While MREL (minimum requirement for own funds and eligible liabilities) bonds provide liquidity benefits, they also have the potential to amplify financial shocks during a crisis, economists Ashley Andrews, Thiago Fauvrelle and Giulia Fusi noted in a blog post by the European Stability Mechanism on Thursday 19 December 2024. They argued that the increasing interconnectedness of the non-bank financial sector with the broader financial system has become a significant concern for policymakers, particularly regarding the holdings of loss-absorbing bonds issued by banks.

MREL issuances

The banking regulation changes that followed the global financial crisis and the euro area debt crisis led to significant reforms in how banks manage financial distress. Specifically, the introduction of MREL was aimed at ensuring that banks could be resolved without the need for public bailouts, requiring debt and equity holders to absorb losses in the event of a bank failure. To meet MREL requirements, banks have increasingly issued loss-absorbing bonds--commonly known as MREL bonds--which have proven attractive to investors, particularly in periods of low interest rates, due to their higher returns compared to other types of bank debt.

Between 2017 and 2023, euro area banks issued a total of €2.88trn in bank debt, of which nearly €1.1trn was in MREL bonds. By the end of 2023, all euro area banks had met their , ensuring that there would be sufficient eligible instruments in place to carry out their resolution strategies in times of financial distress.

Investment funds, which have become key players in the market for MREL bonds, held approximately €221bn in such instruments by the end of 2023. The United States and the euro area are the two largest jurisdictions exposed to these bonds, with the US accounting for 12% of total exposure, while euro area funds accounted for 69%. Luxembourg-domiciled funds recorded the highest share, at 29.8%.

The high demand for these instruments has helped enhance market liquidity and reduce funding costs for banks, which benefits the financial system at large.

Risks

However, despite the advantages, the substantial role of investment funds in the MREL market also introduces potential risks. One of the primary concerns is the concentration of MREL holdings within certain funds, which could exacerbate financial instability in the event of a crisis, emphasised the ESM economists. These funds’ significant exposure to MREL instruments means that any shock to the banking system could lead to a rapid and widespread sell-off of these bonds, amplifying the distress and causing market dislocations.

Credit Suisse

A notable example of this risk was the Credit Suisse crisis in March 2023, when CHF 16.5bn in additional tier 1 bonds were written off during the bank’s with UBS. This event led to a temporary freeze in the market for AT1 bonds, highlighting the vulnerability of these instruments during periods of financial stress. A similar outcome could occur if a major euro area bank were to fail, as investment funds with large holdings of MREL bonds may attempt to pre-emptively sell off these assets to avoid further losses. Such behaviour could set off a chain reaction, with other funds following suit, thereby spreading the financial contagion across the broader banking sector.

The contagion effect could extend beyond MREL bonds themselves, warns the authors. Investment funds heavily exposed to these bonds may face large-scale redemption requests in the event of a banking crisis. This would force funds to liquidate other assets within their portfolios, potentially creating further instability in markets not initially affected by the crisis.

Contagion risks

The concentration of MREL bonds in the portfolios of certain investment funds raises significant concerns about the resilience of the financial system. Euro area investment funds, in particular, hold a larger proportion of their portfolios in MREL bonds than their non-euro area counterparts. This concentration could lead to coordinated selling in times of crisis, causing severe price volatility and potentially overwhelming market liquidity.

The situation is further compounded by the presence of large institutional players in the market. Investment funds with over 20% of their portfolios invested in MREL bonds, particularly those with assets under management exceeding €1bn, could exert outsized influence on the market, especially if they attempt to liquidate their positions en masse.

The ESM economists agree that the growing concentration of MREL holdings in these funds underscores the need for enhanced monitoring of individual fund exposures, especially during periods of heightened market stress. The synchronisation of investment strategies among funds with significant MREL positions could trigger a vicious cycle, where the actions of a few large players lead to a broader market crisis.

Policy implications

In light of these risks, the blog calls for increased attention to the risk management practices of investment funds holding significant concentrations of MREL bonds. Funds with large positions in these instruments should adopt enhanced risk management strategies to account for the unique characteristics of MREL debt, especially its potential to absorb losses in the event of a bank resolution. Regular stress testing, incorporating the correlation between market stress and potential trigger events for MREL bonds, could help mitigate the risks associated with concentrated exposure.

Moreover, investment funds with substantial holdings in MREL bonds may require more robust liquidity management tools to avoid panic-driven asset sales during periods of financial stress. While some progress has been made in implementing these tools, further work is needed to ensure they are fully integrated into the risk management frameworks of funds, said the three experts.

The blog also advocates for improved transparency in the MREL bonds market, especially given the global nature of the market and the diverse range of investors involved. Currently, the securities holdings statistics by sector data available to European authorities only allows them to identify MREL holders within the euro area. Expanding this framework to include cross-border data would enhance regulatory oversight and help prevent the risks associated with concentrated exposures.

The ESM, based in Kirchberg, is the financial backstop for euro area governments.