The market meltdown in eurozone subordinated debt has further eroded faith in the seven-year effort to build a bail-in regime for bank resolution by imposing losses on creditors without recourse to the public purse.
Marco Troiano, Scope
In mid-February, the iTraxx index for Europe banks’ subordinated CDS jumped to over 300bp, levels not seen since the mid-2013 Cyprus crisis. Investors also sounded the alarm over additional tier-1 (AT1) notes, which have a contractual provision to convert to equity or write-down if banks need to raise capital levels.
While investors have long accepted that bonds can be bailed-in during firm-level stress, the capital requirement determining when interest payments can be skipped on AT1 securities has now been brought into question.
If a bank’s capital ratio is above the minimum capital requirement but below an extra buffer national regulators demand – capital conservation, countercyclical and systemic risk – it needs to calculate a Maximum Distributable Amount (MDA).
The MDA factor determines how much of its earnings can be distributed as dividends, bonuses and AT1 coupon payments. Investors assumed that few banks would be caught by this buffer requirement. But this year, the market was taken unawares by the regulatory push to narrow the distance to the MDA.
The ECB now agrees with a December proposal from the European Banking Authority that the buffer should be set as a margin above the total tier-1 requirement, including add-ons set by supervisors, known as Pillar 2.
Marco Troiano, who oversees European bank ratings at Scope, an independent ratings agency, says: “Following the EBA’s opinion, some in the market may have realised that the distance to the MDA is lower than previously thought and prices have responded accordingly by repricing coupon risk."
|Source: Scope Ratings. 1 As of Q3 2015; 2 Pro-forma repayment of state aid; |
3 Requirement for 2016 estimated by Nordea; 4 Requirement for Q4 2015; 5 Pro-forma Hua Xia Bank sale. ADI for 2015 were €1bn; 6 Based on 2015 Pillar 2A requirement;
7 Based on 2015 Pillar 2 requirement. Requirement to be met by year-end; 8 Does not include Pillar 2 requirement as it can be met with AT1 securities; 9 Pro-forma share buyback announced for 2016
The ECB, however, failed to communicate in a direct and timely manner how the capital threshold for the Pillar 2 add-on should be calculated – until February 19, almost two months after the EBA’s proposal. This left investors confused about the circumstances in which the ECB would enforce payment restrictions.
Citi bank analyst Simon Nellis adds: “Regulators and banks have conveyed that, for the purposes of the distribution of 2015 profits, the Pillar 2 add-on is applicable only over minimum CET1 for the purposes of calculating the MDA.”
But for 2016 profits and beyond, some in the market feared – until the ECB released an update on the 2015 Supervisory Review and Evaluation Process (SREP) – that the capital threshold for MDA, including the Pillar 2 add-on, would be on a total capital basis, Nellis says. The ECB has now confirmed this will be calculated on the less-onerous metric of CET1.
“The AT1 is a new asset class,” says Nellis. “What’s needed is a very clear statement from regulators about the triggers, and the thresholds, for these instruments to be converted to equity, and a clarification about the hierarchy of payment priorities once the MDA threshold kicks in.” The ECB said in late February that it would ask EU regulators to change banking laws to permit payments to AT1 investors in the event the MDA buffer is breached.
The ECB also suggests that the supervisory add-ons to bank capital requirements will remain flat year-on-year and will decline commensurate with the increase in the capital-conservation buffer. Korbinian Ibel, the ECB’s director-general for micro-prudential supervision, said: “All things being equal, the capital requirements we have now we find satisfying.”
These clarifications may help to ease yields in eurozone sub-debt; only five banks’ were below hiked supervisory thresholds in 2015. According to Troiano, eurozone banks are generally 1% to 3% above the Combined Buffer Requirement (CBR), which refers to how much CET1 capital a bank holds to meet supervisory add-ons. (When it falls short it is required to calculate its MDA.)
“There is no golden [distance-to-CBR] number that the market is comfortable with,” says Troiano. “It depends on the bank’s business model, as well as the volatility of capital ratios and earnings. For banks more prone to volatile revenues and unexpected losses, I would like to see more cushion.”
The synchronized decline in CoCo securities across financial systems is a reminder of the speed in which markets can reprice bank liabilities thanks to regulatory risk.
In another sign of regulatory-driven market confusion in the eurozone, EC officials have yet to finalize the quantum of gone-concern liabilities banks should hold to facilitate a smooth and quick absorption in resolution, particularly of the cross-border nature.
In January, the European Commission proposed integrating global loss-absorbing rules in the region in a harmonized way, which would provide some capital relief for smaller lenders. Its discussion paper, seen by Euromoney, suggests the Minimum Requirement for own funds and Eligible Liabilities (MREL) – Europe’s version of total loss-absorbing capacity (TLAC) – would be an institution-specific Pillar 2 add-on requirement for smaller banks, and thereby, subject to supervisory discretion.
By contrast, total gone-concern capital, which includes MREL/TLAC, and tier-2 instruments, would be a Pillar I requirement for global systemically-important financial institutions at 12% of risk-weighted-assets by 2022.
“The European Commission didn’t even wait for the EBA’s report on MREL in October before it recommended relaxing gone-concern requirements for smaller institutions,” says a former regulator for a north European central bank. “The ECB is likely to reject this as it prioritizes financial stability, while the EC recite the mantra of proportionality, which effectively means relaxing capital demands on smaller banks in the belief this will boost lending.”
He sums up the perfect storm that has rocked the eurozone bail-in policy, saying: “There’s uncertainty over gone-concern requirements, investors were left confused about the MDA factor – though the market should have known the Pillar 2 add-on would eventually be included – and the Portuguese and Italy bail-outs violated the spirit of the Bank Recovery and Resolution Directive [through fiscal backing while undermining creditor-hierarchy norms]. Investors and issuers don’t know how bail-in should work in practice.”
The bail-in regime has faced criticism over the horse-trading between bankers, regulators and politicians around the world seeking to impose capital requirements without raising core equity. Markets have been complacent about how it will work in practice – until the violent sell-off last month.