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EU’s agreement on bail-ins and its exceptions

June 28, 2013

Published in ‘New Europe’ print & digital editions

Bail-ins and its exceptionsAfter years of negotiations, consultations, and informal meetings, European leaders agreed on Wednesday on a draft directive establishing a framework for dealing with credit institutions and investment firms in difficulty.The procedure is far from being over, as it’s now up to the presidency to start negotiations with the European Parliament in order to adopt the directive before the end of 2013.

The agreement is mostly based on the controversial bail-in model applied in Cyprus earlier this year, which left thousand depositors with heavy losses on their deposits exceeding EUR 100,000. The main logic of the agreement is to place the burden of saving an ailing institution on its shareholders, creditors (meaning: bondholders), and if necessary depositors, and to avoid the rise of national debt due to failure of national banks. However, as was the case in Cyprus, insured deposits under EUR 100,000 would be excluded, as would liabilities to employees of collapsed institutions.

EU Member States will have to set up national resolution funds to reach, within 10 years, a target level of at least 0.8 per cent of covered deposits of all the credit institutions authorised in their country. However, before resolution funds can be used, a minimum bail-in from shareholders and creditors amounting to 8 per cent of total liabilities is required. Under certain circumstances, and after getting a formal approval from Brussels, member states could use the funds to protect certain creditors or to recapitalize banks, with intervention capped at 5 per cent of the bank’s total liabilities.

Looking into the agreement, we can see in some detail the methods adopted for dealing with bank failures. According to the Council’s press release, “The proposed directive is aimed at providing national authorities with common powers and instruments to preempt bank crises and to resolve any financial institution in an orderly manner in the event of failure, whilst preserving essential bank operations and minimising taxpayers’ exposure to losses.”

Recognizing the fact that each case is different, the directive requires each financial institution to draw up recovery plans and update them annually, setting out the measures to be taken in order to restore their financial position in case of major problem. Additionally, resolution authorities are also required to prepare adequate plans to deal with the event of default of each financial institution under their supervision.

In case of resolution, the common model adopted is based on two pillars: i) the separation of assets and their transfer to “bridge” entities (i.e. the principle of good bank, bad bank), and ii) a bail-in “tool”, that is: the imposition of losses, with an order of seniority, on shareholders. The bail-in tool will enable resolution authorities to write down or convert into equity the claims of the shareholders and creditors of institutions which are failing or likely to fail.

Regarding the order of seniority of claims, it has been agreed that deposits from private persons and small and medium-sized enterprises, would have preference over the claims of ordinary unsecured, non-preferred creditors and depositors from large corporations. It is understood that deposits below EUR 100,000, will always have a higher ranking than the above mentioned deposits.

However, national resolution authorities will keep the power to exclude liabilities on a discretionary basis, under certain circumstances, such as: if they cannot be bailed in within a reasonable time; to ensure continuity of critical functions; to avoid contagion; and finally, to avoid value destruction that would raise losses suffered by other creditors. Moreover, resolution authorities will have the right to compensate for the discretionary exclusion of some liabilities by passing these losses on to other creditors, “as long as no creditor is worse off than under normal insolvency proceedings.” In other terms, national authorities have, under this directive, a large discretionary power as to who will incur losses and who will be effectively compensated. This is probably the single most important aspect of this agreement, and reveals the extent of compromises made in order to reach the agreement.

Another point is the requirement for member states to set up ex ante resolution funds (meaning: before a financial problem occurs), and to capitalize them within 10 years through annual contributions from credit institutions, but an exception to this rule rule would allow member states to establish their national financing arrangement through mandatory contributions without setting up a separate fund – another compromise at the basis of this agreement. It is also said that this “flexibility” (in fact – “exception”) would only be available after a minimum level of losses equal to 8% of total liabilities financing arrangement has at its disposal ex ante contributions which amount to at least 3% of covered deposits.

All this leads to the conclusion that although Europe has made a significant step forward to the direction of a unified banking system (the ‘banking union”), a large part of the methods and decisions to take is delegated to the member states, either as formal exceptions, or as discretionary decisions of each national authority. Let’s hope it’ll work.

http://www.neurope.eu/article/eu%E2%80%99s-agreement-bail-ins-and-its-exceptions

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