FI Analysis No. 39: Are the capital buffers fulfilling their purpose?

The minimum requirement for own funds and eligible liabilities (MREL) is designed in such a way that the banks can breach it before they breach the capital requirements. As a result, this can reduce the usability of the capital buffers. This is shown in FI’s analysis of how the capital buffers are impacted when a bank must meet both MREL and the capital requirements.

A bank must hold sufficient capital to cover the risks to which it is exposed. Banks are therefore subject to capital requirements, which include both minimum requirements and buffer requirements. The capital buffers are intended to function as loss absorbers and protect the bank from breaching the minimum capital requirement if it is subject to losses. The buffers also give the bank the opportunity and time to take measures to restore their capital.

Systemically important banks must also fulfil MREL, which aims to ensure that the private sector can carry the costs of a failing bank. The purpose of MREL is that the bank must always have sufficient own funds and liabilities to be able to be dealt with in resolution. MREL is therefore a minimum requirement. A shared characteristic of all the requirements a bank must meet is that the requirements, either in full or in part, may be met using the same resources - the bank's own funds.

FI's analysis shows that the design of MREL entails that a bank can breach the resolution requirements before it breaches the capital requirements. The capital buffers' aim of acting as loss absorbers to avoid resolution is in such case subordinate since the bank instead must meet MREL. This means that the bank may be forced to reduce its activity and shrink its balance sheet and in the long run face the risk of becoming subject to dividend restrictions or an intervention even though it still meets its capital requirements.

However, the impact is not as significant for a bank that meets MREL with a larger share of liabilities. Liabilities, though, unlike common equity Tier 1 capital, need to be refinanced. The analysis shows that the risk that the bank will not be able to replace liabilities that fall due with new liabilities (so-called refinancing risks) can limit the usability of the buffers.