BRRD & SRM: Where do we stand?

The European Parliament’s recent acceptance of key Commission proposals provides further clarity over the EU’s new financial landscape. Jonathan Blondeau, DCM, capital structuring & liability management at Crédit Agricole CIB, reviews the current state of play and its implications for the bank capital market.

The financial crisis has generated a large number of government-funded bank bailouts from European states that were criticised by the public for using taxpayers’ money and creating moral hazard.

Back in October 2011, the Financial Stability Board laid out the foundation for an effective resolution regime in its “Key Attributes of Effective Resolution Regimes for Financial Institutions” and described the objectives of an effective resolution regime in order “to make feasible the resolution of financial institutions without severe systemic disruption and without exposing taxpayers to loss, while protecting vital economic functions through mechanisms which make it possible for shareholders and unsecured and uninsured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation.”

And on 15 April, a major milestone in the Banking Union was reached: the European Parliament accepted the Commission’s proposals on the Bank Resolution & Recovery Directive (BRRD), the Single Resolution Mechanism (SRM), and the Deposit Guarantee Schemes (DGS) Directive.

The BRRD and SRM illustrate the intention of the European Union to take regulatory integration one step further in order to strengthen the stability of the banking system. They also clarify bondholders’ capacity to absorb losses prior to requesting governmental support.

Jonathan Blondeau, Crédit Agricole CIB

How do the mechanisms work, and what is their purpose?

Bank Resolution & Recovery Directive: Bail-in would include all liabilities with the exception of insured deposits (under Eu100,000), secured liabilities including covered bonds, liabilities arising by virtue of client assets or money, liabilities with a tenor of less than seven days, and employees and trade and tax liabilities.

The sequence of the write-down and conversion mechanism is described in Article 43 of the draft document as follows: Common Equity Tier 1 must be written down first, followed by Additional Tier 1, Tier 2, and finally “authorities can reduce to the extent required the principal amount of subordinated debt that is not Additional Tier 1 or Tier 2 in accordance with the hierarchy of claims in normal insolvency proceedings”. This means that senior debt and uninsured deposits can be written down if the amount of subordinated securities does not cover up to 8% of total assets. Once the 8% threshold has been reached, a Member State could submit a request to the Commission to exempt certain creditors from bail-in. At this point the Single Resolution Fund can step in for up to 5% of total assets. A Minimum Required Eligible Liability (MREL) ratio will be set by regulators for each bank and could be above or below this 8% level.

Single Resolution Mechanism: The SRM offers centralised decision-making built around the Single Resolution Board, which involves permanent members as well as the Commission, the Council, the ECB and the national resolution authorities. In most cases, the ECB would notify the Board and the Commission, as well as the relevant national resolution authorities of a pending bank failure. The Board would then assess whether there is a systemic threat and any potential private sector solution. If this is not the case, it will adopt a resolution scheme. A resolution scheme currently needs to be approved within a weekend, from the closing of the US markets to its reopening.

The Single Resolution Fund, owned and managed by the Board, is expected to reach a minimum target level of 1% of covered deposits (around Eu55bn) over an eight year period, instead of over a 10 year period as initially planned. During this transitional period, the fund will start with 40% of the amount in its first year and will include national compartments for each participating Member State. The resources in those compartments should be progressively mutualised. Before the regulation enters into force, the Single Resolution Fund will be enabled to borrow, which is crucial in the first years due to its low capitalisation.

According to the European Parliament’s and Commission’s press releases, the agreed mechanism is described as a major step forward. But this compromise has raised some criticisms.

First, the size of the fund looks limited compared with those that were necessary during the last crisis. Unofficial estimates from economists on the necessary size of the fund vary between Eu500bn and Eu1,000bn. Even if the new prudential regulation is to prevent a new crisis and its potential damages, Eu55bn looks small. In addition to this, the Single Resolution Fund will have no possible recourse to the European Stability Mechanism, which can lend up to Eu500bn, as some states, such as Germany, wanted to avoid a mutualisation, and states will have to negotiate intergovernmental agreements in order mutualise the national contributions to the fund.

Doubts have also been raised about the decision-making process and the ability of resolution to be implemented under the restricted timeframe whilst having to involve the European Commission, the Council of Ministers, the European Central Bank, the supervisory board of the Single Supervisory Mechanism, the executive board of the SRM and the plenary council.

Agenda: A Provisional Agreement between the European Parliament and the Council on the Single Resolution Mechanism was reached on 20 March. The deal has also been approved by Parliament’s political group leaders and was submitted to the vote at the second plenary session on 16 April ahead of European elections in May. The SRM should enter into force on 1 January 2015, whereas bail-in and resolution functions would apply from 1 January 2016, as specified under the BRRD.

Market and rating implications

Is a new bail-in-able subordinated category of securities about to emerge? Some major issuers have already started to publish their Minimal Required Eligible Liability ratios thereby addressing questions from a growing number of investors. Issuers may issue Tier 2 in excess of the 2% requirement in order to protect their senior spreads. Some issuers may consider not calling existing capital securities that may be disqualified as own funds but keep their subordinated status and reset at very favourable levels given the current low interest rate environment.

Another yet to be fully explored possibility may consist in issuing an additional layer of subordinated debt between Tier 2 and senior debt. This could be an option if a significant repricing were to occur – to date senior debt funding levels have remained at historical lows and contagion from the latest bank crisis has remained very limited.

Impact on ratings: These regulatory evolutions have already moved the rating agencies’ positions regarding both sovereign support to banks as well as capital securities rating methodologies.

In order to take into consideration the tougher bail-in stance from regulators, Standard & Poor’s issued a Request for Comment on 8 February that may trigger further downgrades of hybrid capital instruments, mainly legacy ones, after the publication of the updated criteria. On 4 March, S&P announced a review of government support in European bank ratings as a consequence of the recovery and resolution legislation nearing finalisation. The focus of the latter is that senior unsecured creditors of European banks that S&P considers to be systematically important may now be subject to bail-in. This review should be completed by the end of April and mainly result in changes to outlooks, prior to potential downgrades. By way of background, over 77% of the top 100 banks globally rated by S&P benefit from an upgrade for government support of at least one notch.

On 26 March Fitch published a press release warning that downward revisions were likely within the next two years for most banks due to weakening support from sovereigns.

In Moody’s view, the agreement on the BRRD reached in December is sending a negative signal to unsecured bondholders. In this respect, it is widely expected that Moody’s will review its methodology in the course of the second half of 2014.

Conclusion: Tier 2 and AT1s are now available to issuers thanks to highly supportive market conditions, and loss absorption at the right price no longer seems to be a limit for investors. In spite of the threat of bail-in for senior bondholders, subordinated layers of capital now protect them better. These new regulations provide the market with clearer rules, even if their efficacy remains unproven as long as it is untested.