Mandatory Private Sector Bail-in:
A Promising Resolution Tool for Banks in Crisis
Master’s Thesis
Study Programme: European Private Law (LLM)
Supervisor: prof. M. Peeters,
Student: Ieva Rustelyte Student No.: 6159893
2 Table of Contents
I. Introduction 3
II. Importance of Banks and its Relation to Systemic Risk Phenomenon 5
III. Alternative Bank Resolution Regime over Normal Insolvency Proceedings 8
3.1 Flawed Approach of Traditional Insolvency Law towards Large Bank Insolvency 8
3.2. Emergence of Special Resolution Regimes for Large Bank Insolvencies 13
IV. Bail-in ― an Innovative Resolution Tool for Credit Institutions in Financial Distress: European
Approach 16
4.1. Defining Bail-in and its Rationale 16
4.2. Aim and Objectives 18
4.3. Architecture of Mandatory Bail-in Mechanism: Addressing Problems of Moral Hazard
and Creditor Hold-out Behaviour 21
4.3.1 Trigger Event: Sufficiently Clear and Predictable? 21
4.3.2. Scope of the Bail-in Tool and Minimum Amount of Eligible Liabilities 26
4.3.2.1. Scope 26
4.3.2.2. Minimum Requirement for Own Funds and Eligible Liabilities 30
4.3.3. Implementation of the Bail-in Tool: Amount of Bail-in, Sequence of Write Down
and Conversion, and Other Issues 31
3 I. Introduction
Systemically important financial institutions1 (SIFIs) have started dominating financial markets on a regional and global level long before the global financial crisis (GFC) hit in 2007. Modern financial systems have been rapidly expanding and becoming more interconnected, encouraging closer and more intensive intermediation between banking and non-banking institutions.2 While the system of interactions between various financial institutions have become more complex, a rising scale of variety of financial activities had been left unregulated.3 The recent financial turmoil unravelled the consequences of strong interdependencies between financial institutions that significantly contribute to a systemic risk and threaten the global financial system.
In the midst of the crisis, lacking proper tools to address the issues of troubled banks and to prevent the spill-over of negative effects into global financial markets, governments decided to provide failing banks with a substantial financial support in a form of bailout or state-aid4 in order to avoid further destabilization. Such governments’ response has prompted a debate regarding costs, benefits and suitability of the measures employed to deal with systemically important banks and other financial institutions that were balancing on the edge of collapse at the outset of the GFC. Strong criticism of the use of taxpayers’ money to rescue failing institutions5 has impelled
regulators to start a quest of other ways and methods that would enable authorities to early intervene and effectively resolve solvency issues of large, complex and interconnected financial institutions.
In 2014 the European Union enacted the Bank Recovery and Resolution Directive6
(BRRD), creating a harmonized EU-wide framework for recovery and resolution of failing or about
1 The Financial Stability Board (FSB) defines SIFIs as financial institutions “whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity”. FSB, ‘Reducing the moral hazard posed by systemically important financial institutions’, Recommendations and Timelines (20 October 2010), p. 1. Available at <www.financialstabilityboard.org/publications/r_101111a.pdf>last accessed on 31 July 2015.
In order to assess the systemic importance of a bank, some scholarly works identify criteria to be considered, such as the size of its market share through its cross-border transactions, value of deposits which is not covered by deposit insurance ratio of the balance sheet and the GDP, and the risk profile of company. See Swiss Financial Market Authority, ‘Addressing "Too Big To Fail’’, the Swiss SIFI Policy (23 June 2011), p. 6.
2 I Ötker-Robe, C Pazarbasioglu, et.al, ‘Impact of Regulatory Reforms on Large and Complex Financial
Institutions’, International Monetary Fund Staff Position Note, SPN/10/16 (November 3, 2010), p. 7.
3 Ibid. 4
Claessens, et.al, ‘A Safer World Financial System: Improving the Resolution of Systemic Institutions’, Geneva Reports on the World Economy 12, Centre for Economic Policy Research (4 October 2010), p. 17-18.
5 Unless otherwise noted, terms ‘banking institutions’, ‘financial institutions’ and ‘banks’ are used interchangeably. 6
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 (OJ L 173, 12.6.2014, p. 190).
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to fail credit institutions7 and investments firms8. Among other things, this legislation has introduced a bail-in mechanism as one of the resolution tools9, complementing other measures10 implemented to make banks safer and more stable. The new tool aims at stabilising failing large institutions by making its shareholders, unsecured and uninsured creditors to absorb bank losses so that the institution could continue providing essential services as a going concern entity without causing systemic disruptions to financial markets and without a recourse to public funds.11
At the outset of the introduction of the newly developed debt write-down tool at the EU level, this thesis aims to make an initial assessment of the effectiveness of bail-in as a mechanism tailored to deal specifically with systemic credit institutions12 facing solvency issues. The thesis questions whether bail-in regime as created by the BRRD is suitable for effective troubled bank resolution, while at the same time maintaining financial stability and preventing negative spill-over effects to financial markets; whether the mechanism provides for the necessary certainty and clarity for financial markets and ensures more stable functioning of the financial sector while dealing with the institution(s) in distress. The discussion is organized as follows. Chapter II briefly overviews the role of banks in any modern economy, emphasizing the dangers posed by its growth in terms of its size, complexity and interconnectedness, and points out potential systemic implications of its failure. Chapter III undertakes to investigate whether cases of ailing systemically important banks are ‘unique’ and ‘special’ enough to warrant a need for an alternative resolution regime rather than using traditional insolvency regimes. Chapter IV is dedicated to the bail-in tool as adopted in Europe. Starting with the mechanism’s general rationale, aim and objectives, the chapter then follows with a more thorough analysis of the anatomy of the bail-in, pointing out its strengths and
7 For the purpose of this thesis and particularly when used in the context of EU legislation, the terms ‘credit institution’ and ‘bank’ will be used interchangeably as further defined, unless noted otherwise. In the EU the more common name for a bank is a credit institution, which is defined as 'an undertaking the business of which is to take deposits or other repayable funds from the public and to grant credits for its own account’. See point (1) of Art. 4(1) of Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (OJ L 176, 27.6.2013) - Capital Requirements Regulation (CRR).
8 In this context ‘investment firm’ means an investment firm as defined in point (2) of Article 4(1) of Regulation (EU) No 575/2013 that is subject to the initial capital requirement laid down in Article 28(2) of Directive 2013/36/EU.
9 The standard resolution tools are the following: a classic sale of business to a private sector entity, a transfer of business to a bridge institution and asset separation tool.
10 Such other measures as new higher thresholds for mandatory capital requirements and stricter liquidity standards introduced by Basel III agreement and its implementing act in Europe, the so-called CRD IV package which consists of Capital Requirements Regulation (CRR) with its Corrigendum 1 and Corrigendum 2, and Capital Requirements Directive IV (CRD IV) with its Corrigendum 1. These documents are available at <http://ec.europa.eu/finance/bank/regcapital/legislation-in-force/index_en.htm> last accessed 31 July 2015.
11 European Commission, ‘EU Bank Recovery and Resolution Directive (BRRD): Frequently Asked Questions’, Press Release, MEMO/14/297 (Brussels, 15 April 2014), p. 7. Available at < http://europa.eu/rapid/press-release_MEMO-14-297_en.htm> last accessed on 31 July 2015.
12 While the BRRD applies to credit institutions and investment firms, the focus of this thesis is credit institutions (banks), therefore, references in relevant chapters are made only to credit institutions, though the analysis of the bail-in provisions as stipulated in the BRRD is equally applicable to investment firms (as they are defined in the BRRD).
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weaknesses, drawing attention to major concerns. Chapter V concludes with a wrap-up and a few final comments.
II. Importance of Banks and Its Relation to Systemic Risk Phenomenon
Banks are often considered to be ‘special’ in terms of their vital importance for the proper functioning of economy and their particular financial vulnerability.13 Their failures may not only significantly damage a country’s economy as a whole but also cause major negative externalities.14 The more complex and the larger an ailing bank is, the bigger financial liabilities it will have to the rest of financial system, the easier it will trigger the realisation of systemic risk15 through spill-over effects.16
Banks play a crucial role in the modern economy of any country by providing financial services of fundamental importance, such as holding of deposits which can be easily withdrawn, offering transaction accounts the balance of which can be quickly transferred to third parties, extending credits to households, companies, governments and other banks, and operating payments system.17 Its peculiar capital structure that comprises of long-term illiquid loans being funded mostly by deposits, which normally are short-term liabilities payable on demand, makes banks particularly vulnerable to the loss of public confidence18 in bank’s ability to meet its payment obligations. Even a solid ‘good bank’ might risk insolvency if massive deposit withdrawals occur spontaneously.19 As nowadays news spread very fast, even a suggestion or a rumour may lead to a ‘bank run’ which, in turn, may trigger a negative market reaction causing difficulties for the affected bank to obtain funding in the markets.20 In order to cover deposit withdrawals, the bank may need to sell its assets at heavily discounted prices, thus exacerbating the negative effect on its balance sheet.21
13 R Bliss and G Kaufman, ‘U.S. Corporate and Bank Insolvency Regimes: An Economic Comparison and Evaluation’, Federal Reserve Bank of Chicago Working Paper 2006-01 (2006), p. 2.
14
Ibid. p. 3. 15
C Weistroffer, et al., ‘Identifying Systemically Important Financial Institutions (SIFIs)’, Deutsche Bank Research, Current Issues, (August 11, 2011), p. 4.
16 K Moore and C Zhou, ‘Identifying Systemically Important Financial Institutions: Size and Other Determinants’, De Nederlandsche Bank Working Paper, No. 347 (12 July 2012), p. 3.
17
R Bliss and G Kaufman, (n 13), p. 2-3; E G Corrigan, ‘Are Banks special?’, in Federal Reserve Bank of Minneapolis Annual Report (1982), p. 5-7; E Hüpkes, ‘‘Insolvency – Why a Special Regime for Banks?’ in IMF, Current Developments in Monetary and Financial Law Volume 3 (Washington DC, 2003), p. 2-3.
18 M Schillig, ‘Bank Resolution Regimes in Europe I – Recovery and Resolution Planning, Early Intervention’
(August 25, 2012), p. 5. Available at SSRN: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2136101> last accessed on 31 July 2015.
19 E Hüpkes, ‘Insolvency – Why a Special Regime for Banks?’ in IMF, Current Developments in Monetary and Financial Law Volume 3 (Washington DC, 2003), p. 4.
20 Ibid.
21 F Allen and E Carletti, ‘The Roles of Banks in Financial Systems’, Oxford Handbook of Banking, edited by A Berger, P Molyneux and J Wilson (March 2008), p. 7.
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During the last few decades there has been an enormous rise in the scale of bank activities, accompanied by an equally enormous increase in banking concentration caused mainly by financial liberalisation.22 The core functions of the banks have not changed but their practices have evolved and their size has significantly expanded. A clear line separating commercial banking from investment banking has become blurry. Rapidly evolving bank activities, market innovation and new sources of competition, inter alia, out-shadowed concerns about ‘safety and soundness’ of the financial system, i.e. concerns with regard to a concentration of financial power, possible conflicts of interest, appropriate scope of risk banks should incur, taking into account that banks are mostly lending depositors’ money.23
As the size of a financial institution increases, its structure must be adequately and proportionally strengthened in order for the large institution to remain resilient and robust.24.As it turned out, that was not the case with the world’s biggest banks: an enormous expansion and a failure to follow-up with the improvements to its capital structure proved to lead to disastrous consequences in the face of the GFC. Gigantic cross-border banks, operating in many jurisdictions and considering themselves ‘Too Big to Fail’ (TBTF), expected government financial support whenever in need due to their size, complex organisational and operational structure, and importance to the banking system and economy as a whole. An implicit state guarantee against failure strongly encouraged the management of TBTF banks to take excessive risks and engage in a classic moral hazard behaviour, i.e. make investments in riskier financial assets with an expectation to recoup high returns, while enjoying a full protection from bearing any adverse consequences. Being ‘big’ also ensured lower regulation compliance costs, easier access to foreign markets,25 and lower funding costs which, in turn, not only paved the way for further expansion and concentration exacerbating the ‘TBTF dilemma’,26 but also gave a competitive advantage to such banks and distorted competition in the financial markets.
Banks have become not only bigger and more complex but also more than ever closely intertwined financially with one another. Due to the increased interconnectedness between banks through inter-bank loans and deposits, and through each bank’s role in the payment and settlement system, the risk of financial contagion has become very high.27 In comparison to any other industry,
22 A G Haldane, ‘On Being the Right Size’, the Speech given in Institute of Economic Affairs’ 22nd Annual Series, The 2012 Beesley Lectures (25 October 2012), p. 3. Available at <http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech615.pdf> last accessed on 31 July 2015.
23 E G Corrigan, ‘Are Banks special?’, in Federal Reserve Bank of Minneapolis Annual Report (1982), p. 1-2. 24 A G Haldane (n 22), p. 2.
25 P-H Verdier, ‘The Political Economy of International Financial Regulation’, Social Science Research Network Electronic Paper Collection, No. 2012-32 (2012), p. 28 or <http://ssrn.com/abstract=2064875> last accessed on 31 July 2015.
26 A G Haldane (n 22), p. 2. 27 M Schillig (n 18), p. 6.
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contagion in the banking sector is considered to occur faster, spread more broadly, result in a larger number of failures and bigger losses to failed banks’ creditors, spread to other industries and cause substantial damage to the entire financial system and the macro-economy as a whole.28 Such a risk of widespread quickly unfolding failure contagion is referred to as a systemic risk,29 which could be defined more precisely as “the probability that cumulative losses will occur from an event that ignites a series of successive losses along a chain of institutions or markets comprising a system”.30 Systemically important, highly interconnected financial institution is very likely to set-off such a chain of reaction when it becomes distressed and starts struggling.
While part of banks’ fragility is reflected by its high potential for depositor run on the bank which may force unnecessary fire-sale losses, contrary to the popular opinion, it generally does not ignite the initial shock (weak financial state of the bank is likely to have predated a run), though it may accelerate its transmission to other banks.31 A run on a small or medium-sized bank which is perceived to be in risk of failure might finally result in that bank’s insolvency as a market punishment for poor management and inefficiency, however, it would not automatically result in a widespread distrust in the stability of savings and the soundness of all other banks.32
However, everything is quite different when talking about a relation between systemic risk and the payments system. As banks not only lend to and borrow from each other on a continuous basis but also pay and receive third-party fund transfers from each other in the process of clearing payments, a shock (like a default by one bank on an obligation to another bank) may be quickly transmitted to another bank and so on down the remaining chain of banks and possibly beyond.33 The impact of an individual institution’s default is likely to be strongly reinforced because such transfers are usually made in very large amounts, processed almost immediately and involve only a few large participating banks.34 In such context the systemic risk can occur in the case of a failure of only one, though very large bank even in overall stable market conditions; while in the midst of a financial crisis, even smaller banks’ defaults may result in the state intervention with a financial assistance package35 to avoid the occurrence of disruptive systemic risk.
Thus, it is the systemic risk that needs to be controlled and stopped at the outset of any crisis. The aftermath of the bankruptcy of Lehman Brothers Holdings Inc. has proved that the
28 G Kaufman, ‘Bank contagion: A Review of the Theory and Evidence’, Journal of Financial Services Research 8.2
(1994), p. 123-124. 29 Ibid.
30
G Kaufman, ‘Bank Failures, Systemic Risk, and Bank Regulation’, Cato Journal 17, Vol. 16 (1996-1997), p. 20. 31G Kaufman (n 34), p. 26.
32 J H Binder, ‘‘Too Big to Fail‘ – Can Alternative Resolution Regimes Really Remedy Systemic Risk in Large Financial Institutions Insolvency?‘ (1 May 2010), p. 5. Available at SSRN: <http://ssrn.com/abstract=2465008> last accessed on 31 July 2015.
33G Kaufman (n 30), p. 21-28. 34 Ibid.
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failure of a major international financial institution of a great size can cause broad ramifications, bringing down other banks and financial institutions along with it, crippling or causing closures of corporations, disrupting markets and the whole financial system at international level. The magnitude of the potential damaging effects attributable to systemic risk supports the argument of banks being ‘special’,36 thus requiring more rigorous government regulation than other firms.37 Not only ex ante but also ex post regulatory measures are desirable for the reduction of likelihood of bank failures, for the protection against the costs when they do fail and for the prevention or at least mitigation of a widespread bank failure contagion. Is there a need to design, introduce and implement new prudential regulations that would curb moral hazard behaviour and combat the potential occurrence of systemic risk after the failure of one or more large banks, or are the traditional insolvency regimes effective enough to deal with ailing large and complex financial institutions?
III. Alternative Bank Resolution Regime over Traditional Insolvency Proceedings
Large banks can and do fail, despite the existence of prudential regulation and supervision. To ensure financial stability and a healthy economy, ex ante measures aimed at preventing bank failures must be complemented with regulatory framework to effectively deal with financial institutions when they start facing solvency issues.38 During the latest financial turmoil national authorities had tended to complain about the lack of powers to adequately address the emerging systemic issues caused by failing or already failed banks. Is it right to say that traditional insolvency law is not the best strategy in order to pursue a successful resolution of distressed large and highly interconnected banks? Should regulators have considered setting up an alternative administrative resolution regime for systemically important financial institutions?
3.1 Flawed Approach of Traditional Insolvency Regimes towards Bank Insolvency
In many countries procedures regarding troubled banks are often determined on ad hoc basis.39 A lack of a clear legal framework on how to deal with gigantic banks in distress may be caused by the scarcity of bank insolvencies in the past, emergency bail-outs provided by the states and the prevalence in many jurisdictions of the applicability (to a different extent) of traditional
36
G Kaufman (n 28), p. 123-124.
37G Kaufman (n 30), p. 18. G. Kaufman cites G. Corrigan’s, the former president of the Fed of NY: “More than anything else, it is the systemic risk phenomenon associated with banking and financial institutions that makes them different from gas stations and furniture stores. It is this factor – more than any other – that constitutes the fundamental rationale for the safety net arrangement that have evolved in this and other countries”.
38 E Hüpkes (n 19), p. 5.
39 Ibid. p. 6. See also T Glaessner and I Mas, ‘Incentives and the Resolution of Bank Distress’, The World Bank Research Observer 10.1 (1995), p. 53-73.
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insolvency rules to ailing financial institutions.40 Most European national states opted for general41 insolvency laws with some special rules and exemptions expressly tailored to tackle specifics of bank insolvencies, while the US, on the contrary, has adopted a special bank insolvency regime with a Federal Deposit Insurance Corporation (FDIC) acting as an exclusive receiver for failed national and some state chartered banks.42 Could the same insolvency procedures be suitable for failing systemically important banks? This section points out major limitations of traditional approaches when dealing with large unsound and stressed banks.
The first shortcoming of traditional insolvency law is its inability and ill-suited, poor design to deal successfully with systemic issues.43 General insolvency law focuses on maximising the value of assets of an individual company and distributing it equally amongst creditors of the same class (parri passu principle), with little consideration for ‘third-party’ effects, for example, when filing for insolvency principal parties do not take into account the stability of the financial sector as a whole or the systemic consequences it may have.44 Bank insolvency law considers creditor, debtor and the public interest.45 Banking law seeks to maintain the stability and soundness of a financial sector and to prevent any systemic problems, so in a case of a bank failure, the
primary objective is to minimize the negative effects on the banking system as a whole.46
Insolvency judges may, to a certain extent, consider systemic issues when handling the case, however, a full and effective control can only be taken at the very outset of the case.47 When dealing with financial distress of a large, highly interconnected banks, an alternative resolution regime would, in addition to its main objectives, pay considerable attention and give significant weight to ‘externalities’, i.e. the adverse impact of the resolution on the economy as a whole and on financial markets.48
The second issue relates to a general insolvency law provision for a moratorium or a ‘stay’ over a relevant insolvent firm, which takes the effect upon the filing of a petition to open insolvency proceedings and immediately results in a freeze of all debtor’s assets. During the ‘stay’ creditors are restrained from enforcing their claims against the debtor, and the latter’s actions with regard to any disposals of a firm’s assets are also suspended. Such safeguard mechanism, designed to mitigate
40 E Hüpkes (n 19), p. 6. 41
Note that the terms ‘traditional insolvency’, ‘general insolvency’ and ‘normal insolvency’ are being used interchangeably throughout the thesis.
42 E Hüpkes (n 19), p. 6-8.
43 T H Jackson, and D A Skeel, ‘Dynamic Resolution of Large Financial Institutions’, 2 Harvard Business Law Review 435 (2012), p. 448.
44T H Jackson and D A Skeel (n 43), p. 448. 45 E Hüpkes (n 19), p. 12.
46 Ibid. 47
T H Jackson and D A Skeel (n 43), p. 449.
48 R Cohen and M Goldstein, ‘The Case for an Orderly Resolution Regime for Systemically-Important Financial
Institutions’, Briefing Paper 13 (2009), p. 9. Available at
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further losses of stakeholders involved, is useful for providing some space for the debtor to evaluate its situation, possibly to renegotiate with creditors its debts, prepare a reorganization plan, etc.49 The general automatic stay is also applicable to orderly bank liquidations under special bank regime which is more administrative in nature. For example, in US the FDIC has the right to request a ‘stay‘ for up to “60 days of judicial actions (lawsuits) to which the closed bank is a party or becomes a party“, while the courts cannot reject such a request.50 However, such a general stay may not be a suitable measure in the event of large and interconnected financial institution insolvency. Even if a bank is severely distressed, it must continue providing financial services and operating in order to minimise the potential for systemic impact.51 A complete halt to all bank‘s activities, resulting in default on its payment obligations to its counterparties, will destroy its financial relationships with those counterparties and cause accelerated destruction of value in financial contracts.52 Standard master agreements for financial derivatives transactions typically contain close-out netting provisions, designed to mitigate such credit risks. On the occurence of a default of a counterparty to the agreement, these provisions enable a non-defaulting party to invoke early termination rights with respect to the pending relevant transaction, demanding a valuation of the close-out transactions and a determination of a final amount payable. Many national jurisdictions fully support unrestrained enforceability of the close-out netting clauses in the event of institution‘s insolvency (or any other relevant event of default stipulated in the agreement). This means that under applicable master agreements the automatic stay will trigger the right of counterparties to terminate pending transactions and claim the net amount payable against the failing institution, hence ending its trading activities and causing widespread disorder and destruction in the derivatives markets if that financial institution is systemically important.53 On ther other hand, the more prevalent opinion with regard to the usefulness and necessity of effective application of the close-out netting provisions in the case of the ‘stay‘ is that close-out netting mitigates systemic risks because it allows “solvent parties to manage their own exposures“ so avoiding liquidity and solvency issues, and it does not discourage or scare off the counterparties of a debtor in financial distress (but still solvent) from transacting with him or “roll him over“.54
All in all, it is very likely that a successful restructuring of the failing institution may only be possible if done within a very short timeframe, without the application of a comprehensive ‘stay’
49 UNCITRAL, ‘Legislative Guide on Insolvency Law’ (New York, 2005), p. 84. Available at <http://www.uncitral.org/pdf/english/texts/insolven/05-80722_Ebook.pdf> last accessed on 31 July 2015.
50
R Bliss and G G Kaufman, ‘A Comparison of U.S. Corporate and Bank Insolvency resolution’, FRB of Chicago Working Paper (2006), p. 48. Available at < http://users.wfu.edu/blissrr/PDFs/Bliss-Kaufman%20-%202006,%20FRB-C%20EP%20-%20Insolvency%20Regime%20Comparison.pdf> last accessed 31 July 2015.
51 E Hüpkes (n 19), p. 18. 52 J H Binder (n 32), p. 11. 53 Ibid.
54 M Peeters, ‘On Close-out Netting’, Transnational Securities Law, edited by T. Keijser (Oxford: Oxford University
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period and with formal adjustments in the institution’s contractual obligations to its counterparties, if necessary, implemented outside regular trading hours.55 Such transactions as the purchase of a failing large, systemically important bank must be effectuated during the weekend in order to avoid creditor ‘stays’ and its ‘domino effects’ because otherwise that institution will be forced to exit the market due to its inability to transact on a continuous basis with its short-term creditors.56 Those creditors can immediately lose the trust due to the restrictions on their claims against that financial institution and stop doing business with it in the insolvency process or even prior to it, possibly resulting in a failure of the bank when it is even not yet insolvent or illiquid.57
The third shortcoming relates to a lack of discretion with regard to the trigger for initiation of insolvency proceedings and a possibility to make an earlier intervention, i.e. before the actual failure of the institution. Narrowly defined strict conditions for the commencement of insolvency proceedings prevent a bank supervisor from enjoying a broad discretion to decide on bank’s viability and possible closure58 or restructure. Due to the supervisor’s role in monitoring bank’s capital and reviewing its assets quality,59 he is possibly in the best position to decide whether a bank is still financially sound, whether it is threatened by the imminent insolvency or whether it is actually insolvent. The bank may need to employ a set of “prompt and corrective pre-failure actions” before it is proven insolvent, for example, when its capital falls below a certain specified threshold (when it violates mandatory capital requirements), or, save for the systemic risk, a distressed bank might be better off being closed while it still has a positive net worth.60 Financial problems and irregularities need to be addressed and managed in the early stages of a crisis, when the bank is likely to become insolvent in the near future,61 and the actions must be swift, decisive and comprehensive as the forbearance of supervisory and regulatory authorities will only aggravate the problems of a weak bank.62 Protracted efforts to deal with financial instability and to restore financial soundness of distressed institution might cause a further deterioration in the value of its assets63 to the disadvantage of all stakeholders.
Furthermore, normal insolvency proceedings are characterized by quite an active role and involvement of collectively acting creditors whose consent is mandatory in a number of areas.64 The length of insolvency proceedings tend to be extended due to various judicial procedural
55
J H Binder (n 32), p. 12-14.
56 R Cohen and M Goldstein (n 48), p. 9-10. 57 Ibid.
58 E Hüpkes (n 19), p. 10. Check if correct referece 59
E Hüpkes (n 19), p. 10.
60 R Cohen and M Goldstein (n 48), p. 12. 61 J H Binder, (n 32), p. 8.
62 Basel Committee on Banking Supervision, ‘Supervisory Guidance on Dealing with Weak Banks’, Report of the Task Force on Dealing with Weak Banks (March 2002), p. 6 and p. 19. Available at
<http://www.bis.org/publ/bcbs88.pdf>last accessed on 31 July 2015. 63 J H Binder (n 32), p. 10.
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requirements, also an exercise of creditors’ right to be heard, to have access to court whenever they feel their rights to have been violated.65 Thus, there is a huge potential for significant delays, while in bank insolvency the time is of the essence.66 Even the shortest delay may considerably reduce the value of bank’s assets, destroy liquidity and cause additional losses to bank creditors, including depositors.67 The administrative proceedings in which the principal players, such as the creditors, managers and the shareholders, are prevented from participating in decision-making process and can only make requests for information and file claims68 seems better-suited for resolving large bank insolvencies. The administrator’s wider discretion in controlling the insolvency process of the failed institution in combination with overall ‘flexibility’ could contribute to minimizing negative systemic implications.69
Another criticism of traditional insolvency approaches is related to timely availability of funding for a debtor facing solvency issues.70 A bank in financial distress usually needs an immediate liquidity provision to continue making payments; however, additional financing is likely to be delayed when applying traditional insolvency laws as there is a longer approval process involved.71 Even though automatic stay on most of the financial obligations and a possibility of the government backup funding might reduce the negative effects,72 these options are not suitable for dealing with systemic banks as the government is determined to stop using taxpayers’ money and an automatic comprehensive ‘stay’ (moratorium), as previously discussed, should be avoided in all cases. In order to achieve a successful large bank resolution, temporary, quick and considerable funding (not necessarily from the government or its agents) is most likely to be needed to financially support vital ongoing business operations and prevent defaults on systemically important contracts which could force counterparties, and possibly markets more generally, to engage in fire-sale asset reaction.73
Traditional insolvency regimes seem to be rather ill-equipped and not adequate to effectively tailor and deal with unique features of large bank insolvencies that make its failures particularly costly. A new regime needs to be designed to address specifics of systemically important banks and find solutions to technical implications posed by large, complex, cross-border insolvencies in banking sector, introduce additional tools enabling to preserve and successfully restructure a struggling bank. For small and medium-sized banks operating in national or small
65 E Hüpkes (n 19), p. 11.
66 R Cohen and M Goldstein (n 48), p. 10.
67 E Hüpkes (n 19), p. 11-12.
68 R Cohen and M Goldstein (n 48), p. 10. 69 Ibid.
70
T H Jackson, and D A Skeel (n 43), p. 448-449. 71 Ibid. p. 448.
72 Ibid.
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regional markets significantly improved traditional forms of insolvency might prove effective enough to control the spread of systemic stress.74 However, the case for coordination of large, globally active banks or bank groups under financial stress is quite different, and technical and legal challenges posed by the failure of cross-border bank are highly complex, 75 especially with a lack of coordination and cooperation on international level. Given the scale of negative repercussions and broad systemic implications on global economy the failure of a large multinational bank might entail, there is a need for a new resolution process, a functional alternative to traditional forms of insolvency procedures.
3.2. Emergence of Special Resolution Regimes for Large Bank Insolvencies
Even the most loyal proponents of traditional insolvency regimes, who consider it the most feasible mechanism for resolving financial distress of banks, agree that some sort of new administrative resolution approach might be better suited for systemically important ailing financial institutions.76 National legislations tailored specifically for large highly interconnected banks have become the priority for the national and international financial regulatory authorities after drastic measures of some governments were extended to save TBTF banks which got hit by the global financial crisis. National regulators have been determined to take up a task to curb TBTF and end public bail-outs. After the initial wave of the crisis passed, states have started introducing financial regulatory reforms. In 2009 the UK put in place the Banking Act 200977which has introduced a special resolution regime for commercial banks in financial distress. In the US, a new
administrative resolution framework has been implemented by the Dodd-Frank Act78 which
provides for a quick liquidation of systemically important financial institutions of all kinds and
expands resolution powers of FDIC. While Germany’s Bank Restructuring Act
(Restrukturierungsgesetz,)79, introduced in 2011, sets forth a new voluntary rescue and
reorganization procedure as well as broader supervisory powers for the resolution of failing credit institutions.80
International standard setters have joined a quest for new modern concepts for bank resolution, influencing key trends in the design of an alternative bank insolvency regime. The Basel Committee on Banking Supervision (BCBS), an international financial regulatory authority, has proposed a global regulatory framework to strengthen international banking regulation and made
74 Ibid. p. 5.
75 Ibid. 76
T H Jackson, and D A Skeel (n 43), p. 446. 77
Banking Act 2009, 2009 c. 1.
78 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010). 79 Restrukturierungsgesetz [Bank Restructuring Act], Dec. 9, 2010, BGBL. I at 1900 (Ger.).
14
recommendations with regard to cross-border resolution of banking groups.81 Coordinating with BCBS, the Financial Stability Board (FSB) has introduced some recommendations of how to better address systemic and moral hazard risks affiliated with SIFIs, and has suggested the Key
Attributes82 for an effective resolution regime.83
EU policymakers and legislators have also decided to act and address weaknesses that have been exposed during the recent financial crisis. As it was previously noted, the adoption of the BRRD84 has introduced the EU framework for recovery and resolution of credit institutions and investment firms.85 It is noteworthy that the BRRD applies not only to SIFIs but it covers all banking institutions,86 irrespective of their size and complexity as it is not an easy task to determine “with full certainty in advance” the systemic importance of an institution failure.87 This may be
81 See Basel Committee on Banking Supervision, ‘Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems’ (December 2010 (revised June 2011)). Available at <http://www.bis.org/publ/bcbs189.pdf> last accessed on 31 July 2015. See also Basel Committee on Banking Supervision, ‘Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools’, (January 2013). Available at
http://www.bis.org/publ/bcbs238.pdf> last accessed on 27 July 2015.
See also Basel Committee on Banking Supervision, ‘Report and Recommendations of the Cross-border Bank
Resolution Group’, Final Paper (March 2010). Available at <http://www.bis.org/publ/bcbs169.pdf> last accessed on 31 July 2015.
82
Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ (October 2011). Available at <http://www.financialstabilityboard.org/wp-content/uploads/r_111104cc.pdf?page_moved=1> last accessed on 31 July 2015. An update was published in October 2014, available at
<http://www.financialstabilityboard.org/wp-content/uploads/r_141015.pdf> last accessed on 31 July 2015.
83 See Financial Stability Board, ‘Reducing the Moral Hazard Posed by Systemically Important Financial Institutions’, FSB Recommendations and Time Lines (20 October 2010). Available at <http://www.financialstabilityboard.org/wp-content/uploads/r_101111a.pdf?page_moved=1> last accessed on 31 July 2015.
84 This thesis takes a closer look at the bail-in provisions as stipulated in the EU Bank Recovery and Resolution Directive (BRDD). An analysis of the Single Resolution Mechanism (SRM) (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 and amending Regulation (EU) No 1093/2010 (OJ L 225, 30.7.2014, p. 1) falls outside the scope of this thesis. The BRRD and the SRM are complementary legislations. The SRM, being one of the three pillars of the ‘Banking Union’ created by the EU, establishes uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms at the EU or euro area level, while the BRRD provides for more comprehensive and effective framework for the recovery and resolution of failing credit institutions and investment firms at national level. As explained by the Commission in its press release with regard to the BRRD (MEMO/14/297; 15 April 2014) (available at <http://europa.eu/rapid/press-release_MEMO-14-297_en.htm> last accessed on 31 July 2015), “The BRRD provides uniform rules for the whole EU single market and the SRM sets out the institutional and funding architecture for applying those rules in Member States participating in the banking union”. Pursuant to Article 2(1) of Regulation (EU) No 1024/2013, “‘participating Member State’ means a Member State whose currency is the euro or a Member State whose currency is not the euro which has established a close cooperation in accordance with Article 7”.
85 A term ‘credit institution’ further may be referred to as ‘institution’, ‘financial institution’ or ‘bank’. 86
Art. 1(1) BRRD. 87
European Commission, Explanatory Memorandum in a Proposal for a Directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No 1093/2010, COM (2012) 280 final, p. 8.
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considered as a sensible approach as the failure of a globally important and interconnected institution with a huge market share may cause a severe disruption in the global financial system as much as the simultaneous widespread failure of many a bit smaller institutions may result in equally devastating effects on the economy.88 The BRRD, entered into force on 2 July 201489, has three
pillars’: 1) preparatory and preventive measures; 2) early intervention measures; and 3) resolution measures. The ‘third pillar’ introduces a special administrative bank resolution regime, which aims
to ensure continuity of bank’s critical functions in times of a severe financial distress, to avoid severely negative effects on the financial system particularly by preventing contagion and maintaining market discipline, and public funds by reducing to the minimum the need for extraordinary public financial support.90
When taking resolution action91, authorities must observe at all times general principles governing resolution, to name but a few, that “shareholders bear losses first”, creditors of the same class are treated equally and bear losses after the shareholders according to the order of priority of their claims under normal insolvency law, unless provided otherwise, and that neither of them incurs greater losses than they would have incurred had the institution undergone normal insolvency proceedings.92
Though the bail-in tool is a cornerstone of the BRRD, the Directive also provides for three other resolution tools. The first one is the sale of business tool which essentially is a forced take-over or a private sector acquisition of the institution under resolution or parts of its business without the consent of its shareholders. This tool enables resolution authorities to effect a transfer of “shares, all or any assets, rights or liabilities of the institution under resolution” to one or more purchasers.93 The sale must be marketed in “an open, transparent and non-discriminatory process while aiming to maximise, as far as possible, the sale price.”94 The purpose of the bridge bank tool is to preserve and ensure the provision of critical functions of the failing institution (for example, unconstrained depositors’ access to their accounts) and uninterrupted performance of its main financial activities.95 Some or all of the shares, assets, rights or liabilities of one or more institutions under resolution are transferred to a wholly or partially state-owned or controlled institution which
88
Ibid.
89 Art. 131 BRRD. According to Art. 130(1) subparagraph 1 and 2 BRRD, each Member State had to transpose this legislation into national legal system by 31 December 2014 and start applying the implemented provisions from 1 January 2015. Art. 130(1) subparagraph 3 BRRD makes an exception for the bail-in provisions which must be transposed into national law and be applicable from 1 January 2016 at the latest.
90
Art. 31 BRRD.
91 Art. 2 (40) BRRD defines “‘resolution action’ as the decision to place an institution or entity referred to in <…> under resolution pursuant to Art. 32 or 33, the application of resolution tool, or the exercise of one or more of resolution powers”. 92 Art. 34 BRRD. 93 Art. 38(1) BRRD. 94 Recital (61) BRRD. 95 Recital (65) BRRD.
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holds those transferred shares, assets or liabilities on a temporary basis with an intention to sell them on the market.96 If specifically for this purpose created bridge institution does not operate “as a viable going concern”, it is liquidated not later than two years after the last transfer.97 When applying the asset separation tool, some or all of the assets, rights and liabilities of a failing institution are being transferred to a state-owned or controlled asset management vehicle (so-called “bad bank”).98 The purpose of this tool is to properly manage and eventually sell for an equitable price the transferred (usually toxic and not worthy of being maintained) assets or orderly wind them down.99 All resolution tools may be used individually or in any combination, except for the asset separation tool which must always be used only in conjunction with another resolution tool100 in order to avoid a distortion of competition for the benefit of the failing institution.
The bail-in tool, an additional strategy for dealing with financial distress of large institutions in order to retain them as a going concern, will be dealt with next. The subsequent chapter will take a closer look at the anatomy and mechanics of the bail-in regime, describing its rules and assessing its strengths and potential weaknesses.
IV. Bail-in – an Innovative Resolution Tool for Credit Institutions in Financial Distress: European Approach
This chapter is dedicated to the newly introduced bank bail-in rules at the EU level. It starts with an explanation why the bail-in tool is necessary, what purpose it serves and what it is aiming at. The chapter continues with a fairly detailed description of the mechanism itself, underlying relevant rules and procedures as laid down in the BRRD, concentrating on positive aspects of the tool, as well as emphasizing, where relevant, its potential negative implications and remaining challenges.
4.1. Defining Bail-in and its Rationale
Mandatory bail-in imposed by a resolution authority is a relatively new concept in comparison to contractual bail-in.101 On the one hand, there is a great degree of similarity between bail-in eligible debt instruments and contractual contingent capital instruments (also known as
96 Art. 40(1) (2) BRRD. 97 Art. 41(5) BRRD. 98 Art. 42(2) BRRD. 99 Art. 43(1) BRRD. 100 Art. 37(4) (5) BRRD.
101 J H Binder, ‘Resolution: Concepts, Requirements and Tools’ (22 September 2014), p. 33. Available at SSRN:
17 Cocos) in that they both are involved in creditor financed recapitalisation102 through the restoration of institution’s core equity capital on the occurrence of a predetermined trigger event. Also they both can take the form of subordinated or senior debt and both can be required to be fully or partially written down or converted in order to fulfil their purpose.103 On the other hand, they are separated by a few major differences. Contingent capital is set to absorb losses on a ‘going concern’ basis with typically high capital ratio as an objectively defined trigger and predefined conversion or write-down mechanism, allowing these instruments to be structured purely on a contractual basis.104
The bail-in tool is a mechanism that effects the exercise of statutory powers of resolution authorities to write down and convert eligible liabilities105 of an institution under resolution.106 Under this regime, after a cancellation or a substantial dilution of shares of existing shareholders and holders of relevant capital instruments, unsecured creditors must absorb remaining losses of a failing institution in order to recapitalise it and restore its viability. Bail-in is triggered on or near ‘gone concern’ basis that necessitates a regulatory intervention and, at least in certain matters and to a certain extent, an exercise of regulatory discretion which, in turn, necessitates “a backing of a statutory regime” enabling relevant authorities to take indispensable actions and to address consequential issues.107
An essential rationale behind bail-in is that creditors will have a stronger incentive to monitor the health and soundness of the institution in the ordinary course of events because they will be forced to bear the costs arising from its failure.108 In many cases during the recent financial crisis banks were rescued as a going concern by using an injection of public money. Taxpayers had to absorb all the losses while unsecured (subordinated and senior) creditors, already being compensated for taking on the risk of ranking immediately ahead of shareholders, were bailed-out altogether escaping any loss of their principal.109 The bail-in approach has turned unsecured creditors into holders of ‘bail-inable’ liabilities, thereby at risk to suffer losses. Such a change is expected to give a strong motive to creditors to encourage managers of the institutions to pursue
102
J Zhou, et.al, ‘From Bail-out to Bail-in: Mandatory Debt Restructuring of Systemic Financial Institutions’, IMF Staff Discussion Note, SDN/12/03 (24 April 2012), p. 6.
103 Clifford Chance, ‘Legal Aspects of Bank Bail-ins’, Briefing Note for Clients (April 2011), p. 6.
Available at <http://www.cliffordchance.com/briefings/2011/05/legal_aspects_ofbankbail-ins.html> last accessed on 31 July 2015.
104 Clifford Chance (n 103), p. 6.
105 Pursuant to Art. 2(1) (71) BRRD, “’eligible liabilities’ means the liabilities and capital instruments that do not qualify as Common Equity Tier 1, Additional Tier 1 or Tier 2 instruments of an institution or entity referred to in point (b), (c) or (d) of Article 1(1) and that are not excluded from the scope of the bail-in tool by virtue of Article 44 (2) of BRRD”.
106 Art. 2(1) (57) BRRD. 107 Ibid.
108
Recital (67) BRRD.
109 PWC, ‘The Trillion Dollar Question: Can Bail-In Capital Bail Out the Banking Industry?’, Basel III and Beyond, (November 2011), p. 3. Available at < http://www.pwc.com/en_GX/gx/banking-capital-markets/publications/assets/pdf/basel-iii-and-beyond-the-trillion-dollar-question.pdf> last accessed on 31 July 2015.
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less risky policies and engage in a more prudent behaviour,110 thereby helping to restore market discipline.
An implicit public guarantee had a huge negative impact on private incentives and when it materialised into tax-funded financial support, it heavily drained public funds. Major concerns over public bail-outs which create moral hazard problem, impair market discipline and significantly indebt already over-indebted sovereign states have led to a proposition of bank creditor bail-ins that would allow to internalize costs of bank failures and costs of risk that banks assume.111
4.2. The Aim and Objectives
The bail-in mechanism purports to restore financial viability of an insufficiently solvent bank by forcing some creditors to bear an appropriate amount of losses, while preserving other creditors, so the bank could continue operating as a going concern without interrupting the provision of its critical services and without the usage of taxpayers’ money.112 And in case of a real necessity to inject public funds, at least certain groups of creditors will have to absorb losses and contribute to the bank’s rescue before taxpayers’ funds are put at risk.113
Pursuant to the BRRD, the bail-in tool consists of the application by a resolution authority of the write-down and conversion powers114 in relation to liabilities of the institution under resolution. After the institution meets the conditions for resolution115, the write down and conversion powers may be exercised to implement one of the two scenarios: ‘an open bank’ or ‘a closed bank’ scenario. A broader range of options is supposed to ensure the necessary flexibility for resolution authorities to distribute losses among creditors in accordance with the specific circumstances at hand.116
In the ‘open bank’ model, the bail-in tool may be used to recapitalize an institution to the extent sufficient to restore its ability to comply with the conditions for authorization and to continue to carry out the activities for which it is authorized under a relevant Directive117, and to sustain
110 E Avgouleas and C Goodhart, ‘A Critical Evaluation of Bail-ins as a Bank Recapitalisation Mechanism’, CEPR Discussion Paper No. DP10065 (July 2014), p. 29-30. Available at SSRN: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2501539> last accessed on 31 July 2015.
111 E Avgouleas and C Goodhart (n 110), p. 2-5. 112 European Commission (n 11), p. 7.
113 S Gleeson, ‘Legal Aspects of Bank Bail-Ins’, Special Paper 205, LSE Financial Markets Group Paper Series (January 2012), p. 3.
114 These powers are specified in points (e)-(i) of Article 63(1) BRRD and include the following: the power to reduce, if necessary to reduce to zero, the principal amount of or outstanding amount due in respect of eligible liabilities, to convert eligible liabilities into ordinary shares or other instruments of ownership, to cancel debt instruments114 and to require to issue new shares or other instruments of ownership or other capital instruments.
115 The conditions for resolution are laid down in Articles 32 and 33 BRRD. 116 Recital (68) BRRD.
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sufficient market confidence in the institution.118 When the institution is undergoing a resolution process, it may be too difficult to adequately assess just what and how much it is sufficient in order to keep the confidence of the markets in the failing institution, keeping in mind that even perfectly solvent and healthy institutions may be subject to a run.119 To trigger the bail-in tool to effect recapitalization is a bit more complex than it might seem at first. Resolution of the failing institution under this scenario can take place only if there is a reasonable prospect that the application of bail-in in conjunction with other relevant measures120 will not only achieve relevant resolution objectives, but will also restore that institution to financial soundness and long-term viability.121
In this case the objective of the bail-in tool is to resolve a failing institution as a going concern, where the viability restored through imposition of losses on shareholders and creditors could allow a distressed institution to continue operating and remain open, and avoid disorderly liquidation. This could prevent a destruction of value, potentially preserve continuity of critical functions, and reduce the risk of contagion within the financial system,122 thereby mitigating the systemic risks often resulting from an insolvency-induced disorderly liquidation.123 Eliminating insolvency risk could also minimize liquidity risks, prevent runs on financial contracts and reduce the number of assisted mergers that tend to create even larger financial institutions.124
One of the main weaknesses of restructuring an institution’s balance sheet through the bail-in is a lack of bail-infusion of new cash.125 In the open bank model this issue might be addressed to a certain extent. Article 37(3) of the BRRD allows resolution authorities to apply resolution tools in any combination. Such rather broad ambit of the application of the bail-in tool enables the institution to generate some amount of cash through the exercise of partial sale of business tool. However, the proceeds won’t be available immediately, it may only mitigate the extent of negative impact in the longer run. Hence, the survival of the failing institution is possible only with the sufficient market confidence in it, and for that the institution needs to be “credibly creditworthy”, and possibly have “a statutory backing” (in the form of financial support), so that counterparties would agree to continue dealing with it after its recapitalisation and reconstruction.126 The BRRD does not completely rule out a possibility to use taxpayers’ money at a certain point. An extraordinary public financial support through additional financing stabilisation tools is envisaged in the Directive, though it may be used only after a number of strict conditions have been fulfilled,
118 Art. 43(2) (a) BRRD.
119 M Schillig, ‘Bank Resolution Regimes in Europe – Part II: Resolution Tools and Powers’, European Business Law Review 25.1 (2014), p 95.
120 Including measures implemented in accordance with the business reorganization plan. See Art. 43(3) BRRD. 121 Art. 43(3) subparagraph 1 BRRD. 122 S Gleeson (n 113), p. 1. 123 J Zhou, et. al (n 102), p. 9. 124 Ibid. 125 S Gleeson (n 113), p. 1. 126 Ibid.
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including a prior contribution to loss absorption and recapitalisation equal to an amount of at least 8 % of total liabilities to be made by shareholders and creditors through write down, conversion or otherwise.127
The resolution of the failing institution on a going concern basis must be accompanied by recovery and reorganisation measures. The management responsible for the loss is removed and replaced, except under certain circumstances specified in Article 34(c). A business reorganisation plan for the recapitalised institution must be drawn up within one month128 of the application of the bail-in tool and implemented in accordance with Article 52 of the BRRD.129 It will have to indicate the reasons that caused the failure or likely failure of the institution, lay down a number of meticulously described measures that will be employed in order to “restore the long-term viability of the institution” or remaining parts of its business within a strictly set timeframe.130 The plan represents a detailed long-term reorganisation strategy, which should allow relevant authorities to assess whether the envisaged measures are appropriate, sufficient and likely to achieve the objective of restoration of the long-term viability, or whether there is a need to make any amendments to eliminate shortcomings.131 The reorganisation plan should also bring more certainty and clarity with regard to the future of the institution under resolution to the interested parties / stakeholders involved.
If the conditions laid down in Article 43(3) are not met, resolution authorities may apply any of the remaining resolution tools,132 and the bail-in tool referred to in Article 43(2) (b) – the so-called ‘closed bank’ scenario.133 Under the ‘closed bank’ model, the institution is treated as a ‘gone concern’. While the failing institution ceases to exist as a legal entity, all or parts of its business and operations may continue as a going concern under a new ownership, through a private purchaser or a bridge institution. If the systemically important functions and economic services are transferred to a bridge institution or to a private purchaser, the residual part of the distressed institution is orderly liquidated under normal insolvency proceedings.134 Pursuant to the final version of the Directive, the regime under the ‘closed bank’ scenario seems to be a lot more satisfactory than it was envisaged in the Proposal.135 Now the bail-in process may be triggered not only to adequately
127 Art. 56 and Art. 37(10) BRRD. 128
In exceptional circumstances that period might be extended to a maximum of two months. See Art. 52(3) BRRD. 129 Art. 51 BRRD.
130 Art. 52(4) (5) BRRD 131 Art. 52(7) (8) BRRD. 132
The sale of business tool, the bridge bank institution and the asset separation tool. See Art. 37(3) BRRD). 133 Art. 43(3) subparagraph 2 BRRD.
134 Art. 37(6) BRRD. 135
European Commission, ‘Proposal for a Directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No 1093/2010’, COM (2012) 280 final.
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capitalise a bridge institution by converting to equity or reducing the debt that is transferred to a bridge institution from the institution under resolution but it may also be applied to claims or debt instruments that are transferred under the sale of business tool or the asset separation tool.136
One might notice a different terminology in Articles 43(2) (b) (i) and 43(2) (b) (ii) of the BRRD which govern a transfer of creditor claims to the bridge institution, and under sale of business or the asset separation tool respectively. The reasoning behind it seems to be related to different expectations: a bridge institution is expected to comply with requirements of Directive 2013/36/EU (CRD IV)137 and Directive 2014/65/EU138 (MiFID II), and, therefore, its adequate capitalisation must be ensured.139 In the case of the application of the sale of business tool, the purchaser may be able to raise capital through other channels too, if necessary,140 or it may hold sufficient amount of capital itself. Where the asset separation tool is used, Article 46(2) obliges resolution authorities to consider a prudent estimate of the capital needs of the asset management vehicle as appropriate when determining the amount of bail-in.
Under the final version of the BRRD, the bail-in of creditors may facilitate a (re)capitalisation not only of the distressed institution, but also of a bridge institution, a private purchaser or an asset management vehicle. The fairly wide ambit of the application of bail-in tool is very satisfactory. When a distressed institution faces a failure, when the time and fast, decisive decisions are of utmost importance, a wider variety of possibilities might help to build a way to a successful resolution, although a lack of precedents and the variety of choices might slow down the process as well.
4.3 Architecture of Mandatory Bail-in Mechanism:
Addressing Problems of Moral Hazard and Creditor Hold-out Behaviour
4.3.1 A Trigger Event: Sufficiently Clear and Predictable?
The BRRD stipulates that the bail-in tool can be triggered only when a resolution authority determines that three cumulative conditions are met, namely, that (i) a financial institution is failing or is likely to fail; (ii) there is no reasonable prospect that alternative private sector solutions or supervisory actions would prevent that failure within a reasonable timeframe; and (iii) a resolution
136 Art. 43(2) (b) (i-ii) BRRD. 137
Directive 2013/36/EU of the European Parliament and of the Council 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 (OJ L 176, 27.6.2013, p. 338).
138 Directive 2014/65/EU of 15 May 2014 of the European Parliament and of the Council on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (OJ L 176, 27.6.2013, p. 349).
139 European Banking Authority, Single Rulebook Q&A, Question ID 2015_1781 (2015), available at <http://www.eba.europa.eu/single-rule-book-qa/-/qna/view/publicId/2015_1781> last accessed on 31 July 2015.
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action is necessary in the public interest.141 This section will take a closer look at this set of conditions, aiming to find out the extent of clarity surrounding the trigger and the predictability of timing of the implementation of the resolution action(s).
According to Article 32(1) of the Directive, the competent authority, after consulting the resolution authority, makes the determination of failing or likely to fail. Member States may deviate from this general rule by providing that also the resolution authority, after consulting the competent authority, may make this determination, if national legislation provides resolution authorities with the necessary tools, such as access to the relevant information to make this kind of decision.142 The exercise by the Member States of such a discretion could help to overcome a potential issue of supervisory forbearance that the competent authority might engage in.143 Thus, if the supervisory authority restrained itself from acting when it was supposedly necessary, it would only be consulted with, while the resolution authority itself would have the ultimate power to trigger a resolution action after making all three decisive determinations regarding the three resolution conditions.144 However, the cooperation between these two authorities needs to be ensured in any case and arising issues must be discussed during the consultation process, trying to avoid any delays in individual cases.
A general description of certain circumstances when the institution should be considered failing or likely to fail is specified in Article 32 of the BRRD. Pursuant to paragraph 4 of the referred article, an institution is deemed to be failing or likely to fail (a) when it infringes or in the near future will infringe the requirements for continuing authorization in a way that would justify the withdrawal of the authorisation, especially if it incurs, or is likely to incur, losses that will significantly reduce or fully deplete its own funds (failure to meet prudential capital requirements); or (b) when the assets of an institution are or will, in the near future, be less than its liabilities (failure to meet balance-sheet insolvency thresholds); or (c) when the institution is or will be, in the near future, unable to pay its liabilities as they fall due (failure to meet liquidity insolvency thresholds); or (d) when the institution is in need of extraordinary public financial support, save for the exceptions defined in points (i)-(iii) of paragraph 4(d).145 Some of these circumstances might
141 Art. 32(1) BRRD.
142 Art. 32(2) BRRD. 143
Directorate-General for Financial Stability, Financial Services and Capital Markets Union, Q&A document in the context of transposition of Directive 2014/59/EU (1 January 2015), No 117, question with regard to Art. 32.
Available at <http://ec.europa.eu/finance/bank/crisis_management/index_en.htm> last accessed on 31 July 2015. 144 The second and the third condition is determined already only by the resolution authority.
145 Pursuant to Art. 32(4) (d), extraordinary public financial support that takes one of the forms stipulated in subparagraphs (i)-(iii) does not trigger a resolution process if that support is provided to a solvent institution, if it is of a precautionary and temporary nature, and proportionate to remedy the consequences of serious disturbance, and not used to offset losses the institution has incurred of likely to incur in the near future. This provision intends to address specifics situations that arise after the EBA or national authority, where relevant, conduct stress tests, asset quality reviews or equivalent exercises.
