Further Guidance on Bail-in

On 14 May 2013, the Economic and Financial Affairs Committee of the EU Council published a press release following a debate on the proposed Recovery and Resolution Directive (RRD).  The discussion focused on the design of the bail-in tool, identified as a central issue.  A summary of the key points include:

• General agreement on the scope for bail-in and a limited list of defined exclusions;
• General agreement that the level of loss absorbing capacity must be adapted to match the scope of exclusions;
• Agreement amongst most Member States that the deposit guarantee schemes (for deposits under EUR 100.000) should benefit from depositor preference (i.e. last category of assets to be bailed in);
• Overall support for deposits over EUR 100.000 to also benefit from depositor preference (with some reservations towards preference given to large corporate deposits);
• The need for a balance between a harmonised approach to bail-in and limited national flexibility in its application;
• Country-specific concerns regarding euro area vs. non-euro area issues should be addressed.

The Council is expected to reconvene on 21 June, with the hope of reaching an agreement on the directive.

Germany Proposes “Two-Step Approach” to EU Bank Resolution

In an opinion piece published in Monday’s Financial Times, German finance minister Wolfgang Schäuble, discussed the urgent need for a European banking union and stressed that in its present state it would only be ‘timber-framed, not steel-framed’.

The first step towards EU banking union was the development of a single supervisory mechanism, currently scheduled to commence operation in mid-2014.  This is to be followed by a proposal for a single resolution mechanism which includes a resolution authority and resolution fund.  The third (and least likely) pillar of EU banking union to be implemented consists of a common deposit guarantee scheme.

Schäuble believes that the steps taken to date are insufficient and existing EU treaties do not provide a solid foundation for the new supervisory and resolution agencies.  He argues that the single resolution authority in particular, requires a strong legal basis since it is more intrusive in its nature.  To address this situation, bail-in should be implemented as soon as possible rather than in 2018.  In addition, a “two-step approach” to bank resolution should be adopted based, initially, on a network of national authorities and national funding which would be quick to implement and would not require treaty change.  This would buy time to allow EU legislators to erect the long-term ‘steel-framed banking union’ via treaty change.

Update on Banking Reform Bill

The Parliament website has confirmed that the Financial Services (Banking Reform) Bill has been carried over to the 2013-14 session.  The dates of the report stage and third reading have not yet been announced.

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.

The Road to Liikanen

On 6 May 2013, the EU Commission published a roadmap regarding a proposal for a structural reform of EU banks (i.e. the Liikanen reforms).  This followed the publication, on 2 October 2012, of the final report of the High-level Group on reforming the structure of the EU banking sector, chaired by Erkki Liikanen, a summary of which can be found here.

The main issues being considered by the Commission are:

• The definition of relevant activities to be separated from deposit-taking entities.  This could include:
  • proprietary trading;
  • market-making; and
  • securities underwriting.
• The nature and extent of separation and governance of separated entities.  Available options include:
  • functional separation (also referred to as “ring-fencing” or “subsidiarisation”);
  • accounting separation; or
  • full ownership separation.
• Thresholds and de minimis exemptions.  These are likely to be based on:
  • bank balance sheet size; or
  • share of trading activities.

Consideration will also be given to:

• the treatment of derivatives business (as principal or as agent);
• the treatment of non-EU assets; and
• exposures to hedge funds and private equity funds.

A further public consultation will be launched in early May 2013 and a meeting of stakeholders is due to be held on 17 May 2013.  Thereafter, as per its recent update, the Commission intends to adopt a legislative proposal in Q3 2013, although it is not yet certain whether that proposal will take the form of a Directive, a Regulation, or a combination of the two.

The Road to Non-Bank Resolution

On 6 May 2013, the EU Commission published a roadmap regarding a framework for crisis management and resolution for financial institutions other than banks (i.e. central counterparties, central securities depositories, insurance and reinsurance firms, payment systems, investment funds and certain trading venues).  The roadmap follows the consultation paper published on 5 October 2012, a summary of which is available here.

Rather than adopt a broad framework approach in terms of applicable nonbank institutions and general tools for authorities to intervene, the Commission believes that more specific provisions and tools in relation to each sectors is more appropriate due to the different types of risk to which each sector is exposed and the differing consequences their failure would have.  The Commission makes clear that any regulation will be proportionate in nature and “only entities which are big, interconnected or central enough in the financial system to cause widespread disruption should they fail” are to be subject to the regulation.

As noted in this update, the EU Commission currently expects a legislative proposal in this area to be adopted in November 2013.

EU Legislation Update

On 7 May 2013, the EU Commission published an updated summary of the legislative proposals and non-legislative acts that it expects to adopt between 1 May 2013 and 31 December 2013.  Of particular note are the following:

Proposal	Proposed Date of Adoption
Regulation on a single resolution authority and a single resolution   fund within a single resolution mechanism	July 2013 (had previously been due to be adopted in Q4 2013)
Directive/regulation on the reform of the structure of EU banks (i.e. the Liikanen reforms)	Q3 2013
Framework for crisis management and resolution for financial institutions other than banks	November 2013
EMIR delegated regulation concerning procedural rules for fines on trade repositories	October 2013 (had previously been due to be adopted in Q2 2013)
EMIR delegated regulation concerning fees to be charged to trade repositories	May 2013

 

CCP Loss Allocation Rules

This is a link to an interesting paper published by the Bank of England relating to CCP loss allocation rules (first spotted over on The OTC Space).  The paper explains the reasons why CCPs must maintain a matched book at all times and the process typically followed on the occurrence of a clearing member default.  It also provides a useful discussion of the pros and cons associated with various loss-allocation options (particularly around cash calls from clearing members, margin haircutting and contract tear-up) as well as a helpful summary of existing loss-allocation rules of various CCPs, presented in tabular form.

Although it doesn’t provide any answers, the paper does proffer a set of principles, designed to guide CCPs in designing loss-allocation rules.  It notes that the Bank of England will have regard to these principles in assessing the suitability of CCPs’ loss-allocation rules.  In summary, the principles state that:

• loss-allocation rules should provide a full and comprehensive description of the way in which losses would be allocated – they should be clear, transparent and capable of being implemented quickly;
• tear-up of contracts should be a last resort to prevent the disorderly failure of the CCP;
• where tear-up is used, it should as far as possible be isolated to the affected clearing services so as to limit the risk of contagion;
• loss-allocation rules should positively incentivise participation by clearing members (for example in auctions) and avoid incentives to resign membership (which may prove to be destabilising);
• loss-allocation rules should not disincentivise effective risk management by CCPs, for example by imposing losses solely on participants and not shareholders; and
• loss-allocation rules should not compromise the CCP’s risk management of open positions, for example by ensuring the replacement of initial margin which has been made subject to a haircut.