The new European rules on crisis management (BRRD)
The Bank Recovery and Resolution Directive introduces harmonized rules to prevent and manage crises at banks and investment firms throughout Europe. The BRRD still has to be transposed into Italian law but on 2 July Parliament approved the European delegation law enabling the Government to do so.
The BRRD gives the resolution authorities (see below) the powers and tools to: i) plan crisis management; ii) intervene in time to prevent a full-blown crisis; and iii) handle the ‘resolution’ stage in the best possible way. Funds are to be created, out of contributions from financial intermediaries, to finance resolution measures.
While a bank is still operating normally, the resolution authorities should prepare resolution plans detailing strategy and actions to undertake in the event of a crisis. The authorities can intervene, even at this stage, with very wide powers, to create the conditions for easy application of the resolution tools, i.e. to enhance the ‘resolvability’ of individual banks.
The supervisory authorities will approve recovery plans, drawn up by the banks themselves, that specify the steps to be taken at the first signs of deterioration in the financial situation. The BRRD also gives the authorities ‘early intervention’ tools to supplement the traditional prudential measures, graduated according to the severity of the problem: the worst cases might require the removal of the entire management body and all senior management, and if that is not sufficient one or more temporary administrators may be appointed.
Why were the new European rules enacted?
The new rulebook will allow orderly crisis management, with tools that are more effective and using private sector resources, thus buffering the impact on the economy and saving taxpayers’ money.
The financial crisis has shown that a good many EU countries had inadequate tools for managing banking crises, especially for intermediaries with complex organizational structures and a dense network of relations with other financial operators. To stop a crisis at one bank from spreading uncontrollably, significant public interventions were necessary, which did safeguard the financial system and the economy but also involved high costs for taxpayers and in some cases jeopardized public financial stability1. And it was very hard to coordinate the interventions of the national authorities to deal with the problems of intermediaries operating in more than one country.
What is a bank resolution?
A bank resolution is a process of restructuring managed by independent authorities – resolution authorities – that with the tools and powers now available under the BRRD aims to avoid interruption of essential services (for example, deposits and payments), restore the viability of the healthy part of the bank, and liquidate the remaining parts. The alternative to resolution is liquidation. In Italy, compulsory administrative liquidation under the Consolidated Law on Banking will remain as a special procedure for banks and other financial intermediaries, in lieu of the bankruptcy procedures applicable to ordinary firms.
When is a bank subject to resolution?
The resolution authorities can resolve a bank if all these conditions are met:
- the bank is failing or is likely to fail when, for example, as a result of losses, it has entirely written off its capital or significantly reduced it);
- the authorities are convinced that alternative, private measures (such as capital increases) or supervisory action cannot have effect quickly enough to keep the bank from failing;
- the normal insolvency proceedings would not safeguard the stability of the system, protect depositors and customers and ensure the continuation of critical financial services, so that resolution is required in the public interest.
What are the resolution tools?
The resolution authorities can:
- sell a part of the business to a private buyer;
- transfer assets and liabilities temporarily to a ‘bridge bank’ established and managed by the authorities to continue performing critical functions, with a view to subsequent sale on the market;
- transfer non-performing loans to a vehicle (‘bad bank’) that will manage their liquidation in a reasonable timeframe,
- apply a ‘bail-in’, i.e. write down equity and other liabilities and convert them into shares to absorb the losses and recapitalize the existing bank or a new bank able to perform the critical functions.
Public intervention is only envisaged in extraordinary circumstances to prevent serious repercussions on the financial system as a whole. Government intervention, such as temporary nationalization, requires in any case that the costs be borne by the bank’s shareholders and creditors through the application of a bail-in of at least 8 per cent of total liabilities.
What is a bail-in?
When the conditions for resolution are met, a bail-in enables the resolution authorities to write down the value of the shares and reduce some claims payable or convert them into shares to absorb the losses and recapitalize the bank, to restore capital adequacy and preserve market confidence.
The shareholders and creditors cannot, under any circumstances, be required to suffer greater losses than they would incur under normal insolvency proceedings.
How does a bail-in work?
The figure gives a simplified illustration of how a bail-in works:
Initially, when a bank is operating normally (left), its liabilities consist of its capital, claims on it that are subject to bail-in (eligible liabilities) and others that are not (excluded liabilities), such as deposits protected by a guarantee scheme.
When a bank is failing, as a result of losses, the value of its assets is written down and its capital is reduced to zero. In the final stage (resolution or establishment of a new bank), the authorities order a bail-in, reconstituting the capital base by converting a part of the eligible liabilities into shares.
In this way the bail-in keeps the bank operating, providing critical financial services to the community. Since the financial resources to stabilize conditions come from the bank’s own shareholders and creditors, there is no cost to taxpayers.
Which liabilities are excluded from a bail-in?
All the following liabilities are excluded from the scope of application. They cannot be written down or converted into shares:
- deposits protected under the deposit guarantee scheme, i.e. up to €100,000;
- secured liabilities, including covered bonds and other guaranteed instruments;
- liabilities resulting from the holding of customers’ goods or in virtue of a relationship of trust, for example the contents of safe deposit boxes or securities held in a special account;
- interbank liabilities (except those within the same banking group) with an original maturity of less than 7 days;
- liabilities deriving from participation in payment systems with a residual maturity of less than 7 days;
- debts to employees, commercial payables and tax liabilities, if these are privileged under bankruptcy law.
Liabilities that have not been expressly excluded can be included in a bail-in. But in exceptional circumstances, such as when the bail-in entails a risk for financial stability or jeopardizes critical functions, the authorities may, at their discretion, exclude other liabilities as well. These exclusions are subject to limits and conditions and must be approved by the European Commission. Losses that have not been absorbed by the creditors can be transferred, at the discretion of the authorities, to the resolution fund, which can intervene up to a ceiling of 5 per cent of total liabilities, provided that a minimum bail-in of 8 per cent of total liabilities has been applied.
What do savers risk in a bail-in?
Bail-ins follow a ranking whose logic envisages that those investing in the riskiest financial instruments will be the first to absorb any losses or have their claims converted into equity (see the figure). Only when all the resources in the highest-risk category have been deployed can the next category be involved.
First of all, the interests of the bank’s owners – the shareholders – are sacrificed as the value of their shares is written off. Next, when reducing the value of the shares to zero does not fully cover the losses, action is taken vis-à-vis some classes of creditor, whose assets may be written down or converted into equity to recapitalize the bank.
For example, the holders of bank bonds could find that these have been converted into equity and/or their claim is now devalued, but only if the resources of the shareholders and those holding subordinated debt securities (i.e. the riskiest assets) are insufficient to cover the losses and recapitalize the bank, and even then only if the authority has decided not to exercise its discretionary power to exclude this kind of credit in order to prevent contagion and safeguard financial stability.
For bail-ins, creditors are ranked as follows: i) shareholders; ii) holders of other capital instruments; iii) other subordinated creditors; iv) unsecured creditors; v) individuals and small businesses for the part of their deposits above €100,000; vi) the deposit guarantee fund, which contributes to the bail-in in the place of guaranteed depositors.
EU legislation takes the approach to bail-ins, whereby the measures must be applicable also to instruments issued prior to the enactment of the legislation and already in the possession of investors.
Investors must accordingly pay close attention, when they sign on, to the risks attaching to certain kinds of investment. Retail customers who intend to buy bank securities should first be offered certificates of deposit covered by the guarantee scheme instead of bonds, which are subject to bail-in. At the same time, banks must reserve the instruments other than deposits, especially subordinated debt instruments, which come right after shares in absorbing losses, to more expert investors. Banks must provide timely information on all these aspects to their customers; the information must be provided, in great detail, at the time of placement of securities issues.
What do depositors risk?
Deposits up to €100,000, which are protected under the Deposit Guarantee Fund, are expressly excluded from bail-ins. This protection applies, for example, to current accounts, savings books, and certificates of deposit covered by the Fund; but it does not apply to other forms of investment, such as the bank’s bonds.
The portion of households’ and small businesses’ deposits above €100,000 also get preferential treatment These deposits sustain a loss only if all the instruments with a lower insolvency ranking are insufficient to cover the losses and restore capital adequacy.
Retail deposits above €100,000 can also be excluded from the bail-in on a discretionary basis, in order to prevent the risk of contagion and maintain financial stability, on condition that the bail-in has involved at least 8 per cent of total liabilities.
As of when will the bail-in rules apply?
In Italy bail-in rules will not become fully applicable until 2016; but the write-down or conversion of shares and subordinated debt, including capital instruments, applies already in 2015 if needed to avoid a failure.
The Commission’s 2013 guidelines for application of the rules on State aid already require the involvement of shareholders and subordinated creditors, by means of write-downs or equity conversion, as an indispensable burden-sharing measure before public support could be deemed compatible with the restrictions on State aid.
What is the Single Resolution Mechanism?
The Single Resolution Mechanism (SRM) provides for centralized management of banking crises in the euro area. It is an essential part of the Banking Union, flanking the Single Supervisory Mechanism (SSM).
The SRM has already begun preparations for the drafting of the resolution plans of the major European banks and will be fully operational as of 1 January 2016. The Mechanism also envisages a Single Resolution Fund (SRF) to be financed by contributions from banks in the participating countries and progressively mutualized.
The Fund’s primary function is to finance resolution measures, by granting loans or guarantees. However, if some claims have to be excluded under the circumstances specified in the Directive – to prevent contagion, for example – within limits the Fund may absorb losses in place of the excluded creditors, reducing the size of the bail-in.
A common European ‘backstop’ (a financial safety net of last resort) still needs to be designed to supplement the Fund’s resources so as to cope promptly with a crisis at a large bank. The recent Five Presidents’ Report on Completing Europe’s Economic and Monetary Union rightly sets this as a priority2.
The SRM is a complex system embracing the national resolution authorities and a central authority, the Single Resolution Board (SRB), itself made up of representatives of the national resolution authorities and some permanent members.
For the largest euro-area banks (those that qualify as ‘significant’ according to the SSM Regulation and cross-border banking groups), the Board lays down in advance, in the resolution plans, the procedures for dealing with a crisis, decides how to manage a crisis in practice when it arises, adopting a resolution scheme. It will then be up to the national resolution authorities to implement this scheme, exercising their powers under European legislation and transposed national regulations. The resolution scheme must also be submitted to the European Commission and, in some cases, to the Council as well3. This division of tasks also holds for minor banks whenever it is necessary for the Single Resolution Fund to intervene.
In other cases, the national resolution authorities will retain responsibility for planning and crisis management, acting in any case according to the Board’s guidelines.
What is the Bank of Italy’s role?
The recent enabling law assigns national resolution functions to the Bank of Italy, which also serves as Italy’s designated national resolution authority within the Single Resolution Board and the European Banking Authority’s Resolution Committee and for related activities under Article 3 of Legislative Decree 72/2015.
1 According to Eurostat, at the end of 2013 support to the national financial systems had increased the public debt by around €250 billion in Germany, €60 billion in Spain, €50 billion in Ireland and in the Netherlands, €40 billion in Greece, €19 billion in Belgium and Austria, and €18 billion in Portugal. In Italy public financial support was about €4 billion, all now repaid.
2 The report is by Jean-Claude Juncker in close cooperation with Donald Tusk, Jeroen Dijsselbloem, Mario Draghi and Martin Schulz. Available at http://www.ecb.europa.eu/pub/pdf/other/5presidentsreport.en.pdf.
3 At the proposal of the Commission, the Council may contest the satisfaction of the ‘public interest’ requirement or approve changes to the value of the Resolution Fund’s intervention under the scheme presented by the Board. If the Council confirms that there is no public interest, the resolution procedure is stopped and the entity is liquidated by the ordinary procedure. If the proposed change to the value of the Fund’s intervention is approved, the Board must consequently modify the resolution scheme within 8 hours.