Sunday, September 8, 2013

The draft EU Directive on the recovery and resolution of credit institutions and investment firms – The end of “too big to fail?”

Imagine the following situation: You are poor. Luckily, a few years ago, you married the daughter of a wealthy hedge fund manager. Your father-in-law has passed away just a few months after your marriage, so there is – -besides your wife – just your mother-in-law left, sitting on a huge fortune. She has already celebrated her 90th birthday and is, in addition, sick. A trustee has been put in place. Her passing away is just a question of time…

In the above story, your mother-in-law is a systemically important financial institution, her trustee is the regulator, and you are the general public.

What should you do? The European Commission, in its draft proposal dated June 6, 2012, proposes a six step approach:

  • Clarify your goals! (Purpose)
  • Evaluate whether there is any need to act now! (Scope of application)
  • Make sure that your mother-in-law makes the right decisions! (Measures by financial institutions)
  • Verify that the trustee is on your side and makes the right decisions! (Measures by member states’ authorities)
  • Make alliances with other members of your family! (Relation with third countries)
  • Check your own bank account and make sure that you have enough money to pay for your operations! (European system of financing arrangements)

A. Purpose – Which?

  • Strengthen banks’ vital role for the economy and people’s trust on which banks’ business depends.
  • Reduce systemic risk in the banking industry and enhance financial stability by providing resolution tools other than traditional insolvency proceedings.
  • Manage bank failures in an orderly way to limit the risk of contagion.
  • Safeguard financial stability and limit taxpayer exposure to loss from solvency support.
  • Harmonize procedures for resolving credit institutions at EU level.

B. Scope of application – Who?, What?, When?

Who? The directive applies to any financial institution. The definition is large – it namely includes credit institutions and investment firms, whether in subsidiary, independent, or holding form.

What? As its title indicates, the directive applies to recovery and resolution scenarios. Resolution refers to a restructuring of the institution. A recovery is somewhat broader. It refers to a situation in which a financial institution succeeds to redress its financial situation after a significant deterioration.

When? The directive will apply from January 1, 2015 on.

C. Measures financial institutions take

I. Recovery planning– Who?, What, When?

Who? What? The institution must draw up a plan to ensure recovery. In case of a group of companies, the directive requires recovery plans at subsidiary and group level. But what precisely is a recovery plan? It is a document that analyzes the firm’s strategy, how its financial situation and strategy could be affected by stress situations, and how the firm could fix this situation, without public financial support. A detailed list of contents is included in Annex / Section A of the directive. Recovery planning cannot rely on extraordinary financial support.

When? The plan must be in place when the directive becomes applicable, i.e. on January 1, 2015. If its organization or business or financial situation changes materially, it must update the plan. An annual update must be made in any case.

II. Intra-group financial support – What?, When?

What? Intra-group financial support refers to financial support agreements that will become mandatory within a group of financial institutions. The support shall be remunerated and the calculation of consideration fixed in advance.

When? Article 19.1 of the directive provides for detailed support conditions. Namely, support shall only be given for the group as a whole, it must be reasonably likely to be successful, and it should not endanger the financial stability of the entity granting the support.

D. Measures member state authorities take

I. Resolution planning – What, When?

What? Resolution plans are drawn up by public authorities and deal with the question of how to unwind failing financial institutions, without public financial support and without significant adverse consequences for the financial system. Article 9.4 of the directive specifies the content (separation of critical functions and core business lines, timeframe of resolution, valuation of critical functions and core business lines, financing, critical interdependencies, communication plan, etc.). A resolution plan is mandatory at parent and subsidiary level; if different authorities are competent at parent and subsidiary level, they shall coordinate their decision within the resolution college. Resolution planning cannot rely on extraordinary financial support.

When? After first establishment upon entry into force of the directive, resolution plans must adjust to material changes in the legal and organizational structure of the institution and are updated, at least, annually.

II. Early intervention – What?

What? Prior to resolution measures, member state authorities have access to early intervention measures such as requiring the application of recovery tools and preparing specific management decisions (replace the management team, restructure negotiations, contact potential purchasers of the financial institution, appoint a temporary special manager, etc.).

III. Write down of capital instruments – When?, What?

When? A write down of capital instruments is a pre-requisite for the application of any resolution tool. It can intervene if a financial institution meets the conditions for its resolution.

What? A write-down means to reduce the principal value of a capital instrument to zero, usually without any compensation for its holder.

IV. Exercise resolution tools

1. Objectives – Which?, Who?

Which? Objectives all turn around financial stability: ensuring the continuity of critical functions, preventing contagion, and maintaining market discipline.

Who? Resolution planning intends to protect the general public – taxpayers, depositors, investors, and clients.

2. Principles – Which?

  • Ranking: Shareholders shall bear losses before creditors.
  • Treatment of creditors: Within the same class, creditors shall be treated equal. They cannot incur greater losses than under normal insolvency proceedings.
  • Participation of senior management: Senior management of a failing institution shall be replaced and bear losses, through civil and criminal responsibility.

3. Conditions – Which?

  • The institution is failing or likely to fail (i.e. breach of capital requirements, assets less than liabilities, inability of the institution to pay its obligations as they fall due, or institution’s request of extraordinary financial support)
  • There is no reasonable prospect for any alternative private sector or supervisory action that would prevent the failure in a reasonable time frame.
  • The resolution is necessary in the public interest.

4. Valuation – What?, Who?, How?

What? Assets and liabilities of the financial institution

Who? Valuation is usually carried out by an independent expert. In case of urgency, resolution authorities themselves may evaluate.

How? Valuation is normally based on fair market value. If, however, the market is not working properly, valuation shall reflect the long-term economic value of assets and liabilities. Extraordinary public support is not taken into consideration. Finally, the valuation shall indicate the ranking of creditors.

V. Resolution tools – Which?

Which? Resolution tools can be either normal insolvency proceedings or any of the following specific resolution tools:

  • Sale of business
  • Bridge institution
  • Asset separation
  • Bail-in

Resolution tools may be applied separately or in conjunction with each-other.

1. Sale of business – What?, How?

  • Shares or other instruments of ownership
  • Specified assets, rights, or liabilities
  • Combination of assets, rights, and liabilities

How? The transfer must be made on commercial terms. Except for the purchaser, no shareholder or third party consent is required. Guiding principles for the selling process are transparency, non-discrimination, prevention of conflicts of interest, avoidance of unfair advantages on a potential purchaser, rapidity, and sale price maximization.

2. Bridge institution – What?, When?, How?

What? Specific or all assets, rights, or liabilities or an institution under resolution can be transferred to and re-transferred from a bridge institution as well as transferred from a bridge institution to a third party. A bridge institution is a special purpose vehicle (partially) owned by one or more public authorities. Its purpose is to hold the financial securities until selling them to a private investor becomes appropriate.

When? A transfer is possible if the financial institution is under resolution.

How? A transfer requires no shareholder or third-party consent or specific procedure. A re-transfer is only possible if provided for prior to the initial transfer.

3. Asset separation – What?, How?

What? Assets, rights, or liabilities of an institution under resolution can be transferred to a publicly owned asset management vehicle to maximize the value of such assets or wind down the business. Asset separation is only possible if normal insolvency proceedings could have an adverse effect on the financial market.

How? A transfer requires no shareholder or third-party consent or specific procedure. A re-transfer must be provided for prior to the initial transfer.

4. Bail-in – Why?, When?, What?, How?

Why? A bail-in of a financial institution’s liabilities can pursue a dual purpose – to recapitalize the institution to reach sufficient equity levels or to reduce the debt level of the institution.

When? It must be realistic for a bail-in to restore the financial soundness and long-term viability of the institution.

What? All liabilities can be bailed in except guaranteed deposits, secured liabilities, assets held for third parties, liabilities with an original maturity of less than one month, privileged liabilities towards employees, liabilities towards commercial or trade creditors that are essential for the creditor’s operations, and liabilities towards tax and social security authorities.

How? A bail-in must be accompanied by a business reorganization plan.

VI. Resolution powers – Which?

  • Require information from any person to decide upon and prepare a resolution action
  • Take control of an institution under resolution
  • Transfer shares, debt instruments, and specified rights, assets or liabilities of an institution under resolution
  • Write down or convert instruments (other than equity instruments) into equity instruments of the institution under resolution
  • Reduce the principal amount of liabilities of an institution under resolution
  • Cancel shares and debt instruments of the institution under resolution
  • Require the institution under resolution to issue new equity instruments
  • Amend or alter the maturity of debt instruments of the institution under resolution
  • Remove or replace senior management of the institution under resolution
  • Ancillary powers such as modifying contractual terms of the institution under resolution, restrict enforcement of security right against the institution under resolution, and temporarily suspend termination rights towards an institution under resolution

VII. Group resolution – What?

What? In case a financial institution has subsidiaries in several member countries, the resolution of the group as a whole or any of its subsidiaries shall be coordinated within a resolution college. Main features of the cooperation are exchange of information, resolution strategies, and communication plans. The group level resolution authority coordinates the activities.

VIII. Relations with third countries – What?

What? To coordinate resolution issues with countries outside the EU, the directive intends for the European authorities to

  • negotiate international agreements;
  • sign cooperation agreements with non-EU resolution authorities;
  • recognize or refuse third country resolution proceedings.

IX. European system of financing arrangements – What?, Why?

What? The European system of financing arrangement sets up national financing arrangements, provides for borrowing among them, and combines them in case of a group resolution. Its target financing level, ten years after entry into force of the directive, is 1 % of total deposits with credit institutions.

Why? The system is put in place to guarantee or purchase assets or liabilities of an institution under resolution, to grant loans to it, or to contribute to a bridge institution.

As a reminder, the above has not been formally agreed upon by the European legislator. Even though the big picture is not likely to change, details are still under discussion.