European banks face forex volatility on bail-in ratios

European banks raising bail-in debt under new European Union rules are struggling to find fixes for the potential foreign exchange volatility that could arise when funding and risk-weighted assets are denominated in different currencies. The problem is especially acute for banks whose domestic currency funding market – such as Poland, Sweden or the UK – is not as deep as the eurozone or dollar markets.

“The forex volatility issue is a pain,” says Julie Galbo, chief risk officer at Nordea in Copenhagen. “We have RWAs in various currencies, so ideally we’d have non-preferred senior issued in the same currencies as our risk weights. The problem is this is troublesome, costly and not always possible.” 

The Bank Recovery and Resolution Directive, adopted by the EU in 2014, introduced the concept of minimum requirements for eligible liabilities that can be bailed in to recapitalise a failing bank. The European Commission tabled updates to BRRD in November 2016, partly to incorporate total loss-absorbing capacity – the international standard equivalent to MREL for global systemic banks.

The revised BRRD led to the adoption of a new creditor hierarchy in 2017, under which MREL must either be issued by a holding company subordinated to operating companies, or in the form of a new senior non-preferred debt class. These bonds rank senior to subordinated notes, but junior to existing senior preferred notes, and they price accordingly.

Banks have traditionally chosen their funding currencies based on both the currency mix of their assets and the overall price of the forex bonds plus currency swap. Even for banks in the eurozone, the very deep dollar liquidity pool has often represented a cheaper source of funding than the euro.

“We predominantly need to issue in euros and dollars. We will try to have Swedish krona – we already have a little bit – but the Scandinavian market is obviously less liquid,” says Galbo.

A European Banking Authority (EBA) report from December 2016 points out that EU banks issue up to 46% of their funding in currency other than euros, when looking at debt maturing this year or later – with the US dollar making up 19%, the yen at 11% and UK sterling at 6%, among others.

With the advent of MREL, if a bank’s funding mix and its RWAs do not match in terms of denomination, the basis between currency values would lead to a fall or rise in a bank’s MREL ratio. Under parts of the revised BRRD that are still being discussed in the Council and Parliament of the EU, breaches of the MREL ratio could affect the maximum distributable amount of capital, effectively restricting additional tier 1 bond coupon payments and shareholder dividends.

“What no one wants to see are technical MREL breaches arising from currency volatility. There is currently no obvious solution for this problem, so firms may need to consider running buffers on MREL, per se, for their currency volatility,” says a financial institutions group (Fig) banker at a UK bank.

Buffering issues

Gilles Renaudiere, director for capital products at BNP Paribas, agrees there is likely to be a reduced appetite for dollar funding from some EU banks in future to avoid MREL ratio volatility.

“I believe it will be a factor for banks when deciding whether or not to access the US dollar market. Some small banks may favour euros only, and larger ones may still do more euros than what pricing alone would suggest,” he says.

Others say the US dollar market is the only option for some European banks, especially those outside the eurozone, as no other market has the same depth and liquidity. Non-eurozone member states are not part of the banking union, but still implement BRRD.

Some people talk about 10% to 20% price tolerance, and maybe they say they will do their home currency as long as it is not 10% more expensive than foreign currency

Alex MacMahon, Citi

“What we haven’t seen yet, in any great depth, is firms looking to reduce their exposure to dollar funding markets because of any implied MREL volatility on the balance sheet. On a comparative basis, sterling or euro looks more attractive at the moment, but that doesn’t resolve the fact that the onshore dollar continues to offer significant depth,” says the Fig banker at a UK bank.

Sources say a £800 million holding company senior bond issued by RBS in March was the first MREL-eligible issue undertaken by the bank in sterling.

“If you are a UK bank, because the sterling market is often much more expensive, most of them have done most of their issuance in dollars and increasingly [in] euros,” says Alex MacMahon, head of European Fig DCM at Citi.

To offset the risk of an MREL breach, banks will need to include an additional buffer for forex volatility in their issuance. MacMahon explains: “Some people talk about 10% to 20% price tolerance, and maybe they say they will do their home currency as long as it is not 10% more expensive than foreign currency.”

Galbo says Nordea’s approach will be to a run a management buffer for the MREL ratio to absorb the impact of forex volatility in the short term, and then achieve a greater level of matching between issuance and RWA currency in the long term. She declines to say the expected size of the buffer relative to MREL.

“I think the trend will be less dollar MREL issuance from European banks, but likely in the long term,” says Galbo.

Right way risk

Banks are allowed to hedge their capital ratios against forex volatility under the EU rules, and the intention is they will not need to hold capital against the hedge itself when new market risk rules are adopted. Equity capital counts towards the overall MREL ratio, but the majority of the requirement will be met with debt.

Funding experts say the debt component is much harder to hedge, because the key criteria for MREL eligibility is that the instrument can be bailed in. A conventional currency hedge would enable the bank to profit when its MREL ratio deteriorated, but the forex hedging instruments themselves would not be eligible for bail-in, so it is unclear how this would pass muster with resolution authorities.

“If firms want to hedge MREL raised in non-reporting currency from currency volatility, it’s a question of subordination… The principle here is that in order to get an effective MREL hedge, the derivative itself may also need to be considered eligible in some way within the broader context of the BRRD,” says the Fig banker at a UK bank.

However, some bankers look at the forex volatility of MREL from the perspective of a natural hedge strategy. European banks could take the bet that the downside of MREL volatility is worth the upside of an improved MREL ratio in certain scenarios, says one head of capital structuring at a European bank.

If you are issuing or you have outstanding dollar or euro MREL, and you have a bad Brexit, for want of a better phrase, then clearly, sterling depreciates

Senior Fig capital markets banker at a global bank

The negative effects of a localised banking crisis in a single jurisdiction, especially for an EU country with a currency other than the euro, are likely to spill over into that jurisdiction’s currency value, he says. If MREL has been issued in foreign currencies, forex volatility would improve the bank’s MREL ratio just as its profitability was under pressure. In the event of a localised banking crisis in Sweden, for example, Swedish banks with a significant proportion of dollar MREL would have higher ratios than if they held MREL in Swedish krona.

A similar scenario can be imagined in the event of a no-deal Brexit and its impact on UK sterling. UK banks that have issued more MREL in dollars could be well hedged against a hard Brexit, according to a senior Fig capital markets banker at a global bank, who does not expect a significant increase in sterling issuance from UK banks.

“If you are issuing or you have outstanding dollar or euro MREL, and you have a bad Brexit, for want of a better phrase, then clearly, sterling depreciates. So your MREL appreciates [and] so you have actually got quite a nice hedge,” he says.

“If it goes the other way, then clearly your MREL depreciates because sterling is strengthening, but is that a bad thing? Because there has been a good Brexit, there will be good profits and profitability, and you are earning money,” he adds.

But another Fig banker who spoke to Risk.net is less convinced by this approach, saying it amounts to banks taking currency bets through an instrument intended to be a source of stability rather than speculation.

Galbo at Nordea says the expected correlation between currency value and a localised banking crisis might not materialise. In particular, the monetary policy authorities at a central bank are likely to prioritise stabilising their domestic currency, leaving the process of shoring up bank balance sheets to the prudential supervisors and the banks themselves.

“Of course, it is technically correct that if your local currency falls in value and you have dollar funding then that’s going to be a benefit, but I think it may not only be positive, because a real event is likely to be more complex. I also don’t think taking bets on currency for MREL was the incentive structure intended by regulators,” she adds.

Editing and additional reporting by Philip Alexander