THE EU PROPOSAL FOR RECOVERY AND RESOLUTION OF CREDIT INSTITUTIONS AND INVESTMENT FIRMS

THE EU PROPOSAL FOR RECOVERY AND RESOLUTION OF CREDIT INSTITUTIONS AND INVESTMENT FIRMS

SUMMARY:
* Proposed EU Directive gives authorities sweeping powers to preserve essential functions of failing financial firms without spending any public funds.
* Early steps will be based on recovery plans and early intervention measures, which can include voluntary debt restructurings.
* In resolution statutory creditor bail-in will be used to absorb losses, while activities can be sold or transferred away into a bridge bank. Important changes are a new priority of claim, ranking retail and SME deposits ahead of institutional deposits and other senior unsecured creditors. 
* Banks will need to maintain at least 8% of bail-in liabilities, although this is only a minimum ratio and not a limit to loss absorbency. Interbank funding is only carved out for obligations with original maturities of up to seven days. However, full bail-in might only be implemented by 2018.
* Excess collateral for covered bonds becomes bail-in material, unless specifically preserved by national legislation (contractual OC could be out though!).
* Industry funded national resolution financing arrangements can provide short-term funding and participate in the bail-in to a limited extent.
* Additional Tier 1 and Tier 2 capital needs to be fully and permanently loss absorbing at the point of non-viability (but no requirement for permanent loss absorbency in a going concern scenario).


The legal and regulatory framework for banks continues to evolve in large steps. An important recent development was the publication of a draft EU directive for a recovery and resolution framework for credit and investment firms (the Directive), based on agreements reached at the Council of the European Union on 27 June 2013 [Note: EU Directives are legislation which needs to be further implemented in Member States by specific national legislation. In contrast EU Regulations (e.g. CRD IV) have direct legal power without further national implementation]. The draft still needs to go through the European Parliament, but since it is already the result of compromise between the various countries involved it seems to have a reasonable chance to get passed before the end of the year. The following is a summary of key points.

The new rules will give authorities powers “… to resolve any financial institution in an orderly manner in the event of failure, whilst preserving essential bank operations and minimising taxpayers' exposure to losses.” This can be achieved at various stages: preparatory and preventative, early intervention, and resolution.

The new regime explicitly requires that shareholders bear losses first, followed by creditors according to their order of priority, essentially with the only limitation that no creditors should incur greater losses than they would have incurred if the institution had been wound up under normal insolvency proceedings (“no creditor worse off principle”).

RECOVERY PLANS
Institutions will be required to maintain recovery plans that set out measures for the restoration of their financial position following a significant deterioration, including indications at which points actions from the plan are being taken. The goal is to ensure the continuation of critical functions.

Institutions should be resolvable and regulators have the powers to implement measures that make an institution resolvable without threats to financial stability and maintaining its ability to provide critical functions for the economy. This can be achieved e.g. via the following:
* Drawing up of service agreements,
* Exposure limits
* Divestment of specific assets, 
* Changes to the legal structure, etc.

In practice a difficulty with the restructuring plan concept could be that it turns difficulties into a self-fulfilling prophesy, due to the confidence sensitive nature of financial activities, especially for banking and trading businesses.

INTRA-GROUP SUPPORT
Intra-group support should be on a voluntary basis and each party must be acting in its own best interest, although direct as well as indirect benefits can be taken into account for this assessment. Support agreements can only be made before either party would meet conditions for early intervention. Support agreements need supervisory consent as well as shareholder approval in both (supporting and supported) entities and need to be published annually.

The new requirements arguably weaken intra-group support to ring-fence the individual legal entities and prevent contagion within a group. This makes the individual legal entity view and analysis more important going forward, while reliance on intra-group cohesion becomes less appropriate. E.g. assessments of credit strength based on how “core” or not an entity may be within a financial group could become less relevant.


EARLY INTERVENTION POWERS
Beyond self-help recovery plans, authorities should have early intervention powers such as e.g. the appointment of a special manager, implementation of some measures from the recovery plan, change in strategy, etc. Management can also be required to draw up a plan to negotiate the restructuring of debt with some or all creditors and resolution authorities can start to gather necessary information and contact potential purchasers for all or parts of the business. 

Some of the ideas expressed in the Directive can safely be assumed to mean it is game over for a bank, if implemented in practice and similar to restructuring plans would have a high likelihood of ultimately leading to resolution. 

It is also noteworthy that debt restructuring can already be part of the early actions a bank is supposed to take to prevent resolution, although as far as I understand there would be no mandatory bail-in at this stage, i.e. any debt restructuring would need to take place on a voluntary basis, with all the practical complications this would entail.


RESOLUTION
Resolution kicks in once an institution is failing or likely to fail and no alternative private sector solution gets found and early intervention measures are insufficient, including the write down or conversion of capital instruments. The Directive explicitly states that failed institutions should (be able to) exit the market, irrespective of their size or interconnectedness, in order to avoid moral hazard. Resolution can cover individual OpCo entities, but can extend to a holding company if necessary. Objectives are to:

* Maintain critical functions
* Prevent significant adverse effects on financial stability
* Protect public funds
* Protect guaranteed deposits and client assets
* At the same time resolution should avoid unnecessary destruction of value and minimise the cost of resolution, although this seems to be a second order goal.

Resolution kicks in fairly early and should be initiated before balance sheet equity is wiped out, but when a competent authority determines that an institution is failing or likely to fail. In practice tis will be when an institution breaches or is about to breach regulatory minimum standards for operations, both in respect of solvency as well as liquidity, or if there is a near term funding emergency. However, the need for emergency liquidity assistance from a central bank is not in itself a trigger, although it will be in combination with other violations.

As another exception resolution is not triggered if a state takes a precautionary equity stake in an institution which complies or is marginally below its capital requirements, e.g. in case of stress test requirements or due to an impending increase in capital requirements. This would currently be in opposition to State Aid rules of the EU Commission, but in general the EU Commission would be expected to adopt its rules to the Directive.

Resolution gives authorities a wide range of options to deal with a failed institution and the EU’s Directive largely follows a similar playbook as the bank resolution laws which have been implemented in recent years, e.g. in Denmark, the UK or Germany, as well as other countries. Principal resolution tools are:
* Sale of business
* Bridge institution (for a max. life span of two years, but can be extended)
* Asset separation
* Bail-in

A residual institution will normally be wound up under normal insolvency proceedings, but at the same time making sure that it can still provide critical services to continuing parts of the business. 

Key to resolution is that losses get allocated to existing creditors according to the priority of claim of normal insolvency proceedings, i.e. shareholders first, followed by junior creditors, etc. Typically it is likely that this will be implemented via the bail-in tool of the Directive (see below), based on a valuation of assets and liabilities which is to be carried out by an independent valuer if possible. The valuation should fully recognise losses at the moment the resolution tools are applied and exclude any effects of potential public financial support. If time is too short, a provisional valuation gets drawn up with additional loss buffer. 

A significant change to the current situation is that deposits will get a changed priority structure with significant parts ranking ahead of senior unsecured bonds. Deposits will be tiered with deposit guarantee schemes taking top spot in the ranking, followed by deposits of natural persons outside of the deposit guarantee schemes as well as deposits by micro, small and medium companies. 

Other deposits (i.e. by larger corporations, institutions, etc.) and senior unsecured liabilities rank after these deposit claims and also behind the European Investment Bank. Senior unsecured and other deposits therefore become a realistic loss absorbing slice of the liability stack and the changed priority of claim has the potential to significantly reduce the expected recovery such unsecured claims could achieve in resolution. 

Effectively the priority of claim changes to the following:
1. Secured creditors
2. Employee fixed remuneration, trade creditors, resolution costs, taxes, 
social security, etc.
3. Covered deposits and deposit guarantee scheme (guaranteed deposits get 
paid out by this)
4. Deposits by natural pensions, micro, small and medium enterprises
5. European Investment Bank
6. Senior unsecured creditors and other deposits
7. Senior subordinated (Tier 2 capital)
8. Junior subordinated (Additional Tier 1)
9. Common equity and CoCos converting to Common Equity
10. CoCos with full write-off features and no recovery


BAIL-IN TOOL:
The bail-in tool enables authorities to recapitalise an institution to allow it to carry on its activities or to facilitate the other resolution tools – bridge institution, etc. It is a central component of the new Directive as it shifts the burden of bank resolution to private investors and away from public funds. Implementation of the bail-in tool should be via the introduction of statutory debt write-down powers in respective national legislation, but should generally respect the general ranking of debt priorities under insolvency law. 

Implementation of the bail-in tool will be contentious and to soften the blow, the Directive requires national implementation of this only within four years of the entry into force of the Directive at the latest. Based on the current expected schedule this could mean the bail-in tool might only fully apply from 2018 onwards, although some nations might chose an earlier implementation date and indeed some existing resolution laws essentially contain bail-in mechanisms already.

Bail-in is limited by the “no creditor worse off” principle – i.e. no creditor should get less than she would have if the institution would have been wound up as a whole through normal insolvency proceedings. The difficulty with this will be in the valuation of assets and liabilities; but the Directive adds an ex post comparison to buffer the risk of overly conservative valuations to the detriment of existing investors. In case of a discrepancy compensation payments would be made by the resolution financing scheme.

While bail-in powers are extensive, there are nevertheless some carve-outs in the Directive, i.e. the following liabilities will be excluded from bail-in:

* Secured claims (but only the parts that are legally required are covered, 
although national legislation can protect excess collateral for covered 
bonds!)
* Deposits covered by deposit guarantee schemes (the deposit guarantee scheme 
absorbs any respective loss)
* Liabilities to employees and claims relating to goods and services critical 
for the functioning of the institution
* Payment system liabilities with less than 7 days maturity 
* External institutions with original maturity of less than seven days [i.e. 
there is not a carve-out for longer dated interbank liabilities!]
* Liabilities which cannot be bailed in within a reasonable timeframe or which 
cause value destruction for other creditors. In such cases other bail-in-able 
liabilities absorb the additional losses. 

Where the losses cannot be passed to creditors, the resolution financing arrangement (see further below) may make a contribution to the institution under resolution subject to a number of conditions including the requirement that losses totalling not less than 8% of total liabilities including own funds have already been bailed in (or alternatively 20% of risk weighted assets), and the funding provided by the resolution fund is limited to the lower of 5% of total liabilities including own funds or the means available to the resolution fund including the amount that can be raised through ex post contributions within a period of three years. However, it is important to note that the external contribution is “may pay” and that the 8% creditor loss absorption is a minimum level, i.e. creditors may very well be required to absorb losses above and beyond the 8% threshold.

Institutions will be required to maintain bail-in-able liabilities to meet these requirements including potentially contractual bail-in instruments [although with statutory bail-in powers the contractual bail-in seems less crucial]. The EU Commission may until end-2016 submit a legislative proposal to the European Parliament and the Council to harmonise the application of minimum requirements for own funds and eligible (bail-in) liabilities. Bail-in liabilities should be distributed across a group according to the level of risk in the constituent legal entities.

A number of additional requirements and rules relate to the bail-in tool, including the following:

* Derivatives liabilities get included in bail-in, but only upon or after closing out of the respective contract. Netting arrangements continue to be respected.
* In a conversion of debt to equity authorities may apply different conversion rates to different classes of capital instruments and liabilities, reflecting appropriate compensation to the affected creditors. [more deeply subordinated classes would be expected to be very heavily diluted in any case, however].
* The bail-in tool requires at the same time that a business reorganisation plan gets drawn up and implemented.
* Institutions will need to maintain sufficient authorised share capital or other Common Equity Tier 1 instruments to allow the conversion of liabilities into shares or other ownership instruments.
* Bail-in liabilities (any seniority) issued under non-EU law need to have contractual provisions for bail-in to be acceptable under the Directive.
* Additional Tier 1 and Tier 2 capital needs to be fully loss absorbing at the point of non-viability, i.e. at the point of failure these instruments need to be written down in full or converted into Common Equity. Such write-down or conversion as a result of bail-in is permanent. [No requirement of this under a going concern scenario, though!].
* Resolution authorities should be bound to transfer all linked contracts within a protected arrangement, or leave them all with the residual failed bank, i.e. hedge relationships etc. should be preserved.

Decisions taken by resolution authorities remain subject to judicial review, but this should not stop resolution proceedings. Remedies should be limited to compensation, but not annul previous decisions.

Cross-border groups should be resolved via consultation through resolution colleges, although these are not directly decision making bodies (national authorities remain ultimately in charge). EBA (the European Banking Authority) has a binding mediating role between national resolution authorities and for resolution cases which involve states outside the EU, EBA plays a co-ordinating role. 

EU Member States should also enforce resolution proceedings initiated by third countries where the third country institution has domestic subsidiaries or otherwise assets, etc. in an EU member state. However, a Member State can also refuse such enforcement for a number of reasons, such as e.g. if this would have an adverse effect on financial stability, domestic depositors would be disadvantaged relative to foreign depositors, etc. 


FINANCING ARRANGEMENTS 
Member States need to set up financing arrangements to implement resolution since short term funding needs during a resolution should be met by the financial industry rather than national budgets. These funds are available for a range of purposes in the resolution process. 

The respective financing arrangements need to collect funds covering at least 0.8% of covered deposits in each Member State. There might be a switch to total liabilities as a calculation base following an EBA assessment in 2016. Levies on banks will be proportionate to their balance sheet size, adjusted for covered deposits, but also further adjusted for the risk profile of the institution. The financing arrangements can also raise ex-post contributions to cover losses from resolutions.

Financing arrangements in various Member States can borrow from each other to cover higher funding needs. In case of a group resolution all the affected financing arrangements are expected to contribute.


FINAL PROVISIONS
A number of provisions conclude the Directive largely dealing with implementation:

* Member States shall apply the rules of the directive within 12 months after the Directive comes into force. However, the bail-in tools need to be applied from four years following the entry into force of the Directive at the latest.
* EBA will review implementation by 1 June 2018. 
* The Directive itself shall enter into force on the twentieth day following its publication in the Official Journal of the European Union.
* EBA is tasked with developing further technical standards where necessary.
* Various exceptions to auxiliary laws are adjusted to facilitate the rapid application of the resolution powers. E.g. the mandatory takeover bid requirement for all shareholders to protect minority shareholders is derogated during resolution, to prevent a potentially costly bidding process. Notice periods are shortened, etc.