EU officials are looking at increasing the range of structured notes that can count towards banks’ minimum requirement for own funds and eligible liabilities (MREL) and total loss-absorbing capacity (TLAC) ratios, potentially including liabilities with a minimum value that increases over time
When the European Commission published a comprehensive package of banking reforms last November, Article 45b of the bank recovery and resolution directive (BRRD) was updated to clarify that structured notes would be eligible for MREL if they had a fixed amount of principal payable at maturity, and only an additional return was linked to a derivative.
But in a French working paper circulated in February, and seen by GlobalCapital, community members proposed increasing the range of structured notes eligible for MREL to include liabilities that have a minimum value at any time before they are repaid.
The minimum amount of principal would have to be protected by a floor or a contractual guarantee and could increase over time, but never decrease.
“This makes perfect sense,” said a lawyer focused on capital markets. “But at this stage it not clear which proposals will be approved by European Parliament. It is my understanding that it will be agreed in the next few months, so we can hopefully have a final position in the middle of the year.”
Structured notes are debt securities with an embedded derivative component, whose returns are linked to the performance of a reference asset — such as equity indices, interest rates or currencies.
Debate about which structured notes could count towards loss-absorbing debt ratios has centred on the ease with which regulators could determine a value for the security in case of insolvency.
In the working paper, members suggest that valuations for any eligible notes should be easily available and frequently updated — as with mark to market securities — and that valuations should also be as reliable as possible, to limit legal claims under the no creditor worse off principle.
“A possible way to secure the availability of the bail in amount would be to incorporate in notes’ documentation, the amount of protection which would define the insolvency claim and the bail-inable amount,” argued the authors of the working paper.
A new carve-out?
Throughout the working paper members not only make reference to structured notes counting towards MREL, but also towards TLAC.
TLAC is a capital standard drawn up by the Financial Stability Board and only applies to global systemically important banks (G-SIBs). But it could be tricky including structured notes in TLAC valuations, because banks should meet the requirement using subordinated debt instruments that rank in insolvency below senior liabilities that are not explicitly bail-inable.
Indeed, over the course of 2017 European member states will amend bank insolvency hierarchies to make sure that TLAC-eligible senior unsecured bonds rank below TLAC-excluded instruments like covered deposits or tax related liabilities.
Banks could therefore have to find similar means of making sure that structured notes are subordinated in the capital structure, if they want the securities to count towards their TLAC ratio.
To meet MREL, on the other hand, financial institutions do not have meet a “subordination requirement” — though resolution authorities could require subordination on a case by case basis.
One senior credit analyst said the proposals to include more structured notes as loss-absorbing debt were sensible, but would add “yet another complication in working out how much TLAC or MREL banks have”.
“It is definitely beneficial for principal protected notes to count towards G-SIBs’ TLAC, as well as non-G-SIBs’ MREL,” added the capital markets lawyer. “However, I am still not sure if that is their intention.”
The lawyer was referring to the final paragraph of the working paper, which spelled out possible modifications to Europe’s relevant banking legislation.
The paper’s authors said that Article 45b(2) of the BRRD should be updated to take into account structured notes that have increasing minimum amounts over time, as well as those with fixed minimum amounts.
But they said they would use the new paragraph in the BRRD as a reference for defining what is meant by “derivatives-linked features” in Article 72a(2)(l) of the Capital Requirements Regulation (CRR).
The CRR is partly the basis for transposing TLAC into European law, and Article 72a(2)(l) of text presently excludes “liabilities arising from debt instruments with embedded derivatives”.
EU officials may therefore be considering creating a carve-out in the legislation that would allow certain structured notes to count towards TLAC ratios, according to the lawyer.
Source: Tyler Davies, Global Capital
Original article can be viewed here
