The RRD will act as a ’wake-up call’ to firms in many European countries who have so far made only limited progress on resolution planning. These firms will have to provide extensive information to their national resolution authorities and then face the prospect of being required to make significant changes to their structures and business activities.
Even in countries where more progress has been made, such as the UK and the Netherlands, firms will have to adjust to differences between their evolving national regimes and the RRD. Firms will also need to address the new requirements to hold bail-in liabilities and to pre-fund national resolution funds.
Internationally active firms will have a particular interest in any lack of consistency in national standards, and in cross-border resolution arrangements, both within the EU and globally. Such firms will face major challenges in responding to any divergences in requirements across countries, and any lack of cooperation and consistency in their application.
The European Commission has already signalled its intention to move towards a ‘banking union’ based on a single EU supervisor and a single EU resolution authority and resolution fund, at least for systemic and cross-border groups, and a single EU deposit guarantee scheme covering all EU banks.
Implications for firms
- Firms should be developing their recovery plans and resolution packs in line with the requirements set out in the RRD. while keeping a watchful eye on the development of more detailed requirements by the European Banking Authority (EBA).
- Smaller firms will need to discuss with their national authorities what relief they might obtain from these requirements, depending on the nature, size, complexity and systemic risk of their business.
- Firms will face higher costs and constraints on their funding strategies as a result of:
- The development and reporting of recovery plans and resolution packs;
- Changes demanded by the authorities to improve the credibility and effectiveness of recovery and resolution planning, including higher amounts of contingent capital and funding to underpin recovery, and changes to business activities and legal entity and operational structures to facilitate resolution;
- Unsecured and uninsured creditors will demand a higher return on their funding to reflect the removal of implicit state support, and will prefer to provide funding on a secured basis to avoid potential bail-in;
- National requirements to hold bail-in liabilities in each relevant legal entity; and
- The pre-funding of a resolution fund or Deposit Guarantee Scheme, and the additional funding that would be required if a fund proves to be inadequate.
- Firms with cross-border activities should be aware of potentially costly differences in the requirements imposed by national authorities, both within and outside the EU, including:
- The stresses and scenarios that a recovery plan should cover;
- The extent to which national authorities require firms to make their recovery plans more robust;
- The detailed information to be provided within resolution packs;
- Which financial and economic functions should be regarded as being critical;
- The extent to which national authorities require firms to change their business activities and their legal and operational structures in advance to reduce the cost and complexity of resolution;
- The conditions under which the authorities will trigger a resolution; and
- The use of resolution tools and powers by national authorities.
- Firms face a period of continuing uncertainty before the resolution powers of the authorities are finalised - and probably for even longer before effective cross-border resolution measures are introduced.
- Firms need to consider the impact of these proposals – together with all the other elements of regulatory reform - on their business models and on their legal entity and operating structures. The magnitude of reform may threaten the viability ofexisting business activities and structures, requiring a step change if the firm is to emerge with a viable franchise.
- Longer-term, firms may need to adjust to the European Commission’s preference to establish an EU-wide harmonised insolvency regime, a single European supervisory authority for the supervision of systemic and cross-border groups, and a pan-European resolution authority and resolution fund.
- Similar recovery and resolution requirements may be introduced in due course for insurance companies, financial market infrastructure and other financial institutions, mirroring the Financial Stability Board’s (FSB) approach to systemically important firms.
The RRD applies to all credit institutions and investment firms, subject to the Capital Requirements Directives, their financial subsidiaries and parent financial holding companies located in the EU.
The RRD sets out minimum requirements in six main areas:
- The recovery plans that firms will need to put in place;
- The information that firms will have to provide to enable the authorities to draw up resolution plans for each firm;
- A common minimum set of powers under which national authorities could require firms to improve their recovery plans and to change in advance their businesses and structures to make them easier and less costly to resolve;
- A requirement for firms to hold ‘bail-in’ liabilities that could be written off in the event of a resolution;
- A common minimum set of powers and tools which national authorities could use to resolve a failing firm; and
- The pre-funding of national resolution funds.
The RRD is broadly consistent with the approach to recovery and resolution planning established by the FSB and endorsed at the G20 summit in January; and with the national approaches being developed in countries such as Australia, the Netherlands, Switzerland, the UK and the US.
However, the RRD takes a different approach in:
- Applying the requirements to all credit institutions and investment firms covered by the Capital Requirement Directives, rather than just to systemically important firms – although national authorities can apply the requirements proportionately to non-systemic firms;
- Mandating the EBA to write guidelines to provide more detail on how recovery and resolution planning will operate in practice, and to act as a decision-taking mediator in disputes between home and host authorities;
- Enabling national authorities to replace the management of a firm with a ‘special manager’ ahead of resolution if the firm’s recovery plans have not stabilised the firm;
- Providing more detail on the bail-in tool - on the liabilities potentially subject to being bailed-in, the order in which liabilities would be written down to cover losses, and on the criteria that national authorities should use in setting minimum requirements on firms to hold capital and bail-in liabilities;
- Requiring national authorities to impose a levy on firms to pre-fund any official support provided as part of the resolution of a failing firm; and
- Highlighting a longer-term ambition to harmonise insolvency laws across member states, to introduce a pan-European supervisor and resolution authority for systemic and cross-border groups, and to establish an EU-wide resolution fund.
The RRD is expected to come into force in mid-2013 and to be transposed into national legislation by the end of 2014.Meanwhile the EBA is expected to deliver various draft technical standards and guidelines to the Commission by the beginning of 2015.This is considerably later than the end of 2012 deadline by which national authorities have been required by the FSB to assess recovery and resolution planning for global systemically important banks, and the deadline for large UK banks that were part of the pilot programme to submit their recovery plans and resolution packs at the end of June 2012.
However, the provisions relating to the bail-in tool will not apply until the beginning of 2018, to allow time for existing liabilities to mature, to avoid deleveraging and to align with the full implementation of the new capital requirements.
In the detail
The RRD requires firms to produce and maintain detailed recovery plans that are proportionate to the systemic importance of the firm. Recovery plans should be updated on an annual basis, or after any event which requires a significant change to a firm’s plans.
A firm’s recovery plans will be assessed by the competent authority, who must judge whether there is a reasonable prospect that the recovery plan can be implemented and would redress its financial difficulties. If not, then the authority must have the powers to
require a firm to go further, so that it can recover from a severe stress event. These powers would include requiring a firmto:
- Reduce the risk in its business;
- Enable timely recapitalisation measures;
- Change its strategy;
- Change its funding strategy to increase the resilience of its core business lines and critical operations; and
- Change its governance structure.
Firms with operations in more than one country are required to produce both group and legal entity level recovery plans. The RRD envisages that the home state (parent firm) supervisor would assess the group-wide recovery plan, with the EBA acting as a mediator in any dispute between the parent supervisor and the host state supervisor(s) of subsidiaries.
The RRD mandates the EBA to develop robust and severe stress and scenario tests that a firm should be able to recover from, not only through contingent capital and liquidity arrangements but also by selling assets and business lines if necessary.
However, national authorities may take different approaches to firms’ recovery plans, including:
- the extent to which requirements are reduced for less systemic firms;
- requiring firms to be able to meet tougher stress tests than the minimum tests developed by the EBA; and
- the extent to which national authorities demand improvements in firms’ recovery plans and how far firms will be required to go in establishing contingency measures to raise capital and liquidity and to sell off parts of their business.
Resolution information and plans
For resolution planning, firms are required to produce detailed information, from which the resolution authorities - in conjunction with other competent authorities – will develop resolution plans for each firm. Firms will be required to provide this information annually, or when material changes occur; and to provide information at both group and legal entity levels. As with recovery plans, the content and detail of the information provided by firms will be proportionate to the systemic importance of each firm.
The resolution authority is then required to assess whether a credible resolution plan can be constructed, given the information provided by a firm. The RRD emphasises the importance of assessing:
- How easily critical functions and core business lines could be legally and economically separated to ensure their continuity;
- How access to payment and settlement systems could be maintained;
- Whether service level agreements would remain in place during resolution;
- The adequacy of management information systems; and for groups
- The impact of group structure, intra-group exposures and other intra-group arrangements on the potential separability of particular functions or business lines.
Group resolution plans drawn up by the authorities should also determine how group resolution options could be financed; how resolution powers tools could be applied in a coordinated manner across the group; and whether there would be any barriers to the implementation of resolution powers and tools.
For cross-border groups, the RRD envisages that cross-border resolution would be undertaken through group resolution colleges, based on exchange of information, cooperation and collaboration among the relevant national resolution and supervision authorities. As with recovery plans, the home state (parent firm) competent authority would construct a group-wide resolution plan, with the EBA acting as a mediator in any dispute between the parent resolution authority and the host state resolution authority of subsidiaries.
If the resolution authority is not satisfied that a credible resolution plan can be constructed, then it should have the powers to require a firm (or group) to:
- Revise its service level agreements to enable continuity in the provision of critical economic functions or services;
- Limit its individual and aggregate exposures;
- Limit or cease certain activities and restrict new business lines or products;
- Sell specific assets;
- Change legal entity or operational structures (for example, to reduce complexity and to align legal entities with critical functions);
- Establish a parent financial holding company in the EU; and
- Issue ‘bail-in’ liabilities in excess of minimum requirements.
As with recovery plans, it remains to be seen how tough an approach each national resolution authority will take in practice, including:
- how the systemic importance of firms is reflected in the amount of information they are required to provide;
- the standards that have to be satisfied for a firm’s information and structures to be deemed to be sufficient to enable the authorities to construct a credible resolution plan for that firm; and
- the extent to which firms are required to take actions in advance to enable a morecredible resolution plan to be constructed.
The RRD requires national resolution authorities to be given powers to trigger a bail-in of liabilities if a firm goes into resolution. The authorities could then write down the claims of the creditors of a failing firm and to convert debt claims to equity. This would extend beyond capital instruments to a wide range of uninsured and unsecured liabilities (“eligible liabilities”).
The purpose of this bail-in tool is to ensure that creditors rather than taxpayers meet the losses in a failing firm, and to recapitalise and stabilise a failing firm – particularly a large and complex systemically important firm – thereby providing the time and resources to enable an effective reorganisation and restructuring to be undertaken.
ollowing the EU Commission’s short technical consultation paper on bail-in debt a couple of months ago the RRD sets out in detail how liabilities could be bailed-in in a resolution.
First, some types of liability should be excluded from being bailed-in:
- Deposits covered by a Deposit Guarantee Scheme;
- Secured or collateralised liabilities, up to the value of the security or collateral;
- Liabilities with an original maturity of less than one month, to avoid extreme volatility when creditors believe that a firm may be nearing the point of non-viability;
- Liabilities arising from holding client assets, or from a fiduciary relationship; and
- Liabilities to employees, commercial or trade creditors, and tax and social security authorities.
However, despite the protection of insured depositors themselves, the RRD requires each national Deposit Guarantee Scheme (DGS) to bear some of the losses of a firm in resolution. This means that if a failing bank entered resolution the DGS would have to contribute an amount equal to the amount that insured depositors would have been written down had they not been excluded from bail-in.
The Commission may also adopt measures under the RRD to specify further the treatment of derivatives, repurchase transactions and other types of liability.
Second, the RRD sets out the order in which the claims of shareholders and creditors should be written down (or converted into equity) until the losses (and where appropriate the recapitalisation) of a firm in resolution have been met. Equity and retained earnings should be written down first, followed by writing down the value of (or converting into equity) other tier 1 capital instruments, tier 2 capital instruments, other subordinated debt, and other eligible liabilities.
Third, the RRD requires member states to ensure that firms maintain a sufficient aggregate amount of own funds and eligible liabilities, expressed as a percentage of total liabilities of the firm excluding its own funds. The RRD does not set a minimum ratio here, but leaves this for national authorities to establish on a firm-by-firm basis, taking into account (i) the amount of bail-in liabilities that would be required to meet the resolution objectives and in particular to enable a firm to be recapitalised; and (ii) the size, business model, risk profile and systemic importance of the firm. The explanatory memorandum to the RRD suggests that a 10 percent minimum requirement would be appropriate.
These minimum requirements can be applied to groups on a consolidated basis. In this case, a parent company would be required to distribute adequately and proportionately to its subsidiaries the bail-in liabilities raised by the parent . The resulting intra-group liabilities of a subsidiary could then be included within the eligible liabilities that the subsidiary is required to hold; and in a resolution these intra-group liabilities of a subsidiary would be bailed-in ahead of any other eligible liabilities.
Requiring firms and groups to hold bail-in liabilities as a proportion of total liabilities rather than risk weighted assets provides greater protection against extreme ’tail risk’ events. It also means that firms holding large amounts of assets with low risk weights (such as government bonds, mortgages and trading book exposures) will generally have to hold more bail-in liabilities to meet any minimum requirement, since their own funds and subordinated debt will typically be a smaller proportion of their total liabilities. In the UK, the Independent Commission on Banking had recommended that ring-fenced retail banks hold bail-in liabilities calculated as a percentage of risk weighted assets (to hold bail-in liabilities of up to 7% of risk weighted assets, in addition to a 10% equity capital ratio), but the UK authorities may now decide to follow the approach set out in the RRD.
Fourth, if shareholders and creditors are bailed-in as part of a resolution, the RRD requires that they should not receive less than they would have done in normal insolvency proceedings. But it may be difficult in practice to calculate the losses that would have been incurred in a liquidation, and it is not clear who would pay any compensation due – this would have to be a resolution fund (see below) to avoid using taxpayer money.
Fifth, the possibility that a liability could be bailed-in should be included in the contractual provisions governing any eligible liability. However, the absence of such a provision would not prevent the resolution authority from exercising its bail-in powers in relation to that liability.
National authority powers
In addition to the powers that the resolution authority should have in place to assess recovery and resolution planning and to require firms to take actions in advance as necessary, the RRD also lists the powers and tools that should be available to national authorities to undertake the resolution of a failing firm.
First, the authorities should have “early intervention” powers to require a firm to implement its recovery plan, and to replace the management of a firm with a “special manager”. The power to appoint a special manager is intended to be used when a firm’s recovery plan has been insufficient to restore the financial soundness of the firm, but where the trigger for a resolution has not yet been reached. The special manager would then be expected to implement corrective measures to prevent further decline.
Second, the RRD sets out some high-level triggers for resolution, based on whether a firm is failing or likely to fail, whether other measures could prevent failure, whether resolution (as opposed to liquidation or administration) is in the public interest, and whether the firm has received extraordinary public support.
Third, once the resolution of a firm is triggered, national authorities should have powers to:
- Remove the senior management and board of the firm;
- Sell or transfer all or parts of the firm (the “sale of business tool”) ;
- Establish a bridge institution and transfer assets or liabilities to the bridge institution (the “bridge institution tool”);
- Provide short-term funding or capital to the bridge institution, or a guarantee to potential purchasers;
- Separate the assets of the firm and transfer some or all of them to an asset management agency (the “asset separation tool”);
- Impose a temporary moratorium on the rights of creditors and counterparties to enforce claims and the closing out of positions, or to accelerate or terminate contracts against a failing firm; and
- Bail-in liabilities to impose an appropriate share of losses on shareholders and creditors of the firm (the “bail-in tool”).
Resolution powers may not be sufficient to avoid the need for some official support for a failing firm, for example the provision of liquidity to a bridge bank or guarantees to potential purchasers. The RRD therefore requires the establishment of national resolution funds, to be pre-funded by banks and investment firms. These firms would have to pay an annual levy as a proportion of their total liabilities (and in due course possibly also on a risk-based approach) sufficient to raise over 10 years a resolution fund with funds of at least 1 percent of a country’s insured deposits (this would be equivalent to funds totalling €70 billion across the European Union).
If a resolution fund proved to be insufficient to finance one or more resolutions, then surviving credit institutions and investment firms would have to fund the additional costs after the event. The RRD also gives resolution funds facing a shortfall the right to borrow from funds in other EU countries.
Alternatively, a country may use its Deposit Guarantee Scheme (DGS) as a resolution fund. In this case the Scheme would have to be pre-funded to at least the same minimum level as a resolution fund, but levies on firms would be based on their liabilities excluding own funds and insured deposits.