Banking resolution: new rules or a change of paradigm?

August 2015 | EXPERT BRIEFING | BANKING & FINANCE

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On 19 June 2015, the Spanish State Official Gazzette published the Credit Institutions’ and Investment Firms’ Recovery and Resolution Act 11/2015 of 18 June (Act 11/2015), which implemented Directive 2014/59/EU of the European Parliament and the Council of 15 May 2014 (the Directive), which establishes a general framework for the restructuring and resolution of credit institutions and investment firms.

As of late May 2015 there were still 11 member states that had not implemented the Directive and the EU Commission issued a request for those states to speed up the process, as the Directive is considered to be key to the new comprehensive banking regulation landscape. Indeed, resolution and restructuring has evolved from a loose end of the regulatory rulebook, lacking any harmonisation, into a top priority leading to a new, full body of EU law. For the Eurozone, the Directive is going to be coupled with the creation, via a regulation already adopted, of a Single Resolution Mechanism – including a single resolution funding tool in the form of a fund to be established over a transitional period – which constitutes the second pillar of the Banking Union. The first pillar was the already functioning Single Supervisory Mechanism. The third, some day, will be a single deposit guarantee scheme, yet to turn into something more than an aspiration.

Spain already enjoyed a comprehensive banking resolution framework under Act 9/2012, now superseded by Act 11/2015. Designed under the aegis of the EU authorities (the infamous Troika) in the context of the banking recovery programme implemented with the EU financial support in 2012, Act 9/2012 mirrored the drafts of the Directive then available. Spain became a sort of test case and the country’s experience with its banking failures is illustrative of what we can expect a bank resolution process to be like anywhere in the EU in the future. Of course, the main goal of the Directive and the pieces of legislation that will stem from it, both at the EU and national levels, is to avoid having to again pour enormous amounts of taxpayers’ money into failing banks, which has been necessary throughout the banking crisis. In Spain alone, estimates of the cost of banking rescues are at 5 percent of GDP (without taking into account possible recoveries now unknown) – and this is not the worst case.

Act 11/2015 and the Directive incorporate two ideas which are essential and may have far-reaching effects: the notion of contributions from the private sector (bail-in vs. bail-out) and the idea of ‘resolvability’ and planning for resolution.

As stated, the main aim of the resolution framework is to minimise the cost of rescue efforts to the taxpayer. To this end, no bail out should take place before the ailing institution has exhausted any resources it may have available to offset losses, and this should happen without the institution becoming formally bankrupt, i.e., while it keeps being, at least from a commercial and insolvency law perspective, a going concern. Under the former Spanish regime in Act 9/2012, this notion was implemented, albeit to a limited extent; before getting further public aid, common share capital, preferred shares and subordinated debt had to be applied to the recapitalisation of the institution. Under Act 11/2015 and the Directive, the ‘internal recapitalisation’ (bail-in) notion applies, not only to a higher quantitative extent but also differently qualitatively. The principle is that any liability of a bank, unless expressly excluded, may be applied to offset losses. Liabilities excluded from contribution to bail-in are basically deposits guaranteed by the deposit guarantee fund, other forms of client money and fiduciary assets, covered bonds, short term liabilities resulting from settlement operations and non-financial liabilities (employees, social security and tax liabilities, suppliers, etc.).

Hence, from now on, a senior, unsecured creditor of a Spanish bank (or of any EU bank or investment firm, once the Directive has been implemented) may see its credit applied to offset losses or converted into capital. It is difficult to envisage how markets may react to this. In theory, it could be argued that the new legislation does not impair the creditors’ position if the term of the comparison is insolvency proceedings leading to liquidation (and, of course, if bail-in calculations are made on the basis of sound valuations of the institution). If a failing institution was left to its fate, creditors who do not benefit from some guarantee (depositors above all) would recover as much as the net worth of the assets may yield. Hence, it could be affirmed that, rather than worsening the creditors’ position, the new regime deprives them of an undue benefit (i.e., the expectation of being bailed out together with the institution); an expectation that was almost certain in those institutions that were too big to fail. The issue is, of course, that whether legitimate or not, that expectation existed and was most likely priced by investors. Now, all this will have to be reassessed.

The second relevant notion introduced by the new Act (and the Directive) is the idea of ‘resolvability’. All institutions, at least all relevant institutions, will need to have resolution plans in place. Those plans, supervised by ‘preventive resolution’ authorities (which, as it is the case of Spain, may be different from ‘executive resolution’ authorities that will effectively resolve the institution should the need come) should ensure that the institution, if in need, is ‘resolvable’ without undue effort. The issue here is that ‘resolvability’ is highly dependent on organisational structure. Roughly, the more complex an institution is – the more geographical markets it is present in, the more business lines it operates, the more it relies on external, critical suppliers – the more difficult it may become to resolve. Legal structure is not neutral either – whether a bank operates cross-border through subsidiaries or branches, and whether it develops its activities directly or through other institutions, will be relevant if the bank has to be resolved. As mentioned, bank funding structure is becoming a critical variable as far as resolvability is concerned – the higher the proportion of liabilities subject to bail-in on the liabilities side, the less likely it is that the institution will have to seek public support. So, whereas prudential regulation (i.e., regulation applied to the bank as a going concern) may be purported to be structure-neutral, there is no point in holding the same about resolution provisions; the structure and organisation of a banking group will matter for when it comes to resolution, and matter greatly.

It is right to affirm that regulators have always had a say about how banks do business. But impacts on structure could be considered side effects of other debates. So, for instance, when a bank decided to organise a business line in a given way, it mattered what the impact might be on the bank’s solvability, liquidity or soundness of governance, but the decision was still the bank’s choice. Is it going to be the same when we come to resolvability? Doubts are legitimate. There are business decisions that could be perfectly logical and may even be desirable from the perspective of day-to-day supervision (because they strengthen the bank’s financial or operational position) but may turn an eventual resolution into a more complex task.

When high-level regulatory bodies (the Basel Committee, above all) started their review of what might have gone wrong with prudential regulation in view of the financial crisis, one of their first conclusions seemed to be that there was no reason to alter the so-called ‘supervisory paradigm’ in force from the 1980s. In short, regulators are, in respect of the game of banking, a sort of referee and not a player. Business should be left to banks. Basel III, for instance, tightened up capital rules both quantitatively and qualitatively, and it became a much more demanding standard than its predecessors; but it kept within the paradigm, not invalidating it.

Resolution rules, whether prospective or executive, do not necessarily operate under the same logic. The undeniable fact that the taxpayer is called into playing more often than desired makes it difficult to continue maintain that banking is a game to be left entirely to bankers.

We should expect this to matter, and to matter significantly, in everyday banking business and practice.

Fernando Minguez Hernandez is a partner at Cuatrecasas, Gonçalves Pereira. He can be contacted on +34 915 247 177 or by email: fernando.minguez@cuatrecasas.com.

Fernando Minguez Hernandez

Cuatrecasas, Gonçalves Pereira