Bail-in and Protection of Retail Investors

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Bail-in and Protection of Retail Investors

Are retail investors effectively protected under MiFID II and BRRD II in an

event of bail-in?

Master’s Program in Law and Finance LL.M.

Name: Rafailia-Maria Gkilla

Student Number: 12306932

Supervisor: Edoardo Martino

Second Reader: Alessio M. Pacces

Submission date: 17 July 2019

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ABSTRACT

The purpose of this thesis is to analyse the impact of the post-crisis banking resolution framework on the protection of retail investors. During the global financial crisis, the lack of sufficient measures to prevent the failure of “too big to fail” financial institutions led to the extensive use of public funds in an effort to handle a potential “domino” effect. In the aftermath of the crisis, a revolutionary innovation, namely bail-in, gave a different perspective to the existed banking resolution mentality. Simply shareholders and creditors, rather than taxpayers, are the ones who contribute to the costs borne by the failure of a financial institution. However, the existence of 262.4 billion of bail-inable securities held by retail investors within the European Union challenges the application of the bail-in mechanism. Most importantly, the fact that many of those retail investors were not aware of the dangerous nature of the financial products they were buying call into question their protection. The mis-selling of the relevant products to retail investors by banks was a common practice due to the widespread impression that these securities are as safe as deposits. The violation of retail investors’ rights led to a political backlash, challenging the trust to the banking system and raising doubts as regards banks’ effective resolution in an hypothetical next financial meltdown. The regulatory response to this twofold problem (i.e. retail investors protection and effective resolution of financial institutions) arrived with MiFID II (2018) and BRRD II (2019) legislations. Nevertheless, due to their recent application and the shadow of past mis-selling scandals, the major question is whether this time retail investors are sufficiently protected in case of a bail-in scenario. The research aims to give an answer to this question through a joint study of MiFID II and BRRD II. In this direction, the thesis discusses the potential shortcomings of the new legal framework and provides suggestions for further improvement of retail investors’ protection regime. A silver line between retail clients protection and financial stability through the tackle of any impediment to banks’ resolvability is the ultimate goal of this contribution.

Keywords: Law & Finance; Bail-in; Retail Investors; Mis-selling; Financial Regulation; MiFID II;

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LIST OF ABBREVIATIONS

BRRD Bank Recovery and Resolution Directive

CJEU Court of Justice of the European Union

CoB Conduct of Business rules

CRD V Capital Requirements Directive V

CRR II Capital Requirements Regulation II

EBA European Banking Authority

EBU European Banking Union

ECB European Central Bank

EU European Union

ESMA European Securities and Markets Authority

DGSD Deposit Guarantee Scheme Directive

G-SIBs Global Systematically Important Banks

MiFID Markets in Financial Instruments Directive

MiFIR Markets in Financial Instruments Regulation

MREL Minimum Requirements for Own Funds and Eligible Liabilities

NCAs National Competent Authorities

SRB Single Resolution Board

SRF Single Resolution Fund

SRM Single Resolution Mechanism

SRMR Single Resolution Mechanism Regulation

SSM Single Supervisory Mechanism

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CHAPTER 1 – INTRODUCTION

The purpose of this thesis is to analyse the impact of the post-crisis banking resolution framework on the protection of retail investors. The global financial crisis (2008-2009) revealed that the lack of specific rules to address the failure of financial institutions can generate detrimental consequences.1 The threat of a financial meltdown led to the extensive use of public funds (i.e. bail-out) in order to save “too-big-to-fail” 2 financial institutions. In the aftermath of the crisis, significant steps have been taken by the European regulators to address the externalities born by collapsing banks.3 In this context, a major innovation of the banking resolution regime is the introduction of the “burden-sharing” principle by the Banking Communication on State Aid of 2013 (the “Banking Communication”)4. Building in this concept, the Banking Recovery and Resolution Directive (the “BRRD”) 5_implements

officially the bail-in tool. The idea of bail-in is simple and entails the transfer of costs from taxpayers to banks’ investors (i.e. shareholders and creditors).

The existence of 262.4 billion of retail holdings of bail-inable securities within the EU6_{implies the}

significant impact of the bail-in mechanism to retail investors.7_{The massive investment of retail}

investors into banks’ subordinated debt and the change of their risk profile to bail-inable debt after the implementation of the new banking resolution framework has huge implications for their life savings. The issue becomes even more urgent since many of those retail investors were not aware of the risky features of the products they invested in. A combination of retail investors’ limited knowledge and the production of a widespread impression by banks that these investments are as safe as deposits led to mis-selling scandals throughout Europe. The relevance of the problem is twofold, affecting both retail investors rights and banks’ effective resolvability. Regarding the latter, the impact on household

1_{For a general understanding of the reasons that regulation is required, I refer to Zingales, L. (2009). The future of securities}

regulation. Journal of Accounting Research, 47(2), 391-425.

2_{Stern, G. H., & Feldman, R. J. (2004). Too big to fail: The hazards of bank bailouts. Brookings Institution Press.} 3_{Wagner, W. (2009). In the quest of systemic externalities: A review of the literature. CESifo Economic Studies, 56(1),}

96-111 and Pacces, A. M. (2010). Consequences of uncertainty for regulation: Law and economics of the financial crisis.

European Company and Financial Law Review, 7(4), 479-511.

4_{European Commission. (2013). Communication from the Commission on the application of State aid rules to support}

measures in favor of banks in the context of the financial crisis.

5_{DIRECTIVE 2014/59/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 15 May 2014}

establishing a framework for the recovery and resolution of credit institutions and investment firms.

6_{European Banking Authority and European Securities and Markets Authority (2018). Statement on the treatment of}

retail holdings of debt financial instruments subject to the Bank Recovery and Resolution Directive.

7_{For more information regarding the composition of bail-inable security holders in EU countries, I refer to Martino, E.}

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6 investments challenges the trust to the whole banking system and increases the political reluctance to apply the bail-in mechanism.

The regulatory response to this problem arrived only lately with the enforcement of Markets in Financial Instruments Directive (the “MiFID II”)8 in 2018 and of BRRD II9 in 2019. While MiFID II focuses on the protection of retail investors, BRRD II targets on banks’ effective resolution through the introduction of restrictions on retail holdings of bail-inable securities. The recent application of the directives and the shadow of past mis-selling scandals call for an investigation of the new regulatory regime in order to detect whether this time retail investors are sufficiently protected in case of bail-in. The thesis aims to give an answer to this question through a joint study of MiFID II and BRRD II.10 To achieve this goal, a positive analysis will be followed in order to discover whether MiFID II and BRRD II protect retail investors whose interests are at stake in case of bail-in. The research will be executed from a Law & Finance perspective and the underlined economic rationale of the two legislations constitutes an indispensable part of their critique.

The thesis concludes that financial institutions should keep selling bail-inable securities to interested retail clients but regulatory reform is necessary to minimize banks’ incentives to proceed to opportunistic behaviours. For these purposes, MiFID II and BRRD II are clearly in the right direction. However, several shortcomings both in the field of existing and newly issued retail holding create doubts about the sufficient protection of retail clients in case of bail-in. The thesis underlines potential regulatory loopholes and provides recommendations for further improvement of the current framework. In a nutshell, the ultimate goal is the provision of a strong retail investors protection regime which empowers the faith to the baking system, enhancing banks’ resolvability.

This thesis is structured as follows. In Chapter 2 a presentation of the post-crisis banking resolution framework paves the way of the discussion. The introduction of the bail-in policy idea and a brief review of the biggest reform in Eurozone level, namely the Banking Union constitute the main part of the Chapter. As a step forward, the implications of bail-in specifically for retail investors (Chapter 3) are analysed indicating the need for their special protection. After discussing inefficient ways to protect

8_{DIRECTIVE 2014/65/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 15 May 2014 on}

markets in financial instruments.

9_{DIRECTIVE (EU) 2019/879 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 20 May 2019 as}

regards the loss-absorbing and recapitalisation capacity of credit institutions and investment firms and Directive 98/26/EC.

10_{To the best of my knowledge, due to the enforcement of BRRD II a month ago (27}th_{June 2019), the issue has not been}

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7 them, the regulatory response via MiFID II and BRRD II (Chapter 4) is examined in detailed. Chapter 5 builds on the previous ones evaluating the sufficiency of the new regime for the protection of retail investors through the discussion of potential shortcomings and suggestions for further improvement. Chapter 6 concludes.

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CHAPTER 2 - THE NEW LEGAL FRAMEWORK OF BANKING

RESOLUTION IN EUROPE

2.1 Policy idea of bail-in and the difference with bail-out

The biggest dilemma during the global financial crisis was the choice between saving large financial institutions with public funds (i.e. taxpayers’ money) or risking a systemic breakdown.11_{The treat of}

the last scenario led to the states’ rescue practice of “too-big-to-fail” financial institutions, followed by the failure of the sovereign and banking system. Against this background, a critical evaluation of the bail-out and the transition to the policy idea of bail-in took place.12 It is important to highlight the distinction between the burden-sharing principle13 (i.e. policy idea of bail-in), which was officially adopted by the Banking Communication and the bail-in tool, regulated by the BRRD and the Single Resolution Mechanism Regulation (the “SRMR”)14_{in a later stage. While the burden-sharing}

mechanism provides that the burden from a bank’s failure is born by its shareholders and junior creditors, the bail-in tool does not limit its scope to junior creditors but also affects senior creditors and depositors up to 100 thousand. The most substantial difference with the burden-sharing principle is that the bail-in tool as such has not been applied yet in practice and as a result, my analysis focuses on its policy idea which constitutes an indispensable part of EU banks’ resolution after 2013.15

In order to understand the dichotomy between bail-out and bail-in, it is crucial to delve into banks’ specific nature as opposed to non-financial institutions.16_{The main reason for banks differentiation is}

that the social costs generated by its failure are higher than the private ones, especially in the case of systemically important financial institutions. In particular, three main factors justify the huge impact of a failing bank to the financial stability, namely its over-levered nature, the “domino” effect it produces to other financial institutions and the impact on market prices. To begin with, shareholders bear only a fraction of the overall risk, due to the financing of banks with high leverage. The risk is shifting to banks’ creditors, as opposed to non-financial institutions, where shareholders are the main

11_{For a definition of systemic risk:}_{Schwarcz, S. L. (2008). Systemic risk. Geo. LJ, 97, 193}_.

12_{For the first time the conception of the policy idea of bail-in presented by P. Calello and W.Ervin in 2010 at}

https://www.economist.com/finance-and-economics/2010/01/28/from-bail-out-to-bail-in

13_{For reasons of simplicity, the terms bail-in and burden-sharing are used as synonymous in the analysis.}

14_{REGULATION (EU) No 806/2014 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 15 July 2014,}

establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund, art 27.

15_{I refer to Appendix 1 “Bail-in in the EU between 2013 and December 2015”.}

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9 parties bearing the cost of failure.17_{Secondly, the critical role of banks to the payment system and their}

lending capacity to the real economy have a direct impact on its creditors’ trust in the market. As a result, the failure of a financial institution challenges the public’s faith in the banking sector, producing contagion risks to other institutions.18 Lastly, in the case of financial distress, banks sell their asset in a fire sale to obtain liquidity, which might suppress the overall value of assets in the market. The generated liquidity risks affect the credit lines provided by other institutions and decrease the available liquidity. To conclude, all these elements are calling for a different treatment of a failing bank, indicating the need for a special resolution regime.

During the financial crisis, a public-funded rescue of “too-big-to-fail” financial institutions was the response to the abovementioned negative externalities. The social demand for a stable banking system constitutes the cornerstone of the bail-out policy idea. In fact, trust is banks’ “solvency” and the only way to preserve financial stability is the provision of states’ guarantee in banks failing scenario. As a result, the call for a fiscal backstop led to the widespread use of bail-out both in the United States and Europe. The bail-out19 can take different forms. The most common one is realized through capital injections from states in exchange for shares.20 The main problem of the bail-out mechanism is the moral hazard born by banks’ reliance on public funds which consequently increases their incentives for excessive risk.21_{Moreover, states’ financial support operates at the expense of taxpayers, who are}

the main parties absorbing the costs produced by failing financial institutions. In contrast, bank’s creditors bear minimum or none risk, a fact that triggered high criticism and played a decisive role in the post-crisis legal reforms.

In the aftermath of the crisis, a radical rethinking of the existed regime led to the introduction of a burden-sharing mechanism. More specifically, some of the costs of distressed banks must be borne by its investors, giving a priority to public interests. As stated in the Banking Communication, “state aid should be limited to the minimum necessary and an appropriate own contribution to restructuring costs should be provided by the aid beneficiary”. In brief, state aid can only be granted after creditors bear

17_{Martino, E. (2018). Law & Economics of Banks Corporate Governance in the Bail-In Era. Available at SSRN 3100703,}

page 10.

18_{Rutledge, V., Moore, M., Dobler, M., Bossu, W., Jassaud, N., & Zhou, J. (2012). From bail-out to bail-in: mandatory}

debt restructuring of systemic financial institutions. Journal Issue, 2012, 3.

19_{For the needs of our analysis, the term bail-out is limited to the provision of resources to a failing financial institution}

by the state.

20_{Armour, J., Awrey, D., Davies, P. L., Enriques, L., Gordon, J. N., Mayer, C. P., & Payne, J. (2016). Principles of}

financial regulation. Oxford University Press, chapter 16.2.

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10 the losses together with the shareholders.

The internalisation of costs is based on the principle of the free market and produces essential benefits. First of all, the transfer of costs to private investors prevents the use of public funds, which not only hinders states’ financial situation but also raises questions regarding the fairness against taxpayers. Moreover, the prohibition of the implicit state guarantee addresses the moral hazard defect, which derives from banks’ established belief that public guarantees will always back them up, due to the systemic threat their failure may incur. In addition, the threat of creditors’ participation in failing bank’s risks incentivizes them to better monitoring of shareholder’s practice, minimizing their tendency to excessive leverage. In fact, bank’s shareholders build high leveraged levels, in an effort to maximize their return, ignoring the detrimental consequences of their behaviour. As a result, the return of risks to the parties where they belong put some “skin in the game”, promoting market discipline. It should be highlighted that there is no explicit dichotomy between bail-out and bail-in in practice. The reality is more complex and as a result, the bail-in mechanism needs to be approached with a critical point of view taking also into account its potential shortcomings.22 One of the issues can be raised in the field of retail investors protection who are not excluded from the burden-sharing effect when the financial institution they invested in is in trouble.

2.2 Banking Union

The introduction of the burden-sharing principle by the Banking Communication in 2013 put the foundations of a new banking resolution framework and arrived as a response to the inadequate legislation to address the failure of “systemic” financial institutions. The step forward to the initiation for a new banking regulatory environment established with the creation of the European Banking Union (the “EBU”) in 2014, which constitutes the biggest innovation in European level after the financial crisis. This major development aims in the creation of a deeper and more integrated banking system.23 It should be mentioned that even if EBU is structured on a Eurozone level, other EU members have the opportunity to join in “close cooperation”.24_{The EBU consists of three pillars among which}

22_{Avgouleas, E., & Goodhart, C. (2014). A critical evaluation of bail-in as a bank recapitalisation mechanism.}

23_{The main idea behind the creation of the EBU is to break the vicious cycle between sovereign and bank credit, which}

constituted the root of the Eurozone crisis. For more information I refer to European Systematic Risk Board. (2008). Regulating the doom loop.

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11 only the first two are fully established and operational.25_{The first policy is established with the Single}

Supervisory Mechanism (the “SSM”) which transfers the supervision of the euro banks form a national level to the control of the European Central Bank (the “ECB”).26_{More specifically, ECB acts in}

cooperation with National Competent Authorities (the “NCAs”), apart from the case of “significant”27

banks where ECB has exclusive supervisory competence. Related to the current analysis is the second pillar of the EBU, namely the Single Resolution Mechanism (the “SRM”) which governs the new regime of the bankruptcy and restructuring of financial institutions and will be presented below. The last pillar of the EBU is a proposal for an harmonized deposit guarantee scheme (the “DGSD”)28 in an effort to provide a European solution for the protection of retail depositors.29

2.3 Single Resolution Mechanism and Single Resolution Rulebook

For the first time in the EU, harmonized rules are settled in the resolution field. The SRM establishes the transfer of resolution of euro banks within the control of the Single Resolution Board (the “SRB”). More precisely, the SRB is authorized to take decisions regarding the resolution of failing banks, which are then implemented by the relevant national resolution authorities. Support can be provided, if needed, by the Single Resolution Fund (the “SRF”). The single rulebook of the banking resolution regime consists of SRMR which is only applicable to eurozone member states and the BRRD, which provides more substantive rules, applicable to all EU member states. It should be mentioned that SRMR builds on the pre-existed BRRD and therefore their rules will be analysed on the basis of the latter. Both legislations establish a bank resolution framework that interacts rather than replaces national insolvency laws.30

The BRRD constitutes the foundation of the new resolution framework. The main objectives of the new regime are the continuity of the critical functions of financial institutions, the balance between

25 _{European Commission. A rulebook for all financial actors in EU. At}

https://ec.europa.eu/info/business-economy-euro/banking-and-finance/banking-union/what-banking-union_en.

26_{Please note that the main decision-making body is the Supervisory Board, created within the ECB and supported by an}

entirely new administration, a fact which indicates the separation of ECB’s Monetary and Supervision Policy.

27_{REGULATION (EU) No 1024/2013 of 15 October 2013, conferring specific tasks on the European Central Bank}

concerning policies relating to the prudential supervision of credit institutions, art 6.

28_{Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending}

Regulation (EU) 806/2014 in order to establish a European Deposit Insurance Scheme.

29_{For more information regarding Banking Union, I refer to}_{Véron, N. (2015). Europe’s radical banking union. Bruegel}

Essay and Lecture Series, 5.

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12 financial stability and market discipline and the protection of public funds as well as covered depositors.31_{It should not be overlooked that the proposed resolution regime is just an alternative to}

the regular national insolvency route and can be applied only after the fulfillment of a number of conditions.32 Specifically, the bank needs to be declared as failing or likely to fail33, there should not be other private ways to prevent its failure and the resolution needs to cater the public interest.34 The BRRD provides four tools for the resolution of the failing institution35, namely the sale of business, the bridge institution, the asset separation, and the bail-in.36 The role of the bail-in tool in the radical reconsideration of the whole resolution idea and its impact to retail investors constitute the reasoning of the current research.

2.4 Bail-in tool

Among the other resolution tools provided by BRRD, the bail-in tool is the most revolutionary one. The rational of its importance is the provided legal power to resolution authorities to impose the costs of a bank’s failure to its shareholders and creditors rather than taxpayers.37_{More specifically, the}

institution is recapitalized by writing off, wholly or partially, and by converting eligible liabilities into equity. The control gained by former debtholders is in line with the objective of BRRD to dilute existing shareholders.38_{The bail-in has an impact on the liability side of the balance sheet, transferring}

the costs of the resolution to investors who should not only be benefited by bank’s profit but they should also be exposed to any losses it incurs. To showcase the differences, the balance sheets below provide an oversimplified example of a bail-in and bail-out situation.

31_{BRRD, art. 31(2).} 32_{BRRD, art. 32(1).}

33_{When extraordinary financial support is provided, the bank is deemed to be failing or likely to fail. However, an}

important exception is the case of precautionary recapitalisation [BRRD, art. 32(4)(d)]. In this case, an extraordinary public financial support is provided “in order to remedy a serious disturbance in the economy of a Member State and preserve financial stability”. A characteristic example where this practice was followed is in Monte dei Pashi di Siena in 2007. For more information, I refer to Véron, N. (2017). Precautionary recapitalisation: time for a review? (No. 2017/21). Bruegel Policy Contribution.

34_{The term “public interest” has the meaning that the resolution objectives would not be met to the same extent if the}

bank were wound out under normal insolvency proceedings.

35_{BRRD, Title IV, Chapter IV.}

36_{For a full overview of the BRRD, I refer to}_{Lintner, P., Lincoln Nagy, M. A. J., Pyziak, P., Godwin, A. J., Schroeder,}

S. C., & Irsalieva, N. (2016). Understanding bank recovery and resolution in the EU: a guidebook to the BRRD.

37_{BRRD, recital 67.} 38_{BRRD, art. 44(2).}

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14 As it was already mentioned in the example above, BRRD excludes certain liabilities from the bail-in procedure such as secured claims and covered deposits. The law provides a detail list of exceptions39 in order to be consistent with the previously mentioned parallel goals of the resolution. In addition to these eligible liabilities clearly excluded by the law, the Directive authorizes resolution authorities to proceed to further exemptions in special circumstances.40 However, the broad discretion given to resolution authorities has the potential to undermine the resolution procedure since all eligible liabilities can potentially be excluded at the altar of financial stability.41 In view of this risk, the Commission’s consent constitutes necessary condition before the exercising of the relevant discretion

39_{BRRD, art. 44(2).} 40_{BRRD, art. 44(3).}

41_{Tröger, T. H. (2018). Too complex to work: A critical assessment of the bail-in tool under the European bank recovery}

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15 by resolution authorities.42

An indispensable condition for an effective bail-in is the existence of sufficient loss absorption capacity of financial institutions. As a result, resolution authorities impose minimum requirements for own funds and eligible liabilities (the “MREL”)43_{on European banks.}44_{Simply put, not all bail-inable}

liabilities will be part of MREL. The MREL liabilities have a higher loss-absorbing quality and guarantee the easier execution of the bail-in tool. However, the other bail-inable liabilities need to be readily available when the 8% requirement for private contribution is not covered by MREL. The MREL is set on a firm-specific basis at all times, in a way that secures the resolvability of the institution. At a global level, a new minimum requirement for total-loss absorbing capacity (the “TLAC”) came into force in 2019 and it concerns only global systematically important banks (the

“G-SIBs”). Like MREL, TLAC is designed to ensure that G-SIBs have a certain amount of loss-absorbing

capacity in case they need to be resolved. From 2022, TLAC’s minimum requirements will be increased on the basis of risk-weighted assets and leverage exposure.45

To conclude, as an aftereffect of the financial crisis, a vital regulatory response took place to address the absence of sufficient resolution regime. Following a great number of discussions and communications, the European legislator finally endorsed the BRRD which targets on the prevention and management of crisis of failing financial institutions. The resolution package is completed with the SRMR which establishes a centralized resolution framework under the power of SRM. Among the proposed resolution tools, bail-in is the most revolutionary one, putting an end to the past too-big-to-fail mentality. However, the use of bail-in mechanism raises a wave of issues, one of which can be found in the field of retail investors protection. In the next chapter, an analysis of the implications of bail-in for retail investors will stress the need for their special protection.

42_{BRRD, art. 44(12).}

43_{The BRRD II introduces various changes to the MREL framework in an effort to harmonize it with the TLAC}

standards. The mechanism of MREL is complex and is out of the scope of this research.

44_{BRRD, art. 45.}

45_{Bundesbank, D. (2016). Bank recovery and resolution–the new TLAC and MREL minimum requirements. Monthly}

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CHAPTER 3 - IMPLICATIONS OF BAIL-IN FOR THE

PROTECTION OF RETAIL INVESTORS

3.1 The reasoning behind retail investors protection

The new banking resolution environment and the introduction of the bail-in idea entails important changes to retail investors46 position. Their contribution to the costs borne by the failure of the investment provider institution is really likely when they invested in bail-inable securities. It should be highlighted that the bail-in of retail investors affects not only their rights but also the effectiveness of banks’ resolvability. As a result, the sufficient protection of retail investors, holders of bail-inable debt should constitute an indispensable part of financial regulations goals. In this section, an analysis of the various parameters which advocate on the need for retail investors special protection will be presented.

Firstly, retail investors “suffer” from a general market imperfection, named asymmetric information.47

To explain, financial institutions possess greater substantial knowledge than investors in relation to the relevant economic transaction and products, a fact which is also empowered by the opaqueness of banks assets. In addition, banks hold non-public information regarding their solvency and general financial soundness.48_{It is not rare that investors are not or at least were not in a position to verify}

either the quality of the financial products they invest in or the robustness of their counterparty. In particular, in the case of retail clients who invest in bail-inable products this problem is even more grave due to the complex nature of bail-inable securities and their inherent risk to be written off and/or converted into equity. Therefore, appropriate supervision of banks is a one-way solution to protect investors from defective purchases.49

46_{To define the term “retail investor” the definition provided by MiFID II will be borrowed. According to}_{MiFID II,}

art.4(1)(11) “retail client means a client who is not a professional client” (i.e. clients meeting the criteria laid down in Annex II of MiFID II). Important elements for the classification as a retail investor is their investment experience, relevant education, and financial resources.

47_{Sinn, H. W. (1997). The selection principle and market failure in systems competition. Journal of Public Economics,}

66(2), 247-274.

48_{However, it is worth mentioning that the Pillar 3 of Basel III provides regulatory disclosure requirements for banks in}

an effort to boost market discipline. For more information, I refer to Walker, G. A. (2011). Basel III market and regulatory compromise.

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17 Secondly, the demand for legislative protection derives from retail investors behavioural biases, forcing them regularly to false decisions. Their excess optimism and the philosophy that they can “beat” the markets stem from their propensity to instantaneous gratification.50_{In addition, the lack of}

retail investors’ financial education prevents them from a real understanding of the nature and complexity of their investment. They end up “leaving money on the table”,51_{ignoring the implications}

of their actions. This is the reason behind the fact that many “victims” of mis-selling cases are unsophisticated investors, who do not have the ability to assess the risk of their investments.

Moreover, the self-placement of bail-inable products by banks directly to their clients and the consequent conflicts of interest constitute a vital reason for retail investors protection. This practice is really common for the following reasons. First of all, the issuance of bonds in public markets is more costly for small and medium-size banks in comparison with the self-placing of debt products. The reason is that a requirement for the issuance of publicly traded bonds is the design and distribution of prospectus which entails high costs for the issuing bank. In contrast, big banks counterbalance these costs with the issuance of a large number of bonds, “spreading with this way the costs over a large amount of goods”.52_{Moreover, the self-placing financial institution can be profited by the}

long-established relationship with its customers, misleading its clients as regards the safety of their investment. In fact, according to the statement issued by EBA and ESMA (the “ESMA Statement”)53_,

“In some cases, investors are proactively approached by credit institutions and are wrongly given the impression that the recommended product is as safe as a deposit or is protected by a deposit guarantee scheme, neither of which fact is true”. In a nutshell, the confidence of retail clients to their “local banker” increases the mis-selling of bail-inable products to unsophisticated clients giving space to the flourishing of conflicts of interest from the part of banks. In short, the lower cost of debt issuance trough self-placement for small and medium-size banks and the exploitation of relationships with clients increase the cases of conflicts of interests and underline the importance of special retail investors protection.

A legal argument for the protection of retail investors is the infringement of the right to property in case their investments are subject to bail-in.54 This issue arose several times in front of the Court of

50_{Baker, H. K., & Nofsinger, J. R. (2002). Psychological biases of investors. Financial services review, 11(2), 97.} 51_{Armour, J., Awrey, D., Davies, P. L., Enriques, L., Gordon, J. N., Mayer, C. P., & Payne, J. (2016). Principles of}

financial regulation. Oxford University Press, chapter 10.2.1.

52_{Stigler, G. J. (1958). The economies of scale. The Journal of Law and Economics, 1, 54-71.}

53_{European Banking Authority and European Securities and Markets Authority (2018). Statement on the treatment of}

retail holdings of debt financial instruments subject to the Bank Recovery and Resolution Directive.

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18 Justice of the European Union (the “CJEU”). However, the CJEU clearly stated that “the right to property is not absolute and that its exercise may be subject to restrictions justified by objectives of general interest pursued by the European Union”.55_{As a result, it can be supported that the bail-in of}

retail investors does not breach their right to property since it services the public interest.

Last but not least, retail investors require special protection due to the implications their bail-in can have for the effective resolvability of banks. First of all, the bail-in of retail clients produces extended losses in households, challenging the trust to the banking system and creating a fruitful ground for potential bank runs. In fact, in cases where banks have big exposures to retail holdings, this scenario can even affect the overall financial stability. In addition, the feasibility of the resolution procedure is questioned because of the political reluctance to bail-in retail investors. The consequent political reaction and the loss of politicians’ popularity explain their unwillingness to apply losses to retail investors.

To conclude, the need for a sufficient legal regime for retail investors protection is justified by a series of reasons. Briefly, investors insufficient information regarding the opaque nature of their bail-inable investment in combination with their inadequate financial educational background constitute a primary reason for their protection. Most importantly, the self-placement of bail-inable securities can produce consumer detrimental risks when banks’ opportunistic behaviour takes place via the mis-selling of bail-inable products. Last but not least, the inadequate safeguard of retail clients when they invest in bail-inable products undermines the social demand for financial stability, through the jeopardize of a solid resolvability system.

3.2. Ways of retail investors protection

Following the analysis of the reasons behind the need for retail clients protection when they invest in bail-inable products is time to consider the ways this goal can be achieved.

3.2.1 Ex-post reimbursement - Legacy Problem

The fact that prior to the Banking Communication in 2013 and the BRRD in 2014 there was no banking resolution regulation creates a legacy issue as regards the bail-inable securities issued before 2013. In

55_{Judgment C-8/15 P to C-10/15 P, cit., paras. 69–70. Add Judgment T-680/13, cit., para. 254 and Judgment T-786/14,}

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19 countries where retail investors hold a big amount of bail-inable debt, their bail-in constitutes a legal challenge especially for the cases where mis-selling of the relevant securities took place. A characteristic example of poor management of risks affecting retail investors constitutes the case of four Italian banks56, resolved by the Bank of Italy in 2015. The resolution took place before the enforcement of BRRD, under the burden-sharing principle of the Banking Communication. More precisely, all the assets57 and liabilities of the four banks were transferred to temporary four bridge banks, while equity and subordinated debts were transferred to an Asset Management bank (the “bad

bank”).58 The whole mission was financed by the Italian Resolution Fund59, which borrowed funds from the Italian banking sector, in order to absorb losses in the four banks and consequently recapitalize the new 4 bridge banks and the bad bank. An inevitable part of the resolution procedure constituted the full bail-in of equity holders and subordinated debt holders in the bad bank. However, the bail-in of “small” investors produced severe political and market reaction due to the widespread impression that their investments are as safe as bank deposits.60 Indeed, the banks under resolution were selling subordinated instruments to their clients providing insufficient information for their bail-inable nature and high-risk profile. For instance, “In 2013, Sergio Picinotti, a 63-year-old unemployed

man living with his elderly mother, invested much of their nest egg of EUR 40 000 in a bond issued by Banca Etruria, their local bank based in the medieval Tuscan city of Arezzo. They (bank staff) said ”what are you doing keeping that in your checking account? Put it here, you’ll earn 4 % flat”, Mr. Picinotti recalls. “A friend at the bank told me: Trust me, it will take the third world war to shut down Banca Etruria”.61

In a nutshell, deposits and bonds subscriptions were treated in the same way and as a result, the disclosure requirements for banks’ bonds were way looser in comparison to other financial products. Due to the salient infringement of retail investors rights and the following political backlash, the Italian government reimbursed ex-post the affected investors, encroaching the main idea of the burden-sharing principle. Another indicative example of ex-post inefficient solution can be found in the resolution of the Veneto Banca S.p.A and the Banca Popolare di Vicenza S.p.A. (the “Veneto

banks”).62 In 2017, the SRB decided not to pursue the resolution of Veneto banks on the basis of lack

56_{Cassa di risparmio di Ferrara SpA, Banca delle Marche SpA, Banca popolare dell’Etruria e del Lazio SC and Cassa di}

risparmio della Provincia di Chieti SpA.

57_{The assets of the four banks had an aggregate total value of EUR 47 billion.}

58_{Martino, E. (2017). Subordinated Debt Under Bail-in Threat. U. Bologna L. Rev., 2, 254.}

Law Review, p. 252

59_{The total capital injection from the Italian Resolution Fund estimated to 3.6 billion.}

60_{Merler, S.}_{& Minenna, M.}_{Hard times for Italian Banks. At https://bruegel.org/2016/02/hard-times-for-italian-banks/} 61_{Politi, J., Italy bank rescues spark bail-in debate as anger at Renzi grows, Financial Times, December 22, 2015.} 62_{European Central Bank. (2017). ECB deemed Veneto Banca and Banca Popolare di Vicenza failing or likely to fail.}

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20 of public interest.63_{However, liquidation aid was provided outside the BRRD and SRM. The European}

Commission authorized the state aid in order to safeguard the public interests of the local economy. A fundamental requirement for the assessment of the compatibility of the state aid is the compliance with the burden-sharing principle, where shareholders and subordinated debt holders are bailed-in. The critical problem, in this case, is once again the mis-selling of bail-inable products to retail clients of Veneto banks, who were not aware of the riskiness of their investment. Due to the reasonable political turmoil, the Italian state announced its intention to reimburse not only misled subordinated retail investors but also equity holders.64 The ex-post reimbursement of retail investors simply entails a governmental bail-out of bailed-in investors, which is totally unreasonable. To conclude, the presented Italian experience illustrates the insufficiency of ex-post solutions and the poor management of inevitable public reactions.

3.2.2 Ban of complex financial instruments

In an effort to address the high risks born by the households, the ban of the distribution of complex financial instruments to retail investors has been proposed.65 There is no doubt that in this way the risk to “small” investors will be minimized since they will have access only to safe investments. On the other hand, it cannot be ignored that this proposal intervenes to a free market, where individuals should be allowed to invest in products of their preference. According to the ex-chairman of the European Banking Authority, Andrea Enria, “as individual retail investors are entitled to purchase bank equity, they should also be allowed to invest in subordinated or senior non-preferred debt, as long as they are adequately informed of the potential risks attached to such financial instruments. What is crucial is that all issuers comply with the relevant conduct rules and that competent authorities enforce them in a rigorous manner”.66_{Moreover, the banning of investments in subordinated debt instruments}

is social expensive, since retail investors are willing to purchase these products, albeit their potential risk. In fact, according to the data published at the ESMA Statement the retail holding of senior and subordinated debt represents a considerable amount of the total debt issued by EU banks67 (i.e. 12.7%

63_{The “public interest” constitutes one of the conditions of resolvability in the context of BRRD and SRM (art. 32}

BRRD). The interpretation of this term is mainly political and depends on the current view of the SRB.

64_{The reimbursement of equity holders constitutes a salient infringement of a fundamental insolvency and corporate}

finance principle, according to which shareholders are the first ones who bare the risks.

65_{Götz, M. R., & Tröger, T. (2016). Should the marketing of subordinated debt be restricted/different in one way or the}

other? What to do in the case of mis-selling? (No. 35). White Paper Series.

66_{Hearing of Andrea Enria in the Treasury Standing Committee of the Senate of the Republic of Italy. (2017). The}

‘banking reform package’: CRD 5/ CRR 2/ BRRD 2.

67_{The situation is strongly diversified in the EU member states and clearly retail investors in some countries have a}

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21 of the total issuance of 1796.7 billion of the total senior and subordinated debt)68_{. However, the}

implementation of higher regulatory requirements to banks naturally leads to a decrease in the amount of bail-inable products invested by retail investors.69 Last but not least, the placement of subordinated debt to parties other than institutional investors is critical for the safeguard of financial stability, since institutional firms can always suffer from contagion. Shortly, the fact that there is a sizeable amount of bail-inable products held by retail investors proves that restricting the consumption of investment products will have inevitable consequences to the market, affecting directly the available liquidity and financial stability.

3.2.3 Regulatory Response

The regulatory response for the protection of retail investors in a bail-in scenario arrived with the implementation of MiFID II & BRRD II.70 Prior to their enforcement there was limited grandfathering provisions since from one hand MiFID proved to be inefficient to address the past mis-selling scandals and from the other hand BRRD did not regulate at all retail holdings of bail-inable debt. MiFID II, which came into force as of January 2018, regulates the financial markets and targets the increase of transparency and the improvement of investors protection, in this case, retail investors. On the other hand, BRRD II aims at the effective resolution of banks and regulates for the first time retail holdings of newly issued subordinated bail-inable instruments.71 The combined application of the directives aims to address the poor protection of retail investors in case of bail-in, guaranteeing in parallel banks’ resolvability. However, since they entered into force only recently there is no evidence on the effectiveness of the relevant provisions. Therefore, the ultimate goal of this research is to investigate whether this new legal framework offers sufficient protection to retail clients, holders or future investors of bail-inable instruments. In the following chapter, I will present the current legal framework governing the protection of retail investors when they invest in bail-inable products, in order to be able to test its sufficiency in Chapter 5.

68_{ESMA Statement (2018). (Appendix 2).}

69_{I refer to Appendix 3, “Dynamic graph presenting the amount of EU household holdings of subordinated debt from}

2013 until 2018 by ECB”.

70_{The BRRD II is part of the banking package on revised rules on capital requirements (CRR II/CRD V) and resolution}

(BRRD/SRM), entered into force in June 2019.

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22

CHAPTER 4 - REGULATORY RESPONSE

4.1 Protection of retail investors under MIFID II

The main question of this thesis is whether retail clients who invest in bail-inable securities are sufficiently protected by the combination of MiFID II and BRRD II regime. This section will focus on MiFID II72_{which provides the EU legal framework for investment firms regarding investment}

activities and services. The main reasoning behind the legal protection of investors is the establishment of a broad fiduciary duty of the firms to act in accordance with the best interest of their clients.73_For

the purposes of this research, the analysis takes into account only the category of non-professional clients (i.e. retail investors) who invest in complex financial instruments (i.e. bail-inable securities) under both investment advice and non-advised services. First of all, an exposition of the disclosure and reporting legal requirements will be presented in order to indicate their limitations when it comes to retail investors protection. Next, the suitability and assessment test, which together with the disclosure provisions were already a part of MiFID, need to be defined since it constitutes a fundamental part for the protection of retail clients. Lastly, one of the major changes of MiFID II, namely the product governance and intervention rules will be the main part of the analysis. At the end of this section, primary conclusions as regards the different ways of retail investors protection by MiFID II will be given.

To start off, investment providers are required to disclose all the relevant information to retail clients about the transaction and the financial instruments shelled. MiFID II clearly states the disclosure principles, establishing the obligation of investment firms to provide “fair, clear and not misleading” information in “comprehensive form”.74_{There is a detail list of the disclosure contents aiming to}

provide investors with a full picture of the followed investment strategy.75_{The Delegated Regulation}

of MiFID II provides more details regarding the information content, requiring an explanation of the associated risks generated by the insolvency of the issuer in case of bail-in.76_{The disclosure regime}

is empowered by reporting obligations of financial advisors, both on-going and record-keeping as

72_{MiFID II, Title II, Chapter II.} 73_{MiFID II, art 24(1).}

74_{MiFID II, art 24(3)(5).} 75_{MiFID II, art 24(4).}

76_{COMMISSION DELEGATED REGULATION (EU) 2017/565 of 25 April 2016, supplementing MiFID II, art}

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23 regards to the suitability of the transaction.77_{Moreover, the obligation of investment firms to disclose}

“the general nature and/or the sources of conflicts of interest” should be highlighted.78_{As it has already}

been indicated in the cases of the Italian banks, the conflicts of interest are a sensitive issue especially in the case of self-placement of bail-inable products. In this stage, someone needs to reflect on the efficiency of the disclosure method. Even if disclosure provides a solution to the asymmetry of information between the counterparties, how effective it can really be when investors’ biases take place? The availability of the above-mentioned information can be considered as adequate protection only if investors are in a position to understand them, something that rarely happens. In contrast, investment firms can easily use the disclosure route in order to get off the hook knowing that their clients are not able to realize the implications of their investment. In addition, the general problem of the absence of private law remedies for investors against investment firms which breach their fiduciary duty deteriorates the existed problem.79

An important element of the analysis is the issue whether other disclosure requirements provided for example from the Prospectus Regulation80 or the packaged retail and insurance-based investment products (PRIIPs) Regulation81 are sufficient to protect retail investors from banks’ opportunistic behaviours. The answer should be negative regarding all the disclosures by banks as long as retail investors most of the times either will not read the disclosure documents or will not be in a position to understand their content. In short, the mere disclosure by investment providers is inefficient due to the limited knowledge of retail investors. Moreover, even when certain knowledgeable investors (the “marginal consumers”) are able to comprehend the associated risks, they cannot affect the system overall due to their limited number.82 The refrain of these marginal consumers from the purchase of subordinated debt or their request for higher risk compensation (i.e. higher interest rate) cannot sufficiently protect other investors who will still purchase and overpay for bail-inable securities. To

77_{MiFID II, art 25(6).} 78_{MiFID II, art 23(2).}

79_{Della Negra, F. (2014). The private enforcement of the MiFID conduct of business rules. An overview of the Italian}

and Spanish experiences. European Review of Contract Law, 10(4), 571-595.

80_{REGULATION (EU) 2017/1129 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 14 June 2017}

on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/71/EC.

81_{REGULATION (EU) No 1286/2014 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 26}

November 2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs).

82_{Wilde, L. L., & Schwartz, A. (1979). Equilibrium comparison shopping. The Review of Economic Studies, 46(3),}

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24 summarize, even if disclosure remains an important tool for investors protection, it should be seen as a supplement to strict and effective protective rules rather than a stand-alone protection vehicle.83

A vital demand in the MiFID II investors protection regime is the assessment of the suitability and appropriateness of provided investment services.84 In case of investment advice and portfolio management activities, investment firms are obliged to assess the suitability of the product based on the knowledge and experience of the client, taking into account its financial situation and objectives.85 On the other hand, in services where the element of personal recommendation is absent (i.e. non-advised services)86, financial institutions need to warn their clients in case the product is inappropriate with a warning which can have a standardized format.87 In case investment firms infringe their above-mentioned obligations, supervisory and remedy powers are provided to NCAs based on national law.88 However, the main problem arises when investment providers comply with MiFID II requirements, but in a formalistic way. For instance, the success of the appropriateness test is questionable, especially in the case of subordinated debt bought by retail investors, who have, or at least had, the illusion that bank’s subordinated bonds are as safe as the bank’s insured deposit. In Chapter 5, a thorough analysis will be followed and recommendations will be provided regarding the improvement of the appropriateness test, which was/is carried out with an inefficient for the protection of retail investors way.

It should be mentioned that neither suitability nor appropriateness is needed in case of “execution or reception and transmission of clients orders”.89_{The primary condition for the application of the}

execution-only regime is the non-complexity of the financial product. Subordinated bonds do not fall into this category since they are by definition complex products in contrast with the regular bonds. First of all, retail investors are not in a position “to understand the risk involved”90 due to the opaque nature of subordinated bonds and secondly the possibility that they can be converted into equity, in a scenario of bail-in, implies their complexity.91 As a result, retail investors should always be covered

83_{Avgouleas, E. (2009). The Global Financial Crisis and the Disclosure Paradigm in European Financial Regulation: The}

Case for Reform. European Company and Financial Law Review, 6(4), 440-75doi: 10.1515/ECFR.2009.440.

84_{The test of suitability and appropriateness was already introduced by MiFID I, but MiFID II regulated it more detailed.} 85_{MiFID II, art 25(2).}

86_{MiFID II, art 4(4).} 87_{MiFID II, art 25(3).} 88_{MiFID II, art 69, 70.} 89_{MiFID II}_{, art 25(4).} 90 _{MiFID II}_{, art 25(4)(a)(ii).} 91_{Delegated Regulation, art 57(d).}

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25 by the “safety” net of suitability and appropriateness assessment before the purchase of subordinated debt.

The big innovation of MiFID II comes with the adoption of conduct of business rules (“CoB”), where the focus is transferred to the behaviour of investment firms. MiFID II introduces product governance requirements into rules for the first time, creating a silver line between investors protection and markets development. In particular, conduct regulation consists of overarching principles that impose fiduciary duties to firms which manufacture and distribute financial instruments. The governance obligations aim to limit the exploitation of consumer biases and targets mainly on suitable investment advice. Characteristic examples are the high-level standards of managing conflicts of interest92 and acting in accordance with the best interests of the clients.93 The product governance regime specifies these duties through a list of provisions under the new MiFID II. It should be noted that investment firms which sell financial instruments to retail investors are subject to the full set of CoB rules, as opposed to the sale of products to financial institutions and professional investors. The classification of investors is based on their experience and knowledge and retail investors need to be protected by a high level of rules due to their “unsophisticated nature” as explained in the previous Chapter.94

The set of CoB rules consists of the articles MiFID II 24(2), 16(3), 24(10) and Delegated Regulation 41(2)(4), as analysed below. First of all, investment firms shall design financial instruments in accordance with the identified target market of the client, both during the manufacturing and distribution of products.95 The target market assessment constitutes the cornerstone of the product governance rules and aims to improve the compatibility between purchased products and the needs and nature of clients. ESMA specifies in its guidelines the categories that should be considered for the identification of the potential target market by the manufacturer.96 More specifically, manufacturers should take into account the type of clients, their knowledge and expertise, their financial situation as regards their ability to bear losses, their risk profile, and their investment horizon. As a complement to the life cycle of the product, distributors shall as well identify the target market but within the limits set by the manufacturer.97 A really important element is that according to ESMA “.. for more

92_{MiFID II}_{, art 23(2).} 93_{MiFID II, art 24(1).}

94_{MiFID II, Annex II MiFID II.} 95_{MiFID II,}_{art 24(2).}

96_{ESMA. (2017). Final Report-Guidelines on MiFID II product governance requirements.}

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26 complicated products such as bail-inable instruments or less common products, the target market should be identified with more detail”.98

Moreover, an important improvement was the integration of product governance in the internal organization of investment firms. Notably, the requirement of an effective organisational and administrative system of financial advisors aims to a better impediment and management of conflicts of interests.99 Within the same context, MiFID II mandates the design of employees’ remuneration and assessment schemes with a way that is in line with the best interests of clients.100

The philosophy of product governance goes a step further through an innovative and highly important provision regarding self-placement. First of all, it should be mentioned that as opposed to MiFID, MiFID II clearly qualifies self-placement as an investment service, through a broad definition of “execution of orders on behalf of clients”.101_{In the case of self-placement of financial products,}

investment firms are obliged to refrain from activities where the conflicts of interests cannot be managed, so as “to prevent any adverse effects on clients”.102_{The purchase of bail-inable products}

creates unambiguously adverse effect to retail investors as long as they are not aware of the underlying conflict of interest. As a result, the provision is vastly relevant for the self-placement of bail-inable instruments since their opaque nature in combination with the poor awareness of retail investors for their inherent risks gives space for banks’ opportunistic behaviours. However, the most important provision for this analysis is given in paragraph 4 of the same article. In case of “offering own-securities that used for capital-debt requirements under BRRD”, financial institutions are obliged to explain the different nature between the purchased product and bank deposit “in terms of yield, risk, liquidity and any protection provided in accordance with the Deposit Guarantee Schemes Directive”.103_{This specific provision highlights the need for special treatment of investors when they}

invest in bail-inable products and lead to a reduction of mis-selling risk since it targets the self-placement of unsafe investments. In short, the goal of ex-ante product governance rules is to work as a “lifeline” for unsophisticated investors, re-establishing in parallel their confidence in financial markets.

As a step forward, the new MiFID II framework provides an ex-post product intervention regime in an effort to safeguard the implementation of the above-mentioned requirements. The threat of product

98_{ESMA Statement (2018), point 41.} 99_{MiFID II, art 16(3).}

100_{MiFID II, art 24(10).} 101_{MiFID II, art 4(1)(5).}

102 _{Delegated Regulation, art 41(2).} 103_{Delegated Regulation, art 41(4).}

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27 intervention is the main guarantee against the risk of non-compliance of investment firms. More precisely, both NCAs and ESMA are empowered to prohibit product distribution when the CoB rules are infringed. National intervention can be justified when the main goal set by product governance (i.e. management of conflicts of interest) is not achieved.104 ESMA is entitled to exercise its temporary intervention powers when the competent authorities have not acted or the actions taken are inadequate to address the significant investor protection concern.105

To conclude, MiFID II regime targets mainly on investment firms’ responsibility, addressing the mis-selling scandals occurred before and during the crisis. The main goal of the EU investor protection regime is to guarantee that financial products, for this research bail-inable instruments, are sold only to investors who are aware of the risks they undertake. The way to achieve this outcome is the establishment of a system from the banks’ side that can sufficiently manage the conflicts of interest. While the disclosure requirements seemed to be inadequate to contribute to sufficient protection of retail investors, the promising provisions of suitability and appropriateness need to be carried out in a non-formalistic way, guaranteeing that banks and investment firms do not exploit investors’ behavioural biases. On the other side, the product governance provisions support the ultimate goal of investors protection via high-level principles, having in parallel the assurance of product intervention by the national authorities and ESMA. What is remaining is to detect whether the new MiFID II regime protects overall retail investors in case of bail-in. Before this, it is important to analyse the protection of retail investors from the scope of the new BRRD II provision.

4.2. Protection of retail investors under Banking Recovery and Resolution

Directive II

BRRD II constitutes part of the revised banking package which was adopted in May 2019 and introduces important modifications to capital, funding and liquidity requirements.106

Due to various mis-selling cases detected the previous years and the big amount of banks’ MREL instruments107_{held by retail investors, the banking package introduces for the first time safeguards for}

104 _{MiFID II}_{, art 69(2)(t).}

105_{REGULATION 648/2012/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 15 May 2014}

establishing a framework for markets in financial instruments, art 40(2) and art 9 of the ESMA Regulation.

106_{European Parliament. (2019). Amending capital requirements The 'CRD V package'.} 107_{For a definition of MREL instruments, I refer to Section 2.4.}

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28 retail investors. More specifically, the regulator recognizes that “If a significant part of an institution's

or entity's MREL instruments is held by retail investors that might not have received an appropriate indication of relevant risks, that could in itself constitute an impediment to resolvability.”108 From this reasoning it is clear that the new provisions aim to address the risks born in case of banks’ poor resolvability. As opposed to MiFID II which focus on retail investors protection, BRRD II aims to an effective resolution of the failing financial institution. In this regard, BRRD II109 provides a number of conduct requirements when retail investors purchase newly issued subordinated MREL instruments. More precisely, member states shall ensure that retail investors do not invest excessively in debt instruments eligible for the MREL.110 This goal can be achieved via the following requirements. First of all, the seller of MREL liabilities must perform a suitability test in accordance with the rules currently applicable to investment firms providing investment advice or portfolio management under MiFID II. Member states may extend this requirement to all instruments qualifying as own funds or as bail-inable liabilities.

Secondarily, where the retail clients’ portfolio does not exceed EUR 500,000 the seller must ensure that the retail client does not invest an aggregate amount of more than 10% of its portfolio in such instruments and that the required initial investment amount is at least EUR 10,000. As an alternative to these requirements, member states may instead set a minimum denomination amount of at least EUR 50,000 for investments in MREL products. In brief, member states shall ensure that issuing banks obey with their responsibility, namely the reassurance that investments to MREL eligible instruments by retail investors do not represent an excessive part of their portfolio or that the minimum denomination amount of such securities is relatively high. In case of an infringement of the above-mentioned requirements, resolution authorities have the power to recommend to an institution to address any impediment to their resolvability.111 In particular, resolution authorities need to exercise their powers to address or remove impediments to resolvability.112 It is important to underline that these requirements are only applicable to instruments issued after the transposition of the discussed directive and as a result, they do not affect existed holdings by retail investors.

As a final remark, retail holdings of bail-inable securities are also protected under the SRMR II.113 An important part of the SRB role is the resolvability assessment of banks, which also includes the analysis

108_{BRRD II, recital 15.} 109_{BRRD II, art 44a.} 110_{BRRD II, recital 16.} 111_{BRRD II, recital 15.} 112_{BRRD, art 17.}

113_{REGULATION (EU) 2019/877 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 20 May 2019 as}

Bail-in and Protection of Retail Investors