Public funding of failing banks in the European Union (LBF vol. 19) 2020/4.5.3.4:4.5.3.4 Conditions for the application of the bail-in tool

Public funding of failing banks in the European Union (LBF vol. 19) 2020/4.5.3.4

4.5.3.4 Conditions for the application of the bail-in tool

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As said, the bail-in tool should be distinguished from the transfer tools due to the fact that it has as its purpose:

1.

to recapitalise a bank that meets the conditions for resolution to the extent sufficient to restore its ability to comply with the conditions for authorisation and to continue to carry out the activities for which it is authorized under CRD IV or MIFID II and to sustain sufficient market confidence in the bank, or

2.

to convert to equity or reduce the principal amount of claims or debt instruments that are transferred (i) to a bridge institution with a view to providing capital for that bridge institution or (ii) under the sale of business or the asset separation tool.1

The bail-in tool may only be used for recapitalisation purposes, if there is a reasonable prospect that the application of that tool will, in addition to achieving relevant resolution objectives, restore the bank to financial soundness and long-term viability.2 Where these conditions are not met, the bail-in tool may still be used for the purpose set out under 2.3

The conditions under which the bail-in tool can be applied, are the following:

a)

The bail-in tool should be applied conform the valuation conducted under Article 36 BRRD;

b)

The bail-in tool can only be applied in relation to eligible liabilities;

c)

The bail-in tool should be applied in accordance with the required sequence of write down and conversion;

d)

The bail-in tool should be applied in accordance with the hierarchy of claims in normal insolvency proceedings;

e)

The bail-in tool should be applied in accordance with the equality principle; and

f)

The bail-in tool should be accompanied by a business reorganisation plan.

Ad a: Valuation

Before applying the bail-in tool, a valuation has to be carried out to inform the decision of the resolution authority on the extent of the write down or conversion of eligible liabilities (Valuation 2).4 In addition, the valuation has to indicate the subdivision of the creditors in classes in accordance with their priority levels under the applicable insolvency law and give an estimate of the treatment that each class of shareholders and creditors would have been expected to receive, if the bank in resolution were wound up in normal insolvency proceedings.5

Ad b: Scope

The bail-in tool applies to ‘eligible liabilities’. Eligible liabilities are the liabilities and capital instruments that:

1.

do not qualify as Tier 1 or Tier 2 instruments of a bank, and

2.

are not excluded from the scope of the bail-in tool by virtue of Article 44(2) BRRD (Article 27(3) SRMR).6

In accordance with Article 44(2) BRRD (Article 27(3) SRMR), the following liabilities are excluded from the scope of the bail-in tool:

a)

deposits covered under deposit guarantee schemes,7

b)

secured liabilities,8

c)

any liability that arises by virtue of the holding by the bank of client assets or client money, including client assets or client money held on behalf of undertakings for collective investment in transferable securities (UCITS) or alternative investment funds (AIFs), provided that such a client is protected under the applicable insolvency law,

d)

any liability that arises by virtue of a fiduciary relationship between the bank and another person provided that such a beneficiary is protected under the applicable insolvency or civil law,

e)

liabilities to institutions, excluding entities that are part of the same group, with an original maturity of less than seven days,

f)

liabilities with a remaining maturity of less than seven days, owed to (operators of) payment or settlement systems or their participants and arising from the participation in such a system,

g)

a liability to an employee, in relation to accrued salary, pension benefits or other fixed remuneration,9 a commercial or trade creditor arising from the provision to the bank of goods or services that are critical to the daily functioning of its operations, including IT services, utilities and the rental, servicing and upkeep of premises, tax and social security authorities, provided that those liabilities are preferred under applicable law and deposit guarantee schemes arising from contributions due in accordance with the DGS Directive.

In exceptional circumstances the resolution authorities may exclude or partially exclude other liabilities where certain conditions are met.10 These conditions are:

1.

it is not possible to bail-in that liability within a reasonable time notwithstanding the good faith efforts of the relevant national resolution authority;

2.

the exclusion is strictly necessary and is proportionate to achieve the continuity of critical functions and core business lines in a manner that maintains the ability of the bank in resolution to continue key operations, services and transactions;

3.

the exclusion is strictly necessary and proportionate to avoid giving rise to widespread contagion, in particular as regards eligible deposits held by natural persons and micro, small and medium-sized enterprises, which would severely disrupt the functioning of financial markets, including of financial market infrastructures, in a manner that could cause a serious disturbance to the economy of a Member State or of the EU; or

4.

the application of the bail-in tool to those liabilities would cause a destruction in value such that the losses borne by other creditors would be higher than if those liabilities were excluded from bail-in.

Where an eligible liability or class of eligible liabilities is excluded or partially excluded, the level of write-down or conversion applied to other eligible liabilities may be increased to take account thereof, provided that the level of write-down and conversion applied to other eligible liabilities complies with the ‘no creditor worse off principle’, as further discussed in section 4.5.5.11

Ad c: Sequence of write down and conversion

As set out in section 4.4.3.4, prior (or simultaneously) to the application of the bail-in tool, the PONV conversion power has to be exercised. As a result of the exercise of the PONV conversion power, CET 1 items, AT 1 and Tier 2 instruments will be cancelled, transferred and/or diluted. Where this is not sufficient to restore the net asset value of the bank in resolution and/or its CET 1 ratio, subordinated debt should be converted or written down under the application of the bail-in tool. Senior liabilities should be converted or written down, if the subordinated classes have been converted or written down entirely.12

Ad d: Hierarchy of claims

Where the bail-in tool is applied, the principal amount of subordinated debt that is not AT 1 or Tier 2 capital should be reduced in accordance with the hierarchy of claims in normal insolvency proceedings.13 Only, if this is still insufficient may the outstanding senior eligible liabilities be reduced in accordance with the hierarchy of claims in normal insolvency proceedings. Certain derogations however apply in accordance with Article 108 BRRD:

1.

The part of eligible deposits from natural persons and micro, small and medium-sized enterprises which exceeds the coverage level of deposit guarantee schemes (that is, EUR 100,000) and deposits that would be eligible deposits for coverage by deposit guarantee schemes from natural persons and micro, small and medium-sized enterprises, were they not made through branches located outside the EU of banks established within the EU rank higher than the ranking provided for the claims of ordinary, unsecured, non-preferred creditors (hereinafter referred to as ‘semi-covered deposits’); and

2.

Deposits that are covered by the deposit guarantee scheme and that do not exceed the coverage level of deposit guarantee schemes (also referred to as ‘covered deposits’14) and deposit guarantee schemes subrogating to the rights and obligations of covered depositors in insolvency rank higher than the ranking provided for the semi-covered deposits.15

Article 108 BRRD was amended by BRRD II bis.16 In accordance with BRRD II bis, Member States should ensure in their national laws governing normal insolvency proceedings, that ordinary unsecured claims have a higher priority ranking than that of unsecured claims resulting from debt instruments that meet the following conditions:

(a)

the original contractual maturity of the debt instruments is of at least one year;

(b)

the debt instruments contain no embedded derivatives and are not derivatives themselves;17

(c)

the relevant contractual documentation and, where applicable, the prospectus related to the issuance explicitly refer to the lower ranking.

In addition, unsecured claims resulting from debt instruments that meet the aforementioned conditions have a higher priority ranking than the priority ranking of claims resulting from CET 1, AT 1, Tier 2 and other subordinated debt.

This new asset class of non-preferred senior debt should only be bailed-in in resolution after other capital instruments, but before other senior liabilities.18

Ad e: Equality

When exercising the bail-in tool, resolution authorities have to allocate the losses represented by the sum of the amounts necessary to restore the NAV and CET 1 capital ratio of the bank equally between shares or other instruments of ownership and eligible liabilities of the same rank by reducing the principal amount of, or outstanding amount payable in respect of, those shares or other instruments of ownership and eligible liabilities to the same extent pro rata to their value, except where a different allocation of losses amongst liabilities of the same rank is allowed. This is allowed where liabilities are excluded from the scope of the bail-in tool (pursuant to Article 44(2) BRRD) or resolution authorities decide to exclude or partially exclude other liabilities in exceptional circumstances (pursuant to Article 44(3) BRRD).19

Ad f: Business reorganisation plan

Where resolution authorities apply the bail-in tool to recapitalise a bank in resolution, arrangements should be adopted to ensure that a business reorganisation plan for that bank is drawn up and submitted to the resolution authority within one month (extendable up to two months) after the application of the bail-in tool.20 The contents of the business reorganisation plan are discussed in more detail in section 4.7.1.2.

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