It spooked the markets for good reasons, but the leaked EC document on the merger of TLAC and MREL did not receive the attention that it deserves.

Yes, Reuters reported on the leaked Information Note from the Commission Services for the European Commission Expert Group on Banking, Payments and Insurance. However I am not sure if Reuters realized that the EC is planning a merge of all gone concern capital, that is, for only the G-SIIs, a select group of very big banks:

For all other banks, MREL will be a mere Pillar 2 add-on. These banks will basically be subjected to the Basel III rulebook requirements from 2010: they will have to satisfy an 8% Total Capital Requirement … back to the BIS ratio requirement of yesteryear. Ignoring the buffer requirements, going concern capital will be 6%, gone concern will be 2% on top of that: together that is it: 8%.

Some observations:

Does the EC care? The EC document claims that the amalgamation of TLAC and MREL accommodates all types of subordination (ie, structural, statutory and contractual). This, and other simplifications, may have led some people to think that the document has been written hastily. However, there may be a different reason for the amalgamation and simplifications: maybe the EC intends to lower its commitment to the BRRD, or parts thereof. The Basel III definition of capital, MREL, and TLAC were carefully crafted over many years. The EC document looks like “carefully crafted” in reverse: less care, less crafting.

We are six weeks into full implementation of the Bank Recovery and Resolution Directive. With countries like Italy and Portugal showing signs of not caring and the EC giving in to this apparent lack of care, other countries are bound to follow. Think about the headaches the BRRD and the lack of harmonisation of this Directive may cause for many years ahead. With that prospect, the EC may think of quietly abandoning it.

Not so fast? Although pundits may think that the EC document is hastily drawn up, I don’t think so. Europe has shown many signs of dissatisfaction with the post-crisis  bank reforms. One example is the well-known non-paper that urges Europe to “get it right” on the Banking Union. More importantly, however, is Lord Hill’s relentless push for “proportionality“, which in practice just means lower capital requirements for smaller banks. Despite the lack of evidence on the effects of capital requirements on bank lending in Europe (see this ECB document), Jonathan Hill has now the support from the Bank of England and from Germany. Just recently, Reuters quoted a report that mentions that “Germany and the UK believe that now is an appropriate time for the EU to consider how to achieve a more proportionate and fit-for-purpose prudential framework for smaller/less complex banks and credit institutions.”

The leaked document is only the beginning and the EC wants to move quickly. It even refuses to wait for EBA’s report on MREL, which is due in October (see Article 18 and 19 of the BRRD). 

What about Tier 2? The demotion of MREL to a Pillar 2 add-on may disincentivise EU non-G-SIIs from issuing Tier 2 instruments over and above the Basel III requirement of 2%. Tier 2 is expensive, investors will figure out that any amount of Tier 2 over 2% has been issued at the behest of the resolution authorities. This may make Tier 2 more expensive.

Not helping either is that existing Tier 2 instrument contracts may need modification. The maturity of five years under Basel III will have to change to a one year residual maturity under TLAC. This may adversely affect pricing if, under the EC proposal, Tier 2 requirements move towards those of old style (permanent) Upper Tier 2. The EC document, unfortunately, seems oblivious to markets and effects on pricing and assumes that there is a deep and liquid Tier 2 market, which there ain’t.

Why these layers anyway? It is not unlikely that eventually there will be two types of Tier 2 capital: one for non-GSIIs and one for GSIIs. This makes me wonder: why bother about a designated gone-concern layer of capital in the first place? The layering is soooo Big Short. It is complex and puts other interests (e.g. tax deductibility) before financial stability.

If the EC really wants to keep it simple, it should propose this:

• For going concern: let CET1 satisfy Tier 1 requirements; abandon Additional Tier 1.
• For gone concern: eliminate Tier 2 and expose all liabilities to bail-in, except of course the liabilities that are protected (see Art 44.2 of BRRD).

The EC was audacious when it decided to implement Basel III through a Regulation, which was the right decision, a decision that worked out well. With a Bank Recovery and Resolution Directive that presents one challenge / head-ache after another, maybe it is time for the EC to make such a bold move again.