Eurozone banks bet on 2024 MREL deadline to ease Brexit pain

SRB says legacy English law bonds ineligible, but BRRD grandfathering could solve the problem

Bankers are hoping that grandfathering rules, which they expect to be adopted as part of an updated bank resolution regime in Europe, will also alleviate the problem of English law bonds no longer being deemed eligible for bail-in by the eurozone’s Single Resolution Board.

In a position paper published on November 15, the SRB confirmed that after Brexit, eurozone banks should be prepared for legacy bonds issued under English law to be discounted from their minimum requirement for own funds and eligible liabilities (MREL) – the bail-in buffer banks must hold under the Bank Recovery and Resolution Directive (BRRD). The UK is expected to leave the European Union in March next year, although subject to agreement, it may continue to apply EU rules under a transition period that is scheduled to run until at least December 2020.

The European Commission, Council of the EU and European Parliament are currently negotiating an update – dubbed BRRD II by the banks – that will further clarify MREL rules. Bankers are confident this trilogue negotiation will result in a deadline for full MREL compliance in 2024, rather than 2022 as originally proposed by the EC in November 2016.

“In terms of the trilogue drafts we’ve seen, 2024 is pretty much agreed now, and I don’t think there’s much opposition. If you think about the average bank’s MREL stack, the average tenor is about five years, so between now and 2024 they’ll be able to rollover a large chunk of that,” says one debt capital markets (DCM) expert at a US bank in London.

The SRB’s decision to rule English law bonds as ineligible for MREL confirmed warnings bankers had flagged to Risk.net in May this year. It presents a challenge to eurozone banks left with a potential shortfall in their MREL buffers. Last year, investment bank Nomura estimated the stock of legacy English law bonds that could be discounted from eurozone banks’ MREL buffers – mostly tier 2 and additional tier 1 (AT1) debt – is worth €126 billion. Putting this into context, Europe’s fourth largest bank, Deutsche Bank, had total available MREL of €118 billion as of September 30, 2018.

However, the 2024 deadline for MREL compliance was agreed in the Council’s version of BRRD II in May this year, and was also included in the parliamentary compromise text in June. That consensus among two of the co-legislators should push the EC to accept the two-year delay to its original proposal. The grandfathering clause is designed to give banks time to replace existing senior preferred debt that is not legally subordinated to ineligible liabilities, and will therefore not count towards MREL.

Similarly, the EU’s second capital requirements regulation (CRR II), which is being negotiated at trilogue alongside BRRD II, will require banks to change the documentation of AT1 and tier 2 debt – which are, together with common equity, known under EU law as own funds. The new provisions require that these bonds can explicitly be written down by a resolution authority in the event of resolution. The Council text (also agreed in May) proposed grandfathering existing AT1 and tier 2 bonds for six years, although the parliamentary draft included no grandfathering provision.

Sauce for the goose

Bankers expect the planned grandfathering of ineligible senior preferred, AT1 and tier 2 bonds should equally work for English law debt. One DCM expert at an Asian bank in London says it does not make sense for the SRB to refuse to grandfather legacy English law bonds at least in line with the Council’s CRR II proposals for own funds.

“Elke Koenig has made some comments specifically about the grandfathering of MREL bonds, saying it wouldn’t work, which doesn’t make any sense given it’s almost certain that own funds treatment will be grandfathered for six years. This is pure politics in my opinion, with no good technical reason,” he says.

Elke Koenig

If BRRD II and CRR II grandfathering provisions apply to any ineligible bonds, then banks can simply issue new MREL-compliant bonds to replace legacy English law paper as it reaches maturity. The new MREL could be either under local law within the EU27, or in the law of non-EU third countries (including the UK), as long as there is a contractual recognition of EU bail-in decisions included in the documentation.

The SRB has offered a transition period on a case-by-case-basis to banks left with an MREL shortfall due to Brexit, as outlined in its November 15 position paper. “The SRB will consider each situation on a case-by-case basis, while ensuring consistency across all banks under its remit. This may entail an extension of transitional periods for banks having MREL shortfalls as a consequence of ineligibility of the issuances governed by the law of the UK for MREL purposes,” stated the paper.

Although welcoming the transition period offered by the SRB, DCM experts say this is likely to be unnecessary if the eurozone MREL deadline is 2024.

“I tend to think the suggestion from the SRB of a transition period may not be something banks need to rely on, particularly if the CRR and BRRD revisions come out with 2024 as the implementation date. That would already be sufficient to see a large proportion of the troublesome instruments issued under English law redeemed before the final requirement date in any case,” says a capital structuring expert at a European bank.

In particular, new forms of MREL-compliant debt issued in the senior non-preferred format, or from a legally subordinated holding company, should be covered by the grandfathering provision, according to a DCM expert at a UK bank: “These tend to be anywhere between three and seven years, so the most transition a bank will need is about six years and that is consistent with what is being considered at the trilogue level of BRRD II anyway.”

Where there will be more of a problem, he says, is for longer-dated tier 2 debt, which can be 10 years or more in duration. In this case, ad hoc SRB forbearance and the potential for an additional transition period may be more useful. The Association for Financial Markets in Europe (Afme) has argued that the Council’s proposed six-year grandfathering provision for AT1 and tier 2 bonds that don’t incorporate explicit bail-in powers for resolution authorities should be lengthened to at least 10 years to mirror the tenor of the instruments it covers.

Holding out hope

Although the chances of legacy English law bonds counting towards eurozone MREL permanently now appear slim, there is still the possibility they could be grandfathered explicitly as a part of a post-Brexit trade deal.

“There could theoretically be a deal where the UK unconditionally recognises an EU bail-in decision, or the EU might accept the draft statutory instrument from the UK as equivalent, although those are far from clear today,” says the capital structuring expert at the European bank.

In preparation for a no-deal Brexit, the UK government published a draft statutory instrument amending the UK implementation of BRRD, which stated third-country resolution decisions would be recognised by the UK as long as they did not damage UK financial stability or treat UK creditors worse than other creditors. While the UK is a member of the EU, bail-in decisions by the SRB and other EU27 resolution authorities are automatically recognised.

On November 13, Afme and law firm Allen & Overy published a report that argued EU authorities should be confident their bail-in decisions will be recognised by UK law, even where contractual recognition of bail-in is absent. This is because the UK has implemented BRRD, follows the global Financial Stability Board’s key attributes of effective resolution regimes, and would have “no foreseeable grounds” on which to refuse an SRB bail-in decision, the paper argued.

However, the SRB’s November 15 paper made clear that explicit contractual recognition of bail-in must be included for debt to be considered MREL compliant.

The 585-page Brexit withdrawal agreement unveiled by the UK government on November 14 does not include an agreement to automatically recognise EU bail-in decisions. But lawyers at Linklaters point to the existing statutory framework under which – in most foreseeable circumstances – the UK would recognise third-country resolution actions. Any further amendment to that framework to provide additional certainty would only come during the transition period, they say, perhaps alongside a future trade agreement with the EU.

“If we agree a withdrawal agreement with the EU, we then go into a transition period where we would continue to apply BRRD. It’s only during that period that something like unconditional reciprocal recognition of bail-in decisions for the period following the transition might be negotiated,” says Neil Dixon, a capital markets partner at Linklaters.