Resolving Europe's largest and most complex banks without jeopardizing financial stability or using public funds undoubtedly poses a significant challenge, but it is one that these banks and their regulators are increasingly well-prepared to tackle. That said, as S&P Global Ratings has previously noted, recapitalizing and restoring to viability some of the region's many middle-ranking systemic banks could also prove tricky (see "Europe's Middle Ranking Banks Face A Peculiar Resolvability Conundrum", published Dec. 3, 2020). Notably, it is unclear to us how an open bank resolution could reliably be executed without sizable recapitalization capacity.

In confronting this problem, the Swiss regulator has taken a different approach to that of other regulators in Europe--one which we consider is conceptually similar to our own methodology, but uses different building blocks. Swiss banks create two buffers to absorb losses, one for use before the point of nonviability and one that can only be accessed after that point. Capital hypothecated to the gone-concern buffer is no longer part of the going-concern buffer; is not available to absorb losses in all circumstances; and therefore, may not be included in certain of our capital measures.

Creating A Gone-Concern Resource

European and North American resolution authorities would likely all acknowledge that an open bank resolution of a large systemic bank that fails due to insolvency is likely to require substantial gone-concern resource to recapitalize the bank after its assets have been written down. To restore the bank's solvency to a viable level, a bail-in-led process will likely be needed, and the claims of contractually and structurally subordinated creditors will be written down or converted to equity. The process could also affect the claims of some senior creditors if the subordinated buffer is not large enough. The Financial Stability Board clearly accepted this as fact when it agreed the total loss-absorbing capacity (TLAC) buffer requirements for global systemically important banks (GSIBs).

Despite this, when it comes to Europe's domestic systemically important banks (DSIBs), national requirements differ. Most European regulators do not stipulate that the loss-absorbing capacity (LAC) buffer includes a substantial minimum gone-concern element. Reasons vary, but some may not want to give banks an incentive to reduce the size and quality of their regulatory capital base by reducing their equity and increasing debt. As a result, many banks in Europe are, in theory, free to use common equity to meet a substantial proportion of their LAC requirement. That said, in the EU and U.K., where the LAC buffer is known as the minimum required eligible liabilities (MREL), most banks do, in practice, include a substantial debt element in their buffer. It's cheaper than holding very high equity buffers.

Banks that have very high common equity Tier 1 (CET1) ratios might be less likely to fail than those with much smaller common equity buffers, but if one does get into trouble, the authorities could struggle to restore it to viability. Chart 1 explains our view of this challenge for a classic solvency stress and, through scenarios B and C, shows that early intervention would be necessary to ensure that resolution authorities could restore the bank capital ratios to a sound level.

Chart 1

The Swiss Approach

The ordinance underlying the Swiss emergency plan requires that a minimum portion of a bank's LAC buffer is available only after the bank has failed, that is, in a gone-concern scenario. Banks can choose how to meet this requirement. They may use subordinated debt instruments or a mix of subordinated debt and common equity. When a bank chooses to allocate some of its common equity or additional Tier 1 (AT1) hybrids to the gone-concern buffer for this purpose, these instruments are removed from going-concern capital and earmarked instead as part of the gone-concern buffer. Banks that hypothecate common equity or AT1 hybrids in this way receive a discount to their gone-concern requirement, partly in acknowledgment of the high quality of this resource.

Swiss GSIBs are bound by the FSB's TLAC rules, so have chosen the debt instrument route to meeting the gone-concern buffer requirement. The Swiss regulator has designated three additional banks as systemically important: Zuricher Kantonalbank, Raiffeisen Schweiz, and Postfinance. These banks would likely be subject to open bank resolution if they failed, that is, they would likely be fully recapitalized and generally restored to viability. All three banks have relatively high CET1 ratios, and so have modest historical reliance on subordinated debt issuance. In recent months, their management teams have been considering how they would prefer to meet the gone-concern requirement--through subordinated debt, common equity, or a mix of the two--ahead of a deadline of end-2024 to fully meet these requirements.

Chart 2

Rating Implications Of Hypothecated Equity

In our criteria article, "Financial Institutions Rating Methodology," published on Dec. 9, 2021, we acknowledge the importance of:

• Going-concern capital, measured using our risk-adjusted capital (RAC) ratio. This supports a bank's stand-alone credit profile and helps it to avoid failure; and
• A gone-concern buffer, which we measure using our additional loss-absorbing capacity (ALAC) ratio. This may be used in resolution to restore viability and help to avoid default on senior preferred obligations.

Chart 3

Going-concern capital normally counts toward total adjusted capital (TAC), which is the numerator in our RAC ratio. In deciding how we treat going-concern capital that a bank has hypothecated to its gone-concern buffer, we take account of these key principles, which are embedded in our ratings methodologies:

• Our measure of core capital, adjusted common equity (ACE), encompasses all the tangible equity that a bank can use to absorb losses in all circumstances;
• Where appropriate, ACE can differ from regulatory measures of tangible common equity.
• Hybrid instruments are only included in TAC if they count toward the bank's regulatory capital.
• ALAC comprises all instruments that have the capacity to absorb losses as a bank enters a resolution process, but before it becomes insolvent.

In the Swiss context, we draw the following conclusions:

• Hybrid instruments that are hypothecated to the gone-concern buffer are no longer eligible for TAC, but could be included in ALAC.
• Our methodology gives rating committees the flexibility to decide whether or not to include in ACE (and therefore TAC) any common equity that has been hypothecated to the gone-concern buffer from CET1 capital.
• If a Swiss bank earmarks common equity to the gone-concern buffer, it cannot freely move the common equity back into the CET1 capital buffer. The Swiss banking ordinance only allows such a move if the bank would still be able to meet its gone-concern buffer requirements using other instruments.
• Hypothecated common equity is no longer available to absorb losses in all circumstances. The reduction in the CET1 ratio also brings the point of regulatory intervention (point of nonviability) incrementally closer.
• We would therefore expect to exclude hypothecated common equity from ACE, and therefore also from TAC. We would include it in ALAC.

Thus, when a Swiss bank hypothecates CET1 or AT1 capital to its gone-concern buffer, its RAC ratio is likely to fall and its ALAC ratio to rise, by an equal amount. Particularly where the ratios are close to applicable thresholds, this could change our assessment of the bank's capital and earnings, or our broader assessment of its stand-alone credit profile.

That said, as long as we consider that the resolution strategy for the bank is likely to support the full and timely payment of senior preferred obligations, the bank's expanded ALAC ratio could lead us to increase ALAC uplift to its issuer credit rating (ICR). Whether this happens in practice will depend on whether the ratio is projected to exceed the applicable threshold, and whether other forms of potential external support, such as government support, provide more scope for ICR uplift.

Related Criteria And Research

Related criteria

• Hybrid Capital: Methodology And Assumptions, March 2, 2022
• Financial Institutions Rating Methodology, Dec. 9, 2021
• Risk-Adjusted Capital Framework Methodology, July 20, 2017

Related research

• The Resolution Story For Europe's Banks: The Final Push To Resolvability, Sept. 30, 2022
• Europe's Middle Ranking Banks Face A Peculiar Resolvability Conundrum, Dec. 3, 2020