Banking reform updater: Bank Recovery and Resolution Directive II

Introduction

The EU banking package was adopted on May 20, 2019 by way of two Directives (the Capital Requirements Directive V¹(CRD V) and the Bank Recovery and Resolution Directive II² BRRD II)) and two Regulations (the Capital Requirements Regulation II³ (CRR II) and the Single Resolution Mechanism Regulation II⁴ (SRMR II)). .

The objective of the package is to further reduce risk in the EU banking sector by making a number of targeted amendments to existing EU legislation that implement the international reforms agreed by the Basel Committee on Banking Standards and the Financial Stability Board (FSB).

In particular, the FSB standard on ‘Total Loss-Absorbing Capacity’ (TLAC), applicable to global systemically important banks (G-SIBs), is incorporated into existing EU rules on the ‘minimum requirements for own funds and eligible liabilities’ (MREL). The reason for this is that both have the same objective – loss absorption and recapitalisation capacity – and therefore need to be harmonised.

In this briefing note we consider the amendments that the BRRD II make focussing in particular on TLAC adoption and the changes to contractual recognition of bail-in. We then take a brief look at how the COVID-19 pandemic has affected the position.

TLAC adoption

Introduction

On November 9, 2015 the FSB published its TLAC standard which was endorsed by the G20 in November 2015. The objective of the TLAC standard is to ensure that G-SIBs (referred to as global systemically important institutions (G-SIIs) in the EU legislative framework) have the loss-absorbing and recapitalisation capacity necessary to ensure that, in, and immediately following, a resolution, those institutions can continue to perform critical functions without putting financial stability at risk.

In its communication of November 24, 2015⁵ the European Commission (Commission) committed itself to bringing forward a legislative proposal by the end of 2016 that would enable the TLAC standard to be implemented in EU law by the internationally agreed deadline of 2019.

As the TLAC standard was being published, the EU had already introduced, as part of the Bank Recovery and Resolution Directive⁶ (BRRD I) a similar requirement – MREL. MREL pursues the same objectives as the TLAC standard but is of wider application in the sense that it applies to EU credit institutions and investment firms⁷ (hereafter financial institutions). The MREL requirement also has to be set specifically for each financial institution by the EU Member State resolution authority, without a default statutory minimum requirement. The BRRD I does not provide for mandatory MREL subordination, although the TLAC standard requires minimum subordination levels for G-SIIs.

TLAC standard

The TLAC standard for G-SIBs is being implemented in the EU through changes set out in the CRR II and CRD V⁸. The BRRD II introduces targeted amendments to MREL calibrating it with the TLAC standard.

In terms of the TLAC standard, the FSB expected G-SIBs to meet from January 1, 2019:

• A minimum external TLAC requirement of 16 per cent of the resolution groups’⁹ risk weighted assets rising to 18 per cent from January 1, 2022.
• A minimum TLAC requirement of at least 6 per cent of the Basel III leverage ratio denominator, rising to 6.75 per cent from January 1, 2022.

A TLAC term sheet produced by the FSB specifies the criteria for instruments and liabilities that qualify as TLAC eligible instruments.

MREL harmonisation

Under BRRD I MREL is currently expressed as a percentage of a financial institution’s total liabilities and own funds. It is also set by the EU Member State resolution authority for each financial institution.

BRRD II changes this by imposing a minimum MREL requirement on G-SIIs which is calibrated at the same level as the TLAC standard. The calculation of MREL is by reference to a risk-based ratio based on risk-weighted assets and a non-risk-based ratio based on the leverage ratio exposure which represents a hard floor. Financial institutions that are classified as ‘resolution entities’ under the BRRD II (see below) and are deemed to be G-SIIs or part of a G-SII must at all times:

• Satisfy an external TLAC requirement of a risk-based ratio of 16 per cent of total risk exposure amount / a non-risk based ratio of 6 per cent of leverage ratio exposure measure, calculated on a consolidated basis at resolution group level, from June 27, 2019 until December 31, 2021.
• 18 per cent of total risk exposure amount / 6.75 per cent of leverage ratio exposure measure from January 1, 2022.

BRRD II enlarges the group of banks that will be subject to the minimum MREL requirement. It does this by creating a new category referred to as “top tier banks”¹⁰. These are non G-SIIs with total assets in excess of €100 billion. Financial institutions not meeting this criteria can still be classified as a top tier bank under certain conditions.

Top tier banks will be subject to MREL requirements comprising¹¹:

• A risk-based ratio of 13.5 per cent, representing own funds and eligible liabilities of the financial institution expressed as a percentage of risk weighted assets.
• A non-risk-based ratio which, when fully in force, will be set at a ratio of 5 per cent, representing the own funds and eligible liabilities of the financial institution expressed as a percentage of the leverage ratio exposure measure.

For financial institutions that are neither G-SIIs nor top tier banks, there will be no statutory minimum MREL requirement. The EU Member State resolution authority will continue to determine this. In addition, it will remain open to resolution authorities to impose on G-SIIs and top tier banks institution specific requirements that exceed the minimum MREL requirement.

BRRD II introduces a new Article 45b in BRRD I which cross-refers to a new Article 72a of CRR I, introduced by CRR II, specifying which liabilities are eligible to qualify as MREL. The eligibility for the TLAC standard as incorporated by CRR II and CRD V and the BRRD II MREL requirement are aligned with the exception of subordination and embedded derivatives. In terms of subordination, to be eligible for the CRR II TLAC standard, an instrument must be wholly subordinated to claims arising from excluded liabilities¹². This is dis-applied for the purpose of the eligibility for the MREL requirement. For embedded derivatives, certain debt instruments with derivative-like features (such as structured notes) may be MREL eligible liabilities, provided certain conditions are met¹³.

Access to EU Single Resolution Fund

It’s worth noting that BRRD II inserts an EU specific requirement not found in the TLAC standard by introducing a minimum requirement of 8 per cent of total liabilities and own funds as from 2024. The purpose of imposing this EU centric requirement is so that large EU financial institutions may fulfil the requirements for accessing the EU Single Resolution Fund.

Subordination

Subordination is important in the sense that it sets how much of the MREL requirement has to be met with subordinated liabilities (those ranking below traditional senior debt). Under BRRD I the resolution authority could require subordination on a case-by-case basis. Rather than introducing full MREL subordination, BRRD II opts for certain partial subordination requirements applicable to different categories of banks.

In summary these are:

• G-SIIs – subordination criteria reflects the TLAC standard but with the addition of a mandatory floor of 8 per cent total liabilities and own funds¹⁴.
• Top tier banks – highest of 13.5 per cent total risk exposure amount, 5 per cent leverage ratio exposure amount, 8 per cent total liabilities and own funds (capped at 27 per cent total risk exposure amount)¹⁵.
• Banks not meeting the top tier bank criteria but whose failure poses a systemic risk to the EU Member State, as determined by the national resolution authority – same as top tier banks without the cap of 27 per cent total risk exposure amount.¹⁶.
• All other banks: subordination can be required where there are risks of no credit worse off claims¹⁷.

Resolution entity and resolution group

BRRD II introduces the concepts of ‘resolution entity’ and ‘resolution group’ and makes a number of amendments to BRRD I as regards group resolution planning, in order to take into account both the Single Point of Entry (SPE) resolution strategy and the Multiple Point of Entry (MPE) resolution strategy as recognised by the TLAC standard. Under the SPE resolution strategy, only one group entity, usually the parent undertaking, is resolved, whereas other group entities, usually operating subsidiaries, are not put under resolution, but transfer their losses and recapitalisation needs to the entity to be resolved.

Under the MPE resolution strategy, more than one group entity might be resolved. The amendments introduced by the BRRD II provide further clarification as to which the entities that might be subject to resolution actions.

Internal MREL

Principle (vi) of the TLAC standard concerns the concept of internal TLAC which is the loss absorbing capacity that resolution entities have committed to material sub-groups. It provides for a mechanism whereby losses and recapitalisation needs of material sub-groups may be passed with legal certainty to the resolution entity of a G-SII resolution group, without entry into resolution of the subsidiaries within the material sub-group. A material sub-group consists of an individual subsidiary or a group of subsidiaries that are not themselves resolution entities and that, on a solo or sub-consolidated basis, meet certain quantitative criteria specified in the TLAC term sheet, or are identified by a bank’s crisis management group as material to the exercise of the bank’s critical functions.

BRRD II introduces a new Article 45f into BRRD I which provides for internal MREL. The requirement applies to financial institutions that are subsidiaries of a resolution entity but are not resolution entities in their own right. Such entities are required to issue eligible (debt) instruments within the group that would be bought by resolution entities. Where the entity reaches the point of non-viability, these instruments will be written down or converted into equity and the losses of that entity will be up streamed to the resolution entity. Under certain conditions an EU Member State resolution authority may waive the application of internal MREL to a subsidiary that is not a resolution entity. Also, an EU Member State resolution authority may permit the requirement for internal MREL to be met in full or in part with a guarantee provided by the resolution entity.

According to Article 92b of CRR II, the target for internal MREL is set at 90 per cent of the requirement that would apply to the subsidiary if it were a stand-alone bank. Thus, the target in the EU is at the higher end of the 75-90 per cent target determined by the FSB for the TLAC of G-SIIs.

In the UK, the Bank of England has previously published a Statement of Policy on its approach to setting MREL (including internal MREL)¹⁸. Internal MREL is set for a ‘material subsidiary’ of a group and is scaled in the range of 75 per cent to 90 per cent of the full amount of external MREL.

Selling MREL liabilities to retail clients

A new Article 44a of BRRD I will place certain conditions on firms wishing to sell MREL-eligible liabilities to retail clients. Firms will have to perform and document a suitability test prior to the sale. The suitability test will be carried out in accordance with Article 25 of MiFID ¹⁹. Should a retail client have a financial instrument portfolio of less than EUR 500,000, he/she must not invest an aggregate amount exceeding 10 per cent of the portfolio in MREL eligible liabilities and that the initial investment in these liabilities is at least €10,000. Alternatively, EU Member States will introduce a minimum denomination of at least €50,000 for MREL eligible liabilities.

MDA restriction

Where a financial institution does not meet its MREL requirements, the EU Member State resolution authority may impose a maximum distributable amount restriction after consulting with the competent authority²⁰. During the first nine months of the breach, the resolution authority will assess whether to impose such restriction. Such assessment must be carried out monthly while the MREL breach persists. After nine months, the maximum distributable amount restriction becomes mandatory unless certain conditions apply²¹.

Timing

EU Member State resolution authorities will determine the appropriate transitional periods for financial institutions to meet both MREL and the required level of subordination. The deadline for compliance is January 1, 2024. An intermediate MREL will be set, as a rule, on a linear progression to remedy any shortfall (the shortfall will be remedied on a pro rata basis per year). The deadline for the implementation of the intermediate MREL is January 1, 2022²².

Contractual recognition of bail-in

Background

Since January 1, 2016, Article 55 of BRRD I has required financial institutions established in EU Member States to include contractual terms in any agreements governed by the laws of non-EU Member States, which create certain payment and other liabilities to specify that those liabilities may be subject to bail-in under BRRD I. ‘Bail-in’ refers to powers exercisable by resolution authorities in EU Member States to rescue troubled EU banks by writing down their debt or converting bonds into equity. The rationale is to ensure counterparties contracting with EU financial institutions under third country law (i.e. not the law of an EU Member State), acknowledge and agree to the bail-in powers exercisable in the EU.

Legally or otherwise impracticable

BRRD II amends Article 55 by introducing an exemption where it would be legally or otherwise impracticable to include a contractual recognition of bail-in clause in a contract.

The recitals²³ to BRRD II provide some further learning on impracticability:

“For example, under certain circumstances, it could be considered impracticable to include contractual recognition clauses in liability contracts in cases where it is illegal under the law of the third country for an institution or entity to include such clauses in agreements or instruments creating liabilities that are governed by the laws of that third country, where an institution or entity has no power at the individual level to amend the contractual terms as they are imposed by international protocols or are based on internationally agreed standard terms, or where the liability which would be subject to the contractual recognition requirement is contingent on a breach of contract or arises from guarantees, counter-guarantees or other instruments used in the context of trade finance operations. However, a refusal by the counterparty to agree to be bound by a contractual bail-in recognition clause should not be considered as a cause of impracticability.”

The European Banking Authority (EBA) is to develop regulatory technical standards (RTS) on the conditions where it would be impracticable to include a contractual recognition of bail-in clause.

Notification

Where a financial institution determines that it is legally or otherwise impracticable to include a contractual recognition of bail-in clause in a contract it must notify its EU Member State resolution authority. EU Member States are to ensure that the obligation to provide contractual recognition of bail-in in a contract is automatically suspended from the moment its resolution authority receives the notification from the financial institution. Where the resolution authority concludes that it is not legally or otherwise impracticable to include a contractual recognition of bail-in clause it shall require within a reasonable timeframe after the notification for the inclusion of a such a term. The resolution authority may also require the financial institution to amend its practices concerning the application of the exemption from the contractual recognition of bail-in.

The EBA will prepare draft RTS on the conditions in which an EU Member State resolution authority may determine that it disagrees with a financial institution’s assessment of impracticability and the reasonable timeframe in which the contractual term must be rectified. The EBA will also prepare draft implementing technical standards to specify the formats and templates for the notification of resolution authorities. The EBA will submit these draft RTS to the European Commission by June 28, 2020.

Current UK position

In the UK the Prudential Regulation Authority (PRA) currently has a Supervisory Statement²⁴ that sets out its views as regards impracticality in the context of the contractual recognition requirement and the considerations financial institutions could take into account when determining impracticability. Whilst the PRA expects financial institutions to make their own assessment on impracticality, it gives the following non-exhaustive list of examples:

• Relevant third-country authorities have informed the financial institution in writing they will not allow it to include contractual recognition language in agreements or instruments creating liabilities governed by the law of that third country.
• It is illegal in the third country for the financial institution to include contractual recognition language in agreements or instruments creating liabilities governed by the laws of that third country.
• The creation of liabilities is governed by international protocols which the financial institution has in practice no power to amend.
• Contractual terms are imposed on the financial institution by virtue of its membership and participation terms in non-EU bodies, whose use is necessarily on standard terms for all members and impracticable to amend bilaterally.
• The liability which would be subject to the contractual recognition requirement is contingent on a breach of the contract.

Intervention powers

BRRD II inserts a new Article 33a into BRRD I giving EU Member States the power to ensure that their resolution authorities have the power to suspend payment or delivery obligations. This power is subject to certain conditions and is triggered once the financial institution is declared “failing or likely to fail”. The power includes covered deposits and can be imposed for a maximum duration of two days. When exercising the power to suspend payment or delivery obligations the resolution authority is also able, for the duration of the suspension, to restrict secured creditors from enforcing security interests and suspend termination rights for the same duration.

Contractual recognition of resolution stay powers

EU Member States are to require financial institutions to include in any financial contract to which they enter into and which is governed by third country law, terms by which the parties recognise that the financial contract may be subject to the EU Member State resolution authority exercising its powers to suspend or restrict obligations.

EU Member States may also require EU parent undertakings to ensure that their third country subsidiaries include in their financial contracts terms to exclude that a resolution authority exercising its powers to suspend or restrict obligations of the parent undertaking is a valid ground for early termination, suspension, modification, netting, exercise of set-off rights or enforcement of security interests on those contracts.

SRMR II

Mirror amendments

The single resolution mechanism (SRM) is a process that applies to all banks established in EU Member States participating in the single supervisory mechanism²⁵. The SRM is co-ordinated by the Single Resolution Board (SRB) which assesses whether these banks are failing or likely to fail, and prepares for such banks for resolution. A single resolution fund has also been established that provides funding support for the resolution of these banks. The SRM was established by the SRMR I which applied in full from January 1, 2016. The resolution mechanisms in the SRMR I correspond to those set out in the BRRD I. SRMR II contains revisions to SRMR I that mirror the amendments that BRRD II makes to BRRD I.

SRB alters its approach to MREL

On February 17, 2020, the Single Resolution Board (SRB) issued a public consultation on proposed changes to its policy on the minimum requirement for own funds and eligible liabilities. The consultation paper was published in response to the proposed revisions to the SRB’s MREL policy in light of the EU banking package.

In terms of MREL calibration the SRB is modifying and extending its approach in accordance with the new framework. It will calibrate binding MREL intermediate targets and final targets in the 2020 cycle, to be communicated to banks in early 2021. For setting MREL in the 2020 cycle, the SRB will use end-2019 balance sheet data and the final supervisory review and evaluation process decisions and Pillar 2 requirements applicable in 2020.

In the 2020 resolution planning cycle, the SRB also intends to issue internal MREL decisions for non-resolution entities, progressively expanding the scope of the entities covered. The SRB may waive subsidiary institutions qualifying as non-resolution entities from internal MREL, for example, where free transferability of funds is assured.

The deadline for comments on the consultation paper is March 6, 2020. The responses to the consultation will support the SRB in preparing its final MREL policy, expected to be published in Q2 2020. Based on this policy, MREL decisions applying SRMR II.

Timing

At the time of writing the timetable for MREL compliance is as follows:

The EBA plans to continue to monitoring the progress in building up MREL resources and will publish a report annually. The EBA will also soon publish a report on the quality of MREL instruments. Beyond MREL, the EBA will deliver a number of technical standards as mandated by the EU banking package and continue its work in ensuring progress on the topics of resolution planning and resolution execution. At the time of writing the timetable currently stands as follows:

COVID-19

On March 11, 2020, the European Banking Federation (EBF) issued a letter calling on European institutions to implement certain measures to deal with the COVID-19 pandemic. Among such measures the EBF called on the SRB to be flexible with the timing of its MREL decisions so that banks could use the period envisaged in the BRRD II until 2024 and avoid the pressure to issue or renew issuances during the current market instability.

On March 31, 2020, the SRB published its Expectations for Banks document setting out the capabilities that banks within its supervision are expected to demonstrate in order to show that they are resolvable. On the same day the SRB issued a letter from its chair Elke König to banks under the SRB’s remit on potential operational relief measures related to the COVID-19 pandemic.

Among other things, the SRB stated that it was committed to working on the 2020 resolution plans and issuing 2020 MREL decisions according to the planned deadlines in early 2021. However, the letter added that the SRB would apply a “pragmatic and flexible approach” in order to consider postponing less urgent information or data requests to this upcoming 2020 resolution planning cycle. However, the following reports were deemed essential: the Liability Data Report, the Additional Liability Report and the MREL quarterly template. Similarly, the PRA is approaching the COVID-19 pandemic in a pragmatic manner instituting a number of measures that include delaying certain regulatory reporting requirements (for instance resolution plan reporting is delayed by one month). However, the PRA has so far not issued a statement as regards MREL decisions and of those regulatory reporting requirements that have been delayed the templates that deal with MREL reporting (MRL001, MRL002 and MRL003) have not been among them.