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Summary of Proposal for a Common EU Definition of Tier 1 Hybrids

Core Content

This document outlines a proposal by the Committee of European Banking Supervisors (CEBS) to develop a common EU definition of Tier 1 hybrid instruments. The goal is to ensure a consistent interpretation and implementation of eligibility criteria across the European Economic Area (EEA), without compromising the quality of regulatory capital. The proposal is based on the Sydney Press Release (SPR) issued by the Basel Committee in 1998 and aims to align with the prudential objective of improving capital quality.

Main Objectives

• To provide a common and clear EU-wide interpretation of eligibility criteria for Tier 1 hybrid instruments.
• To ensure that hybrid instruments meet the key economic features of permanence, loss absorbency, and flexibility of payments.
• To address the lack of EU legislation on hybrid instruments and promote convergence among regulatory approaches.
• To limit the impact on financial markets by considering grandfathering for existing instruments.

Key Terminology

• Regulatory Own Funds: Composed of two main layers: original own funds (highest quality and permanence) and additional own funds (lower quality and may be less permanent).
• Hybrid Instruments: Eligible Tier 1 capital instruments that may have features of both debt and equity. They are categorized as:
  • Innovative instruments (e.g., with step-ups or redemption incentives)
  • Non-innovative instruments
  • Non-cumulative perpetual preference shares, which some members treat as core Tier 1 capital.
• Tier 1 Capital: The highest quality capital that can absorb losses and support the institution's ongoing operations.

Key Economic Features

1. Issued and Fully Paid-Up

• The instrument must be issued and fully paid-up; outstanding amounts are not eligible.
• Proceeds must be immediately available to the institution or convertible into a direct issuance at a predetermined trigger point.

2. Publicly Disclosed and Easily Understood

• Main features, including grandfathering status, must be periodically and publicly disclosed.
• The instrument must be non-cumulative and allow for the suspension of payments.

3. Loss Absorption in Liquidation

• Must rank junior to depositors, general creditors, and subordinated debt.
• Cannot be secured or guaranteed by the issuer or related entities.
• Must not be taken into account for determining insolvency.

4. Loss Absorption in Going Concern

• Must help prevent insolvency by allowing the issuer to cancel payments when necessary.
• Should include mechanisms such as write-downs or conversion into equity to support recapitalization.
• Loss absorption is crucial in stress situations to ensure the institution can continue operations.

5. Permanence

• Instruments must be undated unless callable with supervisory approval.
• Callable hybrids must be replaced with instruments of the same or better quality.
• Call options may be permitted after 5 or 10 years depending on incentives.
• Only one rate step-up is allowed over the life of the instrument, with a cap on conversion ratios.

6. Flexibility of Payment

• Instruments must be non-cumulative, with no obligation to pay unpaid coupons or dividends.
• The issuer must have full discretion over payment amounts and timing.
• Payments can be waived in case of capital breaches or financial stress.

Quantitative Limits for Inclusion in Tier 1 Capital

CEBS proposes two options for the limits of hybrid instruments in Tier 1 capital:

Option 1

• Tier 1 hybrids may not exceed 30% of the required Tier 1 capital at any time.
• If a bank operates above its minimum required Tier 1 capital, hybrids may represent up to 50% of Tier 1 capital after specific deductions.

Option 2

• Innovative instruments (e.g., with conversion or write-down features) must not exceed 15% of Tier 1 capital.
• Instruments with equity-like features (e.g., mandatory conversion or write-down) must not exceed 50% of Tier 1 capital.
• Non-innovative instruments must not exceed 25% of Tier 1 capital.

Grandfathering

• Existing instruments that no longer qualify under the new definition will be gradually phased out over a 30-year period.
• Any redemption of grandfathered instruments must be initiated by the issuer and subject to supervisory approval.

Methodology and Scope

• The proposal is based on the SPR guidelines and the characteristics of eligible hybrids across the EEA.
• CEBS conducted public hearings and bilateral meetings to gather input from market participants.
• The draft was consulted publicly, and feedback was incorporated where appropriate.
• The scope includes all hybrid instruments, regardless of category or issuance form, and applies to all institutions under the Capital Requirements Directive (CRD).

Key Principles

• Substance over form: The economic characteristics of the instrument must reflect its actual risk transfer to the market.
• Pragmatic approach: CEBS aims to build on existing market knowledge and experience, especially since 1998.
• Respect for capital structure: Hybrid instruments must be subordinate to ordinary shares, with ordinary shareholders absorbing losses first.
• Regulatory consistency: The rules should not be more onerous than those for ordinary shares.

Conclusion

The proposal aims to harmonize the treatment of hybrid instruments across the EU while maintaining the quality and stability of regulatory capital. It emphasizes the importance of loss absorbency, permanence, and payment flexibility, and suggests a pragmatic and structured approach to defining and regulating Tier 1 hybrids. The two quantitative limit options provide flexibility to supervisors, with grandfathering mechanisms to ensure a smooth transition for existing instruments.