BKLM391000 - Loss absorbing instruments issued by overseas subsidiaries: Overview

For chargeable periods ending on or after 1 January 2021, a reduction in a group’s equity and liabilities chargeable to the Bank Levy is available for certain loss absorbing instruments.

Broadly, this reduction applies to intra-group instruments issued by an overseas subsidiary in order to meet a loss absorbing capacity or recapitalisation requirement imposed by a regulatory authority which is funded by a chargeable UK sub-group or entity. The regulatory background is discussed in more detail below.

Reductions are streamed and capped to match equivalent instruments issued in the UK sub-group or entity that would otherwise fall within its chargeable equity and liabilities.

The reduction is framed with reference to instruments issued by overseas subsidiaries but can also be understood from the opposite perspective. That is, as a broad summary, the reduction removes from chargeable equity and liabilities an amount relating to certain loss absorbing instruments issued by UK group members in accordance with relevant regulatory requirements, where these would otherwise have fallen within the chargeable equity and liabilities, and where the instruments fund loss absorbing capacity or recapitalisation requirements imposed on overseas subsidiaries by a regulatory authority.

Brief overview of the reduction

The reduction is made at FA11/SCH19/PARA15N(1) Step 3. This means that it falls before the reduction made in respect of high quality liquid assets (para15N(1) Step 4) but after all other exclusions and adjustments made in calculating the Bank Levy (para15N(1) Steps 1-2).

The reduction is calculated by identifying assets of a chargeable UK sub-group or entity that are or that represent qualifying loss absorbing instruments issued by overseas subsidiaries (para 15X(1)). There is more information about what is meant by a qualifying loss absorbing instrument at BKLM392000 Loss absorbing instruments issued by overseas subsidiaries: loss absorbing instruments.

Amounts in respect of these assets are then streamed so that:

  • Reductions relating to Tier one equity and liabilities of overseas subsidiaries are only available against equity and liabilities that would have been excluded from charge as Tier one were it not for regulatory capital deductions from the Tier one amount for holdings in financial sector entities (para15X(1)(a)) (discussed at BKLM393000 Loss absorbing instruments issued by overseas subsidiaries: amount of reduction under “3. Cap amount of reduction: Tier one instruments”), and
  • Reductions relating to other loss absorbing instruments issued by overseas subsidiaries are only available against other loss absorbing instruments issued by the UK sub-group or entity, which are not Tier one equity and liabilities (para15X(1)(b)).

There is more detail on streaming of assets and liabilities and on the amount of the reduction at BKLM393000 Loss absorbing instruments issued by overseas subsidiaries: amount of reduction.

Background on banks’ loss absorbing capacity

Banking entities are required to hold a certain amount of regulatory capital by Basel III. The function of regulatory capital is to be available to be called upon when an entity is in financial difficulties. This allows the entity to remain in business thereby protecting customers’ interests and avoiding disruption to the economy. It acts like a buffer, absorbing losses and preventing the capital position becoming depleted to critical levels.

Basel III includes a requirement that global systemically important banks (G-SIBs) must allow all regulatory capital instruments and certain types of debt liabilities to be written off or converted to equity if a bank is judged to be non-viable. The aim is to move the responsibility for ‘bailing out’ a bank deemed ‘too big to fail’ from government and taxpayers to shareholders and creditors.

The Financial Stability Board issued its total loss absorbing capacity (TLAC) standard for G-SIBs in 2015 and this was brought into EU law via the EU Bank Recovery & Resolution Directive (BRRD). Under the BRRD, resolution authorities were given the power to direct all banks, building societies and certain investment firms to comply with a minimum requirement for own funds and eligible liabilities (MREL). This was adopted in the UK in an amendment to the Banking Act 2009 and through the introduction of the Bank Recovery and Resolution (No.2) Order 2014. The resolution authority for UK banks is the Bank of England. The Bank of England published a Statement of Policy in June 2018 setting out its approach to setting a minimum requirement for own funds and eligible liabilities. This included criteria relating to subordination, the holders of such instruments, contractual triggers and mismatching of internal and external MREL.

The MREL rules for UK G-SIBs were imposed by the UK’s implementation of the EU Capital Requirements Regulation (EU CRR). Article 92a of the EU CRR sets out the minimum requirements for own funds and eligible liabilities for G-SIBs. The EU CRR became retained EU law (under s3 of the European Union (Withdrawal) Act 2018 (“EU(W)A 2018”) and so formed part of domestic UK law from the end of the implementation period. It was amended by various statutory instruments, and from 1 January 2021, the EU CRR as amended became part of UK domestic law (UK CRR). The references to the CRR in the legislation follows UK CRR as it is amended by UK law from time to time (EU(W)A 2018, Sch 8, para 1).

Accordingly, with effect from 1 January 2021, a UK bank which is a G-SIB will need to comply with the own funds and eligible liabilities requirements under Article 92a.

TLAC sets a global standard for G-SIBs and describes a minimum requirement. In the UK, MREL rules apply to all banks, building societies and large investment firms, and their requirements provide the framework for resolution planning for these institutions.

These standards involve the identification of one or more resolution entities within a group, to which resolution powers will be applied in the event of bank failure. A resolution entity issues external loss absorbing instruments, which help ensure that when a bank fails, its own financial resources can be used to absorb losses and recapitalise the business. This allows the bank to continue to provide critical functions without relying on public funds.

Other legal entities in the group issue internal loss absorbing instruments. These internal instruments are issued directly or indirectly to a resolution entity and are designed to be written down or converted to equity to recapitalise the issuer. The effect is that losses are passed up within the group to a resolution entity.

The loss absorbing capacity of the group as a whole is thus supported by external loss absorbing instruments issued by one or more resolution entities, with losses passed to them by other entities in the group through internal loss absorbing instruments.

There are additional own funds requirements that apply to banks under Article 92 of CRR. Own funds instruments also count towards satisfying MREL requirements where such requirements are imposed, as there is a significant degree of overlap between MREL and such own funds instruments, which represent the highest categories of loss absorbing capital for regulatory purposes.

Precise eligibility criteria for loss absorbing instruments may vary between jurisdictions. However, broadly, these instruments consist of:

  • Tier 1 capital: shareholder funds such as ordinary share capital, certain types of reserves, and Additional Tier 1 instruments;
  • Tier 2 capital: subordinated debt; and
  • Eligible liabilities.