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August 2016

Sometimes two things appear to perform a similar function. For example, Celsius and Fahrenheit; Degrees and Radians; VHS and Betamax. The world is then faced with a choice: keep both, or converge on a common standard? This was the nature of the decision facing the European Commission, with respect to MREL & TLAC, when it published updated drafts to its key legal texts on resolution (BRRD & SRMR) in November 2016.

Highlights

• FSB’s Key Attributes of Effective Resolution Regimes are the starting point for MREL and TLAC
• How to implement TLAC into EU law?
• Resolution group concept & ‘internal MRELâ€�
• Conclusion

FSB’s Key Attributes of Effective Resolution Regimes are the starting point for MREL and TLACÌý

By way of a reminder, MREL (Minimum Requirement for Own Funds & Eligible Liabilities) is the EU standard for ‘bail-inâ€� capital, introduced via the 2014 BRRD/SRMR package. ÌýIn chronology, MREL came before TLAC. ÌýIt is a broad bail-in standard, as BRRD applies to all EU banks, and is effective since January 2016.

TLAC, by contrast, is a global standard applicable to G-SIB banks only. It was introduced by the Financial Stability Board (FSB) and defined in a ‘Term Sheetâ€� in November 2015. ÌýIt therefore came later, but has a global reach, with G20 sponsorship. TLAC will enter into effect on 1 January 2019.

In a sense both MREL and TLAC are tributaries of the same source, namely the FSB’sÌýÌýof Effective Resolution Regimes, published in 2011 (updated 2014). This landmark document sets out principles for resolution powers, crisis management and resolution planning. MREL and TLAC both address banksâ€� loss-absorbency and recapitalization capacity under this framework.

At the time of writing, MREL is part of EU law, whereas TLAC is not, hence an imperative for the European Commission to update its legal framework.

There are also significant differences between the two initial standards, including but not limited to:

• Minimum requirements:Ìýas set out in ourÌýearlier article,ÌýTLAC has prescriptive minimum levels for all G-SIBs, beginning with 16% of RWA and 6% of the Basel III leverage ratio denominator in 2019. ÌýMREL is, however, defined bank-by-bank by EU resolution authorities (SRB, NRAs), taking account of whether a bank would be liquidated or resolved if it were to fail.
• Eligible instruments:ÌýTLAC is more prescriptive on the type of instruments that are eligible; it requires that such instruments be clearly subordinated to ‘excludedâ€� instruments (contractually, statutorily, structurally). MREL is a deliberately broad standard, recognising that across all EU banks, many types of debt will be used and different insolvency hierarchies exist (though this list is expected to narrow somewhat under BRRD 2).
• ¶Ù±ð²Ô´Ç³¾¾±²Ô²¹³Ù´Ç°ù:ÌýTLAC is calculated as a percentage of Risk Weighted Assets (RWAs), like CET1 capital. MREL was designed as a percentage of total liabilities and own funds, so conceptually closer to a leverage ratio for bail-in capital requirements.

How to implement TLAC into EU law?Ìý

The Commission considered different options in preparing its proposal to update the BRRD and SRMR to implement TLAC into EU law:

• Applying TLAC to all banks?ÌýThis would be an elegant solution in some respects, but lacks ‘proportionalityâ€�, as rules designed for G-SIBs (circa 30 banks globally) would then become applicable to all European banks (of which there are nearly 6,000).
• Applying MREL but not TLAC to EU banks?ÌýThis was not legally possible, given G20 commitments to implement a common TLAC framework across G-SIB banks.
• Revising MREL to incorporate TLAC features,Ìýwhile continuing to have two distinct standards?ÌýThis is, in effect, the strategy which that has been chosen. Under the Commission’s draft proposals, MREL will be enhanced in the following ways:Ìý
  • The denominator will be switched to RWAs and a Basel III leverage ratio floor, mirroring TLAC.
  • The concept of ‘resolution groupsâ€� which is central to TLAC, will be applied to EU resolution groups. This will replace the existing requirement to set MREL individually for all EU banking entities (both parents & subsidiaries).
  • Introduce the concept of ‘external MRELâ€� and ‘internal MRELâ€�. This links directly with the concept of resolution groups.
  • Introduce a partial harmonization of the bank insolvency creditor hierarchy across the EU, by creating a new class of ‘non-preferredâ€� senior debt instruments that would be bailed-in in resolution after capital and other subordinated instruments but before other senior liabilities, and would rank behind other senior liabilities under national insolvency laws. Non-preferred senior debt instruments would be eligible to meet minimum TLAC and MREL requirements.

Resolution group concept & ‘internal MREL’�

By way of analogy, under the original MREL standard, each EU bank (parent or subsidiary) was like a town required to maintain its own emergency water supply. It could not rely on an ‘upstream� reservoir belonging to its parent.

Under TLAC, however, banks form part of resolution groups and only the resolution entity (the parent) has a reservoir of ‘external TLAC�. There are then arrangements to distribute that loss-absorbency capacity through internal instruments (internal TLAC), which can technically be bailed-in without putting the subsidiary into resolution.

The ‘external� and ‘internal� TLAC concepts have been introduced into MREL in the latest drafts. For EU subsidiaries of non-EU G-SIBs, internal MREL is to be set at 90% of the ‘external� MREL requirement, which is at the upper end of the 75-90% range for internal TLAC, per the FSB’s term sheet.

ConclusionÌýÌý

If the new drafts of BRRD and SRMR are passed into law, while there will continue to be two bail-in standards in Europe - MREL (for all banks) and TLAC (for G-SIBs only) - the two will be much closer than they were previously. We expect this development to be welcomed by the sector.
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