Different jurisdictions are likely to implement different standards and legal frameworks for total loss-absorbing capital, making investor analysis challenging.

What is happening?

At its September 2015 plenary meeting, the Financial Stability Board (FSB) agreed a final term sheet for total loss-absorbing capacity (TLAC). This is the layer of liabilities that must be held by global systemically important banks (G-SIBs) that could be bailed in or written down to recapitalise the bank in a resolution event. The FSB agreed to complete and publish final standards and an implementation timeline before ministers from the G20 governments meet in Ankara, Turkey, on November 15 and 16, 2015.

“Members support consistent implementation, over the appropriate timelines, of this robust minimum standard,” the FSB said in a press release after the plenary session.

In a first draft term sheet published in November 2014, the FSB proposed that banks should hold TLAC equivalent to the higher of 6% of total assets, or 16% to 20% of risk-weighted assets (RWAs). At least one-third of TLAC was to be in the form of debt securities rather than regulatory capital.

Did someone say 'consistent'?

The problem is that legislators and regulators on both sides of the Atlantic have already worked on their own bank resolution legislation – the EU’s bank resolution and recovery directive and the US orderly liquidation authority (OLA) regime. This will pose significant challenges to the FSB’s quest for consistency.

The FSB is basing its judgement of the adequate level of TLAC on a series of quantitative impact studies conducted during 2015, which will be published alongside the final term sheet in November. This data will be essential to inform responses to consultations by individual jurisdictions as they seek to implement the TLAC standards into local rules. In particular, there is a widespread expectation that the US may set its own higher standard, especially if the FSB opts for the lower end of the range. Banks have been briefed that the final term sheet is likely to cap TLAC at 18% of RWAs rather than 20%.

“The key questions now are implementation timeframe, disclosure and whether the market will expect compliance ahead of the proposed 2019 deadline. We would hope for major jurisdictions to line up on the timeframe, but that has not been the case with some other regulations, and we also need to see if certain jurisdictions immediately gold-plate the FSB requirements,” says Oliver Moullin, a director at the Association for Financial Markets in Europe responsible for resolution issues.

Legal complexity

In addition to potential differences over the quantity of TLAC required, legal definitions of this new buffer could also vary. TLAC must comply with a principle that is vital to avoiding litigation against a resolution authority – that no creditor should be worse off in a resolution than they would have been if the bank had simply been placed into insolvency. This principle concerns both bail-in and the concept of set-off rights, which allow counterparties to a failed bank to set off their own liabilities to the bank with any liabilities of equivalent seniority that it owes to them.

“What people are gradually realising is that, because of the no-creditor-worse-off principle, the only way to ensure TLAC can be bailed in without regard to liquidation set-off rights is to legally subordinate TLAC, effectively creating a new layer of tier-three securities,” says Simon Gleeson, a partner at law firm Clifford Chance in London who is a member of an FSB legal advisory panel.

The three ways to achieve subordination are structurally (such as through the US holding company whose liabilities are subordinate to all operating companies), through legal statute, or contractually. As the FSB does not have legislative authority, it has necessarily advocated the contractual approach. But most countries are also anticipating further statutory changes to facilitate TLAC. The US will most likely modify elements of the OLA regime. Germany has tabled legislation that would explicitly make senior debt junior to operational liabilities such as wholesale deposits, while Italy is considering the opposite approach: granting senior status to deposits.

“We are potentially looking at different liability waterfalls in different countries, making it much harder for investors to calculate and compare recovery rates,” says Filippo Alloatti, a senior credit analyst at UK fund manager Hermes.

Such a situation would seem to deviate from the FSB’s desire for a consistent TLAC minimum standard. In a legal opinion published in September 2015, the European Central Bank (ECB) recognised that Germany’s proposed law would make it easier for banks to comply with TLAC requirements without issuing significant quantities of new subordinated debt. However, the ECB also expressed concern about the risks of legal fragmentation. Germany has delayed implementation of the bill, and the European Commission is now considering a possible pan-European approach to senior debt bail-in.

“A common framework at EU level on the degree of subordination of senior unsecured bank debt instruments to other senior unsecured bank liabilities in bank resolution and/or insolvency proceedings may help to avoid fragmentation of the market within the EU for these instruments,” the ECB noted. Avoiding fragmentation between the EU and US, however, is likely to be considerably more difficult.

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