Stockholm (NordSIP) – This week, NordSIP covered the launch of Nordea‘s new set of bonds tied to its Sustainability-linked loan portfolio. The transaction was interesting for its unusual structure. These days, one hears the words “sustainability-linked” and “bonds” seems to be the logical conclusion when considering bond markets.
The result of this malfunctioning predictive syntactic shortcut left me confused. Upon coming across the information on Nordea’s transaction, I was immediately struck by the complete absence of information on the terms of the sustainability-linked bond (SLB). Of course this was inevitable. There was no SLB to speak of in this transaction, as I soon became aware of by reading Nordea’s transaction details and having Maria Caneman, Head of Debt Investor Relations (IR) and Ratings at Nordea, generously, politely and patiently confirm them for me.
Upon understanding the transaction, I was left with another question: Why do such a transaction when Nordea could simply have issued a SLB? As it turns out, there are two answers to this question.
Leveraging Non-“Green” Transition Loan Portfolio
The first reason is that this bond accomplishes something that a SLB would not necessarily accomplish. What distinguishes SLBs from green bonds is not the fact that the funds borrowed through the bond are supposedly ring-fenced for sustainability-linked activities as is the case with green bonds for example, but rather that the terms of the SLB contract include step ups and step downs conditional on the achievement of some pre-agreed sustainability goal.
SLBs are linked to sustainability targets of the issuer and the achievement of improvement on some sustainability relevant key performance indicator (KPI). To simplify a complex contract, if the targets are achieved, the SLB may redeem at par or at a discount, while missing the target will cause the SLB to redeem at a premium. However, the goal here was not to create a commitment device for Nordea to meet its own sustainability targets. The goal was to give investors some exposure to Nordea’s porfolio of SLLs.
“As the largest financial services group in the Nordic region, we are well positioned to support our customers in the transition to net zero. While the SLL Funding framework is not ‘green’ per se, it is designed to cater for the transition assets not included in Nordea’s green bond asset portfolio, but that still have a strong alignment to ambitious sustainability goals,” Nordea argued on the occasion of the bond issuance.
“Green bonds and the use-of-proceeds structure focus on what you do with the money now. Sustainability-linked loan structures, which set targets into the future, are about transitioning,” says Jacob Michaelsen, Head of Nordea Sustainable Finance Advisory, on this occasion. “With this bond, we’re giving investors an opportunity to confirm that they’re actively supporting the companies in their transition,” Michaelsen adds.
Given this goal, it can be argued that a SLB wasn’t necessarily the most adequate structure, thus explaining why it wasn’t used.
Minimum Requirements and Eligible Liabilities
However, in principle, Nordea could have actually issued a SLB against its own sustainability goals where the coupon would step up if the target were missed. It was in this spirit that I inquired with Nordea’s Caneman why the bank had not simply issued a SLB. The answer was very interesting. “Sustainability-linked bonds are a bit problematic to banks, at least at the moment. The EBA has expressed concern regarding bonds linked to sustainability targets with a step up coupon. If targets are missed, it could be seen as an incentive to redeem and hence contradicting the eligibility criteria for own funds and eligible liabilities,” Caneman explains.
The issue of “eligibility criteria for own funds and eligible liabilities” refers to broader considerations regarding the minimum requirement set by resolution authorities that applies to a financial institution alongside its prudential minimum capital requirements.
What’s Going On?
Should a bank come into difficulties, by virtue of some market dynamic that causes it to be on the verge of declaring bankruptcy, two approaches to resolving such crises are available. In “bail-outs” governments or businesses buy (some part of) the bank and inject capital and liquidity into it. In “bail-ins”, debts owed to creditors and depositors are renegotiated on better terms to the bank, including their complete cancellation.
As the World Bank reviewed in 2016, bail-ins became particularly relevant in the Euro-zone in the aftermath of the sub-prime debt crisis of 2007-2009 and the increased burdens created by bail-outs on the bloc’s governments’ own solvency. To attempt to address this failure, the EU adopted the EU’s Bank Recovery and Resolution Directive (BRRD) which came into effect in 2015.
According to the EU’s Single Resolution Board (SRB), the BRRD provides that institutions established in the Union should meet a minimum requirement for own funds and eligible liabilities (‘MREL’) to ensure an effective and credible application of the bail-in tool. The World Bank notes, “a key element of the [BRRD] is the bail-in tool, requiring banks to recapitalize and absorb losses from within, which was made mandatory as of January 1, 2016.”
“The minimum requirement for own funds and eligible liabilities (MREL) is set by resolution authorities to ensure that a bank maintains at all times sufficient eligible instruments to facilitate the implementation of the preferred resolution strategy,” according to the SRB. “MREL serves to prevent a bank’s resolution from depending on the provision of public financial support, and so helps to ensure that shareholders and creditors contribute to loss absorption and recapitalisation,” the SRB adds.
The point that Nordea’s Caneman made was that the European Banking Authority (EBA) expressed a concern in 2021 that the possibility that a bank may miss its SLB targets could create an incentive for it to redeem the SLBs early. In that case, the SLBs would no longer be a liability on the balance sheet and thus pertinent for any bail-in. The incentive underlying such a decision is enough as to challenge the validity of including SLBs as part of the provisions under MREL.
No SLBs From Banks?
For all their financial value, SLBs may not be regulatorily very efficient for banks. They would sit on the balance sheet but may potentially not be useful for MREL pruposes. A traditional bond such as the one that Nordea issued, on the other hand, would not face such constraints.
In light of these dynamics, one is left but to wonder: Does this mean we won’t be seeing EU banks issue SLBs any time soon? It certainly would make sense.