Since then, supervisors and regulators have been working at the international level to find a solution to the problem posed by institutions that are "too big to fail". Essentially, the goal is to ensure that such institutions can also be wound up in an emergency, without unsettling the market.

Several important steps forward were made in this regard in November. First, the Financial Stability Board published a proposal stating that global systemically important institutions should be obliged to have sufficient resources available for resolution, should it become necessary. In addition, the 18 largest global systemically important banks have committed themselves to recognising certain orders by foreign authorities for cross-border resolution and to temporarily waiving their termination rights for derivatives in the event of difficulties.

Sufficient loss-absorbing capacity

Basel III increased banks' capital requirements to ensure that they are able to absorb any unexpected losses incurred by a going concern. In the event of resolution, however, these resources are depleted. But that is exactly when capital is urgently needed in order to cover all of the losses and to recapitalise the bank, at least temporarily, so that resolution can be carried out successfully. Where do these resources come from?

In September 2013 the Financial Stability Board raised this as an essential issue in its report on the "too big to fail" dilemma. In order to ensure effective resolution and manage systemic risk, institutions must have sufficient loss-absorbing capacity.

In November 2014 the Financial Stability Board issued a proposal for consultation. It contains principles, and requirements derived from those principles, which are to apply to global systemically important banks.

Liabilities and own funds

The Financial Stability Board wishes to make it obligatory for global systemically important banks to hold a minimum amount of own funds or liabilities which, in case of an institution's failure, can be written down or converted into equity (GLAC). This is to ensure that losses that are not covered by the Basel III minimum capital requirement can be absorbed and that the institution can be recapitalised in order for resolution to be implemented in an orderly manner. The GLAC requirement prescribes certain qualitative criteria alongside the minimum amount. These criteria aim to ensure that the conversion can be done quickly and without posing any risks to financial stability.

According to the Financial Stability Board, the Basel III capital requirements and the GLAC requirement should be combined into a single minimum requirement (TLAC). The reference value for the requirement is the risk-weighted assets (RWA) or total liabilities for calculating the leverage ratio under Basel III, depending on which gives the highest result. A single ratio would harmonise the Basel III and GLAC requirements and ensure that the functioning of the capital buffers is not impaired.

GLAC and TLAC

Minimum requirement

The Financial Stability Board proposes a minimum TLAC requirement of 16% to 20% of risk-weighted assets and double the leverage ratio, which under current plans therefore makes 6% (see chart). Both requirements would have to be met in parallel. The RWA-based TLAC requirement is made up of the Basel III minimum capital requirement of 8% (after full implementation) and a further 8% to 12%, which under the GLAC proposal is to be met with suitable debt capital or surplus own funds. The TLAC requirement based on the leverage ratio corresponds to 3% of own funds as required under the Basel III leverage ratio and a further 3% of eligible debt capital and additional own funds.

The capital buffers of Common Equity Tier 1 capital introduced by Basel III must also be maintained. These capital buffers should be drawn on first to offset losses, before the capital held under the Basel III minimum capital requirement and the TLAC requirement. If an institution does not have enough liabilities or own funds to meet the TLAC requirement, the capital buffers would be drawn down to the extent necessary to cover the difference. The TLAC allocation would therefore only be eaten into once the capital buffers have been fully depleted. The sanction regime for violation of capital buffers would already come into effect before a TLAC violation: the institution would no longer be able to distribute capital and would have to draw up a capital maintenance plan.

The final level of the minimum requirement will be set at the end of 2015. The decision will be made based on the results of a comprehensive impact study to be conducted next year by the FSB together with the Basel Committee on Banking Supervision and the Bank for International Settlements. The competent authorities also have the power to set further requirements on individual institutions beyond the minimum requirement.

Chart: Total Loss-Absorbing Capacity (TLAC)

Total Loss-Absorbing Capacity (TLAC)

BaFin

Suitable debt capital

The purpose of the TLAC requirement is to have a minimum of capital instruments available in the event of resolution which can be converted or written down without any legal or practical difficulties, ensuring the speedy recapitalisation of the institution in question. Not all liabilities are eligible to count towards the TLAC requirement. For example, covered deposits, secured liabilities, derivatives and operating liabilities, particularly those which have not been contractually agreed, cannot be included.

In addition, the liabilities must have a residual maturity of at least one year. Moreover, liabilities eligible for the TLAC requirement, such as unsecured loans or large deposits, must be subordinate to ineligible liabilities. This is intended to ensure that the principle of equal treatment under insolvency law (pari passu principle) is honoured, as failure to do so could lead to compensation claims.

Resolution strategy

Within a group of institutions, the TLAC requirement must be implemented and maintained by the companies to which, according to resolution planning, resolution measures would be applied in the event of failure (resolution entity). This could be one or several companies; often it is the parent company of a group of institutions. The TLAC requirement is therefore neutral as far as the chosen resolution strategy is concerned.

Nevertheless, some of the resources must be passed on internally to significant foreign subsidiaries. If a subsidiary gets into difficulty, liabilities to the parent company can be converted or written down and used for recapitalisation in accordance with contractual arrangements, thereby avoiding the need to apply resolution measures. Resolution measures are thus carried out exclusively at the level of the resolution entity. This internal TLAC concept seeks to ensure that losses incurred by significant foreign subsidiaries can be transferred to the resolution entity without the subsidiaries themselves having to be wound down. The aim is to reassure the host country authorities that the subsidiary would not be left alone in case of distress. This should reduce the incentive for ring-fencing, i.e. resolution and preparatory measures that deviate from the agreed resolution strategy.

Investors

Owing to the risk of contagion, it would be counterproductive if global systemically important banks overly invest in TLAC instruments. Therefore, banks that invest in other banks' TLAC instruments must deduct these amounts from their own TLAC calculation. The detailed rules on deductions are likely to be based on the Basel III rules for regulatory capital.

You can read more on this topic in an interview with BaFin's President, Dr Elke König (only available in German). She outlines some important aspects of the Financial Stability Board's proposal and explains why, in her view, such a regulation is necessary.

Tackling legal barriers

In addition to financial issues, the debate on cross-border resolution of global systemically important financial institutions is also focused on how to overcome the legal barriers still in existence. In its peer review last year, the Financial Stability Board came to the conclusion that national resolution authorities do not yet have sufficient powers. In particular, they are not able to fully recognise measures taken by foreign resolution authorities, if at all, nor can they implement them effectively.

This is why many national rulebooks on resolution do not yet fully meet the requirements set out in the Financial Stability Board's Key Attributes of Effective Resolution Regimes. Most will be subject to a time-consuming recognition process in the national courts. As well as the question of equal treatment of domestic creditors, underlying national values also play a role.

Treatment of derivatives

An important step forward on the road to overcoming these obstacles was taken in mid-November: the 18 largest global systemically important banks signed a supplementary protocol to the International Swaps and Derivatives Association (ISDA) Master Agreement, which significantly simplifies the treatment of derivatives in the event of resolution.

Under this protocol, the institutions have voluntarily committed themselves to complying with stays on early termination rights implemented by foreign resolution authorities for over-the-counter derivatives that fall under the Master Agreement. In addition, they will temporarily waive their right to immediately terminate financial futures contracts in the event of a parent company or another affiliated company of a counterparty becoming subject to US insolvency proceedings (cross-default clause).

ISDA Master Agreement

Temporary stay of termination rights

If, with the start of resolution proceedings by a resolution authority, this early termination right were automatically triggered, it would lead to the maturity and offsetting of all positions with that institution at market values (close out). For an institution in resolution, the amount of net liabilities that then become immediately payable can be substantial. This can hinder the resolution process given that after ordering resolution proceedings, the resolution authority would be immediately confronted with hefty payment demands arising from a terminated financial futures portfolio.

The voluntary signatories to the protocol, however, have now agreed to the resolution authority being able to temporarily suspend early termination rights. This will allow the resolution authority to implement resolution proceedings in an orderly manner. Legally, the mutual cross-border recognition of such stay orders operates with the parties to the protocol acting, purely as regards these measures, as though the regulations agreed in the Master Agreement were that of the resolution regime to which the institution in resolution is subject (opt in).

Expansion of the scope of application

The national supervisory authorities have announced their intention to expand the protocol's scope of application to additional financial market participants by means of accompanying regulatory measures. The aim is to achieve broad market coverage and the highest level of harmonisation possible, as well as to prevent migration effects and the fragmentation of contracts currently on the market.

BaFin intends to adjust its administrative practices so that, at least for systemically important institutions, resolution is impeded if, due to the contractual design of derivatives contracts, the effectiveness of the resolution authority's stay orders is not guaranteed. This is the case for cross-border contracts, for example, which are not subject to German law owing to choice-of-law agreements or where one of the parties does not expressly recognise the temporary stay of termination rights ordered by the counterparty's national resolution authority. In order to remove this impediment to resolution, the ISDA protocol stipulates that, in future, cross-border derivatives contracts must contain a contractual recognition clause.

Supervisors of the 18 largest global systemically important banks want to have reached an agreement by the end of 2014 as to what scope the accompanying regulatory measures for institutions and contracts should have. In the course of next year, consultations will take place within the Financial Stability Board and with the industry. The new regulatory measures are expected to be implemented by the end of 2015.