Not everything can be tier two
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Not everything can be tier two

The European Commission's group of ‘experts’ are making welcome steps towards unraveling the complexities of bank capital. But the multiplicity of loss-absorbing instruments exists for a reason — not everything can become tier two capital.

The group advised revamping regulations at the highest level, including the EU’s capital requirements regulation (CRR), to harmonise and simplify the total loss absorbing capacity (TLAC) and minimum requirement for own funds and eligible liabilities (MREL) capital frameworks.

That is an excellent initiative.

TLAC and MREL are essentially baroque euphemisms for ‘capital’. 

What the crisis taught us is that there wasn’t enough capital in the system, and that has changed. There is little need for other synonyms for ‘capital’. 

There is also some certainty about which capital instruments are actually loss absorbing — equity, basically. Tier two debt may not have absorbed losses in the crisis, but its contractual features are well understood. Other, newer forms of capital, have yet to go through the wringer.

Too much consistency

The "expert group" suggested that the definition of tier two as set down in CRR be modified to include the definition in the TLAC term sheet, increasing maturity flexibility for issuers, among other things. They also recommended allowing tier two, like TLAC-eligible debt, to be contractually, structurally or statutorily subordinated to other liabilities, allowing banks without holding companies to more easily comply with TLAC.

Some MREL debt could also be made eligible to be CRR tier two debt under this approach.  

These initiatives could make important regulations easier to understand and easier to comply with. Making everything "tier two" should also make bank structures clearer to regulators and investors, making them easier to analyse and to resolve — at least at first glance.

But it also risks classifying fundamentally different types of debt capital as ‘tier two’ purely for the sake of tidying up bank capital structures. Having one class of ‘gone concern’ capital is superficially simpler, but the different forms of debt that banks could use to comply are still....different.

For example, holding company senior would be just as much ‘tier two’ as actual tier two. 

But, unlike what we call tier two now, holdco senior doesn’t contain call periods. And where does it sit in the capital structure for resolution purposes? The market is pricing it as safer than, say, tier two issued out of bank operating companies — so surely it must be less capital-like?

Perhaps the group’s idea is to render everything that falls under this new modified category of tier two pari passu with one another, but that would be spectacularly difficult to enforce in practice. Holdco senior holders signed off on very different documentation than their tier two peers, so it wouldn't just mean changing the law — it would mean ripping up contracts.

Scrapping ideas of tier three and holdco senior or contractually/statutorily subordinated senior unsecured debt would make things simpler. But regulators and politicians allowed banks to use those options because forcing banks to raise enough tier two to meet TLAC rules would be prohibitively expensive.

Give banks the choice

Keeping flexibility means banks need options across a number of instruments to fill whichever regulatory capital rules they have to meet. Regulators need a set of instruments which can safely be called loss-absorbing. Any redrawing of bank capital rules should be able to give clarity to both sides.

Tier two is really the most subordinated instrument that can be called gone concern capital. And though the difference has not been tested in reality, the market has expressed an opinion that it is riskier than, say, holdco senior. 

That suggests making all ‘gone concern’ capital ‘tier two’ may be too simplistic. The rules could use some clarity and some consistency across Europe, and this proposal was a step in the right direction. But regulators and legislators should be careful not to ignore distinctions where they do in fact exist. 

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