On 9 November 2015, the Financial Stability Board finalized its Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution, including the Total Loss-absorbing Capacity (TLAC) Term Sheet. It introduces a new international standard for quantitative and qualitative requirements for external and internal TLAC as well as new disclosure requirements.

By René Bösch / Benjamin Leisinger (Reference: CapLaw-2015-58)

1) Introduction

On 9 November 2015, the Financial Stability Board (FSB) finalized its Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution, including the Total Loss-absorbing Capacity (TLAC) Term Sheet (the Term Sheet).

These principles go back to the G20 Leaders’ assignment in 2013 to the FSB to assess and develop proposals on the adequacy of global systemically important financial institutions’ (G-SIBs) loss-absorbing capacity when they fail.

The draft principles and proposals for a common international standard for TLAC by G-SIBs had been prepared in consultation with the Basel Committee on Banking Supervision (BCBS) and have been subject to consultation between 10 November 2014 and 2 February 2015 (also see CapLaw-2015-15). The final principles issued on 9 November 2015 (the TLAC Principles) reflect changes made following the public consultation and comprehensive impact assessment studies.

The TLAC Principles will form a new international standard for G-SIBs.

2) Quantitative Requirements

According to the TLAC Principles, the G-SIBs must have sufficient loss-absorbing and recapitalization capacity available in resolution for authorities to implement an orderly resolution that minimizes impacts on financial stability, maintains the continuity of critical functions, and avoids exposing public funds (i.e., funds other than those of creditors of the respective G-SIB) to loss.

G-SIBs will be required to meet the TLAC requirement alongside (and in addition to) the minimum regulatory requirements set out in the Basel III framework and implemented by national regulation. Specifically, G-SIBs will be required to meet a Minimum TLAC Requirement of at least 16% of the resolution group’s risk-weighted assets (TLAC RWA Minimum) as from 1 January 2019. As from 1 January 2022, the TLAC RWA Minimum amounts to at least 18%. Minimum TLAC must also be at least 6% of the Basel III leverage ratio denominator (TLAC Leverage Ratio Exposure Minimum) as from 1 January 2019, and at least 6.75% as from 1 January 2022. G-SIBs headquartered in emerging market economies are subject to a different – more generous – phase-in.

In order to reduce the risk of contagion, G-SIBs must deduct exposures to eligible external TLAC instruments and liabilities issued by other G-SIBs from their own TLAC position their own or regulatory capital in a manner generally parallel to the existing provisions in the Basel III framework. On 9 November 2015, the BCBS released a consultative document on TLAC holdings in this respect; the consultation period runs until 12 February 2016.

Home authorities of resolution entities are requested to apply additional firm-specific requirements above these minimum standards if they, in consultation with the Crisis Management Groups (CMG) and subject to review in the Resolvability Assessment Process, determine that this is necessary and appropriate in the specific case to meet the intended goals of the TLAC Principles.

The FSB will monitor the implementation within the stated periods.

3) Consequences of a Breach

According to the TLAC Principles, the Minimum TLAC Requirements should be treated the same as regulatory capital requirements. Accordingly, a breach or likely breach should be treated as severely as a breach or likely breach of regulatory capital requirements.

4) Core Features of External TLAC

The Term Sheet lists the core features for TLAC-eligible external instruments (External TLAC) in Sections 7 to 14. As expressly stated in the TLAC Principles, the Term Sheet and the core features should be read in conjunction with the TLAC Principles.

In order to qualify, External TLAC must fulfill the following:

1. It must generally be issued and maintained directly by resolution entities. There are, however, important exemptions from this rule. For example, debt liabilities issued indirectly by a wholly and directly owned funding entity of the resolution entity prior to 1 January 2022 are also recognized if certain additional requirements are met. These additional requirements, for example, refer to the Basel III framework and the requirement for special purpose vehicles, including the requirement of a downstreaming of the proceeds in a form that meets or exceeds the TLAC requirements.
2. It must be fully paid-in.
3. It must be unsecured. The Term Sheet still does not specify what type of security would make the instrument ineligible. In light of the TLAC Principles, any security that would either prevent that these instruments absorb losses when needed or that enhances the instrument’s ranking in the relevant situation should not be permissible. In contrast, in our understanding, guarantees by the resolution entity in situations where the External TLAC is issued by the funding entity (see at (1) above) should be permissible.
4. It must not be subject to set off or netting rights that would undermine their loss-absorbing capacity in resolution.
5. It must not be redeemable by the holder (i.e., no holder put option) prior to maturity. Where such a put option exists, the date for this must be specified in the terms of the instrument and the minimum maturity (see at (7) below) is calculated based on the earliest possible date on which the holder can exercise the redemption/put option.
6. Redemption by the issuer is not possible without supervisory approval if the redemption would lead to a breach of the G-SIB’s Minimum TLAC Requirements.
7. It must be perpetual or, if dated, must have a minimum remaining maturity of at least one year. Further, according to the Term Sheet, the appropriate authority should ensure that the maturity profile of a G-SIB’s External TLAC is adequate to ensure that its TLAC position can be maintained in times where access to capital markets is temporarily impaired. This requirement and the minimum maturity requirement effectively increase the TLAC position a G-SIB must hold.
8. It must not be funded directly or indirectly by the resolution entity. However, an exemption is available for G-SIBs applying a multiple point of entry resolution strategy if the relevant home and host authorities in the CMG agree.
9. It must not qualify as an excluded liability. This means that it must (i) not be an insured deposit, (ii) not be a sight or short term deposit, (iii) not qualify as a liability arising from derivatives, (iv) not be a debt instrument with derivative-linked features (such as structured notes), (v) not arise otherwise than trough a contract, (vi) not be preferred to senior unsecured creditors under the relevant insolvency law, (vii) not be excluded from bail-in, and (viii) not be subject to a material risk of successfully legal challenge or valid compensation claims in the case of a bail-in.
10. It must be able to absorb losses prior to excluded liabilities (see above at (9)) in insolvency or in resolution by way of contractual, statutory, or structural subordination without giving rise to material risk of successful legal challenge or compensation claims. As clarified in a footnote in the Term Sheet, External TLAC may be senior to regulatory capital instruments, including tier 2 instruments. The Term Sheet introduces a new limited exemption from the requirement that External TLAC must be junior to all excluded liabilities (see above at (9)): Subordination of eligible external TLAC to excluded liabilities is not required if (i) the amount of excluded liabilities on the balance sheet of the resolution entity that rank pari passu or junior to the TLAC eligible liabilities does not exceed 5% of the resolution entity’s eligible External TLAC; (ii) the resolution authority of the G-SIB has the authority to differentiate among pari passu creditors in resolution (i.e., order a bail-in with respect to the External TLAC but not with respect to the excluded liabilities raking pari passu); (iii) differentiation in resolution in favor of such excluded liabilities would not give rise to material risk of successful legal challenge or valid compensation claims; and (iv) this does not have a material adverse impact on resolvability.The entire subordination requirement does not apply in those jurisdictions in which all excluded liabilities are statutorily excluded from the scope of the bail-in tool. Where such exclusion may only be ordered by the resolution authority in exceptional circumstances, the relevant authorities may permit liabilities that would otherwise be eligible to count as External TLAC but which rank alongside excluded liabilities to contribute up to 2.5% (when the TLAC RWA Minimum is 16%) or up to 3.5% (when the TLAC RWA Minimum is 18%) of the resolution entity’s Minimum TLAC Requirement.
11. It must either be governed by the laws of the jurisdiction in which the relevant resolution entity is incorporated, or, if subject to the law of another jurisdiction, include legally enforceable contractual provisions recognizing the application of resolution tools by the relevant resolution authority if the resolution entity enters resolution, unless there is equivalent binding statutory provision for cross-border recognition of resolution actions.
12. It must either contain a contractual trigger or be subject to a statutory mechanism which permits the relevant resolution authority to expose the instrument to loss or convert it to equity in resolution.

5) Core Features of Internal TLAC

In addition to the requirements for External TLAC, the Term Sheet also specifies the quantitative and qualitative requirements for internal TLAC (Internal TLAC). Internal TLAC is defined as loss-absorbing capacity that resolution entities have committed to material sub-groups. Its primary objective is to facilitate co-operation between home and host authorities and the implementation of effective cross-border resolution strategies by ensuring the appropriate distribution of loss-absorbing and recapitalization capacity within resolution groups outside of their resolution entity’s home jurisdiction. The core features of eligible Internal TLAC are the same as those for External TLAC (except with regard to the issuing entity and permitted holders).

However, additional requirements are also set forth in the Term Sheet. For example, the Term Sheet clarifies (i) who has to hold Internal TLAC (i.e., who must be an issuer), (ii) which additional criteria Internal TLAC must comply with if such instruments qualify as regulatory capital (e.g., regarding the write-down or conversion by the relevant host authority at the point of non-viability, subject to consent by the relevant home authority), or (iii) which criteria collateralized guarantees have to meet in order to substitute on-balance sheet Internal TLAC.

6) Increased Transparency via New Disclosure Rules

In order to increase transparency as to the TLAC positions and ranking of External TLAC in resolution, the Term Sheet introduces new disclosure standards, to be further specified by the BCBS:

• G-SIBs must disclose the amount, maturity, and composition of external and internal TLAC that is maintained, respectively, by each resolution entity and at each legal entity that forms part of a material sub-group and issues internal TLAC to a resolution entity.
• Moreover, resolution entities must disclose, at a minimum, the amount, nature, and maturity of any liabilities which in the relevant insolvency creditor hierarchy rank pari passu or junior to External TLAC.
• Entities that are part of a material sub-group and issue internal TLAC to a resolution entity must disclose any liabilities which rank pari passu with or junior to internal TLAC issued to a resolution entity.

René Bösch (rene.boesch@homburger.ch)
Benjamin Leisinger (benjamin.leisinger@homburger.ch)