The total loss-absorbing capacity metric has now been finalised. Its subordination exception has important ramifications for many European G-Sibs
The Financial Stability Board (FSB) released, on November 9 2015, its final total loss-absorbing capacity (TLAC) standard for global systemically important banks (G-Sibs).
Regarding the topic of subordination, the so-called Final Standard makes an important change to the framework proposed in the initial TLAC consultation paper, released by the FSB in November 2014. While the proposal set out a strict requirement for TLAC-eligible liabilities to be subordinate to 'operating liabilities' (in particular, deposits and derivatives), the Final Standard contains an exception to subordination which is likely to be of significant importance for many continental European banks.
Specifically, the Final Standard provides that subordination of eligible external TLAC to excluded liabilities is not required if the following requirements are met:
i the amount of excluded liabilities (as per section 10 of the FSB Term Sheet) on the balance sheet of the resolution entity that rank pari passu or junior to the TLAC-eligible liabilities does not exceed five percent of the resolution entity's eligible external TLAC;
ii the resolution authority of the G-Sib has the authority to differentiate among pari passu creditors in resolution;
iii differentiation in resolution in favour of such excluded liabilities would not give rise to material risk of successful legal challenge or valid compensation claims; and
iv this does not have a material adverse impact on resolvability.
The requirements specified under items ii and iv refer to issues addressed under the EU Bank Recovery and Resolution Directive (BRRD) and its framework for resolution planning and the taking of resolution action. In other words, these requirements should be met for all European G-Sibs once the BRRD has been implemented in national legislation.
"The NCWO claim may not be as material as many observers may have assumed"
Item ii is a question of legal interpretation, in respect of which a G20 Survey on Bail-in conducted by the International Bar Association in 2009 is relevant. This survey confirmed that, while article 1 of the First Protocol (A1P1) to the European Convention on Human Rights protects the rights of creditors as 'possessions', infringement with such rights is possible if imposed in the public interest and prescribed by law, which requirements are certainly met under the BRRD framework. In terms of 'compensation claims', the same survey cites case law of the European Court on Human Rights which imposes a requirement for indemnity when Convention rights are infringed, but has also held that it is not necessary to compensate affected parties at full value. More broadly, unequal treatment among creditors has been considered justified so long as it is based on objective criteria which do not discriminate among creditors based on purely arbitrary or personal considerations.
The only claim available under the BRRD for bailed-in creditors, whether or not impacted by an exclusion of otherwise equally ranking liabilities such as derivatives, is in terms of the no-creditor-worse-off principle (NCWO). This protects the position of a bailed-in creditor as compared to what he or she would have received in a liquidation proceeding under normal insolvency laws commenced at the time of the bail-in. Importantly, NCWO does not purport to indemnify any creditor suffering a bail-in in terms of what would have been received had otherwise pari passu creditors who were excluded from the procedure been bailed in alongside. This is significant since winding-up proceedings inevitably result in huge destruction of value, due to the fire-sale nature of the liquidation process. In other words, the NCWO claim may not be as material as many observers may have assumed.
Item (i) essentially allows banks to have a de minimis basket of non-senior ranking operating liabilities (liabilities which are not senior to TLAC). Looking to the list of excluded liabilities set out in section 10 of the Final Standard, any of the following would need to go into the basket if they rank pari passu with or junior to TLAC-eligible liabilities:
1. insured deposits;
2. sight deposits and short-term deposits (with original maturity of less than one year);
3. liabilities arising from derivatives;
4. debt instruments with derivative-linked features, such as structured notes;
5. liabilities arising other than through a contract, such as tax liabilities;
6. liabilities which are preferred to senior unsecured creditors under the relevant insolvency law; or
7. any liabilities that, under the laws governing the issuing entity, are excluded from bail-in or cannot be written down or converted into equity by the relevant resolution authority without giving rise to material risk of successful legal challenge or valid compensation claims.
Of this list, numbers 1, 2, 5 and 6 will not be relevant for the purposes of the five percent basket, since all rank ahead of senior unsecured bonds in insolvency. Importantly, Italian implementation of the BRRD has ensured preference in the insolvency hierarchy not only for insured deposits and excess deposits (beyond the €100,000 mandatory coverage level) of individual and small and medium-sized enterprises; it has also introduced a further (but lower) level of preference for large corporate and inter-bank deposits.
Item 7 in the FSB list of excluded liabilities likewise relates, for the most part, to items which will not be included in the five percent basket. As a starting point, item 7 will be limited, in the case of Italian banks, to liabilities subject to the mandatory exclusion from bail-in under article 44(2) of the BRRD. Although the resolution authority might theoretically wish to undertake a discretionary exclusion from bail-in for additional categories of liability when actually presiding over the resolution of an Italian bank, there are no additional categories of liability which, as a matter of Italian law, would necessarily give rise to a material risk of successful legal challenge or valid compensation claims. The election of a resolution authority to undertake a discretionary exclusion in the future would be purely opportunistic, based on considerations arising at the relevant time for an individual bank. But there is no basis in Italian law for considering certain types of exclusion, in addition to those set out in the BRRD itself, as indispensable.
Liabilities subject to mandatory exclusion under the BRRD include:
(a) covered deposits;
(b) secured liabilities including covered bonds and liabilities in the form of financial instruments (derivatives) used for hedging purposes which form an integral part of the cover pool, and which according to national law are secured in a way similar to covered bonds;
(c) any liability that arises by virtue of the holding of client assets or client money, including client assets or client money held on behalf of Ucits [undertakings for collective investments in transferable securities], provided that such a client is protected under the applicable insolvency law;
(d) any liability that arises by virtue of a fiduciary relationship between the institution (as fiduciary) and another person (as beneficiary), provided that such a beneficiary is protected under the applicable insolvency or civil law;
(e) liabilities to institutions, excluding entities that are part of the same group, with an original maturity of less than seven days;
(f) liabilities with a remaining maturity of less than seven days, owed to systems or operators of systems designated according to Directive 98/26/EC or their participants and arising from the participation in such a system; and
(g) a liability to any one of the following:
(i) an employee, in relation to accrued salary, pension benefits or other fixed remuneration, except for the variable component of remuneration that is not regulated by a collective bargaining agreement;
(ii) a commercial or trade creditor arising from the provision to the institution of goods or services that are critical to the daily functioning of its operations, including IT services, utilities and the rental, servicing and upkeep of premises;
(iii) tax and social security authorities, provided that those liabilities are preferred under the applicable law;
(iv) deposit guarantee schemes arising from contributions due in accordance with Directive 2014/49/EU.
Making the five percent
Looking at the requirements of the FSB Term Sheet together with the BRRD, there are essentially two conditions which must be met in order for the liabilities listed above to be included in the five percent basket:
- ranking must be pari passu or junior to TLAC-eligible liabilities, meaning senior unsecured bonds (Ranking Requirement); and
- liabilities must be excluded from bail-in under the BRRD (No Bail-in Requirement).
Covered deposits are not relevant in light of the depositor preference granted under Italian implementation of the BRRD. In other words, covered deposits meet the No Bail-in Requirement but not the Ranking Requirement, and are therefore not relevant for the basket.
Likewise, secured liabilities are not relevant since, up to the amount of the liability that is secured, the Ranking Requirement is not met. For the unsecured portion of any liability, the No Bail-in Requirement would not be met.
In respect of client assets and client money, as well as assets held in a fiduciary capacity by an Italian bank, the situation under Italian law depends on what form the assets take.
Assets in the form of securities are ringfenced by law, and this is guaranteed also in insolvency. However, since clients' claim is on a specific pool of ringfenced assets, it would not be correct to consider these claims to be junior to or pari passu with senior unsecured bonds. The fact is that clients will be privileged creditors on the specific asset pool represented by securities held for clients. Therefore, so long as the bank under resolution respects the segregation requirements imposed by Italian law, the Ranking Requirement would not be met. If the bank failed to observe the proper segregation requirements for client securities, clients would be pari passu creditors with holders of senior unsecured bonds (and therefore the Ranking Requirement would be met), but since they would have no protection under the civil or insolvency law, the No Bail-in Requirement would not be met. As a result, claims for the return of client assets in the form of securities would not be relevant for the purposes of item 7 of the FSB list.
Client assets in the form of cash are not ringfenced, but the client doesn't have any protection under applicable insolvency or civil law. In other words, the Ranking Requirement would be met but not the No Bail-in Requirement, with the result that, once again, claims for the return of client monies would not be relevant for item 7 of the FSB list.
Liabilities with an original maturity of less than seven days, or a residual maturity of less than seven days if owed to a securities or payment settlement system operator, will need to be included in the five basket since no preference is granted under Italian law.
Employee, tax and social security claims, as well as any amounts due to commercial or trade creditors arising from the provision of essential goods and services are not relevant for the purposes of computing the five percent basket since all are preferred in insolvency. Therefore, the Ranking Requirement is not met.
Derivatives and structured notes
The most important items to be included in the five percent basket are derivatives liabilities and structured notes.
Derivatives liabilities should sensibly only refer to the net, unsecured liability arising from over-the-counter derivatives, following application of close-out netting and any financial collateral. Whether or not this is actually the case is somewhat unclear as a result of the language in the Final Standard which refers to 'the amount of excluded liabilities … on the balance sheet of the resolution entity'. There is an important difference which exists between US GAAP and International Financial Reporting Standards (IFRS, which applies to European companies, including banks), which leads to US entities being entitled (though not required) to report the fair value of their derivative transactions on a net basis by counterparty. European reporters are required to record derivatives positions gross.
Under the US rules, net reporting is possible so long as there is a legally enforceable right to offset the amounts owned under individual transactions pursuant to a master netting arrangement. By contrast, IFRS imposes an 'intention to settle net' requirement. Today, this prevents European entities from showing derivatives liabilities on a net basis on their balance sheets, even if all requirements for obtaining recognition of netting from a regulatory capital standpoint have been met. (Put differently, this is irrespective of whether transactions are documented pursuant to a master agreement and the bank has obtained legal opinions confirming the enforceability of netting according to the laws of all relevant jurisdictions, including in the event of admission of its counterparty to insolvency proceedings). It is unlikely that the Final Standard was intended to be wholly dependent on the accounting standards used by G-Sibs. And it is certainly hoped that this (albeit persistent) discrepancy in accounting practice for derivatives between Europe and the US will not trump the prudential policy considerations which should logically dictate the future funding requirements of European G-Sibs. A similar approach was ultimately used in setting the Base III leverage ratio, whereby derivatives exposures are considered on a net basis for each master agreement entered into with a counterparty, regardless as to accounting treatment, provided that the enforceability of netting (including in insolvency) is substantiated by the appropriate legal opinions.
On the subject of structured notes, the FSB does not offer any guidance as to what types of instrument should be relevant. There is generally confusion among market participants as to where the line should be drawn between 'structured' and 'vanilla' instruments. The recent proposal from the US Federal Reserve defines structured notes in terms of any debt instrument that:
- has a principal amount, redemption amount, or stated maturity that is subject to reduction based on the performance of any asset, entity, index, or embedded derivative or similar embedded feature;
- has an embedded derivative or similar embedded feature that is linked to one or more equity securities, commodities, assets, or entities;
- does not specify a minimum principal amount due upon acceleration or early termination; or
- is not classified as debt under US generally accepted accounting principles.
The Fed does, however, clarify that non-dollar dominated instruments or instruments linked to an interest rate index (such as Libor) will not automatically be considered 'structured'.
"The most important items to be included in the five percent basket are derivatives liabilities and structured notes"
The reluctance to allow structured notes to meet the TLAC requirement, as evidenced by both the FSB Term Sheet and the US Fed approach, appears to be based on a concern that valuation may prove difficult for the purposes of ensuring that bail-in can be carried out in a short time-frame, rather than because regulators wish to protect the relevant investors. Clarity continues to be lacking in the market. But it seems that fixed and floating rate notes, including bonds incorporating a step up or step down feature – so long as triggered at pre-set intervals and not by the occurrence of uncertain events such as changes in the credit standing of the issuer or any other entity or fluctuations in the value of equities, commodities or other assets – plus zero coupon bonds should be considered vanilla instruments. The fact is that all of these types of instrument have relatively simple market risk features, with a large degree of standardisation, including back-office functioning, listing and, importantly, valuation processes. Moreover, in the case of admission to insolvency proceedings under Italian law, since no claims are permitted in respect of interest accruing after the date of admission to proceedings, there is no need to calculate the net present value of future coupons. The Fed does not express a clear view in relation to inflation-linked instruments, but in terms of standardisation and valuation, as well as treatment under Italian insolvency laws, there appear to be good arguments to apply the vanilla label.
Finding an appropriate definition for 'structured notes' is important not solely in the context of banks relying on the five percent basket. It must also ensure that resolution policy for global banks does not inadvertently create a paradigm in which sophisticated investors in highly structured products are preferred to investors in plain vanilla instruments. This is particularly in light of the fact that the latter may often be retail investors or institutional investors providing important financial services to the retail market (such as insurance companies or pension funds).
In Italy, there has been no appetite for preferring investment in complex structured debt products. This reflects in part the considerable presence of retail investors in senior unsecured bonds issued by Italian banks, but also justifiable concern at either encouraging retail investment in more complex structured products or implementing bail-in in a manner that would see sophisticated hedge fund investors preferred to individual savers. The fact is, while the FSB may not wish to count on structured notes as a readily available source of loss absorption for TLAC purposes, there is no intention on the part of the Italian authorities to automatically prefer these instruments in insolvency or resolution. It is likely that, in practice, every attempt will be made to ensure that burden sharing extends to holders of even complex debt.
By Allen & Overy senior of counsel Lisa Curran in Rome and partner Craig Byrne in Milan