times.

- CET1 must be at least 4.5% of RWA at all times.

- Total capital (Tier 1 and Tier 2) must be at least 8.0% of RWA at all times.

These minimum requirements are based on capital ratios. For example, the total capital ratio is given by

Total capital ratio =Tier 1 capital + Tier 2 capital

Total RWA ≥ 8.0%

These requirements imply that AT1 capital and Tier 2 capital are allowed to make up 1.5% and 2.0% of RWA, respectively.

In addition, Basel III has different capital buffers that together are defined as the combined buffer requirement (henceforth CBR). The following illustrates the total minimum capital requirement, and subsequently discusses the different capital buffers.

(20)

Figure 1: Minimum Capital Requirements under Basel III

Source: Authors’ own creation

2.3.1. Capital Conservation Buffer

In addition to the minimum capital requirement of 8.0% of RWA, Basel III requires all banks to keep a capital conservation buffer (henceforth CCB) of 2.5% of RWA outside of periods of stress. This buffer must consist entirely of CET1 capital, and is established above the regulatory minimum capital requirement of 8.0% (BIS, 2010). The aim of this buffer is to ensure that banks have a minimum amount of capital to absorb losses in periods of financial distress, and to drive banks to build up their buffer in normal times. If a bank fails to meet this requirement, capital distribution constraints will be imposed, but the bank will still be able to conduct business as usual (BIS, 2010). This feature will be described later.

Since the CCB consists entirely of CET1, the minimum amount of CET1 is required to be 7.0% of RWA during normal times, and the total Tier 1 capital at least 8.5%

of RWA. The sum of Tier 1 and Tier 2 capital must be at least 10.5% of RWA.

CET1 AT1 Tier 2 Capital Conservation

Buffer Counter- Cyclical Buffer

G-SIBs

% of RWA

Minimum Capital Requirement

8%

Combined Buffer Requirement

≥2.5%

(21)

2.3.2. Counter-Cyclical Buffer

The purpose of the counter-cyclical buffer (henceforth CCyB) is to ensure that banks’ capital requirements reflect the economic environment in which banks oper- ate (BIS, 2010). To this end, the buffer aims to protect banks against cyclical earnings. Each individual country can choose whether to implement the buffer or not. It can be set between 0.0% and 2.5% of RWA, and must consist entirely of CET1 (BIS, 2010). With the counter-cyclical buffer, the CET1 requirement ranges between 7.0% and 9.5% of RWA. According to the European Systemic Risk Board, as of May 2017, Norway, Sweden, and the Czech Republic are currently the only European countries to have implemented the CCyB. Here, the buffer is 1.5%, 1.5%, and 0.5% of RWA, respectively.

2.3.3. Global Systemically Important Banks

Basel III addresses systemic risk and the too-big-to-fail issue – where the failure of one important financial institution makes the whole financial system collapse – by introducing an extra buffer of capital for banks classified as global systemically important banks (henceforth G-SIBs). The extra buffer requirement is between 1% and 3.5% of RWA and must also consist entirely of CET1 (BIS, 2013). At the end of 2016, the Financial Stability Board published a list of 30 institutions iden- tified as G-SIBs. Of these, 15 were EU member state institutions.

2.3.4. Pillar 2

The aim of Pillar 2 is to establish a closer link between a bank’s risk exposures, its risk management tools, and its capital assessment process. Pillar 2 consists of two sections: (i) the internal capital adequacy assessment process, and (ii) the supervisory review and evaluation process (henceforth SREP). The SREP is conducted once a year; it provides supervisors with tools to assess a bank’s risk profile from multiple perspectives, and to impose stricter capital requirements for the individual bank if needed. This additional individual capital requirement is usually referred to as the Pillar 2 buffer (Supervision, 2016).

The Pillar 2 buffer is divided into two parts: a Pillar 2 requirement (henceforth P2R) and Pillar 2 guidance (henceforth P2G) (ECB, 2016). The P2R is legally binding, and breaching it can have direct legal consequences. The P2G, on the other hand, is a soft trigger, and breaches do not automatically result in any legal action. Nevertheless, banks are expected to comply with the P2G, and breaches

(22)

will lead to increased supervision and specific measures intended to restore an appropriate level of capital. Both P2R and P2G should consist of CET1, but national supervisory authorities can allow for Pillar 2 to consist partly of both AT1 and T2 capital (SSM SREP, 2016). The division of Pillar 2 is not universally applied yet in the EU. For example, the Nordic countries have not adopted it (Natixis, 2016).

Because of the variation in P2R on a bank-by-bank basis and between countries, the amount is difficult to generalize.

CRD IV and CRR

As Basel III is a regulatory framework and not a law, it must be implemented into national legislation to be legally binding. For the countries in the EU, this is done through the Capital Requirements Directive IV (henceforth CRD IV) and the Capital Requirements Regulation (henceforth CRR). The CRR is a regulation and thus becomes immediately enforceable as a law in all member states simultaneously, whereas CRD IV is a directive and thus has to be implemented into national legislation. The requirements concerning capital, liquidity, and leverage are implemented through CRD IV.

The CRD IV and CRR introduce several additional requirements to the regular Basel III requirements; this included additional capital buffers, which will be described below.

2.4.1. Additional Capital Buffers under the CRD IV

In addition to the CCB, the CCyB, and the G-SIB buffer introduced under Basel III, the CRD IV enables individual member states to introduce (i) a buffer for other systemically important institutions (henceforth O-SIIs), and (ii) a systemic risk buffer (EC, 2013). These buffers allow national supervisory authorities to impose stricter capital requirements on domestic systemically important banks that are not classified as G-SIBs and thus not covered under Basel III.

The CRD IV gives national regulators the possibility to implement an additional capital buffer for “other” institutions classified as systemically important, a so- called O-SII buffer. The upper limit for the size of the buffer is set to 2.0% of RWA, and it must consist entirely of CET1 capital.

(23)

If member states want to impose higher capital requirements than 2.0% for certain banks, they can use the systemic risk buffer. The systemic risk buffer aims to address systemic risks not covered elsewhere, and can be implemented by national supervisors for the whole financial sector of a country or for one or more subsets of the sector. There is no maximum limit for the buffer, but buffers greater than 5.0%

RWA will need authorization by the European Commission (ECB SRB, 2016). All in all, the systemic risk buffer allows individual countries to impose capital requirements above the O-SII buffer on institutions classified as national systemically important financial institutions. In Denmark, the systemic risk buffer is set within a range of 1.0 to 3.0%, where the appropriate buffer for an institution depends on its level of systemic risk. The systemic risk buffer must also consist entirely of CET1 capital (Deloitte, 2013). In cases in which an institution is subject to both a G-SIB buffer and an O-SII buffer as well as a systemic risk buffer, the highest of the three buffers will apply.

2.4.2. Maximum Distributable Amount

According to the CRD IV, financial institutions are required to meet the Pillar 1 requirement and the CBR at all times. If a bank fails to do so, it must calculate its maximum distributable amount (henceforth MDA), and will be prohibited from distributing more than that amount. These mandatory distribution restrictions will concern payments of dividends to shareholders, coupons on AT1 instruments, bo- nuses, and pension rights. These automatic restrictions are implemented to guarantee that a bank does not jeopardize its capital position by paying out its earnings (EU Parliament, 2016).

The MDA is calculated as the bank’s distributable profits not yet included in the CET1 capital, multiplied by a factor between 0.0 to 0.6 depending on how far short of the CBR the bank’s capital falls. Thus, the imposed restrictions are linear if the bank breaches the CBR.

(24)

Figure 2: MDA Trigger

Source: Authors’ own creation

A key factor of the CRD IV is the MDA trigger point, i.e. the point where the bank must calculate the MDA and restrictions are imposed. As each jurisdiction has some freedom to choose the implementation, the calculation of the MDA trigger is not uniform. However, for all banks in the Euro area, the MDA trigger is calculated as the sum of

(i) the Pillar 1 minimum CET1 requirement of 4.5%, (ii) the CBR, and

(iii) the P2R.

Thus, the P2G is not used to determine the MDA trigger (SSM SREP, 2016).

The European Banking Union

During the financial crisis, many banks and credit institutions ran into significant financial difficulties. Some were considered too-big-to-fail and were bailed out using public money, whereas other institutions, such as Lehman Brothers, were allowed

CET1 Pillar 2R

CBR Pillar 2G

CET1 Requirements MDA restriction

trigger point

Restrictions on Distributions (% of MDA)

- 60%

- 40%

- 20%

- 0%

(25)

crisis was the highest ever seen. While there were no other real alternatives than to bail out the distressed banks to prevent a far-reaching collapse of the financial system and the real economy, the substantial capital injections of taxpayers’ money led to both fiscal deficits and public debt (Hull, 2015). At the same time, the series of bank failures during the crisis exposed some major pitfalls of the existing tools available for authorities to prevent such failures. Therefore, a more comprehensive recovery and resolution framework was needed.

Because banks play a special role in the economy, normal insolvency procedures cannot be applied to them. The objective of a standard insolvency process is to maximize the value of the firm’s remaining assets for the creditors, which can often be a prolonged process. In contrast, the main objective of bank resolution is to take immediate and resolute action to prevent financial instability and minimize social losses, especially in relation to taxpayers. The primary focus of the bank resolution process is the protection of specific important stakeholders and critical functions of the failing institution, such as depositors and payment systems. Non-critical areas of the bank will be allowed to fail in the usual way (European Commission, 2014).

Furthermore, instead of counting on taxpayers’ money, the resolution framework must also ensure that losses will be borne by shareholders and debt holders.

In 2012, the leaders of the Eurozone took the first step towards addressing the shortcomings of the financial system in the EU by establishing the European Bank- ing Union (henceforth EBU) (European Commission, 2014). The EBU is a significant step towards a real Economic and Monetary Union, and it ensures consistent application of banking rules in the EU member states (EMU, 2017). The EBU consists of two main pillars:

1. The single supervisory mechanism 2. The single resolution mechanism

The single supervisory mechanism (henceforth SSM) is the system of banking supervision in Europe, comprising the European Central Bank (henceforth ECB) and the national supervisory authorities of the EU member states. They supervise the banks that are considered significant by the ECB, whereas local authorities supervise smaller banks.

The main purpose of the single resolution mechanism (henceforth SRM) is to ensure an efficient resolution process of failing financial institutions that minimizes cost to society, i.e. taxpayers and the real economy. The set of rules that provide the legislative regulatory and supervisory standards in all EU countries are collected

(26)

in what is called the Single Rulebook (henceforth the rulebook). The aim of this rulebook is to ensure a harmonized regulatory framework within the EU, and it consists of multiple legislative acts of the European Parliament and the Council.

These are presented in Table 2.

Table 2: Legislative Acts

Legislative act Purpose Abbreviation

The Capital Requirement Directive IV Access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms

CRD IV

The Capital Requirement Regulation Prudential requirements for credit institutions and investment firms

CRR

The Bank Recovery and Resolution Directive

Establishing a framework for the recovery and resolution of credit institutions and investment firms

BRRD

The Deposit Guarantee Scheme Ensures a level of protection for depositors up to €100,000

DGS

The Commission Delegated Regulation Implementing regulations and guidelines of the European Banking Authority

CDR

Source: Maragopoulos, 2016

The Bank Recovery and Resolution Directive

The Bank Recovery and Resolution Directive (henceforth BRRD) is the legislative framework for harmonizing the recovery and resolution approach for banks in the EU. As the MREL is a part of the BRRD, it is important to understand the context in which the former is introduced to investigate the effects of the requirements.

This section will be based on several articles from the Directive.

The BRRD offers regulatory and resolution authorities a set of comprehensive and efficient tools to handle bank failures at the national level, as well as cooperation tools to prevent cross-border banking failures. It was established in 2014 to achieve a common framework and rules for handling a failing financial institution

The foundation of the BRRD is three core pillars, reflecting the different stages of the recovery and resolution planning and execution:

1. Preparation and prevention

(27)

It is important to examine these different phases to understand how they impact the MREL-eligible instruments.

Phase 1: Preparation and Prevention (Articles 4-26 BRRD)

In the prevention of bank failures, an important step is to ensure the ability to react immediately when a bank encounters financial trouble. The BRRD requires banks to follow both recovery and resolution plans on how to handle problematic situations that could ultimately lead to their failure. In this way, both the bank management and the authorities can draw on an already prepared plan if the worst- case scenario should occur (BRRD MEMO, 2014).

If the recovery plan is found to be insufficient, authorities can require a bank to improve it, or to take measures such as changes to risk profile or corporate and legal structures (Deutsche Bundesbank, 2014).

Phase 2: Early Intervention (Articles 27-30 BRRD)

Early intervention happens when the bank is in breach of or is likely to breach any CRD IV/CRR requirements. The directive gives supervisory authorities an ex- tended set of tools and powers to enable them to intervene at the first sign of financial distress (BRRD MEMO, 2014). In this phase, the bank has most likely breached the MDA trigger, and has been forced to restrict payments to certain stakeholders. The supervisors are empowered to replace the management of the bank with a temporary administrator, change the bank’s business strategy, or require the implementation of measures included in the recovery plan (Deutsche Bun- desbank, 2014).

Phase 3: Resolution (Articles 31-86 BRRD)

The resolution phase is the main part of the BRRD, and its objective is to ensure that critical functions of a bank continue to run, to minimize costs borne by the public, to retain financial stability, and to protect depositors. When the financial condition of a bank has deteriorated, it might ultimately meet the point of non- viability (henceforth PONV), the point at which supervisors determine that the bank is no longer able to function. At this point, the BRRD (Article 32) states that three conditions must be met to trigger resolution:

1. The bank is failing or is likely to fail, meaning that it has reached a point of distress where there are no realistic prospects of recovery within a reasonable timeframe.

(28)

2. Given the timing and other relevant circumstances, there are no reasonable prospects that any private sector or supervisory intervention measures can restore the bank to viability.

3. Resolution is in the public interest, because winding up the bank under normal insolvency proceedings would lead to financial instability or prolonged uncertainty.

It should be noted that it is at the discretion of the resolution authorities to determine whether these conditions are met. In cases in which an institution does not meet the conditions, winding-up of the institution will be done under normal insolvency proceedings. In most cases, however, resolution authorities will decide that the conditions are satisfied, and resolution proceedings will be initiated (World Bank 2016). The BRRD provides authorities with a set of resolution tools and powers in resolution. These tools are the following.

Table 3: Resolution Tools under the BRRD Table XXX Reslution tools

Tool Resolution authority power Article nr.

Sale of business Power to transfer ownership and any assets, rights or liabilities to a purchaser that is not a bridge institution

38-39

Bridge institution Power to transfer ownership and any assets, rights, or liabilities to a bridge instituion

40-41

Asset separation Power to transfer assets to an asset management vehicle to maximize the value through eventual sale or wind down

42

Bail-in Power to recapitalize the institution to restore its ability to comply with the conditions for authorization, and to continue to carry out the activities for which it is authorized to under the BRRD

43-44;46-58

Source: BRRD

Bridge institution and asset separation are available tools when resolution authorities do not choose the option to sell the business. The bail-in tool is the available option if resolution authorities deem the other options to be implausible.

The Bail-In Tool

The bail-in tool is the cornerstone of the BRRD; it is a vital tool given to resolution authorities. Instead of relying on public bailout, the bail-in tool imposes losses on the shareholders and creditors of a failing bank. The loss absorption mechanism is

(29)

instruments (Article 60 BRRD). Once the total amount of capital needed to cover losses has been estimated, losses will be allocated to shareholders and creditors in accordance with a liability cascade (Article 48 BRRD). The liability cascade is commonly referred to as “the waterfall”.

All liabilities that are not backed by assets or collateral can potentially be bailed- in. However, bail-in will not be applicable to liabilities that are secured, including covered bonds, deposits protected by a deposit guarantee scheme (henceforth DGS), short-term inter-bank lending, claims of clearing houses and payment and settlement systems, client assets, or liabilities such as salaries, pensions, or taxes (EU BRRD MEMO 2014).

The bail-in hierarchy follows the ordinary ranking in insolvency. First, losses are incurred by shareholders and other CET1 instruments. If CET1 capital is not sufficient to cover losses, AT1 instruments are converted or written down, followed by Tier 2 instruments.

Figure 3: Order of Bail-In

Source: Ramirez, 2017

However, the loss cascade does not end once the bank’s regulatory capital has been exhausted. If Tier 1 and Tier 2 capital is inadequate to cover losses, other subordinated liabilities not qualifying as regulatory capital instruments are written down according to the ranking of claims under the normal insolvency proceedings (Deutsche Bundesbank, 2014). If this is still not sufficient, uncovered senior debt and uncovered corporate deposits are also written down. Finally, retail deposits and

• CET1 instruments

• AT1 instruments

• Tier 2 instruments

• Tier 3 and all other debt with equity conversion or write-down provisions

• Senior unsecured debt (with maturity longer than 1 week)

Bail-in Ranking

• Senior secured debt (covered bonds, repos, …)

• Guaranteed deposits of individuals and SMEs

• Liabilities to banks with original maturity shorter than 1 week

• Most derivatives

• Bank employee fixed salaries and pensions

• Government tax liabilities

• Payment system liabilities with remaining maturity shorter than 1 week

• Fiduciary relationship liabilities First

Last

Bail-in Excluded Instruments

(30)

deposits held by small and medium-sized enterprises (SMEs) in excess of the

€100,000 per unit, which is the deposit guarantee threshold, are bailed-in.

For the bail-in tool to be effective, sufficient liabilities need to be available. There- fore, the BRRD introduces a minimum requirement for funds available to be used for bail-in. This is where the MREL comes into play. The following will provide a numerical example of the loss cascade when a bank starts to face losses. We will then investigate the MREL requirement under the BRRD.

Loss Attachment / Detachment Example

The following will give an example of a bank subject to the current capital requirements, and illustrate how senior bonds can currently incur losses. Take a senior bondholder of a hypothetical European bank, ABC Bank, and suppose that capital levels and requirements are given by percentages of RWA. Table 4 shows the capital requirements of the bank, and what instruments used to meet them.

When losses start to be incurred, not only the amount of CET1 capital is important for senior bondholders, but also the full amount of subordinated debt and capital.

First, losses are attached to shareholders, and holders of AT1 instruments. There- after, Tier 2 is depleted.

For senior bondholders, losses start to attach once capital and debt instruments ranking junior have been exhausted, and detach when the full amount of that class is depleted. Therefore, the width of the senior stack is important for the recovery in a bail-in event, as well as the number of other creditors ranking pari passu.

Assuming that the width of the senior debt stack of ABC Bank is 10.0%, and that no other creditors are ranking pari passu to senior debt holders. Then the loss attachment level is 17.5% and the detachment level is 27.5%. Thus, as long as losses are lower than 17.5% of RWA, the recovery of senior bondholders is 100.0%, whereas when losses are equal to or greater than 27.5%, the recovery is 0.0%. To ensure that senior bondholders are protected from losses, there needs to be sufficient capital buffer below the senior tranche. To this end, the BRRD introduces the MREL, and therefore increases the loss attachment level for senior bondholders.

(31)

Table 4: ABC Bank Parameters Table XXX for ABC bank example parameters

Requirement Amount CET1 Tier 2 AT1

Pillar 1 minimum requirement 8.0% 4.5% 2.0% 1.5%

Capital Conservation buffer 2.5% 2.5% - -

Counter-Cyclical buffer 0.5% 0.5% - -

Systemic risk buffer 2.0% 2.0% - -

Pillar 2 Requirement 1.5% 1.5% - -

Total capital requirement 14.5% 11.0% 2.0% 1.5%

Pillar 2 Guidance 1.0% 1.0% - -

Additional paid-in capital 2.0% 2.0% - -

Total capital ratio 17.5% 14.0% 2.0% 1.5%

Capital amount Minimum capital requirements

Source: Authors’ own creation. Values are expressed as a % of RWA. The table shows an example of ABC bank and its minimum capital requirement. In addition to the total capital requirement, ABC bank has a Pillar 2 Guidance which it fulfills with CET1, and an additional paid in capital That it keeps as a safety buffer.

(32)

3. Minimum Requirements for Own Funds and Eligible Liabilities

The MREL is introduced under the BRRD to ensure that a bank has sufficient capital for loss absorption if it enters resolution. It allows the resolution authority of a EU member state to exercise its write-down or conversion powers, and sets a minimum requirement of eligible capital on which to apply these powers on (BRRD, recital 78-79). The MREL should be met at all times. It is set to support the resolution strategy in place for the bank, and to protect senior bonds from losses, as shown in the loss cascade.

The MREL is slightly different from other bank capital regulations. Where regulations such as Basel III, the CRD IV, and the CRR attempt to reduce the likelihood of the bank failing, the MREL’s objective is to minimize the effects on society if a bank fails. It allows the bank to be recapitalized without the use of public funds. If a bank fails, the existing shareholders are “wiped out” and creditors are bailed-in so that the bank can return to operations by converting claims into equity (EBA, 2016). Another possibility is that the claims will be written down without being converted into equity. The figure below illustrates the use of the MREL if the decision is made under the BRRD for a bank to be recapitalized.

Figure 4: Example of Recapitalization

Source: Morgan Stanley Research, 2016

Assets

Equity Sub Senior

Assets

Equity Senior Losses

Equity Sub Senior

Loss Absorption Amount

Recapitalisation Amount Deposits

Deposits Deposits

Assets Losses

1 ^Going_Concern:

Pre-resolution

2 Gone Concern:

Valuation and Loss Absorption

3 Recapitalisation: Back To Going Concern

(33)

The scope of the BRRD requires all credit institutions, investment firms, and financial holding companies in the EU to comply with the MREL, except for certain mortgage credit institutions (Danske Bank, 2017). Thus, all major banks in the EU will have to comply with the MREL.

The EU parliament is expected to pass a directive that formalizes the MREL requirements by the end of 2017, and banks are expected thereafter to comply with the MREL, with a fully phased-in deadline in 2022 (SEB, 2017). As the requirements have not been passed yet, great uncertainty remains about them. However, some clarity on the rules and requirements has been provided through the EBA’s final report on MREL and discussion papers on the MREL from several EU countries.

The high level of uncertainty can make the final MREL requirements difficult to analyze, but to do so is still useful for the discussion on the pricing of the T3 instruments. Therefore, the following section will analyze the expected MREL requirements, and discuss their aspects that are likely to affect the T3 price. Further- more, as the MREL is the requirement that gives rise to the T3 instrument, it is appropriate to gain an understanding of it. For the purpose of this thesis, we are mostly interested in what the final amount of the MREL will be for a bank, as well as the consequences on the capital structure. As such, we will limit our investigation to the most important aspects of the regulation related to these topics.

MREL Amount

How the MREL amount is set for a bank will directly influence the T3 tranche size.

It is therefore essential to understand what MREL amount comprises, how it is set, and what might influence how it is set. As with the P2R in Basel III, the MREL amount is decided on a bank-by-bank basis:

“First, MREL should be set (for each bank) at a level necessary and sufficient to implement the resolution strategy by absorbing losses and recapitalizing the institu- tion; and second, that this [the MREL estimation] calibration exercise should be consistent with the prudential capital requirements applicable to the institution be- fore and after resolution.” (EBA, 2016, p.7)

Therefore, the local authorities ultimately set the amount of MREL – and the provisions of resolution planning – in compliance with the minimum requirements set out in the BRRD and the final EBA paper (BRRD; EBA 2016). The MREL is

(34)

expected to be expressed as a percentage of RWA, as recommended by the EBA final report (EBA, 2016)¹.

The MREL amount consists of two components, a loss absorption amount (henceforth LAA) and a recapitalization amount (henceforth RA), and any applicable adjustments to these amounts. As it is a case-by-case requirement, it can be difficult to generalize what the final amount will be. However, as a guiding principle, the MREL will be twice the Pillar 1 and Pillar 2 requirements, and once the CBR requirement (EBA 2016; SRB 2016). Figure 5 illustrates the expected MREL requirement and how it will be set – that is, the LA and RA, as well as any adjustments to the final amount.

Figure 5: MREL Amount

Source: EBA, 2016; SRB, 2016

As a general safeguard of the requirement, it is expected that the MREL amount might be subject to certain backstop provisions, which ensure that the amount is at least the amount set by the backstop but can be adjusted by resolution authorities (EBA, 2016). The total MREL amount is likely to come with a minimum floor

P1 P2R CBR

P1 P2R

P1 P2R CBR P1 P2R

8% TLOF

+

Maximum of Other adjust.

-

Loss absorption

amount Recapitalization amount

Exclusionsfrom bail-

! in

SREP adjustment

!

Size and systemic

! risk

DGS adjustment -

+ ± ≤ ^MREL

Adjustments of

(35)

as a backstop, and the EBA assumes this backstop to be defined as 8.0% of a bank’s total liabilities and own funds (TLOF) (EBA, 2016).

To identify the final requirement for a bank, it is necessary to understand how each component of MREL is set.

3.1.1. The Loss Absorption Amount

The LAA is the amount aimed at absorbing potential losses that an institution has to meet by using capital instruments. The LAA is therefore viewed as the going- concern amount of the MREL. The LAA mainly consists of the current capital requirement under Basel III, the CRR, and the CRD IV. That is, the LAA should be set to correspond to the Pillar I requirement and any P2Rs. Resolution authorities can adjust the LAA if they deem it appropriate. For a regular² O-SIIs, the LAA amounts to 8.0% of RWA (EBA Pres., 2016).

3.1.2. The Recapitalization Amount

The RA is the capital amount set to support the resolution strategy defined under the BRRD. The exact figure for the RA should be set such that a bank can function post-resolution. Therefore, the RA is set so that the post-resolution bank will meet any applicable capital requirements for banks, and adjusted for an amount necessary to sustain sufficient market confidence in the bank post-resolution. The RA is the main addition to the existing capital requirement amounts, and is viewed as the gone-concern part of the MREL.

The resolution strategy determined by resolution authorities will greatly impact the RA. In broad terms, there are three categories of resolution strategies:

1. Resolution with full recapitalization 2. Resolution with partial recapitalization 3. Liquidation

When full or partial recapitalization is chosen as the strategy, the RA will be set accordingly. If liquidation is chosen, on the other hand, a bank will be liquidated under normal insolvency proceedings and no RA will be set. It is important to highlight the implications of the chosen strategy. A smaller European bank that does not impose any form of systemic risk is likely not to have a large RA. In

2 A regular O-SII is one that has the Pillar I requirement of 4.5% CET1, 1.5% AT1, and 2.0% T2 capital requirement, adding up to a total requirement of 8.0% of RWA

(36)

contrast, larger O-SIIs can have the full RA amount. Thus, the RA can vary greatly between banks, and the size and importance of a bank is likely to determine the final MREL requirement.

In general, with full recapitalization, the expected capital requirement for a bank is the 8.0% Pillar I requirement and any other P2R, where the sum of these is the minimum capital requirement for a regular O-SII (EBA, 2016).

3.1.3. Setting the Recapitalization Amount

The need for additional RA to sustain market confidence can depend on many different circumstances, and is at the discretion of regulators. As the post-resolution bank might look different than the pre-resolution bank, the resolution authority should consult with the supervisory authority and take the SREP assessment into account when setting the RA.

Because it can take any form, the final RA is difficult to fully estimate in cases in which partial recapitalization is applied. In its final report on MREL, the EBA set the partial recapitalization to 50.0% of the full RA (EBA, 2016).

In setting the RA, authorities should consider the most recent reported values of RWAs or leverage ratio denominators (Commission 1450, Article 3).

3.1.4. Adjustments to the MREL Amount

Finally, resolution authorities have the ability to adjust the MREL amount. The general factors in adjusting the amount are illustrated in Figure 5. In particular, the resolution authorities may adjust the MREL amount because of uncertainty regarding instruments being eligible for bail-in. This uncertainty primarily concerns whether the instrument is in violation of the “no creditor worse off principle”

(henceforth NCWO) (Maragopoulos, 2016).

No Creditor Worse Off

The NCWO principle is one of the general safeguards in the BRRD and the resolution process. The NCWO principle states that no creditor should incur losses that are greater under the BRRD resolution process than if the institution were winded up under normal circumstances (BRRD, article 34(G)). The NCWO essentially establishes that a creditor cannot be worse off than if normal liquidation took place.

(37)

An example of this is uncovered corporate deposits ranking pari passu to other senior unsecured debt. Whereas uncovered corporate deposits are excluded from bail-in, other senior unsecured debt classes are not. Thus, such debt classes will effectively be left worse off in a bail-in solution compared to a normal liquidation.

As this violates the NCWO principle, other senior unsecured debt instruments are likely to be excluded from bail-in as well. In general, if an instrument violates the NCWO, it will be excluded from bail-in. To assess whether a creditor or a share- holder is worse off, a post-resolution valuation must be conducted (Maragopoulos, 2016)

Other Adjustments

The MREL amount may further be adjusted based on institution-specific characteristics, systematic risk factors, and other adjustments under national legislation if regulators deem it necessary. These are broadly listed as the SREP adjustment, the size and systematic risk adjustment, and the DGS adjustment. However, as these adjustments are heavily focused on bank- and country-specific characteristics and have not yet, to our knowledge, been decided for any bank, we will not go further into detail on these topics.

3.1.5. Interaction with TLAC

The total loss absorption capacity (henceforth TLAC) requirement is similar to the MREL, but only applies to G-SIBs. It is a proposal from the Financial Stability Board. The TLAC sets a minimum level of capital and liability requirement of at least 18.0% of a bank’s RWA when fully phased-in by 2022 (TLAC term sheet, 2015). G-SIBS incorporated in EU member states will have to comply with both the TLAC and the MREL. Even though both requirements have similar objectives and share many similarities, they also differ in key areas: the level of the requirement, the role of capital buffers, the eligibility of instruments, and the implementation date (Maragopoulos, 2016).

In the scope of this thesis, we do not investigate G-SIBs as there are only 13 in Europe. However, it should be noted that the EBA has made the effort to align the two requirements (EBA, 2016).

How to Comply with the MREL

It is clear from this analysis that the MREL amount will be significantly larger than the current capital requirements, even though it may vary significantly on a

The Capital Market Effects of the Minimum Requirements for Own Funds and Eligible Liabilities.