Bail-in Begins to Take Shape

Introduction

On 8 May 2013, the EU Council published a note regarding the “state of play” of on the proposed Recovery and Resolution Directive (RRD).

The design of the bail-in tool has been identified as a central issue with three main approaches (all of which adopt preferential treatment for insured depositors and provide for a broad scope of bail-in with a limited list of defined exclusions) being defined:

  • the Harmonised Approach;
  • the Discretionary Approach; and
  • the Mixed Approach.

Harmonised Approach

The Harmonised Approach defines a limited set of exclusions from bail-in.  Insured depositors would benefit from preference treatment (with Deposit Guarantee Schemes (“DGS”) substituting for insured depositors), meaning in practice that they would be unlikely to be bailed in as other classes of creditors would have to absorb losses first.  The only discretionary exclusion from the bail-in regime relates to derivatives.  It is designed to provide a high degree of harmonisation across Member States by promoting ex ante predictability and legal certainty to markets regarding the treatment of creditors.

A variation of the Harmonised Approach (which reflects the original Commission Proposal) would still see DGS substituting for insurance depositors but being bailed-in pari passu with all other all other senior unsecured creditors, rather than on a preference basis.  However, it is felt that, in these circumstances, the low size of DGS funds compared to insured depositors balances would mean that the DGS would not be able to cover the losses in the event of a bail-in of a large bank, potentially making the bail-in tool unusable.

The EU Council notes that many Member States feel that the Harmonised approach suffers from a lack of flexibility.  Specifically, there is a belief that the inability to exclude a creditor or class of creditors from the scope of bail-in may have adverse consequences in terms of financial stability.  In turn, this may damage the practical usefulness of bail-in as a tool with the result that resolution authorities have no option but to resort to using the resolution fund or taxpayer funded bail-outs.

Discretionary Approach

The Discretionary Approach attempts to address the flexibility deficiencies of the Harmonised Approach by providing resolution authorities with a degree of discretion on how the bail-in tool is used.  A number of alternative models are possible.  These include:

  • A small number of discretionary exclusions, e.g. relating to:
    • eligible deposits;
    • short term debt;
    • liabilities related to the participation in payment, clearing and settlement systems; and
    • OTC derivatives.
  • A general exclusion from bail-in of eligible deposits (over €100,000) of a natural person unless inclusion is necessary in order to absorb losses and where it does not raise financial stability risks; and
  • Providing a resolution authority with the discretion to exclude any liability from bail-in on a case by case basis (subject to strict criteria and perhaps limiting the actual exclusion to a percentage of the total pool of bail-inable liabilities).

What the Discretionary Approach gains in terms of flexibility, it loses in terms of harmonisation of the bail-in regime across Member States and providing legal uncertainty for investors and other unsecured creditors.  It is likely that the Discretionary Approach would also require an institution to hold a higher minimum amount of own funds and bail-inable liabilities in order to ensure it maintained sufficient and appropriate loss-absorbency capacity.

Mixed Approach

The Mixed Approach defines a limited set of exclusions, some mandatory and some discretionary, from the scope of the bail-in tool.  It seeks to provide a compromise solution to the issue of harmonisation.  The EU Commission believes that it makes the bail-in tool more credible, as it removes the risk that Resolution Authorities will not deploy the bail-in tool due to concerns about the impact on public confidence.

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