First, here is a piece of text from the preamble (67) of the Bank Recovery and Resolution Directive (BRRD):
“An effective resolution regime should minimise the costs of the resolution of a failing institution borne by the taxpayers. It should ensure that systemic institutions can be resolved without jeopardising financial stability. The bail-in tool achieves that objective by ensuring that shareholders and creditors of the failing institution suffer appropriate losses and bear an appropriate part of the costs arising from the failure of the institution. The bail-in tool will therefore give shareholders and creditors of institutions a stronger incentive to monitor the health of an institution during normal circumstances and meets the Financial Stability Board recommendation that statutory debt-write down and conversion powers be included in a framework for resolution, as an additional option in conjunction with other resolution tools.”
What’s at stake?
Given the recent market turbulence in some of the large banks in Europe, I thought it might be useful to go through the steps how bank resolution works today in Europe and more specifically in the Banking Union (BU). There is a rather thick pile of new european legislation and therefore, in order to avoid misunderstandings, some facts might be in order, so here we go.
The Banking Union institutions
First of all, Banking Union in Europe consists of the following three pillars:
-Single Supervisory Mechanism (SSM)
-Single Resolution Mechanism (SRM)
-Single Rule Book
SSM, i.e. ECB together with the national supervisors take care of the daily supervision of banks. This includes, but is not limited to, capital adequacy monitoring, liquidity adequacy monitoring, credit risk, market risk, operational risk and the like. ECB is the central prudential supervisor in the BU and it directly supervises the large banks in the BU.
SRM consists of the Single Resolution Board and national resolution authorities. SRB prepares the resolution plans and decides on the resolution process, including on the use of the Single Resolution Fund (SRF) and on the use of the bail-in tool.
Single Rule Book includes most importantly the capital requirements directive (CRDIV), capital requirements regulation (CRR) and the bank recovery and resolution directive (BRRD). These rules are EU law, with regulations directly binding.
How resolution is triggered and carried out?
First of all, it should be noted that the SRB has the task to prepare resolution plans for large banks in Europe. This means that once the resolution commences, the SRB follows the pre-agreed resolution plan. The resolution plan includes the intended resolution actions and tools that are planned to be used, including the bail-in tool.
Now let’s assume a large, internationally active bank based in the BU goes into trouble (for example unexpectedly large losses). The regulation establishing the SRM provides the following procedure:
First, the conditions for resolution require that the entity is failing, or is likely to fail (~equity is non-positive) and resolution action is needed. ECB is responsible for making this assessment (there are exceptions). The Single Resolution Board will then take the decision to put the institution in resolution.
When resolution commences, the SRB will decide e.g. on the applicable resolution tools and determine on the use of the Single Resolution Fund (SRF). If the fund is to be used, European Commission will have to assess whether the use of the fund is in line with the state aid rules.
If a bank is to be resolved, first an independent valuation of its assets and liabilities must be made. After the valuation, a conversion/write down of capital instruments takes place. Thereafter the resolution might involve an asset separation, sale of business, bridge bank establishment and the use of the bail-in tool.
The Single Resolution Fund
The Single Resolution Fund is owned by the SRB. The target size of the Fund is 55 billion euros. Banks in the BU contribute annually to the fund to raise the money needed. The fund can be used in extraordinary circumstances.
The Single Resolution Fund (banks will provide the funds by paying ex-ante contributions) can take part in the financing of the resolution action according to the following rules:
1.Within the resolution scheme, when applying the resolution tools to entities referred to in Article 2, the Board may use the Fund only to the extent necessary to ensure the effective application of the resolution tools for the following purposes:
(a) to guarantee the assets or the liabilities of the institution under resolution, its subsidiaries, a bridge institution or an asset management vehicle;
(b) to make loans to the institution under resolution, its subsidiaries, a bridge institution or an asset management vehicle;
(c) to purchase assets of the institution under resolution;
(d) to make contributions to a bridge institution and an asset management vehicle;
(e) to pay compensation to shareholders or creditors if, following an evaluation pursuant to Article 20(5) they have incurred greater losses that they would have incurred, following a valuation pursuant to Article 20(16), in a winding up under normal insolvency proceedings;
(f) to make a contribution to the institution under resolution in lieu of the write-down or conversion of liabilities of certain creditors, when the bail-in tool is applied and the decision is made to exclude certain creditors from the scope of bail-in in accordance with Article 27(5);
(g) to take any combination of the actions referred to in points (a) to (f).
No more bail-outs !
The process I’ve described above ideally means that banks are not be bailed out by the tax payer anymore. First of all, the philosophy is that banks should hold sufficient amount of bail-inable debt (MREL) on their balance sheet in order to be able to convert /write down the debt if a bank suffers huge losses and its equity is wiped out. Even if the SRB would decide to use the Fund to inject capital in a bank, the money is collected from the banking sector. One should also note that the Fund can only be used after a sufficient amount of debt has been written down/converted into equity (8 % of the balance sheet).
What is the role of the central banks ?
Given that problems related to solvency are dealt with the SRB, the only role for the ECB and the national central banks is to provide extraordinary emergency liquidity assistance (ELA) to the solvent bridge institutions or to the new resolved institutions.
Is Deutsche Bank in trouble?
Legally speaking, this is to be assessed by the ECB. Given the current market valuations of insurance contracts for the subordinated debt (5y sub CDS) , the market is clearly pricing an element of increased risk there (in terms of bail-in). Given the systemic role of DB, not least through its huge derivatives book, I can only hope that the ECB and the SRB do what the EU legislation is requiring from them.