Market Discipline Strengthening via Resolution Planning
& Resolvability Assessment under BRRD & SRMR
Master’s Program in Law and Finance LL.M.
Student Name: Alexandros Koumoutzis-Mitsos
Student Number: 12735345
Email address: alec1996@hotmail.com
Supervisor Name: Edoardo Martino
2 Table of Contents
Abbreviations………....3
Abstract……….4
SECTION 1: Introduction………...5
SECTION 2: Bank Governance……….10
2.1. The Concept of Corporate Governance……….10
2.2. The Peculiar Nature of Bank Governance……….………12
2.2.1. Bank Governance from Two Different Angles……….12
2.2.2. Bank Specialness and Governance Implications………...12
2.2.3. Agency Conflicts………..17
2.3. Interim Conclusion……….………...19
SECTION 3: Evaluation of Bank Governance Reforms in the Post-Crisis EU and Comparative Advantage of Bail-in ………...…20
3.1. The European Banking Union……….………...20
3.2. Executive Remuneration……….………...21
3.3. Board of Directors – Risk Management………22
3.4. The Resolution Tool of Bail-in……...………..………….23
SECTION 4: The Legal Framework of Resolution Planning and Resolvability Assessment and its Relationship with Bank Governance………28
4.1. Resolution Planning and Resolvability Assessment as Operational Part of BRRD & SRMR Resolution Framework……...……….28
4.2. The Impact of Resolution Planning and Resolvability Assessment on Market Discipline………..……….30
4.2.1. Impact under the Current EU Regime?...30
4.2.2. Potential Impact through Resolution Planning……….32
4.2.3. Potential Impact through Resolvability Assessment……….34
SECTION 5: Conclusion………39
3 Abbreviations
AT1 Additional Tier 1
BRRD Bank Recovery and Resolution Directive CBR Combined Buffer Requirement
CDOs Collateralized Debt Obligation CDSs Credit Default Swaps
CEO Chief Executive Officer COCOs Contingent Convertibles
CRD IV Capital Requirements Directive IV EBA European Banking Authority EBU European Banking Union EU European Union
FSB Financial Stability Board
G-SIIs Global Systemically Important Institutions LTV Loan to Value
MREL Minimum Requirements for Own Funds and Eligible Liabilities NCAs National Competent Authorities
NGOs Non-Governmental Organisations NPV Net Present Value
NRAs National Resolution Authorities
OECD Organisation for Economic Co-operation and Development SRB Single Resolution Board
SRF Single Resolution Fund SRM Single Resolution Mechanism
SRMR Single Resolution Mechanism Regulation SSM Single Supervisory Mechanism
TLAC Total Loss Absorbing Capacity T2 Tier 2
4 Abstract
Systemic stability is threatened owing to bank insiders’ excessive risk-taking. Such behaviour originates from the overleveraged bank capital structures and it is subsidized due to the lessened debt governance and the laxness of financial regulation. The resolution tool of bail-in, as is enacted in the post-crisis European legislation, can be viewed as compensating the aforesaid lack of safeguards. Bail-in application makes private investors of a failed bank bear the losses in order to keep their institution afloat. Theoretically, bank shareholders and creditors, being aware of their potential economic deterioration, are becoming interested in preventing the failure. We point out that the preparation of bail-in by resolution authorities could constitute the precise way and moment at which investors become aware of the bail-in threat. Specifically, the content of a drafted resolution plan and a conducted resolvability assessment could turn the abstract bail-in threat into a concrete one, motivating market players to act prudently. Yet, under the current European regime, this potential market discipline effect is not taken advantage of, since the dissemination of information included in plans and assessments is not permitted. This is due to concerns that disclosure of such data would disrupt financial stability, compromise commercial confidentiality and limit flexibility for future resolution actions. Overall, shedding light on the unexplored potential of resolution’s preparatory phase for strengthening market discipline, we aim at contributing to the debate regarding the trade-off between enhanced disclosure for the sake of market discipline and non-disclosure for the sake of countervailing standards.
Keywords: bail-in, bank governance, disclosure, incentives, financial stability, market discipline, preparatory phase of resolution, resolution authority, resolution planning, resolvability assessment.
5 1. Introduction
During the financial crisis of 2007-2009, banking system’s failure has been attributed not only to inadequate capitalization and insufficient liquidity but to improper corporate governance as well.1 Therefore, the optimization of bank governance is considered critical in forestalling future failures.
In general, governance concerns the development of the right incentives, that would enhance the value of a corporation, ensuring efficient managerial decision making. In the pre-crisis era, the non-financial companies’ governance norm, which focuses, mainly, on shareholder value maximization,2 was deemed to be appropriate for banks too. However, several reasons justify the post-crisis consensus in the literature,3 supported by empirical evidence,4 that banks need special treatment regarding their governance.
Firstly, in the case of banks, the application of the governance model for non-financials facilitates shareholders’ practices, that can lead to their institution’s failure. Banks, primarily, accept deposits and grant loans. In order to carry out this business, they raise a great part of their capital through debt.5 Due to the overleveraged bank capital structures, equity-holders have perverse incentives to enhance the riskiness of their bank, causing negative externalities.6 Bank owners are inclined to adopt this behaviour, since they expect that they will not bear the relevant costs, thanks to the limited liability they enjoy and to the possibility of a bail-out of their bank in the event of failure. In fact, in a bail-out scenario the failed institution would be saved by public subsidies (i.e. taxpayers’ contributions) instead of private investors’ monies.7
1 See Armour et al (2016), p. 370.
2 See Friedman (1970) pointing out that the objective of the corporation is maximizing shareholders’ value while
conforming to basic rules of society.
3 See, indicatively, Mulbert (2009), pp. 10-14, Becht et al (2011), pp. 444-445, Armour et al (2016), pp. 374-375
and Ferrarini (2017), pp. 5-7. It should be noted that the discussion about the specialness of bank governance had already started before crisis; see indicatively: Prowse (1997), Macey & O’Hara (2003), Adams & Mehran (2003), Levine (2004).
4 See, indicatively, Beltratti & Stulz (2012) and Erkens et al (2012). See also Becht et al (2011) and Ferrarini
(2017), pp. 7-9 summarizing empirical works, which support the opinion that what is considered ‘good governance’ for non-financial firms is not proper for banks.
5 See Armour et al (2016), p. 374.
6 See Becht et al. (2011), p 459. See also Jensen & Meckling (1976) formalizing this ‘risk-shifting’ or
‘overinvestment’ problem.
7 See Berk & DeMarzo (2019), p. 612 explaining that bank bail-outs are the reason behind the ‘too big to fail’
6 Secondly, within banks, debt governance, which is supposed to be a mechanism of control of the above-described shareholder behaviour, is, extremely, reduced if not absent.8 Bank creditors, who are supposed to act as monitors, fall short of doing so. On the one hand, they are unable to exert their disciplining role, facing collective action problems.9 On the other hand, they are not incentivised to monitor, having modest amounts at stake,10 being insured against potential bank losses11 and expecting a bank bail-out in the event of failure.12 Thus, debtholders’ passivity exacerbates even more the potential for a systemic meltdown.
Thirdly, setting aside the abovementioned drawbacks, financial regulation, which could be viewed as the last resort for system protection, is suboptimal in the case of banks, perhaps due to political economy reasons.13 Supervision is, extremely, lenient during non-crisis periods, allowing banks to follow their socially inefficient behaviour, and only when crises arrive does it become more stringent.14 This procyclicality means that regulation does not prevent bank failure but only tries to cope, belatedly, with the consequences of an already occurred failure. Finally, all the limitations laid down above do not lead to a disruption with a constrained systemic impact, as it would be the case for a non-financial corporation. In reality, their consequence is a breakdown with extremely huge systemic repercussions; the negative contagion of an individual institution’s failure is, rapidly, spread due to the interconnected structure of banks and due to the sharp loss of peoples’ trust to the financial system.15
On the above grounds, various legal reforms took place in the post-crisis period, aiming at the development of the appropriate bank governance. These alterations occurred within the context of the institutional construction of the European Banking Union (EBU).16
socially harmful behavior, bank shareholders overly engage in risky activities and bank creditors tend to overly forbear such activities.
8 See Admatti and Hellwig (2013). 9 See Armour et al (2016), p. 374.
10 See Diamond & Dybvig (1983) and Armour et al (2016), p. 374.
11 See DIRECTIVE 2014/49/EU of the European Parliament and of the Council of 16 April 2014 on deposit
guarantee schemes.
12 See Avgouleas & Goodhart (2015), p. 4 on the so-called ‘creditor inertia’.
13 See Armour et al (2016), pp. 553-576 on the political economy of financial regulation. 14 See Heremans & Pacces (2011), p. 560 and Dewatripont & Tirole (2012), pp. 18-19. 15 See Mülbert & Citlau (2011).
16 See Veron (2015), pp. 9-10 describing EBU as the pooling of banking sector policies (i.e. regulation,
7 The Bank Recovery and Resolution Directive (BRRD)17 and the Single Resolution Mechanism Regulation (SRMR)18 brought one of the most promising and heavily discussed reforms: the resolution tool of bail-in.19 Bail-in was not meant to be a governance reform. However, many scholars seem to recognize that, at least theoretically, bail-in has incidental implications on corporate governance.20 In particular, if a bank failure occurs and if a bail-in centered resolution is to be applied,21 those who suffer the consequences of the collapse are not the taxpayers but the private investors of the failed institution. Actually, in contrast to a bail-out, the application of bail-in has as a result that, instead of public funds, namely taxpayers’ contributions, debtholders’ and shareholders’ monies are employed in order to keep the bank afloat. Creditors and equity-holders, being aware of their potential economic deterioration in the failure scenario, may develop the right incentives in order to prevent such failure. Put differently, it is possible that bank lenders are going to exert better monitoring of bank activity and that bank owners are going to act more prudently, supporting less risky activities.22 Consequently, bail-in operates as a threat towards private bail-investors and, thus, enhances market disciplbail-ine23 and, accordingly, systemic resilience.
It must be noted that a bail-in execution can be prepared well before a bank failure. In particular, a preparatory phase is set out for this purpose24 consisting of two mechanisms, which constitute the focus of our interest: i) resolution planning and ii) resolvability assessment.25
17 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 and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No 1093/2010 and (EU) No 648/2012, of the European Parliament and of the Council.
18 REGULATION (EU) 806/2014 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 and amending Regulation (EU) 1093/2010.
19 See BRRD art. 37(3)(a-d) and SRMR art. 22 providing four different resolution tools: 1) the bail-in tool, 2) the
sale of business tool, 3) the bridge bank institution tool and 4) the asset separation tool.
20 See, indicatively, Avgouleas & Goodhart (2015), pp. 4-5 and 20, Chiu (2014), p. 612, Armour et al (2016), pp.
359-361.
21 See BRRD art. 32(1)(a-c) and SRMR art. 18 providing the three conditions that should be met concurrently so
that resolution can be applied: 1) the bank is declared as failing or likely to fail, 2) there is no alternative private solution that could prevent the failure within a reasonable timeframe, and 3) the resolution action is in the public interest.
22 See BRRD Recital 67.
23 See Flannery (2001) defining the term as: market investors’ ability to monitor (identify) changes in bank
condition [and as] their ability to influence a firm's actions. See also BRRD art. 31(2)(b) and SRMR art. 14(2)(b)
where the maintenance of market discipline is stated, explicitly, as a resolution objective.
24 To be sure, besides bail-in, the preparation concerns the other resolution tools too.
25 See BRRD art. 4-26 and SRMR art. 8-12 for the preparatory phase of resolution.Recovery plans, which fall
out of the scope of the present study, constitute a third core mechanism of the preparatory phase. Such plans shall be produced and updated at least annually by the bank itself and shall include the measures to be taken for the financial restoration of the institution, in the hypothetical scenario of a severe financial deterioration thereof (see BRRD 2(1)(32) and 5-9 and SSMR art. 4(1)(i)).
8 Resolution plans are documents produced and updated for each bank by the resolution authority.26 They include the authority’s resolution actions27 to be taken if the bank meets the conditions for resolution.28 Plans are complemented by the so-called resolvability assessment, which is also conducted by the authority. The latter evaluates whether the plan can be implemented at the moment of the assessment. If it concludes that this is not the case, because of impediments to resolvability, then it can exercise specific powers in order to remove such impediments and facilitate resolution.29
Against this backdrop, the thesis tries to find how and when the aforesaid impact of bail-in on bank private investors’ incentives, could, precisely, occur. Perhaps, it is not the mere enactment of bail-in that strengthens market discipline. Instead, it can be advocated that the preparation of bail-in could be the concrete way and moment at which the right motives are shaped and bank governance is enhanced, if at all. To be more specific, regarding resolution planning, we argue that there are certain content elements of a drafted resolution plan that could correct market participants’ incentives. Regarding resolvability assessment, we judge that the statutory powers conferred on resolution authorities, especially after the introduction of BRRD II,30 are quite intrusive, preparing the bank to be effectively subjected to bail-in and shaping private investors’ incentives.
Admittedly, under the current EU legal regime, the content of a drafted resolution plan and the details of a conducted resolvability assessment remain confidential.31 Thus, since the relevant information is not available to the market, any strengthening of market discipline is prevented.32 For that reason, it would be sounder for one to claim that the preparatory phase has disciplining effects, directly, on bank management, with which the resolution authority interacts during this phase, rather than on bank shareholders and creditors. Nevertheless, our
26 See BRRD art. 2(1)(18) and SRMR art. 3(1)(3). 27 See BRRD art. 2(1)(40) and SRMR art. 3(1)(10).
28 See BRRD art. 2(1)(41), 10-14 and SRMR art. 3(1)(6), 8-9 for resolution planning.
29 See BRRD art. 15-18 and SRMR art. 10 for resolvability assessment. The assessment must be conducted
simultaneously with and for the purposes of a resolution plan’s drafting/updating. It could be said, that the assessment concerns the present, since the resolution authority is evaluating whether the bank is, currently, resolvable and, if not, it employs its powers to make it such. The plan concerns the future, being prognostic, since the authority is planning, given the assessment of bank’s current situation, the actions that could enable an effective resolution at a later point.
30 DIRECTIVE 2019/879/EU of the European Parliament and of the Council of 20 May 2019 amending Directive
2014/59/EU as regards the loss-absorbing and recapitalization capacity of credit institutions and investment firms and Directive 98/26/EC.
31 See BRRD Recitals 36 and 86 and SRMR Recital 116 for the rationale of this secrecy.
32 See Martino (2020), p. 5-6 on the conditions (one of which is information availability) under which debt
9 core purpose is to shed light on the unexplored potential of resolution’s preparation for correcting private investors’ incentives. Therefore, in order to do so, we base our analysis on a hypothetical regime, one allowing the dissemination of the contents of resolution plans and resolvability assessments. It must be clarified that we do not, necessarily, develop a normative argumentation through this way, since we do not prove why enhanced disclosure for market discipline purposes should prevail against the countervailing interests (i.e. preservation of: financial stability, commercial confidentiality and authority’s flexibility for future actions); our goal is to explore the unchartered relationship between resolution’s preparation and market discipline and to, accordingly, contribute to the existing debate regarding the optimal degree of disclosure.
In the spirit of the above, the rest of the thesis proceeds as follows. Section II illustrates banking’s specialness in presenting systemic risks, which is the justification for special governance in order to address such risks. Section III welcomes the bail-in reform under BRRD and SRMR as a step towards the development of such special governance. Section IV specifies the precise aspect of bail-in reform that could influence market incentives. Particularly, it points out the content elements of a resolution plan and the resolvability assessment powers, which could influence private investors’ motives under the hypothetical scenario of enhanced disclosure. Section V summarises the conclusions of the paper.
10 2. Bank Governance
2.1. The Concept of Corporate Governance
In corporate finance literature, a widely accepted formal definition of corporate governance is given by Shleifer and Vishny: “corporate governance deals with ways in which suppliers of
finance to corporations assure themselves of getting a return on their investment.”.33 Financiers
need to have appropriate checks and balances in order to prevent corporate insiders from, directly, stealing their money or investing them in negative NPV projects. This positive definition is open to interpretation.
Specifically, two aspects need clarification: a) who are the financiers of a corporation, namely who should benefit from corporate governance and b) what should be the best way to ensure such benefit.
As for a), strictly speaking, equity-holders and debtholders are those financing a firm. However, in the banking context, financing is done by others too: the taxpayers. The latter ones provide an implicit subsidy to the bank due to the bank’s expectations of a bail-out in the event of failure. So, the treatment of taxpayers as ‘indirect corporate financiers’ means that they should enjoy the protection of corporate governance. Correspondingly, governance should also protect financial stability by preventing the accumulation of systemic risk; this holds, since in the occurrence of a systemic failure those who suffer the consequences are, foremostly, the taxpaying citizens.
As for b), namely as for which is the best way to ensure the benefit of all those entitled to governance protection (i.e. shareholders, creditors and taxpayers), there are two distinct views. On the one hand, according to the narrow-shareholder oriented view, maximizing solely shareholder profits is enough to ensure the welfare of the rest stakeholders too and thus to preserve financial stability.34 This is explained by the existence of other external legal means that serve the interests of the rest stakeholders: contracts35 and tort liability36 protect creditors and substantive regulation37 protects the taxpayers. Such legal mechanisms internalize to the
33 See Shleifer & Vishny (1997), p. 737. 34 See note 2.
35 See Coase (1960) on contractual internalization.
36 See Calabresi (1971) on the complemental role of tort law internalization to contractual internalization. 37 See Pigou (1920) on the penal and tax imposing role of regulation concerning an activity that yields negative
11 firm’s profit function any externalities that may arise from the internal activity of shareholder value maximization.38 A governance description that expresses this shareholder-centred idea is the one given by Sir A. Cadbury: “[… corporate governance is] a structure […] which is robust
enough to give the shareholders what they ought to get and what they can rely upon […]”.39
On the other hand, according to the wider-stakeholder oriented view, the welfare of the totality of stakeholders and by extension of the whole system is not ensured through the absolute pursuit of shareholder profit. This is attributed to the failure of the abovementioned external legal mechanisms to internalize properly any externalities.40 Thus, an internal corporate governance model, which is not, solely, pro-shareholder but which, directly, serves the interests of all stakeholders, is an imperative.41 A definition embracing this idea is given by Tirole: “Governance is a set of relationships between a company's management, its board, its
shareholders and other stakeholders. Corporate Governance also provides the structure through which the objectives of the company are set, and the means of attaining those
objectives and monitoring performance are determined.”.42 In the same vein goes the definition
by Becht, Bolton and Roell: “Corporate governance is concerned with the resolution of
collective action problems among dispersed investors and the reconciliation of conflicts of
interest between various corporate claimholders”.43
The thesis adopts the definition given by Shleifer and Vishny, as interpreted under the light of
Tirole’s definition.44 Therefore, governance is about ensuring that all the constituencies, which
provide finance to the corporation either explicitly (i.e. shareholders and creditors) or implicitly (i.e. taxpayers), do not end up being exploited. This can be ensured by shaping the incentives of market players within the corporation in such a way as to take into account the interests of all the involved stakeholders and strike a balance between them. Against this background, our focus is on a specific form of governance: market discipline.45
38 See Armour & Gordon (2014), p. 37. 39 See Cadbury (1992).
40 See Armour & Gordon (2014), pp. 45-50. 41 See Armour & Gordon (2014), p. 37.
42 See Tirole (2001). See also OECD (2015) adopting the same definition. 43 See Becht et al (2003).
44 Yet, in Tirole’s definition, the term ‘stakeholders’, apart from taxpayers, includes also NGOs, workers etc. 45 See Heremans (2007), p. 7 for the several forms of governance.
12 2.2. The Peculiar Nature of Bank Governance
2.2.1. Bank Governance from Two Different Angles
There are two distinct views about bank governance: 1) the assimilation theory and 2) the bank
exceptionalism theory.46
Consistent with the first theory, which was prevalent prior to the crisis, it was deemed appropriate for banks to have the governance mechanisms of non-financial firms (i.e. pro-shareholder mechanisms). In a similar manner as the narrow-pro-shareholder oriented approach, this theory assumed that any adverse consequences, stemming from banking to third parties, could be internalized, efficiently, through contracts or regulation. The global crisis of 2007-2009 showed credibly that this does not hold, since banks, which had in place pro-shareholder mechanisms suffered the greatest losses during the crisis.47
According to the second theory, which is the prevailing one post crisis, bank corporate governance should be special in order to deal effectively with the special threat that these institutions present for the whole system. Scholars48 have identified a list of attributes, that endorse this specialness, and which are analyzed right below.
2.2.2. Bank Specialness and Governance Implications
In contrast to non-financial corporations, banks pose systemic externalities in a unique way, owing to their peculiar business structures, the incentives of people they involve49 and the magnitude of the system-wide effects they generate. This specialness is clearly illustrated by the following features:
i) highly leveraged capital structure, ii) opaqueness of bank assets and activities, iii) extremely poor debt governance,
iv) regulatory failure, and
v) great amplitude of systemic externalities.
46 See Armour et al (2016), p. 371. 47 See notes 3 and 4.
48 See note 3.
13
i. Highly Leveraged Capital Structure
Banks’ principal business is to transform short term liabilities, such as deposits, into long term assets, such as loans. So, the larger part of these institutions’ capital is raised through debt.50 These high debt levels in bank balance sheets are the reason behind the engagement of bank owners in excessive risk taking, that can lead to systemic externalities.51
Equity-holders prefer risky activities, which simultaneously have a huge upside and downside potential. Increased creditors’ stake subsidizes the pursuit of such risky operations. On the one hand, if the activity is successful, then any economic surplus yielded after paying creditors will be enjoyed, solely, by shareholders. The reason for this is that creditors are fixed claimants, being not entitled to more money than the amount owed to them. On the other hand, if the activity fails, then shareholders have nothing to lose, thanks to the limited liability construction, whereas creditors’ claims may not be fulfilled in total or at all. Thus, shareholders can only gain and have nothing to lose from risky operations, while creditors do not gain anything or even end up suffering losses on their claims. Debt elevates this selfish behavior of bank owners; the greatest the amount of debt within the bank, the more acute this investment distortion can become.
As it is explained below, this practice of shareholders is not properly blocked by bank creditors. Moreover, equity-holders are inclined to adopt this behavior during prosperous times, when financial regulation is laxer and when they have reasons to believe that their bank will be bailed out in the event of failure.52 As a result, the build-up of systemic risk is facilitated without proper safeguards being in place.
ii. Opaqueness of Bank Assets & Activities53
Another aspect that exacerbates the socially suboptimal risk-taking within banks, is the fact that bank assets are complex and bank activities have a fiduciary nature.54
The characteristics of bank borrowers are not commonly known, so, the loans granted to them are hard to observe and measure. Apart from bank loans, the quality of other bank assets too, such as credit derivatives (e.g. CDOs, CDSs), is not easily observable.55 This poses a serious
50 See note 5. 51 See note 6. 52 See note 7.
53 See contra: Flannery et al. (2004) providing evidence that bank assets are not opaque. 54 See Diamond (1984).
14 obstacle to the effective monitoring of bank activity by creditors and to the scrutiny of these bank assets’ value by potential hostile bidders.56 Additionally, this, partially, explains why the market for corporate control, a form of external market discipline, is lessened in the banking sector.57
Overall, bank opacity weakens the monitoring role of several market players and thus further enhances risk taking activity.
iii. Extremely Poor Debt Governance
In a non-financial corporation, there are standard debt governance mechanisms, that could address the abovementioned risk-taking problem. Such mechanisms take either the form of covenants, namely, contractual restrictions on corporate activity,58 or the form of price adjustment to the risk profile of the corporation (i.e. imposition of higher cost of debt capital on the borrower).59 Both are contractual tools devised by creditors. However, within banks, the use of these powers is suboptimal.
Aside from asset opaqueness, the inefficient disciplining role of debt can be, largely, attributed to other elements too, which exacerbate the lack of creditors’ incentives and/or competence to monitor.
In particular, insured depositors, who represent a great proportion of short-term bank creditors, are not motivated to keep an eye on the bank, because they have only modest amounts at stake60 and, most importantly, in the event of a bank failure, they are, up to a certain point, protected from any potential losses, thanks to deposit insurance.61 Therefore, they end up not caring about bank performance and specifically about risk accumulation.62 Such creditor apathy is further enhanced if the failing bank is expected to be saved by the government with public money, so that creditors will end up not bearing any consequences of the failure.63
Having said that, even if deposit insurance was not in place, it is a fact that bank depositors and other long-term bank creditors are widely dispersed and inexperienced, facing serious
56 See Armour et al (2016), p. 375.
57 See Armour et al (2016), p. 375 mentioning the banking supervisors’ control over bank ownership structure as
an additional reason for less active takeover activity within banking. See also Heremans (2007), p. 15 claiming that an active market for corporate control would not be conductive to bank stability.
58 See Berk & DeMarzo (2019), p. 914.
59 See Martino (2020), p. 4 for a third type of debt governance: creditors’ voice. 60 See note 10.
61 See note 11.
62 See Ferrarini (2017), p. 6. 63 See note 12.
15 collective action problems,64 in contrast to a non-financial corporation’s sophisticated creditors, which are usually banks. The coordination obstacles and the lack of expertise weaken even more the screening of the bank.
Hence, the governance role of debt is not strong or it is even absent in the case of banks.65 This has implications not only in relation to creditors’ interests but with respect to other parties’ interests alike; bank lenders fail to control an activity which affects the taxpayers and the system as a whole.
iv. Regulatory Failure
Since debtholders do not operate as ‘brakes’ to the risk-taking activities of a bank, one could consider financial regulation as an additional safeguard against the systemic threat of excessive risk taking. Regulation is supposed to constrict an activity of a market player (e.g. a bank) that produces negative effects on third parties, by imposing costs upon that player.66
However, in the case of banks, this does not work properly. Bank activity is procyclical. Banks tend to take excessive risks (e.g. they lower credit standards, granting loans to marginal borrowers) during economic upswings, while they only tighten their activity (e.g. they enforce stricter lending criteria) during economic downturns. This behavior can create credit booms, which, at some point, produce a crisis for the whole system.67 Financial regulation, being procyclical too due to political economy reasons, cannot cope efficiently with this problem.68 Regulation is overly lax during economic booms and becomes stricter only during economic dooms.69 Therefore, banks are not properly regulated at the crucial moment when they should be.
This ‘gap’ in regulation should be compensated with internal governance. Specifically, it is necessary that the right market participants’ incentives are in place in order to prevent a failure, which substantive regulation is on its own unable to stop.
64 See note 9. 65 See note 8. 66 See note 37.
67 See Borio (2014) on financial cycles. 68 See note 13.
16
v. Great Amplitude of Systemic Externalities
If neither creditors nor financial regulation constrain excessive risk taking, then great social costs may occur.
In particular, these are: a) the detrimental impact on taxpayers in case of an individual bank’s bail-out; and/ or b) the broader financial instability that can be caused by an individual institution’s breakdown; the failure can be rapidly spread either directly through the interconnected banking structure or indirectly through the negative impact on bank depositors’ trust in financial system.70 In any event, the failure implications are extensive and are borne by the taxpaying citizens.71
To be more specific, banks are extremely interconnected institutions, since a bank’s liabilities may be another institution’s assets (e.g. interconnection through the payment system).72 Thus, in the event of an individual bank failure, the destabilization of other institutions (‘domino
effect’) is highly probable. Banks are vulnerable to failure due to the special transformative
functions they perform: maturity, liquidity and credit transformation.73 They convert short-term, liquid, safe liabilities (e.g. deposits) into long-short-term, illiquid, risky assets (e.g. loans). Inherently, this type of business carries a huge risk. Due to the maturity and liquidity mismatch, in the occurrence of a massive funds’ withdrawal by bank depositors (‘a bank run’), the financial institution, in order to meet its depositors’ demands, may end up to ‘fire sales’74 of its illiquid assets, suffering the corresponding losses.75 Things can get even worse if:
- the depositors’ withdrawal from an individual bank affects the trust of other banks’ depositors, and thus leads to further withdrawals from other banks (failure of the ‘confidence trick’),76 and/or
- the fire sales of the failed bank’s assets lead to a value decline of similar assets in other institutions’ balance sheets and thus to a broad financial distress.77
70 See note 15.
71 See Schillig (2013), p. 754 about the ‘quasi-utility function of banks’; banks provide critical services to society
(e.g. payment system, lending etc.). So, their failure, which leads to the cease of critical services’ provision, is disastrous.
72 See Armour et al (2016), pp. 281-283. 73 See Armour et al (2016), pp. 277-278.
74 See Shleifer & Vishny (1992) defining ‘fire sales’ as forced sales occurring at suboptimal prices. 75 See Armour et al (2016), p. 280.
76 See Armour et al (2016), p. 278.
17 It can easily be observed that bank systemic spillovers have a great breadth and their spread is well facilitated.
2.2.3. Agency Conflicts78
For systematic purposes and given that Agency Theory is a classic and convenient framework for analyzing corporate governance, it is appropriate to, cursorily, go through the agency conflicts, which may arise within a bank. This will allow us to see how such conflicts present themselves under the light of the above-described bank peculiarities.
Agency costs originate from the ownership-control separation (see below: i-ii) and the provision of external financing (see below: iii-iv).79 For our purposes, we are focused on the conflicts stemming from external financing provision, since those under i. and ii. are less pronounced within banks. Nevertheless, a brief description of the latter is also provided for the sake of comprehensiveness.
To start with, conflicts may arise between the following ‘principals – agents’ within a bank:80 i) shareholders – managers,
ii) minority shareholders – dominant shareholders,
iii) parties providing explicit contractual financing to the corporation (creditors) – corporate insiders, and
iv) parties providing implicit contractual financing to the corporation (taxpayers) – corporate insiders.
It can easily be observed that the principals under i-ii are internal financiers (shareholders) while those under iii-iv are external financiers (creditors and taxpayers). As we already explained, corporate governance protects financiers. Bank governance should, primarily, protect, the principals under iii-iv who are the most vulnerable, since, as it was shown, contracts and substantive regulation do not effectively protect them.
i. Shareholders – Managers81
Shareholders, not being best qualified to run their company on their own, grant control powers to hired managers. For that reason, they end up vulnerable to these agents’ opportunistic
78 See Kraakman et al (2017), p. 29 for a definition of the term.
79 See Pacces (2008), p. 152 on the forms that agency conflicts’ exploitation can take. 80 See Kraakman et al (2017), pp. 29-30 for a similar classification.
18 behavior. In a non-financial corporation, the separation of ownership and control problem82 can be solved by pro-shareholder governance mechanisms, that could tackle managerial opportunism (e.g. independent board of directors, performance-based executive remuneration etc.). However, within banks, such mechanisms would subsidize even more the risk-taking behavior of shareholders, allowing an unconstrained risk accumulation.
ii. Minority Shareholders – Dominant Shareholders83
Non-controlling owners can get expropriated by the dominant shareholder who may extract private benefits of control (i.e. disproportionate returns at the expense of minority).84 This conflict is predominant where ownership is concentrated in the hands of a few shareholders rather than diffused. An effective way to cope with it is the provision of minority shareholder rights (e.g. pre-emptive rights).
iii. Creditors – Corporate Insiders85
Shareholders are residual claimants while creditors are fixed.86 This difference in claims’ nature may induce equity-holders to engage in practices detrimental for debtholders.
During prosperous times, as it was already analyzed, bank owners tend to take risky activities, enjoying the upside potential of those operations while being indifferent about the downside, since the latter is, totally, borne by creditors (‘risk shifting’).87
During poor times, shareholders tempt to forego projects that could increase the value of their company, because they know that any profit yielded would not reach them but, instead, it would reach fixed claimants, who enjoy priority in payment (‘debt overhang’).88
As it is already indicated, our focus is on risk-shifting, since it is not affecting solely creditors, but it also poses a serious threat against systemic stability.
82 See Grossman & Hart (1986).
83 See Johnson et al (2000) and Shleifer & Vishny (1997).
84 See Kraakman et al (2017), p. 79. See also Pacces (2008), p. 403 on the different forms of these benefits. 85 See Clark (1977) on debtor’s duties to its creditors.
86 See Tirole (2006). 87 See note 6.
19
iv. Taxpayers – Corporate Insiders
Banking as any corporate activity generates adverse effects on other third parties besides creditors. These negative externalities are market failures, which should be corrected.89 In the case of banks, taxpayers constitute the third parties. Typically, financial regulation, which serves the public interest, protects taxpayers, since the latter, unlike creditors, do not have any private means, such as contracts, for self-protection.90 Nevertheless, as it was shown, regulation does not offer efficient protection.
2.3. Interim Conclusion
Overall, that far, we treated corporate governance as the development of market participants’ incentives to act in such a way so that the interests of all corporate financiers are respected. We considered taxpayers as financiers of banks, who deserve governance protection. So, market incentives should be shaped in a way to ensure that taxpayers’ interests are taken into account. In particular, systemic concerns should be taken into account because a threat against the system is tantamount to a threat against the taxpayers. Therefore, the protection of the whole system can be considered as a governance objective.
It was clearly illustrated, that the core problem regarding banks is, exactly, the great potential for an amplified systemic failure because of excessive risk-taking by bank insiders. This behavior originates from the peculiar capital and business structures of banks (i.e. high leverage and liquidity and maturity mismatch), and it is subsidized by the lack of necessary checks and balances that could, otherwise, confine it (i.e. lessened debt governance and regulatory failure). We indicated that the remedy to this problem is to reinforce internal bank governance; bank shareholders and creditors should be motivated to care about the effects of risky bank operations. The following section evaluates some of the most popular post-crisis bank governance reforms in the context of EBU and acknowledges bail-in reform as the most appropriate to promote the abovementioned solution.
89 See Armour et al (2016), p. 57. 90 See Van der Elst (2015), pp. 24-25.
20 3. Evaluation of Bank Governance Reforms in the Post-Crisis EU and
Comparative Advantage of Bail-in
3.1. The European Banking Union
The two main, fully functioning, policies underpinning the institutional construction of EBU are: 1) the Single Supervisory Mechanism (SSM), within which the main decision-making body for bank supervision is the European Central Bank’s Supervisory Board, and 2) the Single Resolution Mechanism (SRM), within which the decision-making powers for bank resolution belong to the Single Resolution Board (SRB). Both policies concern financial institutions91 of Eurozone countries.92
SSM aims at implementing, in the context of SSM Regulation,93 the ‘Single Rulebook for supervision’, consisting, mainly, of Capital Requirements Directive (CRD IV)94 and Capital Requirements Regulation (CRR).95 On the contrary, SRM, on which is our focus, aims at implementing, in the context of SRMR, the ‘Single Rulebook for resolution’, consisting, principally, of BRRD and BRRD II.
To better illustrate the relationship between BRRD and SRMR, on the one hand, BRRD is applicable to all EU Member States96 and lays down the substantive rules of resolution, determining as resolution authorities the National Resolution Authorities (NRAs).97 On the other hand, SRMR is only applicable to Eurozone countries98 and implements the rules of BRRD, determining SRB as the resolution authority, in cooperation with NRAs.99 For the rest of the analysis, we treat SRB as the resolution authority.
In the post crisis era, several reforms, in the context of EBU, are deemed to influence either incidentally (see under iii) or deliberately (see under i-ii) the incentives of bank players and, in general, bank governance. Based on already expressed views in the literature, we try to point
91 See BRRD art. 2(1)(23). We focus on credit institutions (i.e. banks). 92 Yet, participation in EBU is allowed to other EU countries too.
93 REGULATION (EU) 1024/2013 of 15 Oct. 2013 conferring specific tasks on the European Central Bank
concerning policies relating to the prudential supervision of credit institutions.
94 DIRECTIVE 2013/36/EU of 26 June 2013 on access to the activity of credit institutions and the prudential
supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC.
95 REGULATION (EU) 575/2013 of 26 June 2013 on prudential requirements for credit institutions and
investment firms and amending Regulation (EU) 648/2012.
96 See BRRD art. 1(1). 97 See BRRD art. 3. 98 See SRMR art. 2(a). 99 See SRMR art. 5.
21 out the limitations of the SSM reforms (see under i-ii) and show why the SRM reform of bail-in should be considered as the most promisbail-ing one to achieve the desired shapbail-ing of market incentives.
Particularly, the following reforms are discussed: i) executive remuneration,
ii) the board of directors – risk management, and iii) the resolution tool of bail-in
3.2. Executive Remuneration
As it was indicated, the managerial conflict is less prominent within banks, since bank owners and their executives may be allied in risk taking activities. Thus, the tying of executive compensation to stock performance, which aligns shareholder and managerial incentives, needs to be tailored to the case of banks.100 This is what CRD IV tried to do.
The directive introduced several strict rules regarding executive remuneration.101 The most notable is the following: the imposition of an upper threshold (‘cap’) on the amount of managerial compensation’s variable component (i.e. the latter shall not exceed the 100% of the fixed component).102
The formal objective of the variable pay cap provision is the curtailing of excessive risk taking.103 However, the true impact of the reform on bank governance is ambiguous. Suffice it to say that a considerable strand of the literature is critical towards capping104 on the grounds that: it is an ‘one size fits all’ solution which is not appropriate for all banks;105 it may increase the base pay, having, ultimately, an odd impact on risk taking;106 it may eliminate executives’ incentives for better performance, once the cap is reached, and it may, furthermore, cause employment selection effects, since the talented individuals could migrate to financial firms, where the pay restrictions do not apply.107
100 See Armour et al (2016), p. 380. 101 See CRD IV art. 92-96.
102 See CRD IV art. 94(1)(g). 103 See CRD IV Recitals 64 and 65. 104 See contra Van der Elst (2015), p. 29. 105 See Ferrarini (2015), p. 37.
106 See Murphy (2013), Ferrarini (2015), pp. 36-37 and Armour et al (2016), p. 387 explaining how the
confinement of variable pay can incentivize executives to take more risks with downside potential rather than risks with upside potential.
22 Given the already expressed concerns laid down in the previous paragraph, it can be deduced that the relevant CRD IV provision tends to distort rather than correct managerial incentives, failing to achieve the envisaged reduction of bank risk-taking.
3.3. The Board of Directors & Risk Management
If managers are not incentivized through the capping of their variable pay to reduce suboptimal risk-taking, then one should assess the effectiveness of other types of checks and balances provided under CRD IV.
There is empirical evidence that banks with pro-shareholder boards were associated with greater risk-taking pre-crisis and ended up to greater losses post crisis.108 CRD IV considered this and tried to ensure that the bank board of directors does not simply act in the interest of shareholders but it also manages, prudently, the risks that are assumed by the financial institution.109
The directive introduced a number of relevant rules. Regarding risk management,110 it requires the board of directors to dedicate the necessary time for risk consideration and systemic banks to establish a risk committee, within their boards, absolutely charged with risk management tasks.111 Moreover, the national regulator should provide analytical guidelines for the management of the different kinds of risk that a bank may face.112 With respect to purely board reforms, the most remarkable alteration is the split of the, potentially, conflicting roles of the CEO, who is supposed to serve shareholder interests and thus support risk taking, and of the Chairman of the board, who is supposed to govern a board whose task is to, prudently, manage risks.113
The effectiveness of these governance reforms cannot be taken for granted. The guidelines of national regulators for the management of different risk types may be, extremely, complex, making it difficult, if not impossible, for the bank boards to comply with their procedural duties.114 Furthermore, the provisions concerning bank boards of directors have been
108 See note 4.
109 See Armour et al (2016), p. 377. 110 See Armour et al (2016), p. 379-380. 111 See CRD IV art. 74(2) and 76(2)(3). 112 See CRD IV art. 77-87.
113 See CRD IV art. 88(1)(e) and 91. 114 See Armour et al (2016), p. 380.
23 characterized by some scholars as ‘quack corporate governance’ reforms, arguing that the
status quo ante was preferable.115
Overall, the extent to which, if at all, the relevant CRD IV provisions achieve the envisaged prudent risk management is questionable.
3.4. The Resolution Tool of Bail-in
After casting doubt on the effectiveness of the two previous reforms in countering excessive risk taking, we should elaborate on why bail-in, one of the resolution tools provided under BRRD and SRMR,116 is more likely to reinforce bank governance.117
It should be noted that the enactment of bail-in has two distinct positive effects on financial stability:
i. the direct effect: in the event that a bank failure has been approached or has occurred,
bail-in replaces the bail-out tactic and thus it, directly, protects systemic stability and taxpayers, who would be harmed in a bail-out scenario,118
ii. the indirect effect: well before the vicinity or occurrence of bank failure, the threat of
bail-in enhances, theoretically, market discipline, incentivizing market players to limit excessive risk taking. Thus, bail-in can prevent the failure, offering indirect protection to the system and to the taxpayers. This second effect is the focus of our interest. In the event of a bank collapse, bail-in can be applied.119 This means that SRB has a far-reaching statutory power; it can impose the losses of a failure on bank shareholders and bail-in able creditors120 within the context of an administrative procedure.121 The authority can, effectively, do this if and only if the ‘minimum requirement of own funds and eligible
liabilities’ (MREL)122 is met by the concerned bank. Specifically, the sufficiency of ‘own
115 See Enriques & Zetzsche (2015). 116 See BRRD art. 43 and SRMR art. 27.
117 See however, Avgouleas & Goodhart (2015), pp. 14-22 for an analysis of the challenges that accompany a
bail-in application.
118 See BRRD Recitals 1 and 5. 119 See note 21.
120 See BRRD art. 44(2)(3) and SRMR art. 27(3)(4)(5) outlining the types of liabilities that are excluded from the
scope of bail-in either by law or by SRB’s decision.
121 See Wocjcik (2016), p. 95.
122 In a global level, the corresponding minimum requirement for global systemically important banks is the so
24
funds’123 and ‘eligible liabilities’124 is necessary in order to ensure a proper loss absorption and
recapitalisation with a minimum impact on taxpayers and on financial stability, in the event of failure;125 so, eligible liabilities are high-quality ‘bail-in able liabilities’126 regarding loss absorption and for that reason they are essential in tandem with own funds for an easier and more effective bail-in execution.
BRRD II created a novel MREL framework, that outlines the details with respect to MREL, its determination and application.127 The determination, namely the calculation of the sufficient amount of own funds and eligible liabilities that a bank should hold, is done on a firm-specific basis and it is different for each of the following types of bank entities: i) ‘ordinary’ banks,128 ii) ‘top-tier’ banks whose total assets exceed EUR 100 billion,129 iii) Global Systemically Important Institutions (G-SIIs)130 and iv) non-resolution entities.131 The application, namely the compliance of each type of bank entity to the determined MREL for it, is distinguished for resolution entities and non-resolution entities.132
Overall, if MREL is sufficient within a bank and thus in is effectively prepared, then bail-in application can have adverse consequences for the private bail-investors of the bank.
From a shareholder perspective, in execution may lead to cancellation, transferal to bail-in able creditors or dilution of existbail-ing shares.133 Ex ante, this prospect induces bank owners to monitor more prudently their managers and to lessen excessive risk taking. Ex post, new conservative investors substitute for the previous excessive risk-taking bank owners.134
From the perspective of bail-in able debtholders, who are, principally, long-term creditors, either senior or subordinated,135 bail-in implementation can deteriorate their financial position through the amendment of their lending terms, the cancelation, the write down or the
123 See BRRD art. 2(1)(38) and SRMR art. 3(1)(40) for the technical definitions of ‘own funds’.
124 See BRRD art. 2(1)(71a) and SRMR art. 3(1)(49) for the technical definitions of ‘eligible liabilities’. See also
BRRD Annex Section C (17).
125 See BRRD II Recital 5 and art. 1(1)(d).
126 See BRRD art. 2(1)(71) for the technical definition of ‘bail-in able liabilities’. 127 See BRRD art. 45 and BRRD art. 45h.
128 See BRRD art. 45c(3). 129 See BRRD art. 45c(5).
130 See BRRD art. 45d. See also BRRD art. 2(1) point (83c) for the definition of G-SIIs. 131 See BRRD art. 45c(7).
132 See BRRD 45e and 45f. See also BRRD art. 2(1) point (83a) for the definition of ‘resolution entities’. 133 See BRRD art. 47(1)(a) for cancellation, art. 63(1)(c)(h) for transferal, art. 47(1)(b) and art. 63(1)(f) for dilution
(which is caused due to the conversion bail-in able creditors’ claims into shares or other ownership instruments). See also SRMR art. 27.
134 See Armour et al (2016), p. 360.
135 See Armour et al (2016), pp. 360-361 explaining why short-term funders are not the best candidates for
25 conversion of their claims;136 in other words, these investors may end up lending in less favourable terms, their claims may be directly reduced or they may become holders of riskier securities (i.e. shares). Thus, ex ante, they are incentivized to exert better effort in monitoring their borrower’s (i.e. bank’s) activity.137 A simple example will be provided in the end of this subsection, illustrating how bail-in can damage subordinate bank creditors.
To summarise, it is assumed that private investors, having in mind the above-described economic harm, which they may experience in a bail-in scenario, will be inclined to prevent the main precondition for bail-in, namely bank failure,138 in order to prevent the undesirable bail-in itself. To be sure, investors will still act individualistically, trying to avoid the negative effects of bail-in upon themselves. However, their individualistic incentives will now be aligned with the prevention of a bank breakdown.
As it will be argued, this alignment of motives with systemic concerns could be, precisely, attributed to the preparation of an effective bail-in execution, rather than to the bail-in enactment in abstracto. The preparatory phase of resolution could constitute the way and moment, when bank investors could conceive clearly their potential economic deterioration due to bail-in. Having this in mind, we should proceed in the next section to shed light on resolution’s preparatory phase.
Oversimplified Illustration of Bail-in Operation
The first table below presents a bank balance sheet before any losses incurred.
136 See BRRD art. 63(1)(j) for the power of SRB to amend the maturity and the amount/date of interest payable,
art. 63(1)(g) for cancelation, (e) for write down, and (f) for conversion. See also SRMR art. 27.
137 See Armour et al (2016), p. 361. 138 See note 21.
BANK BALANCE SHEET BEFORE LOSSES
ASSETS LIABILITIES
AAA Government Bonds: EUR 100,000 Equity held by original bank shareholders: EUR 100,000
Mortgages 90% LTV: EUR 200,000 Deposits: EUR 100,000
Mortgages 75% LTV: EUR 120,000 Subordinate Debt: EUR 25,000 Cash: EUR 35,000 Senior Debt: EUR 230,000
26 Assumptions:
✓ The bank suffers losses of 40% on its Mortgages 90% LTV, owing to risky operations, induced by its managers. In particular, the losses are ascribed to the laxness of the relevant lending criteria set by the bank, since the institution ignored the profile of its margin borrowers.
✓ Bank equity that is already in place absorbs the losses. So, in absolute terms, the losses are equal to EUR 80,000 and consequently, equity is reduced from EUR 100,000 to 20,000.
✓ Of course, after this, the bank does not become balance sheet insolvent but it qualifies as ‘likely to fail’ under BRRD art. 32 and the rest of resolution conditions are also met. ✓ According to the chosen resolution strategy, the minimum equity capital post resolution
must be 12% of balance sheet total (i.e. EUR 45,000).
✓ Subordinate debt is bailed-in, being converted into equity at a rate of 1:1.
BAILED-IN BANK BALANCE SHEET AFTER LOSSES
ASSETS LIABILITIES
AAA Government Bonds: EUR 100,000 Equity: EUR 45,000. From this amount: • EUR 20,000 are still held by the
original bank shareholders, and • EUR 25,000 are held by the bailed in
claimants of subordinate debt. Mortgages 90% LTV: EUR 120,000 Deposits: EUR 100,000
Mortgages 75% LTV: EUR 120,000 Subordinate Debt: 0 Cash: EUR 35,000 Senior Debt: EUR 230,000
27 Conclusion:
Post bail-in, subordinate debtholders are still entitled to the same value of EUR 25,000, as prior to bail-in. Nevertheless, they end up in a worse economic position for a series of reasons:139
✓ Bail-in converts their fixed-safer claim into a residual-riskier claim (i.e. equity claim) and their risk exposure to the bank business continues.
✓ Apart from risk issues, they end up holding a non-cash illiquid instrument and their right to liquidation has been extinguished.
✓ Although it is not shown in our example, they face another potential peril: they may end up undercompensated due to unfavourable conversion rates employed by the resolution authority.
Overall, subordinate debtholders, knowing that a potential operation of bail-in would be harmful for them, will be incentivized to make sure that the bank does not suffer the losses described above, which are the triggering factor of bail-in.
139 See Tollenaar (2017) for a similar argumentation regarding creditors’ worse off in the context of a corporate
28 4. The Legal Framework of Resolution Planning and Resolvability Assessment and its
Relationship with Bank Governance
4.1. Resolution Planning and Resolvability Assessment as Operational Part of the BRRD & SRMR Resolution Framework
In general, resolution can be qualified as a better alternative to ordinary insolvency proceedings and to the bail-out of a bank.140 First, resolution rules are harmonized at EU level (i.e. BRRD and SRMR). Second, theoretically, resolution could prevent or, at least, minimize bail-out’s negative effects upon taxpayers. Finally, a cumbersome national insolvency proceeding, which may be extremely costly141 and obstruct the continuation of a bank,142 can be sidestepped thanks to resolution.
The term ‘resolution framework’ is used to describe all the consecutive phases that can lead to bank resolution. BRRD and SRMR distinguish between three different phases, which are the following chronologically:
i) The preparatory phase of resolution (i.e. recovery planning, resolution planning and resolvability assessment).143 Resolution plans, on which we are focused, are being developed and updated by SRB at least annually or in the event of any material alterations.144 The bank is involved in the development of the plan, if it is requested to do so by SRB in order to provide its assistance.145 As we already mentioned, a plan is complemented by a resolvability assessment.146 A bank’s resolvability depends on SRB’s ability to implement the prepared resolution plan and, specifically, the preferred resolution strategy.147 So, for our purposes, a bank is resolvable when bail-in can be applied either as a freestanding tool or in conjunction with one of the other resolution tools. When assessing resolvability,148 SRB has a dual mission: (1) the determination of whether the bank is resolvable and, in the negative, the identification of the impediments to swift resolution, as
140 See Armour et al (2016), p. 343 presenting resolution as the ‘third way’.
141 See Armour et al (2016), p. 342 claiming that the bankruptcy costs of bank failure are extremely higher than
those of a non-financial company’s failure.
142 See Wojcik (2016), pp. 92-93. 143 See note 25.
144 See BRRD art. 10(1)(6), 12(1) and SRMR art. 8(1) and 9(1). 145 See BRRD art. 10(5), 11 and SRMR art. 8(8).
146 See note 29.
147 See BRRD 15(1) for single banks, 16(1) for bank groups and BRRD II art. 1(5)(a). See also SRMR art. 10. 148 See BRRD art. 15(2-4) and 16(2-4) for individual banks and groups, respectively. See also SRMR art.
29 well as (2) the removal of these impediments by making use of powers granted for this objective.149
SRB conducts resolvability assessment operating within the framework of a specific procedure, which adopts an almost similar course for both single banks and groups.150 In broad lines, initially, the bank will be, informally, notified about SRB’s conclusion regarding the existence of impediments and will be requested to remove them.151 If this is not effective, then impediments are qualified as ‘substantive’ and, formally, SRB notifies the concerned bank about their existence. Within four months after this notification, the bank must propose to SRB measures, that could tackle the identified hurdles to resolvability.152 Later on, SRB assesses whether the proposed measures are appropriate and if this is not the case, it requires the bank to take alternative measures indicated in writing. Within one month from this written notification, the bank shall propose a plan to comply with these alternative measures.
ii) The early intervention phase.153 In this prompt corrective action stage,154 the competent public authorities can intervene well before a bank has, economically, deteriorated up to a point where resolution is the only viable alternative.155
iii) The resolution itself.156 In this core phase, if the resolution conditions have been met,157 then four different types of resolution tools158 can be applied either individually as freestanding tools or in conjunction,159 in order to achieve the resolution objectives.160 The focus is on the bail-in tool, which was described in the previous section.
In each of the above three phases, different powers are conferred on public authorities
vis-à-vis the bank and the intensity of these powers escalates as resolution is approached but not
149 See Binder (2015), p. 3.
150 See BRRD art. 17 for single banks and 18 for bank groups. See also SRMR art. 10(7-13). 151 See SRM – Introduction to Resolution Planning (2016), p. 38, about this ‘informal stage’.
152 See BRRD art. 17(3) second subparagraph: these four months are reduced to two weeks with respect to specific
impediments.
153 See BRRD art. 27-30 and SRMR art. 13. 154 See Armour et al (2016), p. 358. 155 See Schillig (2013), p. 775.
156 See BRRD art. 31-98 and SRMR art. 14-29. 157 See note 21.
158 See note 19.
159 See BRRD art. 37(4). Only the asset separation tool cannot be applied as a freestanding tool. 160 See BRRD art. 31(2)(a-e) and SRMR art. 14(2)(a-e).
30 necessarily reached.161 The goal of this study is to point out that the powers conferred on SRB within the first phase and, specifically, within resolution planning and resolvability assessment, could improve market discipline under the threat of a well prepared and effective administrative resolution action,162 if certain details of the latter’s preparation could be made known to bank private investors.
However, the whole resolution framework should be kept in mind, because an operational cohesion can be observed, especially, between the first and the last phase; actions of resolution authorities within the preparatory phase facilitate and can make credible their actions within the final stage of resolution, when they, ultimately, apply the bail-in tool.
Particularly, if SRB uses its powers and makes a bank resolvable, opting for a bail-in tool in the preparatory phase, then, from the moment the institution becomes resolvable, which is a moment situated well before a potential bank failure, bank’s private investors, in case they were accordingly informed, could start adjusting their incentives and reconsidering their actions in order to prevent resolution. They would act in this manner, because, if their bank is ‘resolvable’, then in the event of resolution, SRB will apply the harmful, for their interests, bail-in.
4.2. The Impact of Resolution Planning and Resolvability Assessment on Market Discipline
4.2.1. Impact under the Current EU Regime?
Resolution planning and resolvability assessment could affect bank private investors’ incentives, making bail-in application predictable.
However, under the current European regime both the contents of a drafted resolution plan and the details of a conducted resolvability assessment remain confidential.163 In sharp contrast, the US take a bold step, allowing whole parts of resolution plans and resolvability assessments to be, publicly, available on the websites of the relevant US authorities.164 The disclosed parts include information about the preferred resolution strategy and balance sheet data regarding
G-161 See Wojcik (2016), p. 97. 162 See Binder (2015), p. 9. 163 See note 31.
