Background
In 2015 the Financial Stability Board (FSB) issued the Principles on Loss-absorbing and Recapitalization Capacity of Global Systemically Important Banks (G-SIBs) in Resolution setting out the total loss-absorbing capacity (TLAC) standard. The TLAC standard “requires G-SIBs to have financial instruments available during resolution to absorb losses and enable them to be recapitalised to continue performing their critical functions while the resolution process is ongoing”. The objective of the FSB standard is that in the event of bank failure there is an orderly resolution by making equity and debt holders absorb losses, thus enabling a “bail-in”, instead of using taxpayers’ funds. Thus, these bank loss-absorbing instruments are financial instruments designed to absorb losses in times of financial distress, such as insolvency or severe financial difficulty. They are part of regulatory frameworks intended to prevent taxpayer-funded bailouts and are intended to promote the stability of the financial system. Established by the FSB, TLAC requires G-SIBs to hold a minimum level of loss-absorbing instruments to ensure they can be recapitalized in the event of failure. The Minimum Requirement for Own Funds and Eligible Liabilities (MREL), a European Union framework similar to TLAC but applicable to all banks in the Union, mandates banks to maintain sufficient loss-absorbing capital.
Types of Loss-Absorbing Instruments
In addition to TLAC, there are other types of loss-absorbing instruments that banks use to ensure that they can handle financial distress internally, without resorting to government bailouts, while maintaining the overall stability of the financial system. These include the following:
- Common Equity Tier 1 (CET1) Capital: This is the highest quality of capital held by a bank, consisting primarily of common shares and retained earnings. This is the first buffer to absorb losses which in times of distress, can be written down or diluted to cover losses.
- Additional Tier 1 (AT1) Capital: These are instruments that are perpetual bonds or other securities that have no fixed maturity date and can be converted into equity or written down in a crisis. AT1 capital can absorb losses once the CET1 buffer is exhausted.
- Tier 2 Capital: These are instruments which are subordinated debt that ranks below other types of debt but above equity. These are also used to absorb losses after CET1 and AT1 are depleted.
- Bail-in Debt: This refers to senior unsecured debt that can be “bailed-in” or forcibly converted into equity to recapitalize a failing bank. Bail-in mechanisms are part of the resolution process, where certain debt holders bear the cost of bank failures instead of relying on taxpayer funds.
- Contingent Convertible Bonds: These are bonds that automatically convert into equity or have their principal written down when a bank’s capital falls below a predefined threshold. These are designed to absorb losses in times of stress before a bank reaches insolvency, acting as an automatic stabilizer.
Introduction of Financial Loss Absorbing Capacity (FLAC) Instruments in South Africa
The Financial Sector Regulation Act, 2017 as amended by the Financial Sector Laws Amendment Act, 2021 (Act No. 23 of 2021) defines FLAC instruments in section 1 of the amended Act in the context of South Africa. In essence, FLAC instruments which are the South African version of the FSB TLAC instruments are unsecured debt instruments that must be issued by the holding company of banks that have been designated as systemically important financial institutions (SIFIs). Six banks have been identified by the South African Reserve Bank (SARB) as SIFIs. These are ABSA, CAPITEC, FirstRand, INVESTEC, NEDBANK, and Standard Bank. In December 2023 the Prudential Authority published the Draft FLAC Standard entitled – FLAC Instruments Requirements for Designated Institutions. It set out the qualifying criteria for a new financial loss absorbing capacity instrument – FLAC instrument – which designated SIFIs which need to hold for implementing an open-bank resolution strategy as well as the proposed quantum of FLAC instruments and other eligible instruments which the designated SIFIs will need to build to ensure sufficient loss absorption and recapitalization capacity under financial stress.
From January 2025 SIFIs are required by the SARB to start issuing FLAC instruments. The SARB estimates that the top six designated banks should have raised up to 360 billion rand of these instruments by 2030. These instruments are designed to enable orderly resolution of struggling banks, these instruments can convert to equity in a “bail-in” scenario, and thus avoiding use of taxpayer funds. Rating agencies view the introduction of FLAC instruments as positive.
Bail-in is one of the stabilization tools the SARB as resolution authority utilizes under Chapter 12A of the Financial Sector Regulation Act to ensure that investors, rather than public funds bear losses incurred by the six largest designated South African banks. It allows the SARB to impose losses on shareholders and to write down and/or convert liabilities, other than protected liabilities, into equity, so that the struggling bank can be recapitalized and continue operations during the resolution and exit the resolution as a viable entity. The recapitalization through bail-in is designed to restore the designated institution’s capital to levels where it meets the prescribed regulatory capital requirements and be able to maintain its licence to continue operations.
A Comparison of South African FLAC and EU MREL Frameworks
Both frameworks are designed to enhance financial stability by insuring that banks can absorb losses and continue critical functions during financial distress without the need for taxpayer-funded bailouts. However, there are three key differences between the two frameworks, viz:
- Regulatory framework: FLAC is specific for the South African financial stability of its financial system, whereas MREL is a component of the broader EU Banking Package.
- Scope and Application: FLAC focuses on six major South African banks whereas MREL covers a wide range of EU banks.
- Implementation: FLAC requirements are managed by the SARB’s Prudential Authority while MREL requirements are set and managed by EU resolution authorities.
Challenges
The South African FLAC framework faces several challenges that must be tackled to improve its effectiveness. Firstly, enhancing market perception and acceptance of FLAC instruments is crucial, as limited market confidence can negatively impact their pricing and liquidity. Secondly, concerns persist regarding the precise valuation of bank assets during a resolution, which could compromise the FLAC instruments’ ability to effectively absorb losses. Lastly, ensuring the South African Reserve Bank (SARB) can maintain the continuity of operations and access to financial market infrastructure for a distressed institution during the resolution process remains a significant challenge.
Conclusion
FLAC and TLAC instruments are essential for ensuring that globally systemic banks (G-SIBs) maintain sufficient capital and debt to absorb losses and recapitalize during periods of financial stress, thus preventing taxpayer-funded bailouts. The 2007-2008 Global Financial Crisis highlighted the significant risks posed by non-banks, including shadow banks, investment funds, and other unregulated financial intermediaries, which exacerbated the crisis. However, these non-bank entities remain outside the regulatory scope of TLAC and FLAC instruments. To bolster financial stability comprehensively, it is imperative to develop an expanded regulatory framework that encompasses both banks and non-bank financial entities. This inclusive approach would mitigate systemic risks across the entire financial sector and enhance the resilience of the global financial system.
