EU Banking Reform Legislation Expected January 2014

On 11 December 2013, the European Commission published a press release containing remarks made by Michel Barnier, European Commissioner for Internal Market and Services on EU banking structural reform.  Mr Barnier stated that the legislative proposal on EU banking reform will be presented at the beginning of January 2014.  Following the recent publication of the Volcker Rule on 10 December 2013, the Commission will also look at the details of this new rule (see this blog post for more details).  For certain banks deemed too big to fail, he explained that the EU banking reform proposal will consider separation, calibration and treatment of the risks taken by these banks.

FMLC Provides Additional Commentary on RRD

On 25 October 2013, the Financial Markets Law Committee (FMLC) published a second discussion document on the EU Commission’s General Approach to the proposed Recovery and Resolution Directive (RRD).

The document is generally supportive of the changes made within the General Approach, but highlights a few remaining areas of concern with respect to legal uncertainty, including those set out below:

  • Bail-in: The RRD does not provide a set of principles to guide a resolution authority’s choice as to whether to convert debt to equity or whether to write-down debt.  In addition, contractual bail-in provisions may not operate in the same way as statutory bail-in provisions;
  • Valuation:  It is unclear on what basis the valuation (which must be independent) is to be carried out, notwithstanding that Article 30 of the RRD provides that the valuation should be fair and realistic.  This drafting ambiguity gives rise to legal uncertainty as to the status of a resolution action which is taken when a valuation at the proscribed standard has not been carried out, owing to practical difficulty or impossibility; and
  • General Resolution Powers:  Articles 56(1)(h) and 56(1)(l) of the RRD give a resolution authority the power to cancel or amend the terms of “debt instruments”.  However, this definition is wider than that of “capital instruments” – the term used to describe the instruments that are eligible to be ‘bailed-in’.

RRD Pushed Back Yet Again

On 20 September 2013, the EU Parliament updated its procedure file on the Recovery and Resolution Directive (RRD).  It seems that the RRD proposal will now be considered at the Parliament’s plenary session scheduled for 3 to 6 February 2014, rather than the session scheduled for 18 to 21 November 2013, as was previously the case.

EU Council Publishes new RRD Proposal

On 16 July 2013, the EU Presidency published a compromise proposal amending the EU Commission’s previous compromise proposal (dated 19 June 2013) relating to the Recovery and Resolution Directive (RRD).

As detailed in Annex 2 to the document, the main changes address issues such as:

  • the scope of the bail-in tool; and
  • resolution financing arrangements.

RRD Pushed Back Again

On 3 July 2013, the EU Parliament updated its procedure file on the Recovery and Resolution Directive (RRD).  It seems that the RRD proposal will not now be considered until the Parliament’s plenary session scheduled for 18 to 21 November 2013, rather than the session scheduled for 21 to 24 October 2013, as was previously the case.

EU Council Agrees Approach to RRD

On 27 June 2013, the EU Council published a press release confirming an agreed position with respect to the Recovery and Resolution Directive (RRD) and calling on the EU Presidency to start trilogue negotiations with the EU Parliament with a view to adoption of the RRD at first reading before the end of 2013.

The press release focuses on three areas:

  • Bail-in;
  • Resolution funds; and
  • Minimum loss absorbing capacity.

It does not contain much in the way of detail beyond that widely reported over the last week.  However, it is perhaps noteworthy that only inter-bank liabilities with an original maturity of less than seven days are to be excluded from the scope of the bail-in tool.

EU Council Proposal Highlights Future Direction of RRD

Introduction

On 20 June 2013, the Presidency of the Council of the EU published a note on the current “state of play” with respect to the Recovery and Resolution Directive (RRD), together with a compromise RRD proposal.  It also invited the EU Council to agree the compromise and mandate the Presidency to undertake negotiations with the EU Parliament with a view to reaching an agreement on the RRD as soon as possible.

The “state of play” summary focuses on the need to achieve an optimal balance between three interlinked elements of the RRD, dubbed the “Resolution Triangle”:

  • the design of the bail in tool;
  • minimum requirements for own funds and eligible liabilities (MREL); and
  • financing arrangements.

The Presidency has proposed a “mixed approach” to each ‘angle’ of the triangle, as set out below.

The Design of the Bail-in Tool (Article 38)

The Presidency is seeking to strike a balance between harmonisation and flexibility with respect to bail-in, proposing:

  • a limited discretionary exclusion for derivatives – this would only apply in particular circumstances and only where necessary to achieve the continuity of critical functions and avoid widespread contagion; and
  • a power for resolution authorities, available in extraordinary circumstances and limited to an amount equal to 2.5% of the total liabilities of the institution in question, to exclude certain other liabilities from bail-in where it is not possible to bail them in within a reasonable time, or for financial stability reasons.

Minimum Requirements for Own Funds and Eligible Liabilities (Article 39)

In recognition of the general consensus around the need for adequate MREL, but in an effort to marry the need for harmonisation in this area with the practical difficulty of defining an appropriate level of MREL (particularly with respect to different banking activities and different business models), the Presidency proposes that the MREL of each institution should be determined by the appropriate resolution authority on the basis of specific criteria, including:

  • its business model;
  • level of risk; and
  • loss absorbing capacity.

The concept of a minimum percentage of MREL for global SIFIs will not be pursued.

Financing Arrangements (Articles 92 and 93)

The key features of the Presidency proposal in this area are that:

  • Member States should be free to keep Deposit Guarantee Schemes (DGS) and resolution funds separate or to merge them; and
  • a resolution fund should have a minimum target level of:
    • 0.8% of covered deposits (and not ‘total liabilities’ of a Member State’s banking sector as suggested by some Member States) where kept separate from the DGS, or
    • 1.3% where combined with the DGS.

Other Issues

The Presidency proposes to maintain the current 2018 date for the introduction of bail-in, rather than bring that date forward to 2015 as suggested by some Member States.

Bail-in and the Central Clearing of Derivatives

Pursuant to Article 38(3) of the original EU Commission proposal for a EU Directive establishing a framework for the recovery and resolution of credit institutions and investment firms (the “RRD”), resolution authorities may exclude derivatives transactions from the scope of the Bail-in tool if that exclusion is “necessary or appropriate” to:

  • ensure the continuity of critical functions; and
  • avoid significant adverse effects on financial stability.

Much has already been written as to whether derivatives should be in- or out-of-scope as far as the Bail-in tool is concerned.  The practical difficulties of implementing bail-in in relation to portfolios of derivatives transactions is generally recognised.  In addition, whilst excluding derivatives from the scope of bail-in creates a clear regulatory arbitrage in the way in which deals can be structured between counterparties, this risk is mitigated by the fact that firms which are subject to the RRD will be required to maintain a minimum amount of bail-inable debt at all times.

In many ways, the greater risk lies not in whether derivatives themselves are in- or out- of scope, but in the fact that Member States are given discretion to choose whether they are or not.  The extent to which this is really consistent with the concept of a single market is unclear, and some commentators have questioned whether this aspect of the EU Commission draft would survive the EU trialogue process under which the EU Commission, EU Parliament and the Council of Ministers thrash out their differing opinions with respect to proposed legislation with a view to arriving at a compromise position.  However, this question was largely answered on 5 June 2013, when the EU Parliament’s Economic and Monetary Affairs Committee published a report which sets out the Parliament’s proposed amendments to the RRD, in anticipation of the beginning of the trilogue process.  Within the EU Parliament document, the concept of Member State discretion in determining whether derivative transactions are in- or out-of-scope for the purposes of the bail-in tool remains intact and so seems unlikely even to arise during the trilogue discussions.

Interestingly, the EU Parliament has taken matters a step further, suggesting a different amendment which would, if passed, require that cleared derivatives are treated as more senior than non-cleared derivatives in a bail-in situation.  In other words, non-cleared transactions stand to be bailed-in before cleared transactions.  This is understandable in the context of the drive towards central clearing.  However, it will potentially change the risk associated with counterparties which are subject to the RRD and are established in jurisdictions where derivatives are within the scope of the Bail-in tool.  It will also potentially impact on the price at which such trades are executed.  It remains to be seen just how this provision interacts with another exclusion from the scope of the Bail-in tool – that relating to secured liabilities.  It may be that only uncollateralised non-cleared transactions would be affected.  Moreover, in light of requirement to enact the BCBS/IOSCO “Margin requirements for non-centrally cleared derivatives” in Europe, there may not be much of this trading activity taking place in the future.  Of course, excluding secured derivatives from the scope of the bail-in regime would likely defeat the point of bailing in derivatives in the first place.  In this scenario the discretion afforded to Member States may be more illusory than real.  Either way, as we don’t currently have answers to any of these questions we’ll be monitoring how this conversation develops, so watch this space.

Legislative Update

Recovery and Resolution Directive

On 29 May 2013, the Presidency of the EU Council published its latest Compromise Proposal with respect to the Recovery and Resolution Directive (RRD).  Additions to the original legislative proposal are underlined and additions to the most recent compromise proposal (dated 15 March 2013) are marked in bold.

EU Banking Union

On 30 May 2013, the EU Parliament updated its procedure file relating to the establishment of the single supervisory mechanism (SSM).  It now appears that the SSM proposal will be considered at the Parliament’s plenary session to be held from 9-12 September 2013 instead of the 20-23 May session, as had previously been the case.