The future of MREL

In this latest banking reform updater, we discuss the international standard set by the Financial Stability Board (‘FSB’) regarding Total Loss Absorbing Capacity (‘TLAC’) and its European counterpart, the Minimum Requirement for Own Funds and Eligible Liabilities (‘MREL’) together with the European Banking Authority’s (‘EBA’) October 2017 opinion on the UK’s departure from the EU.

In November 2015, the Financial Stability Board (‘FSB’) published its final TLAC standard for global-systemically important banks (‘G-SIBS’). Importantly, the standard is not a legally binding requirement, rather a political commitment from G20 members. Essentially, TLAC is a minimum requirement on the liabilities side of G-SIB balance sheets. It absorbs losses and recapitalises failed G-SIBs or their successors in resolution. The standard requires G-SIBs to hold minimum levels of loss-absorbing capital consisting of an external fixed minimum (Pillar 1) TLAC requirement (which can largely be comprised of Tier 1 and Tier 2 regulatory capital instruments and long term unsecured debt) of 16 – 18% of risk weighted assets and at least 6 – 6.75% of the Basel III leverage ratio denominator (excluding capital held for the purposes of meeting the Basel III buffer requirements), plus a firm-specific (Pillar 2) requirement. The standard applies from 1 January 2019 and is subject to phase in provisions.

Whilst TLAC and MREL cover the same objectives (continuity of critical functions and an orderly wind-down / restructuring) they do differ and part of the reason for this is that MREL was already enshrined in the EU Bank Recovery and Resolution Directive (‘BRRD’) before the TLAC standard was finalised. Whilst TLAC is explicitly designed for G-SIBs, MREL is much broader in its application, being aimed at all European institutions within the scope of the BRRD. The MREL calculation is also different when compared to the TLAC standard, being the amount of own funds and eligible liabilities expressed as a percentage of the total liabilities and own funds of the institution. MREL is set by the Member State resolution authority on an institution-by-institution basis, depending on preferred resolution strategy. Whilst there is no minimum level of MREL, the BRRD sets out criteria which the resolution authority must consider when setting it. The criteria are further described in European Commission Delegated Regulation (EU) 2016/1450 (the ‘MREL RTS’).

Following a public consultation in the summer of 2016, the EBA submitted a final report on the implementation of MREL to the European Commission (‘Commission’) in December 2016. In its report, the EBA recommended certain changes to MREL in order to improve its technical soundness and implement the TLAC standard as an integral component of the MREL framework.

Shortly before the release of the EBA’s final report, the Commission issued a package of legislative proposals in November 2016 which, among other things, sought to merge the TLAC standard into MREL where it is applied to G-SIBs. Among other things the Commission’s proposals sought to amend the BRRD, the EU Capital Requirements Regulation (‘CRR’), the Capital Requirements Directive IV (‘CRD IV’) and the EU Regulation establishing the Single Supervisory Mechanism (the proposals are therefore referred to as ‘BRRD II’, ‘CRR II’, and ‘CRD V’). The proposals are generally in line with the EBA’s views, including provisions that common equity tier 1 capital (‘CET 1’) used to meet MREL should not be double counted towards meeting capital buffers (i.e. the prevention of double stacking), and that resolution authorities be given the power to waive the application of Article 55 BRRD (contractual recognition of bail-in) for certain instruments where it would be impractical for such a requirement to apply. These proposals are still being negotiated by the EU institutions in trialogue (see below).

The main provisions implementing TLAC into EU legislation, in particular the new ‘Pillar 1 MREL’ requirement for G-SIIs are being introduced by CRR II and CRD V. This new requirement is based on both risk-based and non-risk-based denominators and applies only in the case of G-SIIs. The CRR is amended to require stand-alone G-SIIs that are resolution entities to comply with the MREL requirement on a solo basis, whilst another set of amendments to the CRR require resolution entities that are part of groups designated as G-SIIs to comply with the requirement for own funds and eligible liabilities on a consolidated basis. A new chapter on eligible liabilities is also introduced into the CRR which includes the list of excluded liabilities and eligibility criteria as well as deduction rules for TLAC holdings of other G-SIIs. A new article in the CRD IV restricts the concept of ‘Pillar 2 capital’ to covering micro-prudential risks; in particular Member State supervisors cannot impose additional own funds to cover macro-prudential or systemic risk. Another new article is introduced dealing with the concept of ‘capital guidance’ beyond minimum capital requirements and capital buffers.

The proposed amendments to the BRRD seek to align the current MREL requirements with the TLAC standard and make certain other technical amendments. Among other things the amendments introduce the concepts of ‘resolution entities’ and ‘resolution groups’ which derive from the same terms as used in the TLAC standard. These allow for two principal resolution strategies to be used, Single Point of Entry and Multiple Point of Entry, which are given effect by resolution entities (other than the group parent) issuing either internal or external MREL (respectively). The table below¹ sets out the major changes to the MREL framework per the Commission’s legislative proposals, which are closely aligned with TLAC.

At the time of writing this updater we have not yet seen any compromise drafts of the EU legislation from the Presidency of the Council of the EU². The Commission’s preferred deadline for the European Parliament and the Council of the EU to reach political agreement on the legislation is mid-2018, thereby giving at least six months before the amendments become effective on 1 January 2019.

In terms of recent developments, the European Central Bank (‘ECB’) issued an opinion on the proposed revisions to the EU crisis management framework on 8 November 2017. This included comments on the implementation of TLAC in the EU and amendments to MREL. There is insufficient space in this updater to cover every proposal made by the ECB but it is worth noting that the ECB proposed a minimum transition period for MREL implementation with Member State resolution authorities being given the flexibility to determine a longer transitional period on a case-by-case basis.

Following the 2008 global financial crisis the United Kingdom (‘UK’) was the global leader in implementing a statutory resolution regime³. Further amendments were subsequently made to this regime in order to transpose the BRRD into UK law. In relation to the UK’s MREL requirements the Bank of England (the ‘Bank’) sets this requirement for each in-scope UK institution in line with the UK’s implementation of the BRRD and the MREL RTS (which being a Regulation is directly applicable in Member States).

The Bank’s Statement of Policy (published in November 2016) describes the general framework that it uses when setting MREL. In relation to an institution’s baseline MREL, the Bank states that this will be calculated as the sum of two components:

1. a loss absorption amount which is equal to an institution’s minimum capital requirements to absorb losses; and
2. (where needed) a recapitalisation amount, the amount that the Bank considers necessary to recapitalise the institution back to a level necessary to enable it to continue to meet the conditions for authorisation and command market confidence.

The Statement of Policy goes on to confirm that the Bank sets MREL for individual institutions by reference to three broad resolution strategies:

• modified insolvency: the Bank would expect to set the recapitalisation component to zero. This would mean that an institution’s MREL would be set at a level equal to its capital requirements excluding buffers. This strategy would tend to be used for smaller institutions that do not provide significant amounts of transactional banking services or other critical economic functions;
• partial transfer: the Bank would adjust the recapitalisation amount of MREL in accordance with the proportion of the institution’s balance sheet that the resolution plan envisages would be transferred. The strategy would generally be used for institutions that may feasibly transfer critical economic functions; and
• bail-in: the Bank believes that a bail-in resolution strategy would most likely be appropriate for large complex institutions, those with balance sheets above £25 billion or smaller institutions where transfer is not feasible. Such institutions would be required to hold capital sufficient to recapitalise their whole balance sheet. The Bank also expects such institutions to ensure that their MREL resources are subordinated to operating liabilities, using structural subordination (except for building societies which may use contractual subordination).

Supervisory Statement 16/16: The minimum requirement for own funds and eligible liabilities (MREL) – buffers and Threshold Conditions (‘SS16/16’), published by the Prudential Regulation Authority (‘PRA’), should be read in conjunction with the Bank’s Statement of Policy. This sets out the relationship between MREL and both capital and leverage ratio buffers, as well as the implications that a breach of MREL would have for the PRA’s consideration of whether a firm is failing, or likely to fail, to satisfy the Threshold Conditions.

The deadline for responding to the PRA’s summer 2017 consultation on MREL and buffers (Consultation Paper 15/17) has recently passed (29 September 2017). In this consultation the PRA set out its proposed expectations on the relationship between MREL and capital buffer requirements, as well as the consequences of not meeting these. When finalised, these proposals will lead to the PRA making changes to SS16/16. The PRA stated in its consultation paper that it would aim to publish an updated version of SS16/16 before the end of this year.

On 2 October 2017, the Bank issued a consultation seeking to amend the Statement of Policy. The Statement of Policy currently focuses on external MREL whereas the consultation is seeking views on internal MREL. Specifically, the Bank sought views on:

• the scope of internal MREL;
• the calibration of internal MREL;
• the criteria that instruments should meet to qualify as internal MREL resources; and
• transitional arrangements for internal MREL.

The consultation also sets out the Bank’s current thinking on other MREL-related issues: restrictions on firms’ ability to hold each other’s MREL, the disclosure of MREL resources by firms and MREL reporting. The deadline for comments on the consultation is 2 January 2018. The Bank states that it intends to consult further once there is more clarity on the development of the draft EU legislation.

In February 2017, the House of Commons' European Scrutiny Committee published its thirty-second report of the 2016-17 Parliamentary session. Among other things the report considered that the Commission’s proposals to amend MREL did not align with the TLAC standard. Rectifying this would be one of the UK Government’s key priorities in working groups. The UK Government also envisaged that the final legislative adoption of the package would take place no earlier than late 2018 or early 2019.

One additional important development has been the EBA’s October 2017 opinion on issues related to the UK’s departure from the EU. The EBA’s opinion states that institutions that wish to issue new MREL-eligible instruments under English law should at a minimum include clauses in their relevant contracts recognising the eligibility of those instruments to be subject to the write-down and conversion powers of EU resolution authorities. As an alternative to issuing such instruments under English law, the EBA suggested that institutions may issue the instruments under EU27 law. To the extent that institutions’ existing stock of MREL-eligible liabilities are governed by English law, the EBA states that unless EU27 resolution authorities are satisfied that their powers would be given effect in respect of English law contracts, for instance through statutory recognition of their resolution actions by the UK, they should engage with the institutions concerned to replace or renegotiate the contracts to include bail-in recognition clauses. This proposal would have a significant commercial impact, though is tempered by the suggestion that this should only be followed where a material proportion of an institution’s existing MREL-eligible liabilities are issued under English law, and, further accounting for proportionality considerations, having regard to the duration of the contracts in question. The EBA also stated that EU27 resolution authorities should aim to ensure that non-MREL liabilities issued under English law that might be subject to bail-in as part of the resolution action for an institution can also credibly be written down or converted through the inclusion of recognition clauses, unless they can be otherwise satisfied that their resolution powers be given effect in respect of English law contracts.

The UK could give statutory recognition to the actions of resolution authorities in Europe although so far we have not seen any commentary from the UK Government or the Bank confirming whether this will be the case. However, the UK’s resolution regime already envisages the Bank, PRA and Financial Conduct Authority implementing non-binding co-operation agreements with third countries. The BRRD contains equivalent provisions which the EBA notes could be relied upon though this would need the approval of EU authorities.

At the very least one would expect that the UK and EU will address this matter in any transitional deal (absent any formal agreement for the future relationship) to preserve the status quo once the UK leaves the EU. An alternative approach would be the creation of a general provision in UK law automatically amending such agreements. Generally speaking, this issue is an important component of a much bigger issue concerning how the UK regulator will treat UK branches of EU banks and the EU regulators treating EU branches of UK banks. The recent statement by the ECB regarding the progress of banks’ preparation for Brexit and in-country resources expectations is clearly part of that overall discussion.