Spirit of TLAC broken as regulators mark their ground
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Spirit of TLAC broken as regulators mark their ground

A last-minute proposal by the European Commission risks throwing global bank capitalization rules into further flux.

The spirit of international rules on bank capitalization is being broken by rules implemented in the US and UK, and proposed by the EU, that amount to protectionism, market players fear.

UK government officials and bankers have been taken aback by a last-minute addition to proposals from the European Commission that could cause some banks to rethink keeping their European headquarters in London after the UK leaves the European Union.

At a December 6 meeting of European finance ministers, UK Chancellor of the Exchequer Philip Hammond railed against the proposed inclusion of a new provision – Article 21b – in the Capital Requirements Directive.

The provision, presented by the Commission on November 23 as part of a proposed package to update banking regulations and directives in the EU, introduces a requirement that third-country parent companies with “significant” financial activities in the EU establish intermediate holding companies (IHCs) in Europe.

Hammond likened the UK’s preliminary view of Article 21b to that expressed in 2013 by Michel Barnier, then the EU commissioner in charge of financial services, when he called a US proposal to force higher capital requirements on US subsidiaries of European banks “protectionist”.

That proposal, the enhanced prudential standards for foreign banking organizations, came into effect in July, and included a requirement for non-US banks to implement IHCs.

Though the Bank of England (Boe) proposed its own set of rules in December 2015 to govern the amount of internal bail-inable debt held at UK subsidiaries of foreign banks, its most recent policy statement rolled back on the details.

In that statement, the bank said it would wait until the Financial Stability Board (FSB) finalized its guidance on internal TLAC before devising its own rules for the minimum requirement for own funds and eligible liabilities (MREL). The bank indicated it would align its rules with the guidance set out by the FSB.

The BoE does still insist, however, that holding companies be capitalized to achieve structural subordination or that their MREL debt issued by subsidiaries be contractually bail-inable.

Nonetheless, UK market participants who had seen leaked copies of the package were taken aback by the proposed addition to European rules.

“It was not there in the full leaked draft four or so days before publication of the banking reform package – Article 21b didn’t exist,” says one industry lobbyist. “It was probably added in the last week before the Commission presented it.”

Banks headquartered in the US, Canada, Japan and Switzerland would be hardest hit by the rule.

“This is likely to have a profound impact on non-EU banking groups who operate on an unconsolidated basis in the EU in terms of the additional costs, governance requirements and complexity of operations,” according to a client note from law firm Allen & Overy.

However, even banks in the UK are likely to be affected once the country leaves the EU. The proposal requires that third-country financial companies that are global systemically important institutions (G-SIIs) or have €30 billion of assets in the EU, and that also have more than one institution operating in the union, set up IHCs that will need to be independently capitalized.

The result is that some banks headquartered outside the EU might need holding companies in several jurisdictions. JPMorgan, for example, would likely need capitalized holdcos in the US, UK, EU, Switzerland, Canada and Japan.

The question for some banks that have their European headquarters in the UK now is whether they want to operate that many holdcos, or simply move their operations out of the UK entirely.

Those banks are likely to be smaller ones, says one adviser of financial institutions, since larger institutions choose London as their headquarters for more than just access to the EU – physical and legal infrastructure, IT systems and even housing and schools for employees and their families are all part of the mix.

“There will be some situations where the additional friction of setting up holding companies in Europe will result in some smaller institutions saying ‘we will not be based in the UK’,” says the adviser.

However, the technical upshot – that the US, EU and UK are all essentially forcing banks operating in their jurisdictions to take a single point of resolution strategy – leaves some market players to claim that the spirit of post-crisis global regulations is being broken.

“I find it a little a disingenuous that [the EU is] calling for this, given how open they say they are to multiple approaches,” says one industry lawyer.

The FSB’s final term sheet on total loss-absorbing capacity (TLAC) rules allows banks the flexibility to choose between a multiple point of entry (MPE) or single point of entry (SPE) approach to resolution.

However, the result of the requirements being implemented or proposed in the US, UK and EU is that banks with MPE strategies are being forced to pursue multiple SPE strategies – increasing operational complexity and cost.

Some say the implementation of IHC rules in various jurisdictions is a result of distrust between different international resolution authorities. An SPE approach would mean the host authorities of material subgroups would have to rely on the home authorities to make sure capital at the parent is available to the collapsing foreign organization.

Perhaps most illustrative is the Commission’s proposal that IHCs hold 90% of the TLAC requirement they would have if they were resolution organizations – the top end of the range, and before the US has set its own limit. Many bankers have been hoping the Federal Reserve will settle at the low end, or 75%. That hope might now be gone.

“There are a number of areas where the FSB provided flexibility, and [the EU has] adopted a particular approach,” says the industry lawyer. “You have to question whether that’s healthy.”

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