7.5.4.2 Restrictions in the ability of the bail-in tool to perform as intended

Ringe and Patel discuss that the more interconnected banks become, the more likely it is that the authorities will resort to a bail-out rather than a bail-in resolution. This is because both the investor and the issuing bank, in any bank interconnection, are less likely to be bailed in if doing so creates further systemic risk.1 In that respect, the type of counterparties are paramount for the purposes of bail-in. Bail-in powers may actually be increasing systemic risk, particularly systemic risk that arises from banking interconnections. This is because the regulatory framework is inadept of a fundamental concern: the counterparties to banking capital. This creates relative advantages for banks that invest in other banks, because the bail-in framework does not internalise the systemic risk costs that arise out of counterparty selection.2

Götz and Tröger argue that the ability of the bail-in tool under the resolution framework to perform as intended may be restricted as long as (i) investors do not understand the risk of bail-in and are therefore not able to charge adequate risk premiums and thus exert meaningful market discipline on banks, and (ii) investors do not have sufficient loss-bearing capacity to incur a loss when their debt is bailed-in, and (iii) a bail-in endangers the health of other banks because these are the holders of the ‘bail-inable’ debt. Holders of bail-inable debt are ideally sophisticated investors outside the banking sector whose assets and liabilities are matched with regards to their maturity (e.g. insurance companies, pension funds or high net-worth individuals).3

Private households and bank retail customers are less suited as holders of bail-inable debt, since national governments may feel compelled to compensate these parties in case of a loss due to a bail-in. There is however no restriction in selling bail-inable debt to these parties, despite the fact that there are already numerous examples of additional complications to burden-sharing where financial instruments used to finance the bank have been mis-sold to unsophisticated retail investors unable to properly understand the riskiness and the complexity of these financial products.5 According to Asimakopoulos, this impinges on the credibility of the resolution framework.6

These examples of mis-selling show that improving the position of retail investors is important for the ability of the bail-in tool to work as intended,. Certain initiatives have already been taken. Under MiFID II, further investor protection has been introduced, including in relation to bail-inable debt. For example, bail-inable debt instruments have been classified as a ‘complex instrument’ as a result of which this debt cannot be sold to retail investors without conducting an appropriateness test.9 In addition, the ESMA and EBA published a statement on the treatment of retail holdings of debt financial instruments subject to the BRRD on 30 May 2018.

In this statement, the ESMA urges institutions to convey the information on the effects of the BRRD on retail clients holdings through the means of a specific written communication, both in relation to existing holdings and new issuances.11 In addition, resolution authorities are encouraged to pay attention to any material presence of retail investors as holders of debt liabilities in their resolution planning and resolvability assessment. They should for example consider whether additional MREL-eligible liabilities should be issued in order to create an additional buffer of subordinated liabilities, which may help make the risk that retail debt holders would be bailed-in more remote.12 The ESMA and EBA emphasize that making use of the discretionary exemption from the bail-in scope should only be used in exceptional cases.13 Besides this restricted use, it should be noted that this exemption does not exist in relation to the exercise of the PONV conversion power. If capital instruments are held by retail investors, they can only be protected if the investor protection requirements under MiFID II are violated. In the author’s view, the resolution framework could therefore have benefitted from providing the resolution authority the (transitional) power to exclude liabilities from the exercise of the PONV conversion power for the same reasons set out in relation to the bail-in tool.

Besides the restrictions in the ability of the bail-in tool to perform as intended due to retail holdings, Asimakopoulos mentions that the EU authorities and, most prominently, the ECB are still hesitant to wipe-out senior debt holders due to contagion concerns.15 As discussed in section 7.4.3.4, these concerns may however have led to the increase of other layers of eligible liabilities that can be used for bail-in.