On 11 May 2016, the Swiss Federal Council adopted an amendment to the Capital Adequacy Ordinance which sets out the new capital requirements for systemically important banks and introduces a new gone concern requirement for globally systemically important banks in line with G20 standards as promulgated by the Financial Stability Board. It further defines the required features for capital instruments qualifying for the gone concern requirement (so-called “Bail-in Bonds”) and sets out grandfathering provisions for outstanding instruments. The revised Capital Adequacy Ordinance came into effect on 1 July 2016, subject to phase-in and grandfathering provisions as described hereinafter.

By Daniel Hulmann / Stefan Kramer / Benjamin Leisinger (Reference: CapLaw-2016-25)

1) The Revised Capital Adequacy Ordinance

Article 52 of the Swiss Banking Act (Banking Act) requires the Swiss Federal Council to periodically evaluate the recently enacted too-big-to-fail (TBTF) provisions of the Banking Act in respect of their comparability and degree of implementation when compared to corresponding international standards, report thereon to the Swiss Parliament and propose legal changes if appropriate.

The Federal Council delivered its first evaluation report in February 2015. Subsequently, a working group under the leadership of the Federal Department of Finance with representatives of the Swiss Financial Market Supervisory Authority FINMA (FINMA) and the Swiss National Bank (SNB), in consultation with the concerned banks, drew up proposals for the necessary legal amendments. The Federal Council published a draft revised Capital Adequacy Ordinance (CAO) in December 2015 and, after a consultation period, approved the revised CAO on 11 May 2016. The date of entry into force was 1 July 2016.

The revised CAO recalibrates the existing TBTF framework by amending the capital requirements for systemically important banks (SIBs) and introducing a new gone concern requirement for global SIBs (G-SIBs) which may be fulfilled with so-called “Bail-in Bonds”, a newly introduced type of instruments that must meet specific criteria as further set out below.

a) Enhanced Going Concern Requirements for SIBs

SIBs are subject to a going concern capital requirement which seeks to ensure that SIBs have sufficient capital to ensure continuity of service even in a stress scenario without requiring state support or having to be restructured or wound up by FINMA. The going concern capital requirement is set with respect to both the bank’s leverage ratio (LR) and its risk-weighted assets (RWA) (article 128(2) CAO).

The basic going concern capital requirement of a SIB consists of (i) a base requirement of 4.5% LR and 12.86% RWA (article 129(2) CAO) and (ii) a surcharge (annex 9 of the CAO, which replaces the progressive component set out in article 130 CAO until 30 June 2016). The size of the surcharge is set with respect to the degree of systemic importance (i.e., the total exposure and the market share) of the relevant SIB (article 129(3) CAO). This currently translates into a going concern capital requirement for the two Swiss G-SIBs (Credit Suisse and UBS) of 5% LR and 14.3% RWA. The going concern requirement is further split into a minimum requirement component of 3% LR and 8% RWA which the SIB has to maintain at all times, and a buffer component which a SIB, e.g., in case of losses and under strict conditions, may temporarily fall short of. The going concern capital requirement may be fulfilled with Common Equity Tier 1 (CET1) capital and, to a certain extent (1.5% for the LR minimum requirement, 3.5% for the RWA minimum requirement, 0.8% for the RWA buffer requirement, but none for the LR buffer requirement), with Additional Tier 1 (AT1) capital with a high (7%) write-down / conversion trigger (article 131 CAO).

Additionally, as is the case for all Swiss banks, SIBs may be obliged to maintain a countercyclical buffer and a supplementary countercyclical buffer (which together form the countercyclical buffer as promulgated by the Basel III framework in §§ 136 et seq.), calculated on a RWA basis. Finally, FINMA may, in extraordinary circumstances and, on a case-by-case basis, oblige a SIB to hold additional capital or demand that the going concern capital requirement is fulfilled with higher quality capital.

b) Additional Gone Concern Requirements for G-SIBs

In accordance with international standards adopted by the Financial Stability Board (FSB), G-SIBs are subject to a new additional gone concern requirement which aims to ensure either an orderly restructuring of the G-SIB or the continuation of systemically important functions in a surviving entity without requiring state support. G-SIBs for purposes of the CAO are defined as banks which the FSB designates as Global Systemically Important Banks, in Switzerland currently Credit Suisse and UBS. FINMA may, however, continue to designate a bank as G-SIB even after the FSB has withdrawn such qualification if so required due to a strong engagement of such bank outside of Switzerland but it cannot designate a bank as a G-SIB without the FSB having designated the relevant bank as such before.

The gone concern requirement of a G-SIB quantitatively corresponds to its total going concern capital requirement (article 132(2) CAO), i.e., minimum 4.5% LR and minimum 12.86% RWA plus any surcharges applicable to the relevant G-SIB (but does not include any countercyclical buffers), which currently translates into a gone-concern requirement for Credit Suisse and UBS of 5% LR and 14.3% RWA. FINMA, after consultation with the SNB, may grant rebates in relation to this requirement based on the effectiveness of measures taken to improve the global resolvability of the relevant
G-SIB group (article 133 CAO) and in consideration of the interdependencies with other rebates. However, the gone concern requirement must not fall below (i) 3% LR or 8.6% RWA (article 133(2) CAO) or (ii) if higher, applicable international standards, and any rebate must not jeopardize the implementation of the G-SIB’s emergency plan (article 133(3) CAO)).

c) Qualitative Requirements for Bail-in Bonds

The gone concern requirement should primarily be fulfilled with so-called Bail-in Bonds that are designed to, in a restructuring of a G-SIB, absorb losses after regulatory capital of the G-SIB but before other (senior) obligations of the G-SIB. This ranking in restructuring proceedings intends to protect the creditors of operating liabilities and to allow the operating bank to continue its business without interruption. Bail-in Bonds do not constitute regulatory capital instruments and should not be mashed up or confused with them. In particular, Bail-in Bonds do not feature capital triggers that may lead to a write-down and/or a conversion into equity outside restructuring, but only start to bear losses once the G-SIB is formally in restructuring and FINMA orders capital measures (i.e., a write-down or a conversion into equity) in the restructuring plan. Bail-in Bonds may also be structurally subordinated, e.g., in the case of an issuance via the top-tier holding company or a special purpose vehicle and when applying a single-point-of-entry resolution strategy.

According to the revised CAO, Bail-in Bonds have to fulfill a number of criteria in order to qualify for the gone concern requirement. In particular, they:

• have to be fully paid in;
• have to be issued by a Swiss entity or, with the approval of FINMA and until 31 December 2021, by a (Swiss or foreign) special purpose vehicle (SPV);
• have to be subject to Swiss law and jurisdiction of Swiss courts; FINMA may, however, grant an exemption if it is established – e.g., by means of a legal opinion of a reputable law firm – that a write-down and/or conversion mandated by FINMA pursuant to its resolution powers is recognized in the relevant jurisdictions;
• have to be issued by the top holding company of the relevant G-SIB group or, with approval of FINMA and until 31 December 2021, by a Swiss or foreign SPV if it is ensured that the bonds issued by such SPV may be used to bear losses in a restructuring of the G-SIB;
• have to be (i) legally or contractually subordinated to other obligations of the issuer or (ii), in line with a single-point-of-entry resolution strategy where the Bail-in Bonds are issued by the ultimate parent company (or an SPV owned by it), structurally subordinated to obligations of other group companies;
• must not provide for an early redemption option of the creditors (i.e., must not contain an exercisable put, which is also prohibited by the FSB TLAC term sheet, but, taking the requirements for tier 2 instruments into account, standard event of default provisions and related acceleration rights, e.g., in the case of non-payment of interest or in the case of bankruptcy, can be included);
• must not be subject to set-off or be collateralized or guaranteed in a manner that would restrict their loss absorbing capacity in case of restructuring proceedings;
• have to provide, in their terms and conditions, for an unconditional and irrevocable provision pursuant to which the creditors acknowledge to be bound by a potential write-down / conversion ordered by the regulator in restructuring proceedings (so-called bail-in acknowledgement);
• must not contain derivative transactions or be linked to derivative transactions, except for hedging transactions;
• must not be financed, directly or indirectly, by the issuer or any of its group companies;
• have to be issued with the approval of FINMA which may also approve loans that have the same features as Bail-in Bonds; and
• may not be redeemed before their maturity date without FINMA’s approval if the redemption would cause the G-SIB to fall below the gone concern requirement, and otherwise only after giving notice to FINMA.

Bail-in Bonds qualify for the gone concern requirement (i) at their principal amount if the remaining time to maturity is at least two years, and (ii), imposing stricter rules than the FSB, at 50% of their principal amount if the remaining time to maturity is between one and two years. Bail-in Bonds cease to qualify one year prior to maturity (article 127a(1) CAO). Furthermore, in line with Section 9 of the FSB TLAC term sheet, the maturity dates of Bail-in Bonds have to be staggered in a manner which enables the G-SIB to hold sufficient Bail-in Bonds even if it should temporarily be restricted in its capacity to issue Bail-in Bonds (127a(2) CAO).

In addition to Bail-in Bonds, the gone concern requirement may further be fulfilled with Additional Tier 1 or Tier 2 capital instruments with a low (5.125%) trigger for up to 2% LR and 5.8% RWA. The gone concern requirement is reduced by the factor 0.5 to the extent that such instruments are used. This means that the gone concern requirement may be reduced by up to 1% (i.e., 4% instead of 5% requirement) for LR and up to 2.86% (i.e., 11.4% instead of 14.3% requirement) for RWA purposes. The reason for this treatment is the fact that such instruments are of better quality than Bail-in Bonds.

Furthermore, if the G-SIB has CET1 capital instruments and/or high-trigger Additional Tier 1 capital instruments (either newly issued or grandfathered) in excess of its going concern requirements (with respect to both LR and RWA) outstanding, such capital instruments can be used to meet the gone concern requirement (article 132(5) CAO). Similarly, pursuant to the explanatory report issued by the Federal Administration in relation to the revised CAO, Tier 2 capital without a trigger (i.e., “old style” pre-Basel III instruments) may also be used to satisfy the gone concern requirement. Even though they do not meet the requirements for Bail-in Bonds as set forth in article 126a CAO, they are held to be of better quality with respect to loss absorbency compared with Bail-in Bonds and deserve such treatment. Finally, Tier 2 capital which has a remaining time to maturity between five and one years may, in accordance with international standards, qualify in the same manner as Bail-in Bonds to the extent that it no longer qualifies as regulatory capital.

2) Transitory Provisions

The CAO provides for a number of grandfathering provisions for the going concern requirements with regard to the qualification of previously issued Tier 2 capital instruments and Additional Tier 1 capital instruments:

• Tier 2 capital with a high (i.e., 7%) trigger qualifies as high-trigger Additional Tier 1 capital until the earlier of (i) its maturity date or the first call date and (ii) 31 December 2019; Tier 2 capital that no longer qualifies pursuant to this provision qualifies for the gone concern requirement until one year before maturity;
• Additional Tier 1 capital with a 5.125% trigger qualifies as high-trigger Additional Tier 1 Capital until the first call date; Additional Tier 1 capital that no longer qualifies pursuant to this provision qualifies for the gone concern requirement until the call is exercised;
• Tier 2 capital with a 5% trigger qualifies as high-trigger Additional Tier 1 capital until the earlier of (i) its maturity date or the first call date and (ii) 31 December 2019; Tier 2 capital that no longer qualifies pursuant to this provision qualifies for the gone concern requirement until one year before maturity; and
• Additional Tier 1 capital with a 5% trigger qualifies as high-trigger Additional Tier 1 capital until the first call date; Additional Tier 1 capital that no longer qualifies pursuant to this provision qualifies for the gone concern requirement (until one year before maturity, according to the CAO, but which should not apply in the case of perpetual instruments such as Additional Tier 1 instruments).

Furthermore, FINMA approves eligible Bail-in Bonds issued before 1 July 2016, including that FINMA may approve Bail-in Bonds issued or to be issued by a foreign (or Swiss) SPV before 1 July 2016.

Both the going concern requirement and the gone concern requirement are subject to a phase-in with gradually increasing requirements and have to be fully applied by 1 January 2020.

3) Assessment and Outlook

With the new provisions, Switzerland will be one of the countries with the highest capital requirements in the world for G-SIBs and will meet – and even go beyond – the capital standard and TLAC requirements for such banks as approved by the G20 countries.

The next evaluation report by the Federal Council is due by the end of February 2017. According to the Federal Administration, it is expected to also address the question if and to what extent SIBs that do not qualify as G-SIBs (currently, Zürcher Kantonalbank, Raiffeisen and PostFinance) shall become subject to a gone concern requirement as well.

Daniel Hulmann (daniel.hulmann@homburger.ch)
Stefan Kramer (stefan.kramer@homburger.ch)
Benjamin Leisinger (benjamin.leisinger@homburger.ch)