The new asset class introduces an additional layer of bail-inable debt but doubts remain as to how it should be regulated
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|A new senior non-preferred asset class was created with capital requirements provided for by total loss-absorbing capacity and minimum requirement for own funds and eligible liabilities for large banks in mind. The European Commission proposed draft legislation in November 2016 enshrining this new type of debt into law, and amending the Bank Recovery and Resolution Directive (BRRD).|
But Germany will be forced to take further action as the BRRD amendments now grant bank issuers the option to decide at their own discretion whether to issue senior non-preferred or preferred senior bonds – a choice that German bank issuers don’t currently have.
For the past four years, banks have focused on issuing common equity tier 1 (CET1 ie common shares), additional tier 1 (AT1 also known as CoCo bonds) and tier 2 (supplementary) capital instruments as provided for in the Capital Requirements Regulation (CRR) to meet their regulatory requirements. Recently, such a spectrum of asset classes has been broadened. Latest headline news refer to senior non-preferred bonds – an asset class issued by European banks that is news to many European capital markets. As senior non-preferred bonds become increasingly en vogue, the rationale behind the creation of this new asset class needs to be looked into, as do specific issues arising with respect to the still evolving legislation providing for them with a particular focus on the German angle.
Rationale behind the senior non-preferred class
The creation of the new senior non-preferred asset class must be viewed in light of the new capital requirements provided for by total loss-absorbing capacity (TLAC) and minimum requirement for own funds and eligible liabilities (MREL) with respect to (large) banks. The TLAC standard was established by the Financial Stability Board in November 2015 and requires groups identified as global systemically important banks (G-Sibs) to maintain significant amounts of TLAC. MREL applies at the European level and requires EU credit institutions within the scope of the Bank Recovery and Resolution Directive (BRRD) to meet this minimum requirement.
Both standards are part of the post-2008 financial crisis regulatory overhaul and aim to prevent credit institutions from being too big to fail. They also promote financial stability on a global level. As part of a toolbox, resolution authorities are equipped with the power to bail in, which includes the ability to write-down or convert debt into equity, in order to ensure that losses are borne by a bank's shareholders and bail-inable creditors rather than taxpayers. Maintaining the required minimum amount of own funds and eligible liabilities enables bail-in tools to be deployed successfully in the case of a bank crisis, ensuring a smooth resolution, fast absorption of losses and recapitalisation of a failed bank with a minimum impact on financial stability and taxpayers.
Prior to the bail-in of senior unsecured liabilities, losses will be allocated to CET1, AT1 and tier 2 capital instruments. The new senior non-preferred asset class introduces an additional layer of debt in the liability spectrum between tier 2 and senior unsecured creditors so that in the case of a bank issuer's insolvency or resolution, senior preferred creditors rank above the non-preferred ones. The latter creditors therefore, absorb losses before senior preferred creditors take a hit.
Specific issues regarding evolving legislation
Both the TLAC standard and the (amended) MREL requirements need further legislative action to become enforceable in law. To that end, the European Commission published a package of draft legislation in November 2016 amending inter alia the BRRD and the CRR.
While the lack of consistency between the TLAC standard and the (rather vague) MREL criteria as currently provided in the BRRD has often been criticised, the proposed draft legislation is a big step forward in fully harmonising the eligibility criteria of both standards throughout the EU. The Commission's November proposals provide for a far-reaching alignment of TLAC and MREL eligibility criteria for externally raised capital instruments but differ in particular on one decisive aspect: subordination. The TLAC standard requires liability instruments to be subordinated to other liabilities in order to be eligible, ie they have to absorb losses in the event of insolvency or resolution prior to other preferred liability instruments. Hence, liabilities that are unsubordinated are disqualified from TLAC for failing to meet an eligibility criterion. However, this does not apply to MREL as subordination is, unless requested by resolution authorities on an exceptional basis – from a mere technical and legal perspective – generally not required for liabilities to qualify as MREL eligible.
What is new in Germany is that the BRRD amendments now grant bank issuers the option to decide at their own discretion whether to issue senior non-preferred or preferred (plain vanilla) senior bonds
Moreover, TLAC and MREL provide for numerous eligibility criteria which are not reflected in today's market standard terms and conditions of senior bonds issued by German bank issuers. This would very likely apply to other European banks as well. For example, to qualify as TLAC/MREL eligible, liabilities must in particular not be subject to any set off arrangements and contain a contractual bail-in recognition clause. As a result, existing senior debt could fall foul of the proposed criteria and thus, unless a grandfathering provision is introduced in the final law, will not qualify as eligible TLAC/MREL. Further, issuers may face difficulties in printing TLAC/MREL as it is still unclear to what extent the requirements may be changed until completion of the pending legislative process. While bank issuers want to ensure that new issuances will be eligible under future TLAC/MREL requirements, they aim to avoid implementing criteria that are costly and ultimately may not be required pursuant to the final legislation.
Thirdly, the proposed amendments to the BRRD regarding the hierarchy of creditor claims in insolvency (also referred to as resolution waterfall) are not consistent with the resolution waterfall under currently applicable German law. In this respect, it has to be noted that even though legally an unsubordinated liability can qualify as MREL, at least from a factual perspective it is necessary that MREL be subordinated. This is due to the no creditor worse off principle stipulated by the BRRD (NCWO) which provides that creditors shall not suffer worse treatment in resolution than they would have in normal insolvency. If unsubordinated MREL liabilities were bailed-in, the affected unsubordinated MREL creditor would be able to claim that other (non-MREL) unsubordinated creditors technically ranking pari passu should have absorbed losses on equal footing and hence the actual bail-in haircut would have been significantly lower and that, as a result, the NCWO is breached (and potentially raise damage claims on that basis). Therefore, it may not be legally but factually required for MREL liabilities to be subordinated in order to ensure smooth application of the bail-in tool without infringements of the NCWO.
Anticipating such implications, Germany revised its resolution waterfall already in 2015 and stipulated that plain vanilla senior bonds mandatorily rank junior to common unsecured creditors in case of insolvency and/or resolution. This legislative frontrunner move was meant to facilitate German banks to comply with upcoming TLAC and MREL requirements. Thus, whereas the senior non-preferred asset class is fairly new to other European insolvency laws, in a way, German law is already familiar with senior non-preferred liabilities.
However, what is news to Germany is that the BRRD amendments now grant bank issuers the option to decide at their own discretion whether to issue senior non-preferred or preferred (plain vanilla) senior bonds – a choice that is currently not on the table for German bank issuers. Accordingly, it is necessary that German law be amended to allow for opting out of the statutory subordination so that German bank issuers can decide between issuing either the new senior non-preferred or senior preferred.
What will German bank issuers do?
In light of the already existing statutory subordination under German law, but given that today's market standard senior bond notes fall foul of the proposed TLAC/MREL criteria, German bank issuers (but similarly also other European bank issuers) will need to consider the following three options in particular:
- Issuers could fully rely on a grandfathering provision to be introduced in the final legislative package protecting existing senior plain vanilla bonds issued in the past to (continue to) qualify for the purposes of TLAC/MREL.
- Alternatively, as a second option, issuers could adjust their senior bonds' terms and conditions by implementing the full set of eligibility criteria to be fully compliant with the November 2016 draft legislation and issue new debt on the basis of such terms. This option would entail assuming the risk that the draft legislation proposals changes during the continuing legislative process (either by introduction of further unforeseen eligibility criteria or by removal of eligibility criteria – noting that some eligibility criteria have already been subject to changes in legislative drafts provided by working groups – leading to unnecessary funding costs).
- The third option is for the issuers to opt for the middle way: making a best guess as to which eligibility criteria will be adopted in the final legislation package and amend its senior bonds' terms and conditions accordingly. New bonds for MREL/TLAC purposes will be issued as soon as the outcome of this still highly debated legislation becomes clear(er).
While we see that some G-Sibs made use of the second option in early 2017 as an immediate reaction to the Commission's November 2016 drafts, we expect that many non-G-Sib issuers will favour the other two options mentioned above, in order to avoid negative carry on their funding costs. This is in line with recent working papers that acknowledge the need for grandfathering for certain outstanding debt and provide for changes to eligibility criteria (eg the requirement to include a contractual bail-in recognition clause has been reduced to a mere disclosure requirement).
European banks (particularly G-Sibs) will need to deploy the new asset class to meet their TLAC/MREL requirements
Further, while it seems less probable that TLAC criteria will be significantly weakened, some European non-G-Sibs still see realistic chances that some of the eligibility criteria will fall off at MREL-level.
Timing plays an important role when taking choices. The Commission originally proposed a very ambitious timeline with respect to harmonising such national resolution waterfalls requiring national member states to apply (and have adopted) related implementation laws already by July 2017. This hard and fast deadline has not been adopted in the latest working papers. Additionally, in an ideal world, the final TLAC and MREL eligibility criteria are enacted simultaneously with the changes to the resolution waterfalls. Thereby, bank issuers would be provided with the required certainty to build up TLAC and MREL whereas investors would benefit from increased transparency, allowing them to better understand their balance sheet position and giving them more confidence pricing the new senior non-preferred asset class. However, it seems unlikely that the TLAC and MREL eligibility criteria will be finalised very quickly as the proposed law package implementing TLAC and MREL is far from being enacted law (or at final draft stage) in the EU.
Whilst the EU Comission still aims to fast-track harmonisation of waterfalls to give clarity to investors, the member states have diverging views as to what extent the resolution waterfall proposal needs to be negotiated and finalised in one package with TLAC and MREL eligibility criteria and potentially also including further banking union files and regulatory topics. Thus, bank issuers would be well advised to closely monitor all the strings of such further legislative process and their impact on timing. Hence, it continues to be a real rat race for legislators and market participants alike.
Will senior non-preferred become a success?
The framework will (ultimately) become a success story. On the one hand, European banks (particularly G-Sibs) will need to deploy the new asset class to meet their TLAC/MREL requirements. On the other, investors are eagerly looking for some reasonable spread in the current low yield environment. Clearly, there is a major hurdle that needs to be overcome for senior non-preferred bonds to become a real success. The myriad of national resolution waterfalls and their particularities which will make it very cumbersome to compare credit spreads and real economic risks when for instance considering whether to rather invest in an Italian or a German MREL liability.
Hence, it is good news and a crucial step in the right direction that the proposed BRRD amendments tackle one of the major roadblocks for the creation of a highly liquid senior non-preferred market throughout the EU: inconsistencies in national resolution waterfalls must be reduced. At the same time, it feels like being in the base camp of Mount Everest – it's a long way up and you may need to wait out bad weather in favour of the right time to get it done.
By Daniel Baierlein, local partner at White & Case (Frankfurt)
The author would like to thank Thorsten Rohde, referendar and intern at White & Case, for his valuable input and assistance in preparing this article.
White & Case
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