New capital requirements for banks
In the course of the financial crisis, credit institutions had to be shored up using huge sums of taxpayers' money. Systemically important institutions, in particular, whose failure would have had an adverse impact on financial stability and on the real economy owing to their size and interconnectedness, were propped up by governments to prevent them from failing. According to the Bundesbank's latest Monthly Report, however, government bail-outs not only come at a substantial fiscal expense, but also give bank managers misguided incentives.
Back in 2008, the G20 leaders agreed on global reforms in an effort to strengthen the resilience of financial institutions and reduce the risks to financial stability. The measures adopted under the Basel III regime include tightening the requirements for the amount of capital to be held by financial institutions and the introduction of quantitative liquidity standards and a non-risk-based leverage ratio.
A resolution procedure for systemically important institutions was also developed as a further key instrument, which, unlike normal insolvency proceedings, aims to ensure the continuity of a bank's critical functions and thus preserve financial stability. One of the core elements of this resolution regime is a new bail-in tool. It is based on the idea that investors should not only reap a bank's profits but also be exposed to any losses it makes. Once the shareholders have been bailed in, holders of debt instruments will also be exposed to a bank's losses. In order to ensure that sufficient loss-absorbing capacity is available in the event that an institution has to be resolved, minimum requirements were developed for loss-absorbing liabilities.
Global TLAC standard for systemically important institutions
At the global level, the G20 leaders agreed to implement the total loss-absorbing capacity (TLAC) standard, which lays down a minimum amount of loss-absorbing capital. In addition to regulatory capital, this can also include certain liabilities. The new standard will apply to global systemically important banks – that is, to a total of around 30 institutions worldwide.
The TLAC capital requirements are designed to ensure that a possible successor institution, which will take over the critical functions of the bank, is sufficiently capitalised to be able to meet the requirements to hold a banking licence and to restore market confidence. This would be one way of protecting customer funds and preventing a negative impact on financial stability, the Monthly Report states. The minimum TLAC requirement is to be introduced in two stages and will have to be fully met from 2022 onwards.
MREL requirements for European institutions
While the TLAC standard was developed at the G20 level, the EU has already introduced a similar concept, the minimum requirement for own funds and eligible liabilities, or MREL for short. This standard is intended to ensure that financial institutions established in the EU hold sufficient bail-inable capital for the event of a possible resolution. Even though both concepts pursue the same objectives, TLAC and MREL differ in a number of key elements. This is due, in particular, to the fact that MREL targets a much larger group of institutions, generally disregarding their size and systemic importance, whereas TLAC was designed for global systemically important institutions.
MREL is determined on an individual basis for each institution by the competent resolution authority and is thus designed to take account of the heterogeneity of the European banking sector. Unlike in the case of TLAC, no minimum amount of loss-absorbing capital has been legally defined for the MREL. Instead, a set of qualitative criteria has been stipulated, which, despite the individual setting of the MREL, should ensure comparability across the EU member states. With regard to the large number of small institutions, many of which are located in Germany, in particular, it can be assumed that they do not perform any critical functions from the viewpoint of the financial market. This means that these institutions could be wound up under normal insolvency proceedings and will therefore, as a general rule, not be required to comply with an MREL which exceeds the hitherto existing capital requirements.
Outstanding MREL-related issues
The Bundesbank points out that, in contrast to the TLAC, standard double usage of Tier 1 capital to fulfil the regulatory capital buffer and the MREL cannot be ruled out under the current design of the MREL regulations. Whereas the MREL has to be fulfilled at all times, it should be possible to intentionally reduce capital buffers during periods of stress in order to cushion any losses. If Tier 1 capital were to be used for both purposes, this would nullify the function of the capital buffers. Furthermore, in keeping with the TLAC standard, the European regulations need to define the repercussions of falling short of the requirements, the Bundesbank writes in its Monthly Report. These and other outstanding issues with regard to the application of the new MREL, especially a subordination requirement for MREL-eligible liabilities, should be clarified quickly and constructively to create clarity for banks and investors.
Moreover, Bundesbank economists warn against any political initiatives which aim to soften the new regulations. This would send out the wrong signal and jeopardise the credibility of the resolution regime, the economists write. A functioning resolution mechanism is an important step towards severing the close ties between banks and sovereigns. It needs to be rigorously implemented and accompanied by further measures, such as limiting bank lending to sovereigns.