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    EBA Issues Opinion to Address Risk Stemming from Legacy Instruments

    October 21, 2020

    EBA issued an opinion on prudential treatment of the legacy instruments as the grandfathering period nears an end on December 31, 2021. In the opinion, EBA has proposed policy options to address the risk that other layers of own funds or eligible liabilities instruments will be disqualified as the grandfathering period expires. To address this risk, EBA envisaged that institutions could either call, redeem, repurchase, or buyback the instrument or amend the Terms and Conditions of the relevant instrument. Another possible policy option is to keep the legacy instrument disqualified from own funds and total loss-absorbing capacity (TLAC)/Minimum Requirement for own funds and Eligible Liabilities (MREL)-eligible instruments, but to retain it in the balance sheet as a non-regulatory instrument, under strict conditions.

    To ensure that institutions had sufficient time to meet the required levels and definition of own funds, the Capital Requirements Regulation (CRR or Regulation 575/20131) introduced grandfathering provisions in 2013. Certain capital instruments that, at that time, did not comply with the new definition of own funds (referred to as legacy instruments) were grandfathered for a transition period, the objective being that they would be gradually phased out from own funds. The beneficial treatment provided by the grandfathering provisions will come to an end on December 31, 2021. In line with its mandate to monitor the quality of own funds and eligible liabilities instruments issued by institutions across EU, EBA has been working to assess the materiality of the outstanding amounts of legacy instruments and to understand institutions’ actions and intentions regarding the phasing out of these instruments at the end of the grandfathering period. In 2019,  EBA announced its intention to provide clarity on the appropriate prudential treatment to ensure a high quality of capital for EU institutions and a consistent application of rules and practices across EU.

    When reviewing EU institutions’ legacy instruments and examining the clauses that led to their grandfathering, EBA identified two key issues that could create the risk that other layers of own funds or eligible liabilities instruments will be disqualified. The first issue relates to the flexibility of distribution payments principle while the second one regards clauses that might contradict the eligibility criterion of subordination. For this reason, legacy instruments will need to be subject to different tests to be cascaded down into a lower category of capital or as eligible liabilities instruments without creating the risk. To address this risk and preserve the quality of regulatory capital, EBA proposed the following policy options:

    • Institutions can either call, redeem, repurchase, or buy-back the relevant instrument. Institutions are expected to undertake all possible efforts to execute any action that leads to the redemption of legacy instruments. In addition to the possibility to buyback, repurchase, or redeem the instruments, call options, when available, are expected to be exercised for grandfathered instruments. In this context, for instruments with an issuer’s call option in the short to medium term, EBA reasonably anticipates that institutions will use this possibility as a first option to address the risk and will call or redeem the instrument.
    • Institutions can amend the terms and conditions of the relevant instrument. Institutions might attempt to address the risk arising from contractual provisions contradicting the subordination requirement by promoting the instrument in the hierarchy of creditors, for example, by amending a legacy Additional Tier 1 instrument to rank pari passu with Tier 2 instruments; however, this would not exclude the need to assess any other relevant eligibility criteria, including those introduced by CRR2, beyond the criterion of subordination.
    • When it is not possible for institutions to pursue either of the above two options, or in case of residual amounts remaining from legacy instrument buybacks, institutions can keep the legacy instrument disqualified from own funds and TLAC/MREL-eligible instruments but to retain it in the balance sheet as a non-regulatory instrument, under strict conditions. Under this option, the instrument would be excluded from own funds and TLAC/MREL-eligible instruments while remaining in the balance sheet of the institution. EBA is aware of the limitations of this option, given that the risk of fully eligible own funds instruments is not completely addressed by the exclusion of legacy instruments from own funds and TLAC/MREL-eligible instruments. Nevertheless, EBA advises that this last option should be treated as a last resort option; it is intended as a backstop measure for legacy instruments if neither of the other options is available.  

    EBA will monitor the situation of the legacy instruments until the end of the grandfathering period and will focus on the use of the proposed options across jurisdictions to ensure a consistent application. EBA will also consider the transposition of specific provisions of Directive 2014/59/EU into national legislation and how this might alleviate concerns about the existence of risk linked to subordination aspects. The Board of Supervisors has adopted this opinion, which is addressed to competent authorities. 

     

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    Keywords: Europe, EU, Banking, Legacy Instruments, Own Funds, Grandfathering period, CRR, Regulatory Capital, MREL, Basel, EBA

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