The European Banking Authority has put forward options to tackle "infection risk" that threatens to spread from banks' legacy instruments, calling for banks to redeem, repurchase or amend the bonds.
In an opinion paper published last week, the EBA sought to clarify the prudential treatment for legacy instruments beyond the expiration of grandfathering provisions included in the Capital Requirements Regulation on December 31 2021.
The paper, delayed amid the coronavirus pandemic, was keenly awaited.
As market participants had widely expected, the regulatory agency warned of the risks posed by legacy Tier 1 capital instruments to banks' stacks of Additional Tier 1s.
The EBA said the majority of outstanding legacy instruments are grandfathered Tier 1 instruments that may be cascaded down into a lower category, either Tier 2 or TLAC/MREL-eligible instruments, post-2021.
But reclassifying such legacy instruments in a lower tier after the expiration of the grandfathering rules could mean banks' other layers of own funds or eligible liabilities instruments, such as their AT1s, are disqualified, the EBA said.
This is because these problem bonds will retain their legal subordination status as defined in their documentation, which typically states they rank below Tier 2s, thereby disrupting the subordination hierarchy.
The EBA also identified another issue creating infection risk, relating to conflict between legacy instruments' distribution payment features – such as dividend pushers and dividend stoppers – and the principle of the flexibility of distribution payments present in the CRR.
THREE OPTIONS
The EBA put forward two main solutions. The first is that banks either call, redeem or repurchase their legacy instruments.
"Institutions are expected to undertake all possible efforts to execute any action that leads to the redemption of legacy instruments," it said.
The second proposed solution is that banks seek to amend legacy instruments' terms and conditions through liability management exercises.
In particular, the EBA said institutions might attempt to address contractual provisions contradicting the subordination requirement by "promoting" the instrument, for example by amending a legacy Tier 1 to rank pari passu with Tier 2s.
The EBA also outlined a third "last resort" option when neither of its preferred solutions can be achieved: that banks retain legacy instruments on their balance sheets as a non-regulatory instrument that is ineligible for TLAC/MREL.
The EBA said this option does not completely address the risks, but said such flexibility "might be reasonable" in some cases and under strict conditions, where banks can demonstrate to relevant authorities there is no alternative.
HIGH HURDLE
Bankers and analysts now expect calls of legacy instruments to become widespread as many of these securities will be expensive for their banks after they have lost their regulatory value.
Analysts said banks might not all begin immediately, however.
"Banks will face a very high hurdle to justify not calling a bond after the end of the grandfathering period, even if the call is very expensive," wrote Jerome Legras, head of research at Axiom Alternative Investments.
"However, we believe this will only happen gradually, as banks need time to digest the content of this very technical opinion and the market will probably adopt a 'show me the money' attitude – ie, only giving full credit to the opinion when legacy calls become routine practice. Until then, we believe investment opportunities will remain."