European Banks May Need $294 Billion of Loss-Absorbing Funds

  • EBA lowers earlier estimate for banks’ current MREL capacity
  • New rules avoiding bailouts are net-positive for economy

European Union banks need to sell hundreds of billions of euros in loss-absorbing liabilities over the next few years to meet the bloc’s rules designed to prevent public bailouts.

The European Banking Authority estimates as much as 276 billion euros ($294 billion) of financing is needed under the most stringent assumptions, lowering its earlier forecast. While this will increase funding costs for banks and may result in more expensive credit, the measure will help to stave off crises even more damaging to the broader economy, the regulator said in an impact study on the EU’s bank-failure rules.

The requirement to have sufficient eligible liabilities to absorb losses and recapitalize a bank is the cornerstone of the EU’s bank-failure legislation. Requirements will be set for each bank individually by authorities such as the Single Resolution Board and the Bank of England. It is similar to the global total loss-absorbing capacity, or TLAC, standard set by the Financial Stability Board for the world’s biggest banks, including HSBC Holdings Plc and Deutsche Bank AG.

Imposing losses on the creditors of a failed bank, known as bail-in, “is a crucial element of the resolution reforms, but its efficiency depends on whether banks have issued, at the point of failure, enough instruments that are eligible to be bailed-in and that can be bailed-in effectively and credibly without threatening financial stability,” the EBA said.

‘Essential Component’

The EU’s minimum requirement for eligible liabilities and own funds, or MREL, is an “essential complement to the bail-in tool,” the regulator said.

The EBA published a first impact assessment in July, finding a gap of as much as 470 billion euros. The new estimate is based on end-2015 data, and looks at the shortfall on the consolidated level, not including the possible additional needs of banks’ subsidiaries.

The EBA studied a sample of 133 banks from 18 EU member states, covering about two thirds of total EU banking assets, including all but one of the 13 globally systemically important banks based in the bloc, it said. The missing bank wasn’t identified.

As MREL requirements haven’t been finalized yet, the study makes simplified assumptions for how it will be calibrated. In the most conservative scenario, MREL was assumed at the greater of twice the current capital requirement including buffers and systemic risk charges, or 8 percent of total liabilities and own funds, the EBA said. That leads to a gap of 276 billion euros, the EBA said. A less stringent MREL requirement, in which capital requirements are doubled but buffers only considered once, leads to a shortfall of 186 billion euros.

Unsecured Bonds

The EBA recommends that smaller banks observe a subordination requirement for MREL that’s similar to a rule in the TLAC term sheet, under which at least 14.5 percent of risk-weighted assets must be subordinated. This level should be set at 13.5 percent for those EU banks that are not globally systemic but still seen as too big or too interconnected to fail on a national or regional level. The EBA’s calculation assumes that senior unsecured bonds issued by German banks are eligible for this requirement.

The German framework for statutory subordination differs from others, including that of the Italians, potentially increasing market fragmentation, according to the EBA, which is calling for harmonization of the varying national options.

“A single statutory subordination option would improve investor clarity and facilitate resolution planning,” it said.

Resolution authorities and supervisors should get additional powers to police MREL requirements swiftly, the EBA said in the report. Authorities should be empowered to require banks to draw up MREL restoration plans if minimum levels are missed, and to request distribution restrictions. Requirements should be based on firms’ resolution strategies, the EBA said.

To limit the potential for contagion, the EBA proposes that if banks own MREL of other banks, those holdings are deducted from banks’ own MREL, similar to a rule for banks’ equity capital.

The regulator also called for harmonized reporting and disclosure requirements, saying that once the measure is fully implemented doing so would provide transparency, supporting market discipline and reducing speculation about banks’ health. During the transition period, banks should ensure investors are aware of where they stand in the creditor hierarchy, the level of MREL and what it consists of.

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