Take two

Proposals for the next iteration of CRR/CRD and BRRD have been unveiled just as negotiations over Basel III revisions reach a critical stage and an unknown new administration arrives in the US. The EU moves augur well for the second stage of post-crisis financial regulatory reform, but the key question of overall capital requirements remains up in the air.

On 23 November 2016 the European Commission officially moved post-crisis reforms of the European financial architecture into their second phase, with the announcement of changes to key pieces of EU legislation, including the Capital Requirements Regulation (CRR) and the Bank Recovery & Resolution Directive (BRRD).

“Europe needs a strong and diverse banking sector to finance the economy,” said Valdis Dombrovskis, Commission vice-president responsible for Financial Stability, Financial Services & Capital Markets Union, announcing the package of measures in Brussels. “We need bank lending for companies to invest, remain competitive and sell into bigger markets and for households to plan ahead.

“Today, we have put forward new risk reduction proposals that build on the agreed global standards while taking into account the specificities of the European banking sector.”

The package included measures addressing both capital requirements themselves and the instruments that banks can use to meet these requirements, with amendments to CRR, CRD IV and BRRD transforming the pieces of legislation into CRR II, CRD V and BRRD II. According to Crédit Agricole CIB’s capital solutions team, the main amendments and additions deal with: TLAC implementation; MREL update; FRTB introduction; Leverage Ratio as Pillar 1 requirement; Interest rate risk in the banking book (IRRBB); Large Exposures; Pillar 2 technical application and harmonisation; Additional Tier 1 amendments; SME supporting factor and infrastructure investments; exposures to central counterparties; and updated Pillar 3 requirements.

Key highlights of the measures picked out by CACIB include:

• The unification of MREL and TLAC, with both set on an RWA and leverage bases
• The implementation of a split between Pillar 2 requirements and Pillar 2 guidance
• Priority of AT1 coupon payments over dividends and variable remuneration payments in MDA

(Click here for table with more details in pdf format.)

The overall package of measures was on the whole welcomed by market participants.

“The overhaul has been many months in the making and is not expected to be complete until the end of January 2017, but some of the issues announced yesterday have clarified a number of well-discussed points that should be well received by the investor community,” said Gary Kirk, partner and portfolio manager at TwentyFour Asset Management.

“It is worth highlighting the most salient points, which support our earlier views that the deeply subordinated banking sector offers some of the most attractive returns available in fixed income, and these latest changes merely endorse that view.”

AT1 impact

Two key changes affect the treatment of Additional Tier 1 securities.

Firstly, in the event that an institution is subject to MDA restrictions, AT1 payments are given absolute priority over CET1 distributions (such as dividends) and discretionary remuneration (such as bonuses). While the move is not as strong as the introduction of a “dividend stopper” akin to those seen on old-style Tier 1 instruments, which had been rumoured but also resisted by the European Banking Authority, the prioritisation of AT1 payments was welcomed by market participants.

“This provision is a clear positive for AT1 investors as they would have priority of payment claims,” said Pauline Lambert, financial institutions analyst at Scope Ratings.

Balanced against this is a proposal that prior permission must be obtained to reduce, redeem or repurchase AT1 securities, as well as Tier 2 and eligible liabilities, before their contractual maturity, with the supervisor consulting the resolution authority before any call decision. The decision must take into account the economics of the call and replacement.

“They are pushing much more towards approving calls on an economic basis, which means that the extension risk could be heightened,” said Doncho Donchev, capital solutions, debt capital markets, Crédit Agricole CIB. “So while they are giving up flexibility on the coupons, they are taking away some flexibility on the call dates.”

He noted that a proposal to now allow calls prior to year five, while giving greater flexibility to issuers, could be viewed detrimentally by investors.

“So it sounds to me rather unlikely that AT1 will move much into being a substantially cheaper instrument,” said Donchev.

The Commission’s package also included confirmation of a split of Pillar 2 into Requirement and Guidance, with only the former included in MDA calculations. This move had been well anticipated, with various media reports on discussions within the European institutions in the first months of the year later confirmed via separate announcements by the EBA and ECB in July, after uncertainty about the approach to Pillar 2 had contributed to volatility in the AT1 market early in 2016 when fears of more likely restrictions on coupon payments had risen.

The impact of the move was most evident when BNP Paribas on 28 October became the first ECB-supervised bank to disclose its 2017 SREP requirement and reported a reduction in its Pillar 2 requirement from 2.5% in 2016 to 1.25%.

“The 50% reduction in Pillar 2 relevant for AT1 coupons is positive news as it appears to be ahead of market expectations,” said Crédit Agricole CIB’s capital solutions team, and other banks that subsequently disclosed their Pillar 2 requirements also came out with substantial reductions.

(See market section for more on the introduction of senior non-preferred to meet TLAC/MREL requirements.)

Basel awaited

Notably absent from the European Commission’s package of measures was an increase in capital requirements for banks — something that has nonetheless been a focus of negotiations over revisions to the latest iteration of the Basel Capital Accord.

Members of the European Parliament’s economic and monetary committee (ECON) had two weeks earlier, on 10 November, called on the ECB and European authorities to ensure that EU banks are not disadvantaged under upcoming Basel Committee on Banking Supervision changes to Basel III (a.k.a. Basel IV). They voted for two principles to be adhered to: firstly, for revisions to the framework “not to increase significantly overall capital requirements, while at the same time strengthening the overall financial position of European banks”; and secondly, “that the revision should promote the level playing field at the global level by mitigating — rather than exacerbating — the differences between jurisdictions and banking models and not unduly penalizing the EU banking model”.

Talks in Santiago, Chile on 28-29 November failed to yield a final outcome to Basel revisions in time for their scheduled deadline, although Stefan Ingves, current chairman of the Basel Committee and governor of Sveriges Riksbank, said afterwards that “very good progress” had been made and “the contours of an agreement are now clear”. At a high level, he said, this includes (in his words):

• A revised standardised approach to credit risk. This will be more risk-sensitive than the current standardised approach and more consistent with the internal model-based approaches. It will also be neutral in terms of its capital impact;
• The revised framework will largely retain the use of internal models but with the safeguards provided by input floors and revisions to the foundation IRB approach;
• A revised standardised approach for operational risk will replace the four existing approaches, including the Advanced Measurement Approach, which is based on banks’ internal models. I expect this will also be capital-neutral overall, but there will no doubt be increases and decreases in operational risk capital requirements for certain banks;
• A leverage ratio surcharge for global systemically important banks will be introduced to complement the risk-based G-SIB surcharge;
• Finally, I expect an aggregate output floor will be part of our package of reforms. It will be based on the standardised approaches and the final calibration of the floor is subject to endorsement by the GHOS.
• It is important to note that a lengthy implementation and phase-in period is likely to be part of this package. This would allow for banks to migrate to the new framework in an orderly and manageable fashion.

Whether a compromise acceptable to all involved is possible remains to be seen. Ahead of the talks, Bundesbank executive board member Andreas Dombret in a speech laid down demands that included objection to an output floor, and concluded with a warning interpreted by some as meaning that Germany might walk away from an unsatisfactory outcome.

“Currently, we are seeing many citizens calling our globalised world into question, with more and more looking for answers in separation or regionalisation,” said Dombret. After expressing “strong hope” that cooperation on the Basel Committee will continue under the new administration in the US on the basis of mutual trust, he nevertheless stressed that “the Bundesbank is not prepared to reach an agreement at any price”.

Dodd-Frank trumped?

The surprise victory of Donald Trump in the 8 November US presidential election added yet another unknown into the regulatory agenda.

US bank stocks rose in the wake of the Republican’s victory, amid speculation that his administration will roll back key elements of the US’s key post-financial crisis reform package, the Dodd-Frank Wall Street Reform & Consumer Protection Act. Securities & Exchange Commission chair Mary Jo White became the first major Obama appointee to resign in the wake of Trump’s win.

Former SEC commissioner and Dodd-Frank critic Paul Atkins is a key member of Trump’s transition team and considered a potential nominee for either SEC or Federal Reserve chair.

Looking forward to 2017, 60% of economists surveyed by the Securities Industry & Financial Markets Association (SIFMA) said in December that they expect improved financial regulatory policy, if enacted, to raise US GDP growth by 50bp.

“Regulation costs over $1 trillion a year,” said one respondent.

“Eliminating and simplifying some of it would be the equivalent of a massive tax cut.”