The new European resolution framework for banks: the corporate perspective
By Dr. Andreas Wieland, Stuart Willey and Dr. Dennis Heuer, LL.M.
On January 1, 2016, the new European resolution framework for banks took full effect. This forms a cornerstone to what has come to be known as the European Banking Union.
The Banking Union
The European Banking Union rests on three pillars: (a) the Single Supervisory Mechanism (SSM), (b) the European Deposit Guarantee Scheme (EDGS) and (c) the Single Resolution Mechanism (SRM).
Under the SSM, the European Central Bank, headquartered in Frankfurt, supervises all significant banks in the eurozone. This currently comprises 129 banking groups, including all the groups’ banking subsidiaries. European rules on deposit protection reach back to the early 1990s with the enactment of the Deposit Guarantee Schemes Directive. This directive has been subject to various updates, most importantly the increase to €100,000 per depositor in the protected amount following the aftermath of the financial crisis. Presently, the European Commission is planning to expand integration of European deposit guarantee schemes by merging current national deposit guarantee schemes into a single scheme (EDIS). The SRM establishes the European rules for the resolution of banks, in particular the interplay between European and national resolution authorities. The European Banking Union is augmented by a single rulebook for banks whose most important elements include the Capital Requirements Directive IV (CRD IV), the Capital Requirements Regulation (CRR) and the Bank Recovery Resolution Directive (BRRD)
New resolution framework for banks
Two major legal acts underpin the European resolution framework for banks: the BRRD and the SRM regulation. The BRRD applies to all credit institutions and certain investment firms based in the European Union and requires that rules for recovery and resolution of banks be harmonized throughout the 28 member states of the European Union. The SRM regulation calls for further integration and is directly applicable to all member states in the eurozone. It establishes the Single Resolution Board (SRB) based in Brussels, a European resolution authority for the eurozone, and the Single Resolution Fund (SRF), which will facilitate and help finance the orderly resolution of significant banks and cross-border banking groups.
Ending “too big to fail”
The contemporary concept of bank resolution was conceived in the aftermath of the 2008 financial crisis. The Lehman Brothers case demonstrated that bank failures can produce severe spillover effects that adversely affect the stability of the whole financial system and the wider economy.
As a result, governments tended to avoid the insolvency of banks in the past and bailed them out with taxpayers’ money. This phenomenon is also known as the “too-big-to-fail” dilemma. The new bank resolution framework tries to avoid such bailouts by creating a framework for the rescue of systemically important bank functions and the orderly winding down of the remaining parts of a bank without using taxpayers’ money. The new framework shifts the major burden of a bank failure to the bank’s shareholders and other creditors and sees additional support being provided through a common resolution fund sponsored by the banking industry. The use of public money is limited to extraordinary situations and is only allowed after shareholders and other creditors have substantially contributed to the bank rescue through burden sharing. The new bank resolution framework can only be applied to an entity if the application of ordinary insolvency laws would entail systemic risks. As a result, smaller or less-connected institutions remain subject to national insolvency laws.
The new resolution framework provides for the following resolution tools: (a) sale of the business, (b) a bridge institution, (c) asset separation and (d) bail-in. The first three of these resolution tools can be described as good bank-bad bank solutions, in which the parts of the bank that are systemically important are conserved in a good bank and the remaining parts of the bank are placed in a bad bank and wound down in an orderly procedure. The bail-in instrument is the primary and most innovative instrument to ensure burden sharing by shareholders and creditors. Within this context, shares can be cancelled and debt can be written down or converted into equity. The bail-in tool can be used alongside good bank-bad bank solutions.
Banks: the most important debtors of corporates
Corporates are key creditors of banks: All companies assume considerable risk from the banks they deal with. This starts, of course, with a company’s excess cash and other liquidity that is deposited or invested in debt or equity instruments issued by banks. In addition, corporates use bank payment systems and derivatives for hedging purposes. Every company has a multitude of contact points with various banks depending on the size and type of business. As a result, bank failure poses a significant risk to companies.
The new normal: bank failures are a real threat
Given the significance of bank relationships, one would expect the topic of bank failure to always be a major worry of company treasurers and risk managers. Surprisingly, this has not been the case historically, probably because bank failures have been very rare in the past. This is not necessarily the result of effective risk management by banks or prudent supervision, but rather the result of the too-big-to-fail dilemma and the resulting implied state guarantee. With the new banking resolution framework now fully in place, this has changed dramatically.
For the first time, a fully thought-out, workable toolkit is available to supervisors and resolution authorities to rescue or wind down even larger banks in an orderly manner without endangering the stability of the whole financial system. In addition, the resolution authorities are determined to avoid further spending of taxpayers’ money in connection with bank failures. Furthermore, the financial situation of some countries would not allow their governments to sponsor the bailout of a larger bank even if they wanted to. As a result, bank failure is a real possibility, and we expect further banking failures to occur in the future, in particular in the event of an economic downturn. This increased threat is also reflected in the rating decisions of the major rating agencies: Referring to the new resolution framework, they have downgraded most banks on the basis of weakening in the implied state guarantee.
What happens with my company’s claims?
As a result of this threat, it is important for corporates to understand what would happen with their claims in a resolution scenario.
In a bail-in, claims are generally treated in accordance with the order established by the national insolvency law. This means that any bail-in measure would start with equity (or Core Tier 1 capital in banking jargon) – that is, cancellation of shares, followed by holders of Additional Tier 1 instruments (such as contingent convertibles, CoCos), followed by supplementary capital (typically long-term subordinated debt qualifying as Tier 2 capital). In contrast, certain instruments are by definition exempted from a bail-in. This includes covered deposits – that is, deposits protected through statutory deposit protection (typically deposits made by individuals and small and medium-sized enterprises [SMEs] that total up to €100,000) as well as secured liabilities such as covered bonds.
Important new developments affect senior debt instruments, including senior unsecured bonds and commercial paper. Certain EU member states have changed their insolvency laws to declare senior bonds as subordinated. This is true for Germany (among other countries) where, starting on January 1, 2017, generally all bank senior debt instruments will be subordinated by operation of law, even if they were issued beforehand. A bail-in would affect these senior debt instruments prior to any other senior creditor of the bank, including all holders of noncovered deposits. Deposits held by private individuals and SMEs are privileged over holders of noncovered deposits and other senior creditors. Different rules may apply in other countries as the applicable laws in this area have not been fully harmonized under the new European resolution framework and are instead subject to the decisions of individual member states in certain respects.
The end of magic
For creditors of German banks, another development should be monitored: The Association of German Banks has organized its own voluntary deposit protection scheme for the private banking sector in Germany. This scheme supplements and complements statutory deposit insurance and has historically provided very comfortable protection levels of up to 30% of a bank’s own funds for each depositor. Several bank failures and the greater risk of bank failures have led the Association of German Banks to gradually reduce the maximum protection amount to 8.75% of a bank’s own funds. In addition, further changes are currently being discussed including a carve-out of all deposits held by institutional investors. No details have been released so far, but it seems possible that large corporates may also be affected by such carve-outs. A change in the rules of the German banking industry’s voluntary deposit protection scheme would further increase the exposure corporates would face should a bank fail.
What should companies do now?
Corporates should draw a number of conclusions from these developments:
1) Bank failures are no longer theoretical; they pose a real threat to corporates.
2) The changed risk profile of banks may also require that corporate treasuries make changes to their risk management. Corporates need to closely monitor the financial situation of the banks they do business with. This includes conducting an initial due diligence of a bank prior to entering into a broader business relationship as well as continuously monitoring the bank’s financial situation.
3) Corporates should assess all their business relationships with banks and closely monitor each bank’s key financial figures and ongoing development. If risks are identified, the corporate may have to consider broadening its risk diversification as well. For some companies, proper risk management may involve creating backup plans in case of a bank failure.
4) These measures need to be intensi-fied once a given bank’s situation becomes critical. Companies need to increase their monitoring of the situation and may need to reduce their exposure in terms of the bank that is in trouble.
5) A moratorium may precede resolution measures. During this phase, companies will need to determine if they want to agree to a voluntary bank restructuring or to sell their claims to investors with a bigger risk appetite to avoid having their claims written down in a bail-in.