Blog Post

Developing resilient bail-in capital

Europe’s largest banks have made progress in issuing bail-inable securities that shelter taxpayers from bank failures. But the now-finalised revision of the bank resolution directive and a new policy of the SRB will make requirements to issue such securities more onerous for other banks. In order to strengthen banking-system resilience, EU capital-market regulation should facilitate exposures of long-term institutional investors.

By: and Date: April 29, 2019 Topic: Banking and capital markets

The ECB’s March policy meeting announced not just a delay in the expected interest-rate hikes, but also a new round of bank refinancing operations (the so-called LTRO-III). Additional bank funding was justified by substantial amounts of bank bonds falling due just as the previous round of refinancing operations comes to an end. In addition, as of last year, funding policies of European banks have been geared to comply with two new regulations: requirements for long-term liquidity, and also the increasingly prominent need to raise funds with substantial amounts of bail-inable liabilities.

Raising bail-in capital will loom large for Europe’s smaller banks

Bail-in securities are exposed to a write-down once a bank enters a resolution process, and provide an additional buffer against taxpayer-funded bailouts.

The world’s largest banks (‘G-SIBs’, seven of which are headquartered in the euro area) were already required to issue such securities (known as ‘TLAC’) based on standards set by the Financial Stability Board in 2015. The EU bank resolution directive (‘BRRD’) introduced the equivalent concept of ‘Minimum Requirements for Own Funds and Eligible Liabilities’, or MREL.

TLAC and MREL represented a new concept in international debt markets, and required changes in how domestic law defines creditor hierarchies. Most EU countries created a new category of creditors, forcing banks to issue new instruments or convert outstanding liabilities at a cost. Others, most notably Germany, simply subordinated existing liabilities. The so-called banking package adopted by the European Parliament last week has now unified TLAC and MREL, and tightened the requirement for the issuance of sub-ordinated debt. In the euro area the requirement to raise such funds is now gradually enforced by the Single Resolution Board (SRB).

In aggregate, euro-area banks seem to have made good progress in issuing such instruments. The December inter-agency report on risk reduction found that 14 member states exhibited a shortfall relative to targets in effect at end-2017, though this was only about 2% of the total assets.

Europe’s G-SIBs have comfortably met their interim targets for TLAC in January. G-SIBs have kept their bond issuance roughly steady since the financial crisis, though progressively sold more bail-inable securities, which by now constitute half of the roughly €250 billion annual bond issuance.

But Europe‘s smaller banks seem to confront a greater problem. Analysis by the ECB suggests not only that overall issuance by these banks has halved since 2010, but also that bail-in securities amount to only about 20% of this diminished issuance.

For smaller banks the requirement to raise MREL was only gradually introduced following the adoption of the BRRD in 2015, beginning with the more complex banks. The requirements for sub-ordinated debt under the banking package and a new SRB policy are  likely to further raise the requirements for many banks. Crucially, this SRB policy sets requirements not just at group level but also for individual subsidiaries.

These banks suffer from a long-running profitability problem and will now need to issue more costly securities to a relatively inexperienced investor base.

Investors in bail-in securities should make the financial system more resilient

The type of investors that hold MREL will have key implications for how bank funding costs will evolve in the next financial crisis.

Once an individual bank comes close to resolution, short-term investors – such as hedge funds – may flee the asset, leading to a rapid deterioration in funding costs and possibly bringing forward the bank’s point of failure. Moreover, the smaller banks which now begin to sell increasing amounts of MREL will be similar in terms of business model or be exposed to similar asset problems, be it from private-sector excess debt or from concentrated holdings of government securities. A common creditor base of short-term investors could therefore set off contagion – from one institution that comes close to resolution, to others with similar perceived risks, if allocation to the entire asset class is reduced. There will likely be collective bouts of enthusiasm and flight from bail-in securities in individual jurisdictions.

From the outset, BRRD was conceived to deal with idiosyncratic bank failures, and its inherent flaw in dealing with a systemic crisis was well understood. Europe’s short and intermittent history with resolutions as yet does not offer a sufficient case history to assess how investors would behave in a situation of wider banking-sector stress.

Financial-sector supervision should therefore monitor this emerging asset class and its investor base. MREL exposures between banks could aggravate contagion across the banking sector and rightly incur high capital charges. Direct exposures by retail investors should also be limited, and in any case may be exempted from bail-in under the BRRD.

Capital-market regulation should therefore find ways to encourage long-term investors, such as pension and insurance funds, to take on more significant exposures. This could be done, for instance, through requirements for capital coverage and asset valuation in the regulation of insurance funds. As financial system risks have been reduced, and risks have become less correlated between insitutions, bail-in securities could become a more established asset class.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article More on this topic More by this author
 

Opinion

Buy now, pay later: the age of digital credit

A relatively new fintech market, BNPL is currently not regulated in the EU, meaning that consumers do not have the same protection level as they do for other credit products.

By: Maria Demertzis Topic: Digital economy and innovation Date: May 17, 2022
Read about event More on this topic
 

Past Event

Past Event

What is in store for Euro area economies?

ECB Executive Board Member Philip Lane discusses the outlook for Euro area economies.

Speakers: Maria Demertzis and Philip Lane Topic: European governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 5, 2022
Read article More by this author
 

Blog Post

Owning up to sustainability risks: the EU should champion international standards

To keep European Union capital markets open and integrated, new international standards should be reflected in future European law and accounting practice to provide further incentives for a reallocation of capital, reflecting in particular climate risks.

By: Alexander Lehmann Topic: Banking and capital markets, Green economy Date: April 26, 2022
Read article More on this topic More by this author
 

Opinion

China’s Covid policy to be year’s largest economic shock

Beijing’s ‘dynamic zero-Covid’ policy could devastate the domestic economy, but the effects will also be felt globally.

By: Alicia García-Herrero Topic: Global economy and trade Date: April 26, 2022
Read article More on this topic
 

External Publication

What drives implementation of the European Union’s policy recommendations to its member countries?

Article published in the Journal of Economic Policy Reform.

By: Konstantinos Efstathiou and Guntram B. Wolff Topic: Macroeconomic policy Date: April 13, 2022
Read article More on this topic
 

External Publication

Close cooperation for bank supervision: The cases of Bulgaria and Croatia

In-depth analysis on the banking supervision cooperation in Bulgaria and Croatia prepared for the European Parliament's Committee on Economic and Monetary Affairs (ECON).

By: Zsolt Darvas and Catarina Martins Topic: Banking and capital markets Date: March 30, 2022
Read about event More on this topic
 

Past Event

Past Event

Tackling future risks to banks

How to address vulnerabilities in banks in the coming years?

Speakers: Maria Demertzis and Elizabeth McCaul Topic: Banking and capital markets Date: March 29, 2022
Read article More on this topic More by this author
 

Opinion

The week inflation became entrenched

The events that have unfolded since 24 February have solved one dispute: inflation is no longer temporary.

By: Maria Demertzis Topic: Macroeconomic policy Date: March 8, 2022
Read article Download PDF More on this topic More by this author
 

External Publication

Book notes: Monetary policy in times of crisis

Review of 'Monetary policy in times of crisis: a tale of two decades of the European Central Bank' published in the Central Banking.

By: Francesco Papadia Topic: Macroeconomic policy Date: February 17, 2022
Read about event More on this topic
 

Past Event

Past Event

A debate on fiscal rules and the new monetary strategy

Presentation of the Yearbook of the Euro 2022.

Speakers: Maria Demertzis, Fernando Fernández, Gonzalo García Andrés, José Carlos García de Quevedo, Pablo Hernández de Cos and Jorge Yzaguirre Topic: European governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 17, 2022
Read article More on this topic
 

Blog Post

Venture capital: a new breath of life for European entrepreneurship?

Whether the dynamism of European venture capital of the past two years can be sustained and kick start a credible alternative to bank finance in the European Union remains to be seen.

By: Maria Demertzis and Lionel Guetta-Jeanrenaud Topic: Banking and capital markets Date: February 10, 2022
Read article
 

Blog Post

European governanceInclusive growth

12 Charts for 21

A selection of charts from Bruegel’s weekly newsletter, analysis of the year and what it meant for the economy in Europe and the world.

By: Hèctor Badenes, Henry Naylor, Giuseppe Porcaro and Yuyun Zhan Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Date: December 21, 2021
Load more posts