Bank resolution: Constructing new strategies

BRRD, MREL, RWAs… The “alphabet soup” of regulation shows no signs of cooling, and financial institutions are being forced to reassess balance sheet managment and funding in light of the paradigm shifts in bank resolution and other areas. Here, issuers and other market participants discuss the new strategies that are being adopted.

Neil Day, BIHC: At what stage are the various countries with respect to implementation of the Bank Recovery & Resolution Directive (BRRD)?

Mattias Persson, Nordea: It’s being implemented, but it has not yet passed parliament, where it is still being discussed. It has been out for consultation in the domestic market and has been discussed between the different authorities. It needs to be in place January next year, and we understand it will be done.

A problem we have is that this law that will implement BRRD in Sweden will also formulate which authority will be the resolution authority, and as the legislation is not finalised we don’t yet have this counterparty. We know who it is supposed to be – it will be under the Swedish National Debt Office – but as they are still not the authority from a legal perspective they can’t interact with us yet.

So BRRD is coming, albeit a bit late.

In the end it will not resemble BRRD in many other countries — there are twists in the Swedish implementation for national reasons — but I will come back to those in more depth later.

Carlos Pinheiro, Caixa Geral de Depósitos: In Portugal we enacted in March this year a law that is aligned with the final BRRD regime. As you will know, we were, let’s say, early adopters of banking resolution. Already in 2012 there was a financial assistance programme and then a bank that was resolved, which fostered some adaptation of banking laws. But yes, the final BRRD regime has now been adopted.

Renee Bauer, Erste: We have implemented it. The main topic we have now is senior funding going forward and what will happen vis-à-vis the German and Italian approaches, and if there will be an EU consultation.

Nicolò Bocchin, Aletti Gestielle: BRRD is one of the themes, one of the acronyms we have read and heard a lot about over the last two or three years. And to tell you the truth, from my point of view it’s kind of a mess, because there are always new rules, new proposals, new acronyms to take care of. From time to time they change the proposal and therefore I decided to take a very practical approach. This is first of all based on waiting until the rules are finally set and only then eventually going deeper into them. The second is in the meantime to be sure about those ratios that really matter from a portfolio management point of view. To my mind so far the triggers are just MDA (maximum distributable amount) and the buffer to trigger. Then, finally, be comfortable with the issuer — that’s really the most important point.

The process is a very difficult one to handle, but it has been made longer and longer just to get investors to digest the fact that even senior bonds at the end of the day can be part of the capital structure. This is something that really was unbelievable up until a couple of years ago when you had the Cyprus crisis and senior bonds were not touched, or even last year when you had the Banco Espírito Santo fraud and the seniors are still out there.

The Italian case is to me really interesting, because moving up the corporate deposits and leaving the derivatives at the same layer as the senior bonds basically make the senior bonds un-bail-in-able. What the regulator wants to make sure of is that they can bail in a bank over a weekend to preserve financial stability, but derivatives are basically impossible to be resolved within a weekend. Therefore I guess that even with the current legislation, senior debt of Italian banks will be moved to a new bank in case of bail-in.

Doncho Donchev, Crédit Agricole CIB: First of all, we have to ask why we have these various approaches. I think this is an important point that needs to be clarified.

In the European Union obviously we have the BRRD and in the Eurozone we have Banking Union, with supervision and resolution two key components of the framework, so resolution is clearly within the remit of the EU. But when it comes to the point of ranking of senior unsecured under the “no creditor worse off” principle, this links to insolvency laws and proceedings for liquidation, which are a national remit. We then have 28 different countries with 28 different laws — less in the SSM but more than enough for a potential myriad of national approaches. This, really, is the crux of the problem. And because insolvency remains within the remit of the national states, and hasn’t yet been given up to the level of the EU, I think we are likely to see more and more national laws emerge. But eventually, in my view, the Commission will probably consider that this results in a fragmentation of the Common Market principle, and may take some action. But obviously it takes two, or in this case one and 28, to tango, meaning the Commission and all the different countries needing to agree on this principle, that there needs to be a European solution. My view is that we are not at this stage yet.

Day, BIHC: Mattias, you referred earlier to differences in the Swedish approach. How and why is it different? And is it tenable that you will be able to maintain that going forward?

Persson, Nordea: The strategy has been to focus not on resolution, but rather on the probability of default. If you go back a couple of years, the Swedish authorities have set much higher capital requirements for Swedish banks. It’s a question of making the banking system safer — making sure that there is a lot of buffer before you actually go into resolution, so authorities can intervene early — rather than having a big pot of money stashed away somewhere for a situation where you go into resolution. So the strategy has been completely different.

Then on top of that, it has been very, very clear since the Cyprus meetings of EU finance ministers on BRRD two years ago that Sweden had a different view on bail-in. Sweden had a severe banking crisis in the early 1990s and so the Swedish authorities know how to take over a bank over a weekend, but not using bail-in — and many of the people who were involved then are still around: the governor of the central bank, for example, was very much involved, and so were some of the people in the finance ministry. If you also look at the structure of the Swedish financial system, we have less deposits — ordinary deposits — than many other banks, but we have a very well developed domestic market throughout the Nordics in covered bonds, which is more or less recycled deposits, because our savings patterns are very different. And I think the view among Swedish policy-makers has been that bail-in is a less successful strategy for managing the risk in the financial system. So, again, rather than focusing on the probability of default, we have these higher capital requirements. We today have total capital of 20.7%, Tier 1 at 16% in Q2. And then we can discuss other things that are coming on top of that.

So there is from a policy perspective a clear difference between Swedish authorities and some other European authorities.

Regarding your question, will they be able to maintain that? I think that’s really up to the authorities, how they have set up Pillar 2, how they think about the strategy. And that is more in relation to TLAC (total loss-absorbing capacity) and other things that are coming as well now, and when you are moving things from Pillar 2 to Pillar 1, potentially, with RWA (risk-weighted assets) harmonisation… So it’s a lot for the authorities to think about. What we understand is that they are happy with the capital that we have, so we don’t expect them to want to increase capital even further. Then it’s more on how they can adapt and how we can adapt to the new situation.

Day, BIHC: What is the better approach out of what has variously been proposed so far?

Taos Fudji, Standard & Poor’s: From a ratings perspective, the clearer the structure, the better it is for actually resolving investors’ uncertainties. It’s also very much driven by local considerations.

For example, what we have seen is that in the UK, where they have moved ahead in creating this HoldCo structure, is that the ratings outcome for banks has been much more favourable than the ratings outcomes for German banks.

The fact that there is still this very big level of uncertainty on the final tuning means that in Germany we haven’t seen such a strong commitment to build up what we call the Additional Loss Absorbing Capacity (ALAC) buffers. So far there has therefore been quite a divergence in those two countries — which are, along with Austria, the only ones for which we have taken rating actions on in relation to BRRD.

Bauer, Erste: The Austrian approach will probably be to join the EU approach, a solution at the EU level. I don’t think they will go their own route with a new law, it doesn’t look like that would happen. I personally like the Italian approach better than the German one. With the German approach there has of course been the difficulty with the ECB-eligibility of senior bonds. The Germans changed the law, or at least they extended things by a year, so that the EU has a chance to come up with their solution. But obviously the insolvency rules and regulations of all the different countries and the national discretions will make this difficult — as in all the other topics we face: TLAC, MREL (minimum requirement for own funds and eligible liabilities), etc. It is just taking too long, and then we have the harmonisation of RWAs coming up as a new topic… It’s a never-ending story and I don’t know how banks are supposed to get back to doing their business when they are facing regulatory changes on a monthly basis.

Pinheiro, Caixa Geral: We have to recognise that having 28 jurisdictions with different national approaches is a challenge when you are striving for harmonisation. Harmonisation really is the key issue, otherwise there’s no use in having supranational bodies coming out with regimes that aim at having a level playing field. I think these regimes will be better if we converge. For instance, if you take TLAC and MREL, it would be very beneficial for all stakeholders if there is a certain convergence between the two regimes. There are of course some differences at the national level, but I think we should strive to mitigate those differences. So to single out the Italian, German or whatever approach is from my standpoint already biased.

But I’m not too optimistic about it, because in financial markets we really see fragmentation — that’s a fact, it’s not an interpretation.

Donchev, CACIB: As we are hearing in this discussion and also seeing on the news, the approaches are very divergent — from doubting the value of resolution capital buffers and emphasising recovery and early intervention measures in certain jurisdictions, to creating accomplished facts, as expected shortly in Italy and Germany1. This makes it very difficult to have a pan-EU or even SSM discussion on the topic, although the ECB, for instance, invariably stresses the need for a common approach.

I presume that we will first see more national approaches emerging, and we may need to see evidence of market fragmentation within the senior unsecured debt market that goes as far as to begin to affect the efficiency of the credit transmission mechanism within the EU before the Commission has sufficient material to pressure weary legislators with opposing views to reopen the BRRD on the topic of senior unsecured ranking. This, coupled with pressure from supranational resolution and supervision authorities seeing a serious impediment to discharging their obligations effectively and efficiently. And let us not forget that there is the added difficulty of national resolution regimes. But I would presume some European solution emerges eventually, though it may take a few years before we see this implemented.

Day, BIHC: To what extent — if at all — is the market pricing in the different approaches that are being taken?

Pascal Decque, Crédit Agricole CIB: What I have heard up to now is very much in line with what I am hearing on my side when I’m meeting either issuers or investors, and that’s the reason why we called our outlook for the year “The Alphabet Soup of Regulation” — and I don’t see any reason to change the title for the coming year. In fact, all the investors we have met recently — and there is quite a long list — they told me that they were spending at least 50% of their time on regulation. And I am not so sure that’s the thing they like most about their job…

They are trying to understand the regulations and they are trying to assess the value of the different debt instruments — which is not an easy call, as there is much more complexity and much less transparency. And typically they are all waiting – as was mentioned earlier — for the final rules on TLAC and MREL before taking any big decisions. Once the rules are clear, that will determine the funding strategies of the banks, which in turn will determine their own investment strategies. Up to now they have been very much in a holding position.

Regarding harmonisation, I understand that there are different insolvency laws in every country, but personally I find the situation very strange. Every day on my screen I can see the various European authorities insisting on more harmonisation, going back to what has been done on DTAs (deferred tax assets) and so on, but then with the latest rules we are discussing they are not going for harmonisation — it’s something that I have a problem with.

There is also an expectation from investors on a French solution, but we do not have clarity on that.

Donchev, CACIB: What is important to keep in mind on this point is that France has four G-SIBs, more than any other SSM country, and they are all dependent on wholesale senior funding for their business models.

Given the different starting points and business models, it may not necessarily be evident what and if any French solution will emerge. We will see.

Day, BIHC: You mentioned the different rating outcomes of the UK and Germany so far. How complex will it be with different approaches in different countries?

Fudji, S&P: As we have all discussed, it is very much company-specific and country-specific. Right now, in advanced countries, for almost all the banks we rate our approach is to focus on the standalone credit profile (SACP) characteristics. For some of the banks that are highly systemically important there is still one notch of additional government support, and this notch of support may be substituted by some banks that have enough TLAC or what we call ALAC uplift beyond the standalone rating. We consider today that these banks, if they ever enter a recovery or resolution, will continue to receive significant liquidity support from the authorities, because actually you cannot resolve an institution simply over a weekend without central banks giving support, without organising this, or else you will disrupt the market. So what we are saying is that some banks will get less support because the support is less timely, and less predictable, because there is the resolution. That said, we take something out from the extraordinary support on the going-concern basis — so we don’t expect any more banking groups to be completely bailed out with the moral hazard effects that this has created, such as in 2008-2009 — but we include ongoing institutional framework support in the standalone credit profiles. And when we look at the standalone credit profiles — and this is the basis of our counterparty rating and on the rating of most of the liabilities of the banks — we see stable, and in some countries positive trends. We have seen positive trends in Portugal, positive trends in Spain, and positive trends in Ireland so far, because the banks have been restructured, and have got to grips with the pace of inflow of NPAs. In Italy we believe the peak in NPAs will be some time next year, so potentially this can follow. So the trend is mostly now stable.

How much do we want to split up every single little piece of liability? Well, there is not enough clarity today to be able to make this split. What we split out today is covered bonds.

Persson, Nordea: There are some other aspects that are important when it comes to support, such as resolution funds, how they are prefunded and the speed at which they can be used. Again, I think this is one area where Sweden has a different solution. At least in the draft documentation we have seen, there are actually two resolution funds, one financial stability fund that can be used prior to resolution for solvent institutions, and then also a typical BRRD resolution fund. So again, there is a much more flexible approach. That is also something that needs to be reflected in ratings, for example, and which just highlights the fact that we have no harmonisation, with everybody having their own policy — for good reason.

Day, BIHC: Nicolò, What would your wishlist be for the financial authorities in terms of getting certainty?

Bocchin, Aletti Gestielle: First of all, about the rules. I’m not spending 50% of my time following what the latest new proposal are; I am waiting until the very end of the process before looking at them.

When you have an AT1 or a covered bond of a bank, you more or less know how comfortable you are with the issuer and what will happen to your bond in the event the bank goes bust. In terms of what I would like to see — and hopefully we will get that within a few months — is that when the rules are set banks make a full disclosure themselves what are the pillars, the buffers and the clear specific numbers. The most important, as I said earlier, is the MDA, and not every G-SIFI bank has published that; you have to recalculate it yourself or trust some analysts on the Street. So to me the most important point is not really to give the rules, but to force banks to disclose those numbers. Up until a few years ago we just were looking at total Tier 1 capital, then there were new rules and the banks started reporting Tier 1, core equity Tier 1, total capital — in the future we will have other acronyms with the relevant number together with these.

Day, BIHC: Indeed, alongside what we have discussed, there are lots of things like risk weighted assets, leverage ratio, IFRS 9 coming along — which of those are the most notable for you?

Bauer, Erste: The leverage ratio is not a problem. We are a very retail-oriented, stable bank, so we have different problems than the big investment banks. RWA harmonisation will of course be a topic going forward. With IFRS 9, there are lots of open points at the moment, so we are still looking at the impact that will have for us.

Otherwise it’s the MREL/TLAC harmonisation — when is it going to come, how big is it going to be, is senior going to be included? And that is easily the biggest topic we have. We have seen in recent weeks that getting senior funding is very difficult, and what will it be like going forward? We have seen the big banks doing a lot of short floaters and over a two year time period investors can think, OK, there won’t be too much going on until then, but what about five year paper? The investor has no idea if it is bail-in-able senior or what’s it going to be after maybe three years. So I see senior funding very much as an important topic, and it all is connected with MREL/TLAC. What we have also seen is that MREL could be even harsher than TLAC, which seems kind of strange if the smaller banks face harsher ratios than the G-SIFIs.

Pinheiro, Caixa Geral: The leverage ratio is also not a problem for us, being a retail bank. Managing and adapting to all the criteria for RWAs is of course critical. The good news from my standpoint is IFRS 9, because it is proposing a forward-looking measure — I think that is beneficial for markets. There is then this challenge to have models to predict your NPLs, and, again, if each country, even each institution has to come up with its own model with different outcomes… So although it is a very good measure and from my standpoint beneficial, we have to take care not to be too inventive on the models. It’s a learning process and we are very focused on this issue because it has an impact on your capital stack and so on.

Persson, Nordea: I think all of what you mentioned, and then you can add Capital Markets Union, fundamental review of the trading book, interest rate risk in the banking book… There are probably some more. It’s true, there is a lot of uncertainty. It’s very much a question of where it will all end.

Donchev, CACIB: You have heard from the bank issuers what their pressure points are. The accompanying chart lists the menu of regulatory uncertainty facing the banks. I don’t believe my list is exhaustive, but these are some of the topics driving the discussion today. And of course, every bank will have a different pressure point among this menu, as we just heard.

What we will have for some time is further uncertainty. In this context it is important for banks to drive the communication with investors themselves and be as transparent and logical as possible.

Capital, strategic and organisational plans can be adjusted several times without market penalisation provided the communication is transparent, logical and the likely path over three to five years can be seen. The known unknowns must also be named. Whether and to what degree there can be communication on that is another question.

Day, BIHC: On the uncertainty issue, when you have been coming to market this year — Renee mentioned about the difficulties in the market — to what extent is that already a factor in the ability to get deals done, the levels you are paying, and the investor base, and how that might be evolving for senior paper and other instruments?

Persson, Nordea: I think it will change, but I also think there will probably be differences between different issuers, depending, again, on all the regulations that we have and their implementation. We will see different changes in different jurisdictions on the back of how they implement the regulations.

So far we have not seen any big changes. It has been, looking back a couple of years, the case in covered — again, driven by regulation. I think it’s a bit too early — everybody is just trying to understand what is going on. That’s also why some investors are sitting on their money, or investing elsewhere.

Day, BIHC: Are there any aspects to these developments that are underappreciated?

Decque, CACIB: I think personally that banks having more capital and more quality capital is probably a very good thing — I remember at the time of the crisis when many people discovered that what was behind capital ratios was in fact not that much capital in the end. But if the ultimate goal is stable banking, my personal view is that “stable” and “banking” probably don’t go together very well.

Banking is about taking risks, but being good at assessing those risks and pricing them well. So, some are good bankers, and others are not such good bankers. And if you absolutely want stable banking what you end up with won’t actually be banking.

Pinheiro, Caixa Geral: Of course, if you want to have profitability, you have to have risk — that’s in the textbook. There is certainly ever more uncertainty in the market, hailing from different directions — not only from financial markets, but society, political risk, and all that. But it is by taking risks that you make money — if everything were predictable then every investor would have a portfolio of the market and no-one would buy or sell. The efficient market hypothesis is only academic, a starting point, or a base for further analysis – in practice it works very differently, there are very different scenarios that we have to cope with.

But if you don’t price risk appropriately, you will end up like in 2007 and 2008, and perhaps it is difficult because some things really are in flux. So we all have more and more capital, with instruments that can absorb some shocks — not only those that we have experienced but also shocks that we cannot imagine, because if you look back over the past 50 years you see many different crises, and the next crisis won’t be like the last.

I agree that we are in a better shape in terms of having capital and instruments that can absorb losses more effectively. But it’s a challenge being profitable. We have to acknowledge that and adapt models and pricing to this new reality.

Day, BIHC: How in your analysis do you balance a bank having perhaps a stronger capital base versus the ability to generate capital?

Fudji, S&P: That’s a very fundamental question. In our methodology we clearly give a bigger weight to the amount of capital today than to the generation. That said, we do not actually think that holding an oversized amount of capital can significantly uplift your creditworthiness. So we have institutions that are what we consider averagely capitalised under our methodology, and we have those stronger ones to which we can give one notch uplift, and then we have extraordinarily capitalised companies which we may give two notches uplift to — but it will not go beyond that.

What we do recognise is that it is fundamentally important that banks have viable business models, that earnings do not need to be very high but they should be relatively predictable, and that actually very high profitability is probably an indicator that there are risks that are being taken that are maybe not fully reflected in regulatory capital ratios. And so at the end of the day we give equal weighting to business position and to risk position as well as to capital. So capital can help you a little bit, but actually it will not determine whether or not you are more in the single-A range rather than the triple-B range.

Day, BIHC: How are the banks balancing the way in which they meet the greater capital requirements in terms of building up capital, reducing RWAs or any other strategies?

Bauer, Erste: As a retail bank the strategy has been to concentrate on our core businesses. We took a look at that a long time ago, which businesses or areas we want to be active in and which not, and which countries. We left one country and decided to stay in others, and basically decided on our core business area and reduced our non-core business. That’s very important, especially on the RWAs side.

The bank has been very stable with regard to balance sheet and RWA developments — we have not seen excessive RWA development in recent years. Of course, with the new harmonisation we will have to see what they do going forward. But otherwise it’s a question of staying with your core business, as the gentleman mentioned, and seeing that you make money out of it.

Persson, Nordea: I very much agree. The strategy that we have had from 2013 and onwards, and will also continue for the next couple of years, has very much been focused on what we are good at, and the core markets. We also focus a lot on cost efficiency. Something that we see in the Nordics is a huge change in how our customer behaves, so we do much more digital — so mobile, internet — it’s completely different. That has implications for how we do banking and, again, will help us on cost efficiency.

Then, on capital, we build capital each quarter, organically. We have communicated clearly now a strategy as to how we see the management buffer, which we did at our capital markets day in May in London. So we are getting there.

It really is a matter of focusing on cost, on capital. There’s been a lot of internal focus on how we can do things smarter, more capital-light, yet still supporting our customers, across our business. We manage that, but it is a challenge.

Pinheiro, Caixa Geral: Our bank, too, has for the last few years been concentrating on its core business, which is retail banking in Portugal where we have a very strong franchise. We have divested in several areas of business that were not core, while cost reduction has also been on our agenda — not only for a few years but for the last 10 years or so. And also in terms of RWAs, we haven’t had much change recently. Of course, the challenge is being profitable in an environment where growth is not as strong as we would like it to be, so we are still deleveraging. And although there is more demand for credit these days, being in a small and open economy we are of course dependent on what is happening globally.

I think that in banking in general, both in developed and emerging countries, we have to somehow reinvent ourselves when it comes to business models. We are of course discussing what is going on in banking, but we see also shadow banking, with non-bank entities. Banks are being penalised through having all this loss-absorbing capacity while you have certain sectors of the economy that are just bypassing banks. So that is just one more challenge.

And, again, while there is this mantra of being concentrated on your core business and being a dull retail banking guy, this stability is not completely in line with being more profitable. You have to be innovative in terms of products and addressing your customers. But at a certain point regulation, even if it is very important, normally hinders such innovation. So these are new challenges that we really have to address.