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Expect More EU Banks to Act on Legacy Capital by End-2021

DZ Bank’s decision to terminate and redeem EUR1.4 billion of nominal legacy Tier 1 instruments is likely to be followed by similar actions on legacy capital instruments by other European banks this year, Fitch Ratings says. In the short term, such moves could cause slight fluctuations in Tier 1 capital ratios as banks manage their liability structures. Grandfathered liabilities cease to qualify as eligible capital after end-2021.

Germany’s DZ Bank issued the legacy Tier 1 securities via special purpose vehicles (SPVs) between 2003 and 2007. The securities were grandfathered as eligible regulatory capital or own funds until end-2021 under the EU’s 2013 Capital Requirements Regulation (CRR). Instruments issued by SPVs are ineligible as own funds under the CRR as they are viewed as giving less certainty on loss absorption from a prudential regulatory perspective than directly issued instruments.

The ineligibility of legacy capital instruments can also affect the eligibility of other capital instruments. In October 2020 the European Banking Authority (EBA) highlighted the risk that other layers of own funds or eligible liabilities could be disqualified because certain aspects of legacy instruments were not compliant – so-called “infection risk”. The EBA was mainly concerned about Additional Tier 1 instruments that could be pushed down a bank’s capital structure into Tier 2 or the minimum requirement for own funds and eligible liabilities (MREL).

The two key risks cited by the EBA were clauses in legacy instruments’ terms that contradicted CRR ranking provisions, and non-discretionary features that could limit the flexibility of payments on other instruments, such as dividend stopper and dividend pusher mechanisms. Any restrictions that stop distributions from Tier 2 or other lower-tier instruments would disqualify higher layers of regulatory capital under the CRR, even if the lower-tier instrument might otherwise have been eligible.

Before the grandfathering period expires after end-2021, the EBA prefers that banks call, redeem, or buy back the instruments affected, or amend the contractual terms to avoid infection risk. Although banks can choose to keep legacy instruments on their balance sheet while excluding them from regulatory own funds or MREL, the EBA sees this as a last resort. For most banks it would be unlikely to make economic sense given the high funding costs of retaining ineligible capital instruments.

We expect that the ECB’s supervisory teams will closely monitor how eurozone banks manage their liability structures as the grandfathering end date approaches. In the UK, the Bank of England and Prudential Regulation Authority (PRA) share the EBA’s views on infection risks and banks must submit plans to address the issues identified to the PRA by end-March 2021.
Source: Fitch Ratings

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