European Commission publishes working document on proposed bank resolution regime: “Technical Details of a Possible EU Framework for Bank Recovery and Resolution”

in Bankruptcy & Liquidation, Commercial Banks, European Union, Living Wills

By: Peter King & Patricia North

On 6 January, DG Internal Markets and Services, as consultants for the European Commission, published a Working Document on its technical proposals for a European crisis management regime to deal with bank failures. Although much concerns a new supervisory structure, there are features which will be of direct interest to investors and creditors, most notably those on write down or conversion of  bank debt (the “bail-in” proposals).

A summary of the main provisions is set out below, including a more detailed summary of the options for the bail-in proposals and their pros and cons as identified by Commission services. The proposals are open to comment and discussion; interested parties have until 3 March 2011 to respond. The Commission envisages that draft legislation will be published by summer 2011.

The Commission will also investigate the current  bank insolvency regime in the European Union  and will consider whether further harmonisation is necessary; a report will be published in 2012. It is also considers the establishment of a central European Union  resolution regime as desirable, such a process to be concluded by 2014.

The proposed regime will apply to credit institutions, certain investment companies and (potentially) bank holding companies. It  is based on a process of enhanced supervision and prevention processes and, if these fail, a resolution process, to be carried out by a national resolution authority. The primary aim of the latter will be to effect the liquidation or orderly winding up of  a failed institution; restructuring as a going concern will be a last resort if the former processes are not possible to achieve minimum disruption and instability to the financial system.

Supervision

The proposed supervisory process will require banks to draw up recovery plans and undergo annual stress testing, with enhanced regulatory supervision for failing banks. The authorities will also draw up resolution plans for supervised entities, setting out steps to be taken in the event of financial difficulties Various other  preparatory, preventative and intervention powers, designed to improve supervision and facilitate  recovery are also suggested. There are also proposals for intra-group asset transfer regime in a distressed but not insolvent situation.

Resolution

Resolution powers are proposed which will come into effect when a bank fails or is likely to fail. The paper suggests various options for the conditions for resolution,  proposes certain basic objectives and principles (including the principle that losses are borne firstly by shareholders and then by unsecured creditors), possible “resolution tools” and other residual measures, such as suspension of contractual enforcement and close out rights. There is also consideration of compensation and safeguards e.g. for secured creditors.

Proposed “resolution tools” include  the ability to sell a bank or all or parts of its business; use of a publicly owed “bridge bank”; the (limited) ability to put assets into a separate management company, and the “debt write-down” tool.

Debt Write Down as Resolution Tool

It is proposed that the resolution authority will have a general power to write off equity and  write down  or convert subordinated debt, a power designed for use only where winding up or business transfer is not feasible. However it is considered that  further additional write down powers are necessary to maintain flexibility and ensure the objectives of resolution are met.

There are two options: the comprehensive approach  (which would place risk on senior creditors generally) and the targeted approach.

Comprehensive approach: the resolution authority will be able to write down a discretionary amount of all senior debt and/or convert it to equity. The authority will have discretion as to classes affected, haircuts imposed and conversion rates if applicable. The size of the write down would be determined on the basis of the size of the institution, its debt and its impact on the market. The statutory power would be included as a contractual term in all senior debt issued by EU credit institutions.  However to maintain credit markets, there may be certain exclusions from this regime (such as derivative and repo counterparties, deposits and secured debt).

Targeted model: Banks will be required to issue a fixed amount of “bail-in able” debt, which could be written down or converted on a statutory trigger ( in addition to the general write down/conversion powers). Again, the statutory power would be included as a contractual term; the amount of write down and conversion rates may also be included, or may be left to the authority’s discretion  (subject to the principle that the holder should be no worse off in liquidation). There may be a prescribed minimum issue set for institutions by the authorities, to avoid contractual provisions which would reduce the effectiveness of the provision.

There are further proposals on application of the regime to group debt and  possible compensation structures for senior debtholders, including some sort  of “super seniority” status immediately following resolution.

There are acknowledged drawbacks. Exercise of the powers should seek to preserve, as far as possible, the ranking of insolvency claims (e.g. equity should be wiped out and all subordinated debt written down before senior debt is written down) although it is acknowledged that this may not always happen e.g. if some but not all of the senior debt is written down, the principle of pari passu will be compromised. It acknowledges that the targeted approach would not spread risk across all senior creditors and that appropriate levels of issuance may be hard to judge. Exclusions from the regime may lead to extensive financing engineering to restructure debt as instruments within the excluded categories.

As a consequence there may be a high impact on the cost of financing. The proposals are not set in stone, although it is highly likely that the eventual regime will follow very closely the principles set out in the paper.

The full text of the working paper is available here.

The London Financial Regulation Practice will continue to monitor any developments with this proposal and provide coverage at Weil’s Financial Regulatory Reform Center.  If you are interested in discussing the proposal, please contact Practice members Peter King (+44 20 7903 1011 or peter.king@weil.com) or Patricia North (+44 20 7903 1059 or  patricia.north@weil.com).

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