The European Commission (“Commission”), on November 23, 2016, released its legislative proposals to amend the EU’s Bank Recovery and Resolution Directive (“BRRD”) to provide more detailed rules relating to the setting of MREL9 for European banks, and to implement the Financial Stability Board’s final principles for total loss-absorbing capacity (“TLAC”) for global systemically important banks (“GSIBs”). MREL constitutes unsecured debt and other instruments that are considered to have good loss-absorbing abilities in the event of a bank’s resolution and is substantially similar in nature to TLAC.

Under BRRD, derivatives liabilities are excluded from MREL eligibility, though liabilities from securities embedding a derivative, such as structured notes, are not currently excluded. In harmonising the MREL requirements with the TLAC requirements, the expectation was that structured notes would also be excluded from MREL eligibility, as they are excluded for TLAC eligibility.

The Commission’s proposals in this regard are different for EU GSIBs and non-GSIBs. Structured securities will not be eligible for a GSIB’s minimum MREL requirements, i.e. 16%/18% of risk-weighted assets and 6%/6.75% of the Basel III leverage ratio denominator as from January 1, 2019/2022. However, they will be eligible for any additional MREL requirements imposed on the GSIB by the relevant resolution authority and also for a non-GSIB’s MREL requirements, in each case so long as they meet certain conditions. These conditions are that: (a) a given amount of the liability is known at the time of issuance, is fixed, and is not affected by a derivative feature; and (b) neither the instrument, nor its derivative feature, is subject to a netting agreement, and its value would therefore not be determined on a net basis under BRRD. However, only that part of the instrument meeting the requirements in clause (a) may be counted towards MREL.

If the current proposals are enacted, this appears to mean that principal-protected structured notes should be eligible to count towards a non-GSIB’s MREL and towards any GSIB’s MREL requirements above the minimum level, in each case to the extent of the principal-protected amount. This reflects the fact that the principal-protected part (if any) of a structured note does not suffer from the valuation difficulties that exclude other derivatives and derivative-linked liabilities from being considered easily bail-inable in a bank resolution.

MREL, though, is set by each resolution authority on a bank-by-bank basis, and it is open to the relevant EU resolution authority to require the relevant bank to subordinate its MREL-eligible principal-protected structured notes to liabilities that are not eligible for MREL. If required, this could be achieved either in the contractual terms of the note, or by provisions in the laws of the bank’s jurisdiction of incorporation or by issuing the notes from a holding company that does not have any MREL-excluded liabilities ranking pari passu or junior to its MREL.

However, it is not immediately clear from the proposals why the Commission would make a distinction between GSIBs and non-GSIBs in terms of whether these types of structured notes should count towards MREL requirements. If it considers that such notes have good loss-absorbing capacity, one would not expect that to change, based on the type of bank issuing them. The current proposals place GSIBs at a competitive disadvantage to non-GSIBs in terms of raising MREL. The market now eagerly awaits the final TLAC rules to be issued on December 15, 2016 by the U.S. Federal Reserve Bank, which has, no doubt, been studying the Commission’s proposals carefully. [We will be reporting on those final rules as they are released.]

For a fuller description of the EU’s proposed MREL changes, read our client alert.