Resolution mechanisms and funds in focus

EC launches consultation on the contributions of credit institutions to resolution fund: On 20 June the European Commission launched a consultation on the contributions of credit institutions to resolution financing arrangements under the Bank Recovery & Resolution Directive (BRRD) and the Single Resolution Fund (SRF) for the Banking Union.

In the banking union, the national resolution funds set up under the BRRD as of 1 January 2015 will be replaced by the Single Resolution Fund as of 1 January 2016 and those funds will be pooled together gradually. The amount that individual credit institutions will have to pay will depend on the bank’s size and risk profile. The risk adjustment of individual contributions in proportion to the risk profile of institutions is based on criteria set out in the Bank Recovery & Resolution Directive but these criteria have to be specified in greater detail by the Commission in a delegated act. The consultation covers (1) calculation of contributions, (2) application of the principle of proportionality, (3) weight of the flat contribution versus risk adjusted contribution and (4) Individual risk indicators. The answers to the public consultation will contribute to the Commission’s proposals.

BCBS publishes consultation on supervisory guidelines for dealing with weak banks: On 18 June the Basel Committee on Banking Supervision published for comment a consultative document on the supervisory guidelines for identifying and dealing with weak banks. The revised guidelines aim to provide a toolkit for authorities to identify weak banks early and deal with them in an effective manner. Key changes include: (1) emphasising the need for early intervention and the use of recovery and resolution tools, and updating supervisory communication policies for distressed banks; (2) providing further guidance for improving supervisory processes, such as incorporating macroprudential assessments, stress testing and business model analysis, and reinforcing the importance of sound corporate governance at banks; (3) highlighting the issues of liquidity shortfalls, excessive concentrations, misaligned compensation and inadequate risk management; and (4) expanding guidelines for information-sharing and cooperation among relevant authorities. The consultation closes on 19 September.

Eurogroup reaches political agreement on the direct bank recapitalisation instrument: The president of the Eurogroup on 10 June announced that euro area member states had reached a political agreement regarding the operational framework of the European Stability Mechanism (ESM) direct recapitalisation instrument. Following the relevant national procedures and the formal adoption by the ESM board of governors, it is expected that the instrument will be added to the toolkit of the ESM by the start of the Single Supervisory Mechanism (SSM) supervision in November. This new tool may be activated in case a bank is unable to attract sufficient capital from private sources and if the ESM member concerned is unable to recapitalise it. In a transitional period, which will be in place until 31 December 2015, a bail-in of 8% of all liabilities will be a precondition for using the instrument, along with use of the resources available in the ESM member’s national resolution fund. Starting from 1 January 2016, bail-in in line with the rules of the Bank Recovery & Resolution Directive will be required. With a Eu60bn maximum recapitalisation capacity, this new instrument will serve as another important pillar of the Banking Union.

SSM to use Pillar 2 to enforce the results of the comprehensive assessment: On 23 May Sabine Lautenschläger, member of the executive board of the ECB, gave a speech in Madrid on the comprehensive assessment in which she said that the SSM will likely incorporate the outcome of the assessment into the yearly Pillar 2 decision, which will enable the common regulator to use the related range of instruments. These include quantitative measures, including restrictions on the distribution of dividends, limitation or even prohibition of bonus payments, prohibition of credit lending and limitations on opening up new business areas, and a number of qualitative measures (addressing management and reporting issues, for example), internal controls and risk management practices.

Member states sign SRF Intergovernmental Agreement: On 21 May 26 member states (all EU member states except Sweden and the UK) signed the Intergovernmental Agreement (IGA) on the transfer and mutualisation of contributions to the SRF, an essential part of the Single Resolution Mechanism (SRM) and a part of the overall compromise reached by the member states and the European Parliament on the Banking Union. In order to become law, the Council must formally adopt the SRM regulation.

• Content: Under the IGA, the SRF will be built up over eight years, reaching a target level of at least 1% of the amount of covered deposits of all credit institutions authorised in all the participating member states. It is estimated that this will amount to about Eu55bn. Contributions by banks raised at national level will be transferred to the SRF, which will initially consist of compartments corresponding to each contracting party. These will be gradually merged over the eight year transitional phase. This mutualisation of paid-in funds will be front-loaded, starting with 40% in the first year and a further 20% in the second year, and continuously increasing by equal amounts over the subsequent six years until the SRF is fully mutualised. The individual contribution of each bank will be calculated pro rata to the amount of its liabilities (excluding own funds and covered deposits) with respect to the aggregate liabilities (excluding own funds and covered deposits) of all the institutions authorised in the participating member states. Contributions will be adjusted in proportion to the risk profile of each institution;
• Next steps: The SRM will enter into force on 1 January 2015 once published in the Official Journal, whereas the transfers of banks’ contribution to the SRF will start from 1 January 2016. The European Commission will adopt in the coming months a proposal for a Council implementing act on the banks’ contributions to the SRF, which will specify the calculation methodology of the contributions. The act will have to be discussed and adopted by the Council.

EC presents a first comprehensive review of the EU’s reform agenda: The European Commission published on 15 May a first comprehensive review of the financial regulation agenda as a whole. The package includes “A reformed financial sector for Europe”, a Commission Communication, accompanied by a detailed economic review explaining how the reforms reshape the financial sector and the resulting benefits. The communication recalls the objectives that guided the Commission, presents an overview of the reforms it proposed, and takes stock of the key effects that can already be observed today.

Giegold responds to Constâncio over bail-in rules application: A speech by European Central Bank (ECB) vice-president Vítor Constâncio at an OeNB Economics Conference in Vienna on 12 May included the following: “It is worth mentioning that the BRRD rules about bail-in enter into force only in January 2016. They will therefore not apply to the recapitalisations in the context of the Comprehensive Assessment that the ECB is conducting and to be implemented this year and the next. The bail-in rules that will then be in place stem only from the European Commission’s communication on “State Aid rules to support measures in favour of banks in the context of the financial crisis” of July 2013, which establishes that any public support to banks considered as State Aid should be preceded by bail-in of bank shares, capital hybrids and subordinated debt. The text contemplates that exceptions ‘can be made where implementing such measures would endanger financial stability or lead to disproportionate results’. For specific cases at the end of the Comprehensive Assessment, it may be adequate to invoke such principles.” The speech generated controversy at European levels. MEP Sven Giegold said to Bloomberg that “what the ECB is asking for is a new wave of banking recapitalisations by the state, which is from my perspective scandalous”.

Council officially adopts BRRD: On 6 May the Council adopted a directive harmonising national rules on bank recovery and resolution. Member states have until 31 December to transpose it into national law.

European Commission adopts 2 RTS, 3 ITS and releases state of play: The European Commission on 4 June adopted two new sets of Regulatory Technical Standards (RTS) (Geographical location of a relevant credit exposure and Passporting notifications) and three new sets of Implementing Technical Standards (ITS) (Information Exchange, Supervisory practices relating to the securitisation retention rules, and Supervisory disclosure). In addition, a state of play document has been released for both types of standards submitted to the Commission for endorsement.

ECB

SSM Framework Regulation: The ECB published the SSM Framework Regulation for the SSM on 25 April. The document lays the basis for the work of the SSM when it takes over as supervisor of euro area banks in November 2014. The identification of significant banks, which will be subject to ECB direct supervision, will take place according to criteria set out in the SSM Council Regulation and further developed in the SSM Framework Regulation, with the result announced in September.

Eligible instruments to cover capital shortfalls: The European Banking Authority (EBA) released on 29 April the methodology and macroeconomic scenarios for the EU-wide stress test, which include the key features of the common methodology and the design of the adverse scenario. Following the EBA announcement, the ECB has communicated on how capital shortfalls must be addressed by banks following the comprehensive assessment. According to the Note on the comprehensive assessment, if a bank’s capital ratio falls short of the relevant thresholds (8% transitional Common Equity Tier 1 (CET1) for the Asset Quality Review (AQR) and the baseline scenario, 5.5% transitional CET1 for the adverse scenario), it will be requested to take remedial actions within six months for the shortfalls identified in the AQR or the baseline stress test scenario, and within nine months for those identified in the adverse scenario, starting from the release of the results (in October). Capital plans will have to detail how the shortfalls will be covered, with the only eligible instruments being the following:

• AQR and Baseline scenario: CET1 instruments;
• Adverse scenario: CET1 and/or Additional Tier 1 (AT1) instruments

The use of AT1s is limited to the following (as a percentage of overall Risk-Weighted Assets (RWAs)):

• instruments with a trigger below 5.5% CET1: 0%
• instruments with a trigger at or above 5.5% CET1 and below 6% CET1: up to 0.25%;
• instruments with a trigger at or above 5.5% CET1 and below 7% CET1: up to 0.5%;
• instruments with a trigger at or above 7% CET1: up to 1%

Tier 2s with a high trigger (>5.5% CET1) seem to have been excluded from the eligible instruments. However, the EBA has also updated the FAQ on the stress test, and changed the section on capital definition to add a new paragraph, which hints at a degree of discretion from national regulators:

“While CET1 is the only eligible capital for covering stress test losses, banks are also required to report Additional Tier 1 (AT1) and Tier 2 (T2) instruments that convert (or are written down) if CET1 ratio after the stress falls below the trigger level of these instruments. Since the supervisory reactions rest in the hands of national competent authorities, CAs [competent authorities] will decide how to consider this in their reaction functions”.

The ECB note also clarified the treatment for the following securities:

1. Existing convertible instruments that are subject to unconditional pre-defined conversion into CET1 within the stress test horizon are recognised without limitation for the coverage of shortfalls, as long as (i) a certain and mandatory conversion will take place at a fixed date, (ii) these instruments cannot be redeemed before the conversion date and (iii) there is no uncertainty regarding the conversion into CET1; and
2. State aid instruments used by member states (Cyprus, Greece, Ireland and Portugal) in the context of financial assistance programmes are recognised without limitations for the coverage of capital shortfalls in adverse stress test scenarios. For other SSM member states, the grandfathering of state aid instruments provided by the Capital Requirements Regulation (CRR) applies.

EBA Clarifications

Reiterates Q&A 2013_15 principle: The EBA added two new relevant answers to the Single Rulebook Q&A on 20 June:

• Tier 2 instruments [2013_314]: The impact of a buyback on the calculation of the regulatory amortisation amount for a Tier 2 instrument was clarified. According to the authority, should a portion of the nominal amount of the original instrument be reimbursed, the remaining amount becomes the revised nominal amount of what should be considered as a new instrument, and thus the base for calculating the amortisation;
• Q&A 2013_15 principle [2013_50]: Due to the existence of an incentive to redeem, Tier 1 instruments for which the institution was able to exercise a call with an incentive to redeem only prior to or on 31 December 2011, where no call was exercised and when the instrument is not eligible under Article 52 of CRR, would not meet the eligibility criteria for inclusion in fully eligible Tier 2 capital. The answer confirms the principle reported under 2013_15: the fact that the instrument is not called does not mean that the instrument may be reclassified as an instrument without an incentive to redeem.

Three new questions related to own funds were added to the (also recently revised) Single Rulebook Q&A by the EBA in early June:

• Own funds: Buffers [2013_173]: The EBA clarified that the rules in Art 131 (16 and 17) of CRD (Capital Requirements Directive) IV emphasise that buffers imposed on the group should not be taken as a reason for reducing buffers imposed individually on the group’s subsidiaries and sub-groups, and do not mean that the decision of the home regulator as regards the combined buffer requirement (CBR) of the group could effectively introduce a floor for subsidiaries.
• Own funds: Grandfathering [2013_220]: The exchange of a Tier 1 instrument for bonds that have similar provisions but a different issuer would be considered by the EBA as a new issuance. Moreover, if the new instrument is issued after 31 December 2011, even if the exchange offer has been launched prior to 31 December 2011, grandfathering provisions laid down in Article 484 of the CRR would not be applicable.
• Own funds: Grandfathering [2014_1071]: The EBA confirmed that answer 2013_16 (“a material change in the terms and conditions of a pre-existing instrument shall be considered in the same way as the issuance of a new instrument”) still applies, and can include cases where these changes have been imposed by an external party (e.g. court ruling following a litigation). In order for the amended instrument to be reported as fully compliant within a lower own funds category, it would need to meet all CRR eligibility criteria for that category (in particular the absence of incentives to redeem).

Legacy CET1 instruments under the CRR

• 2013_408: A contract with the 100% mother company of an institution according to which distributable profits of the subsidiary need to be fully distributed to the mother company at the end of each year and losses of the subsidiary are to be compensated in full by the mother company would breach Article 28(1)(h) of CRR. The latter specifically prohibits CET1 instruments from including any obligation for the institution to make distributions, to ensure that the issuer has full discretion over the payment of dividends so that the institution can retain capital as necessary to be regarded as an obligation hindering eligibility of the instrument as CET1.
• 2013_541: A profit and loss transfer arrangement between the majority shareholder and the credit institution, which results in a contractual obligation of the majority shareholder of the credit institution to pay a fixed compensation to the minority shareholder of the credit institution, does not meet the requirement of Art. 28(1)(i) of CRR. The latter states that CET1 instruments must absorb the first and proportionately greatest share of losses as they occur, and each instrument absorbs losses to the same degree as all other CET1 instruments. Such a profit and loss transfer arrangement could also result in an obligation on the credit institution to pay distributions if this is required to maintain the fixed compensation payment to the minority shareholder, which would be non-compliant with Article 28(1)(h) of the CRR.

Implications of the supervisory permission to reduce own funds: Questioned over the use of retained earnings as capital replacement, the EBA responded that retained earnings or other CET1, Additional Tier 1 or Tier 2 items that are documented within the own funds planning of the institution are not sufficient to meet the requirement of Article 78 (1)(a) of the CRR, but it would be required by the institution to issue a new own funds instrument to investors. However, the answer did not change the interpretation of provision of Article 78(1)(b) of the CRR.

Grandfathering clarification, but uncertainty remains over pari passu legacy issues: The EBA clarified a number of open issues with regard to the grandfathering of legacy Tier 1 instruments in response to question 2013_542 on 28 May:

• First, the EBA confirmed that grandfathered instruments may include terms according to which the distribution would be cancelled if the institution does not make a distribution on another capital instrument, without that being regarded as interfering with the flexibility of payments required for fully eligible instruments. The same would apply to instruments with or without step-ups. This is due to the fact that grandfathered instruments are not subject to the requirements that apply to capital instruments that are fully eligible in their own right;
• However, when questioned whether an Additional Tier 1 included in the list of pari passu bonds under the terms of legacy Tier 1 would not be eligible due to the presence of pusher provisions, the EBA did not confirm the view, the reasoning being the same as above. However, this does not explain whether the same is true for legacy Tier 1 reclassified as fully-compliant Tier 2 at the end of the transitional period.

Consultation on technical standards on assessment methodologies for the use of advanced measurement approaches for operational risk: On 12 June the EBA published a consultation on draft RTS assessing the criteria that competent authorities need to consider before granting institutions permission to use advanced measurement approaches (AMA) for calculating their capital requirements for operational risk. These RTS will form part of the Single Rulebook aimed at enhancing regulatory harmonisation in the banking sector in the EU. The draft RTS detail the assessment methodology to be used by competent authorities for operational risk AMA models and also clarify the scope of operational risk and operational loss. These RTS form part of the overall review of internal models undertaken by the EBA and show progress in the harmonisation of practices for the approval of internal models. This consultation runs until 12 September.

Comparability of RWA for residential mortgages: The report, published on 11 June and the second on the topic, is part of a wider ongoing EBA work on comparability of RWAs. The analysis confirmed the existence of a positive correlation between the value of the different variables — such as loan to value at origination, indexed loan to value, debt to service at origination, and loan to income at origination — and the risk weights at an aggregated level. The analysis also highlighted the potential impact of market differences, banks’ specific credit policies, as well as modelling choices. While the EBA is currently engaging with competent authorities on the topic, final conclusions at bank level can only be drawn by national competent authorities (NCAs).

Final draft RTS on G-SII methodology and ITS on disclosure for the leverage ratio: The EBA on 5 June published the final draft RTS on the methodology for identifying Global Systemically Important Institutions (G-SIIs). The RTS will have to be formally adopted by the European Commission and published in the Official Journal of the EU.

On the same day, the EBA also published its final draft ITS on disclosure for the leverage ratio, which are still subject to future changes depending on the decisions made in the Commission delegated act.

List of CET1 instruments might still be affected by RTS on own funds part IV: The EBA on 28 May published a list of capital instruments across the EU that national supervisory authorities have classified as Common Equity Tier 1-compliant. This list, which was compiled in accordance with Article 26 of the CRR, is based on information received from the 28 national competent authorities across the EU. However, it does not take into account the provisions on multiple dividends and preferential distributions laid down in EBA final draft RTS on own funds (part IV), as these have not yet been adopted by the European Commission. According to the EBA, the final adoption of these RTS may affect the ultimate eligibility of some of the instruments as CET1.

Treatment of non-grandfathered portion of step-up Tier 1s: On 23 May the EBA published a new set of answers on the Q&A Tool, which included a response to question 2013_696 regarding the recognition as Tier 2 of the amount of a step-up Tier 1 in excess of the Tier 1 grandfathering limit, prior to the first call date. The EBA confirmed that the excess over the Tier 1 grandfathering limit could still be eligible as grandfathered Tier 2, subject to the applicable limit but only until the date of effective maturity of the instrument (i.e. the step-up date). The question originated from controversial response 2013_47, in which the EBA set the criteria for reclassification of legacy Tier 1 instruments.

Restrictions on sale of bail-in-able debt to retail clients: According to sources reported by the Financial Times on 20 May, the EBA could consider higher disclosure requirements or quantitative limits to the sale of bail-in-able instruments to a bank’s own retail customers. The move would be aimed at the protection of investors from the consequences of a potential loss absorption.

Template for the data collection exercise on CVA: The EBA, following the launch of the data collection exercise on Credit Valuation Adjustment (CVA), released on 16 May an updated version of the template that participating banks will be requested to fill in as well as a set of relevant instructions. The exercise was launched on 30 April and will be carried out on a voluntary basis. Participating banks are expected to submit the template of the data collection exercise to their respective national supervisory authority by 31 July.

Consultation on RTS on the treatment of equity exposures under IRB approach: The EBA on 7 May launched a consultation on draft RTS to specify the treatment of equity exposures under the internal ratings-based (IRB) approach. The consultation runs until 7 July. These RTS propose that competent authorities grant institutions a temporary exemption from IRB treatment of certain equity exposures if such exemption was being applied on the last day of application of the CRD I (31 December 2007).

National Regulators

FDIC adopts the Basel III interim final rule as a final rule: The US Federal Deposit Insurance Corporation (FDIC) has adopted the Basel III interim final rule as a final rule with only technical revisions designed to ensure that it conforms with the final rules issued by the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency (OCC). The final rule was effective 1 January 2014, with mandatory compliance beginning 1 January 2014, for FDIC-supervised institutions that are subject to the advanced internal ratings-based approaches (advanced approaches). Mandatory compliance is scheduled to begin 1 January 2015 for all other FDIC-supervised institutions.

BoE publishes summary of feedback received on the stress testing Discussion Paper: In October 2013 the Bank of England published a Discussion Paper that set out the main features of the proposed stress testing framework over the medium term. The aim of the Discussion Paper was to elicit feedback from interested parties to help inform Financial Policy Committee (FPC) and Prudential Regulation Authority (PRA) Board decisions over the ultimate design of the UK stress testing framework. The regulator provided a summary of the feedback received in May. A number of respondents asked for greater clarity around the framework for assessing capital adequacy in the stress test, the usability of capital buffers, the role of AT1 instruments, and the role of the leverage ratio. However, the document is not intended to be the Bank’s response to that feedback, as further material on how it intends to develop the stress testing framework going forward will follow the completion of the 2014 exercise.

On 29 April, the Bank of England set out further details of the scenario for the stress tests that the eight major UK banks and building societies will be undertaking this year. A key threshold for the UK variant test will be set at 4.5% of RWAs, to be met with Common Equity Tier 1 capital in the stress — using a CRD IV end-point definition of CET1 in line with the UK implementation of CRD IV. If a firm’s capital ratio is projected to fall below the 4.5% CET1 ratio in the stress, there is a strong presumption that the PRA will require the firm to take action to strengthen its capital position. However, depending on the outcomes for specific firms, the PRA may still require action to strengthen capital positions even if the threshold is met.

In addition to the stress scenario focussed on the UK, the Bank of England will also assess the impact of an EU-wide baseline macroeconomic scenario exercise co-ordinated by the EBA. Under this baseline scenario, the PRA expects firms to have a CET1 ratio of 7% of RWAs and a 3% leverage ratio using a Tier 1 definition of capital.

PRA completes proposals for implementing capital buffers: On 30 April the PRA set out the proposals for implementing the CRD IV provisions on capital buffers (CP 5/13) in the UK, which include the capital conservation and countercyclical capital buffer frameworks. The rules were not included in its original statement — Strengthening capital standards: implementing CRD IV, feedback and final rules (PS 7/13) — as HM Treasury first needed to designate the authorities responsible for the buffers. The PRA intends to consult on and set out its policy for identifying Other Systemically Important Institutions (O-SIIs) in 2015.

Swedish FSA releases capital buffer legislation: Sweden’s Finansinspektionen (FI) on 8 May released a memorandum on the capital requirements for the nation’s banks, which builds on the power granted by a government bill issued on 3 April, and reflects the agreement with the Riksbank and the Swedish Ministry of Finance. The memorandum is divided into seven main sections, including an impact study.

• The Pillar 2 capital charge is divided between Pillar 2 basic requirements — which represents an assessment of additional capital needs to cover risks not included under Pillar 1 — and a so-called capital planning buffer. The rules apply to all companies subject to the capital adequacy regulations, regardless of size. The capital planning buffer is supposed to be covered in its entirety by CET1, while Pillar 2 basic requirements shall in principle be covered by the same capital allocation as Pillar 1, including the static buffer requirements (capital conservation buffer, systemic risk buffer, and buffers for other and globally systemically important institutions).
• The capital adequacy level at which the maximum distributable amount (MDA) restrictions take effect will not be affected by the special funds requirement as long as these requirements are not formally decided. If a formal decision on special capital requirements for the company has not been taken, the computation of the maximum distributable amount can be made without Pillar 2 basic requirements and capital planning buffer included. FI will not normally make any formal decisions on particular funds requirements. Instead, FI is to inform each company of FI’s overall capital assessment of the company. A formal decision will only be taken in cases where it is deemed necessary. A departure from the general rule of Pillar 2 basic requirements can be made for specific types of risk.

Dutch Central Bank publishes study on national lenders’ capital needs: De Nederlandsche Bank on 23 April published a study on the capital needs of Dutch banks until 2019. This amounts to nearly Eu26.7bn in total, serving to meet the requirements of Basel III, contributions to the deposit guarantee and resolution fund, and the 4% leverage ratio.

Rating Agencies

Moody’s releases proposed approach to rate high trigger CoCos: On 1 May Moody’s presented its new proposed approach for rating bank high trigger contingent capital securities. The agency’s framework employs a model-based approach that incorporates the view of the issuing bank’s current financial strength as represented by its assigned Baseline Credit Assessment (BCA), its current capital level, the capital level associated with the point of non-viability, and the capital level associated with the trigger in the security being rated that determines the distance to trigger breach. Instead of a traditional notching-based approach, Moody’s model will construct a specific curve for each bank, assuming that the distribution of a bank’s future CET1 ratios follows a normal distribution, and using a volatility-computed starting from the BCA. As part of the new proposal, Moody’s is also seeking market feedback on potentially establishing a cap of Ba1 for the ratings of high trigger securities. Lastly, the agency is also proposing to remove the additional notch on non-viability securities classified as Additional Tier 1 relative to the ratings for traditional Tier 1 and Tier 2 securities, and describes circumstances under which it might consider removing the notch from Tier 2 securities. (See Q&A with Moody’s Barbara Havlicek for more.)

S&P clarifies the treatment of insurance subsidiaries in the RAC-F: On 23 May S&P released answers to FAQs relating to the treatment of insurance subsidiaries in the bank RAC framework (RAC-F). In this model, S&P applies a 1,250% risk weighting factor to investments in insurance subsidiaries. The scope of “investments” was not always consistent across jurisdictions, in the sense that often only core equity was captured. In this report, S&P clarifies that the 1,250% factor applies to all forms of capital, including Tier 1 and Tier 2 issued by the insurance company and held by the parent bank.

Moody’s revises approach to Variation or Substitution Provisions: Moody’s on 22 April published a new cross-sector rating methodology that updates and replaces its May 2013 publication “Rating Obligations with Variable Promises” by revising a section on Securities with Variation or Substitution Provisions. When rating securities with these provisions, the agency will consider (1) the likelihood that the contingent event allowing for substitution/amendment will occur, (2) the likelihood that the issuer will exercise its right, taking into account the investor protections, and (3) how the security could be changed in the future, or some combination of these considerations. If the likelihood is low and/or the difference in risk between the original security and the new or amended one is minimal, Moody’s would rate the original security. However, if the likelihood is high or increasing that the original security will be replaced or amended, the agency will look through to the new security and rate on that basis. Moody’s intends to maintain and monitor the ratings assigned under the previous methodology.

Insurance

PRA releases consultation paper on the use of subordinated guarantees: On 30 May, the UK Prudential Regulation Authority (PRA) set out a new consultation paper (CP9/14) on subordinated guarantees and the quality of capital for insurers. The consultation seeks views on the PRA’s expectations in relation to: (1) the use of subordinated guarantees in connection with capital instruments, whereby the payment of coupons and repayment of principal are guaranteed by a different entity (guarantor); (2) how subordinated guarantees should not undermine the quality of capital held by firms to meet capital requirements; and (3) how the guarantor’s regulatory capital position should be reported if the liability created by the guarantee serves to undermine the guarantor’s quality of capital. In summary, the PRA expects the subordinated guarantees to not override the capital instruments’ loss-absorbing features or prevent investors from bearing losses when appropriate. Any subordinated guarantee arrangement will be assessed by the PRA to ascertain whether it is consistent with one of the following two acceptable situations:

1. From the perspective of the guarantor, if a subordinated guarantee is called upon, the guarantee should effectively extinguish or replace an existing subordinated liability. The subordinated guarantee should possess the same, or better, features regarding quality of capital as the subordinated liability it is replacing;
2. Alternatively, the guarantor should acknowledge the existence of the guarantee by disqualifying the guaranteed amount from the guarantor’s Tier 1 capital (the amount may still count towards a lower tier of capital if the terms of the subordinated guarantee meet all of the relevant criteria).

The consultation will close on 11 July and the final supervisory statement should be released during the third quarter. The PRA expects firms to have resolved all issues by December 2015.

PRA publishes SS5/14 on calculation of technical provisions and use of internal models: On 25 April the PRA issued a new supervisory statement (SS5/14) setting out the PRA’s expectations of general insurers in relation to the calculation of technical provisions and the use of internal models. As part of the PRA’s preparations for the Solvency II regime, this statement seeks to ensure that firms set an adequate level of technical provisions and hold sufficient capital, and it is intended to apply to all general insurers within the scope of Solvency II.