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Gleeson on the International Regulation of Banking, 3rd Edition by Gleeson, Simon (30th August 2018)

Part I The Elements of Bank Financial Supervision, 6 Total Loss-Absorbing Capacity

From: Gleeson on the International Regulation of Banking (3rd Edition)

Simon Gleeson

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2015. All Rights Reserved. Subscriber: null; date: 12 December 2018

Bank resolution and insolvency — Regulation of banks — Financial regulation — Tier 1 capital — Tier 2 capital

(p. 93) Total Loss-Absorbing Capacity

A.  TLAC Requirements

6.01  Post-crisis banks are subject to two overlapping authorities—regulatory authority and resolution authority. Both are to some extent concerned with the survival of the bank in a crisis, and to that end both have the power to instruct a bank as to how it should structure itself to address that possibility. Total loss-absorbing capacity (TLAC) is the most significant point of overlap between these two authorities. Viewed from the perspective of a resolution authority, TLAC is simply a name for that proportion of the liabilities of a bank which can be converted into capital in a resolution. However, viewed from the perspective of a prudential supervisor, the TLAC requirement1 can reasonably be viewed as a capital requirement which is capable of being met with a wider range of instruments than those which qualify as Tier 1 or Tier 2. This raises an interesting issue as regards the relationship between the two. Within the Basel regulatory framework, CET1 is going concern capital and T2 is gone concern capital. Within the resolution framework, CET1 is going concern and TLAC is gone concern. It is debatable whether the continuation of two parallel and unaligned concepts of gone concern capital is either necessary or sensible, and the Swiss regulator, for example, has addressed (p. 94) this by simply abolishing the Tier 2 requirements. However, the fact that the Financial Stability Board (FSB) TLAC framework, which addresses resolution issues, exists in parallel with but separately from the Basel capital framework means that it is likely to be some considerable time before these two concepts are fused at the Basel level.

6.02  The requirement for TLAC is in addition to the minimum capital requirement (for this purpose including buffers). However capital instruments of any kind which are not used to meet the minimum capital requirements (ie are in excess of the minimum requirements) may be used to meet TLAC requirements. Thus a firm is not required to issue subordinated debt satisfying the minimum TLAC conditions—if it wishes it may simply issue existing regulatory capital instruments to meet the whole of the TLAC requirement. However, it may not meet the whole of its TLAC and capital requirements through the issue of CET1. This is because the purpose of TLAC is to recapitalize the bank in the event of failure, and failure is described as the extinction of equity—thus if TLAC were met entirely with equity, the exhaustion of equity and the exhaustion of TLAC would occur at the same moment. Consequently the FSB requires that at least 33 per cent of the TLAC requirement is met with debt instruments—ie with TLAC-eligible subordinated debt, T2, or AT1.

6.03  The base TLAC requirement as set out in the FSB termsheet is that each resolution entity within a group must have a minimum level of TLAC. For this purpose a resolution entity means an entity which is identified in the resolution plan for the group as a whole as an entity at which the resolution authorities propose to intervene. Thus if the group is a pure single point of entry group, the only resolution entity within the group will be the top holding company. However, for a group which has a multiple point of entry resolution strategy (an MPE group), each entity which is identified as a target for resolution action will be a resolution entity.

6.04  Each resolution entity and the entities which are below it—ie its direct and indirect subsidiaries—form a resolution group. The TLAC requirement is calculated as a proportion of the risk-weighted assets (RWA) of that resolution group. The minimum TLAC requirement is 16 per cent of the resolution group’s RWA as from 1 January 2019, and at least 18 per cent as from 1 January 2022. Alternatively, if higher, the minimum TLAC should be at least 6 per cent of the Basel leverage ratio denominator, and, as from 1 January 2022, above 6.75 per cent of that amount. However this is intended to be a minimum, and resolution authorities may impose higher requirements.

6.05  Where an entity has a multiple point of entry (MPE) resolution plan and multiple resolution groups, it is likely that those resolution groups will have exposures to each other. For the purposes of the TLAC calculation each resolution group should treat exposures to other resolution groups as part of its RWA. Since such intra-group exposures would be eliminated from the overall group calculation, (p. 95) this more or less guarantees that the total of the RWAs of the different resolution groups will be greater than the RWA figure at the overall group level, and that as a result the amount of TLAC required by an MPE group will be larger than it would have been had the group been a single point of entry (SPE) group.

Internal and external TLAC

6.06  The nomenclature here is non-intuitive. Internal TLAC refers to TLAC put in place within a resolution group. TLAC which is put in place between a resolution subgroup and its parent is external TLAC as regards that subgroup. Thus internal TLAC is TLAC between a resolution entity and its material subgroups. For this purpose a ‘material’ subgroup is a subgroup containing companies in a single jurisdiction, where the subgroup as a whole exceeds 5 per cent of any of the RWAs, the operating income, or the total leverage measure.

6.07  Since resolution should only occur at the level of a resolution entity, the logic of internal TLAC is not immediately obvious, since a legal entity which is not intended to be put into resolution should not need TLAC. The reason for the existence of internal TLAC is to provide reassurance to the national resolution authorities in jurisdictions in which subgroups are located. In particular, the existence of internal TLAC provides some comfort that the resolution authority of the resolution entity will not seek to walk away from the subgroup, and a surety that even if it does so, the authorities in the jurisdiction concerned will have some intra-group claims to write-down in their rescue of the subgroup.

6.08  Internal TLAC levels must be between 75 per cent and 90 per cent of the level of TLAC which would apply to the material subgroup if it were a resolution group. In principle the home authority and the host authority should agree on the appropriate level. The objective of this is to facilitate effective cross-border resolution.

6.09  As noted above, TLAC within MPE groups is ‘external’ if it is between resolution groups. In a group where the holding company is a resolution entity but a subsidiary of that entity has also been designated as a resolution entity, TLAC provided by the group holding company to the subsidiary will be regarded as ‘external’ for this purpose—thus the TLAC requirement for the resolution entity subsidiary will be the same as it would have been had the subsidiary been a free-standing entity, and must satisfy the same requirements as to composition.

B.  The Composition of TLAC

Regulatory capital instruments as TLAC

6.10  TLAC requirements may be met either by regulatory capital instruments or by subordinated debt issued for the purpose. However, it does not necessarily follow that all regulatory capital instruments will qualify as TLAC—they will only (p. 96) qualify as TLAC if they can be written down under the relevant law, if the actions of the resolution authority of the relevant resolution group will be recognized, and if the instruments are capable of being written down at the point of non-viability.

6.11  The position as regards capital instruments is, however, complicated by the question of the appropriate issuer. In principle, a TLAC requirement applied to a resolution entity should only be capable of being satisfied by instruments issued by that entity—if the intervention is intended to be only at the level of that entity, then only securities issued by it should be eligible. However, this raises the complex problem of the eligibility for TLAC purposes of capital instruments issued by subsidiaries. These instruments are recognized for capital requirements purposes as eligible capital (subject to some restrictions), and it seems unreasonable to disregard them completely as TLAC.

6.12  The answer which the FSB has proposed to this conundrum is as follows. There will be a transition period up to 1 January 2022 within which capital instruments issued by subsidiaries will be recognized as TLAC. However, thereafter the only capital instruments recognized as TLAC will be CET1 issued by subsidiaries of the resolution entity concerned and certain instruments issued by co-operative banks and others. This means that AT1 and T2 instruments issued by any entity within a resolution group other than the resolution entity at the head of that group will be disregarded for TLAC purposes, although they will continue to count for regulatory capital purposes.

Other instruments as TLAC

6.13  In addition to regulatory capital instruments, certain other instruments are also eligible to be treated as TLAC. For the sake of clarity, the term ‘instrument’ in this context includes loans and other forms of debt, and is not confined to securities. This is set out in principle (viii), which provides that ‘the term “TLAC-eligible instrument” refers to any capital instrument, debt instrument, liability or other item that is eligible as TLAC under the term sheet’. It is also provided in the termsheet that:

Credible ex-ante commitments to recapitalise a G-SIB in resolution … from those authorities which may be required to contribute … to resolution funding costs … and temporary resolution funding may count towards a firm’s Minimum TLAC, subject to the agreement of the relevant authorities … Such commitments must be pre-funded by industry contributions and may account for an amount equivalent to 2.5% RWA toward the resolution entity’s Minimum TLAC when the TLAC RWA Minimum is 16% and for an amount equivalent to 3.5% RWA when the RWA Minimum is 18%.

6.14  The rules relating to the identity of the issuer are the same for TLAC-eligible subordinated debt as they are for capital instruments—ie, apart from CET1 (which can count if issued by subsidiaries of the resolution entity), in order to count as TLAC such debt must be issued by the resolution entity. However, subordinated (p. 97) debt issued out of a wholly owned funding entity prior to 1 January 2022 may also qualify as TLAC provided that both home and host authorities agree.

6.15  The basic requirements for debt to qualify as TLAC are that it must:

  1. (1)  be paid in;

  2. (2)  be unsecured;

  3. (3)  not be subject to set-off or netting rights that would undermine its loss-absorbing capacity in resolution;

  4. (4)  have a minimum remaining contractual maturity of at least one year or be perpetual (ie have no maturity date);

  5. (5)  not be redeemable by the holder within one year of maturity;

  6. (6)  not be funded directly or indirectly by the resolution entity or a related party of the resolution entity (as an exception to this, MPE groups may be permitted to recognize intra-group funding as TLAC where this is consistent with their resolution strategy); and

  7. (7)  be subordinated to certain ‘excluded’ liabilities.2

The last of these requires a few words of explanation. The excluded liabilities for this purpose are:

  1. (a)  insured deposits;

  2. (b)  sight deposits and short-term deposits (ie deposits with original maturity of less than one year);

  3. (c)  liabilities arising from derivatives;

  4. (d)  debt instruments with derivative-linked features, such as structured notes;

  5. (e)  liabilities arising other than through a contract, such as tax liabilities;

  6. (f)  liabilities which are preferred to senior unsecured creditors under the relevant insolvency law; or

  7. (g)  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.

6.16  Most of these—notably term deposits, derivatives, and debt instruments—are simple unsecured creditors, so that in order for an instrument to be subordinated to these it must in practice be subordinated to unsecured creditors generally.

6.17  The basic criterion is that eligible TLAC must be able to absorb losses prior to liabilities excluded from TLAC in insolvency or in resolution without giving rise to material risk of successful legal challenge or valid compensation claims. What (p. 98) this translates to in terms of practical requirements, is that eligible instruments must be:

  1. (1)  contractually subordinated to excluded liabilities on the balance sheet of the resolution entity (‘contractual subordination’);

  2. (2)  junior in the statutory creditor hierarchy to excluded liabilities on the balance sheet of the resolution entity (‘statutory subordination’); or

  3. (3)  issued by a resolution entity which does not have any excluded liabilities (for example a holding company) on its balance sheet that rank pari passu or junior to TLAC-eligible instruments on its balance sheet (‘structural subordination’).

6.18  As noted above, subordination is not required where the laws of the relevant resolution jurisdiction have the effect of excluding all excluded liabilities from bail-in. However, there are some jurisdictions, notably the EU, where although all of these items are not automatically excluded, the resolution authority may, under exceptional circumstances specified in the applicable resolution law, exclude them from bail-in. For these jurisdictions a curious carve-out is provided. Authorities in these jurisdictions may permit unsubordinated debt to count as TLAC up to a value of 3.5 per cent of RWA (2.5 per cent during the phase-in period while the TLAC RWA minimum is 16 per cent). This means that in jurisdictions which take advantage of this concession banks may have two tiers of TLAC, one subordinated to the other.

6.19  TLAC must be capable of being bailed-in by the resolution authorities of the resolution entity. This means that for any resolution entity, its TLAC must be either subject to the governing law of the place of resolution of that entity, or must contain provisions whose effect is that the powers of the resolution entity in that jurisdiction must be effective and enforceable as regards that TLAC. Thus in practice any TLAC must contain a trigger or other mechanism which permits those powers to be exercised.

6.20  It should be clear at this point that the differences between Tier 2 debt and TLAC-eligible subordinated debt are not very great. The major differences between TLAC and Tier 2 are: (a) maturity—Tier 2 must have an initial maturity of at least five years, and begins to attenuate after five years, whereas TLAC qualifies in full up to one year; (b) subordination—Tier 2 must be subordinated to senior liabilities, whereas TLAC need only be subordinated to excluded liabilities; and (c) TLAC may not take the form of a derivative or an instrument embedding a derivative.

6.21  Since Tier 2 debt satisfies all of the conditions for TLAC qualification, Tier 2 paper with a residual maturity of more than one year qualifies as TLAC for the whole of its face value. This means that Tier 2 with less than five years’ maturity continues to amortize as Tier 2 capital, but the amortized balance will still count as TLAC. Thus if Tier 2 paper is allowed to remain in issue with less than five years (p. 99) to run, its contribution to capital will amortize but its contribution to TLAC will remain unchanged.

Internal TLAC

6.22  The core requirements for internal TLAC are the same as for external TLAC, save that internal TLAC may be issued to members of the same corporate group as the resolution entity, provided that it is not held by members of the same resolution group. The biggest issue for internal TLAC is that although the write-down or conversion of TLAC issued by a member of a resolution group is done by the resolution authorities in the member’s jurisdiction, in principle those resolution authorities should not exercise that power without the consent of the home authority of the resolution entity which heads that resolution group.

6.23  Possibly more importantly, it is also provided that an internal TLAC requirement may be met by a collateralized guarantee. The conditions for this are that:

  1. (1)  the guarantee is provided for at least the equivalent amount as the internal TLAC for which it substitutes;

  2. (2)  the collateral backing the guarantee is, following appropriately conservative haircuts, sufficient fully to cover the amount guaranteed;

  3. (3)  the guarantee is drafted in such a way that it does not affect the subsidiaries’ other capital instruments, such as minority interests, from absorbing losses as required by Basel III;

  4. (4)  the collateral backing the guarantee is unencumbered and in particular is not used as collateral to back any other guarantee;

  5. (5)  the collateral has an effective maturity that fulfils the same maturity condition as that for external TLAC; and

  6. (6)  there should be no legal, regulatory, or operational barriers to the transfer of the collateral from the resolution entity to the relevant material subgroup.

C.  Treatment of a Bank’s Holding of Another Bank’s TLAC

6.24  Banks are required to deduct holdings of capital issued by other banks in order to avoid double-counting of capital within the regulatory system. When the requirement for TLAC-eligible subordinated debt was introduced, this posed a difficult question for regulators as to how this should be treated. The FSB wisely left this issue to the Basel Committee on Banking Supervision (BCBS), and eventually the BCBS determined that the position should be approximated to that of Tier 2. However, this threw up a number of difficult questions.

6.25  The first was as to what should be deducted. As regards subordinated instruments this was not difficult—anything which ranked equally with TLAC-eligible subordinated debt was to be deducted, whether it actually constituted TLAC or (p. 100) not—the same treatment as for Tier 2. However, this created a problem for banks in those jurisdictions which wished to take advantage of the concession by which unsubordinated debt could count as TLAC-eligible. If this principle were applied literally, it would result in all of the senior debt of those G-SIBs being deducted from capital of their bank counterparties—an outcome which would have terminated their business.

6.26  The compromise that was arrived at was that G-SIBs which took advantage of this provision should be required to publish the proportion of senior debt which they actually counted as TLAC on a quarterly basis. Their counterparties are then required to deduct from capital that proportion of any senior exposure to that bank. For example, if a G-SIB resolution entity has funding that ranks pari passu with excluded liabilities equal to 50 per cent of RWA and receives partial recognition of these instruments as external TLAC equivalent to 3.5 per cent of RWA, then an investing bank holding such instruments must include 7 per cent (=3.5/50) of such instruments in calculating its TLAC holdings. The same proportion should be applied by the investing bank to any indirect or synthetic investments in instruments ranking pari passu with excluded liabilities and eligible to be recognized as TLAC by virtue of the subordination exemptions.

6.27  This treatment is likely to be a problem for such banks. Unless term debt structures are reconfigured in order to make them ineligible as TLAC, it is likely that any bank holder of any senior exposure to a G-SIB of more than twelve months’ duration will be required to take a small deduction from capital in respect of the exposure, despite the fact that neither he nor the G-SIB concerned has any intention that that exposure should constitute TLAC. This will be made even more difficult by the fact that the easiest way for a G-SIB to ensure that its ordinary senior debt is not TLAC-eligible is to ensure that its maturity is less than twelve months. However the net stable funding ratio (NSFR) rules will require banks to issue more debt at longer maturities, and in particular will push maturities over the twelve-month threshold at which TLAC eligibility (and therefore deduction) becomes a problem. It is too early to say how this will work out, but it seems likely that this fact will operate as a very significant disincentive to banks to avail themselves of the 3.5 per cent senior debt eligibility window.

6.28  The other problem which the BCBS had to deal with was the proper treatment of TLAC-eligible holdings of non-G-SIBs in the hands of G-SIBs. Since the FSB paper only addressed the position of G-SIBs, this was a question which they could and did avoid. Starting from first principles, it seemed fairly clear that, since TLAC-eligible debt is, at its heart, a mechanism for passing debt from a failing bank to the holder of that debt, other banks should be disincentivized from holding that debt. However, the problem then became the question as to how those exposures should be treated. The BCBS concluded that since TLAC-eligible debt is a form of gone concern capital, the treatment should be the same as for (p. 101) Tier 2—the existing gone concern capital regime—and that therefore any bank which held such instruments should deduct that holding from Tier 2 capital. The BCBS was able to dispense with the alternative proposal—of requiring TLAC holdings to be deducted from TLAC—by observing that since only G-SIBs were required to have TLAC under the FSB framework, a ‘deduction from TLAC’ rule would advantage G-SIBs over non-G-SIBs, since non G-SIBs, not having TLAC in issue, would in any event be required to deduct from Tier 2. We will return to this in the context of the EU’s implementation of this rule.

6.29  The upshot of all of this is that the rules for deduction of TLAC are somewhat complex. The starting point is straightforward—TLAC is treated in the same way as Tier 2. Thus the rule that banks must deduct holdings of the capital of other banks where the total value of those holdings (on a net basis) exceeds 10 per cent of the bank’s common equity is extended so that holdings of TLAC-eligible debt are aggregated with other capital holdings for this purpose. However since this rule alone would have put capital pressure on existing banks, a further ‘TLAC bucket’ has been created. For non-G-SIBs this is straightforward—a non-G-SIB may hold TLAC-eligible debt up to 5 per cent of common equity after adjustments. For G-SIBs, the position is more complex.

6.30  It is likely that, given a free hand, regulators would wish to prevent G-SIBs holding the TLAC of other G-SIBs at all, since such holdings create contagion risk between G-SIBs. However, in practice G-SIBs are the primary market makers and sources of liquidity in respect of the capital instruments of other G-SIBs, and the same is expected to be true when the TLAC-eligible debt market develops. There is therefore a concession built into the deduction rules which permits G-SIBs to maintain holdings of other G-SIBs’ TLAC-eligible debt beyond the 10 per cent bucket provided that such holdings are maintained for market-making purposes. This concession is absolutely limited in size to 5 per cent of common equity after adjustments on a gross long basis. The specific criteria which are applied are that a holding falls within this bucket if

  • •  the holding has been designated by the bank for this purpose;

  • •  the holding is in the bank’s trading book;

  • •  the holding is sold within 30 business days of the date of its acquisition; and

  • •  the total of all holdings covered by this exemption is, in aggregate and on a gross long basis, less than 5 per cent of the G-SIB’s common equity after applying all other regulatory adjustments.

6.31  Once a holding has been designated as falling within this exemption, it may not subsequently be included within the 10 per cent exemption. This is designed to limit the use of the trading book allowance to market-making activities.

6.32  Any holding of capital instruments or TLAC instruments which falls outside these exemptions must be deducted. In the case of capital instruments, deduction (p. 102) should be made applying a corresponding deduction approach. This means the deduction should be applied to the same component of capital for which the capital would qualify if it were issued by the bank itself. This deduction is calculated on a proportionate basis. Thus if 20 per cent of an institution’s total holdings of capital instruments and TLAC constitutes CET1, 20 per cent of any excess should be deducted from CET1, and so on. TLAC instruments, however, must be deducted from Tier 2 and not from TLAC.

D.  The EU’s Approach to TLAC—MREL

6.33  At the time of writing, the EU legislation implementing the FSB TLAC requirement is in draft, and the situation as described below may change in the course of its passage through the legislative process. However, whereas the majority of the world has been content to adopt the FSB TLAC structure, the EU proposes to implement it in an idiosyncratic way which repays closer examination.

6.34  The key point here is that whereas the FSB structure is intended to apply only to G-SIBs at the level of resolution entities and significant national subgroups, the EU approach is to apply a cognate of TLAC known as MREL (minimum requirement for eligible liabilities) to all authorized banks and investment firms within the EU regardless of size. There is of course a good argument for this in theory—it is not only G-SIBs that fail, and it is certainly not only G-SIBs that need to be resolvable.

6.35  The EU approach has therefore been to implement two sets of capital requirements—a TLAC requirement, which follows the FSB model, for EU-based G-SIBs, and an MREL requirement, which is a slightly looser version of the TLAC requirement, for all other regulated institutions.3 What this means in practice is that the EU has established two different eligible liabilities calculations, one for G-SIBs and one for other entities. This does not necessarily mean that all EU banks are required to have capital market instruments in issue—it is open to any bank to meet its MREL requirement entirely through equity and other forms of regulatory capital.

6.36  The EU has broadly followed the FSB in implementing the TLAC regime for globally systematically important institutions (G-SIIs). Thus an institution which is both a resolution entity and a member of a G-SIB group (or is a G-SIB in its own right) must satisfy the minimum requirement for regulatory capital and eligible TLAC together to be at least 18 per cent of the firm’s risk-asset ratio and 6.75 per (p. 103) cent leverage ratio. The relevant resolution authority can impose a further requirement on top of this.

6.37  The EU has not adopted the FSB proposal that at least 33 per cent of the total TLAC requirement must be met by debt liabilities (including AT1 and T2), so this requirement may be met entirely with equity.

6.38  For this purpose a ‘resolution entity’ means an EU entity which is identified by the resolution authority in the resolution plan as an entity in respect of which resolution action will be taken. An institution which is a material subsidiary of a G-SIB but is not a resolution entity must maintain TLAC of 90 per cent of this value.

6.39  TLAC is assessed on the basis of both the consolidated situation at the EU parent level and as the sum of the TLAC of all the resolution entities in the group. Where there are multiple resolution entities in a G-SII EU subgroup, a TLAC requirement calculation shall be done at the level of the EU group. If the amount of the consolidated calculation is lower than the sum of the requirements calculated on a resolution entity by resolution entity basis, then the relevant authorities are required to arrange between themselves to eliminate the discrepancies amount of TLAC on a consolidated basis. If the consolidated calculation is higher than the sum of the individual requirements, authorities may (but are not required to) take action to eliminate this difference.

6.40  In addition to subordinated TLAC, the EU has adopted the FSB provision permitting a layer of unsubordinated TLAC (see para 6.26 above). The rule is that, in addition to the instruments identified above, an institution may elect to include, as part of its TLAC, unsubordinated, unpreferred senior debt which satisfies the other conditions for TLAC up to the value of 3.5 per cent of its RWA requirement. In principle this permits ordinary senior debt to satisfy the TLAC requirements up to a limit, but in order to take advantage of this permission, the relevant liabilities must satisfy all of the requirements for TLAC apart from subordination, and not all senior debt will necessarily satisfy all of these—it is hard, for example, to see how unsubordinated debt issued by an institution could satisfy the requirement that it not be subject to set-off or netting, since this is generally automatic in insolvency.

6.41  Institutions have the right to decide whether or not to take advantage of this permission. However, institutions that do will create difficulties for other G-SIBs that hold their senior debt, as discussed below as regards deductions.

6.42  EU Institutions which are part of a non-EU G-SIB but are not resolution entities will be subject to a TLAC requirement of 90 per cent of the requirement to which they would be subject if they were resolution entities. However TLAC issued to third parties will be disregarded in this calculation, with only TLAC issued to the parent undertaking of the G-SIB counting.

(p. 104) Deduction of MREL holdings

6.43  Holdings of TLAC issued by G-SIBs are required to be deducted from own TLAC by EU G-SIBs. This is a departure from the Basel approach, which generally requires TLAC to be deducted from Tier 2 capital. This means that an EU G-SIB that holds the TLAC of another G-SIB is required to deduct that holding from its own TLAC in issue (or, if it has none, from other capital) before assessing its compliance with the minimum requirement. This does not extend to MREL—thus an EU G-SIB can hold the MREL of an EU bank without penalty, and an EU non-G-SIB can hold the TLAC of a G-SIB without penalty.4

6.44  However, EU G-SIBs are not required to deduct holdings of other G-SIBs’ TLAC from their own TLAC where such holdings (a) are held in the banking book and do not exceed 10 per cent of their Common Equity Tier 1, or (b) are held in the trading book and do not exceed 5 per cent of Common Equity Tier 1. This is where the 3.5 per cent permission becomes problematic. If an institution has elected to avail itself of the 3.5 per cent permission, then other G-SIBs are, in principle, required to deduct all instruments which rank pari passu with those instruments from its TLAC. However, this is then mitigated by a formula which permits averaging. Thus, assume that an institution which has 100m of unsubordinated debt chooses to avail itself of the 3.5 per cent permission, and that this results in 50 per cent of that 100m (ie 50m) being included in TLAC. A G-SIB holder of 10m of that debt would be required to deduct 5m (ie 50/100 × 10) from its TLAC. The nuisance value of this for debt trading purposes suggests that banks will be unwilling to avail themselves of the 3.5 per cent concession.

6.45  Outside the EU, holdings of G-SIB TLAC are required to be deducted from Tier 2 by all banks. Thus an EU non-G-SIB bank is in a better position than other banks, since it will be able to hold the TLAC of a G-SIB without deduction. Also, whereas the EU only requires G-SIBs to deduct holdings of each other’s TLAC from their own TLAC, the Basel standard requires all banks (both G-SIBs and non-G-SIBs) to deduct holdings of TLAC from Tier 2. Thus an EU G-SIB will be able to hold the TLAC of other G-SIBs without a reduction of Tier 2 capital, whereas non-EU G-SIBs would suffer a capital reduction. Finally, there is no deduction requirement at all as regards MREL—thus EU G-SIBs are required to deduct holdings of TLAC but not holdings of MREL.

The EU MREL requirement

6.46  The unique element of the EU's implementation of the FSB's recommendation is that it is extended beyond G-SIBs to all EU institutions. The MREL (p. 105) obligation is not an alternative to TLAC—resolution entities in the EU which form part of G-SII groups will be required to hold both TLAC and MREL—but in principle TLAC will always count as MREL, and MREL requirements are unlikely to be higher than TLAC requirements, so that this overlap will have no practical consequences. However, the minimum required level of capital plus TLAC is specified in hard legislation, whereas the setting of MREL is to be left to resolution authorities, so it is not possible to say that one will always be higher or lower than the other. Thus institutions which are part of a G-SII and designated as resolution entities in the EU will be subject to both an MREL and a TLAC requirement.

6.47  The MREL requirements largely mimic the TLAC requirements. However, the criteria for MREL are more permissive than those for TLAC in two important respects. First, TLAC must be subordinated; MREL need not be. Second, TLAC may not take the form of a security with a derivative element, whereas MREL may—thus structured notes with a guaranteed minimum payment count as MREL but not TLAC.

6.48  There are two levels of MREL, one for resolution entities and a lower one for non-resolution entities.

  1. (a)  The basic requirement for resolution entities is a level of MREL sufficient to ensure that the entity could lose all its capital but be restored through bail-in to a position which ensured that it (or its institution subsidiaries) had sufficient capital to meet its regulatory requirements.

  2. (b)  For non-resolution entities, the requirement is the pillar 1 and 2 requirement of the entity plus a recapitalization amount.

Resolution entities must meet the MREL requirement at the level of the consolidated group below that resolution entity. Subsidiary institutions of a resolution entity which are not themselves resolution entities must comply on a solo basis only.

The directive envisages that the MREL requirement not be applied to financial institutions and financial holding companies. A resolution authority ‘may’ decide to apply this requirement to such an entity which is not a resolution entity.

6.49  The requirement for MREL from non-resolution entities can be met in a significantly wider number of ways than for external TLAC. In particular, MREL for a non-resolution institution can be met by liabilities issued to third parties (provided that the amounts involved are not so large that a bail-in would result in de-grouping) or a guarantee from the resolution entity to the institution which is collateralized to at least 50 per cent of its eligible amount with high-quality collateral. Further, a national resolution authority can waive this completely where the resolution entity and the subsidiary are in the same member state.

(p. 106) 6.50  In addition, non-EU G-SIB groups will be required to implement a holding company structure over their EU businesses.5 This holding company can be either a financial institution or an institution. The question in both cases is whether that holding company will be designated as a resolution entity or not. Given that the preamble to the relevant draft legislation speaks of this measure as intended to ‘simplify and strengthen the resolution process of third-country groups with significant activities in the EU’, the most likely outcome is that these holding companies will be deemed to be resolution entities. Thus a holding company which holds the EU activities of a G-SII is likely to be required to comply with TLAC requirements on a consolidated basis.

The EU subordination mechanism

6.51  A further EU legislative proposal is aimed at facilitating the issuance of subordinated debt securities in countries where the local legal system makes the creation of such securities difficult.

6.52  The basic requirement that TLAC be free-standing and not subject to set-offs or counterclaims has been relatively easily met by US banks, which generally issue out of their holding companies—since such holding companies generally have no creditors (ie are ‘empty’) the set-off point does not arise, since there are no creditors to set-off. However, for an entity looking to issue out of a bank, the problem is more difficult and can generally only be solved by subordinating the TLAC instruments (since a creditor cannot set-off a senior claim against a subordinated obligation). However, many EU banks do not have holding companies, and company law in some European countries makes it extremely difficult to create such entities. As a result, various countries have enacted national legislation whose effect is to subordinate certain debt issued by banks, thereby ensuring that that debt can be bailed-in without counterclaim in the event of a resolution. This legislation was created in a relatively uncoordinated fashion, and the resulting confusion is perceived by the European Commission as potentially damaging the position of European banks in the debt markets.

6.53  As a result, it is proposed that the relevant legislation (Art 108 of the Bank Resolution and Recovery Directive) be amended to vary the distribution of assets on the insolvency of an institution. The proposal is that certain debt instruments with an initial maturity of more than one year and with no derivative features should be able to ‘opt down’ to subordinated status. Linguistically this is achieved by making all debts preferred apart from these debts, which are designated ‘non-preferred senior’. However, it should be noted that this is not a hard rule—a debt instrument is only ‘senior non-preferred’ if its contractual documentation (p. 107) explicitly claims that status. Thus banks may have preferred debt instruments in issue as well as non-preferred debt instruments.

6.54  Art 108 will be able to be opted into on a security-by-security basis—it will only apply to an instrument whose terms explicitly reference it. Consequently it will be possible for EU banks to issue securities which are subordinated by reference to Art 108 alongside equivalent securities which do not. The section does not, however, explicitly vary insolvency set-off, so the question of whether securities issued referencing the Art 108 mechanism will be available to be set-off in insolvency against ordinary claims by the issuer will remain to be addressed country-by-country by national insolvency legislation.(p. 108)


1  The FSB’s TLAC requirements are set out in the ‘Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution and Total Loss-absorbing Capacity (TLAC) Termsheet’ of 9 November 2015. This document, accompanied by the Basel Standard—TLAC Holdings of October 2016 sets out the basis of the TLAC regime.

2  The requirement for subordination is dispensed with in two cases. One is if there are minimal eligible liabilities in the institution—for this purpose minimal means less than 5 per cent of the resolution entity’s external TLAC. The other is if all of the excluded liabilities are excluded from bail-in under the law applicable to the resolution entity, in which case there would be no need for it.

3  Note that the EU, for historical reasons, applies the Basel bank regulatory scheme to all regulated entities, including some non-bank investment firms, and consequently is careful to express the regime to G-SIIs (global systematically important institutions) as well as G-SIBs.

4  As at the time of writing—it is entirely possible that this will be changed in the course of the passage of the legislation.

5  Again, at the time of writing this is currently a legislative proposal rather than enacted legislation, and may change during the enactment process.