Bank ESG Capital: The EBA perspective

On 24 June, the European Banking Authority published an updated AT1 monitoring report highlighting its considerations regarding the use of ESG bonds for own funds and eligible liabilities. At a CACIB event, Delphine Reymondon, head of liquidity, leverage, loss absorbency and capital unit, EBA, expanded on the regulator’s view and tackled key questions.

This article is part of a series, Bank ESG Capital: Where is the Green Line? drawn from presentations and panel discussions that took place as part of a Crédit Agricole CIB event on 7 September. A pdf including all four parts can be downloaded here.

Delphine Reymondon, head of liquidity, leverage, loss absorbency and capital unit, EBA: In June the EBA published its updated report on the monitoring of Additional Tier 1 instruments, and as you will probably know, we included recommendations for ESG-linked capital issuances. Here, I will discuss some of the general observations that we made based on our monitoring and the risks that we identified in relation to capital in the broad sense, meaning own funds as well as TLAC and MREL bonds.

Delphine Reymondon EBA web

In terms of the rationale for us developing this guidance, we had of course noted the rapid development of ESG segments. Up to last year we had seen some green senior non-preferred issuances in particular, which we were more monitoring from a capital perspective. Then in July last year we saw the first issuances of own funds instruments, and this is where we decided that we would develop the guidance that we integrated in our monitoring report.

It is an own initiative guidance. As you know, from time to time we are producing this type of product to complement technical standards or guidelines in a practical manner when we believe that there is a market need, and we deemed it helpful and necessary to start providing some guidance on these issuances. We started with the TLAC/MREL monitoring report that we published in October 2020, looking only at the senior non-preferred issuances, and we had limited recommendations at the time. But following this publication, we had a look at the own funds issuances, and ended up with the detailed guidance that we published in the AT1 report, in particular identifying best practices or clauses that, on the contrary, we would recommend avoiding — as is typical of the way we do our monitoring reports.

I should note that we used — as we have done in the past — a sample of AT1, Tier 2 and senior non-preferred issuances, we did not review all issuances in the market, but we exercised a quite high degree of scrutiny on the own funds issuances.

General observations

What we have said in our guidance is that we believe these ESG bonds in general increase the reputational risk for the issuer compared to normal bonds. There are certain expectations on these bonds from the side of investors. When scrutinising a couple of issuances, we noticed that there were some divergences in the documentation, with some programmes remaining quite general and others being more explicit, in particular on the interaction between the capital side and the ESG or green side. Bear in mind that after the publication of the guidance we have noticed — and it started even after the roundtable we held earlier this year — that there have already been quite some changes to more recent issuances, so the observations I am discussing today are mostly based on the first issuances we saw. A very important point that we mentioned in our guidance is that we wanted to be neutral with this guidance, meaning that our objective was not to prevent or to promote ESG issuances — we just wanted to say that if banks want to use capital bonds for ESG purposes, then this is what we would like to see in the documentation.

A final point — but I will come back to this — is that what we published are first steps — we have committed to do further work. We will of course monitor the implementation of the guidance and the recommendations, but we will do more work, on sustainability-linked bonds in particular.

Identified risks

The risks that we identified are quite well known. There is a reputational risk for the issuer, which we left outside our guidance. These reputational risks can come, for example, from the lack of final definitions or final standard for ESG bonds. The Commission has published a proposal for an EU Green Bond Standard, so some progress is being made there. There is also a specific reference in this proposal to the interaction with CRR and BRRD requirements and that the draft regulation should not be interpreted precisely as restricting the issuer’s ability to use bonds to cover losses resulting from other activities or assets or the exercise of conversion and write down in particular, where needed. Reputational risk might also arise from a potential loss of ESG label or negative review by third party verifiers, or the perception of green-washing. This is outside our guidance, as it is not in our field of competence. That said, as we mentioned when we published the guidance, we believe that being more precise in the documentation, as we recommend, will help mitigate this reputational risk.

I will give some more detail on three other risk areas we identified.

The first is the fungibility of the use and management of proceeds — i.e. where the earmarking of the proceeds might impede the use of proceeds to cover the losses. It is very important that it is clear to investors that the bonds cover all losses that might come from all parts of the balance sheet. There is also the risk that a change in the allocation of proceeds, a loss of ESG label, or lack of ESG assets might lead to the perception that the bond could be redeemed early — which shall of course also not be the case. And then there is the potential mismatch in terms of maturity between the bonds and assets.

The second area of risk is the clear description of the status of the notes. To be brief, it is very important that investors are aware of the subordination of these bonds and where they sit in the capital hierarchy. And then finally, we identified risks in terms of potential link between the performance of the assets and the notes.

The most important aspects here for the months to come will be the remuneration features linked to key performance indicators, for which we know that there are quite some expectations on us to provide more guidance. What we have seen for the time being is classical remuneration for green bonds, for the time being we have been quite satisfied with this. But we will continue to work on the sustainability-linked features part.

I will now elaborate in more detail on each of these identified risks.

Fungibility of the use and management of proceeds

Regarding the fungibility of the use and management of proceeds, here, the idea is to ensure that the bonds will be able to cover all the losses where needed, meaning that the capital nature of the bond, its regulatory nature, supersedes the ESG or green nature from our perspective. We just want this to be crystal clear to investors. What we have seen is that most EMTN programmes mentioned that an amount “equal or equivalent” to the net proceeds would be dedicated to the eligible assets. There were a couple of cases where there were stronger commitments to use the assets towards eligible assets “only”. The vast majority of cases mentioned that the use of proceeds could be allocated to treasury portfolios if, for example, there is a lack of eligible assets, with or without a sustainable character. So the level of commitment varies quite a lot. It is crucial that the duration of the projects or the lack of ESG assets has no consequence on the permanence and loss absorbency. In general, we preferred programmes or issuances where the commitment was a bit less strong. We see issuances mentioning that the use of proceeds will go exclusively to eligible green assets as potentially contradicting the fact that the bonds should absorb all the losses. This is why we recommended to have clear provisions that these bonds are subject to regulatory requirements from CRR and BRRD, that they should cover all the losses — even if the losses do not come from ESG/green assets — and that short term ESG projects or lack of eligible assets should not lead to any consequences on the bond.

When we refer to additional clarification in the “documentation”, we are not prescriptive on which type of documentation, it does not need to be in the terms and conditions of the instruments themselves, it can be in the risk factors, as long as wherever it is located it is fully clear that it applies to the bonds that would be considered as capital in a large sense.

Clear description of status of the notes

Regarding the description of the status of the notes, here the main idea is for investors to have a clear view where the bond ranks in the capital structure. We had seen only a minority of programmes clarifying this and the consequences in case certain events would happen, and also a minority of programmes clarifying the subordinated nature of the note in particular for capital instruments, with corresponding lacking mentions of the bail-in or resolution aspects. The idea is that the documentation should provide full clarity on the risk of bail-in, on the risks associated with coupon payments, in particular for AT1 instruments, and on the status of the notes more generally. As I mentioned before, we have seen quite some progress in more recent issuances, which is of course very welcome.

No link between performance of assets and notes

Regarding the link between the performance of the assets and the notes — and before going into the remuneration aspects — the idea firstly was to ensure that the instruments do not include any incentive to redeem the bonds, no early redemption, no acceleration or additional redemption rights. This means that it should be made clear that failure, for example, to use the proceeds as intended should not lead to any of these events. When we reviewed the sample of issuances, only a few programmes were mentioning this. More programmes mentioned the absence of event of default, but it was rarer for references to the absence of early redemption or acceleration rights. In terms of remuneration, a recent issuance stated that payments on the notes do not depend on the performance of the assets, but we noticed this in only one issuance. All in all, it is clear here as well that the documentation should make it explicit that certain eventualities — again, like a lack of assets or the non-realisation of certain expectations on the underlying assets — would not lead to certain events, i.e. an obligation to (early) redeem, or to acceleration rights, or give rise to any claim, etc.

Sustainability-linked bonds (SLBs)

We know that many issuers are seeking extra clarification from us on the potential future for sustainability-linked bonds in the banking sector. As you have seen in the guidance, this is something that we did not want to elaborate on too much. We know that there are these questions and that this is something we will have a look at, but for the time being we wanted to remain on the cautious side.

We were explicit that we could perceive some of the structures that may be used for SLBs as containing step-ups or incentives to redeem. A call associated with a step-up or fees would be considered as an incentive to redeem. Even without a call, some of these features could still be assessed as incentives to redeem because you could still have some incentive to buyback or repurchase the instruments. Missing ESG targets might also reduce the credit standing of the issuer, potentially creating a link between the interest on the bond in cases of step-up/fees and the issuer’s own credit standing, which would not be compliant with CRR requirements. In summary, at this stage we were not willing to allow these features or encourage them.

As I mentioned and as we said in the guidance, we stand ready to provide further guidance here if needed, and we will continue to work on it.

Other EBA work on capital/loss absorbency

The loss absorbency area is an area where the EBA has been producing quite a lot of monitoring reports. Our objective is, of course, to ensure the robustness of the quality of own funds and eligible liabilities, and very importantly, consistency in the implementation of the rules. On top of the CRR provisions, there are the EBA technical standards on own funds, and also a lot of Q&As clarifying further the implementation of all these requirements. With these monitoring reports that we regularly publish, we want to give some guidance on how the Level 1 provisions should be implemented. This is why we have the regular AT1 monitoring report, and last year we added the TLAC/MREL monitoring report. We also have a report for the monitoring of CET1 issuances, and we intend to publish a new version by the end of this year, together with the regular list of all CET1 instruments that are counted as a CET1 capital for EU institutions.

I also wanted to mention the RTS on own funds and eligible liabilities instruments. You have seen that we have published our final proposal before the summer, which is now in the hands of the European Commission. There have been significant additions from the side of the eligible liabilities, compared to the own funds side. Our intention was to align as much as possible the two frameworks for these instruments since they all contribute to the loss absorbency capacity of a bank.

Last year we also published the RTS on software assets and the RTS on methods of consolidation. The latter is important because it might lead to the consolidation of certain activities that were not previously consolidated in some groups.

Lastly, legacy instruments are a very important point for us and high on our radar. We published our opinion almost a year ago and are currently doing a follow-up of this opinion in terms of what the banks are doing, what they have announced, and what they have discussed with their supervisor. We are also liaising with the competent authorities to understand what will be the actions taken by the banks and this is something on which we will exercise a strong follow-up. We have seen some banks adopting approaches that lead them to get rid of the legacy instruments, in line with the opinion, but others being a bit more cautious on their approach and for example willing to keep the instruments in a lower category or use the last resort option mentioned in our opinion — we would need to understand why this is the case.

Q&A session

Gwenaëlle Lereste, bank analyst, Crédit Agricole CIB: The first question is dedicated to sustainability-linked bonds. As you mentioned in the presentation and also in the updated EBA report on the monitoring of AT1 instruments, the EBA said step-up and/or fees based on missing certain ESG targets should not be allowed on MREL/TLAC eligible instruments to ensure there are no incentives to redeem. The EBA also indicated that it will continue to monitor and assess these features going forward. Do you have any thoughts on the potential timing of the update?

Gwenaelle LERESTE web

Reymondon, EBA: Indeed, we did not want to close the door at this stage. At the same time, we don’t have any precise date in mind. To be honest, we don’t want to rush. We were quite satisfied, as I was mentioning, with the more classic remuneration features that we have seen until now. We understand from the banks that they want to move to the sustainability-linked bond market because at some point there will not be enough green assets in particular, and SLBs provide a far wider scope for issuances. While we do not believe that for the time being there is a need for all of us to rush, we will remain flexible. This guidance on ESG was released based on recent observed developments and on a perceived market need, so based on the evolutions in the market, we will adapt. We might publish further guidance sometime next year, but we will see.

What we would also like to do is to consult with the non-EU regulators, because in the past some of these regulators were and are still reluctant to allow green capital or green TLAC/MREL bonds. We would like to understand a bit better their rationale, we would also like to discuss with them what would be their position on sustainability-linked bonds in particular.

Doncho Donchev, DCM Solutions, CACIB: Moving on to the second question. The net proceeds of a sustainable bond aimed at capital recognition — AT1, Tier 2 or SNP — are used to finance or refinance in whole or in part eligible environmental or social projects. Failure to comply with the general ESG targets set at the issuer level — let’s say, strategic ESG targets — cannot be linked to the performance of the notes and lead to an event of default. You’ve partially covered this, but perhaps you can give us a synopsis again of what are your recommendations and views to avoid this potential clash between the sustainability objectives, on the one hand — also at particularly the issuer level or strategic level — and the prudential nature of the bonds.

Reymondon, EBA: This is not an easy question. As you mentioned, this is why we had this caveat in our guidance that we wanted to be neutral — we did not want to take a view on the precise nature of these bonds. We just wanted to recall that from a regulatory perspective there are some aspects that need to be clear from an investor’s perspective, also to reduce the reputational risk, even if some will always remain. You can also see from the Commission’s proposal that this is not a straightforward topic, with this mention that the proposal is not meant to interfere with the regulatory requirements for capital bonds. I would probably say that there is a space where the two objectives can be compatible, where there is no loss to absorb — start with this one — and the instrument matures, and then you have quite some full compatibility between the two. And you have another space (normally much narrower!), where the objective might conflict a bit more, in case you have losses for example and where the instruments need to be activated. But hopefully the first space, where there is no loss and the instruments do not need to be activated, is far bigger than the second one.

Lereste, CACIB: The third question we received is on hybrid debt. There has been a boom in the market in the number of sustainable bonds issued by banks, and we’ve seen a peak in the senior non-preferred and Tier 2 since the start of the year. Despite the very good investor appetite for sustainable bonds, there is a kind of reluctance toward the green AT1 segment. From a regulatory perspective, do you see any differences between sustainable senior, Tier 2 and AT1 bonds?

Reymondon, EBA: This is an interesting question, also because when we had the roundtable with issuers, you could see that even among the banks, the position is quite different between those who would not see any problem in issuing ESG AT1 bonds, and others who on the contrary would be quite reluctant to do so. What is certain is that in our guidance we did not want to differentiate between the instruments, even if of course we have recorded some of the aspects that would only apply to AT1 instruments. That said, AT1 instruments are, let’s say, a bit more sensitive for us, we would for sure submit these to a higher degree of scrutiny, in particular in the area that we discussed before, on the potential different remuneration features that could come in the future. We would be more cautious on AT1 instruments because from an EBA perspective, we always held the line that the credibility of the AT1 class should be preserved in all its dimensions. We are a bit reluctant on everything that would touch the AT1 eligibility criteria. In the past, for example, we issued some recommendations for not changing the so-called pecking order for AT1 instruments. While the guidance is valid for all instruments without any differentiation, some will naturally arise, for example for TLAC/MREL instruments potential incentives to redeem lead to different consequences compared to for own funds instruments. In a nutshell, we do not say that the banks cannot issue ESG or Green AT1 instruments; they will just face greater scrutiny.

Donchev, CACIB: Coming back to this remuneration aspect, and also the sustainability-linked bonds, you mentioned you are still examining structures. In this context, we would like to ask you if you think, for instance, whether a step-down structure, i.e. a decrease in the cost of the instrument where certain ESG targets are met would meet the regulatory capital criteria?

Doncho Donchev3

Reymondon, EBA: When we worked on the guidance, we were aware of such possible structures. We were told about possible step-downs, and also other types of structure, like gifts to charities or associations, or using bullet loans and absence of calls. We understand that there could be a lot of different possible structures. Still, we would need to examine them further. With regard to the step-ups, it is clear that if you replicate the structures that you can find in the corporate world — with the step-up triggered by the target being missed — this will not work for capital instruments, I don’t think we will need to elaborate much on this. Regarding step-downs or other types of features, in general we favour simplicity, we do not like innovative features too much. Incentives to redeem are not only step-ups; there can be other forms and other incentives for the banks to buy back or repurchase. We do not have any final view at the moment, but we will continue to reflect.

What is also important for us is that whatever structure is proposed it does not lead to an increase in the cost of capital for the bank, or in an increase in the cost of funding, especially in a wrong moment for the bank. This is something we will scrutinise.

We understand that with these sustainability-linked bonds, banks have a strong desire to make their green or ESG framework and targets credible. But our initial question was, do you need to do this via capital bonds? We understand that for understandable reasons it is not in the senior funding space that this would be the most valuable. But still, we have this question, wouldn’t there be other means to ensure the credibility of the ESG/sustainable framework of the bank? In particular, features that would be kept at the level of the bank itself and not going down to the granularity of the capital bonds.

But as I said, we are starting our reflections there, which is also why the exchanges with non-EU authorities will be very important for us.

Lereste, CACIB: The next question is about the green supporting factor. The EBA recommends gradually including ESG risk in the SREP. Do you support the idea of introducing green supporting factors, i.e. climate-adjusted risk weights of green assets to be lower than the current risk weights? And do you consider it would be appropriate prudential treatment to incentivise investments into low carbon?

Reymondon, EBA: There are several mandates for the EBA in this field, being in the CRR or, more recently, in the Investment Firms Regulation. The deadlines for these mandates are still a bit far away, but we anticipate that we could be asked to accelerate a little the deliveries under these mandates, and we have started the work. There are also some mandates in the securitisation field — we organised a roundtable on green securitisation recently. It will take time, of course, to form our final view.

In general — and this will not come as a surprise —  we always start with a bit of a cautious approach, our starting question would probably be if the prudential framework should be the first that you would have in mind for addressing this type of risk, or the most appropriate one. But we are very far from having a conclusion there.

We started to work in the disclosure area, with draft technical standards on prudential disclosure on ESG risks, including a Green Asset Ratio. The general idea would be to start with understanding how the banks would facilitate the transformation of the balance sheet towards a greener economy. Having all the definitions in place will be a key point. We may progress with a discussion paper in the coming months — this is currently under reflection, it is not yet finally decided — before we can deliver on the final mandates. There are a lot of investigations to do and we need to narrow down the issues a bit before we are ready to answer this question.

The relevant EBA report on the monitoring of AT1 instruments of EU institutions can be found by clicking here.

As mentioned above, this article is part of a series, Bank ESG Capital: Where is the Green Line? drawn from presentations and panel discussions that took place as part of a Crédit Agricole CIB event on 7 September. A pdf including all four parts can be downloaded here.