Bail-in rules in EU banking union and financial stability

Stefano Micossi

The European banking union is in pressing need of a unified banking resolution mechanism, but public bail-in has become increasingly unpopular. This column details new legislation towards a single resolution mechanism in the EU that minimises public exposure. The shareholders of an insolvent bank will be the first to take the hit, followed by creditors, before the public. This has the advantage also of mitigating moral hazard.

The Council and the European Parliament have adopted a directive (BRRD)1 and a regulation (SRR)2 establishing uniform rules for bank resolution in the EU. These include rules for the bail-in of shareholders and creditors when a bank is in need of public support.

The pre-conditions and scope of burden-sharing by creditors under state aid control and resolution procedures do not coincide. Moreover, questions have been raised as to whether the guidelines on state aid to banks take sufficient account of systemic stability considerations when imposing the conversion or write-down of creditor claims.3

The analysis in this column concentrates on:

The mutual consistency of the two sets of rules; and

How they address the question of systemic stability when creditor claims are bailed-in in normal market conditions.4

The 2013 Banking Communication on state aid by the European Commission

Since 2008 the European Commission has adopted seven decisions under Articles 107-109 TFEU on the compatibility of state aid measures in favour of banks.5 To foster financial stability and minimise future resort to taxpayers’ resources, the July 2013 Commission Guidelines lay down some conditions. The restructuring plans must be sufficiently timely and decisive to restore the bank to long-term viability, or shut it down. State aid is to be authorised only after junior creditors have been involved in the burden-sharing.

The Communication envisages two scenarios for burden-sharing:

the bank does not meet the minimum regulatory capital requirements or,

the minimum capital requirements are met and yet a capital shortfall is identified by a competent supervisory authority, e.g. as a result of a stress test (precautionary recapitalisations).

In the first case, state aid can only be authorised after equity, hybrid capital and subordinated debt have fully contributed to covering the losses. In the second, the Commission indicates that “in principle” subordinated debt must be converted into equity before granting the state aid only when there are no alternative ways to remedy the shortfall. The write-down of debt is not contemplated.

The Banking Communication also allows the Commission to postpone or avoid resort to bail-in where this could endanger financial stability or lead to disproportionate results (point 45).

Bail-in in the resolution framework

The objective of the directive and the regulation is to manage and resolve bank crises through uniform administrative procedures, whose application will be entrusted to a new EU authority called the Single Resolution Board (SRB). The Single Resolution Fund (SRF) is to be established to serve the needs of the resolution procedure. A specific goal of the new procedure is to minimise resort to taxpayers’ money in bank crises. When a bank is under resolution, its shareholders will bear first losses; creditors will bear losses after them, in reverse order of their priority claims under national insolvency law.

When it decides that a bank is failing or likely to fail, the SRB has the power to write down and convert liabilities of the credit institution by activating the bail-in tool both on a stand-alone basis and within a resolution procedure. A special clause (Article 16.3.d) provides that in certain circumstances financial support to the bank by national authorities or the SRF does not necessarily imply that the institution is failing or is likely to fail6 and thus trigger the start of resolution. This leaves the SRB the flexibility to handle large systemic shocks without triggering bail-in or the resolution procedure.7

Coordination of resolution procedures with state aid control

Article 16a of the regulation coordinates the action of the Board relating to the resolution procedure (Article 16) and that of the Commission in the exercise of its powers for the control of state aid. Use of the SRF is treated as state aid and therefore is subject to prior control by the Commission under Article 107 TFEU. The Board’s adoption of the resolution scheme shall not take place until the Commission has adopted its (positive or conditional) decision on the compatibility of the use of public aid with the internal market (Article 16a of the regulation).

In conclusion

Our analysis shows that the new resolution framework is well coordinated with state aid policy.

As to the relationship between bail-in under the two procedures and concerns of financial stability when a bank is failing (and therefore may be placed under resolution by the SRB), bail-in would just be a particular component of the general process and does not seem to raise specific concerns. Moreover, under the regulation and the directive bail-in is excluded for viable entities when public support is of a temporary and precautionary nature and is proportionate to remedy the consequences of a serious exogenous disturbance.

Thus, the possibility of destabilising effects from fears of bail-in seems mainly to arise from the application of state aid rules for solvent institutions in need of public support to raise capital. When this is the case, Commission guidelines seem to entail that the prudential recapitalisation of a solvent bank, following a stress test, would not lead to losses for junior creditors when, due to general market conditions, there is a need for some temporary public support.

However, this reassuring balance of the elements underpinning the Commission’s decisions in individual cases may not be clear to bank creditors and potential investors out there in financial markets. The impression of an unneeded rigidity on this very sensitive issue has been heightened by official statements over-emphasising that each case will be assessed individually under competition rules, thus raising understandable concerns that the systemic dimension of the issue may be underestimated, precisely when the banks’ comprehensive assessment by the ECB may lead to a need for large capital injections.

Therefore, some further clarification by the Commission may be needed on how the various criteria will be applied during the ongoing transition to banking union – perhaps through a new communication completing the state aid framework for banks in view of the adoption of the new resolution rules.

References

Avgouleas, E and C A E Goodhart (2014), “A Critical Evaluation of Bail-in as a Bank Recapitalization Tool”, paper prepared for the conference on “Bearing the losses from bank and sovereign default in the Eurozone”, organized by Franklin Allen, Elena Carletti and Joanna Gray at the European University Institute, Villa Schifanoia, Florence, 24 April.

DG Internal Market (2011), “Discussion Paper on the debt write-down tool – bail-in”, European Commission, Brussels.

Dűbel, H J (2013), “The Capital Structure of Banks and Practice of Bank Restructuring”, study commissioned by the Center for Financial Studies, University of Frankfurt, October.

Financial Stability Board (FSB) (2011), Key Attributes for Effective Resolution Regimes.

Micossi, S, G Bruzzone and J Carmassi (2013), “The New European Framework for Managing Bank Crises”, CEPS Policy Brief, Centre for European Policy Studies, November, Brussels.

Directive of the European Parliament and the Council 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 PE-CONS, 24 April 2014.

2 Proposal for a regulation of the European Parliament and of the Council 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 Bank Resolution Fund and amending Regulation (EU) No 1093/2010 of the European Parliament and of the Council (COM(2013)0520 – C7-0223/2013 – 2013/0253(COD)), 15 April 2014.

3 The issue has assumed special relevance in connection with the ongoing comprehensive assessment of the quality of banks’ balance by the European Central Bank (ECB), in preparation for the start of the Single Supervision Mechanism (SSM), which may require substantial capital injections to meet the enhanced prudential requirements, and possibly public support in certain cases. As may be recalled, the publication of the new Banking Communication in July 2013 led to a lively exchange of letters between Commissioner Joaquin Almunia and ECB President Mario Draghi (the letters were leaked to the press but never officially published). Mr Draghi reportedly feared that the Commission Communication could be read as the announcement that all banks in need of public support would be preventively subject to a bail-in of junior creditors, regardless of circumstances, potentially aggravating the funding difficulties of individual banks and the banking system as a whole.

4 It does not therefore address the broader issue of the potential impact of bail-in on investors’ confidence under distressed market conditions, which still is a feature of the current transition phase to full banking union. On this issue, readers may usefully refer to Avgouleas & Goodhart (2014). For a general background to bail-in and a description of precedents, see DG Internal Market (2011), Financial Stability Board (FSB) (2011) and Dűbel (2013).

5 Article 107 leaves the Commission sufficient flexibility to adapt the state aid policy in trying times, by permitting it to be considered compatible with common market aid measures that appear necessary and proportionate in order to address market failures. In identifying the market failures specific to the financial crisis since 2008, the Commission had to proceed by trial and error. As it came to recognise the systemic nature of the crisis, it resorted, as a legal basis for the temporary adoption of exceptional measures, to Article 107, paragraph 3, letter b, of the Treaty, which allows the authorities to consider measures needed to “remedy a serious disturbance in the economy of a Member State” as compatible with the common market.

6 When it involves state guarantees to back liquidity facilities provided by central banks (Article 16.3.d.i), state guarantees of newly issued liabilities or recapitalisations (injections of own funds, Article 16.3.d.ii) or the purchase of capital instruments that do not confer an advantage upon the entity (Article 16.3.d.iii). This last exception is limited to capital shortfalls established following the stress tests, asset quality reviews or equivalent exercises.

7 These exceptions only apply to solvent entities and are conditional on approval under state aid rules. In practice, they shall be acceptable when they are of a precautionary and temporary nature and proportionate to remedy the consequences of a serious exogenous disturbance.