The Capital Market Effects of the Minimum Requirement for Own Funds and Eligible Liabilities

Jacob Hvidberg Jensen & Christian Skovsgaard

Student thesis: Master thesis

Abstract

In this thesis, we examine the capital market effects of the new minimum requirements for own funds and eligible liabilities (MREL). Specifically, we investigate the
pricing of the new liability class that banks can use to comply with the MREL.
The MREL was introduced by the European Union under the Bank Recovery and
Resolution Directive to ensure that financial institutions have sufficient funds available for bail-in if they should end up in resolution and have to be recapitalized.
This should guarantee that losses of a failing bank are borne by shareholders and
creditors instead of taxpayers. For banks to comply with these requirements, a new
liability class has emerged: the Tier 3 bond. We investigate how these instruments
should be valued relative to banks’ other well-known instruments, and how the
uncertainty related to bank capital and regulation affects prices.
To do this, we develop a model to value bank debt instruments. The key distinguishing feature of our model is that it incorporates the cash flow waterfall of a
bank into a simple and intuitive framework that is able to capture some of the
complexities of bank capital regulation, such as the MREL, discretionary coupon
payments, mandatory payout restrictions, and conversion of contingent capital.
In our waterfall model, the return of the bank’s assets follows a jump-diffusion
process. This incorporates a realistic feature of bank asset returns: namely, that
they sometimes experience sudden, discrete jumps, for example during a financial
crisis. The cash flow waterfall approach is found to be useful in a valuation setting
for banks because it clearly defines the priority of payments according to the
tranche hierarchy. This results in a model that can be used to make quantitative
and qualitative predictions about the price mechanisms of bank bonds.
We apply our model to numerically analyze how certain factors affect credit
spreads, and investigate how the Tier 3 instruments should be valued relative to
the senior and Tier 2 bonds. An important finding is that certain parameters have
a significant effect on the absolute credit spreads, but not on the relative spreads
between Tier 2 and Tier 3; these are the volatility of assets and the initial CET1
ratio. On the other hand, we find that parameters such as the costs of the resolution
process, the location of the point of non-viability, and the balance sheet composition
have a large impact on the relative spreads between the bank’s bonds.
The considerable sensitivity of credit spreads to the volatility of assets, the costs of
resolution, and the point of non-viability in particular, which are not directly observable in the market, presents significant challenges for investors to accurately assess the prices and risks of the new instruments. An important contribution of
this thesis is therefore that we develop a tool to quantify these uncertainties.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2017
Number of pages141
SupervisorsDavid Lando