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A problem with MREL?

14 June 2018
Richard Kemmish

For banks without existing senior debt the MREL rules could exacerbate, not reduce risk.

The idea of MREL – a minimum amount of debt that can be bailed in when needed to rescue a bank – is the latest trend in a long tradition of slicing the capital structure of a bank into ever finer and more nuanced tranches. Never mind that it isn’t called capital in the way that tier 1 and tier 2 debt is. Senior unpreferred debt is capital. Calling it senior when it is subordinated to another class of debt, senior preferred in this case, is a terminological inexactitude (a phrase invented by Winston Churchill to circumvent the convention that one MP does not call another one a liar).

I suppose the trend towards slicing existing debt ever finer is economically rational – it gives investors the ability to pick and chose their ideal level of risk and return. Never mind that the different tranches seem to have the same value in insolvency or resolution (as happened in the case of Banco Popular).

But, the idea of bail-in is based on the idea of refinancing existing senior debt, as it comes up for maturity into either preferred or non-preferred depending on how much MREL you need. That applies to most banks and makes sense.

But what if you don’t have any senior debt already? Or if your senior debt (plus existing capital) is less than your MREL requirement? Or you get all of your senior funding from covered bonds? All rare in most countries but not in those cases with more independent mortgage banks (that don’t consolidate in a single point of entry resolution group), or where deposits substantially exceed loans (fairly common in central and eastern Europe).

How then should a bank treasurer meet her MREL targets? Simply by issuing bonds with absolutely no funding benefit purely to hit a target. Expensive bonds too. These banks don’t issuer senior preferred debt because it is so expensive relative to deposits. There is even less incentive to issue more expensive senior unpreferred debt.

Putting the cash on deposit with the central bank creates a huge net interest margin problem – central banks pay less for their cash than private sector banks do. And the term securities are further up on the yield curve than the rolling cash deposits. Hundreds of basis points multiplied by – often – quite a large portion of the balance sheet.

History has taught us that giving banks excessive amounts of cash that they don’t need is like giving a toddler a sugary snack and a fizzy drink. Telling them that they need to recoup a big shortfall in net interest margin with that cash is like then giving the same toddler a bazooka.

It won’t end well.

Of course, banking regulators have a strong understanding of and controls for the riskiness of the investment portfolios for the bank’s that they regulate. Ahem.

Our friends in the securitisation market have encountered the same problem – banks who want capital relief for asset portfolios but don’t need the cash can issue synthetic bonds.

Synthetic, MREL eligible, bail-in bonds? It’s a thought.

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