A casual follower of European bank regulation would be forgiven for thinking that the minimum requirements for own funds and eligible liabilities (MREL) were pretty much done and dusted.
Conversations about the rules — the EU’s answer to international standards for total loss-absorbing capacity (TLAC) — have been rumbling on since at least 2013.
But the EU financial institutions affected by this debate have effectively been operating in the dark, trying to figure out what is required of them, based on their interpretations of the latest regulatory consensus.
In 2019 policymakers made a big leap forward with the introduction of MREL. They adopted a wide ranging package of banking reforms in May, including a number of very important clarifications as to how MREL should be calibrated and which types of liabilities should be eligible for the requirements.
“It feels as though the process of re-regulating the banking industry has pretty much now been completed in the areas of capital, liquidity, funding and resolution,” says Peter Mason, head of debt capital markets EMEA at Barclays in London.
“Subsequently, for the first time in a very long time, funding officers and treasurers now have much better clarity about how they should budget for MREL issuance over the next few years.”
That does not mean that banks can see the full picture on MREL yet.
In particular, many firms are still uncertain about how much of their targets will need to be met with funds that rank below their operating liabilities in the hierarchy of insolvency.
The legislative changes adopted in 2019 conferred new powers on the EU’s Single Resolution Board (SRB) and national competent authorities to determine this level, which is commonly referred to as the “subordination requirement”.
“MREL is pretty different to capital requirements, so it is hard to say exactly what each bank will have to issue,” explains Axel Finsterbusch, an executive director in European credit research at JP Morgan in London.
“There is a formula that will allow you to have an idea, but the regulator will ultimately determine the degree of required subordination. We have the maximum subordination and the minimum subordination, so we can only really come up with a range of what the banks could end up issuing.”
Higher or lower?
In basic terms, the absolute minimum level of subordination that the largest EU banks will need to meet is a level equivalent to 8% of their total liabilities and own funds.
But EU resolution authorities can require firms to meet MREL with a higher proportion of subordinated liabilities. Where they see fit, they may even demand that banks meet all of their targets with subordinated instruments, which is already the norm in jurisdictions like Norway and Sweden.
Julien Brune, co-head of DCM solutions and advisory at Société Générale in Paris, describes the situation with subordination requirements as being “very diverse”.
“On the one side you have issuers with relatively low MREL shortfalls, who will generally want to show that they are best in class and fully compliant with their requirements,” he says. “Then you have the issuers with the biggest MREL shortfalls — either because they are global systemically important banks or because they are in jurisdictions that tend to impose high requirements.
“These banks will prepare for the worst, but they will stay on a linear course towards meeting MREL, bearing in mind that any subordinated instruments they issue now will weigh on the net interest margin and may not be strictly needed.”
Banks have been issuing eligible liabilities in anticipation of their final MREL requirements for a number of years now but, because of the lingering uncertainty, nobody is prepared to say that the heavy lifting is over yet.
According to the SRB, the gross amount of outstanding MREL instruments hit €187bn in the first half of 2019.
Research carried out by JP Morgan indicates that the market would probably level out at a size of about €250bn-€260bn if resolution authorities stick to minimum subordination requirements. But it could reach roughly €500bn if they plump for maximum subordination.
Golden age
By and large, the market has been indicating that it is ready for more supply of MREL securities.
Bonds eligible for the requirement tend to be sold at higher yields than ordinary bank funding instruments, helping them to attract a steady stream of investment from fixed income funds.
Many of these funds have been hunting for ways to boost their returns this year, after the European Central Bank changed its tack on interest rates and cut its main deposit rate further into negative territory.
“Am I concerned about there not being demand for MREL product?” says JP Morgan’s Finsterbusch. “In this rates environment the answer is ‘no’.
“What the banks are going to do is refinance preferred senior into non-preferred senior, which helps the banks make the transition towards MREL.”
Even some of the smallest financial institutions with some of the smallest MREL requirements have seen sense in using these market conditions to get their houses in order well ahead of schedule.
“A number of medium and smaller-sized banks have started issuing in the non-preferred senior market this year, having not wanted to accelerate their funding plans in 2018,” explains Eric Meunier, global head of debt capital markets financial origination at Société Générale in Paris.
“They have really benefitted from the new issuance conditions and the spread compression we have seen throughout most of 2019.”
In April, for example, before it had even received a binding target, Dutch lender NIBC Bank decided to raise €300m of non-preferred senior debt to cover what it thought were likely to end up being its final MREL requirements.
‘Haves’ and ‘have nots’
But the impact of the introduction of MREL is unlikely to be neutral for European banks, notwithstanding the strength of the primary bond market going into 2020.
Whatever their final shape, the new rules imply that financial institutions will be issuing more debt than they would ordinarily have to, often in new and more costly formats.
These additional burdens are feeding into what is already a very challenging backdrop for banks in Europe.
Ultra-low rates are hampering their ability to generate interest income, and the emergence of various neo-banks and financial technology companies is further increasing competition for business in the sector.
“The great concern is not necessarily about funding for European banks, it is more about the sustainability of their business models in the prevailing operating environment,” says Mason at Barclays.
There were clear signs during 2019 about how new requirements like MREL could end up exacerbating the problems facing the industry.
The case of Metro Bank was particularly severe. In early October, having failed once to access the bond market and staring down an interim deadline for MREL in 2020, the UK lender decided that it would pay whatever was necessary to get hold of the £350m of non-preferred senior debt that it needed.
The resulting coupon rate of 9.5% meant that Metro Bank would have to shell out £33.25m in annual interest expenditure to remain MREL-compliant — roughly equal to its pre-tax profit for the previous year.
“The coupon on Metro Bank’s non-preferred senior deal was extreme and has ended up becoming a real problem for the bank,” says JP Morgan’s Finsterbusch. “We have never seen anything like this before, where the problem is on the liability side.”
By requiring banks to market more securities publicly, MREL could end up drawing additional attention to institutions whose business models or profit and loss statements are already under scrutiny.
For Mason at Barclays, there is already a sense of “haves” and “have nots” in the market.
“We are seeing record tight issuances for national champions, but some of the weaker European banks are staying away or looking at alternatives to raising funding in the capital markets,” he says.
The upshot, according to Finsterbusch, is that some banks may end up feeling more compelled to consider combinations with other banks.
“You need to achieve economic scale if you want to be able to print these instruments without really harming your P&L,” he says.
No time to waste
It is hardly surprising that the potential impacts of MREL have started to become clearer throughout 2019, just as the shape of the requirements have also come into view.
The SRB has sought to reassure banks that they will have plenty of time to prepare to meet their end-state targets, whatever level of subordination they are eventually subject to.
In a speech at the beginning of November, for example, Sebastiano Laviola, director of resolution strategy and co-operation at the SRB, reminded market participants that MREL should feel like a marathon rather than a sprint.
But he couldn’t help conferring a sense of urgency on to his listeners.
The board member noted that there was an “opportunity” for financial institutions to take advantage of “favourable market conditions”.
The final MREL requirements are almost in place, investors are getting behind new issuances and the ECB is still pumping liquidity through the euro market.