CDS and Senior Loss Absorbing Capacity – A New Tier
The year 2018 marks the 10th anniversary of the collapse of Bear Stearns and Lehman Brothers and still the task of tackling “Too Big To Fail” is far from complete.
On the contrary, regulation aimed at preventing taxpayer-funded bailouts is yet to be fully implemented - a fact that may come as a surprise to many.
But that is about to change. Rules that force global systemically important banks (G-SIBs) to address inadequate loss absorbency will come into effect from January 2019 - the Total Loss Absorbing Capacity (TLAC) standard. Similar regulation encompassing smaller banks in Europe – the Minimum Requirement for own funds and Eligible Liabilities (MREL) - will soon follow. Bond markets have already felt the impact of these changes in the form of new issuance targeted at complying with the regulations. Inevitably, the CDS world will have to adapt to the shifting landscape in cash.
This paper will examine how banks are seeking to comply with TLAC and MREL, the new subordination of liabilities that will result from regulatory compliance, the performance of this new asset class and finally, how the CDS market will adjust in order to accommodate the changes in its bond counterpart.
If there was one aspect of the financial crisis that angered the general public more than most it was the use of taxpayer funds to bailout banks. Institutions that were deemed “Too Big to Fail” were rescued by governments across the globe amid concerns about systemic risk. The idea of bondholders sharing the burden of bank rescues was discussed and usually dismissed by the relevant authorities; contagion was the primary fear.
The justification of such actions is debatable and still a bone of contention, particularly in countries where the bailouts transferred huge amounts of debt to the public balance sheet. But in the aftermath it was clear that the TBTF problem had to be addressed. Regulations were needed that made it possible to resolve systemically important banks without the use of public funds. No more bailouts, but bail-ins.
Step forward the Financial Stability Board (at the behest of G20 leaders). After a lengthy period of consultation with the Basel Committee on Banking Supervision and industry participants, a new standard on Total Loss Absorbing Capacity was published on 9 November 2015. The TLAC standard applies to all G-SIBs, of which there are 30 at the time of writing. The BCBS followed soon after with a standard that establishes how G-SIBs take account of the TLAC requirement in relation to regulatory capital.
The need for subordination
The principles of loss absorbency to aid an orderly resolution were laid out in the TLAC term sheet and seemed clear. But a bail-in of bank creditors is far from straightforward, not least from a legal standpoint. The “no creditor worse off” (NCWO) principle states that no creditor or shareholder shall incur greater losses than they would have incurred if the institution had been wound up under normal insolvency proceedings. In most jurisdictions senior bondholders rank pari passu with other liabilities, for example derivative liabilities, structured notes and deposits – all of which are excluded from TLAC. If senior bondholders were bailed-in but other liabilities ranked pari passu weren’t, then that would create a material risk of legal challenge and prevent the orderly resolution of the bank.
Capital instruments – core equity tier one, additional tier one and tier two – are junior to excluded liabilities so in theory could meet the TLAC requirement and facilitate an orderly resolution. But in most cases this would prove insufficient; therefore an additional layer of liabilities subordinate to excluded liabilities is necessary.
The FSB term sheet outlines three different types of subordination that can achieve the aim of meeting the requisite amount of TLAC without violating NCWO:
- Contractual subordination – liabilities subordinated by a clause in the debt contract
- Statutory subordination – liabilities are made junior to excluded liabilities by statute (national law)
- Structural subordination – debt issued by a holding company that is structurally subordinated to the operating company
The FSB doesn’t state any preference; all three subordination approaches can minimize the risk of legal challenge in the event of a resolution.
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