The impact of bank resolution and bail-in mechanisms on bank management.

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1 The impact of bank resolution and bail-in mechanisms on bank management. January 2014 By Prof Dr Freddy Van den Spiegel (Vlerick Business School and VUB) Bank resolution, including bail-in of bank liabilities will be a normal procedure for managing banks in crisis in the EU, within and outside the banking union. The potential impact of these new rules for bank management goes much further than just complying. Some of the more strategic challenges are: Bank resolution and the principle of bail-in will be pro-cyclical, as deposit holders and other investors in bank debt will not take the risk to be bailedin. It means that banks will have very little time to manage a recovery, once they are considered to be in trouble. Furthermore, pro-cyclicality will force supervisors to switch quickly to resolution. Banks should be prepared to such scenarios. Resolution plans will potentially have an impact on the internal organization of big banks. Improving resolvability will be a key goal of resolution authorities. That leads automatically to pressure for more simple and straightforward structures, occasionally leading to less efficiency. Banks will have to take this new reality into account when optimizing their organization. Managing the bail-in risk will be essential to stabilize a bank in turbulent times and to keep funding costs under control. Using new instruments, pricing correctly bail-in risk, managing the liability structure of the balance sheet and adapting the external communication to the new context will become important issues.. Banks will have to develop a balanced approach in optimizing the funding costs. Looking for cheap funding based on encumbering assets, while convincing the authorities about the sufficient quality of the remaining unencumbered assets will be an important challenge for balance sheet management. Banks will have to assess carefully in how far resolution, including bail-in, on top of all other new banking regulations, will lead to an increased pressure on the traditional banking intermediation channel, in favor of more market based mechanisms. They will have to find a delicate balance between enjoying as long as possible their privileged position of traditional bank intermediation, and getting prepared for the future market and shadow banking developments. 1. The rationale for resolution, including bail-in. On 12 December 2013, the European commission, the European Council and the European Parliament agreed on a framework for a Bank Recovery and Resolution Directive (BRRD), which should be implemented in 2016 by all Member States. Getting this agreement has been a difficult process, because of its impact on the banks of all 28 EU member states, but also because it interacts with the project to have a Single resolution Mechanism (SRM) within the Banking Union for the 17 Eurozone countries, occasionally complemented with non-euro countries wishing to join it. An agreement about this SRM has been reached on 18 December 2013 at Council level, but negotiations with Parliament will continue and will hopefully be finalized before the end of the Parliament s current legislature ( March 2014).

2 The SRM is a key element of the Banking Union, together with the other parts, the Single Supervisor (SSM) and the European deposit guarantee fund. Resolution, combined with bail-in of bank liabilities is becoming a corner stone of financial crisis management in the EU. This is quite a revolutionary change in comparison with earlier practices. Indeed, the crisis demonstrated two major problems in managing a bank crisis. The first one is that banks in crisis cannot be treated within the normal bankruptcy framework for companies, as that could potentially provoke a shockwave in the financial system, followed by a financial meltdown, certainly if systemic banks would be involved. A specific procedure to treat banks in crisis had to be developed, which is the orderly resolution mechanism. The second threat is that using public funds, say taxpayers money, to stabilize banks is socially unacceptable and financially unsustainable, certainly if big banks are involved. The obvious alternative, if public money is excluded, is to make the fund providers to the bank shareholders but also debt and deposit holders participate in the losses. While there are still many challenging issues to be clarified further on, the combination of the two ingredients is expected to be a powerful tool to avoid all the unfortunate experiences of rescuing banks during the ongoing crisis. The purpose of this paper is not to analyze all the remaining technical issues concerning resolution, but to give an overview of the potential market consequences of resolution as a standard tool for crisis management. Bank resolution including bail-in is since long a normal procedure in the US. In Europe, there were only few experiments with resolution, and as an appropriate legal framework was missing, they were generally leading to chaotic situations and legal uncertainty. The Fortis case in the Benelux is a typical example. Bail-in is even more exceptional, but it was a controversial issue when it was used during the banking crisis in Cyprus. In general resolution including bail-in is rather unknown territory in the EU and its implementation raises many questions. Given the huge size of the European banking system, the potential consequences should be fully understood in advance by bank managers and supervisors. 2. The organization of resolution in the EU (BRRD) The resolution procedure is a process by which public authorities take over the management of a bank in an incremental way, without using the normal legal process of bankruptcy, and gradually wind up the bank while keeping its key activities functioning. There are successive phases in the resolution process. As a first step, for all systemic banks, a recovery plan and a resolution plan or living will has to be drafted. The recovery plan is drafted by the bank and has to be approved by the micro-prudential supervisor. It describes what a bank will do to recover from unexpected losses. The resolution plan is drafted by or under the control of the resolution authority and describes what can be done once the banks get into problems which are so important the recovery is no longer viable. Drafting these plans is a first step towards preparing resolution because the supervisor and the national resolution authority can impose conditions which intervene in the normal governance of the bank. For example, the authority can impose to simplify the legal structure in order to make it more transparent, or to increase the amount of liabilities available for bail-in, in order to facilitate an occasional later resolution process. The new regulatory framework contains general rules about resolution plans, but the judgment of the authority is as important.

3 The second step in the process is the early intervention phase, when the bank is in breach or likely to be in breach of any of the requirements which authorizes it to act as a bank, but is still considered to be capable of recovering. In such circumstances, the supervisor can impose to the bank a series of actions such as replacement of managers or changes in business strategy. In case of a significant deterioration, the supervisor can even appoint a special manager. In a third step, if the bank is failing or likely to fail, while private sector solutions such as a take-over but also a write down or conversion of capital market instruments cannot prevent failure, and normal bankruptcy procedures are unacceptable because of systemic risks, the resolution authority can start the resolution process. The goal of resolution is to wind up the bank in an orderly way, keeping the essential functions of the bank intact and running during the process. The resolution authority can use several tools while resolving the bank. It can sell businesses of the bank, transfer part of the assets and/or liabilities to a bridge institution, transfer bad assets to an asset management vehicle and it can use the bail-in tool to reduce liabilities. Certain classes of liabilities are excluded from bail-in such as for example covered deposits, secured liabilities, short term interbank deposits and potentially other liabilities if their bail-in would cause stability or business problems. As banks must have enough liabilities available for bail-in, all costs of failing banks should in principle be covered by investors and clients; A resolution fund in every Member State, and a fiscal backstop should support and finance the resolution process in case the bail-in is insufficient to keep the bank alive until the resolution is finalized. The directive determines however a minimum level of bail-in before external help (bail-out) is possible. The resolution fund should be financed by contributions of the banking sector. The fiscal backstop could be provided by the national treasury of the home country of the bank, or the ESM (European stability mechanism). As soon as public money is used in the process, the process has to comply with the EU rules on state aid and its occasional remedies. 3. The specificities of the SRM process For the Member States, participating in the Banking Union, the resolution process, in parallel with the supervisory process, is organized at European level. The decision to take a bank into the resolution process is a politically and financially very critical act, certainly when it concerns a big bank. It touches all those involved in the bank. In the first place the shareholder and unsecured debt holders who are at risk of losing their investment, but also the clients, the staff, the suppliers and consultants around the bank, those who receive sponsorship from the bank, and even the government. A public decision to close down a big bank is indeed an act of national interest. In a democracy, it is not merely a technical decision. And once the decision to go to resolution is taken, there is no way back. Organizing a resolution process at a supra-national level remains a politically very delicate operation. Therefore, the authority taking this delicate decision must be credible, must use a rational and justifiable decision making process and must be able to justify the decision in court and towards the public at large. The decision making process within the SRM tries to find a balanced approach to this delicate operation. It creates a Single Resolution Board (SRB) and describes

4 in detail how the SRB will cooperate with the national resolution authorities of SRM member states. But the proposed process is far from simple. The initiative to propose the resolution of a bank is, according to the SRM proposal, taken by the single supervisor, the ECB or by a national resolution authority. Being the micro prudential supervisor, the ECB should be best placed to start the process as the ECB is continuously informed about the development of the banks it supervises. According to the SRM, the decision for resolution would be taken by the SRB, and formally adopteded by the European Commission. The resolution authority of the concerned member state(s), home and host, would be involved in the decision making process. In case of banks active outside the SRM member states, MOU s should clarify how cooperation will be organized. While there are legal reasons for this complicated set-up, it is also clear that this procedure is far from straightforward and opens the door for political interference in the process. This could cause problems, as speed is an essential requirement in crisis management. Once a detailed resolution plan is approved by the SRB, and unless objection by the Commission, it will be executed by the national resolution authorities. A Single Resolution Fund (SRF) will be established for all Banking Union Member States. The discussion in how far the financing of the resolution shifts from the national to the SRM level remains difficult. The actual compromise is leading to a complicated and long transition process. Transferring the resolution financing to the European level is a strong fiscal solidarity mechanism, for which many member states, specifically those with a relatively stable banking system, are reluctant. But on the other hand, transferring the power to decide for resolution of a bank at the European level, while the costs of resolution beyond bail-in will have to be funded by the Member States involved is politically unacceptable. 4. The decision to enter into resolution: when? The timing to decide the resolution is a critical issue. If the decision is taken in an early stage, the direct cost to society will in general be limited, but the decision can be contested by the shareholders and the investors being bailed-in, but also by the member state involved. If the decision is taken in a late stage of the crisis, the cost will be higher, but there will be fewer conflicts. The legal framework provides some guidelines when to enter into resolution, but these guidelines require interpretation which can open the door for discussion. In deciding when to enter into resolution, it has to be taken into account that the mere fact that the resolution process exists, could speed up the deterioration of banks in trouble. The resolution concept can become pro-cyclical. Investors in bank debt will become very reluctant as soon as the slightest perspective of resolution is perceived. That will drive up funding costs or even make funding impossible, leading to a situation in which the bank is likely to fail. The panic reaction of investors will undermine stock prices and the price of securities issued by the bank. The new liquidity rules, especially LCR should in principle provide a sufficient buffer of liquid assets to cope with withdrawals of deposits, but it remains to be seen if the anticipated run-off rate of deposits will be realistic in case of problems. If not, the recovery plan becomes completely theoretical. As a consequence, it is likely that there is no other reasonable choice but to enter into resolution in an early stage of deterioration, this is, when the net capital is still positive but below the regulatory levels. That would make the bail-in process less painful and would reduce the risk of a systemic panic but it would mean that

5 resolution is taking the markets by surprise. It is not clear how markets will react, but it seems prudent for bank management to be prepared for increased pro-cyclicality. 5. Impact of resolution and bail-in on bank management 5.1. Impact on governance and organization A living will describes a scenario about what to do in case of problems beyond recovery. For big cross border banks, this is challenging. However, the process will be taken seriously by the supervisor, focusing on the issues that complicate resolution. It is still uncertain how the ultimate standards will look like, but the FSB has already published its Key attributes of effective resolution regimes for financial institutions (FSB, 2011). Key elements are corporate and legal structures, separability of critical functions and intra-group connections. The discrepancy between the legal set-up of banking groups and the practical management structures could well be a point of attention. In many cases, the legal responsibilities of boards and top management of subsidiaries are coherent with management practices which are based on overall strategic decisions at corporate center and an organization of cross border business lines. The complexity of management based on matrix or even three dimensional reporting lines could be considered as an obstacle for resolution. Also the intra-group relations and contracts will get a lot of attention. How will support lines function in case of problems? How will the trade-off between support to suffering entities in the group and the risk that support can lead to contagion of problems throughout the whole group be managed and legally framed? As a result, it is likely that supervisors will push for more simple, straightforward and transparent arrangements. It has to be kept in mind that even the structural split of banks between a retail and an investment bank, still heavily discussed at EU level, finds support because it would facilitate resolution. Also important for the bank is its choice to be considered as a fully integrated operation, or as a string of quasi-independent legal entities. While the integrated approach should be welcomed because of its contribution to financial integration in the EU, the independent structure could get the preference of the supervisors and national resolution authorities as it facilitates the construction of strong firewalls within the group and makes it easier to sell parts of the group, which would make resolution easier. The FSB makes a clear distinction between Single point of entry and Multiple point of entry resolution. (FSB, 2013). However, the European rules are not clear about how group resolution and resolution of subsidiaries will be organized and interact, within and outside of the Banking Union. From now on, banks will have to take decisions about corporate structures which are no longer exclusively driven by efficiency motives, but also by the impact of these decisions on resolvability, and the cost of occasional remedies which the authorities could impose Impact on pricing and cost of funding. Risk is the main driver of pricing of financial instruments. For fixed income instruments, the most important risk is credit risk: the risk that the counterparty will not fulfil his/her contractual obligation, essentially because of default. For

6 instruments issued by banks however, bail-in has the same consequences for the investor as default. That means that logically, the pricing of banking instruments will depend on the assessment by the markets of the risk of bail-in. It is for the time being too early to understand how markets will ultimately define what the appropriate risk premium is for instruments which can potentially be bailed-in, and how their price will behave in good and bad times. It could however be expected that the pricing will be volatile and rather pro-cyclical: as long as bail-in seems unlikely, these instruments could be considered as low risk, but as soon as there are rumors about potential problems in a bank, panic among investors could quickly deteriorate these markets as everybody would rationally try to sell before it is too late. Combined with the uncertainty if and when the supervisor would use the bail-in tool, the market could become highly unstable. Having own funds in excess of the regulatory capital could reduce the bail-in risk premium but comes at a cost. Also issuing specific bail-in able capital market instruments like for example conditional convertible bonds could reduce the bailin risk premium on normal senior debt because these instruments will be bailed in before the normal debt. It seems likely that new instruments will be developed which are specifically designed to take more or less bail-in risk. But also traditional bank products like bank deposits could be influenced by the bail-in principle. Retail deposits up to are excluded from bail-in, but deposits above that amount can be bailed-in, as was already shown in Cyprus. According to the political agreements of the EU institutions (council of the EU, 20 December 2013), retail deposits will have preference over the claims of other unsecured creditors, but nevertheless, banks should offer a higher interest rate on deposits above , as they are more risky for the investor. It remains however unclear in how far the banks will follow the financial logic in pricing deposits. Issuing and investing in bank debt with different degrees of bail-in risk, can become a new discipline in finance. It seems logical that banks will have to be far more transparent about ranking of liabilities in case of bail-in and about the quality of the remaining unencumbered assets in the balance sheet Collateral is king: the art of managing the balance sheet One way to invest in bank debt without bail-in risk is investing in secured instruments: repo, covered bonds, securitized debt, is all excluded from bail-in. Besides the impact that this can have on pricing, it is likely that the pressure on banks to deliver collateral will increase. That could lead to a deterioration of the quality of the remaining unencumbered assets, to a level that is considered unacceptable by the supervisor, as these assets are covering the unprotected debt, including eligible deposits. It is for the time being not clear how supervisors, and especially the ECB will react if such a tendency would become clear, but the EU framework allows resolution authorities to set minimum requirements for own funds and eligible liabilities, based on size, risk and business model (Council of the European Union, 20 December 2013). Banks will have to be even more selective than today when encumbering assets to attract cheaper funding as a consequence could be the obligation to compensate this given collateral with more and potentially more expensive liabilities, eligible for bail-in.

7 5.4. Resolution and bail-in as a supplementary incentive for a more market driven financial system. While resolution and bail-in are not directly changing the financial landscape, it is an additional measure that makes banking less efficient, less safe for investors, more expensive and less profitable. On top of all other new regulations, which all go in the same direction of making the traditional banking channel less attractive for financial intermediation, it will add to the pressure of looking for market based financial intermediation. This will not lead to an immediate revolution, but rather to a gradual and slow tendency. Such slow developments make it more difficult to take fundamental strategic decisions to adapt to the new environment. Banks should assess carefully how they can adapt to a financial system where markets, shadow banks and non-banks become direct challengers for the traditional banking intermediation. Bibliography COUNCIL OF THE EUROPEAN UNION: Council agrees general principle on single resolution mechanism, 18 December COUNCIL OF THE EUROPEAN UNION: Bank recovery and resolution: council confirms agreement with EP, 20 December FSB: Key attributes of effective resolution regimes for financial institutions, October FSB: Recovery and resolution planning for systemically important financial institutions, July 2013.