Bank Recovery and Resolution Directive (BRRD) – Implications for Corporate Treasurers
Background and relevance to clients
- The BRRD came into effect in January 2015 to create a common framework in the EU for the recovery and resolution of banks and investment firms.
- The framework outlines the steps that should be undertaken in preparing for and preventing the financial deterioration of a bank and early intervention measures to be enacted where a bank’s financial conditions rapidly deteriorate. It also provides for a resolution phase, which outlines measures to be taken where early intervention tools have been unsuccessful and the bank is deemed to be failing or likely to fail.
- One of the tools (out of 4 options) available under the resolution phase is called a bail-in. Bail-in allows equity and debt to be written down (or debt converted to equity) and is intended to ensure that unsecured creditors of an institution bear appropriate losses. This was designed to address a perceived deficiency with bank rescues during the financial crisis (where bank creditors emerged relatively unscathed in a wave of taxpayer funded bail-outs) and remove the ‘moral hazard’ of the implicit State guarantee of systemically important financial institutions.
- The main impact to corporates/clients under a bail-in scenario is that if they have funds on deposit or have uncollateralised derivative asset positions with a failed institution. In this situation, and depending on the severity of the institution’s failure, such creditors may not recover the full principal of their deposits or they may have their derivative positions closed out (i.e. terminated).
- Whilst on the face of it, corporates may feel they have a higher degree of credit risk on deposits and uncollateralised derivative positions, a combination of the anticipated operation of resolution procedures in the UK and the overhaul of global prudential standards requiring banks to hold more, and better quality, regulatory capital and other bail-inable liabilities may generally improve the credit position of an unsubordinated creditor of the operating bank.
- Whilst a bail-in scenario is remote, it is an area that Group Treasurers and Finance Directors should be aware of, particularly as it relates to treasury policies and bank counterparties.
Introduction to the Bank Recovery and Resolution Directive (BRRD):
- The BRRD establishes a common approach in the EU to the recovery and resolution of banks and investment firms.
- The main themes of the BRRD are to preserve important functions on failure of a bank and to ensure that on insolvency/resolution, shareholders and creditors, rather than taxpayers, bear the losses.
- As a directive, BRRD is not directly effective in member states, and so regard must be had to its implementation in the relevant jurisdiction. In the UK, the relevant powers are enshrined in the Banking Act 2009. The BRRD is a minimum harmonising directive, which means that it sets a threshold that national legislation must meet but member states are permitted to adopt additional rules on top of those laid down under the BRRD.
- A resolution authority (a public administrative body) is nominated in each member state and is responsible for exercising resolution powers. In the UK this function is largely performed by the Bank of England (BoE) with input from HM Treasury and the Prudential Regulation Authority.
What is resolution?
- Resolution is triggered where the UK resolution authorities deem the financial institution is in breach of its capital requirement, does not have any alternative measure which could prevent it failing, and resolution is necessary in the public interest (in other words where other tools have proved ineffective in preventing a bank from failing).
- The BoE may use a number of tools (see next bullet point) to resolve the failed bank’s financial position.
- There are 4 resolution tools that can be used separately or in conjunction to resolve a bank failure:
- Sale of business tool – involving the transfer of shares or assets, rights or liabilities to a purchaser without shareholder consent.
- Bridge institution tool – involving the transfer of shares or assets, rights or liabilities to a bridge institution (public authority controlled by resolution authority) temporarily without shareholder consent.
- Asset separation tool – involving the transfer of assets, rights or liabilities to a specially created asset management entity (owned by public authority and controlled by resolution authority). The aim of which is to maximise the value and/or limit losses.
- Bail-in (outlined below)
- In addition, the BoE has the power to write down (or convert to equity) regulatory capital instruments (tier 1 and tier 2 capital) of the bank at the “point of non-viability”. This power may be exercised outside of a resolution, and must be used before other resolution action can be taken.
- The BoE is required to set up a resolution fund. Annual contributions from institutions will be required and in exceptional circumstances additional funding will be required. The main purpose is to guarantee the assets/liabilities of an institution under resolution, make loans to a bridge institution, and/or purchase assets of an institution under resolution.
- The resolution fund can absorb losses in exceptional cases but only after a minimum of 8% of total liabilities have been bailed in. The funding is capped at 5% of total liabilities until all liabilities except eligible deposits have been used. Public funds may be used after this point but only in exceptional circumstances.
- In an ‘open bank resolution’, assets will be written down or converted to equity and shareholders are likely to be severely diluted or wiped out, and management be replaced.
- In a ‘closed bank resolution’ the bank would be split into two, a good bank and a bad bank. The good bank will continue to operate while the bad bank will be liquidated. Bank creditors that are not systemic can either be left with the old bank and undergo losses as part of the liquidation or be transferred to the new bank either reducing their claims or converting them into equity.
- As a result of the overhaul of prudential standards globally following the financial crisis (led by the Basel III reforms and implemented in the EU through the CRD IV package), banks should be better able to withstand losses without risk of failure, given the significant boost in the quality of minimum capital requirements and the addition of extensive equity ‘buffers’.
- However, banks are also required actively to prepare for resolution. For example, banks must prepare “recovery and resolution plans” (more commonly known as “RRPs” or “living wills”) mapping out possible routes to resolving the bank if it fails.
- Banks are also currently in a transitional phase during which they are required to build up additional reserves of own funds and other liabilities which are designed to be bailed-in ahead of other operating liabilities:
- Banks identified by the Financial Stability Board (“FSB”) as global systemically important banks (G-SIBs) will be required to comply with the FSB’s “TLAC” (total loss absorbing capacity) framework, whilst all EU banks are required to comply with the “MREL” (minimum requirement for own funds and eligible liabilities) requirements under BRRD.
- Whilst these two regimes are disparate in certain respects1, they are both intended to achieve the same goal: that if a bank needs to be resolved, there will be sufficient liabilities in issue which can be easily bailed in without giving rise to a material risk of successful legal challenge or valid compensation claims under ‘no creditor worse off’ protections (discussed below).
- It is intended that all MREL or TLAC liabilities should generally suffer losses before deposits and other unsubordinated operational liabilities of a bank.
- Many resolution authorities are also considering their policy approach to resolution. The BoE’s preferred resolution strategy for the large UK lenders (other than building societies) leverages the group structure, where the ultimate parent is a holding company (the “HoldCo”) and the banking business is conducted through one or more banking subsidiaries (a “Bank”). Generally speaking:
- the BoE expects the HoldCo to issue capital and senior bonds (“external TLAC”) to the market, and then pre-position that TLAC within the Bank by down- streaming the proceeds in a form that would be subordinated to other operational liabilities of the Bank (“internal TLAC”).
- if the banking group failed, the BoE would put the HoldCo into resolution and write down (or convert to equity) all the external TLAC issued by HoldCo, and the corresponding internal TLAC pre-positioned in the Bank would be written off
- ideally without the BoE having to put the Bank itself into resolution.
- Whether or not the Bank itself (as opposed to the HoldCo) is put into resolution is an important distinction. Only in a resolution would the BoE have the power to bail in corporate deposits and other unsubordinated liabilities (including net positions under uncollateralised derivatives) of the Bank. If the amount of TLAC / MREL which the group is required to issue pre-emptively for potential resolution scenarios is calibrated sufficiently highly to restore the Bank to viability without having to put the Bank into resolution, the risk of the resolution regime to corporate depositors with the operating Bank recedes.
- This also illustrates the different risk profiles between an unsubordinated investment in the parent HoldCo (higher risk) and an unsubordinated investment in the operating Bank (lower risk).
- The bail-in tool allows the resolution authorities to write down equity and debt of a bank or its holding company (or convert its debt to equity). It is intended to ensure that unsecured creditors of an institution bear appropriate losses in a resolution (as they would have done had the bank been allowed to enter into normal insolvency proceedings).
- Whilst deposits placed with an institution are classified within “unsecured creditors”, in the context of a UK bank2 deposits are usually placed with the operating entity rather than with the parent holding company. For reasons noted above under “Pre-emptive measures”, it may be that unsubordinated creditors of the operating entity remain untouched in a resolution of the banking group. However, if the institution finds itself in a situation where losses are severe, there is a possibility that losses may also need to be borne by the operating bank’s unsecured creditors and deposit holders may bear losses.
- Different classes of deposits are treated differently. For instance, retail and SME deposits enjoy preference over larger corporate and institutional deposits while insured deposits and secured liabilities are excluded from bail-in.
- Bail-in will potentially apply to any unsecured liabilities of the institution (including uncollateralised derivatives) except for liabilities expressly excluded under BRRD. Excluded liabilities include deposits protected by a deposit guarantee scheme, short-term inter-bank lending or the claims of clearing houses and payment and settlement systems (that have a remaining maturity of less than seven days), client assets, or liabilities such as salaries, pensions, or taxes. In exceptional circumstances, authorities can choose to exclude other liabilities on a case-by-case basis.
- The write-down or conversion of liabilities will generally follow the ordinary allocation of losses and ranking in insolvency, i.e. equity has to absorb losses in full before any debt claim is subject to write-down, followed by own funds (regulatory capital) instruments, then other subordinated liabilities and then evenly on senior unsecured creditors (including debt holders) that are not preferred under insolvency legislation.
- In addition to respecting the creditor hierarchy, BRRD also affords the protection that no creditor should be worse off in a resolution than it would have been had the bank entered normal insolvency proceedings (the “no creditor worse off” or “NCWO” protection).
- Banks which perform systemically important functions and provide critical public services can, in the event of failure, be expected to be resolved through the use of the new resolution tools, rather than being put into insolvency or being bailed out by taxpayers.
- Shareholders and unsecured bondholders, including senior bondholders, of the parent company of a UK banking group can expect to bear losses before depositors and other unsubordinated creditors of the operating bank.
- In the past, banks have been able to take on risk without being fully responsible for dealing with the consequences. The directive is ensuring that authorities have the necessary tools and powers to intervene before problems occur to maintain stability.
- In addition, creditors have perhaps in the past relied on the expectation of bail-out on an implicit understanding that the State cannot afford to let a systemically important bank fail. With the removal of that prospect, investors in unsecured debt instruments may now consider that they are more likely to suffer losses, and so may demand higher rates of return.
- Safeguards built into the regime seek to ensure that no creditor is left worse off than they otherwise would be in an insolvency.
- There will be a reasonable level of uncertainty as to when a bail-in might happen as it is at the resolution authority’s discretion when the power might be exercised.
- The BRRD provides a framework so that national authorities will be able to coordinate resolution measures when a cross-border banking group fails.
- BRRD is arguably a double edged sword as far as risks to corporate depositors are concerned. The new directive enshrines the principle that bank creditors rather than taxpayers should bear the brunt of losses incurred by failed institutions. While this might be argued to increase depositor risk, the combination of the increase in banks’ reserves of capital and other liabilities designed for absorbing first losses in a bail-in, together with the process envisaged by the BoE for resolution of a UK banking group, leaves depositors in UK operating bank entities with substantial buffers in terms of the risk waterfall. However, these factors need to be weighed up against the assumed removal of taxpayer funded bail outs of banks.
- Nonetheless, there remains a risk that in an extreme scenario, institutional/corporate deposits could bear losses in the event the bail-in tool is used. It is important to note that, in a UK banking group, the equity holders and unsecured creditors of the parent company can be expected to bear losses before unsubordinated creditors of the operating bank are impacted.
- Existing counterparty credit risk measures in Treasury Management Policies (TMP) should be sufficient to monitor and mitigate the risk of losses in the bail-in scenario.
- Treasury Management Policies should already contain a Counterparty Credit Risk section which defines authorised counterparties, credit limits and minimum credit ratings. Treasurers should ensure the correct bank counterparty is listing within their policy and the correct rating is monitored (i.e. holding company vs operating entity).
- Regular counterparty reporting and the monitoring of counterparty credit ratings and CDS spreads should identify problem counterparties well in advance of a bail-in scenario.
- Centrus recommends that Treasurers review the Counterparty Credit Risk section of their TMPs and ensure they mirror best practice and regular counterparty credit risk reporting is adhered to.
- Centrus is able to provide advice as to whether TMPs are in line with best practice.
- In the event that Treasurers and Finance Directors are concerned about the risk of bi-lateral deposits with individual financial institutions, deposits can instead be placed with money market funds which generally have a higher credit rating than financial institutions because of the diversification of underlying investments.
- Uncollateralised derivatives could also bear losses where they are considered unsecured liabilities of a bank. Centrus recommends that Treasurers review their ISDAs to clarify any netting and collateral provisions.
1 The European Commission is exploring options to harmonise the two regimes in the EU, and the BoE expects to implement the TLAC model within the current MREL framework for large UK institutions in any event.
2 UK building societies and many continental EU banks do not have holding company structures, and accordingly a different analysis would apply. This note focuses on the UK bank model.