The move — which kicked off a two month consultation period — came after the Australian regulator in September 2023 floated a reduction in “reliance on AT1” or large scale modifications to the AT1 structure, including materially increasing the trigger levels. The country’s four large banks have around A$39bn (€24bn, US$26bn) of such issuance outstanding.

“Unfortunately, international experience has shown that AT1 does not fulfil this function in a crisis situation due to the complexity of using it, the potential for legal challenges and the risk of causing contagion,” said John Lonsdale, chair of APRA.

“These risks are heightened in the Australian context due to the unusually high proportion of AT1 held by retail investors.”

While the total amount of regulatory capital banks would be required to hold would remain unchanged under the proposed approach, large, internationally active banks would be able to replace the 1.5% AT1 bucket with 1.25% Tier 2 and 0.25% Common Equity Tier 1 capital.

Advanced bank requirements for CET1 would rise 0.25% to 10.5%, and Standardised banks’ remain at 8.0%. Smaller banks would be able to fully replace AT1 with Tier 2, upon a reduction in Tier 1 requirements.

After 2027, existing AT1 instruments will be eligible as Tier 2 capital until their first scheduled call date.

APRA expects the volume of Tier 2 funding needed to replace AT1 over the next several years to be around A$35bn. Its base case puts the estimated funding cost — stemming from a potential repricing of Tier 2 instruments without AT1 in the capital structure — at A$70m for Advanced banks.

Although Australian Tier 2s widened on news of APRA’s proposals, with some knee-jerk selling, they are only expected to be slightly negative for the asset class over the medium to long term, according to Daniel Dela Cruz, head of debt capital markets, Australia and New Zealand for Crédit Agricole CIB, with the transition very manageable.

“It will be interesting to see where the circa A$40bn of AT1 liquidity goes once they are called,” he said. “Most of the domestic investors in these securities consider them ‘fixed income’, as they are already exposed to bank equity, and so a good portion of it could well migrate to ETF funds that invest in Tier 2 bonds to continue to chase yield.

“Meanwhile, other domestic investors in these securities who take advantage of the ‘franking credits’ will move to other alternative products or buy more bank equity.”

Dela Cruz notes that Australian banks enjoy healthy demand for their Tier 2 in offshore markets, particularly euros and US dollars, where they are appreciated as low beta, safe haven product and offer a pick-up over senior (non-preferred) paper. He points to a US$1.25bn 11 non-call 10 Tier 2 for ANZ on 23 September that was tightened from the US Treasuries plus 175bp area to 147bp after books peaked at around US$5.5bn — having been recently upgraded, the notes are rated single-A by all the bank’s three rating agencies.

However, a conclusive verdict will only be possible once the new regime is finalised.

“Most investors are still comfortable with the instrument and see very minimal call risk in the new regime,” added Dela Cruz, “although others warned of further price reaction if the proposal is confirmed with more details.”

Outstanding AT1s have benefited from the news, while a A$800m floater perp for ANZ Holdings New Zealand printed the day after APRA’s announcement traded up a point on the day of launch.

“The proposals are positive for AT1 from a technical perspective,” said Dela Cruz, “and mean a much lower risk of non-call, even if this was already negligible.”

Australian banks meanwhile generate very strong capital from their earnings and remain well above APRA minimum requirements, meaning the 0.25% increase in CET1 requirement should not be problematic, he notes.

The revised Australian capital framework also remains more conservative than Basel requirements.

Moody’s said the proposals are neutral for bank capital adequacy but positive for banking system stability because they promote a simpler resolution regime that would limit the severity of losses for investors in a bank resolution.

“In APRA’s discussion paper, it noted banks’ potential reticence to suspend AT1 securities distributions and the complexity of multiple stakeholders as potential hurdles to the effectiveness and timeliness of bank resolution,” the rating agency said.

“Additionally, contagion risk is heightened in Australia because these securities have a high volume of retail investors who may be less equipped to absorb losses.”

Fitch said few countries are likely to follow the Australian example, unless the Basel Committee on Banking Supervision were to issue a recommendation. The committee is nonetheless just one of many looking into the role of AT1.

“While most investors do not expect other regions to follow with similar framework,” said Dela Cruz, “one investor in particular noted that what APRA proposed was indeed a wake-up call — people need to take a step back and reevaluate AT1 as an effective loss absorption instrument.”

Insurance companies and their AT1 instruments are not affected as their position in the capital regime will be retained, APRA confirmed.

Insurers’ ability to continue to issue AT1, while banks cannot, should make them one of the biggest beneficiaries of the move, said Dela Cruz.

You can download a pdf of this article, supplemented by comprehensive details of the regulators’ presentations by Crédit Agricole CIB DCM Solutions, here.

Delphine Reymondon, head of liquidity, leverage, loss absorbency and capital unit at the European Banking Authority (EBA), kicked off the three presentations by saying that while European banks are generally robust in terms of profitability, capital, and liquidity, they face a macroeconomic outlook that is increasingly uncertain — with regard to energy supplies, geopolitics, inflation, monetary policy and a “high risk of recession”.

“The first downside risks are materialising,” she said, with banks reporting the first signs of a deterioration in asset quality, notably in relation to SMEs, consumer credit and energy-intensive sectors.

Along with Reymondon, Korbinian Ibel, director general, universal and diversified institutions, European Central Bank (ECB), flagged a first increase in Stage 2 loans.

“It’s not yet super-worrying,” he said, “but it’s something we are looking at very carefully. As we all know, when interest rates go up, the first thing that comes for most banks is that interest income increases, but the defaults that might follow the interest rate increases come much later, which is why we look at Stage 2 loans as a leading indicator.

“We believe there is a risk — let’s hope it’s not going to be realised — that a scenario will develop which leads to a much worse cost of risk in the future. This is why you see us giving so many warnings.”

While the regulators noted some parallels between the risks of the pandemic and those faced today, Ibel said there is a big difference between the Covid crisis and the Russia-Ukraine crisis.

“During the coronavirus (Covid-19) pandemic, basically everyone assumed a very, very dire scenario,” he said, “and then quarter by quarter you saw improvements in the forecasts because it didn’t turn out to be so bad — fiscal, monetary and supervisory measures were successful, and the economy stabilised much quicker than everybody had anticipated.

“Regarding the current crisis, in 2022 everybody assumed that it was going to be bad economically, but not so bad, and then quarter by quarter, with the energy crisis and the supply chain crisis coming in, the forecasts got worse and worse. This should be kept in mind.”

Banks should not expect a repeat of pandemic support measures, Ibel (pictured below) stressed.

“When we talk to bankers that we supervise, we sometimes have the feeling that they believe they navigated one of the deepest crises of the past decades without any scratches because everything is so great in banking,” he said. “Bankers did an excellent job, of course, and we fully appreciate and acknowledge that, but what should not be forgotten is that many of the positive developments were based on a lot of supervisory support.

“So bankers should not base their modelling on those times.”

In light of these considerations, the ECB has been looking anew at banks’ capital planning and Ibel said that supervisors will challenge management actions to ensure an appropriate level of conservatism.

He noted that dividend restrictions were a price paid for pandemic support measures, but that the ECB has not asked for an extension of its supervisory powers in this respect, judging its current powers to have proven sufficient. However, during a Q&A session, Ibel again advised prudence in respect of dividends.

“If you see an environment in which you will not only most probably observe a deterioration of the economy, but, on top of that, you know that the forecasts might not be 100% accurate, and they are going in a direction that is getting worse and worse, then what is the right reaction for a bank?

“In that situation, it must be to say, ‘I will keep my capital a bit higher. If I pay out now and later face a difficult situation… We saw after the great financial crisis how difficult it is to raise additional fresh capital. If the environment turns out to be very good, and much better than feared at this point in time, I can still pay out later.’

“That is why we like Common Equity Tier 1 (CET1) capital.”

Funding and interest rates: banks must tackle challenges

Reymondon at the EBA warned that the development of interest rates also means a worsening of funding market conditions, just as banks are replacing TLTRO funding. She also elaborated in detail on a specific area of scrutiny for the EBA being the management by banks of the interest rate in the banking book (for example in terms of modifications of assumptions underlying modelling of IRRBB risks, changes in hedging strategies, business model changes if any) and more generally the impact of the increase of interest rates on several prudential aspects.

“Servicing debt will be more costly,” she said, “and we are working on this, running some simulations, also to measure the impact on liquidity ratios in particular.

“There will be the need to substitute in particular this central bank funding with market funding,” added Reymondon, “and we have of course already seen a widening of spreads in wholesale markets, meaning that as some banks still need to reach final MREL targets arriving in 2024, there might be some more difficulties for banks especially of a smaller size and in certain jurisdictions.”

Sebastiano Laviola, director of resolution strategy and cooperation and board member at the Single Resolution Board (SRB), said such a scenario was foreseeable.

“For all the banks that essentially have resolution as a strategy, we always told them to exploit the period when the sun was shining to issue,” he said. “Some did. Others did less.

“We are closely monitoring the development of the markets and the funding plans of the banks,” added Laviola (pictured below). “In a period of extreme uncertainty, for lesser known names and those with weaker ratings, it is clearly more difficult to issue, even at higher prices. Notwithstanding that, some banks of this type have issued recently — albeit certainly at higher prices.”

In addition to the issue of funding, Ibel at the ECB said the development of deposits and in particular greater deposit outflows is a key question. He noted that deposits are typically invested on the basis of non-maturing deposit models, calibrated in a period in which interest rates were falling or stable.

“Many of these models do not even have the interest rate as an explanatory factor,” he said, “meaning that interest rates are not assumed to play a role, which is a very brave assumption for banks to make.

“My biggest concern — which is a scenario that banks should at least consider — would be if interest rates rise further and we suddenly see more and new market entrants with big platforms who see a chance to collect deposits for very low fees and invest them risk-free at a much higher rate. Banks which have invested deposits long term on the basis of their models have no way to counter this, because the assets they have invested in over recent years have relatively low yields.

“It’s not clear whether this will happen,” added Ibel. “The complexity of the regulatory framework, which is mostly seen as a burden by bankers, also gives the system strong protection. But there may be a trigger point where the benefits of entering the market for new players are very large and this is not included in the multi-year business plans of banks, so we have already had this in focus and will keep a close eye on any such developments in future.”

Capital framework: handle with care

While acknowledging that the capital framework for banks has become very complex, Reymondon at the EBA said it is not the time to be making changes to it.

“Some work is being done at the Basel table in terms of buffer usability, the role of AT1 and these types of aspects, and we are also doing some work there, but with a different perspective,” she said. “Our perspective is more to gain a better understanding of how all the different bricks in this framework are working together, and we are making some comparisons between different international frameworks to see what could be learned to maybe one day simplify the framework.

“But not today. When we replied to the Commission call for advice on reflections to amend the macro-prudential framework, our view was that we should not do it now. The current framework was not properly tested even during the Covid-19 pandemic, particularly in view of all the government support measures, and it is not even fully implemented yet.

“Simplifying the framework would also involve big hurdles,” added Reymondon (pictured below). “Since it’s so complex, if you wanted to simplify it, you would need to restart from… I wouldn’t say zero, but it’s really difficult to just touch some bits and pieces — it would be quite long term work. Stability in the regulatory framework is also key from an EBA perspective.”

Ibel echoed Reymondon’s sentiments, while highlighting that, in its response to the European Commission’s call for advice, the ECB had recommended other changes.

“The most important thing, and a lesson from the pandemic, is that it would be beneficial to have more macroprudential policy space via larger releasable capital buffers,” he said. “When we entered the pandemic, the buffer that was supposed to do that was the countercyclical buffer (CCyB), but there was not enough capital in the CCyB to be really impactful. This is why we had to use other measures, but that was a patch and not an optimal solution.

“There are different policy options to do this. You could have a fully or partially releasable capital conservation buffer. You could have a higher CCyB in normal times, so basically a positive neutral rate. Or you could have a core rate for the systemic risk buffer.”

Ibel then turned to the revised Capital Requirements Regulation (CRR3), reiterating the ECB’s opposition — shared by the EBA — to proposed deviations from Basel III.

“There is an international standard,” he said. “It was negotiated with the Europeans in the room — I’m the representative of European banking supervision at the Basel table — and this was already a compromise. Deviating from it now will most probably just lead to scepticism among international investors about the viability of European banks and whether or not they can trust the numbers — which is, of course, the worst thing we can do, because in the end it will increase funding costs and just make European banks less investible.

“So, from a bankers’ perspective, one might consider it a little bit short-sighted — all this lobbying to deviate here and there and get a little relief on different aspects. International investors are fully aware that Europe was and is materially non-compliant with the Basel framework. So please understand the importance of deviating as little as possible — it’s an issue that’s really dear to our hearts.”

You can download a pdf of this article, supplemented by comprehensive details of the regulators’ presentations by Crédit Agricole CIB DCM Solutions, here.

You can also download a pdf of this article, also including SRB priorities and the latest regulatory updates from CACIB, here.

The European Banking Authority and European Central Bank representatives both opened their presentations by commending the health of the European banking sector.

“Fortunately, the banking system has shown its resilience,” said the ECB’s Fernandez-Bollo, “not only to the shocks of the last year, but also its capacity to absorb further shocks. In the troubled situation we find ourselves in, we do believe in the structural resilience that has very much improved in the European banking system.”

Indeed, Vaillant at the EBA said that key to the European banking sector’s ability to navigate and weather the “unbelievable shock” of the pandemic “with no definitive hurt” was its capital and liquidity position going into the Covid crisis. Compared with a fully-loaded CET1 ratio of less than 11% at the start of the Great Financial Crisis, EU banks entered the Covid crisis with a level of 14.7%, and this rose to 15.3% at the end of 2020, she noted, while they had a liquidity coverage ratio of 173% at the end of 2020, up from 148% at end-2019. NPLs declined further in 2020, from 3.1% end-2019 to 2.5%.

“But also as regulators and supervisors, we could react in a different way than we could have ever done in the past,” added Vaillant. “The adaptive changes that we took were quite quick and well coordinated.”

She cited, for example, the postponement of stress tests, moratoria guidelines and the regulatory relaxation, containing both temporary and permanent measures, known as the CRR Quick Fix.

Management buffer build-up in 2020 - Indicative estimates* June 2020

Source: Supervisory reporting data (preliminary data for Q4 2020), EBA calculations and estimates. *Based on a reduced sample of 116 banks.

Vaillant also hailed the functioning of capital instruments during the crisis, even if the EBA continues to scrutinise developments to weed out unduly complex practices.

“One of the best achievements we have in Europe is that there is no longer doubt about the quality of capital of European banks,” she said.

“When I entered the EBA 10 years ago, this was quite a problem. It’s not anymore.”

Fernandez-Bollo meanwhile pointed to the 2021 stress test results, which he said offer additional comfort. These showed a system level fully-loaded CET1 ratio depletion of around 5.2 percentage points (from 15.1% to 9.9% under the adverse scenario).

“It was a significantly more adverse scenario than the previous one in 2018,” added Fernandez-Bollo, “but the losses were still really manageable, so we can see that banks’ capacity to absorb losses is good.”

Basel III: speedy, fair, loyal

Implementation of the final Basel III reforms (previously referred to by market participants as “Basel IV”) in line with international standards was cited as a priority by both the banking authority and the central bank to ensure continued stability of European banks.

“The regulatory package that is on the way will consolidate the resilience of the European banking system,” said Fernandez-Bollo, “so we will very much welcome that.”

Vaillant called for the “speedy and fair” adoption of the Basel III package to maintain the strength of the banking sector. She acknowledged the importance of “no significant increase” in capital requirements, but noted this constraint is valid on an average level: thus, certain banks and business types will see material increases in risk-weighted assets.

“We are quite happy with the proposal as it is now,” she said.

“It’s very important for us that we remain loyal to the global standards,” added Vaillant. “It’s such a great asset to have global standards that we should not deviate from them.”

And Fernandez-Bollo stressed that banks should be able to grow into the new Basel requirements.

“They can fully absorb it just by continuing the path they are on in terms of risk-weighted assets and CET1 with their current distribution policies,” he said. “We can thereby have a very smooth transition to finalising the new regulatory environment.”

Still lagging on profitability

European banks’ profitability was, however, flagged by the EBA and ECB as a cause for concern, as it has been for many years since the Great Financial Crisis of 2008.

“This post-pandemic situation should be used by the banks of the Eurozone to tackle in particular the structural challenge to profitability,” said Fernandez-Bollo. “Profitability has now rebounded to pre-pandemic levels, but it’s still lagging behind the peers, and the cost-to-income ratio is still really high.”

He acknowledged that the latter may partly be the result of banks investing heavily to transform themselves and prepare for the future.

“And we think that the [Covid] crisis has really been a big driver for M&A,” he added.

“But some are moving, and some are not, so we are really in a mixed situation, and we think that at system level we really need very important steering action.”

Vaillant also cited overcapacity and cost reductions as issues to be addressed, as well as improving confidence in group supervision in order to tackle capital and liquidity trapping at Member State level (also referred to as the Home-Host issue).

Fernandez-Bollo at the ECB said preparations for the challenges of the post-pandemic era now need to be made, particularly a likely delayed increase in non-performing loans (NPLs).

“We have had the paradoxical situation of a very, very strong economic crisis without, for the time being, seeing the pandemic fallout materialising in the position of banking clients,” he said.

Asset quality going forward is also high on the EBA’s agenda, according to the priorities for supervision that it released in November, noted Vaillant.

“What I would like to highlight is that we will need now to manage the long exit path from this crisis,” she said. “The longer the crisis goes on, the greater attention we have to pay to structural effects on the economy, with some sectors declining while others strengthen.

“So we will stress that there is a need for banks to conduct comprehensive risk assessments. Early recognition and having good provisioning policies are very important, as is proactive engagement with individual borrowers — this is what we think is always the best solution.”

Fernandez-Bollo highlighted pockets of risk building up in certain sectors. He said that the environment of abundant liquidity and search for yield had let to the loosening of underwriting standards, for instance, in the leveraged loan market, while the pandemic situation had contributed to greater risks in real estate.

“We have seen the return of very traditional risks that stem from the fact that the financial cycle has not, in fact, been broken by the crisis,” he added. “We can see from equity prices and stresses in fixed income that we are in a traditional high phase of a cycle, even if we are in a non-traditional situation.

“This cycle at some point will reverse, and we need to be prepared for the downturn phase of this cycle.”

In the context of credit risk management, the Vaillant mentioned the report it issued in late November on the benchmarking of IFRS 9 implementation by banks. She said that banks have made significant efforts in implementing the standard, while noting that although the regulator found variations in the way banks have been implementing IFRS 9, this was only to be expected, given the high level of judgement embedded in the standard.

Limited use of the Significant Increase in Credit Risk (SICR) collective assessment is nevertheless one aspect that warrants further scrutiny, noted Vaillant.

Buffers need reviewing post-crisis

The EBA and ECB representatives both acknowledged that regulatory buffers had not operated as intended during the crisis, and Vaillant said the situation definitely has to be reviewed.

“During the crisis, we called many times, as regulators and supervisors, for the buffers to be used, because this is indeed the right moment to dip into the buffers and continue lending to the economy,” said Vaillant. “But there was no such use of the buffers, despite the good capital and liquidity positions that I highlighted.

“There are many possible causes for this,” she added. “Sometimes it may mean that we have not yet built sufficient space for these buffers to be used without too high a stigma. There is obviously the role of the macro-prudential buffers [e.g. the counter-cyclical and systemic risk buffers; these buffers are releasable], which were quite lean in Europe — probably too lean — but also various types of buffers that are individual to banks [e.g. the G-SII/O-SII and Pillar 2 buffers and requirements], where we need to gain a little bit of space for the market to accept the moment they have to be used.”

CACIB notes that some of the early ideas around enhancing buffer usability consist in having a larger share of releasable buffers in “normal times” or reviewing the automaticity of MDA application upon buffer breach (e.g. the UK recently modified its rules such that a pending buffer breach does not mean automatic MDA, as long as there is a credible path to buffer restoration and buffers are breached for the “right reasons”, such as avoiding deleveraging in a recession).

Fernandez-Bollo echoed Vaillant’s thoughts, noting that any enhancements in the usability of buffers must be made without the need for any significant deviations from international standards.

He also underlined that the ECB is not seeking new exceptional or system-wide legally binding powers in respect of stopping dividends or other variable payments outside of the MDA zone, such as AT1 coupons/redemptions and variable compensation. (Note: this matter is the subject of a review article in the CRR Quick Fix).

“We were quite happy with how things evolved, because the banks understood and followed the [dividend retention] recommendation, even if they were not particularly happy about that,” said Fernandez-Bollo. “It was the prudent thing to do at a time of unprecedented uncertainty and it contributed very much to the build-up of the capital base, at the same time that we relaxed some other regulatory standards. But then you’ve seen, once the uncertainty come back to, I would say, normal levels, we were also very happy to withdraw, because we don’t think this should become a regular crisis measure and we are not asking for that.

“Why? Because we think this will give the wrong message, that now, in each crisis, you could expect a general ban on dividends. Dividend measures should be related to the specific situation of a bank — in past crises, it was a quid pro quo for receiving help from the state. In a future crisis, we hope there will never be help from the state, and what has replaced this quid pro quo is the MDA.”

Climate, cyber challenges in focus

Alongside these “classic” risks, the EBA and ECB flagged “emerging” risks — even if they noted that these are already upon us.

“The first one, unsurprisingly, is how to address climate change risks,” said Fernandez-Bollo.

He noted that more than 90% of banks are not aligned or only partially aligned with the ECB’s supervisory expectations on climate risk, and furthermore over 10% of banks neither expect plans to implement these supervisory expectations to be ready by the end of next year, nor have short term deliverables in place.

“We will be taking very important action next year to see that those with plans really go ahead with implementing these, and that the others really start to do something in 2022,” said Fernandez-Bollo. “This is really one of the biggest priorities for next year.

“We don’t expect to find all the answers next year, but we surely should be on track to find them.”

The ECB’s first climate stress tests next year will be a tool in this regard, he noted, although this is unlikely to result in higher capital charges under Pillar 2R or 2G.

“If there is a credible plan, there is no reason why there should be a capital charge,” said Fernandez-Bollo. “As for more traditional risk management issues, we normally ask for qualitative improvements, and it’s only when we are not happy with the path in the qualitative improvements that we go for the quantitative.

“So we hope we will not have to have any quantitative effects next year — this would be a good result.”

Vaillant said the EBA is on board to better define and measure climate risks, and agreed with the ECB that banks need to adopt specific strategies in this regard, noting that the EBA has a mandate to measure the potential impact on Pillar 1 capital charges of climate risk.

“This will be quite a difficult task, because we lack data,” she said, “but intuitively it’s clear to everybody that this risk is growing, so there would probably be a need to better consider the capital charges against it.”

Vaillant meanwhile reiterated the EBA’s cautious stance on banks issuing loss-absorbing instruments in sustainability-linked bond formats (e.g. with step-up features upon ESG KPI breach).

“It’s obvious to everyone that there can be contradictory objectives in such green instruments,” she said, “between their greenness and their loss absorbency. We have to be clear that loss absorbency is the top priority when it comes to capital, and we will never sacrifice that.”

Cyber and IT challenges were the other key emerging risks cited by the EBA and ECB, whether operationally or in terms of competition.

Fernandez-Bollo said that although banks have reported slight improvements with respect to IT, they see potential disruption as the number one operational risk and have reported both an elevated number of incidents and issues with end-of-life systems and greater outsourcing.

“I’m not completely sure the banks are currently identifying the challenges that are arising,” he said, “so this will really be a key factor in our actions in the next years.”

Vaillant also flagged digitalisation as a factor in the profitability issue, although she noted positive changes and investments, alongside the impact of the EBA’s software RTS, and the Digital Operational Resilience Act (DORA).

“Increasing competition from FinTech and BigTech firms require regulators to ensure the level playing field and banks should streamline their digital capacities,” she said.

Vaillant and Fernandez-Bollo both highlighted their institution’s work to enhance “fit and proper” governance, with the EBA keen to facilitate a database that authorities can refer to in respect of board appointments, and the ECB seeking to improve internal governance.

Timeliness of banks’ plans to implement the 13 supervisory expectations set out in the ECB Guide

Source: European Central Bank

Click here for coverage of the Single Resolution Board’s priorities, as discussed by Sebastiano Laviola, board member and director of strategy and policy coordination at the SRB

In 2021, the banks were asked to identify key entities, drivers and quantum of liquidity and funding needs in resolution. In 2022, the banks will be asked to identify the sources of liquidity and collateral necessary to cover funding needs in resolution.

Banks will also be requested to demonstrate the capabilities of their Management Information Systems to produce the necessary data for bail-in valuation and execution, building further on the work undertaken in 2021.

A new focus for the SRB in 2022 will be to assess banks’ work on separability and reorganisation after bail-in.

“Separability is particularly important for resolution cases where you have a partial asset sale as part of the resolution strategy,” said Laviola, “but also for banks with an open-bank bail-in, because they have to work on credible reorganisation measures and demonstrate capability to support the restoration of the bank’s long term viability post bail-in. It is very likely that in a reorganisation plan, after the bail-in, you will have to spin-off some assets and sell some legal entities, and therefore, again, an asset transfer system needs to be in place.”

Depending on the use of a partial transfer tool as either preferred (“Plan A”) or variant (“Plan B”) resolution strategy, the SRB expects either an advanced separability analysis report (SAR) (and a transfer playbook), or a preliminary SAR.

The SRB will also enhance the MREL policy for resolution strategies involving transfer tools.

“Today, if you use a transfer strategy and certain balance sheet indicators indicate a certain degree of marketability of the separated part, there is essentially a reduction in the MREL requirement,” said Laviola. “However, we would like to better link the recapitalisation amount of MREL to the overall assessment of resolvability.”

MREL policy: modifications on NCWO calculation and discretionary bail-in exclusions

In respect of MREL more generally, after the overhaul of the policy determined by the introduction of the banking package (CRR-CRD-SRMR-BRRD), the general framework is now relatively clear and stable.

The SRB will reflect more elements in the assessment of the “no creditor worse off” (NCWO) risk, in particular the methodology will take into account that in the run-up to resolution banks’ balance sheets do not remain stable but change; in addition, the SRB aims instead at introducing in the methodology the potential impact of discretionary exclusions of classes of liabilities from bail-in (discretionary exclusions are decided by the SRB with a view towards preserving financial stability (or for other reasons) and can potentially include corporate and retail deposits, retail-held debt in securities format, etc).

“It is clear that when you approach the point of resolution, normally the balance sheet doesn’t stay constant, it develops, and therefore we have to anticipate — to the extent possible — what type of balance sheet we might face when the bank is coming close to the Point of Non-Viability (PONV) and how this impacts the NCWO calculation,” said Laviola.

“The other part is the potential impact of the discretionary exclusions. We all know that in the hierarchy of the liabilities it is possible for the resolution authority, for a number of reasons, to discretionarily exclude some liabilities. Of course, this means that other liabilities pay more, or there has to be compensation ex post from the resolution fund, and this may impact the NCWO calculation. So, what are these discretionary exclusions? What are the constraints? What is the impact?”

He said an update to the SRB MREL policy reflecting the evolution of the bank’s balance sheet in the run-up to resolution and NCWO calculations will likely be introduced in 2022, and changes relating to discretionary exclusions may be introduced in 2023.

M-MDA applies, but is different to classic MDA

Laviola then took the opportunity to discuss the MREL Maximum Distributable Amount (M-MDA), highlighting that — in contrast to prudential MDA — the M-MDA regime is not automatic, but subject to a discretionary decision of the resolution authority, following specific procedural steps and assessment criteria.

Where the combined buffer requirement considered on top of the MREL requirement is breached — or expected to be — banks should notify the SRB immediately and then, in stage one, provide the SRB with monthly information while it assesses the criteria in Article 10a(2), in consultation with the ECB, whether to impose a M-MDA restriction. If the breach continues, nine months later, under stage two, the M-MDA is, in principle, applied — unless, Laviola noted, at least two of five exceptional conditions set out in Article 10a(3) SRMR are fulfilled.

“For example, if there is general financial turmoil, so that the reason why the bank cannot issue is not idiosyncratic to the bank but a generalised condition,” he said. “Another condition is that exercising the powers would lead to negative spill-over effects in other parts of the banking sector, meaning there could be a financial stability impact.”

How will the SRB assess whether to impose M-MDA?

Source: Single Resolution Board

Permissions regime: banks make limited use of the General Prior Permission

The SRB Permissions regime for early reductions of MREL-eligible liabilities (e.g. calls, repurchases, etc) has been refined, with changes valid from 1 January 2022, and at CACIB’s event Laviola said that, according to a preliminary assessment, more than 40 applications for General Prior Permission (GPP) to reduce eligible liabilities instruments by a predetermined amount for a specific period had been received.

Following the publication by the EBA of its final report on the draft RTS on own funds and eligible liabilities in May 2021, the European Commission was expected to publish a delegated regulation by the end of 2021. Since the publication has been delayed and this is now expected around the middle of 2022, the SRB has updated the provisions of its transitional regime to reflect the final report on the draft EBA RTS. Banks were thereby requested to apply for General Prior Permissions until 1 October 2021, so that they could be effective on 1 January 2022 and remain in place when the delegated regulation will come into force, unless it contains substantial changes from the draft RTS.

According to the legislative framework, banks are requested to respect a margin above the MREL requirement after deducting the GPP predetermined amount, and according to the draft RTS, the predetermined amount cannot exceed 10% of the total amount of outstanding eligible liabilities.

“This represents normally a substantial amount,” said Laviola, “and in fact, the banks have not used the full envelope; rather, half of it, except for a few cases.”

In addition to being able to call, redeem, repay or repurchase eligible liabilities under a GPP, banks can also request ad hoc permissions to redeem specific instruments, in accordance with Art.78a CRR.

Final MREL shortfall reduced by €23bn in a year, to €40bn

The average final 2024 MREL overall target is 26% of total risk-weighted assets (RWAs) including the CBR, and the average subordination target 17.6%, while the average MREL and subordination binding intermediate targets, effective 1 January 2022, are 25.2% and 17.5%, respectively. According to the SRB’s MREL dashboard, as of June 2021, the aggregate shortfall of 77 banks versus their binding intermediate targets (including the CBR) was €5bn — “not very big,” according to Laviola — with 20 banks in shortfall. The overall shortfall versus final 2024 MREL targets meanwhile fell by 37% (around €23bn) with respect to the previous year, to about €40bn.

Laviola said banks had been helped by “very buoyant” market conditions and very low rates.

“Therefore, we expect almost all banks to respect the binding intermediate target,” he added.

Weekly euro-banks’ issuances (EUR bn)
(Weeks start on Wednesday and end on Tuesday)

Source: Dealogic, ECB calculations

Is senior preferred debt a funding or MREL instrument? It is always bail-in-able, but bigger banks have more subordinated liabilities

Laviola then addressed a question from the audience on whether senior preferred debt can be seen as a funding instrument, or whether it is always a bail-in-able and MREL-eligible instrument. He began by making a clear distinction between senior preferred debt in securitised format (bonds, certificates, etc) and pari passu debt in non-securitised format, such as deposits, operational liabilities, etc. Laviola reminded the audience that when BRRD 1 was introduced, it preceded the TLAC term-sheet and that, outside of own funds instruments, senior preferred debt constituted the majority of bail-in-able resources of the banking system.

In the wake of statutory preparations for the banking system to meet TLAC, the European legislator introduced senior non-preferred (SNP) debt. This is a good innovation as it ranks below liabilities that are, or can, be excluded from bail-in and therefore helps in addressing the NCWO issue. However, SNP comes at an extra cost given its enhanced loss absorbency.

Laviola then made the link to the liabilities structure and hierarchy of banks’ liabilities that is the critical determining factor for which types of liability are subject to bail-in and which get excluded. And the liabilities structure of a bank is closely linked to its size and international reach.

• On one side, large international banks tend to have all types of liabilities on their balance sheet and therefore resolution, in CACIB’s understanding, may be carried out by using largely own funds and SNP debt.
• At the other end of the spectrum, there may be banks which have a balance sheet size of below €30bn and may still be earmarked for resolution, in which case also a full MREL requirement will apply. However, such banks tend to have predominantly only capital and deposits. In such cases, senior unsecured debt that such banks may raise will serve predominantly for MREL purposes.

Are deposits and debt sold to retail really bail-in-able? Legislation says, yes, with caveats

This then prompted a question as to whether MREL-eligible deposits and debt sold to retail and SME investors is really bail-in-able or should the market assume that it will be subject to discretionary exclusion from bail-in? Laviola first reminded the audience that according to the legislation such liabilities are bail-in-able. However, there are certain caveats:

• The first caveat is the discretionary exclusion itself, which is decided by the resolution authority. However, in order for the resolution authority to decide, it needs full information on the liabilities side of the bank as to instruments and their exact ranking — this would then enable the resolution authority, when drafting the resolution scheme, to decide which liabilities cover losses and in what order. This is then complemented by an analysis as to the depletion in the run-up to resolution and financial stability and confidence effects of the bail-in of certain debt types.
• The second caveat is that the regulation provides certain restrictions as to what type of retail investor can be considered as a “bail-in-able” counterparty: the retail investor must have a well-diversified financial portfolio of a certain size, must be documented as well-versed in financial matters, and must be able to invest in material minimum sizes [CACIB: this serves to ensure that a natural person investor can actually afford the loss due to bail-in without having to face financial ruin].

CMDI review can substantially enhance resolvability, but needs deposit ranking and DGS reform

Beyond the current legislation, Laviola then stated that the bail-in-ability of certain deposits and debts sold to retail/SME clients is one of the core debates on the Crisis Management & Deposit Insurance (CMDI) legislative review (covering the BRRD and DGSD and their interactions).

Clearly, there may be issues as to the resolvability of banks at the low end of the size scale that are earmarked for resolution (the “middle class” banks: too large for liquidation and “too small” for resolution) — these issues relate to whether there is a sufficient amount of liabilities that can be truly bailed in without triggering considerable adverse effects. In this case, the SRB’s position on solving this issue consists of introducing up to four elements:

• Introduce a general depositor preference in the EU, meaning that large corporate deposits rank senior to senior preferred debt uniformly throughout the EU rather than the current mixed situation — such a ranking would largely resolve the NCWO issue created in situations where certain pari passu debts are excluded from bail-in in a resolution, but would be included in the insolvency waterfall of a hypothetical liquidation.
• Abolish the super-preference for DGS as per current legislation and let all deposits rank pari passu.
  • What is “super-preference” of DGS and role in resolution? Outside of secured debt and certain liabilities that may be preferred by law, such as the liquidation expenses, employees’ salaries, etc, DGSs subrogating to the rights of covered depositors have the most senior liability ranking and rank above SME and large corporate deposits, making their potential contribution in a resolution scenario rather difficult and limited.
  • This would contribute to enhancing the Least Cost test that limits DGS’s intervention in resolutions to the maximum final loss the DGS would suffer in a liquidation of the bank (which is today rather limited, given the DGS super-preference in liquidation, after having reimbursed covered deposits).
• Harmonise the criteria for the Least Cost Test throughout the EU.
• In this context, the introduction of a European Deposit Insurance Scheme (EDIS) would be a game-changer.

With such a scheme in place, upon entry into resolution the DGS could intervene once the bank’s own funds and “side effect free” bail-in-able debt are consumed and there remains a shortfall to be covered until the achievement of the liquidation or resolution plan target.

The DGS could be further supported through SRF contributions once the 8% TLOF threshold is met, whilst the introduction of EDIS would mean that there would be no danger that national DGS’s can run out of resources.

Finally, DGS intervention is fully compatible with the BRRD, as it does not represent public money, but contributions from the banking industry.

MREL calibration and transparency: here for TLAC, MREL to come in 2024

At the end of the CACIB event, the question of MREL calibration and transparency was addressed — the legislation and its own MREL methodology provide the SRB with various options to customise the MREL quantum to resolution plans, with the result that the final MREL may be different from the MREL determined on the basis of the default MREL formula. At the same time, there is no compulsory standardised disclosure on MREL, which means there is a rather mixed picture in terms of bottom-up MREL transparency. The whole situation may be rather frustrating for investors.

Here, Laviola reminded the audience firstly that TLAC disclosure is already mandatory and has to be disclosed in a pre-determined format, whereas MREL disclosure will become mandatory from the 1 January 2024 date from which the final MREL has to be met.

Laviola clarified some of the general adjustments to MREL that the SRB undertakes:

• Pillar 2 adjustments are mostly limited to the banks with higher Pillar 2, as here it can be assumed that many of the potential losses in the run-up to resolution will be covered by the Pillar 2 setting — hence, a lower Pillar 2 can be justified in the recapitalisation amount element of MREL under certain conditions, and depending on the riskiness profile of the bank post-resolution. But this adjustment is not material.
• The adjustment for transfer strategies is much more important as it impacts the RWA amount used to calibrate the recapitalisation amount and market confidence charge. Here, the SRB uses currently a corridor of 15%-25% of assets calibrated based on balance sheet characteristics capturing the overall marketability of the entity. The adjustment estimates the lower perimeter and recapitalisation needs of the entity post-resolution.

Turning then to the disclosure of individual MRELs and its components, there is a trade-off to be made in the run-up to the final MREL target in 2024, with potentially market sensitive information that may adversely impact legitimate interests of the impacted bank.

Laviola sees this matter as also linked to the disclosure of resolution plans or elements thereof.

The disclosure of resolution plans that exists in the US and is about to be introduced in the UK cannot be compared to the situation in the EU. If one looks at the US, the banks are required to produce their own resolution plans under Title I of the Dodd Frank Act — these are the plans that are partially disclosed. Under Title II of the same act, the FDIC as US resolution authority may draw up its own resolution plan and it is free to deviate from the bank’s resolution plan. Resolution plans in the EU are prepared by the SRB and therefore are more similar to Title II plans in the US that are not disclosed.

The SRB clearly acknowledges the positive effects of more transparency: one of the ways in which the SRB considers enhancing disclosure is the yearly publication of resolvability heatmaps — overviews of the progress of the European banking system towards achieving resolvability in anonymised format. Such disclosure is expected in the near future.

The publication of the heatmap would allow each bank to position itself, and all stakeholders to understand how the system is progressing towards full resolvability of each risk profile and dimension.

Why is Moody’s proposing the introduction of the Moody’s Capital Tool?

Our new capital tool is a stochastic and market-consistent framework. We already look at similar metrics in our analysis of insurers’ capital, notably in Europe, following the introduction of Solvency II, and in some parts of Asia. Market-consistent capital ratios add value because they are more economic than accounting ratios. Nonetheless, these ratios are not available in every country and are computed directly by companies thanks to complex models that can vary significantly across the industry. Our new proprietary tool will allow us to perform a market-consistent analysis globally, and in a consistent manner.

What is the targeted scope of application in terms of sectors and geographies?

We are only updating our life and P&C insurance methodologies. Therefore, the tool will not apply to reinsurers and specialised insurers such as credit insurers or mortgage insurers.

The tool is global by design, and we will use it in Europe, Asia-Pacific and the Americas. We are still adding life products in some countries such as the US or Japan, and we do not have scenarios in the Middle East region, but we will continue to expand the scope of the tool.

How is Moody’s going to use the MCT in the rating process?

The tool will complement, but not replace, our existing analysis. We are not proposing to change the scorecard in our insurance methodology and we will continue to look at and discuss regulatory solvency ratios reported by insurers. The tool will add value, but we are also aware that market-consistent capital ratios can be volatile, as we learnt with Solvency II. Therefore, we are not incorporating a direct linkage between the new tool’s capital ratios and our capital adequacy score.

The main benefit of the tool is to improve our discussions with insurers around their management of capital and risks. The tool will, for example, also provide an allocation of capital per risk or by product that will give us more insights and will provide a basis to discuss and better understand how insurers measure and manage the main risks they are facing.

Benjamin Serra, Moody’s

What is the expected rating impact?

There will be no change in ratings because of the introduction of this tool. As I said, the tool will complement our analysis, not replace it. In addition, by construction, this tool incorporates and reflects our current views around risks. In other words, the outputs of the tool should reflect our current thinking. In some instances, the tool will help us formalise this thinking. In other instances, we know, however, that the tool will not be able to capture all the specificities of an insurer, and in these cases, the tool will be less relevant in our analysis.

What is the overall architecture of the MCT?

The tool will project the balance sheet of insurers over a one year horizon in a large number of stochastic scenarios. We have collaborated with Moody’s Analytics — a sister company of Moody’s Investors Service but separate from the rating agency — to build this tool. We have leveraged existing Moody’s Analytics’ products to generate the scenarios, for example, but also to create proxy functions that we use to recalculate how assets and liabilities change in all scenarios.

We then use the results of all these simulations to compute capital ratios, but also other types of outputs that can help us slice and dice the results in multiple dimensions.

Source: Moody’s Investors Service

What are the key sources of information used as inputs to the MCT?

We have decided to rely on public information and on a certain amount of private information that we already collect today for our rating process. We use, for example, a breakdown of investments by asset category, a breakdown of liabilities by country or by product, exposure to cat risk, or relative synthetic indicators such as the duration of assets.

Simple data may be a source of limitation of the tool, but with more than 600 inputs, we believe we struck a good balance between granularity, relevance and keeping use of the tool manageable. In particular, we will not ask insurers for new information; we would rather spend time with companies discussing the risks we have identified and how they manage these risks, than focusing too much on the inputs.

How would you describe the economic scenarios compared to the Solvency II formula (e.g. more, or less severe)?

We have not tried to replicate the Solvency II methodology and it is therefore difficult to compare the two frameworks. Our scenarios are also updated every year, so we are not using static capital charges.

Having said that, we did look at some specific risk factors, such as equity risk. The 99.5% quantile of the European equity markets distribution in our scenarios is actually very close to the 39% capital charge used in the Solvency II standard formula.

One of the differences is the treatment of sovereign bonds: we factor in the default risk of sovereign bonds, while Solvency II does not.

Does Moody’s intend to publish the output of the MCT?

Initially we will only share some outputs with issuers and engage in credit discussions based on these outputs when we think that the tool is relevant. The introduction of the tool in our rating process and the disclosure of outputs in our research will be gradual. Again, we will continue to use and analyse regulatory capital ratios and our scorecard ratios in the assessment of capital.

Will the MCT template be available to external stakeholders?

We have not planned to make the tool available to external stakeholders. The value of the tool resides in all the outputs that are generated besides the capital ratios. We will see which outputs are more valuable for issuers and which ones are more valuable for investors, and we will work to increase transparency over time if we think it is valuable for external stakeholders.

In terms of the available capital, what will be the main adjustments performed by Moody’s, in particular regarding subordinated and hybrid capital instruments?

As we do today for other ratios, we look at capital and at quality of capital in various ways.

In the tool, the standard definition of “available capital” will be calculated from our current definition of shareholders’ equity, calculated based on accounting figures and adjusted to reflect the economic balance sheet (by taking into account, for example, the difference between the fair value of assets and their accounting value, or the difference between the market-consistent value of liabilities and their accounting value). One of the traditional adjustments in shareholders’ equity that we are performing today is the addition of equity credit for hybrid debt. This means that the available capital will incorporate credit for Solvency II Tier 2 debt — which is generally considered as 25% equity and 75% debt — and Restricted Tier 1 (RT1) — which is considered 75% equity and 25% debt.

However, we also look at capital more holistically. For example, when we look at Solvency II ratios today, 100% of the debt component is included in capital, and we will also consider ratios under our new tool by including all hybrid instruments within capital. We also know that the future profits of long term P&C products can be a key source of economic capital for some insurers in Asia, and although this is not explicitly included in our stochastic tool, we will take this into account in our analysis.

After more than a decade of development and a few false starts, IFRS 17 is now due to be implemented as of 1 January 2023. Compared to the existing IFRS 4 accounting framework, IFRS 17 will be a revolution, in particular in the life sector, in terms of profit recognition (no more front-loading of profitability) and accounting rules for insurance liabilities, which will be held at current values by applying current discount curves.

“IFRS 17 will have a disruptive impact on insurance companies, primarily from an accounting perspective, but potentially also on the companies’ underlying business model,” says Alberto Messina, director, EMEA insurance, at Fitch Ratings.

Investors, rating agencies and other stakeholders will need to grapple with the new standard to understand business performance and companies’ credit dynamics.

One of the purposes of the new framework is to bring greater comparability and transparency around the profitability of new and in-force business, but this might not be fully achieved.

“There are many options and underlying assumptions in IFRS 17, in particular in the Contractual Service Margin (CSM), which may hinder the comparability of the key performance indicators,” says Michael Benyaya, co-head of DCM solutions at Crédit Agricole CIB (CACIB).

Comparing IFRS 4 and IFRS 17 balance sheet (liability side)

Note: the relative size of each accounting items is only for illustrative purposes; Source: Crédit Agricole CIB

The opening balance sheet and the comparative year will be a key focus point for the market, adds Szymon Wypiorczyk, DCM solutions at CACIB.

“A comprehensive set of disclosures will be crucial to help investors distinguish between the impact of movements resulting from accounting changes and those related to underlying business performance,” he says.

The new framework will result in the emergence of two new components on the liability side: the CSM, which represents the unearned profit of the group of insurance contracts that the entity will recognize as it provides services in the future; and the Risk Adjustment, which reflects the compensation an entity requires for bearing the uncertainty associated with non-financial risks. Concurrently, shareholders’ equity may decline for some companies.

According to Stephan Kalb, senior director, EMEA insurance, at Fitch, the CSM is expected to be included in the shareholders’ equity in the rating agency’s Prism Factor-Based Capital Model and in the denominator of capital-based ratios.

“As the CSM represents the profit that a company expects to earn over the contract duration, we consider it to have the characteristics of loss-absorbing capital,” he says. “This treatment also means it would compensate for the decline in shareholders’ equity compared to current accounting standards, as day one gains are not recognized immediately under IFRS 17.”

By contrast, the CSM will be treated differently by S&P Global, as up to 50% credit will be granted to the CSM in the S&P insurance capital model. In addition, the Risk Adjustment component will be treated like reserve surpluses not reviewed by S&P, which receive a maximum of 25% credit. As such, it is likely that life insurance companies will have a lower capital output. Regarding financial leverage, the CSM will not be included in the equity base. Although this could result in an increase of the ratio for some companies, it should generally remain below the 40% limit for a “Neutral” assessment under S&P’s criteria.

Moody’s has not publicly commented, but it is expected that the CSM will not be part of the equity base for the computation of leverage ratios.

In the past, a change in solvency or accounting frameworks has not resulted in massive rating changes. In that regard, Messina at Fitch confirms that the rating agency’s view of underlying capital strength and financial performance will most likely not change following the implementation of IFRS 17, as the underlying economic substance remains the same.

“We therefore expect minimal rating impact to insurers under our coverage,” he says.

Companies have not yet communicated on preliminary IFRS 17 figures, but the new framework could have broader implications for insurance rating methodologies.

“We may need to consider adjusting the rating bands associated with the capital-based ratios that we use as part of our rating analysis, depending on the results of the calibrations that will be run as IFRS 17 company data becomes available,” concludes Kalb.

The report, “Exposure Draft: Bank Rating Criteria”, specifies Fitch Ratings’ methodology for assigning new ratings to banks and monitoring existing ratings. Fitch’s proposed rating framework for banks is largely consistent with previous criteria with respect to the core VR and Support Rating aspects of the framework.

The most material changes proposed relate to notching applied to senior and subordinated (AT1 and Tier 2) unsecured debt:

●  Fitch proposes a more forward-looking approach to determining when to notch up a senior debt rating, Derivative Counterparty Rating (DCR) and/or deposit rating:

o  Based on resolution plan and forward-looking issuance expectations — of note, no timeframe on forward-looking horizon provided by Fitch

•  For reference, Moody’s takes MREL/TLAC issuance plans/targets up to three years in advance (base case two years), while S&P has a two year forward-looking horizon

o  Threshold for upgrade revised to a generic 10% of RWA — this replaces current framework of Fitch calculating individual recapitalization amounts on a per bank basis

•  10% of RWA = approximation of 8% P1 + generic 2% P2R assumption (CACIB view)

o  For jurisdictions with general deposit preference (e.g. Portugal, Italy, Greece, Cyprus, Bulgaria, Romania, etc), Fitch will notch down senior (preferred) debt from the IDR (= VR + support, if any), to take into account situations where:

•  “debt buffers are thin or resolution debt buffers are likely to include more senior liabilities”

●  Tier 2 debt notching (banks with VR of bbb- or above):

o  Currently Tier 2 debt is notched down one notch from the relevant rating anchor (typically the VR in the EU + UK)

o  Future proposed method: notch down twice from the relevant rating anchor (same approach as S&P; Moody’s rates Tier 2 debt based on LGF outcome)

●  AT1 debt notching (banks with VR of bbb- or above):

o  Currently AT1 debt is notched down five notches from the relevant rating anchor (typically the VR in the EU + UK)

o  Future proposed method: four notches down from the relevant rating anchor (same approach as S&P; Moody’s typically three notches down)

•  Of note, this is the base case notching for AT1 by Fitch. It remains to be seen whether additional notches will be applied for cases with heightened non-performance risk (e.g. risk of coupon reduction or cancellation due to low ADI or MDA)

●  Additionally, Fitch suggests it can factor sovereign support more routinely into junior debt of banks with IDRs that are driven by sovereign support

●  Fitch also proposes a new approach for its core capitalization metric. Where disclosed, Fitch proposes to use the regulatory Common Equity Tier 1 ratio instead of its existing approach based on Fitch Core Capital. If fully-loaded CET1 ratios are disclosed, this is the measure that Fitch intends to take, otherwise transitional CET1 ratios will be applied

Fitch is currently gathering market feedback until 31 December, after which it will consider the feedback and finalise the criteria. During the exposure draft period, it will apply the existing criteria to existing ratings, but will already apply the criteria described in the exposure draft to new rating assignments. We expect the finalisation to occur in 1H20.

With the base case Tier 2 notching of -2 (from -1), some banks’ Tier 2 ratings are more at risk of falling into sub-investment grade category and losing index eligibility. UniCredit Tier 2 bonds (Baa3 Stable/BB+ Stable/BBB- Negative) may be vulnerable to falling back to sub-IG if downgraded by Fitch. This is after they received index eligibility on 18 July when Moody’s upgraded its Tier 2 rating to IG. Tier 2 bonds from CaixaBank, Commerzbank and Aareal Bank could also be vulnerable because of the review, still remaining IG, but closer to sub-IG territory.

With the base case AT1 notching of -4 (from -5), notable beneficiaries include Lloyds (Baa3/BB-/BB+) and Nationwide (Baa3/BB+/BB+), with a Fitch upgrade resulting in two out of the three ratings being IG.

Please see table with more details of Fitch’s proposals and their potential direct rating impact in the pdf of this article here.

SRB updates banks on MREL post Banking Package adoption

In light of the recent adoption of the Banking Package (7 June) — comprising CRR2, CRDV, BRRD2 and SRMR2 — the Single Resolution Board organised its eighth industry dialogue with banks under its remit, in which the authority clarified how it intends to apply MREL and resolution planning under the new legislation.

The SRB clarified that until the BRRD2 transposition (28 December 2020), it will issue MREL decisions based on the current legal framework (SRMR1/BRRD1) implemented via the SRB 2018 MREL policy, while resolution entities of G-SIIs and material subsidiaries of third country G-SIIs will be subject to the external and internal TLAC requirements, based on CRR2, in parallel with the SRB MREL decisions based on BRRD 1/SRMR1.

Additionally, the SRB announced the introduction of an authorisation process with institutions being required to seek approval to call, redeem, repay or repurchase eligible liabilities instruments before they reach their contractual maturity. The permission regime is applicable to G-SIIs and institutions with MREL decisions, while the two types of permissions announced are an instrument-by-instrument permission regime and a general prior permission regime.

Regarding the new Banking Package, the SRB intends to publish the new MREL policy in March 2020, with banks receiving their MREL targets under BRRD2/SRMR2 by March 2021.

Following the eighth industry dialogue, the SRB also published on 25 June an addendum to the 2018 SRB MREL policy for the second wave of resolution plans, which applies to all institutions for which MREL decisions have or will be taken for the 2018 and 2019 resolution planning cycles.

One of the addendum’s key elements is that no prior permission will be required in order to perform market-making and other secondary market activities in own eligible liabilities instruments until 31 December 2019 (subject to specific conditions). In order to continue performing these activities as of 1 January 2020 without an instrument-by instrument approval, banks must have obtained a general prior permission.

Finally, the SRB communicated that an allowance for senior instruments may be granted for external TLAC purposes, of up to 2.5% of RWA until 31 December 2021, 3.5% of RWA from 1 January 2022 and where excluded liabilities ranking pari passu or lower do not exceed 5% of the amount of the own funds and eligible liabilities of the institution. As a transitional arrangement in the CRR, an allowance of 2.5% of RWA will be applicable for G-SIIs until the SRB assesses if there is any material risk of successful legal challenge or valid compensation claims in relation to the no creditor worse off (NCWO) principle.

FSB publishes technical review of TLAC standard

On 2 July, the Financial Stability Board (FSB) released a review of the technical implementation of the FSB principles and term sheet on the adequacy of total loss-absorbing capacity (TLAC) for globally systemically important banks (G-SIBs).

According to the review, progress has been steady and significant in both the setting of external TLAC requirements by authorities and the issuance of TLAC by G-SIIs, while all relevant G-SIBs meet or exceed the TLAC target ratios of at least 16% of RWAs and 6% of the Basel III leverage ratio denominator. Additionally, the FSB concluded that there is no need to modify the TLAC standard.

Finally, the FSB aims to support the implementation of the TLAC standard, among other actions, by continuing to monitor implementation and issuance of TLAC instruments, reporting annually on progress, and considering, as part of ongoing work on bail-in execution, any technical issues relating to bail-inability of TLAC, including TLAC issued under third country law and securities law issues.

EBA publishes updated risk dashboard

On 4 July, the European Banking Authority (EBA) updated its risk dashboard for the first quarter of 2019. The key findings show that the fully-loaded and transitional CET1 ratios remained unchanged, at 14.5% and 14.7%, respectively, non-performing loans (NPLs) improved, while only 25% of banks expect improved profitability in the next six to 12 months.

Countercyclical buffer on an upward trend in Europe

The National Bank of Belgium and Germany’s Federal Financial Supervisory Authority (BaFin) introduced in June Countercyclical Buffer (CCyB) requirements of 0.50% and 0.25%, respectively. Additionally, Denmark’s Systemic Risk Council announced that it expects to recommend a further increase of the CCyB requirement to 2% in the 3rd quarter of 2019 unless the build-up of risks slows down considerably, while it stated that “it is the Council’s opinion that the buffer rate should be gradually increased to a level of 2.5%”.

EIOPA consults on harmonisation of national insurance guarantee schemes

On 12 July, the European Insurance & Occupational Pensions Authority (EIOPA) issued a consultation on the harmonisation of national insurance guarantee schemes to assist with preparing its advice to the European Commission. EIOPA is calling for the establishment of a European network of national insurance guarantee schemes to protect policyholders in the event of a failure of an insurer.

EIOPA launches consultation on opinion on sustainability within Solvency 2

On 3 June, EIOPA launched a consultation on a draft opinion on sustainability within Solvency 2. The draft opinion aims at integrating sustainability risks, in particular those related to climate change, in the investment and underwriting practices of insurance companies. The opinion addresses the valuation of assets and liabilities, assesses current investment and underwriting practices, and seeks to contribute to the integration of sustainability risks in market risks and natural catastrophe underwriting risks for the solvency capital requirements for standard formula and internal model users.

According to the report, stakeholders generally argue that sustainability considerations, in particular climate change, could not usefully be reflected in Pillar 1 requirements. Firstly, a prudential framework for capital requirements, based on a one year time horizon, would be too short for solvency capital requirements to reflect climate change risks. Secondly, specifically for traditional non-life business, the insurance cover period (during which claims can occur) only spans the next 12 months, at the end of which insurers can theoretically adjust the pricing for the future, based on claims experience.

EIOPA publishes recommendations following the 2018 insurance stress test

On 26 April, EIOPA published its recommendations to National Competent Authorities (NCAs) of how to address vulnerabilities identified by the 2018 Insurance Stress Test. EIOPA recommends that NCAs:

- strengthen supervision of the groups identified as facing greater exposure to Yield Curve Up and/or Yield Curve Down scenarios

- carefully review and, where necessary, challenge the capital and risk management strategies of the affected groups

- evaluate the potential management actions to be implemented by the affected groups

- contribute to enhancing the stress test process

- enhance cooperation and information exchange with other relevant authorities, such as the ECB/SSM or other national authorities, concerning the stress test results of the affected insurers that form part of a financial conglomerate.

EIOPA will support NCAs and undertakings through guidance and other measures, if necessary.

Main photo: SRB headquarters, Brussels

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.”

In an information update on the 2016 EU-wide stress tests — the results of which are due on 29 July — the regulator effectively said that it would split out from Pillar 2 “Capital Guidance” it deems necessary to cover potential shortfalls in own funds based on the outcomes of the stress tests.

The move breaks from the EBA’s previous stance of Pillar 2 wholly being included in maximum distributable amount (MDA) calculations — a surprise position announced in December that wrought havoc upon the AT1 market in the first quarter, as market participants had to try to reassess upwards the likelihood of coupons not being distributed.

A relaxation of the moves had been anticipated after pressure from various quarters including the European Parliament, and European Central Bank and EBA representatives had in recent months flagged a likely change. Danièle Nouy (pictured, right), chair of the supervisory board of the SSM at the ECB, for example, said on 8 June that Pillar 2 would be split into binding and non-binding guidance, with only the binding element relevant to MDA.

In its update, the EBA said that the quantitative results of the stress test should be used by Competent Authorities to assess whether a bank will be in a position to meet its Total SREP Capital Requirement (TSCR) under all scenarios (i.e. also the most severe scenarios) and what would be the impact on the Overall Capital Requirement (OCR). In EBA terminology, the TSCR refers to the sum of Pillar 1 and Pillar 2 capital requirements, and the OCR to TSCR plus the applicable Combined Buffer Requirement (CBR — the sum of the Capital Conservation Buffer, systemic buffers, countercyclical buffers, etc).

The EBA then clarified what Competent Authorities may undertake in the event of a breach of the TSCR under the stress test. If there is no danger of imminent TSCR breach, then the Competent Authorities should perform additional analysis as per paragraph 366 of the EBA SREP Guidelines.

Following this analysis the EBA details two specific measures the Competent Authorities could consider:

• Potential restrictions on dividend payments to shareholders; and/or
• The setting of additional Capital Guidance, positioned above the CBR.

According to Doncho Donchev, capital solutions, debt capital markets, Crédit Agricole CIB, of critical importance are the EBA’s clarification that (i) the Capital Guidance sits above the CBR and (ii) the Capital Guidance is not included in the calculations of the MDA, i.e. a breach of the Capital Guidance does not lead automatically to distribution restrictions, including the payment of coupons on AT1.

He said that the EBA is effectively introducing into the EU framework a split between Pillar 2 into Pillar 2A and 2B —akin to that used by the UK Prudential Regulation Authority (PRA), where Pillar 2B (equivalent to the Capital Guidance) is dubbed the PRA buffer.

“Provided the ECB/SSM applies the EBA statements in this update, then the Pillar 2 included for SSM banks supervised by the ECB should be reduced and thus the threshold for restrictions which apply to AT1 coupon payments should be lowered by the amount of the stress test-related component currently included in Pillar 2,” said Donchev.

He said that this should provide welcome relief to the sector.

“After the surprise SREP decisions which led to the sell-off — the violence of which obviously surprised even the regulators — they have sought to calm the market and make structural improvements,” said Donchev. “So, following the informal announcements from Danièle Nouy and Sabine Lautenschläger, now we have the first regulatory announcement in writing, which obviously provides a further brick on the road to regulatory repair.”

He noted that if the stress tests reveals the danger of an imminent TSCR breach, Competent Authorities nevertheless have the flexibility to include the Capital Guidance in the Pillar 2 requirement, i.e. Pillar 2B is added to Pillar 2A and repositioned below the CBR.

The results of the stress tests must be factored into the 2016 SREP, applicable from 2017.