European Parliament Publishes Draft Report on RRD

Introduction

On 16 October 2012, the European Parliament’s Committee on Economic and Monetary Affairs (ECON) published a draft report (the “draft report”) on the EU Commission’s proposal for a Directive establishing a recovery and resolution framework for credit institutions and investment firms (the “RRD”).  The overriding concern of the authors of the draft report relates to the level of interference with property rights permitted by the current draft of the RRD and the need to provide certainty to investors.  There is a perceived need to draw a more definite distinction between the pre-resolution period, where management remains in control of the firm, and the post-resolution phase, where control passes over to the relevant authority.  As a consequence, the draft report suggests far-reaching amendments to the RRD in areas such as:

  • resolution authority powers during the recovery phase;
  • preventative powers;
  • early intervention powers;
  • triggers to resolution; and
  • resolution tools: proposing both new resolution tools and amendments to existing resolution tools, particularly bail-in.

A more detailed summary of the main proposals is provided below.

Role of resolution authorities

In order to safeguard legal certainty and avoid conflicts of interest, the draft report proposes that national supervisory authorities should not also be able to act as resolution authorities.

Recovery Phase

Replacement of management

Currently, the draft RRD authorises competent authorities to replace the management of a firm during the recovery phase.  The draft report suggests replacing this power with a right to request  the replacement of the management body, on the basis that, during recovery (as opposed to resolution) shareholders should retain full control of a company.

Assessment of recovery plans

Article 6 of the draft RRD empowers a resolution authority to take the following actions in the event that it considers deficiencies to exist in a firm’s recovery planning: 

  • the reduction of the risk profile of the institution;
  • recapitalisation measures;
  • changes to the firm strategy;
  • changes to the funding strategy;
  • changes to the governance structure of the institution.

The draft report proposes to remove all of these powers on the basis that they constitute too great an imposition on the way in which a firm is run during a recovery stage.

Group recovery planning

Article 7 of the draft RRD currently states that recovery plans must cover each entity in a group.  The draft report suggests amending this provision so that the requirement applies only to relevant entities.

Preventative Powers

Article 14 of the draft RRD requires resolution authorities to notify firms about “potential substantive impediments to resolvability”.  Once notified, a firm must formulate proposals to remove these impediments within four months, failing which the authority can suggest a number of alternative measures.  The authors of the draft report believe that the current list of powers goes far beyond what is necessary and represent a “far reaching interference with property rights in banks”.  Of the current list of powers detailed within the RRD, the draft report suggests deleting those highlighted in red below:

  • requiring the institution to draw up service agreements to cover the provision of critical economic functions or services;
  • requiring the institution to limit its maximum individual and aggregate exposures;
  • imposing specific or regular information requirements relevant to resolution;
  • requiring the institution to divest specific assets;
  • requiring the institution to limit or cease specific existing or proposed activities;
  • restricting or preventing the development or sale of new business lines or products;
  • requiring changes to legal or operational structures;
  • requiring a parent undertaking to set up a parent financial holding company in a Member State or a Union parent financial holding company;
  • requiring a parent or holding company to issue subordinated debt/loans;
  • where an institution is the subsidiary of a mixed-activity holding company, requiring that the mixed-activity holding company set up a separate financial holding company to control the institution.

Early Intervention

Early intervention measures

Article 23 of the draft RRD allows for early intervention by a resolution authority if a firm does not meet, or is likely to breach, the terms of the Capital Requirements Directive (“CRD”).  The draft report suggests amending this so that early intervention is triggered where a firm’s capital is reduced below an amount equal to 1.25% above the level required by CRD IV.  In addition, the draft report proposes the removal of the early intervention power in Article 23(1)(g) of the RRD which allows authorities to contact potential purchasers in order to prepare for the resolution of the institution on the basis that this could damage attempts by management to restore the viability of the institution in question.

Special Management

The draft report proposes moving Article 24 (Special Management) of the RRD in its entirety from the recovery phase to the resolution phase.  The authors of the draft report believe that, during recovery, the owners should have full control over the institution and that this control should only pass to authorities once resolution has commenced.

Resolution Phase

Preparation of resolution plans

The report proposes that national competent authorities should be able to waive the requirement to prepare a resolution plan if a firm is judged to be not systemically important.

Conditions for resolution

Article 27 of the RRD triggers resolution in circumstances where a firm “is failing or likely to fail”.  The authors of the draft report believe that the term “fail” is vague.  Given the impact which application of the resolution tools can have on property rights, it is felt appropriate that resolution should only be used where a firm is very close to insolvency.  However, the authors of the draft report remain keen to avoid liquidity related triggers to resolution due to the possible systemic effects of triggering resolution on this basis.  Accordingly, the draft report proposes to:

  • include an additional condition for resolution such that the firm is also no longer viable pursuant to CRD IV; and
  • remove the trigger that the “institution will be, in the near future, unable to pay its obligations as they fall due”.

Resolution Tools

The draft report proposes the inclusion of a new resolution tool, the “government financial stabilisation tool”.  This takes the form of a new Article 50 (replacing the current Article 50 which addresses contractual recognition of bail-in).  Broadly, there are three elements to the government financial stability tool:

  • Guarantee tool – which facilitates government guarantees of assets or liabilities of institutions in resolution;
  • Equity support tool – which facilitates government recapitalisation of an institution in resolution; and
  • Temporary public ownership.

The authors of the draft report view this very much as a last resort and state clearly that taxpayers must be the beneficiaries of any surplus that may result.

Bail-In

Use of the Bail-In Tool

The draft report suggests amending Article 37 of the RRD to clarify that bail-in must not be used until a firm is beyond the point of non-viability and then only to meet the objectives of resolution as specified by Article 26.  Furthermore, a new Article 37(a) is proposed.  This would require Member States to conduct an assessment of the potential impact on the stability of the EU financial system before the bail-in tool is applied.

Scope of the Bail-In Tool

The draft report proposes amending Article 38 of the RRD to:

  • remove the exclusion relating to guaranteed deposits;
  • specifically refer to covered bonds in the context of the exclusion relating to secured liabilities; and
  • Extend the short-term exclusion from liabilities with an original maturity of less than one month to include liabilities with an original maturity of less than 6 months (so as to minimise the risk of bank runs).

Replacement of management

Recital 46 of the draft RRD states that, following application of the bail-in tool, management should always be replaced and the firm should be restructured.  The draft report proposes removing the reference to ‘replacement of management’.

Minimum amount of bail-in

The draft RRD requires firms to hold a minimum amount of bail-in debt, calculated by reference to the total liabilities of the institution.  The draft report of the Parliament proposes changing this to refer to the “risk exposure amount” (i.e. risk weighted assets) under CRD IV which is to be added to a firm’s minimum capital requirements.  The report claims that the reference to “total liabilities” introduces a totally new capital requirement on firms.  Moreover, in practice, this would operate as a leverage ratio which would not distinguish between low-risk banks and high-risk banks. 

Assessment of amount of Bail-In

Article 41 of the draftRRD requires resolution authorities to calculate the amount of bail-in that would be necessary not only to restore the Common Equity Tier 1 capital ratio of the institution to regulatory minimums but also to “sustain sufficient market confidence in the institution and enable it to continue to comply with the conditions for authorisation”.

The authors of the report point to the uncertainty that application of the bail-in tool can cause to investors in a firm and the increased funding costs firms may experience as a result.  The draft report highlights the need to strike a balance between providing certainty to investors on one hand and the need for creating capital for a bank under resolution on the other.  It suggests removing reference to ‘amounts necessary to sustain market confidence’ on the basis that this is, by definition, an arbitrary assessment, which may be artificially high during times of market stress.

Hierarchy of Claims

In order to provide certainty to investors regarding the hierarchy of claims, the draft report proposes to clarify Article 43 of the RRD.  Specifically, in order to avoid the unfair consequences associated with the upside potential of an equity position as opposed to the write down of a debt position, it is proposed that resolution authorities shall not write down the principal of one class of liabilities, while a class of liabilities that is subordinated to that class is converted into equities.

Contractual recognition of bail-in

In light of the fact that the RRD will apply to all capital and debt instruments regardless of any contractual provision, the draft report proposes the deletion of Article 50, which deals with contractual recognition of bail-in, believing it to be both irrelevant and potentially confusing.

Resolution Financing Arrangements

Ex-ante contributions

The draft report proposes that resolution should be funded ex-ante, rather than ex-post on the grounds that:

  • large ex-post contributions might exacerbate systemic risk during a financial crisis; and
  • properly managed banks would, in effect, be liable for the losses of failed banks.

The draft report also proposes using contributions to pay down public debt, rather than creating a formal fund with necessitates an investment strategy.  The financing arrangements would effectively form the premia of an insurance scheme provided by Member States.  The authors believe that a structure along these lines would render the target funding level of 1% of aggregate deposits within 10 years of the entry into force of the directive, as detailed within Article 93, irrelevant.

Borrowing between financing arrangements

Broadly, under Article 97, the RRD gives financing arrangements of one member state the right to borrow (and the obligation to lend) to other member state financing arrangements.  The draft report proposes amending this so that financing arrangements have the opportunity to borrow and the authorisation (but no obligation) to lend.

Deposit Guarantee Schemes

The draft report proposes amending Article 99 of the RRD to make clear that DGS may not be used for resolution purposes (other than through a potential bail-in of the DGS) so as to “safeguard the credibility of the deposit guarantee scheme”.

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