On 6 July 2017, the Financial Stability Board published its guiding principles on the loss-absorbing resources to be committed to subsidiaries or sub-groups that are located in host jurisdictions and deemed material for the resolution of a G-SIB as a whole (iTLAC). The guiding principles support the implementation of the iTLAC requirement in each host jurisdiction and provide guidance on the size and composition of the iTLAC requirement, cooperation and coordination between home and host authorities and the trigger mechanism for iTLAC.

By René Bösch / Benjamin Leisinger / Lee Saladino (Reference: CapLaw-2017-45)

On 9 November 2015, the Financial Stability Board (the FSB) released the Principles on Loss-absorbing and Recapitalisation Capacity of global systemically important banks (G-SIBs) in Resolution (the TLAC Principles), together with a Total Loss-absorbing Capacity (TLAC) term sheet implementing these principles (the TLAC term sheet). Although the TLAC term sheet is largely focused on so-called “external TLAC”, section 16 et seqq. of the TLAC term sheet sets forth basic elements of the purpose, general size and core features of internal TLAC (iTLAC), i.e., the loss-absorbing resources to be committed by a G-SIB’s resolution entity or entities (which is, in the case of a single-point-of-entry (SPoE) resolution strategy, the ultimate holding company) to its subsidiaries or sub-groups located in host jurisdictions and deemed material for the resolution of the G-SIB as a whole (Material Sub-Groups).

On 6 July 2017, following a consultation based on a draft issued by the FSB on 16 December 2016, the FSB issued the final Guiding Principles on the Internal Total Loss-absorbing Capacity of G-SIBs (the iTLAC Guiding Principles). These high-level principles are designed to assist authorities that are part of a G-SIB’s Crisis Management Group (CMG) in the implementation of iTLAC mechanisms consistent with the TLAC term sheet. The responsible regulatory authority in a G-SIB’s “home country” (Home Authority) and the authorities in the foreign jurisdictions in which the G-SIB has a presence (Host Authorities) are expected to take the iTLAC Guiding Principles into account when identifying Material Sub-Groups and when establishing the iTLAC requirements and trigger mechanisms applicable to such Material Sub-Groups.

1) Subject-Matter of the iTLAC Guiding Principles

The iTLAC Guiding Principles consist of five major parts: Material Sub-Group identification and composition (part I.), the size of the iTLAC requirement (part II.), the composition and issuance of iTLAC (part III.), features of trigger mechanisms for iTLAC (part IV.), and the home-host process for triggering iTLAC (part V.). Each of these five parts contain guiding principles on the respective topic.

a) Material Sub-Group Identification and Composition

The process for identifying Material Sub-Groups consists of several coordinated steps between the Home Authority and the Host Authorities and, in certain cases, the CMG.

The Home Authority initiates the process by identifying Material Sub-Groups based on group-level information to which it has access. Taking into account the Home Authority’s proposed list of Material Sub-Groups, each Host Authority should then identify a Material Sub-Group in its jurisdiction, in consultation with the Home Authority and the CMG. If a subsidiary or sub-group has been identified as a Material Sub-Group based solely on a determination that it exercises critical functions for the G-SIB, rather than based on one of the quantitative criteria set forth in Section 17 a.-c. of the TLAC term sheet, such subsidiary’s or sub-group’s inclusion in the list of Material Sub-Groups requires the consent of the CMG. Once a resolution entity’s Material Sub-Groups have been identified as a result of this process, the Home Authority and the Host Authorities that are members of the CMG should review the list of Material Sub-Groups on an annual basis.

A similar process exists to determine whether a subsidiary or sub-group no longer qualifies as a Material Sub-Group: In the annual review, the Home Authority may provide evidence that a subsidiary or sub-group should no longer be identified as material for purposes of the iTLAC requirement, i.e., is no longer a Material Sub-Group. The relevant Host Authority would then have the opportunity to provide evidence to the contrary. However, the ultimate decision as to whether such subsidiary or sub-group remains a Material Sub-Group lies with the Host Authority following consultation with the Home and other Host Authorities that are members of the CMG, and is subject to the consent of the CMG if such subsidiary or sub-group’s designation was based on a determination that it exercises critical functions for the group as a whole.

For so long as a subsidiary or sub-group qualifies as a Material Sub-Group, the relevant Host Authority determines, in consultation with the Home Authority and the CMG, the composition of the Material Sub-Group (taking the existing scope of regulatory or accounting sub-consolidation as a starting point), and the distribution of iTLAC among the entities that form the Material Sub-Group. When making such determination, the resolution strategy of the G-SIB should be supported by facilitating the stabilization of the relevant entities within the Material Sub-Group through the passing of losses and recapitalization needs of the Material Sub-Group on to the resolution entity (i.e., in the case of an SPoE resolution strategy, the ultimate holding company).

As a principle, the composition of Material Sub-Groups should be limited to subsidiaries located in a single jurisdiction. Exceptionally, if the CMG agrees that it is necessary to support the agreed resolution strategy of the G-SIB and to ensure that iTLAC is appropriately distributed within the Material Sub-Group, Material Sub-Groups may consist of entities located in more than one jurisdiction, so long as there is a single resolution regime covering those jurisdictions or a high degree of cooperation and coordination between the Host Authorities in those jurisdictions.

The decision to include (or not include) any regulated or unregulated non-bank entity in a Material Sub-Group should be based on the resolution strategy for the G-SIB and an assessment of the risk that the entity could generate losses and would need to be recapitalized.

b) Size of the iTLAC Requirement

The responsibility – and authority – for setting the iTLAC requirements for the Material Sub-Groups in their jurisdiction lies with the Host Authorities, following consultation with the Home Authority.

As a guiding principle, the iTLAC requirement for a particular Material Sub-Group should be scaled within the 75%-90% range of the external minimum TLAC requirement that would apply to the Material Sub-Group if it were a separate resolution group, as calculated by the Host Authority, consistent with the TLAC term sheet. When fixing the exact requirement, a Host Authority should take into account (i) the purpose of iTLAC to ensure that there is sufficient iTLAC to cover the loss-absorption and recapitalization needs of the Material Sub-Group and to support the agreed resolution strategy for the resolution group, and (ii) that the requirement will have implications for the resolution group, e.g., by limiting the resolution entity’s flexibility to use loss-absorbing capacity within the resolution group where and when needed as required by principle (vi) of the TLAC Principles.

Unfortunately, however, while the iTLAC Guiding Principles acknowledge that it shouldn’t be the case, they explicitly contemplate (and permit) a scenario in which the sum of the iTLAC requirements set by Host Authorities for a resolution entity’s Material Sub-Groups exceeds such resolution entity’s external TLAC requirement, which may cause an increase in the resolution entity’s external TLAC (iTLAC Guiding Principle 6). If a resolution entity’s aggregate iTLAC requirements were to exceed its external TLAC requirement after taking into account consolidation effects, the Home Authority – absent any downward adjustment in the iTLAC requirements by Host Authorities – would need to take action to ensure that the resolution entity has sufficient external TLAC (i.e., increase the external TLAC requirement). In other words, by setting the iTLAC requirements in their respective jurisdictions, Host Authorities are indirectly able to increase the external TLAC requirement that would otherwise be applicable to a resolution authority pursuant to the TLAC Principles, the TLAC term sheet and, potentially, the national regulations implementing the foregoing in the Home Authority’s jurisdiction. In our view, this ability runs counter to the very purpose of iTLAC, which has as its primary objective the facilitation of co-operation between Home and Host Authorities (Section 17 of the TLAC term sheet). When Host Authorities choose to set the iTLAC requirement so high that the requirement also drives the amount of the resolution entity’s external TLAC requirement, they may eventually lose the incentive to co-operate with the Home Authority in times of a crisis to the extent that they need little to no outside assistance to recapitalize their Material Sub-Groups.

If there are proceeds of external TLAC that are neither distributed to Material Sub-Groups – despite the problem identified in the preceding paragraph – nor required to cover risks on the resolution entity’s solo balance sheet (so-called Surplus TLAC), it should be readily available to the resolution entity so that it can be used to recapitalize any direct or indirect subsidiary when needed. In order to ensure this, Home Authorities should consider the characteristics of the corresponding assets in which such Surplus TLAC is invested to ensure that it is readily available and that there are no legal and operational barriers to using it to recapitalize a resolution entity’s subsidiaries. For example, the iTLAC Guiding Principles mention that Home Authorities may consider it appropriate for Surplus TLAC to be invested in assets that can be promptly and easily valued and that are likely to retain sufficient value in times of market-wide stress.

G-SIBs are expected to meet the iTLAC requirement as from the date when they are expected to comply with the TLAC sheet and implement the minimum external TLAC requirement as provided in section 21 of the TLAC term sheet. This means that G-SIBs designated by the FSB as such before the end of 2015 and that continue to be designated as such thereafter, must meet the iTLAC requirement by 1 January 2019. If during the iTLAC implementation period or thereafter a new Material Sub-Group is identified, for example due to an acquisition or operational changes, such new Material Sub-Group must meet the iTLAC requirement within 36 months from the date of its identification as a Material Sub-Group, or within an appropriate shorter period as determined by the relevant Host Authority in consultation with the Home Authority.

c) Composition and Issuance of iTLAC

When determining the composition of iTLAC, i.e., in which form iTLAC may be issued by a Material Sub-Group, a Host Authority should consult with the Home Authority, including on the impact of the composition on the credibility and sustainability of the resolution strategy of the G-SIB and the ability of the Material Sub-Group to effectively pass losses and recapitalization needs of the Material Sub-Group on to the resolution entity.

The general expectation under the iTLAC Guiding Principles is that at least 33% of a Material Sub-Group’s iTLAC requirement will consist of debt liabilities. The reason being, inter alia, because iTLAC in the form of equity could result in a scenario in which the resolution entity is unable to finance its interest payments on its external TLAC debt because it has not earned sufficient dividend payments on iTLAC in the form of equity.

Notwithstanding this expectation, at the time a Material Sub-Group must begin to comply with its iTLAC requirement, it will likely already have equity and other instruments in place that may be counted towards satisfying such requirement. Accordingly, the composition of a Material Sub-Group’s existing iTLAC, if any, and the practicality of making changes to it, should be taken into account. In other words, a Material Sub-Group should not be required to issue additional iTLAC beyond the requirement set by the Host Authority, if it has initially met the quantitative but not the qualitative requirements set out in the iTLAC Guiding Principles (or national law implementing such principles in the Host Authority’s jurisdiction).

Home and relevant Host Authorities may also jointly agree to substitute on-balance sheet iTLAC with iTLAC in the form of collateralized guarantees, subject to the conditions in Section 19 of the TLAC term sheet. The iTLAC Guiding Principles contain several considerations that Home and Host Authorities should take into account when determining if the conditions for using of collateralized guarantees that are set out in Section 19 of the TLAC term sheet have been met.

When deciding which entity in the Material Sub-Group should issue iTLAC to which resolution group entity, it is of paramount importance to credibly support the resolution strategy of the G-SIB and to ensure that the losses and recapitalization needs of the Material Sub-Group will be passed on to the resolution entity. One way of ensuring this is by issuing back-to-back iTLAC through multiple legal entities in the chain of corporate ownership (so-called daisy chain), starting with the resolution entity.

The iTLAC Guiding Principles also discuss the law applicable to iTLAC. According to Guiding Principle 11, iTLAC should generally be subject to the governing law of the jurisdiction in which the Material Sub-Group entity issuing the iTLAC is incorporated or formed. However, iTLAC may instead be governed by or be otherwise subject to the laws of another jurisdiction if, under those laws, the application of resolution tools by the relevant Material Sub-Group’s Host Authority, or the write-down or conversion into equity of such iTLAC by such Host Authority, is effective and enforceable under the laws of such other jurisdiction on the basis of binding statutory provisions or legally enforceable contractual provisions for the recognition of the exercise of such Host Authority’s resolution tools and statutory write-down powers.

d) Features of Trigger Mechanisms for iTLAC

Section 19 of the TLAC term sheet stipulates that iTLAC must be subject to a write-down and/or conversion into equity by the relevant Host Authority at the point of non-viability, as determined by such Host Authority in line with the relevant legal framework, without entry of the issuing entity into statutory resolution proceedings. In addition, it states that any such write-down or conversion is subject to obtaining the consent of the Home Authority, unless the relevant iTLAC instrument is a regulatory capital instrument.

According to iTLAC Guiding Principle 13, Home and Host Authorities should consider if the extent of the write-down and/or conversion into equity of iTLAC (i.e., full or partial) and the length of the period the Home Authority will be granted to provide its consent to any such write-down and/or conversion into equity should be incorporated into the trigger conditions set forth in the relevant iTLAC instrument or agreed separately. In particular, the benefits of greater specificity in the iTLAC instrument itself should be weighed against the potential risks of constraining the flexibility of Home and Host Authorities in times of crisis.

e) The Home-Host Process for Triggering iTLAC

The process for triggering a write-down or conversion into equity of iTLAC within a Material Sub-Group consists of several stages:

• First, the Home and relevant Host Authority should communicate regarding the condition of the Material Sub-Group. This ensures that the Home and Host Authority have the opportunity to consider alternative options to restore the Material Sub-Group’s viability (including through application of measures contemplated in the G-SIB’s recovery plan) and, most importantly in the case of an SPoE resolution strategy, allows the Home Authority, if necessary, to prepare for the potential resolution of the resolution entity. The Home Authority should inform the CMG of any actions it plans to take to restore the Material Sub-Group’s viability.
• Second, the Host Authority should determine whether some or all of the iTLAC within the Material Sub-Group should be triggered. iTLAC should be triggered only as a last resort, if and to the extent that no credible alternative options are available to restore the Material Sub-Group’s viability in an appropriate timeframe (including, in the case of an SPoE resolution strategy, the option to recapitalize the Material Sub-Group top-down). In any event, under no circumstances should iTLAC be hardwired to automatically trigger if resolution proceedings with respect to the resolution entity are opened or if a write-down and/or conversion into equity of TLAC occurs elsewhere in the resolution group (including the triggering of iTLAC in another Material Sub-Group). Pursuant to Section 19 of the TLAC term sheet, the consent of the Home Authority is required for the triggering of non-regulatory capital instruments that are used to meet iTLAC requirements. If the Home Authority objects to the write-down and/or conversion into equity of any such iTLAC instrument, or does not provide its consent within the – ideally – ex ante agreed timeframe, the Host Authority may choose to apply its own resolution bail-in or other resolution powers to the Material Sub-Group. However, iTLAC Guiding Principle 17 emphasizes that this should be avoided to the greatest extent possible.
• Third, the Host Authority must determine the capital shortfall with respect to the Material Sub-Group and the extent of recapitalization required. At a minimum, a sufficient amount of iTLAC will have to be written-down and/or converted into equity so that the Material Sub-Group will meet the jurisdiction’s regulatory capital requirements (e.g., the minimum Basel III capital requirements and firm-specific additional requirements, if any). When deciding between a write-down and a conversion of into equity, changes in the control of the Material Sub-Group and material risks of legal challenge should be taken into account.

2) Critical Assessment

In our view, two features of iTLAC are of paramount importance: First, the iTLAC requirement set by a Host Authority must predominantly “facilitate co-operation between Home and Host Authorities” (Section 16 of the TLAC term sheet) and, second, there must be sufficient flexibility to use loss-absorbing capacity within a G-SIB group where and when it is needed and there must be credible mechanisms in place to be able – with legal certainty – to pass losses on to the resolution entity and meet the recapitalization needs of members of the resolution group (Section 18 of the TLAC term sheet). Host Authorities should themselves be interested in the resolution entity (i.e., in the case of an SPoE resolution strategy, the ultimate holding company) having sufficient flexibility to use loss-absorbing capacity where needed: if the resolution entity’s operations in their jurisdiction experience a “black swan event”, instead of being limited to the pre-deployed/prepositioned loss-absorbing capacity in their jurisdiction (which may not be sufficient to recapitalize the relevant Material Sub-Group), they could benefit from the additional “free” loss-absorbing capacity-resources available to the resolution entity.

While the iTLAC Guiding Principles provide for a good basis and contain valuable concepts for iTLAC of G-SIBs, we believe that certain elements could jeopardize the very concept underlying iTLAC, which is to facilitate co-operation between Home and Host Authorities and to maintain sufficient flexibility to use loss-absorbing capacity within a G-SIB group where and when it is needed. In particular:

• The iTLAC Guiding Principles still leave room for separate or supplementary local TLAC requirements to be instituted in addition to iTLAC (see footnote 6 of the iTLAC Guiding Principles); such local requirements would substantially limit the comparability of iTLAC requirements between jurisdiction and could undermine the international standard;
• The iTLAC Guiding Principles mention that Host Authorities may, in certain circumstances, introduce additional firm-specific iTLAC requirements (see Guiding Principle 5); the ability of a Host Authority to introduce such additional requirements and, thereby, increase the resources available to it to recapitalize the Material Sub-Group in its jurisdiction could limit the Host Authority’s incentive to co-operate with the Home Authority in times of crisis to the extent that it needs little to no outside assistance to recapitalize such Material Sub-Group; and
• The external TLAC requirement applicable to a resolution entity does not function as a ceiling on the aggregate iTLAC requirements set by the Host Authorities or influence the calibration by a Host Authority of the iTLAC requirement applicable to the Material Sub-Group in its jurisdiction within the 75%-90% range (see Guiding Principle 6); if a resolution entity’s external TLAC requirement is not used to set the upper limit for the aggregate iTLAC requirements set by Host Authorities, there is no “corrective” in place to limit the Host Authorities’ appetite for iTLAC and to ensure that they are properly incentivized.

It remains to be seen to what extent the Host Authorities make use of the above-mentioned critical aspects. The authors’ hope is that the discussions in the CMGs and the close cooperation between their members prior to a crisis will lay the groundwork for mutual trust and that this trust – even more than the “insurance” intended to be created by iTLAC – will facilitate cooperation between Home and Host Authorities in times of crisis and help to maintain sufficient flexibility to use loss-absorbing capacity within a G-SIB group where and when it is needed.

René Bösch (rene.boesch@homburger.ch)
Benjamin Leisinger (benjamin.leisinger@homburger.ch)
Lee Saladino (lee.saladino@homburger.ch)