Close encounters with a third kind (of capital)
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Close encounters with a third kind (of capital)

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Soon, banks will have more TLAC and MREL than equity. The new bond classes are a immensely important part of the financial structure of a bank, but the risks to investors aren’t yet clear. Just how will this alien new instrument class behave — or misbehave?

The events of 2008 taught us sobering lessons. The bankruptcy of Lehman Brothers brought contagion that nearly finished off the financial system. The taxpayer bail-outs of other too-big-to-fail banks felt like blackmail, with bank creditors seemingly avoiding any real losses.

New rules on bank resolution are meant to change all that, and creditor bail-in is the central element. If a bank has horrendous losses, it is recapitalised by its creditors — not the taxpayer. Resolution processes are mapped out and likely scenarios are rehearsed in the resolution plan, or living will.

To make it all work, the creditors have to be explicitly, consciously, wide-awake aware that they are on the hook. This requires the creation of a TLAC/MREL layer of liabilities that are expressly, clearly and undeniably subordinated to other, more operational liabilities.

So far, so good. Requiring another layer of subordinated capital is pretty much the same as increasing capital requirements.

With TLAC/MREL requirements typically coming in at 25%-30% of risk-weighted assets, a bank’s capital structure is going to be pretty much half equity (with a sliver of additional Tier one CoCos allowed) and half subordinated capital (of which only a small amount needs to be in Tier two regulatory capital format). Something like 13% equity, 2% AT1, 3% Tier two and 10% TLAC/MREL debt will not be atypical.

The alien aspect is that TLAC/MREL is not technically capital at all. Remember, the “C” in TLAC stands for capacity not capital.

In fact, the majority of it is likely to hit the market with a wrapper that very clearly says “senior” on it. This could be senior debt of the holding company (as in the USA, UK and Ireland, for example), even though the proceeds of that debt will be used to subscribe to subordinated capital of the operating company. 

Or, it could be called “junior senior” or “non-preferred senior” in a peculiar grammatical set-up that reminds us that “senior” is, in fact, a comparative adjective with no absolute meaning. It could even be a new “Tier three” layer of capital. Most confusingly of all, it could theoretically be the actual senior debt of a bank, in exceptional cases (that hardly anyone has quite fathomed, to be honest) and to a very limited extent.

This semantic debate matters. Some investors can buy instruments only if they are “senior”. So HoldCo senior is fine, even if the bank in question uses the proceeds to buy Tier two sub debt from its operating company, but Tier three is a no-no. Likewise, HoldCo seniors are part of the senior bond index, which guarantees high demand.

Mostly, though, TLAC/MREL is alien because we just don’t know how it functions. There’s a lot of speculation, but very few answers. The resolution authorities, understandably, want to retain flexibility. Recent experiences don’t serve as insightful case studies for the future, because those failed banks had legacy capital structures.

Concepts such as “point of non-viability” and “point of resolution” are difficult to describe with any certainty. We even have the notion of a state-led “precautionary recapitalisation” for banks that fail stress tests, making bail-in an even more remote prospect.

So with a hazy view of how resolution will affect them, it’s hardly surprising that investors are having trouble assessing the risk in TLAC/MREL instruments. A fundamental approach, using Probability of Failure (PF) and Loss Given Failure (LGF) yields extremely broad ranges of estimates.

That’s one of the reasons that credit agency ratings have such diverse views in this area. 

It seems that most investors are resorting to market-based, relative value approaches to pricing, favouring the technical over the fundamental.

This pragmatic approach may be the best we can hope for at present. But if capital is not properly priced on a fundamental basis it risks being, at best, inefficient and, worse, potentially volatile and unreliable. Bail-in creates one helluva refinancing risk.

Like all good space explorers, the voyagers that discover TLAC/MREL may be very cautious and fearful of the alien life forms. They may take a while to recognise that enhanced supervision and thick regulatory capital buffers provide strong credit enhancement. Perhaps their risk is genuinely tail risk.

As the FIG market boldly goes into these alien liability classes, investors are hoping their experience is more “ET” than “Independence Day”. 

The FIG Idea is written by a market participant with more than 20 years experience advising banks