France Can Lead Way on Bank-Failure Loss Rules, Koenig Says

Updated on
  • European Commission pushing to unify rules on creditor losses
  • French working on new category of senior non-preferred debt

European Union policy makers in Brussels would do well to look to Paris as they push to unify rules for imposing losses on the bondholders of failing banks, according to Elke Koenig, head of the euro area’s central resolution authority.

The French approach to making sure creditors share the cost of bank failures involves creating a new class of “senior non-preferred” debt designed to smooth the wind-down process by providing legal certainty that the instruments are eligible to absorb losses. That differs from Germany, which subordinated plain-vanilla senior unsecured debt to deposits, derivatives and structured notes to make it available to take losses, a process known as bail-in.

Elke Koenig

Photographer: Rolf Schulten

“Both the German and the French models for subordination are feasible,” and if the European Commission, the bloc’s executive arm, “is tending toward a compromise based on the French model, the SRB can live with that perfectly,” Koenig said in a recent interview, referring to the Single Resolution Board which she leads.

The Brussels-based commission is considering a standardized approach to creditor ranking in insolvency, since divergence among member states could hinder use of the bail-in tool that came into effect this year, especially for cross-border banks. The issue has gained in urgency after the hammering that bank shares took following the U.K.’s decision to secede from the EU.

Senior Debt

The French government has proposed allowing banks to issue “non-preferred,” or Tier 3, notes that sit between existing senior and subordinated bonds and would gradually replace most of the senior notes. While no French bank has yet issued such securities, Copenhagen-based Nykredit Realkredit, Denmark’s biggest issuer of covered bonds, last month issued “senior resolution notes” designed to function like senior debt while the lender is in good health, but available to be written down if it goes into resolution. The bank on Thursday said it plans a second issue.

At the same time, Koenig’s SRB is busy setting bank-specific loss-absorbency requirements, known as MREL, for the euro area’s biggest lenders. For the “big banks” -- those of global and national systemic importance -- Koenig said she’s “convinced” the minimum level will be set at 8 percent of total liabilities including own funds, even though efforts have been made to water down the standard.

“We will only give an indication for the MREL requirement this year,” Koenig said. “We won’t decide in detail how much will have to be subordinated and how much of it must be senior. Here of course we are also closely following the discussion in the EU about the harmonization of the creditor hierarchy.”

TLAC Standard

The MREL standard itself doesn’t require subordination, Koenig said, “but the bigger or the more complex a bank is, the more likely it is that subordination is required to ensure resolvability.”

As the EU gets to work on MREL, it’s also implementing a global standard for minimum total loss-absorbing capacity, or TLAC, adopted by the Group of 20 nations last year with the goal of allowing the world’s biggest banks to fail in an orderly fashion and without recourse to public funds.

The TLAC rules require global banking giants to issue ordinary shares, subordinated debt and other potentially loss-absorbing securities equivalent to 18 percent of risk-weighted assets and 6.75 percent of leverage exposure by 2022.

Deposit Insurance

For the globally significant banks in Europe, the SRB will “cover the main TLAC requirements when setting MREL,” Koenig said. The FSB has given banks until 2019 to meet the initial TLAC requirements. “In practice we think a three- to four-year period will be needed for banks to build up the required MREL in many cases,” she said.

Smaller banks may get lower MREL requirements since their failure would pose a lower risk to financial stability, Koenig said.

“A stylized case where you may not need 8 percent MREL is a bank that has on its liability side nothing but equity and guaranteed deposits,” she said. “Would you really ask them to add MREL to their balance sheet to get to the 8 percent? You could also argue that the deposits will be safeguarded by the deposit insurance scheme and the rest just goes into insolvency.”

For Koenig, the key issue is being able to resolve a bank by inflicting losses on bondholders without risking a legal challenge. That is particularly true for the bigger lenders.

‘Legal Risk’

“In particular for a large bank, and the banks under our remit can be assumed to be systemically relevant for the member state at least, certainty on the ability to bail-in the debt instrument without any material legal risk is crucial,” she said.

On Italy’s bank woes, Koenig said that in recent years a “pretty high stock” of non-performing loans has built up in the country’s lenders, “and it has to deal, like other markets, with structural issues.”

The precautionary recapitalization of banks, which the Italian government has been pursuing, “has certain conditions” under EU bank-failure rules, she said.

The EU Bank Recovery and Resolution Directive is “a good law and a good basis for recovery and resolution, and one of the rules in that law is, under certain conditions, the precautionary recapitalization.”

“This rule was made for cases where a recapitalization had to be done by the state, temporarily, for financial stability reasons,” Koenig said. “That’s state aid and therefore has to meet the state aid rules.”

(Updates with Koenig comments on Italy in last four paragraphs.)
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