Banking recovery and resolution directive

To end moral hazard and “too big to fail”, investors, not taxpayers, should bear the loss associated with bank failures. Recently, ECOFIN took a major step in this direction. It agreed a common position with respect to the Banking Recovery and Resolution Directive. If confirmed in the trialogue with the Commission and the European Parliament, the Directive will:

• Introduce bail-in of investor capital as a means to recapitalise banks that fail to meet threshold conditions and require resolution.
• Require banks to issue a minimum amount of liabilities subject to bail-in.
• Establish resolution funds financed by the industry to finance resolution tools so that immediate recourse to taxpayer money is only a remote possibility; and
• Exempt (via what might be called a 'carve-out' approach) from bail-in some customer obligations, such as insured deposits, and certain short-term wholesale obligations.

All of which assures that banks will have to submit to the discipline of investors who are genuinely exposed to the possibility of loss, should the bank reach the point of non-viability/fail to meet threshold conditions/ be unable to finance itself in private markets. This discipline should induce banks to better manage their risk.

This column comments on the interaction of the bail-in tool with the proposed resolution funds and on the effects of the carve-out approach to bail-in.

The common position on the Directive clearly mandates that bail-in should be part of the tool kit available to resolution authorities. Non-core Tier 1 and Tier 2 capital as well as certain senior unsecured debt will be subject to conversion or write down (bail-in) at the point of non-viability. This will recapitalise the institution and create the basis for the institution to remain a going concern.

The Directive mandates that at least 8% of the bank’s total liabilities should be subject to bail-in. Presuming that the authorities pull the trigger on resolution promptly (i.e. as soon as the bank fails to meet threshold conditions for its authorisation and operation), this requirement – which is well above the minimum capital requirement – should be sufficient in all but the most extreme scenarios to assure that the failed bank can be recapitalised without recourse to taxpayer funds.

Should losses exceed the amount of total liabilities subject to bail-in, recourse will be made (provided the bank had met the 8% minimum outlined above) to the member state´s resolution fund. National resolution funds should be built up over time through levies on the banking system until such time as the fund reaches a certain percentage of “covered deposits.” The maximum amount that such a resolution fund could contribute will be capped at 5% of the failed bank’s total liabilities. This could bring the total contribution by the private sector (investors in the bank’s obligations subject to bail-in and banks via contributions to the resolution fund) to 13% of the failed bank’s liabilities. Only then could there be recourse to either the member state’s own taxpayer resources (provided such recourse received state aid approval from the Commission) or, in the case of banks headquartered in the Eurozone to the European Stability Mechanism’s direct bank recapitalisation facility.

The thrust of the recently agreed position by the ECOFIN is admirable, but some aspects deserve attention and possibly revision. First, the Directive fails to define a common trigger for resolution. Considerable discretion is left to member states and this is likely to create confusion as to when the authorities could initiate bail-in. Second, the bail-in regime will not be compulsory until 1 January 2018. Although this allows banks a transition interval, it leaves open how banks should be resolved prior to 2018 and/or prior to their reaching the 8% minimum.

Third, the “carve out” approach to bail-in creates complications. It implies a discrepancy between legal and economic priority in the creditor hierarchy. Under the ECOFIN common position certain senior unsecured obligations are subject to bail-in (and therefore exposed to the possibility of loss) whilst others (insured deposits and wholesale funding with maturity of less than seven days) are exempted from bail-in. In economic terms the liabilities subject to bail-in are effectively subordinate to the liabilities of the same class that are carved out/exempt from bail-in. This violates the pari passu principle. To limit the deviation from this principle, the ECOFIN common position adopts the precept that no creditor should be worse off than it would have been in liquidation. If a creditor did become worse off, the Directive states that the creditor would be entitled to compensation for the difference from the resolution fund of the home member state of the failed bank. If this fund had insufficient resources, the fund would be entitled to borrow from the market and/or from resolution funds in other member states.

Accordingly the risk of senior debt subject to bail-in will depend, not only on the riskiness of the bank’s assets, but also on the amount of non-core Tier 1 and Tier 2 capital outstanding, the amount of debt and deposits pari passu with the senior debt but exempt from bail-in and the state of the resolution funds in the EU, especially in the bank’s home member state. National (even if limited) discretion with respect to setting the exemptions from bail-in will make this “resolution map” even more complex. Such discretion impairs coordination among national resolution authorities, and imposes different burdens on national resolution funds. This seems at odds with the possibility that resolution funds can borrow from one another, if the national fund cannot meet its obligations.

Fourth, the purpose, status, and mechanics of the resolution funds are somewhat unclear. The Directive envisages that resolution funds could (i) provide short-term financing of resolution tools such as bridge bank financing or impaired asset purchase; (ii) compensate investors who fared worse in resolution than in liquidation, and (iii) absorb losses over and above the losses that are compensated by the bail-in. It notes that such loss absorption might entail the direct recapitalisation of the failed bank by the resolution fund.

What the Directive does make clear is the limit on the “use” of the resolution fund. This is capped at 5% of the failed bank’s total liabilities. But the Directive does not define how use against this limit would be calculated or the priority that different uses would have (e.g. if uses [i] and [iii] exhausted the limit, what recourse would investors with claims under [ii] have?). Nor does the it clarify whether the resolution fund can borrow from the member state against future recoveries from the estate of the failed bank and against future contributions of banks to the fund. The Directive leaves open the possibility that the resolution fund could be combined with the deposit guarantee scheme but fails to spell out how this should be done (except that payment to insured depositors takes preference). Finally, it leaves open how the resolution fund should be financed. Member states may not elect to create a separate fund at all, but choose to meet resolution expenses through general revenues and ex-post assessments. It also leaves open the possibility that member states may decline to earmark the revenues currently being raised via bank levies as contributions to the resolution fund, so that contributions to the resolution fund will be in addition to rather than instead of the bank levy.

Finally, the ECOFIN common position recognises that extreme tail risks (losses exceeding 13% of the bank’s liabilities) ultimately belong to the government. Such tail risks might arise, if the economy suffers a very severe macroeconomic shock or if the supervisor exercises forbearance (allows the bank to continue in operation even though it fails to meet threshold conditions). In such cases recourse may be had to taxpayer funds, either at the member state level or via the European Stability Mechanism’s Direct Bank Recapitalisation facility. Any such taxpayer support would be subject to the Commission’s recently strengthened restrictions on state aid.

Despite these caveats, the Directive is very much a game changer. It assures, principally through the introduction of the bail-in tool that investors, not taxpayers, will primarily bear the cost of bank failures, and it opens the door to resolving banks in a manner that will not significantly disrupt financial markets or the economy at large. It will limit moral hazard and strengthen market discipline. And, if the trialogue addresses the issues outlined above, a very good directive could become even better. If the trialogue does not, the Single Resolution Mechanism should consider doing so for the member states included in banking union.

Editor's Note: The views expressed in this column are the authors’ and do not necessarily represent those of the Bank of Spain, the Eurosystem or Ernst & Young.

Huertas, Thomas F. “The Case for Bail-ins” in Patrick Kenadjian, (ed.) The Bank Recovery and Resolution Directive: Europe's Solution for "Too Big to Fail" (Berlin: de Gruyter, 2013): 167-188.

Nieto, Maria J and Gillian G Garcia (2012), "The insufficiency of traditional safety nets: What bank resolution fund for Europe?" London School of Economics FMG Paper Series, SP 209.