The second pillar of the Banking Union

The second pillar of the Banking Union

The supervisory playing field expanded to include a new referee in January, and has left many to ask the question: who is the referee for European banks?

Partner, ECB Office, Lead for Deal Advisory

KPMG in Germany

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With Euro 2016 upon us, it is a good time to ask: who is the referee for European banks?
Six months ago, the answer was clear: the Single Supervision Mechanism (SSM), hosted by the ECB in Frankfurt. But since January, a second referee is on the pitch: the Single Resolution Board (SRB), an EU authority based in Brussels. 

What is the SRB’s remit?

The SRB is the Eurozone’s new Resolution Authority. Its stated mission is to “ensure an orderly resolution of failing banks with minimum impact on the real economy and on public finances of the participating Member States and beyond”.
As Elke Konig, the SRB Chair, commented in a 2016 speech: “By avoiding bail-outs and worst-case scenarios, the SRB will put the banking sector on a sounder footing”.

How can this be achieved?

The SRB oversees a new regime, underpinned by the Bank Recovery & Resolution Directive (BRRD), whereby instead of distressed banks being ‘bailed-out’ by the state (as were over 100 European banks in 2008-2013), investors will now be ‘bailed-in’. This new regime became effective on 1 January 2016.

Eurozone banks are now required to prepare Resolution Plans (similar to US ‘Living Wills’), setting out their business model, the critical functions they provide to the economy and how they would be resolved in distress (‘the Resolution scheme’). The equity for implementing resolution will come from:

  • The write-off of existing equity
  • The bail-in of eligible liabilities (conversion of debt to equity)
  • Support from the Single Resolution Fund (where conditions are met)
  • State Aid, as a last resort.

Importantly, liquidity in resolution should come only from private sources and banks are not allowed in their Resolution Plans to assume receipt of Emergency Liquidity Assistance (ELA) from the ECB.
 

SRB work-plan 2016

The SRB’s work plan for 2016 (its first full year of operation) is to review/approve Resolution Plans and also to set each banks’ Minimum Requirements for Eligible Liabilities (MREL).  It does this for all the 128 directly supervised SSM banks and 15 additional cross border groups. 

What is MREL and what is the minimum level?

These are surprisingly difficult questions.

At a high level, MREL comprises a bank’s existing equity and its bail-in capable debts. More precisely: Eligible Liabilities have been defined in a European Commission delegated Act, in May 2016. This being said, the Act is pending adoption and in practice gives the SRB some discretion to decide case-by-case what is included.

The minimum level of MREL, if banks want access to resolution funds in resolution, is 8%. This is expressed as a percentage of total liabilities and own funds. The SRB is able to set MREL above this 8% level at its discretion, based on factors set out in BRRD (Article 45). It can also set a lower MREL target, if a bank is expected to be liquidated rather than resolved in distress, as in this scenario the bank would not require ‘fresh’ equity after its original equity has been written off.

Interestingly BRRD stipulates that liquidation, rather than resolution, should be the default strategy for failing banks unless they perform Critical Functions for the wider economy. In practice, most do, so resolution is the de-facto default.
 

MREL and TLAC

The lack of a concrete definition of MREL is further complicated by the EC’s commitment to harmonize MREL with TLAC (Total Loss Absorbing Capital) for G-SIB banks. TLAC is a global standard, set by the G20 Financial Stability Board.

TLAC is expressed as a percentage of RWAs (like CET1), whereas MREL is a percentage of total liabilities and own funds. TLAC is also a ‘Pillar 1’ requirement, whereas MREL is ‘Pillar 2’. Aligning both is therefore not straightforward, even if the objectives of both sets of requirements are aligned.
 

Issuing MREL / TLAC debt

Most banks supervised by the SRB will need to issue additional bail-in capable debt to comply with MREL / TLAC. However, they are understandably reticent to make such issuances while there is a risk of requirements changing.

This is causing nervousness for the SRB and its chairperson Elke Konig told banks in a recent speech (14 June 2016) “We are aware the European Commission has started work on how to implement TLAC into European Law, but that is not a reason to sit back and wait until they have finalized this work, because we have to set MREL now… we could all agree that the day before you enter resolution is not the day you can issue bail-inable debt. If you don’t have it when you are alive, you won’t have it when you are dying”. (Speech to European Financial Congress)

Banks are under pressure to issue debt, and start-paying the risk premium investors require on this, even before the MREL definition or amount is fully known.

In a low-yield, low-profit environment, this can be a costly demand.
 

Weighing the importance of the SRB

Who will be the more demanding of the European bank referees?

In terms of intrusiveness and data requirements, the answer is clear: it will remain the SSM (ECB), not least because the SRB agreed in a December 2015 memorandum of understanding to receive most of the information required for its resolution work directly from the SSM. Remaining in the ‘background’ will also help the SRB not to spark unnecessary panic.

From a capital perspective, however, an 8% or higher MREL requirement will be the ‘biting’ constraint for many banks, particularly if they have low existing CET1 leverage ratios. This will particularly apply to banks with low average risk weights for whom a CET1 ratio of (e.g.) 10% might only equate to a 3% leverage ratio. For such banks, the SRB could impact their liability structure and profitability more than the SSM.
 

Regulatory challenges

KPMG’s Financial Services Regulatory Centers of Excellence can provide insights into the implications of the raft of regulatory change.

 
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