Buying a challenger bank in the UK: what about MREL?

Anyone buying or taking a majority stake in a UK or EU bank or large investment firm will be aware of the regulatory challenges, most notably securing central bank and other approvals and ensuring the deal structure is consistent with rules on regulatory capital.

Many, however, will not be familiar with the minimum requirements for own funds and eligible liabilities better known as MREL, a requirement placed on banks, including challenger banks.

The rules on regulatory approval for acquisitions and bank regulatory capital are not new, even if the rules may have tightened and regulators become more probing in their scrutiny of bank acquisitions; a lesson learnt from the financial crisis, some say.

MREL, however, is a direct consequence of the financial crisis. It flows from lawmakers’ focus on effective measures to deal with or “resolve” failing banks and investment banks. MREL is one of the components of the Bank Recovery and Resolution Directive, a central pillar of the EU regime for rescuing banks.

Although MREL’s direct impact is on the banks on whom it imposes additional funding requirements, those looking to invest in banks, especially challenger banks, need to be aware of the burdens which MREL may impose on them.

Who does MREL apply to?

MREL applies to banks, building societies and investment firms which are required to hold an initial capital of €730,000. In broad terms, this includes investment firms which deal on own account or underwrite or place financial instruments on a firm commitment basis. We describe these as banks in this briefing.

What is MREL designed to achieve?

MREL (and the related concept, total loss-absorbing capacity (TLAC)) aim to ensure that a bank (and its group) have sufficient liabilities to be “bailed-in” (for example, converted from debt to equity) in the event of financial distress, at the behest of the relevant resolution authority (the public authority charged with “resolving” the bank). The further aim is to ensure that the bank retains sufficient regulatory capital to enable the resolution authority to nurse the bank back to good health or have it wound down in an orderly fashion.

How does MREL achieve this?

To achieve this, the relevant resolution authority (the Bank of England (the BoE) in the UK) is empowered to set the level of MREL for each bank and the members of its resolution group.

Members of the group identified as resolution entities must either maintain own funds or issue financial instruments, typically senior, non-preferred debt subordinated to operating liabilities, such as bonds. Where these are issued to external investors, they are known as external MREL.

Where, by contrast, the instruments are issued, directly or indirectly, by one entity in a resolution group to the resolution entity or entities in the resolution group, this is known as internal MREL.

Similar in effect to intragroup liquidity and other emergency financing facilities but different in legal status and operation, the internal MREL should allow subsidiaries in a resolution group to recapitalise and pass losses up to the entity which has issued external MREL. The external MREL should then allow the bank to absorb losses and support the actions of the resolution authority in, for example, requiring the “bail-in” of the liabilities owed under the external MREL instruments.

Are the MREL rules due to change?

Yes: the Second Capital Requirements Regulation (which applied from 27 June last year) has set new requirements for entities identified as Global Systemically Important Institutions (GSIIs) aligning EU requirements with the international TLAC framework developed by the Financial Stability Board (FSB). As referred to below, this is likely to lead to an increase in minimum requirements between now and 2022.

The Second Bank Recovery and Resolution Directive (BRRD II) broadly aligns the EU’s MREL framework with the internationally accepted TLAC standard set by the FSB for non-GSIIs. This includes the setting of a minimum MREL requirement for the resolution entities of groups with total assets exceeding €100bn but which are not otherwise subject to the minimum requirements for GSIIs.

In line with these changes, the BoE has published actual and indicative MREL which must be maintained by each of the larger banks headquartered in the UK as well as by UK challenger banks. Whilst the levels of MREL for 2020-21 and 2022 are indicative, it nonetheless demonstrates a clear upward trend in the MREL which will have to be maintained by both larger banks and challenger banks alike.

Finally, it is not currently clear if or to what extent the UK will adopt BRRD II. Given that the implementation date for BRRD II is prior to the end of the Brexit transitional period, the working assumption is that it will.

What does this all mean for buyers/owners?

Those buying or investing in a UK challenger bank should consider the following.

• Early engagement – MREL is an institution-specific requirement. Buyers should raise the issue of MREL early and engage the management of a bank or any other part of a resolution group to determine the impact of MREL on any investment.
• Due diligence – Buyers should investigate thoroughly the composition and validity of the resolution entity’s MREL. Any due diligence undertaken should be on a group basis to cover both internal MREL and external MREL.
• Re-negotiation – The BoE has a power to require the resolution entity to re-negotiate any eligible liability or relevant capital instruments to ensure that any decision by the BoE to write down or convert the liability or instrument would have effect under the law governing that liability or instrument. Anyone acquiring the debt issued by a member of a resolution group must be aware, therefore, that this debt may be re-negotiated in the event that the BoE is concerned that there are impediments to the orderly resolution of the resolution group with potentially adverse consequences for the holder.
• Structuring the transaction to stay away from the BoE – Structuring should be considered at an early stage. Non-EU parent undertakings are not subject to the BoE’s direct power to issue directions and are not therefore under a legal requirement to provide financial support. The considerations are the same where the buyer/owner is looking to side-step UK consolidated supervision. 
• Managing expectations on support – Even if the transaction is structured to keep the bank’s buyer/owner off-shore, the BoE’s wide-ranging powers to require resolution entities to take any steps to maintain MREL, may leave an owner in the position that it has to contribute further capital to meet MREL requirements. Care should, therefore, be taken in setting out the buyer’s obligations to contribute further capital and, in any event, the position of the buyer, once it has become an owner, to provide further support.