Banking Resolution

Information on bank resolution and bail-in

As of 13 June 2019

As a reaction to experience made during the financial crisis in 2008, many countries adopted rules designed to resolve a bank at risk of default without involving taxpayers in the future. As a result shareholders and creditors of banks under resolution may have to participate in the losses of those banks. The objective is to ensure the resolution of a bank without the use of public funds.

To achieve this, the European Union adopted the following legislation:

  • the Bank Recovery and Resolution Directive (“BRRD”) and
  • a Regulation establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund (“SRM Regulation”).

The details of the measures the resolution authorities may take on a national level may differ. Below, we explain possible resolution measures that may be applied in Germany as an example. Resolution procedures in other countries, in particular outside Europe, may deviate and be more incisive.

You may be affected as a shareholder or creditor of a bank if you hold financial instruments issued by the bank (e.g. shares, bonds or certificates) or have claims against the bank as a contracting party (e.g. transactions subject to a master agreement for financial derivatives transactions).

Securities held in a custody account and not issued by the custodian bank are not subject to a resolution measure against this bank. In the case of a resolution of a custodian bank, your proprietary rights to these financial instruments in the custody account remain unaffected.

In order to ensure a controlled resolution in the event of a crisis, resolution authorities have been established. Under certain resolution conditions, the resolution authority responsible for the affected bank has the power to order resolution measures.

The Single Resolution Board (“SRB“) and the Federal Financial Supervisory Authority (“BaFin”) are the responsible resolution authorities in Germany. For ease of reference, we do not differentiate between the SRB and BaFin in the following.

The resolution authority may order certain resolution measures in the event of the following resolution conditions:

  • The affected bank’s existence is endangered. This assessment is made in accordance with legal requirements and applies if the bank no longer complies with the legal requirements for obtaining authorisation for the taking up of the business of credit institutions due to losses suffered.
  • There is no prospect of preventing the bank’s default with alternative measures in the private sector or other measures from the resolution authorities.
  • The measure is required in the public interest, i.e. necessary and proportionate, and liquidation in regular insolvency proceedings is no viable alternative.

If all resolution conditions are met, the resolution authority can adopt -prior to insolvency – comprehensive resolution measures that may have a negative effect on the bank’s shareholders and creditors:

  • The bail-in tool (also called creditor participation): The resolution authority may, as a whole or in parts, write down and/or convert into common equity (stocks or other company shares) certain financial instruments or liabilities of the bank in order to stabilise the bank.
  • The sale of business tool: The resolution authority may transfer shares, assets, rights or liabilities of the failing institution as a whole or in parts to a third party. Insofar as shareholders and creditors are affected by the sale of business, another already existing institution will then be the new debtor.
  • The bridge institution tool: The resolution authority may transfer shares in the bank or parts or the whole of the banks assets including its liabilities to a so-called bridge institution. This may affect the bank’s capability to meet its payment and performance obligations vis-à-vis the creditors and it may reduce the value of the shares in the bank.
  • The transfer to an asset separation tool: Assets, rights or liabilities are transferred to an asset management company. Assets are to be managed with the objective of maximising their value prior to their sale or liquidation. Similar to the sale of business tool, the creditor faces a new debtor after the transfer.

The resolution authority may amend, by means of an official order, the terms and conditions of the financial instruments issued by the bank and the existing receivables, for example the maturity date or the interest rates can be changed to the detriment of the creditor. Furthermore, payment and performance obligations may be modified, e.g. temporarily suspended. Termination and other contractual rights that arise for creditors from financial instruments or liabilities may also be temporarily suspended.

Whether you as a creditor are affected by the bail-in resolution measure depends on the scope of the ordered measure and on which category your financial instrument or receivable falls. Within the framework of a bail-in, financial instruments and liabilities are divided into different categories and held liable in accordance with a statutory ranking order (so-called liability cascade).

For the shareholders and creditors of the respective categories to be affected, the following principles apply: Only if a category of liabilities has been drawn upon in full and this is insufficient to compensate for losses to an extent that the bank is stabilised may the following category in the liability cascade be written down or converted.

Certain types of financial instruments and liabilities are legally exempted from bail-in. These include deposits of up to EUR 100,000 covered by the statutory deposit protection scheme and secured liabilities (e.g. covered bonds).

In the liability cascade of a bank located in Germany the following categories are to be distinguished as follows:

(1) The resolution measures first apply to the Common Equity Tier 1 capital and thus the bank’s shareholders.

(2) Then, the creditors of Additional Tier 1 capital are called upon (holders of unsecured, subordinated perpetual bonds and silent partnerships with conversion or write-down clauses that are subordinated to instruments of Tier 2 capital).

(3) This is followed by Tier 2 capital. This applies to creditors of subordinated liabilities (e.g. owners of subordinated loans).

(4) In the liability cascade, unsecured subordinated financial instruments and liabilities that do not meet the Additional Tier 1 capital or Tier 2 capital requirements come next.

(5) These are followed by unsecured non-subordinated and non-structured debt instruments 1).

In this category, debt instruments are only drawn upon if either (a) they were issued before 21 July 2018 and are not money market instruments or structured products or (b) they have been issued since 21 July 2018, have a contractual maturity of at least one year, are not structured products and where explicit reference to their lower ranking compared to the liabilities of the following category (6) is made in their contractual terms and conditions and, in the case of an obligation to publish a prospectus, also in said prospectus.

This category is also referred to as senior non-preferred.

1) Debt instruments are bearer bonds, negotiable registered order bonds and similar rights which by their nature are tradable on the capital market as well as registered bonds and promissory note loans, insofar as these do not fall into category (6) as preferred deposits or are exempt from write-down and conversion as covered deposits.

(6) The next step of the liability cascade are the following unsecured non-subordinated liabilities

  • Debt instruments which do not fall into category (5), for example debt instruments that have been issued since 21 July 2018 and do not have the indication of lower ranking required for classification in category (5).
  • Structured, unsecured financial instruments and liabilities (such as certificates on stock indices or liabilities from derivatives). In these cases, the amount of the repayment or interest payment depends on an uncertain future event or is settled by means other than cash payment.

Furthermore, this also includes deposits exceeding EUR 100,000 of companies that do not fall into category (7).

In contrast to category (5), this category is also referred to as senior preferred.

(7) Finally, deposits held by natural persons, micro-enterprises or small and medium-sized enterprises can also be drawn upon if they exceed the statutory deposit guarantee of generally EUR 100,000 (“other preferred deposits”).

The simplified liability cascade shown on the last page thus applies (starting in the direction of the arrow with Common Equity Tier 1), whereby a lower category is only used for the absorption of losses if the higher categories are insufficient to compensate for losses (see figure on the last page).

The resolution authority may deviate from this general principle in individual cases.

If the resolution authority orders or takes a measure following these rules, the creditor is not permitted to terminate the financial instruments and liabilities based on this measure alone or claim any other contractual rights. This shall apply as long as the bank fulfils its main obligations under the terms and conditions of the financial instruments and claims, including payment and performance obligations.

If the resolution authority takes the measures described above, a total loss of the affected shareholders’ and creditors’ investment is possible. Shareholders and creditors of financial instruments and liabilities may therefore lose in full the price paid for the purchase of financial instruments and liabilities plus any other costs related to the purchase.

The mere possibility that resolution measures can be ordered may complicate the sale of a financial instrument or liability on the secondary market. This could mean that the shareholder and creditor can sell the financial instrument or receivable at a considerable discount. Even with existing repurchase obligations of the issuing bank, a significant discount is still possible when such financial instruments are sold.

In the event of a bank resolution, shareholders and creditors are not to be placed in a less favourable position than in normal insolvency proceedings affecting the bank. If resolution measures nonetheless lead to a situation where a shareholder creditor is placed in a worse position that would have been the case in regular insolvency proceedings against the bank, the shareholder or creditor is entitled to compensation from the fund set up for resolution purposes (Restructuring Fund or Single Resolution Fund, “SRF“). Should a claim for compensation arise against the SRF, there is a risk that the resulting payments are made much later than would have been the case if the bank had properly fulfilled its contractual obligations.

Certain financial instruments issued by credit institutions and investment firms serve to meet the regulatory capital requirements defined by Regulation (EU) No. 575/2013, Directive 2013/36/EU and Directive 2014/59/EU.

This includes in particular the Common Equity Tier 1, Additional Tier 1 or Tier 2 capital instruments issued in categories (1)-(3), the subordinated financial instruments and liabilities described in category (4) and the non-preferred debt instruments classified in category (5).

These instruments typically have a higher return than bank deposits, but carry, in the event of insolvency or resolution measures, a higher default risk due to their lower ranking and the generally non-existent deposit protection. In contrast to bank deposits, these instruments are usually tradable on the secondary market, where possibly secondary market buyers or sellers may not be found (liquidity risk) and the market price may change to the detriment of the investor (price change risk).

Details regarding the opportunity and risk can be found in the financial instrument product documentation.

The German Federal Financial Supervisory Authority („BaFin“) has published information on the resolution of banks and insurance companies and the potential loss participation of clients:

https://www.bafin.de/EN/Aufsicht/BankenFinanzdienstleister/Massnahmen/SanierungAbwicklung/sanierung_abwicklung_node_en.html

https://www.bafin.de/DE/Verbraucher/BaFinVerbraucherschutz/Schieflage/sicherungseinrichtungen_node.html (Only in German).

Graphic Liability Cascade