October 2021 marks a full decade since the Financial Stability Board published its "Key Attributes of Effective Resolution Regimes for Financial Institutions", the global standard of elements underpinning an effective resolution regime. This publication catalyzed national regulators and policymakers to create or improve their resolution frameworks and to push systemic banks to make themselves resolvable. That said, policymakers' responses have been highly variable in their speed and ultimate intent (see "Ending Too Big To Fail: Different Journeys, Different Destinations," published April 4, 2019). Policymakers in Europe and the U.S. in particular were at the vanguard of the response, and showed a clear intent to move away from the trend of bank bail-outs in previous decades. This led us to remove uplift for extraordinary government support in our ratings on commercial banks in these jurisdictions in 2015.

For banks, resolvability is best seen as a spectrum, rather than a binary (resolvable / nonresolvable) state. Still, by 2022 in the U.K. and end-2023 in the EU, regulators expect systemic banks to have made themselves substantially resolvable. In practice, this means meeting interim and final deadlines to build bail-in buffers, and to address other important operational barriers to resolution, whether in the execution phase, or in later business restructuring. With this in mind, European banks have continued to take advantage of highly accommodative capital markets, with some of them issuing senior nonpreferred debt (SNP) for the first time, some rolling over their already sizable stock of minimum requirement for own funds and eligible liabilities (MREL), the EU's measure of bail-in buffer, and some trying to achieve multiple objectives by issuing green or sustainability-linked instruments. This build-up of subordinated buffers means that some European banks continue to gain rating uplift for their additional loss-absorbing capacity (ALAC), as long as the resolution strategy is likely to avoid a default on all senior preferred liabilities.

For their part, EU policymakers are developing concrete proposals to improve the bank resolution framework. This is a question of evolution, not revolution, but there is widespread agreement that the framework needs to be more predictable and consistent in its application. To be effective, the framework would need to ensure that banks of all shapes and sizes can be dealt with efficiently if they fail, without resorting to bail-outs and without harming financial stability. What this means in practice is that, even if the European Commission publishes a policy proposal in spring 2022, the EU's crisis management framework will remain in flux and incomplete for a few more years.

This initiative also goes to the heart of policymakers' second challenge--to convince investors that resolution is available as a credible regulatory option, and that the authorities will consistently pursue it when a major bank fails. Market views on this remain split, and, since no significant European bank has failed since 2017, they are unlikely to have changed much in the past year. Still, if we look ahead over the next two years, the presence of substantially resolvable major banks, a more credible and consistent crisis management framework, and improved public disclosure could go some way to addressing investor skepticism, even if it might not affect our European bank ratings.

European Banks Wide-Ranging Access To Debt Markets Will Support Their Build-Up Of Bail-In Buffers

Except for a brief hiatus in April 2020 and short-lived spikes in market volatility, European banks have now long benefited from a strong market appetite for positive-yielding debt, the assurance about refinancing and liquidity that the targeted longer-term refinancing operations (TLTRO) have provided, and the firm establishment of an SNP debt class since French banks first issued such debt in 2017. Swelling issuance volumes by a growing band of European banks and the major Canadian banks have since made SNP debt an important asset class in its own right (see chart 1).

Spreads on SNP debt remain low, trading roughly midway between senior preferred and subordinated debt (see chart 2). This adds further margin pressure for banks that cannot invest the proceeds in higher-yielding assets, but remains affordable for most. Large and midsize banks remain the key issuers, but smaller banks continue to come to the market. Notable recent issuances include the first SNP instruments issued by Czech and Polish banks Ceska sporitelna a.s. (Ceska) and mBank S.A. respectively).

Chart 1

Chart 2

The recent European Banking Authority survey of banks' funding plans confirms the expectation built into our bottom-up projections that European banks will remains net issuers of subordinated MREL through 2023 (see chart 3). This is consistent with the fact that overall, European banks will need to continue to build their buffers through end-2023. The year-to-year trends imply a continued net switch from senior preferred to subordinated debt through end-2021, before banks start to prefinance maturing TLTRO III drawings in 2022 and 2023, either in unsecured or secured senior forms.

Chart 3

Questions Remain On The Appropriate Format And Distribution Of MREL

The vast majority of MREL issuance remains vanilla in nature and marketed to an institutional investor base. However, there are two notable exceptions, MREL linked to environmental, social, and governance (ESG) objectives, and capital instruments owned by retail investors, where the situation might be more problematic.

ESG-linked MREL

Some banks continue to address a dual objective in their unsecured wholesale issuances--to meet MREL requirements, and to develop a franchise as an ESG-friendly issuer. The investor jury still seems to be out on whether green- and sustainability-linked hybrid capital instruments are investible or not. There is an inherent structural tension between the use of such hybrids to earmark funds for qualifying ESG projects, and the role that this capital plays on a bank's balance sheet. Capital is fungible as it can back all banking activities and be used to leverage the balance sheet (see "Environmental, Social, And Governance: The Greening Of Financial Services: Challenges For Bank And Insurance Green And Sustainability Hybrids," published Aug. 12, 2020). We believe this is why the green or sustainability promises incorporated in such hybrids have so far been light on specific commitments, and why such hybrids may not match the investment mandate of some green and sustainability investment portfolios. Still, SNP debt and nonoperating holding company senior debt are not capital instruments, and it seems that some investors might be willing to hold ESG-linked issuances even if they wouldn't buy green- or sustainability-linked capital instruments.

Retail investors

Regulators remain mindful of one the lessons since the 2008-2009 financial crisis--that they cannot assume that they will be able to enforce losses on retail bond investors. Whether in the U.K., Italy, or elsewhere, capital instruments held by retail investors either avoided losses, or the investors were later compensated for their losses on the pretext that they had likely been missold such risky bonds. Retail investors remain unrestricted in their ability to own bank common equity instruments on the basis that these are widely understood to be highly risky. But Article 44a of the second EU bank recovery and resolution directive (BRRD II) sought to prevent unsophisticated retail investors from holding MREL debt instruments, leaving EU member states to make a choice: either impose a high (€50,000) minimum ticket size on MREL debt instruments, or allow a lower €10,000 minimum ticket, but one that is subject to concentration constraints for smaller portfolios. Despite the end-2020 deadline on member states to implement BRRD II, many have not yet done so. However, we see a characteristically mixed approach emerging (see table 1).

We include retail investor-owned MREL instruments in our ALAC measure as long as these instruments meet other eligibility requirements. However, we remain acutely conscious of the enforceability risk from a political and practical, rather than contractual and statutory, perspective. We could, for example, raise the ALAC threshold for a bank where we had doubts that this debt would absorb losses in practice.

Table 1  |  View Expanded Table

Resolvability Remains An Important Rating Driver

We include ALAC notches in our ratings on European banks where we see the likely resolution strategy and the bail-in buffer as likely to support the continued servicing of obligations to senior preferred creditors. This reflects our forward-looking expectations about how fast and how far European banks will build ALAC over the coming years, and our expectation that over time, they could address other barriers to an effective resolution. Banks' public statements and emerging track records of issuance may confirm or challenge our assumptions.

We now include ALAC uplift in our ratings on 45 banks headquartered in 13 European countries (see chart 4), up slightly from 44 banks in those same 13 countries one year ago. Among them, the ALAC buffers for 37 banks already exceed our thresholds for one or two notches of ALAC uplift. A further eight banks receive ALAC uplift already, but are still in the process of completing the ramp-up of their buffers. The annexes at the end of this report set out the ALAC thresholds that we apply for selected European banking groups and our expectations for when the groups will achieve these threshold ratios.

Chart 4

While most of our ratings on major European banks currently have stable outlooks, ALAC remains an important rating driver. However, for the following banks, ALAC is a dynamic topic, leading to a nonstable outlook.

Deutsche Pfandbriefbank AG and Hamburg Commercial Bank AG

• We understand that the Single Resolution Board's (SRB's) preferred resolution strategy for these banks now targets liquidation instead of a bail-in-led resolution. However, the situation is nuanced as the SRB continues to review its policy on how it interprets the public interest assessment. If we ultimately conclude that the preferred resolution strategy will be unlikely to support timely and full payment to all senior preferred creditors, we will remove ALAC uplift in our ratings on these banks and withdraw the resolution counterparty ratings.

AIB Group PLC (AIB)

• AIB continues to build its subordinated bail-in buffers. Like its close peer, Bank of Ireland, in future, this accretion could merit a second ALAC notch that would benefit the issuer credit ratings on AIB's operating companies.

UniCredit Bank AG and UniCredit Bank Austria AG

• UniCredit SpA says that it will make the group resolvable in a way that is consistent with a single point of entry (SPE) resolution approach. SPE envisages bail-in-buffer issuance from a single resolution entity at the top of the group. This contrasts with our perception of the group's current operational setup as more like a multiple point of entry (MPE), reflecting in particular the substantial financial autonomy of its two key subsidiaries.

Erste Group Bank AG (Erste) and Ceska:

• In the opposite scenario to UniCredit, we see Erste as moving from a de facto SPE setup to an MPE one, catalyzed by the recent issuance of SNP debt by Ceska, Erste's key Czech subsidiary. Erste and Ceska could both gain ALAC uplift in future if we revise our ALAC projections because we expect that the banks will build ALAC ratios sustainably above the relevant thresholds.

Additionally, while it is not an outlook driver today, we continue to monitor developments in two jurisdictions where we do not yet uplift any bank ratings for ALAC:

• Liechtenstein, where we see the resolution framework as sufficiently effective, and where the major banks will soon receive their bail-in buffer requirements; and
• Iceland, where policymakers are implementing a resolution framework with key features similar to those in the EU.

Some systemic European banks might never gain ALAC uplift (see "Typical Barriers To Banks Gaining ALAC Uplift" below and "The Resolution Story For Europe's Banks: More Flexibility For Now, More Resilience Eventually," published Sept. 29, 2020).

Our Analytical Focus Goes Far Beyond MREL Building

While our principal analytical focus is undoubtedly on the likely resolution strategy and the level of subordinated MREL that a bank will build, resolvability goes far beyond these features. Our analysts and rating committees are therefore keen to understand the progress that banks are making in other key areas (see "Questions Our Analysts Are Asking European Banks" below). The implications for the banks' subsidiaries are also important, as they can vary depending on the nature of the subsidiary's activities and its jurisdiction.

Recovery planning is a key component of the recovery and resolution regulatory agenda. As banks enhance their resolvability, they also tend to bolster their recoverability, that is, their resilience under stress, whether due to capital, liquidity, or other issues. Recovery plans are owned by management rather than the regulator, and the European Central Bank (ECB) in particular has challenged management teams on the credibility of the assumptions in these plans, and the related governance and preparedness necessary to execute them. In a similar way to regulatory stress-testing exercises, which inform our understanding of a bank's potential resilience to solvency stress, we view banks that have strong recovery options as supportive of rating stability, and thus of investment-grade ratings.

For regulators and policymakers, the resolution frameworks are now codified. Our analytical questions therefore tend to center on how regulators might apply the frameworks in practice, as we analyze what this could mean for different classes of creditors (see "Questions Our Analysts Are Asking European Regulators" below). Public disclosure is also a key influence on the market, guiding expectations and helping establish resolution as a viable course of action.

Policymakers Are Addressing Complexity In The EU Crisis Management Framework

The EU resolution framework is riven with complexity, both in its construction and its application. At best, it impedes predictability of outcomes and investor comprehension. At worst, it may undermine the effectiveness of banks' resolution plans and actions.

Predictability is already undermined by the fact that resolution frameworks are novel and relatively untested--there is no strong precedent to guide decision-making in the future. However, even within the EU, marked differences in national implementation and national insolvency frameworks lead to a fragmented picture and undue uncertainty.

The scope for improvement is widely acknowledged--by the resolution authorities themselves, policy think-tanks, and other market observers, who tend to home in on the following problems:

An incomplete banking union. 

• Despite banks making good headway in reducing legacy nonperforming loans since 2017, their progress is limited by a complex web of interlinked, but intractable, initiatives that are technically and politically difficult. The most evident symptom is the stalled proposals to deliver a European deposit insurance scheme (EDIS).

Backsliding.  This is the persistent use of public funds for failed banks, and occurs because:

• It is harder for authorities to use resolution funds than give state aid;
• It is too easy to use precautionary recapitalizations;
• National insolvency frameworks are unequal in the availability of stabilization and intervention tools; and
• Midsize banks have built insufficient subordinated MREL to make bail-in a possibility.

Inconsistency. 

• Causes include unequal national insolvency frameworks in terms of the availability of regulatory tools, and diverging FOLTF concepts in the BRRD and national law, specifically, prospective versus retrospective concepts.

Predictability. 

• Causes include divergent interpretations of the PIA, diverging creditor hierarchies, or variability in state aid decisions.

Complex decision-making. 

• This can impede effective resolution, particularly cross-border resolution, because of the differing rules of national deposit insurance schemes.

We anticipate that a policy proposal will emerge in the first half of 2022 and deliver partial progress. We don't anticipate any material progress on EDIS, and it seems likely that there will be no concurrent removal of the state aid loophole that allows governments to deploy "liquidation aid" to a failed bank where they are averse to imposing losses on senior creditors. Still, we expect that the framework will:

• Improve the harmonization of national insolvency frameworks and creditor hierarchies;
• Harmonize deposit insurance scheme coverage; and
• Better enable the authorities to undertake U.S. Federal Deposit Insurance Corporation-style purchase and assumption transactions (selling books of assets and liabilities to other banks) when small banks fail, aided where necessary by funding from deposit insurance schemes.

We also look for progress in the creation of a liquidity backstop guarantee that would allow the ECB to go beyond its emergency liquidity assistance facilities and lend uncollateralized funds to an otherwise solvent bank in resolution.

When the changes are finally legislated, they would add to the credibility and predictability of the EU framework. What they won't address are some of the practical choices in how to apply the rules. Positively, we expect that the new disclosures on bank resolvability assessments–-which have already started in Switzerland and which will arrive in the U.K. next year--will enhance transparency and help impose market discipline on laggard banks. Negatively, we expect inconsistency to persist for similar systemic midsize banks across the EU, whether in terms of the preferred resolution strategy, or the size and degree of subordination of the MREL buffers. It is this practical application of the rules that tends to limit whether banks will receive ALAC uplift.

Taken together, much has been achieved in the past years to reduce the burden on taxpayers when banks fail. But the EU in particular faces several more years of relentless execution of framework changes to make banks truly resolvable and resolution the credible, predictable exercise that it needs to be to ensure financial stability.

Related Criteria

• Methodology For Assigning Financial Institution Resolution Counterparty Ratings, April 19, 2019
• Bank Rating Methodology And Assumptions: Additional Loss-Absorbing Capacity, April 27, 2015
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011

Related Research

• ALAC Considerations For Post-Brexit English Law MREL Instruments, Dec. 14, 2020
• Europe's Middle Ranking Banks Face A Peculiar Resolvability Conundrum, Dec. 3, 2020
• Extending Depositor Preference To All Depositors Would Not Trigger Rating Changes On Spanish Banks, Nov. 25, 2020
• The Resolution Story For Europe's Banks: More Flexibility For Now, More Resilience Eventually, Sept. 28, 2020
• Environmental, Social, And Governance: The Greening Of Financial Services: Challenges For Bank And Insurance Green And Sustainability Hybrids, Aug. 12, 2020
• What's Next For Resolution Counterparty Ratings?, March 2, 2020
• Continued Bank Bailouts Stretch The Credibility Of Europe's Resolution Framework, Feb. 26, 2020
• Ending Too Big To Fail: Different Journeys, Different Destinations, April 4, 2019
• An Illustrative Rating Path For A Systemic Bank In A Bail-In Resolution: RCR Update, July 26, 2018
• To Fail Or Not To Fail: The Point Of Nonviability Is Unclear For European Banks, May 31, 2017
• Bank Resolution In Central And Eastern Europe: Many Unanswered Questions, May 26, 2017

Annex

Table 2

Table 3

Table 4