Hong Kong Strengthens Banks’ Resilience To Shocks By Implementing Loss-Absorbing Capacity Rules.

In line with recent global priorities, Hong Kong has been working towards further safeguarding financial stability by strengthening banks’ resilience to shocks. The implementation of FIRO in 20172, the statutory resolution framework, was the first step in the process. FIRO gives the Hong Kong Monetary Authority (“HKMA”) wide powers to intervene and manage a within scope bank when it becomes non-viable. Another key pre-requisite identified by the HKMA is to ensure that Hong Kong banks have enough financial resources to absorb losses so that it is the shareholders and creditors (rather than taxpayers) that are first in line to meet any losses. Hong Kong’s loss-absorbing capacity (“LAC”) rules (the “LAC Rules”) aim to ensure that Hong Kong banks have sufficient financial resources that can bear losses ahead of other liabilities and/or provide recapitalisation resources. The LAC Rules are scheduled to come into effect on 14 December 2018.3 The LAC Rules generally align with the provisions set out in the Financial Stability Board’s term sheet on total-loss absorbing capacity (“TLAC”) for G-SIBs4, subject to a few adjustments necessary for the Hong Kong market. In this alert, we will provide some background to the LAC Rules, an overview of the application and timing of the LAC Rules and a summary of the LAC requirements and eligibility criteria. In the second part of this alert, we will focus on LAC debt instruments and certain practical implications on the issue of LAC debt instruments. 

 

Background to the LAC Rules 

 

The FIRO establishes a cross-sectoral resolution regime for within scope financial institutions in Hong Kong. It is designed to meet the international standards set by the Financial Stability Board.5 Subject to certain conditions, the HKMA can initiate the resolution of a failing bank by applying its resolution tools. These tools include (i) a ‘bail-in resolution stabilisation option’, whereby certain liabilities issued by the bank are cancelled or modified (e.g. written down or converted into equity) and (ii) ‘transfer stabilisation options’ whereby some or all the assets, rights or liabilities of, or securities issued by, the bank are transferred out. To facilitate the orderly use of such stabilisation options, a bank needs to have sufficient LAC that can readily bear losses in resolution and the LAC Rules have been designed for this purpose. In this respect, Hong Kong is at the forefront of global efforts to implement comprehensive resolution planning when compared to other jurisdictions in Asia. 

 

Application and timing of the LAC Rules

 

The FIRO empowers the HKMA to devise a resolution strategy to secure the orderly resolution of a bank.

 

However, it is neither practical nor desirable that a resolution strategy be devised for every bank in Hong Kong. Hence, the HKMA has confirmed that it is only where the non-viability of a bank would likely pose a risk to the stability and effective working of the financial system in Hong Kong that a resolution strategy will be devised.

 

The HKMA has proposed that a framework based on a simple measure of the size of a bank should be the threshold for developing a resolution strategy. The framework should also allow for deviations with reference to institution-specific factors – e.g. metrics relating to the relevant authorised institution’s deposit-taking activities such as number of depositors, volume of depositors, number of transactional accounts and number of depositors who have deposits at that authorised institution which exceed the compensation limit under the Deposit Protection Scheme. Currently, the HKMA has proposed that any locally-incorporated bank with total consolidated assets above HK$150 billion (approximately US$19.13 billion) should expect a resolution strategy to be devised by it.6

 

Where the resolution strategy envisages the application of a stabilisation option to a Hong Kong incorporated entity, the HKMA can classify such entity as a ‘resolution entity’ under the LAC Rules. A resolution entity will be subject to an ‘external LAC requirement’ (see “External LAC” below). In addition, the HKMA can group together entities (whether incorporated in or outside Hong Kong) and designate them as a ‘resolution group’ and can classify one or more of the Hong Kong incorporated subsidiaries within such resolution group as a ‘material subsidiary’. A material subsidiary designated by the HKMA will be subject to an ‘internal LAC requirement’ (see “Internal LAC” below).7 

 

Under current HKMA timetable (which is subject to change), classifications of domestic systemically-important banks (“D-SIBs”) that are part of non-emerging market economy headquartered G-SIB groups should be made in 2019 once the LAC Rules have come into force. It is intended that such D-SIBs will be required to begin complying with the LAC Rules within three months of their classification as classifiable entities. For other relevant authorised institutions, it is expected that resolution strategies should be finalised during 2019, with classifications made by 1 January 2020 and compliance with the LAC Rules to occur by no later than 24 months after classification (i.e. 1 January 2022).

 

External LAC

 

If an entity is classified by the HKMA as a resolution entity, such entity would be required to meet a minimum level of external LAC (the “External LAC Requirement”). External LAC is LAC issued by a resolution entity outside the issuer’s resolution group. It represents the financial resources external to a resolution group that are available to absorb losses and fund recapitalisations within the resolution group, should that prove necessary. 

 

The External LAC Requirement for a resolution entity will be equal to the product of (i) the sum of its capital component ratio (i.e. regulatory capital requirement including Pillar 1 and Pillar 2A) and its resolution component ratio and (ii) its risk-weighted assets (“RWAs”), unless its capital position is constrained by the leverage ratio requirement, in which case a measure of its total assets is used instead of RWAs. The LAC Rules support External LAC Requirements of between 16-29% of RWAs.

 

An illustration of the External Lac Requirement (based on RWAs) for a resolution entity is set out in Figure 1 below.

 

Internal LAC

 

Depending on an authorised institution’s group structure and the preferred resolution strategy, it may be that the entity which initially suffers losses is not itself a resolution entity. In these circumstances, a mechanism is required to pass losses up from the authorised institution in which such losses first crystallise to a resolution entity, whose external LAC can then absorb the losses (e.g. by an erosion of its equity and/or by non-equity LAC being written down or converted into equity). This is particularly likely to be the case for an entity that constitutes a significant part of its resolution group. Therefore, if an entity is classified by the HKMA as a material subsidiary of a resolution group, such entity would be required to meet a minimum level of internal LAC (the “Internal LAC Requirement”).8 Internal LAC is LAC issued by an entity that is in a resolution group but is not itself a resolution entity and issued (either directly or indirectly) to the resolution entity in that group. The definition of ‘material subsidiary’ in the LAC Rules closely follows the equivalent concept in the Financial Stability Board’s TLAC term sheet for G-SIBs.9

 

The Internal LAC Requirement for a material subsidiary will be equal to the product of (i) the sum of the capital component ratio and the resolution component ratio that would have applied if it had been a resolution entity, (ii) its RWAs, unless its capital position is constrained by the leverage ratio requirement, in which case a measure of its total assets is used instead of RWAs (i.e. its modelled External LAC Requirement) and (iii) its internal LAC scalar. The scalar is expected to be between (a) 75-90% for LAC issued to an entity in another jurisdiction and (b) 75-100% for LAC issued to a Hong Kong incorporated entity.

 

An illustration of the relationship between external LAC and internal LAC is set out in Figure 2 below.

 

Figure 1: Illustration of External LAC Requirement (based on RWAs) for a resolution entity

(extracted from the Proposed LAC Rules Code of Practice, page 5)

 

Please click on the table to enlarge.

 

1 This illustration does not include the Pillar 2B buffer, which would be set off against the regulatory capital buffer.

2 The CCB is the capital conversation buffer; the CCyB is the countercyclical capital buffer; and the HLA requirement is the higher loss absorbency requirement applicable to domestic systemically-important banks.

3 Subject to eligability criteria. See Schedule 1 of the LAC Rules.

4 In this illustration, the AI’s binding regulatory capital requirements are based on RWAs. In practice, they could be based on its exposure measure.

5 For illustrative purposes regulatory capital is shown here as contributing equally towards the regulatory capital requirements and the external LAC requirements. In practice, there are likely to be some minor differences - see rule 37 of the LAC Rules.

 

Figure 2: Illustration of issuances of external LAC and internal LAC 

(extracted from the HKMA consultation paper on LAC Rules, page 17)

 

Please click on the image to enlarge.

Interaction with capital buffers and consequences of a breach

 

The External LAC Requirement and Internal LAC Requirement are calibrated to include loss-absorbing capacity needs both before resolution and in resolution. Regulatory capital buffers however, are designed to be used on a going concern or pre-resolution basis. Hence, such buffers should be separate from, and additional to, any LAC requirements. The HKMA has confirmed that Common Equity Tier 1 (“CET1”) that counts towards a LAC requirement that is calibrated with respect to RWAs cannot also count towards meeting the regulatory capital buffers.

 

The HKMA has said that LAC requirements should be treated as ‘hard’ requirements, not buffers as they are designed to ensure that sufficient resources are available to absorb losses and support recapitalisation in resolution. As such, the breach of a LAC requirement by an authorised institution could be considered a breach of such institution’s minimum criteria for authorisation.

 

LAC eligibility criteria

 

If LAC requirements are to fulfil their purpose, eligible instruments should, at the very least, be available to bear losses at the point of non-viability. Hence, LAC instruments can either consist of (i) CET1 (but see “Interaction with capital buffers and consequences of a breach” above) or (ii) LAC debt instruments (either external or internal LAC debt instruments). 

 

External LAC debt instruments

 

Broadly speaking, external LAC debt instruments can consist of

 

(i) eligible Additional Tier 1 capital instruments,

(ii) eligible Tier 2 capital instruments and

(iii) other non-capital liabilities that meet the external LAC debt instrument eligibility criteria (i.e. a new class of LAC instruments).

 

The external LAC debt instrument eligibility criteria include instruments that must:10 

 

  • be fully paid in
  • not arise other than through a contract (e.g. exclude tax liabilities)

 

  • be unsecured

 

  • be contractually subordinated to depositors and general creditors and/or be issued by a ‘clean Hong Kong holding company’ (i.e. the liabilities of such holding company that are not eligible as external LAC and that rank pari passu or junior to any liabilities that are eligible, do not exceed 5% of its liabilities that are eligible)

 

  • not be subject to set-off or netting rights or any arrangement that would undermine their LAC

 

  • not be excluded liabilities under section 58(9) of FIRO

 

  • have a remaining contractual maturity of at least one year or are perpetual, with limited rights to early redemption by the holder

 

  • be subject to Hong Kong law (subject to limited exceptions)

 

  • not be funded or guaranteed directly or indirectly by the issuer or another entity in the resolution group, unless otherwise agreed to by the HKMA

 

  • contain contractual recognition of the statutory bail-in power under FIRO

 

  • not arise from derivatives or otherwise have derivative-linked features

 

  • contain language that such instruments are intendedto be eligible as LAC

 

 

Restrictions on sale and distribution of external LAC debt instruments

 

The HKMA has said that external LAC debt instruments are complex in nature, particularly the hybrid nature of such instruments. Hence, they are not suitable for retail investors and if issued in Hong Kong, should generally only be issued to professional investors (“PIs”). In addition, external LAC debt instruments must have a minimum denomination of HK$2 million (if denominated in HK$), US$250,000 (if denominated in US$), €200,000 (if denominated in Euro) and the equivalent of HK$2 million in the relevant currency (if denominated in any other currency). The LAC Rules also require relevant offering and product documents for external LAC debt instruments to contain appropriate risk disclosures and selling restrictions.

 

The above restrictions are not currently part of the eligibility criteria for Additional Tier 1 and Tier 2 capital instruments. However, given that issuers will most likely want any future Additional Tier 1 and Tier 2 capital instruments to be eligible for classification as LAC debt instruments, it is likely that such restrictions will also find their way to the eligibility criteria for Additional Tier 1 and Tier 2 capital instruments.

 

Grandfathering of existing Additional Tier 1 and Tier 2 capital instruments

 

Eligible Additional Tier 1 and Tier 2 capital instruments issued before the LAC Rules come into operation should qualify as external LAC debt instruments.

 

Internal LAC debt instruments

 

Broadly the same criteria need to be met if an instrument is to qualify as an internal LAC debt instrument. In addition, the contractual terms of an internal LAC debt instrument need to specify that it is subject to write down and/or conversion into equity upon notification from the HKMA that the issuing entity has ceased, or is likely to cease, to be viable. Where internal LAC is issued cross-border, authorities in both jurisdictions should be involved in the decision to trigger internal LAC.

 

Minimum component of LAC debt instruments

 

The HKMA has stipulated that at least one-third of a LAC requirement must be constituted by LAC debt instruments (for both the External LAC Requirement and Internal LAC Requirement). This is because, although CET1 automatically absorbs losses on an ongoing basis and is the best form of capital, by the time a bank reaches the point of failure, it is likely that much of its CET1 will have been depleted. LAC debt instruments however, is not at risk of depletion before failure and provides a fixed quantity of financial resources that can support an orderly resolution. 

 

Although in its consultation conclusion on the LAC Rules released in July 2018, the HKMA had stated that Additional Tier 1 and Tier 2 capital instruments only had to evidence indebtedness (whether or not treated as debt or equity for accounting purposes) to count towards the minimum 1/3 LAC debt requirement, we have recently clarified this with the HKMA following the publication of the final LAC Rules. We understand that the HKMA has now adopted a different consideration to the 1/3 LAC debt requirement such that Additional Tier 1 and Tier 2 capital instruments will continue to be eligible for LAC recognition but that only those Additional Tier 1 and Tier 2 capital instruments which are liabilities for accounting purposes will now count towards the minimum 1/3 LAC debt requirement.

 

Tax treatment of LAC debt instruments

 

Due to the loss-absorbing characteristics of LAC debt instruments, they may not readily be treated as debt for tax purposes. If so, interest payments on LAC debt instruments would not be deductible from taxable profits, leading to higher tax liabilities for entities required to issue LAC debt instruments. It was because of this that relevant tax legislation was amended in 2016 to allow non-CET1 capital instruments issued by banks to be treated as debt for tax purposes. Based on similar principles, it has been proposed that existing tax legislation be amended11 to, subject to certain conditions, also allow non-capital LAC debt instruments issued by a bank and LAC debt instruments issued by a ‘clean Hong Kong holding company’ to be treated as debt for tax purposes. In addition, based on feedback received from market participants, the HKMA has acknowledged that it is desirable to avoid disadvantaging affiliated operational entities who may be required to issue LAC debt instruments. Hence, it has been proposed that debt-like tax treatment also be afforded to affiliated operational entities which are classified by the HKMA as a resolution entity or material subsidiary and thus subject to a LAC requirement. In addition, interests, gains or profits derived from LAC debt instruments made by such affiliated operational entities would be assessed as trading receipts and hence brought into the scope of chargeable profits, on the same basis as for ‘clean Hong Kong holding companies’.

 

Restrictions on treatment of LAC investments

 

To mitigate the risks that may arise when a bank invests in LAC issued by another bank that eventually becomes non-viable (i.e. where such LAC bears losses and potentially acts as a contagion, spreading losses from one bank to another), the HKMA has prescribed that certain deductions of LAC holdings be made. Where a bank invests in external LAC issued by an entity in a different resolution group, that investment should be deducted from the holder’s capital. Where an entity holds internal LAC issued by another entity in its resolution group, to the extent the holding is not already deducted from the holder’s capital under the capital deductions framework, it should be deducted from the holder’s LAC issuance.

 

Practical implications on issuing LAC debt instruments

 

We envisage that going forward, Hong Kong banks will need to significantly increase the amount of debt securities that they issue to meet their respective one-third LAC debt requirement. In addition, with the current HKMA timetable, it is likely that certain D-SIBs will need to lead the way in terms of compliance. However, the HKMA has not yet provided detailed guidance on the approval process that may be required by an entity when issuing LAC debt instruments. With existing regulatory capital instruments, we would typically expect the HKMA approval process to take, on average, approximately one month. With the need to issue more LAC debt instruments, would a shortened upfront or post-issuance process be more appropriate? We hope that the HKMA will provide guidance on the approval process in due course.

 

Hong Kong is a unique global financial centre as it plays host to 29 of the 30 G-SIBs without being the home jurisdiction for any of them. This is probably one of the factors that the HKMA took into consideration when prescribing the Internal LAC Requirement to allow a subsidiary to pass up losses to an entity incorporated outside Hong Kong, to be absorbed by that non-Hong Kong entity’s external LAC. However, it is unclear how this would be done in practice as many other jurisdictions have not yet implemented loss-absorbing capacity regimes and it is not clear how non-Hong Kong resolution authorities would treat internal LAC debt instruments issued by a Hong Kong material subsidiary. The HKMA has, however, said that it will act in close co-ordination with relevant authorities in other jurisdictions.

 

In addition, it is uncertain what impact the restrictions on the treatment of LAC investments will have on the existing interbank market (e.g. the certificates of deposit market). Will the restrictions change the overall method of funding going forward? Although any impact is unclear at this stage, we do expect to see the market adjust as the LAC market develops.

 

Conclusion

 

Hong Kong is at the forefront of global efforts to implement comprehensive resolution planning when compared to other jurisdictions in Asia. However, more clarity on certain issues (e.g. approval process) from the HKMA would be helpful. In addition, we expect to see certain issues ironed out as the market adjusts with the development of the LAC market.

 

For more see Conventus Law.