The Challenges of Challenging Banks (Part 3)
Tags: Fintech, Neobanks, Challenger Banks, Banks, Regulation

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The Challenges of Challenging Banks (Part 3)

For Challengers, MREL, BRRD and SRR could turn out to be anagrams of Trouble clewbay Follow Nov 27, 2020 · 10 min read

This is the third part of our series on the Challenges of Challenging Banks in which we have argued that the “Fin” in FinTech can be every bit as important as the “Tech” (albeit often less exciting). In Part 1 we discussed how the need for regulatory capital placed a burden on FinTech banks that few tech start-ups experience and that this gives an urgency to the quest for profits (tech style KPIs like market share, clicks, traffic don’t cut it for banks). In Part 2 we discussed the different ways in which the Challengers can distinguish themselves from their incumbent competitors in order to make profits. Now we turn to another burden that banks must shoulder in their quest for growth, market share and sustainability: regulation. Regulation is a large topic and one that rarely quickens the pulse, so we have limited ourselves to one part on the regulatory landscape that is starting to affect challenger banks. We should warn you that you are about to encounter a blizzard of abbreviations and banking arcana but please hang in there, it’ll be worth it. By the end you will have a new respect for the management teams of challengers like Starling, Monzo and Metro, who have to cope with burdensome regulation in order to grow their businesses and insight into an aspect of their business models that is often not spoken about.

Too big to fail? Never again

During the financial crisis of 2008 countless billions of taxpayers’ money was spent propping up the global banking system. Even though we may have resented the fact that our taxes were spent like this, it was money well spent as we’d have been far worse off if the banking system had been allowed to fail. But governments around the world were determined that in future, the burden of fixing the banks would fall on the banks’ shareholders and lenders and not on taxpayers. Never again did they want to be caught with banks that were ‘too big to fail’ and be compelled to bail them out.

So here’s what they did in 2009. The coordinator of the world’s central banks, the FSB (Financial Stability Board), concocted the idea of TLAC (Total Loss Absorbing Capital) that would apply to G-SIBs (Global Systemically Important Banks) and other banks, that was implemented in Europe via the BRRD (Bank Recovery and Resolution Directive) which established something called MREL (Minimum Requirement for own funds and Eligible Liabilities) which would ensure that if a bank got into trouble, its regulator could protect the depositors and ensure the smooth running of the financial system without needing tax payers’ money. We did warn you about those abbreviations.

Which boils down to the fact that a bank needs to have capital not just to support its assets and business (as it has had to for years) but have an additional stock of issued securities (the ‘Eligible Liabilities’ in MREL) that will turn into capital if the bank gets into trouble.

MREL is a stock of extra capital on top of the share capital we are already familiar with, ready for a rainy day to pay for the bailout if needed

How much MREL a bank must have varies according to the sort of bank and what a regulator would expect to do if it got into trouble. The PRA (Prudential Regulatory Authority), part of the Bank of England describes its approach in detail in this link but be warned it’s not an easy read — we have simplified it below.

George Bailey played by James Stewart tries to reassure nervous depositors to avert a run on his bank in ‘It’s a Wonderful Life’

How to fix a broken bank

If a bank got into trouble, (for example, more loans went bad than expected, eroding its capital, spooking depositors and potentially causing a run on the bank) the PRA would first try a market solution. It would tell the bank to raise more capital from its shareholders or encourage a stronger bank to buy it, take on its liabilities thus reassuring depositors and stabilising the situation. But if these market solutions were ineffective, the PRA has significant legal powers to place the bank into ‘resolution’ under what’s called the SRR (Special Resolution Regime). Under SRR the PRA can do pretty much whatever is appropriate in the public interest to stabilise the failing bank. It has three broad approaches to resolution depending on the type of bank.

Small Banks: simple, have few current accounts and are not important to the smooth running of the payments system nor any other critical function.

Resolution: would be allowed to go bust.

Examples: small credit union

Mid-sized Banks: have at least 40,000 current accounts, assets below £15–25 billion, may have critical economic functions e.g. substantial role in the payments system.

Resolution: partial transfer. The critical liabilities (e.g. deposits), and assets would be transferred to another bank or a PRA vehicle. The transferred assets would be financed by the MREL liabilities that would be converted to equity and act like a dowry for the entity that took them over.

Examples: Starling, Monzo

Large Banks: have at least 40,000 current accounts, assets above £15–25 billion, have critical economic functions.

Resolution: Bail-in. Too big and complicated to be transferred to another bank. It would remain a stand-alone entity but recapitalised and restructured. The existing equity and subordinated debt would be written down to zero and the bank recapitalised using the MREL liabilities that would be written down or converted to equity.

Examples: Lloyds, Barclays, Virgin Money, Metro

This matter of fact description does not do justice to the remarkable powers the PRA has been granted. The need to ensure the continuous smooth running of the financial system (to ensure, for example, that when you put your card in the cash machine, cash comes out; that when a company sends money to pay a bill, the money goes), means that the PRA must act well before a crisis blows up and certainly long before any insolvency. It has discretion to, among other things, decide when a bank is in trouble (and what ‘in trouble’ means), to put the bank into the SRR and force the transfer of assets and liabilities and write-off liabilities. There is a sinister phrase: the Point of Non-Viability (PoNV) and the PRA decides when that point has been reached and what to do about it.

So if you are an investor in a bond that qualifies for MREL, with no warning you could find your investment wiped out but the bank that issued it, might not be even close to insolvency. And that wipe out can’t be challenged in court!

What does an MREL bond look like?

Notwithstanding its alarming characteristics when a bank gets into trouble, an MREL bond has few special features. It must have a maturity of at least a year, be fully paid, it can’t be a derivative nor a deposit. As a matter of practice, MREL qualifying bonds are typically structurally or contractually subordinated to other senior liabilities. It is worth noting that equity qualifies as MREL and a bank could meet its MREL requirement by issuing more equity rather than bonds but that would of course be very costly.

How much MREL does a bank need?

The amount of MREL a bank needs is determined by how much extra capital the PRA reckons a bank will need if it enters resolution. With all these abbreviations flying around it would be a shame not to have an equation as well. The amount of MREL is based on the following:

MREL = loss absorption amount + recapitalisation amount

The loss absorption amount is the capital a bank needs for its everyday business (the minimum capital it has to have and we are all familiar with that capital). The recapitalisation amount is the extra amount needed to ‘pay for’ the resolution.

For a Small Bank the recapitalisation amount is zero because it would be allowed to go bust; there would be nothing to recapitalise. Thus the MREL equals the minimum capital.

The PRA assumes that a Large Bank in trouble would wipe out its existing capital (the loss absorption capital) and need to start again from scratch. So the recapitalisation amount would equal the existing minimum capital. Thus MREL roughly equals twice the existing minimum capital.

For the Mid-sized Banks it is more complicated as the size of dowry required to facilitate a partial transfer of assets and liabilities is hard to gauge. The PRA isn’t explicit yet about the numbers but it looks as if the recapitalisation amount will trend towards the loss absorption amount. So the MREL will be roughly twice the minimum required capital (like Large Banks).

The PRA has published indicative levels for MREL for UK banks which suggest that after a phase-in period the MREL for Medium and Large Banks will be c. 24% of risk weighted assets or roughly twice the minimum capital required — another BoE paper for your enjoyment.

Why does this matter to the neobanks?

The good news is that for the moment it doesn’t matter much. They are very well capitalised as they have raised plenty of capital to finance growth and the cost of growth. So for now any MREL requirement is comfortably covered by equity. Furthermore, the MREL requirements are phased in from 2022 to 2024.

But let’s look ahead. As they grow, (and neobanks are all about growth) their growing assets will consume the regulatory capital and they will need to address how best to issue MREL bonds and the cost implications.

Preparation: Successfully issuing MREL bonds will need preparation. Bond investors much prefer familiarity and tend to favour well known issuers of bonds because they have done their analysis, the issuer has a track record and there are existing bonds trading in the market with which to compare the new bonds. To build this familiarity, issuers typically issue a variety of bonds (different maturities, senior and subordinated etc) over time. No bank will want to go to the market for the first time with an urgent need for MREL and find that investors aren’t interested or demand a high rate of interest to make up for their unfamiliarity.

Cost: It won’t be a surprise that investors in MREL bonds require them to pay a decent rate of interest to compensate them for the risk of providing this ‘rainy day capital’. Lloyds pays a rate of around 1.5% for MREL, Metro Bank paid 9.5% when it issued in 2019 and today its MREL bonds trade with a yield of c.17% (see below for the full story). It’s much too early to know what rate a neobank will need to pay for MREL. But to give some idea of the likely significance of MREL, we have done some calculations assuming a 5% coupon, (which is quite a contrast to zero on deposits) that suggest that once a neobank has grown its earning assets sufficiently to match its capital, the cost of MREL alone could be around 8% of its net interest margin. That’s pretty significant. The neobanks know their forecasts far better than us and will already be factoring in MREL.

Each year banks are required to publish a detailed report about their risks, risk management, and capital, so called Pillar 3 disclosures. This link takes you to Starling Bank’s Pillar 3 Disclosures where they say on page 47 that their MREL requirements are covered by minimum capital. Quite rightly, MREL is not an issue for urgent attention today.

Metro Bank’s experience is salutary

Last year Metro showed how extremely uncomfortable it is to be stuck between an unforgiving regulator and an uncompromising bond market. Metro had a tough 2019. In January it discovered that it had made a mistake calculating the risk weights on £900 million of commercial loans which had a big impact on its capital ratios and in May it had to raise £375 million of new equity from its shareholders to correct the error. There was no mistaking what the investors thought: between January and May its share price dropped about 60%.

Having fixed its equity problem it still needed to issue MREL bonds (the phase-in timing is different to that of the neobanks such as Starling). In September 2019, Metro went to the bond market to raise around £200 million of MREL bonds proposing a coupon of 7.5%. It turned out that there wasn’t enough demand from investors so the deal was pulled and spooked investors marked the shares down another 30%. MREL was a regulatory matter that couldn’t be dodged or delayed and in October Metro returned to the bond market and successfully issued £350 million of MREL bonds but had to pay a whopping 9.5% coupon. The success must have had a bitter taste. In H1 2020, Metro’s net interest income (NII) was £116 million and in that period it paid £16.6mn in interest on the MREL bond or 14% of NII. In its H120 results presentation Metro said that ‘we may consider raising £200–300 million further MREL in 1H21’. Regulators can be remorseless.

For some more background reading on these topics:

More exciting than you expected?

Financial regulations are as dry as dust and if you clicked through to the Bank of England publications above you certainly know that. Their complexity can mask their significance and as we watch the neobanks successfully making progress changing banking around the world we say, don’t forget the Fin in FinTech!