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Resolution Tool: Bail-In A Paradigm Shift in the Global Banking

Landscape and Its Legal Framework within the European Union

by

Chayanis Aueamnuay

HütteLAW AG

Alte Steinhauserstrasse 1

6330 Cham

Switzerland

Tel: +41 729 36 36

Fax: +41 41 729 36 35

http://www.huettelaw.ch

(Latest Developments since 2014)

1

Contents List of Abbreviations ................................................................................................................................ 3

Introduction ............................................................................................................................................... 5

Chapter 1 ................................................................................................................................................... 7

1. Historical Proposal of Bail-Ins ......................................................................................................... 7

2. Bail-In and the Recent Financial Crisis ............................................................................................ 7

3. Framework for Bail-Ins .................................................................................................................... 8

3.1 Recapitalization through Liability Adjustments ........................................................................ 9

3.2 The No-Creditor-Worse-Off Principle.......................................................................................... 11

3.3 The Trigger of Bail-In Powers ...................................................................................................... 12

3.3.1 Insolvency-Related Triggers ................................................................................................. 13

3.3.2 Pre-Insolvency Triggers ......................................................................................................... 13

3.4 Preserving the Critical Functions and Going Concern Value ....................................................... 14

4. Contingent Convertible Bonds ....................................................................................................... 15

Chapter 2 ................................................................................................................................................. 17

1. Why Consider Bail-In? ................................................................................................................ 17

2. Bail-In – An Alternative to Liquidation and Bailout ................................................................... 17

3. Moral Hazard and the Too-Big-to Fail Problem ......................................................................... 18

4. Market Discipline ........................................................................................................................ 19

5. Allocations of Banks’ Losses to the Stakeholders....................................................................... 20

6. The Legitimacy Problem of Bailouts .......................................................................................... 21

7. Critical Analysis of Bail-In Powers ............................................................................................. 22

7.1 Bail-In and the Principle of Proportionality Based on the Human Rights Perspective ................ 22

7.2 The Constraint of Bail-Ins on Certain Causes of Failures ............................................................ 24

7.3 Bail-Ins and the Changing in Banks’ Funding Models ................................................................. 25

7.4 Bail-Ins’ Hurdles Concerning Their Legal Implementation and Governance .............................. 26

Chapter 3 ................................................................................................................................................. 28

1. The Move toward a Consolidating Economic and Monetary Union (EMU) within the EU ......... 28

2. The Uniform Rules for Bank Resolution in the EU ........................................................................ 29

3. Crisis Management ......................................................................................................................... 29

4. Resolution Tools Provided in the BRR Directive .......................................................................... 31

5. The Interpretation of Different Situations when a Bank shall be assessed as ‘Failing or Likely to

Fail’ ..................................................................................................................................................... 32

5.1 When to Pull the Trigger? ............................................................................................................. 32

5.2 Guidelines on Failing or Likely to Fail for Banks ........................................................................ 33

6. Power to Exclude Certain Liabilities Subject to Bail-In of the Resolution Authorities ................. 36

7. National Pre-Funded Resolution Fund According to the BRR Dirctive ......................................... 36

2

8. The Single Resolution Fund .......................................................................................................... 38

8.1 Financing of the Single Resolution Fund ..................................................................................... 38

9. Member States Financing the Single Resolution Fund in Numbers .............................................. 40

Chapter 4 ................................................................................................................................................. 42

1. How to Improve the Effectiveness of Bail-Ins ............................................................................... 42

1.1 Contractual Approach to Promote Cross-Border Recognition by Including Debt Instruments of

Clauses into Financial Contracts ........................................................................................................ 42

1.2 Sufficient Loss Absorbing Capacity of G-SIBs in Resolution ..................................................... 44

Conclusions ............................................................................................................................................. 47

3

List of Abbreviations ABSs asset-backed securities

BCBS Basel Committee on Banking Supervision

BRR Directive Council Directive 2014/59/EU of 15 May 2014

establishing a framework for the recovery and resolution

of credit institutions and investment firms and amending

Council Directive 82/891/EEC, and Directives

2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC,

2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU,

and Regulations (EU) No 1093/2010 and (EU) No

648/2012 [2014] OJ L173/190

CoCo Contingent convertible

Commission European Commission on Human Rights

Dodd-Frank Act Dodd-Frank Reform and Consumer Protection Act of

2010

EBA European Banking Authority

ECtHR European Court of Human Rights

EMU Economic and Monetary Union

EU European Union

FDIC Federal Deposit Insurance Corporation

FSB Financial Stability Board

G-20 Group of Twenty

G-SIBs globally systemically important banks

G-SIFIs global SIFIs

IMF International Monetary Fund

Key Attributes Key Attributes of Effective Resolution Regimes for

Financial Institutions

LGD loss-given-default

OLA Orderly Liquidation Authority

PD probability of default

repos repurchase agreements

SIFIs systemically important financial institutions

SREP supervisory review and evaluation process

4

SRM Regulation Council Regulation (EU) No 806/2014 of 15 July 2014

establishing uniform rules and a uniform procedure for

the resolution of credit institutions and certain investment

firms in the framework of a Single Resolution

Mechanism and a Single Resolution Fund and amending

Regulation (EU) No 1093/2010 [2014] OJ L 225/1

SRR Special Resolution Regime

TFEU Treaty on the Functioning of the European Union

5

Introduction The unfolding of financial crisis in 2007 has brought economical and financial systems worldwide

into turmoil. Although the crisis initially began in the U.S. with the collapse of Lehman Brothers Holdings

Inc., which filed for the US’s Chapter 11 bankruptcy protection on Monday, September 15, 2008 1

, the

impact of its spillover effect was felt globally.2

The world is now in the era of deregulated banking systems. Banks no longer limit their services to

traditional banking like taking deposit and making loans to borrowers. Their financial services and sources

of funding have an international level playing field.3 The absence of proper tools and powers to manage

the failure of systemically important institutions led to a very painful and costly lesson to the financial

system.4

Handling with such gigantic failures like the one of Lehman Brothers without an appropriate

resolution regime has proven to be disorderly, due to the disruptions it caused to the financial markets. It

was a time-consuming process, since the ordinary bankruptcy proceeding had lasted longer than two

years. Apart from this, the process was expensive, because the total fees paid to advisors involved in

Lehman case have exceeded $1 billion.5

This paper feels the need to examine the recently developed resolution mechanism that was planned to

resolve failures of financial institutions in crises in an orderly and less costly manner.6 The paper focuses

its discussion particularly on bail-in mechanism, which is one of the resolution tools,7 in banking

institutions.

The first chapter is dedicated to address the international statutory frameworks of bank bail-ins. It

begins with the historical proposal of bail-ins to provide a board overview concerning this mechanism. It

then continues with an in depth information why bank bail-ins are necessary to resolve bank failures. The

chapter looks at the core elements of bail-in powers and the safeguards bank bail-ins need to have to

protect shareholders and creditors.

The second chapter focuses purely on critical evaluations of public bailouts and bail-ins of

stakeholders. It examines the negative effects that bail-ins could generate. The discussion covers a wide

range of topics starting from the infringement of the right to property, that is protected under fundamental

1 Antor R Valukas, ‘Examiner’s Report: United States Bankruptcy Court Southern District of New York - Chapter 11

Lehman Brothers Holdings Inc Case’ (2011) 1 Examiner’s Report 11 March 2011, 2 2 Patrick Jenkins, ‘Unfinished Business in Battle to Fix the Banks’ Financial Times (London, 8 September 2013)

<http://www.ft.com/intl/cms/s/0/8bf4f926-1713-11e3-9ec2-00144feabdc0.html#axzz3JpgUwS8N> accessed 1

September 2014; Martin Wolf, ‘Five Years on, Lehman Still Haunts Us - The Bank’s Collapse Was But A Symptom

of A Crisis Caused by the Poisoning of the Financial System’ Financial Times (London, 17 September 2013)

<http://www.ft.com/intl/cms/s/0/19bd18d0-1c62-11e3-8894-00144feab7de.html#axzz3JpgUwS8N> accessed 1

September 2014 3 Suk-Joong Kim and Michael D McKenzie, ‘Introduction to International Banking In the New Era: Post – Crisis

Challenges and Opportunities’ in Suk-Joong Kim and Michael D McKenzie (eds), International Banking In the New

Era: Post – Crisis Challenges and Opportunities (International Finance Review vol 11, 1st edn, Emerald Group

Publishing 2010) 4 4 Financial Stability Board, ‘Consultative Document Effective Resolution of Systemically Important Financial

Institutions Recommendations and Timelines’ 19 July 2011 (Bank for International Settlement, Basel 2011) 7 5 Federal Deposit Insurance Corporation, ‘The Orderly Liquidation of Lehman Brothers Holding Inc. under the

Dodd-Frank Act’ (2011) 5 FDIC Quarterly 31, 33 6 Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ October 2011

(Bank for International Settlement, Basel 2011); Financial Stability Board, ‘Key Attributes of Effective Resolution

Regimes for Financial Institutions’ October 2014 (Bank for International Settlement, Basel 2014) 7 Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ (n 6)

http://www.ft.com/intl/cms/s/0/19bd18d0-1c62-11e3-8894-00144feab7de.html#axzz3JpgUwS8N

6

rights, caused by bail-ins, the constraints of bail-ins on both economical and juridical perspectives. This

chapter ends with a remarkable court decision from Spanish jurisdiction.

The third chapter turns its discussion from the international level to the European level. It aims to

provide a concrete understanding on how the European Union (EU) transposed this resolution framework

into their directive and regulation. The focus of this chapter is stressed on when and how resolution

authorities should exercise statutory bail-in powers. It also discusses the powers of resolution authorities

to exclude certain liabilities from being bailed in to avoid contagion effect. Furthermore, this chapter gives

insightful information on how the EU funds its resolution arrangements in order to increase the

effectiveness and smooth functioning of the bail-in regime.

The forth chapter highlights the next step that international bodies tending towards to strengthen the

effectiveness of bank bail-ins. It first discusses the contractual approach to promote cross-border

recognition of statutory bail-in powers. It then explains the importance of sufficient loss absorbing

capacity afterwards. This chapter also provides some criticisms concerning this loss absorbing capacity

and an alternative to this approach suggested by two dominant economic scholars.

The conclusions address some issues that the author thinks they are worth mentioning when

discussing about bail-in regime. They link some points of the bail-in regime together with other popular

topics being debated in the international arena and provide some personal opinions of the author

concerning these issues.

7

Chapter 1

1. Historical Proposal of Bail-Ins

There is a claim from Credit Suisse that the bail-in concept is created by their executives. In an article

named Bail-In – The Key to Ending “Too Big To Fail” available on their website states ‘in 2009, Credit

Suisse executives began exploring a new concept they called "Bail-in" – a high speed recapitalization

using a bank's own resources.’8 However, the term bail-in which refers to forcing creditors to absorb

losses when banks could not pay back the loans by having their claims restructured or written down has

already been used long before 2009.9

Before the recent financial crisis began with the collapse of Lehman Brothers in 2008, bail-in was

discussed as a resolution to solve financial problems sovereign countries faced because they could not

repay their creditors when the debts were maturing. These countries were normally the ones with

emerging-market economies. Some of these countries were Mexico (1995), Thailand (1997), Korea,

Russia, Brazil (1998), and Argentina (2000 - 2001).10

In these times, there were suggestions that it would

be more efficient and leave the creditors better off if the countries were able to negotiate for a debt

restructuring agreement with their creditors.11

The financial supports that these sovereign countries

received from the International Monetary Fund (IMF) should not be used to save private investors from

their imprudent decisions on lending.12

Arranging this in other words, official funds should not be spent to

bailout private sectors in a way that they can privatize gains and socialize losses. Bail-in was then viewed

to be a key that would correct market bias creditors or bondholders had toward sovereign debts.13

It was

also seen to be a tool for reducing moral hazard and provide a better incentive to engage in prudential

lending agreements.14

2. Bail-In and the Recent Financial Crisis

The discussion about the bail-in mechanism has again been focused by finance and legal scholars

when the recent financial crisis broke out in 2007. The major difference is that this time it is not the

sovereign governments’ defaults that cause the crisis. The root of this recent crisis is connected to the

8 Corporate Communications, ‘Bail-In – The Key to Ending “Too Big To Fail”’ (14 January 2014)

<https://www.credit-suisse.com/ch/en/about-us/corporate-responsibility/approach-reporting/responsibility-

chronicle.article.html/article/pwp/news-and-expertise/2013/05/en/bail-in-the-best-alternative-to-address-systemic-

risk.html> accessed 2 September 2014 9 Barry Eichengreen, ‘Bailing In the Private Sector: Burden Sharing in International Financial Crisis Management’

(1999) vol 23 The Fletcher Forum of World Affairs 57; Gerhard Illing, ‘Bailing In the Private Sector On the

Adequate Design of International Bond Contracts’ (2000) vol 35 Intereconomics 64, see also International Monetary

Fund, ‘The Key Attributes of Effective Resolution Regimes for Financial Institutions – Progress to Date and Next

Steps’ 27 August 2012, 10 10

Nouriel Roubini and Brad Setser, Bailouts or Bail-Ins?: Responding to Financial Crises in Emerging Economies

(Institute for International Economics 2004) 8 11

Stanley Fischer, ‘Learning the Lessons of Financial Crises: The Role of the Public and Private Sectors’ (Emerging

Market Emerging Market Traders' Association Annual Meeting, New York, December 9, 1999)

<http://www.imf.org/external/np/speeches/1999/120999.HTM> accessed 3 September 2014 12

Barry Eichengreen, ‘Bailing In the Private Sector: Burden Sharing in International Financial Crisis Management’

(1999) 23 The Fletcher Forum of World Affairs 57, 58-59 13

Gerhard Illing, ‘Bailing In the Private Sector On the Adequate Design of International Bond Contracts’ (2000)

35 Intereconomics 64 14

Eichengreen, ‘Bailing In the Private Sector: Burden Sharing in International Financial Crisis Management’ (n 12)

57-59

http://www.imf.org/external/np/speeches/1999/120999.HTM

8

subprime defaults which are due to the collapse of the housing market and the collapse of two hedge funds

with great investment in subprime asset-backed securities (ABSs).15

This time the initiation of bail-in is raised by the Group of Twenty (G20) through the Financial

Stability Board (FSB) in term of policy recommendations for domestic resolution regimes. With more

effective arrangements for resolution of systemically important financial institutions (SIFIs) in place,

taxpayer funds would be protected from the risks of bail-out. The moral hazard problems linked with the

‘too-big, too-complex and too-interconnected-to-fail’ characteristics of global SIFIs (G-SIFIs) will also be

addressed.16

As part of the resolution mechanisms, bail-in is designed to provide national authorities with statutory

power to restructure and recapitalize a distressed financial institution as a going concern.17

Although bail-in is proposed by the FSB as a tool for resolving every SIFI, but this paper focuses only

on the bail-in within resolution of the banking system. The underlying reason is that the ability to contain

the total fiscal cost for a restructuring of the banking system plays a significant role in restoring public

confidence and the smooth functioning of the financial system.18

When banking institutions fail they tend to pose systemic risk on other solvent banking institutions and

financial sectors. National authorities in the past - before there was a proper bail-in mechanism in place -

used to rescue these banking institutions by bailing them out with taxpayers’ money. This led to systemic

distortions in the banking industry and unreasonable costs for the taxpayers.19

The moral hazard in the

banking industry is a lot more severe than in other financial industries due to the failure of losses

allocation. When a financial crisis unfolds, creditors, equity holders and private investors benefit from the

fact that the government has a bigger interest in stabilizing a distressed systemic bank with public funds

than finding out about who should be the one to bear the losses.20

Banks bail-in is, therefore, the most

important key to answer the critical issues in loss allocation of distressed banks that need to be analyzed.

Moreover, implementation of the Key Attributes of Effective Resolution Regimes for Financial

Institutions (Key Attributes) within the banking sector has taken more progressive steps compared to the

non-bank financial sectors.21

Bail-in resolution in relation to banks is the most comprehensive factor that

can be observed to understand how far the regime has moved forward.

3. Framework for Bail-Ins

Bail-in - as designed by the FSB in the Key Attributes - is the result of objectives of the FSB to

improve the capacity of authorities in all jurisdictions to resolve SIFIs without systemic disruption and

15

Viral V Acharya and others, ‘A Bird’s-Eye View The Financial Crisis of 2007-2009: Causes and Remedies’ in

Viral V Acharya and Matthew Richardson (eds), Restoring Financial Stability: How to Repair a Failed System,

(John Wiley & Sons Inc 2009) 89 16

Financial Stability Board, ‘Consultative Document Effective Resolution of Systemically Important Financial

Institutions Recommendations and Timelines’ (n 4) 23, 27,35 17


Institutions Recommendations and Timelines’ (n 4) 35 18

Martin Čihák and Erlend Nier, ‘The Need for Special Resolution Regimes for Financial Institutions—The Case of

the European Union’ (2009) IMF Working Paper WP/09/200, 3

<http://www.imf.org/external/pubs/ft/wp/2009/wp09200.pdf > accessed 10 September 2014 19

Andreas Dombret, ‘Solving the Too-Big-To-Fail-Problem for Financial Institutions’ in Patrick S Kenadjian (ed),

The Bank Recovery and Resolution Directive Europe’s Solution for „Too Big To Fail“? (Institute for Law and

Finance 2012) 7-8, 10, 12 20

John L Douglas, ‘Too Big to Fail: Do we need Special Rules for Bank Resolutions? The Treatment of Creditors in

Bank Insolvencies’ in Patrick S Kenadjian (ed), The Bank Recovery and Resolution Directive Europe’s Solution for

„Too Big To Fail“? (Institute for Law and Finance 2011) 199-218 21

Financial Stability Board, ‘Progress and Next Step Towards Ending “Too-Big-To-Fail” (TBTF): Report of the

Financial Stability Board to the G-20’ September 2013 (Bank for International Settlement, Basel 2013) 11

9

without shifting the burden to bear losses to taxpayers. Every resolution regime, including bail-in under

the Key Attributes, aims to set an international standard and seeks to promote cooperation between the

competent authorities that would provide all member jurisdictions with the capacity to orderly resolve

SIFIs when the future crises hit.22

Bail-in is an administrative power. It provides a statutory competence for resolution authority to

unilaterally restructure the liabilities of a distressed bank.23

Restructuring in this sense means to convert or

to write down unsecured or uninsured equity or other instrument of ownership such as debts that creditors

claim against the distressed bank. The conversion or writing down process by the resolution authorities

must take the hierarchy of the claims into account. Another equally important point is the no-creditors-

worse-off principle, which resolution authorities need to respect.24

3.1 Recapitalization through Liability Adjustments

The recent financial crisis - with Lehman Brothers’ bankruptcy filing as a classic example - has

demonstrated the need to expand the authorities’ power to resolve failing banks. Rescuing a distressed

systemic bank by injecting public fund through bailout or allowing it to file for bankruptcy proceeding as

a general insolvent corporation could create mixed results with serious undesirable consequences to the

financial system.25

Therefore, a resolution regime that is better tailored to particularly deal with the

problems posed by the balance sheets and financial activities of systemically important banks is more

suitable to resolve a distressed bank than general corporate liquidation procedures.26

As examined by the Federal Deposit Insurance Corporation (FDIC), the disorderly bankruptcy

proceeding of Lehman Brothers, which later contributed to the massive financial disruption in 2008, has

generated the following outcomes:27

1. Lehman brothers’ trading counterparties demanded increasingly higher overcollateralization to

cover their borrowing and clearing exposures with Lehman Brother.

2. It generated negative effect on the US financial stability and confidence in the national banking

system.

3. Without any special resolution regime, resolving Lehman Brothers under bankruptcy law led to

disorderly liquidation, time consuming and expensive proceeding costs, which added up to more

than $1 billion of fees for advisers.

4. The swaps and derivatives markets were disrupted due to the Lehman Brothers’ default. It also

resulted to a market-wide unwinding of trading contracts in the financial markets.

22

Financial Stability Board, ‘Effective Resolution of Systemic Important Financial Institutions: Overview of

Responses to the Public Consultation’ November 2011 (Bank for International Settlement, Basel 2011) 23

International monetary Fund, ‘The Key Attributes of Effective Resolution Regimes for Financial Institutions –

Progress to Date and Next Steps’ 27 August 2012, 10 24

Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ October

2011 (Bank for International Settlement, Basel 2011) 8-9,11 25

Jianping Zhou and others, ‘From Bail-out to Bail-in: Mandatory Debt Restructuring of Systemic Financial

Institutions’ (SDN/12/03, International Monetary Fund 24 April 2012) 8 26


Institutions Recommendations and Timelines’ (n 4) 9 27

Federal Deposit Insurance Corporation, ‘The Orderly Liquidation of Lehman Brothers Holding Inc. under the

Dodd-Frank Act’ (2011) 5 FDIC Quarterly 31

10

5. The asset values and the value of underlying collateral in derivatives of the firm rapidly declined

because of the panic selling. General unsecured creditors of Lehman Brothers were, therefore, left

with substantially less value than they would have received in the orderly resolution process.

6. As the result of number 5, the going-concern value of Lehman Brothers could not be preserved

under the general corporation insolvency process.

The Key Attributes 3.528

empowers the resolution authorities with three major bail-in powers to

(i) write down in respect with the ranking of claims in the creditor hierarchy equity or other

instruments of ownership of the firm, unsecured and uninsured creditor claims to absorb

losses

(ii) convert into equity (as opposed to the write-down) wholly or partly of unsecured and

uninsured creditor claims in a manner that respect the hierarchy of claims in the liquidation

(iii) upon entry into resolution, convert or write-down any contingent convertible or contractual

bail-in instruments whose terms had not been triggered prior to entry into resolution and treat

the resulting instruments in alignment with (i) or (ii).

These resolution powers assure resolution authorities that the exercise of bail-in powers with a

distressed bank will be able to fully spread the unequal liabilities in order of seniority to bear losses of the

bank to the shareholders and unsecured and uninsured creditors. This results to the outcome that equity

holders or holders of instruments of ownership of the bank (as in (i)) are the first to absorb losses. If the

equity is insufficient to absorb losses, the residual losses will be absorbed by subordinated creditors, then

senior (general) creditors, followed by preferred creditors who entitled to preferred debts including

deposits, accrued payroll and wage claims, social security and claims of the fiscal and other public

authorities. Several classes of preferred debts can vary from jurisdictions to jurisdictions.29

When resolution authorities execute bail-in powers, they should do it in a transparent manner.

This requires disclosure of information regarding the hierarchy of claims. The disclosure of information

will allow investors, creditors, counterparties, customers and depositors to have a clear overview about

how their claims would be used to absorb losses and in which order in advance.30

Bail-in is a legal innovation to minimize the harm that a failing financial institution could cause to

the public.31

It increases the capital level of a distressed bank without having to use public subsidy.

However, there might be cases in which due to reasons of financial stability or effectiveness where

financial support from public sector is still necessary to manage a crisis. Nevertheless, a bail-in regime

will substantially reduce the burden of cost put on taxpayers. This regime could put an end to the criticism

28

Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ October

2011 (Bank for International Settlement, Basel 2011) 9, 11; Financial Stability Board, ‘Key Attributes of Effective

Resolution Regimes for Financial Institutions’ October 2014 (Bank for International Settlement, Basel 2014) 9, 11 29

Financial Stability Board, ‘Recovery and Resolution Planning for Systemically Important Financial Institutions:

Guidance on Developing Effective Resolution Strategies’ July 2013 (Bank for International Settlement, Basel 2013)

7-8 30

Financial Stability Board, ‘Adequacy of Loss-Absorbing Capacity of Globally Systemically Important Banks in

Resolution – Consultative Document’ November 2014 (Bank for International Settlements, Basel 2014) 12 31

KPMG, ‘Bail-in Liabilities: Replacing Public Subsidy with Private Insurance’ (Financial Services, KPMG

International Corporative, July 2012 ) 3

11

that governments invariably prefer stability over letting creditors suffer the losses.32

A well-designed bail-

in regime will free the government from this dilemma and allow it to choose an appropriate public policy

choice by bailing in the unsecured and uninsured creditor claims to the extent that will not jeopardize

financial stability.

When resolution authorities bail in the equity holders and creditors by writing off their claims,

they can immediately stretch the loss absorbing capacity of a distressed bank beyond its common equity

without the need to put the bank into liquidation.33

And by converting debt instruments into equity (as in

the Key Attributes 3.5 (ii)) the distressed bank will be recapitalized using the creditors-financed funds.34

Bail-in regime, thus, allow recapitalization of a bank through liabilities adjustment.

3.2 The No-Creditor-Worse-Off Principle

In the Key Attributes 5, the FSB provides the safeguards for creditors by giving the guarantee that

their claims will be treated in a way that respects the hierarchy of claims and that they will not be worse

off than they would after a liquidation merely on the ground that they are under the bail-in regime.35

Respecting the hierarchy or statutory ranking of creditor claims does have some differences from

the absolute respect for the ranking of priority and the principle of equal (pari passu) as it is used in

bankruptcy law. In order to maximize the value for the benefit of the creditors as a whole or to avoid

certain negative systemic effect of a bank’s failure and to provide some flexibility to the bail-in regime the

resolution authorities might treat creditors ranged within the same class differently. This unequal

treatment is justified particularly for depositors and other parties who are involved in providing critical

funding for a systemically important bank. The most crucial reason for this justification is to prevent bank

runs that could lead to systemic disruption or collapse of financial system consequence.36

The right to compensations or remedies, as in the Key Attributes 5.2, should be granted when

there is evidence that the affected creditors are worse off than in liquidation due to the fact that financial

institution enter the bail-in regime. This is an ex-post safeguard to protect basic rights of creditors. It also

provides a certain degree of predictability of results in resolution which should help to increase the

accuracy in price bank funding in the future.37

However, the no- creditor-worse-off safeguard might not

be an easy task to achieve in practice due to the difficulties of how losses should be calculated under a

liquidation procedure and the uncertainty about who would be the most appropriate party to pay for this

compensation.38

Each jurisdiction perceives the way to make this safeguard achievable differently.

On the design of the United Kingdom’s resolution regime, the Special Resolution Regime (SRR)

has introduced the ‘No Creditor Worse Off’ safeguard to apply to creditors of a bank that involve in a

partial transfer. Creditors of such a bank are entitled to compensation from the state if the amount they

receive in the remaining bank’s insolvency is less than the sum they assumingly would have recovered

32

John L Douglas, ‘Too Big To Fail: Do We Need Special Rules for Bank Resolutions? – The Treatment of

Creditors In Bank Insolvencies’ (n 20) 199 33

Thomas F Huertas, ‘The Road to Better Resolution: From Bail-Out to Bail-In’ (The Euro Area and the Financial

Crisis Conference, Slovakia, 6 September 2010, revised 21 January 2011) 16 34

Eva Hüpkes, ‘Living Wills – An International Perspective’ in Patrick S Kenadjian (ed), The Bank Recovery and

Resolution Directive Europe’s Solution for „Too Big To Fail“? (Institute for Law and Finance 2013) 71-86 35

Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ (n 28) 36

Financial Stability Board, ‘Effective Resolution of Systemically Important Financial Institutions’ (n 4) 6-7 37

Institute of International Finance, ‘Making Resolution Robust – Completing the Legal and Institutional

Frameworks for Effective Cross-Border Resolution of Financial Institutions’ June 2012, 23-25 38

KPMG, ‘Bail-in Liabilities: Replacing Public Subsidy with Private Insurance’ (n 31) 9-10

12

had the whole bank been placed into general insolvency procedure. The exact difference between these

two numbers will be assessed by an independent valuer.39

The European Union chose to require their member states to establish ex ante resolution funds to

ensure that resolution tools can be implemented effectively. Resolution funds would also be available to

provide compensation to shareholders or creditors whose claims are worse off than in liquidation under

the bail-in regime. The financial funding of these national funds is derived from the contribution of all the

credit institutions within the member states. The calculation of the annual contribution of each credit

institution is based on its liabilities. Member states which do not wish to establish a separate fund might

opt for setting up national financing arrangement through mandatory contributions under two contingents.

The first contingent is that the member states would have to raise the financial resources not lower than

the amount they oblige to raise under a separate fund. The second contingent is to ensure that the

arrangements can be immediately transfer to the resolution authorities upon their requests.40

However, this

requirement is subject to change under the establishment of the banking union within the euro area.41

The United States also provides safeguard on minimum recovery right to creditors in financial

institutions. This safeguard is reflected in Title II of the Dodd Frank Wall Street Reform and Consumer

Protection Act under the Orderly Liquidation Authority (OLA) provision. Unsecured and uninsured

creditors subjected to OLA provision are entitled to minimum recovery right from the FDIC. This right

represents an important creditor protection principle because the claimants can be ensured that even

though they are subjected to an OLA proceeding they will still receive at least the amount they would

have received in liquidation under the Chapter 7 of the Bankruptcy Code. The calculation of the

hypothetical liquidation value will be evaluated by the FDIC.42

3.3 The Trigger of Bail-In Powers

As demonstrated in the previous subchapters, the Key Attributes only give the general outline of

statutory bail-in powers, leaving the other essential issues to be decided by the national authorities when

resolution regimes are transposed into a national legislation. One important procedural issue that

resolution authorities need to evaluate before exercising the bail-in powers is the question about when

bail-in should be triggered.

It is clear that the bail-in regime has to be more concentrate and more precise on the national level

to avoid the issues of legal uncertainty. A clear expression of the resolution objectives for which proposes

they will be implementing and guidance on how the authorities exercise the intervention powers are

therefore the determining conditions for the success of the resolution regimes.43

Since every jurisdiction has different insolvency procedures, the need for the bail-in regime to be

triggered could be at different period of times, in different ways and concerned with different thresholds.44

Moreover, the trigger for bail-in power should be harmonized with other available resolution tools.45

39

Greoffrey Davies and Marc Dobler, ‘Bank Resolution and Safeguarding the Creditors Left Behind’ [2011] Bank of

England Quarterly Bulletin 2011 Q3 213 40

Council of the European Union, ‘Council Agrees Position on Bank Resolution’(The Economic and Financial

Affairs Council Meeting, Brussels, 27 June 2013, 11228/13 PRESS 270) 3 41

See Chapter 3 section 7 42

David Polk and Wardwell LPP, ‘A Creditor’s Guide to the FDIC’s Orderly Liquidation Authority’

<http://www.davispolk.com/What-if-Your-Counterparty-Fails-12-02-2011/ > published 30 November 2011;

Institute of International Finance, ‘Making Resolution Robust – Completing the Legal and Institutional Frameworks

for Effective Cross-Border Resolution of Financial Institutions’ June 2012 43

Charles Randell, ‘Triggers For Bank Resolution’ in Patrick S Kenadjian (ed), The Bank Recovery and Resolution

Directive Europe’s Solution for „Too Big To Fail“? (Institute for Law and Finance 2011) 116-119 44

Commission, ‘Consultation on a Possible Recovery and Resolution Framework For Financial Institutions Other

Than Banks’ (working document of the Commission services for consultation)

http://www.davispolk.com/What-if-Your-Counterparty-Fails-12-02-2011/

13

3.3.1 Insolvency-Related Triggers

Under the insolvency-related triggers, bail-in powers will be implemented when a bank is in the

stage of being nearly either balance-sheet or cash-flow insolvent. This approach allows the resolution

authorities to intervene before the bank will be in actual balance sheet insolvency.46

The DG Internal

Market and Services indicates in the working document on the technical details of a possible EU

framework for the management of failing credit institutions the three circumstances regarding insolvency-

related conditions as the following.47

(a) The bank has incurred or is likely to incur losses that will deplete its equity.

(b) The assets of the bank are or are likely to be less than its obligations, or

(c) The bank is likely to be unable to pay its obligation in the normal course of business.

Industry respondents who prefer this approach have made further conditional remarks that this

trigger should be applied after the exhaustion of all other alternatives to keep the bank in going concern

and the trigger should not be automatic and as objective as possible.48

However, bail-in power might be

constrained under the insolvency trigger that it could not restore the viability of the bank and, therefore,

could not meet its objective to preserve the going concern value of the distressed bank.49

3.3.2 Pre-Insolvency Triggers

In contrary to the insolvency-related trigger, pre-insolvency triggers mean that bail-in powers are

executed at an earlier stage when the bank is still not close to balance sheet insolvency. Resolution

authorities could implement bail-in powers in relation to either qualitative - such as repeated breach of

regulatory standards - or quantitative measures such as equity capital falling below a pre-determined level.

Pre-insolvency triggers would allow the resolution authorities to react promptly when a bank’s problems

occur. However, this pre-insolvency approach has some disadvantages. It could raise legal issues

concerning the creditors at a lower hierarchy which might be more adversely affected than other creditors.

It could also raise questions about the justification of contractual rights’ intervention by the authorities.50

Both insolvency-related triggers and pre-insolvency triggers have their advantages and

disadvantages and national authorities need to give them a good evaluation before deciding which

approach would be the most appropriate tool. On the international level, the discussions regarding trigger

of statutory bail-in powers are still on the debate at this point.51

45


Institutions’ (n 25) 10 46



DG Internal Market and Services Working Document, ‘Technical Details of a Possible EU Framework for Bank

Recovery and Resolution’ (2011) < http://ec.europa.eu/internal_market/consultations/docs/2011/crisis_

management/consultation_paper_en.pdf> accessed 13 October 2014 48

Commission, ‘Overview of the Results of the Public Consultation on Technical Details of a Possible EU

Framework For Bank Resolution and Recovery’ (Internal Market and Services DG) 5 May 2011 49





Thomas Conlon and John Cotter, ‘Anatomy of a Bail-In’ (2014) UCD Center for Financial Markets,

Smurfit Graduate School of Business, University College Dublin, Ireland 26 March 2014

<http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2294100 > accessed 13 October 2014

http://ec.europa.eu/internal_market/consultations/docs/2011/crisis_

14

3.4 Preserving the Critical Functions and Going Concern Value

Banks are special and need to be distinct from non-financial corporations because their essence of

business as financial intermediaries involves in financial transactions including the extension of credit to

the economic agents, the taking of deposits and the providing efficient transfer of payments.52

With this

distinction, banks, therefore, cannot be operated as a gone concern.53

International purpose of bank

restructuring is designed to allow a distressed bank to continue to service its customers and counterparty

obligations and perform its critical functions by preserving its business continuation as a going concern

entity.54

As demonstrated, using the classic case of Lehman Brothers55

, when a systemically important

financial institution has to be disorderly wound down as a gone concern under general corporate

insolvency law, it could disrupt critical functions in the financial system.

According to the definition provided by the FSB, critical functions are the combination of two

elements56

:

(i) They are systemic relevance activities provided by a firm (G-SIFI) to third parties.

(ii) The sudden failure to perform these functions would lead to a substantial impact on the

third parties, generate contagion or destroy the confidence of market participants.

The critical functions of banks are broadly assessed in five categories, but not intend to be exhaustive, as

deposit taking, lending and loan servicing, clearing and settlement, wholesale funding markets activities

and capital markets and investments activities.57

Since bail-in powers can be unilaterally exercised by the resolution authorities without contingent

to transfer assets and liability to another institution58

, allowing the operational of the distressed firm to be

maintained, it could significantly prevent the panic selling or fire sales that could suddenly depreciate

asset value of the firm in the markets.59

This relates to the other objectives of bail-in in resolution. Apart

from allocating losses to creditors, the objective of bail-in powers most importantly aims to restore a

distressed financial institution to viability60

and to assist it to comply with prudential requirements.61

52

Thorsten Beck and others, Bailing Out the Banks: Reconciling Stability and Competition – An Analysis of State-

Supported Schemes for Financial Institutions (Center for Economic Policy Research, 2010) 9 53

Thomas Huertas and Rosa M Lastra, ‘The Perimeter Issue: To What Extent Should Lex Specialis Be Extended to

Systemically Significant Financial Institutions? An Exist Strategy From Too Big to Fail’ in Rosa M Lastra (ed)

Cross-Border Bank Insolvency (Oxford UP 2011) 250-280 54

International Monetary Fund and the World Bank, ‘An Overview of the Legal, Institutional, and Regulatory

Framework for Bank Insolvency’ 17 April 2009, 15, 35 55

See Chapter 1 section 3.1 above 56


Guidance on Identification of Critical Functions and Critical Shared Services’ July 2013 (Bank for International

Settlement, Basel 2013) 7 57


Guidance on Identification of Critical Functions and Critical Shared Services’ (n 56) 6, 14-32 58

International Monetary Fund, ‘The Key Attributes of Effective Resolution Regimes for Financial Institutions –

Progress to Date and Next Steps’ 27 August 2012, 10 59

Federal Deposit Insurance Corporation, ‘The Orderly Liquidation of Lehman Brothers Holding Inc. under the

Dodd-Frank Act’ (n 21) 34 60


Institutions’ (n 25) 9, 12, 18 61

International Monetary Fund, ‘The Key Attributes of Effective Resolution Regimes for Financial Institutions –

Progress to Date and Next Steps’ (n 58) 10

15

4. Contingent Convertible Bonds

Contingent convertible (CoCo) bonds - also known as enhanced capital notes or contingent capital62

-

should not be confused with bail-in powers of the resolution authorities. The design of CoCo bonds is

pioneered by Mark J. Flannery (2002) and Alon Raviv (2004).63

They are considered to be one of the

approaches policy-makers use to develop an effective way to respond to the risks posted by major,

interconnected banks. Coco bonds should improve legal powers of the authorities to restructure a

distressed bank and living wills.64

CoCo bond is a subordinated security that will convert to common equity of bank under certain

conditions. Similar to bail-in, CoCo bonds can be converted under gone-concern and going-concern

scenarios.65

Under gone-concern scenario, CoCo bonds convert to common equity when the financial situation of

a bank has reached the point of non-viability. Gone-concern CoCo bonds will assist in a resolution

framework to resolve the bank. On the other hand, going-concern CoCo bonds convert to common equity

at an earlier stage, well before the bank reaches the point of non-viability such as in a circumstance where

there are relatively moderate erosions of capital.66

Even though CoCo bonds are structured to be able to convert from debt to equity to absorb losses like

bail-ins67

, the main distinction between bail-ins and CoCo bonds is the trigger mechanism. Bail-in is an

administrative power and it will be triggered according to conditions provided in a national statutory

legislation.68

The trigger point of CoCo bonds, in both gone-concern and going-concern scenario, on the

contrary, is related to contractual mechanism. The conversion of CoCo bonds will be predetermined in the

contractual terms when investors purchased these financial instruments. This conversion event in the

contractual terms could be related to a breach of a given threshold such as debt-to-capital ratio of the

issuer bank or when the value of the bank’s stocks fall below a given level.69

The target of going-concern CoCo bonds is to reproduce elements of early intervention and provides a

bank with automatic recapitalization. Since the threshold of CoCo bonds is predetermined in the

contractual documentation, it should therefore reduce the scope of forbearance in the exercise of

supervisory powers. For gone-concern CoCo bonds, their first objective is to support the resolution action

undertaken by the resolution authorities to a failing bank. Gone-concern CoCo bonds will provide capital

to the bank when it cannot recapitalize itself through private makers. The second objective of gone-

concern CoCo bonds is to ensure that shareholders and other regulatory capital providers, as well as major

creditors of banks have some ‘skin in the game’. They might face a risk of loss or a risk of being diluted,

even though the problematic banks is not closed and liquidated. Consequently, both type of CoCo bonds

should improve market discipline and reduce moral hazard. Furthermore, they would also reduce the

possibility of a government bailout of systemically important banks and prevent taxpayers from bearing

the cost of banks’ losses.70

62

Christian Koziol and Jochen Lawrenz, ‘Contingent Convertibles – Solving or Seeding the Next Banking Crisis?’

(2012) 36 Journal of Banking & Finance 90 63

Jin Cao, Banking Regulation and the Financial Crisis (1st edn, Routledge 2012) 195 64

Chris D’Souza and Toni Gravelle, ‘Contingent Capital and Bail-In Debt: Tolls for Bank Resolution’ (2010)

December 2010 Bank of Canada Financial System Review 51 65

Chris D’Souza and Toni Gravelle, ‘Contingent Capital and Bail-In Debt: Tolls for Bank Resolution’ (n 64) 52 66


Thomas Conlon and John Cotter, ‘Anatomy of A Bail-In’ (n 51) 3 68

See Chapter 1 section 3 above 69


Chris D’Souza and Toni Gravelle, ‘Contingent Capital and Bail-In Debt: Tolls for Bank Resolution’ (n 64) 53

16

CoCo bonds equipped with contractual bail-in liabilities could be viewed as a secret weapon for the

resolution authorities with the intention to mitigate some operational difficulties and litigation intensive of

the statutory bail-in regime.71

71

Philipp M Hildebrand, ‘Why Central Banks Need a Macroeconomic Toolkit’ in Andreas Dombret and Otto Lucius

(eds), Stability of the Financial System – Illusion or Feasible Concept? (Edward Elgar Publishing Limited 2013)

17

Chapter 2

1. Why Consider Bail-In?

When referring to ‘rescue package’ or ‘bailout’, there is no precise legal definition for these

extensively used terms. Rescue package and bailout in the context of recent financial crisis cover very

broad range of actions undertaken by governments in order to prevent financial institutions from falling

apart. These governments’ actions include guarantees, insurance, purchase of assets, direct recapitalization

and other forms of support.72

In order to rescue the distressed banks in the UK, US and the euro-area during the recent financial

crisis, governments in these jurisdictions granted financial aid in total amount of over $14 trillion, which

is almost a quarter of global GDP. These financial aids include emergency liquidity and capital injections,

debt guarantees, deposit insurance and asset purchase.73

Focused on European countries alone, the subsidy used to control adverse effects resulted from the

financial turmoil between 1 October 2008 and 1 October 2012 approved by the Commission to the

financial sector amounts €3394 billion on aggregate. This is a massive intervention that equals 40.3 per

cent of the EU’s GDP.74

By providing implicit guarantees for banks through bailouts, governments risk to draw their own

solvency into jeopardy. Considering the level of government indebtedness and the size of the globally

systemically important banks (G-SIBs), it is inevitable that banks are now ‘too big to save’.75

Bail-in regime is brought into consideration in order to give a government an alternative to liquidation

and bail out failing banks which distort fair competition in the financial market. 76

It should address moral

hazard risks associated with the too-big-to-fail problem, increase market discipline and allow losses to be

allocated to the stakeholders of the bank, namely shareholders, and creditors, without causing significant

stability-threatening to the financial system.77

2. Bail-In – An Alternative to Liquidation and Bailout

The essence of banking business as a financial intermediary is to honor the commitments to pay at

maturity.78

If governments want to avoid bailout by injecting taxpayers’ subsidies to a distressed bank,

they must avoid solving the bank with liquidation through general bankruptcy procedure. In order to

achieve this aim, the risk associated in the banking business must be incorporated in the pricing of bonds

72

Rosa M Lastra and Geoffrey Wood, ‘Government Rescue Packages’ in Rosa M Lastra (ed), Cross-Border Bank

Insolvency (Oxford University Press 2011) 22 73

Andrew G Haldane and Piergiorgio Alessandri, ‘Banking on the State’ (The International Financial Crisis: Have

the Rules of Financial Changed? The Federal Reserve Bank of Chicago Twelfth Annual International Banking

Conference, Chicago, 25 September 2009) 74

Commission, ‘Report from the Commission State Aid Scoreboard – Report on State Aid Granted by the EU

Member States’ Autumn 2012 Update, COM(2012) 778final, 9 75

Jim Millstein, ‘Europe’s Largest Banks Have Become Too Big To Save’ Financial Times (London, 14 November

2011) <http://www.ft.com/intl/cms/s/0/461464fa-0617-11e1-a079-00144feabdc0.html#axzz3HdUIEGPd> accessed

19 October 2014 76

Thomas F Huertas, ‘The Case For Bail-ins’ in Patrick S Kenadjian (ed), The Bank Recovery and Resolution

Directive Europe’s Solution for „Too Big To Fail“? (Institute for Law and Finance 2013) 167 77

Financial Stability Board, ‘Policy Measures to Address Systemically Important Financial Institutions’ 4 November

2011 (Bank for International Settlement, Basel 2011) 78

Thomas F Huertas, ‘The Case For Bail-ins’ (n 76) 168, See also Chapter 1 section 3.4

18

issued by the banks themselves. Otherwise this risk will appear in a form of expensive sovereign

borrowing costs when the governments have to intervene by bailing out the banks.79

The government interventions through bailouts have an incidental consequence on banking

competition.80

Empirical studies show that public bailouts and public guarantees, which give the protected

banks the access to low refinancing costs, intensify the competitive distortions by encouraging the

competitors of protected banks to complete more aggressively and, hence, shoving these banks toward

higher risk-taking. The effects from these implicit or explicit government guarantees induce to the market

that the banks will be saved and this could initiate a threat to the solvency of banking systems in the long

run.81

Moreover, as a result of implicit government subsidies during 2007 and 2009, several financial

institutions with this funding advantage received a better rating grade (ratings uplift) from the rating

agencies.82

3. Moral Hazard and the Too-Big-to Fail Problem

Addressing moral hazard risks posed by too-big-to-fail banks is one of the international aims to

strengthen the international financial regulatory system. This aim is highlighted in the Group of 20 (G-20)

Pittsburgh Communiqué in September 2009 as G-20 leaders committed themselves with the following

statement, saying that:

‘We should develop resolution tools and frameworks for the effective resolution of financial groups to

help mitigate the disruption of financial institution failures and reduce moral hazard in the future. Our

prudential standards for systemically important institutions should be commensurate with the costs of their

failure.83

’

During the recent financial crisis that started in 2007, public sector funding to restore financial

stability came with financial, economic moral hazard costs. Moral hazard is a type of negative externality

associated with banks that are interpreted as not being allowed to fail due to their size, interconnectedness,

complexity, lack of substitutability or global scope are well recognized.84

Moral hazard normally appears with implicit guarantees derived from government support. The costs

of moral hazard and any direct costs of support are borne by taxpayers. Negative externalities of moral

hazard are created when banks want to maximize their private benefits. In order to have their benefits

maximized, banks might rationally opt for the outcomes that are sub-optimal for the economy in the

system-wide level. The negative externalities generated from the sub-optimal outcomes will not be taken

into account by these banks and they can later on create financial and economic costs to the society.85

79

Paul Tucker, ‘Resolution – A Progress Report’ (The Institute for Law and Finance Conference, Frankfurt)

<http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech568.pdf> 3 May 2012 80

Cesar Calderon and Klaus Schaeck, ‘Bank Bailouts, Competitive Distortions, and Consumer Welfare’ April 2012

(The World Bank, Washington DC, 2012 ) 81

Reint Gropp and others, ‘Competition, Risk Shifting, and Public Bail-out Policies’ January 2010 (Max Planck

Institute for Research on Collective Goods, Bonn, 2010) 82

Cesar Calderon and Klaus Schaeck, ‘Bank Bailouts, Competitive Distortions, and Consumer Welfare’ April 2012

(The World Bank, Washington DC, 2012 ) 4; Marc Labonte, ‘Systemically Important or “Too Big to Fail” Financial

Institutions’ 19 September 2014 (Congressional Research Service, Washington DC, 2014) 7 83

The G20 Research Group, ‘G20 Leaders Statement: The Pittsburgh Summit’ (Pittsburgh , 24-25 September2009)

<http://www.g20.utoronto.ca/2009/2009communique0925.html> accessed 15 September 2014 84

Basel Committee on Banking Supervision, ‘Global Systemically Important Banks: Assessment Methodology and

the Additional Loss Absorbency Requirement Rules text’ November 2011 (Bank for International Settlements, Basel

2011) 1 85

Basel Committee on Banking Supervision, ‘Global Systemically Important Banks: Assessment Methodology and

the Additional Loss Absorbency Requirement Rules text’ (n 84) 1-2

19

The Basel Committee on Banking Supervision (BCBS) has developed a methodology for assessing

the systemic importance of G-SIBs based on an indicator-based measurement approach which focuses on

measuring the worldwide impact of a bank’s failure by a loss-given-default (LGD) rather than a

probability of default (PD) concept. This indicator-based measurement approach represents the size of

banks, their interconnectedness, the absence of substitutes or financial institution infrastructure to perform

their services which could be services related to the critical functions86

, their global (cross-jurisdiction)

activities and their complexity.87

In 2013, 29 banks were identified as G-SIBs by the FSB and the BCBS.88

In November 2014, the FSB has updated the list of G-SIBs. The Agricultural Bank of China has been

added to the list and, therefore, increase the overall number of G-SIBs from 29 to 30.89

Apart from being listed as G-SIBs, other financial institutions can also be categorized to be too-big-to-

fail when their failures could constitute unacceptable systemic disruptions that could not be contained

without great difficulties to the economy at large. Being labeled as too-big-to fail makes the creditors and

the counterparties of the banks wrongly believe that they will be shielded from the banks’ downsides

because the government will not allow them to fail. This false belief creates moral hazard among the

creditors and counterparties of the banks because they will be less incentivized to monitor the banks’ risk-

taking activities or imprudent lending.90

Besides raising moral hazard problems, too-big-to-fail banks are also inefficient on economic

rationales. Allocation of resources cannot achieve its maximum productivity because too much financial

intermediation occurs at large banks and too little at other banks.91

This could create a constraint on access

to banking services. Empirical tests show that bank branch density and bank density itself are materially

reduced when big banks receive financial rescue through liquidity support and nationalizations.

Government interventions move the major flow of credit away from borrowers that are dependent on

direct access to banks and bank branches. These borrowers are typically smaller firms and startup

companies who do not have the potential to indirectly receive credit from other sources such as bigger and

more mature firms. Hence, these government supports available typically to too-big-to-fail banks

adversely and disproportionately affect the ability of smaller firms to access financial services.92

Furthermore, empirical studies explored the overall effect of bank concentration with cross-country

analysis including developed, developing and transition economies discover that the effect of bank

concentration can be magnified through government interventions. Bank concentration is considered to

have positive correlation with the increase in financing obstacles, especially for small and medium-size

firms in comparison to larger firms.93

4. Market Discipline

Market discipline can be described as a force that frequently plays an extensive role in financial

policy. Strong compelling signals from the market perceptions will promote the effectiveness of market

discipline. Effective market discipline will ensure sustainable fiscal policies, create appropriate incentives

86


Basel Committee on Banking Supervision, ‘Global Systemically Important Banks: Updated Assessment

Methodology and the Higher Loss Absorbency Requirement’ July 2013 (Bank for International Settlements, Basel

2013) 88

Financial Stability Board, ‘2013 Update of Group of Global Systemically Important Banks (G-SIBs)’ November

2013 (Bank for International Settlements, Basel 2013) 89

Financial Stability Board, ‘2014 Update of List of Global Systemically Important Banks (G-SIBs)’ November

2014 (Bank for International Settlement, Basel 2014) 90

Marc Labonte, ‘Systemically Important or “Too Big to Fail” Financial Institutions’ 19 September 2014

(Congressional Research Service, Washington DC, 2014) 91

Marc Labonte, ‘Systemically Important or “Too Big to Fail” Financial Institutions’ (n 90) 6 92

Cesar Calderon and Klaus Schaeck, ‘Bank Bailouts, Competitive Distortions, and Consumer Welfare’ (n 80) 25-27 93

Thorsten Beck and others, ‘Bank Competition and Access to Finance: International Evidence’ (2004) 36 Journal

of Money, Credit and Banking 627

20

in sovereign lending to pursue policies corresponding to solvency and, most importantly in relation with

financial institutions, market discipline should prevent unsustainable behavior by inducing financial

intermediaries like banks to make prudential lending.94

One of the conditions needed for effective market discipline is that no bailout should be anticipated

from the market participants.95

This implies that creditors and shareholders of a bank must believe that

they will bear the losses when the bank has financial distress, is likely to fail or becomes insolvent.96

A study, which examined the relationship between the risk profiles of financial institutions in the US

and the credit spreads on bonds issued by these institutions, comes to the conclusion that the risk-to-spread

relationship does not positively correlate within the large institutions like other small and medium

institutions. This reflects the belief of bondholders of large financial institutions that government bailouts

will save them from the failures. The consequence resulting from this belief is that bond premiums in

large financial institutions do not fully reflect the risk taking in these institutions and, thus, reduce the

institutions’ cost of issuing debt. The anticipation of implicit government guarantees, therefore, hinder the

market discipline to work effectively by reducing investors’ incentive to monitor and accurately price the

risk taking of large and especially too-big-to-fail institutions.97

With a strong intention to strengthen market discipline, reduce moral hazard and the too-big-to-fail

problem in financial markets, there is an enactment of the Dodd-Frank Reform and Consumer Protection

Act of 2010 (Dodd-Frank Act) in the US and the recent adoption of the Bank Recovery and Resolution

Directive (BRR Directive) in Europe. 98

The Title II of the Dodd-Frank Act provides authorities in the US the competence to achieve outcomes

equivalent to bail-in within resolution through the application of bridge institution resolution powers.99

The BRR Directive in the EU required haircuts on equity and convertible liabilities of a bank’s equity

holders and creditors before any state financial aid can take place. This means that if the losses exceed the

equity buffer of the bank, junior and senior creditors would be bailed in prior to government bailouts.100

5. Allocations of Banks’ Losses to the Stakeholders

The debt write-down tool gives the authorities the competence to trigger statutory bail-in powers when

a bank meets the trigger conditions to enter into resolution. The debt write-down tool under bail-in regime

can be used at a going concern stage where it will absorb losses of a distressed bank and recapitalize the

94

Timothy D Lane, ‘Market Discipline’ (1993) 40 Staff Paper – International Monetary Fund Palgrave Macmillan

Journals 53 95

Timothy D Lane, ‘Market Discipline’ (n 94) 96

Viral V Archarya and others, ‘The End of Market Discipline? Investor Expectations of Implicit State Guarantees’

(2013) <http://ssrn.com/abstract=1961656> accessed 13 October 2014 97


(n 96) 98

Eurofi, ‘Feasible of Banking Crisis Management at Global Level’ (The Eurofi Financial Forum, Milan, 10-12

September 2014) 99

Financial Sector Division, ‘Taxpayer Protection and Bank Recapitalization Regime: Consultation Paper’

(Canada’s Department of Finance) <http://www.fin.gc.ca/activty/consult/tpbrr-rpcrb-eng.pdf> accessed 13 October

2014 100

Eurofi, ‘Feasible of Banking Crisis Management at Global Level’ (The Eurofi Financial Forum, Milan, 10-12

September 2014)

21

bank to viability. It can also be used in a gone concern or liquidation stage as to allow resolution

authorities to wind down the bank in an orderly manner.101

A resolution regime -like statutory bail-in- mirrors the features of reorganization under a general

corporate insolvency law by providing legal mechanism to resolution authorities to unilaterally impose

losses on the stakeholders of the firm, namely, shareholders and creditors without their consensus or the

agreement of the majority of creditors as required under a conventional insolvency law.102

It should not be

too difficult for regulators to accept bail-in regime that allow writing down unsecured creditor claims like

senior and subordinated debts since they are familiar with the concept of tier one, tier two and tire three

capital issued by a bank to support itself when facing difficulties.103

During the recent financial crisis, many authorities in jurisdictions where too-big-to-fail banks are

operated did not have adequate legal tools to solve the problems posed by these banks when they fail. The

only choice these authorities had to stabilize the broader economy was to rely on capital support funded by

taxpayers. Capital support through bailouts imposes direct costs to save a failing bank on taxpayers.104

It

is indisputably unfair to do so since taxpayers do not have the authority to control the risk-taking behavior

of banks.105

These costs should be reallocated under the bail-in regime. Bail-in powers as international

best practices introduced by the FSB and endorsed by the G-20 leaders will enable resolution authorities

to protect taxpayers from losses of banks failures by ensuring that shareholders and creditors of a

distressed bank will bear these losses.106

6. The Legitimacy Problem of Bailouts

Another important remark on the problems of bailouts is its legitimacy issue. The recent financial

crisis has placed a great pressure on government to intervene in the financial markets in an unprecedented

extent and manner.107

A study from the UK revealed that the decision in early October 2008 to rescue

HBOS and RBS, two of the UK’s largest banks, which worth £3 trillion, which is more than twice the

UK’s annual GDP, was made merely by a small group of personnel within the Treasury. Even though the

Treasury has increased the number of staff working on financial stability issues during that time, it is

found that the availability of qualified personnel having relevant skills and experience within the Treasury

was extremely stretched. This is because the Treasury has to perform its traditional role as supervisor of

policy on financial regulation while at the same time trying to accomplish its new roles arising from the

crisis such as major investor, guarantor of banks in the wholesale markets and insurer of assets of the

101

DG Internal Market, ‘Discussion Paper on the Debt Write-Down Tool – Bail-in’ (European Commission

Discussion Paper, 2011) <http://ec.europa.eu/internal_market/bank/docs/crisis-management/ discussion_

paper_bail_in_en.pdf> accessed 13 October 2014; See Chapter 1 section 3.3 102

DG Internal Market, ‘Discussion Paper on the Debt Write-Down Tool – Bail-in’ (European Commission

Discussion Paper, 2011) <http://ec.europa.eu/internal_market/bank/docs/crisis-management/ discussion_

paper_bail_in_en.pdf> accessed 13 October 2014 103

Clifford Chance, ‘Legal Aspects of Bank Bail-ins’ (Sea of Change – Regulatory Reforms to 2012 and Beyond,

May 2011) <http://www.cliffordchance.com/briefings/2011/05/legal_aspects_ofbankbail-ins.html> accessed 1

October 2014 104

Financial Sector Division, ‘Taxpayer Protection and Bank Recapitalization Regime: Consultation Paper’ (n 99) 105

Benoît Cœuré, ‘The implications of bail-in rules for bank activity and stability’(Conference on “Financing the

recovery after the crisis- the roles of bank profitability, stability and regulation”, Bocconi University, Milan, 30 September 2013) < http://www.ecb.europa.eu/press/key/date/2013/html/sp130930.en.html> accessed 13

October 2014 106

Financial Sector Division, ‘Taxpayer Protection and Bank Recapitalization Regime: Consultation Paper’ (n 99) 107

Julia Black, ‘Managing the Financial Crisis – The Constitutional Dimension’(2010) LSE Law, Society and

Economy Working Papers 12/2010 <http://www.lse.ac.uk/collections/law/wps/WPS2010-12_Black.pdf> accessed

14 October 2014, 14-15

http://www.ecb.europa.eu/press/key/date/2013/html/sp130930.en.html

22

bailed out bank.108

This type of small group decision-making in the time of crisis which requires

immediate action could raise the question of validity under the constitutional ground.109

Julia Black, from

London School of Economics and Political Science, summarized this situation in her paper with one

sentence that reads ‘in constitutional terms, decision-making during the crisis most often took the form of

decide now, act immediately, explain quickly and validate later.’110

7. Critical Analysis of Bail-In Powers

Bail-ins could be superior to bailouts and liquidations111

in the sense of fairness and some economical

and legal aspects. However, bail-ins does receive some criticisms from academics and practitioners as

well. As demonstrated in the previous chapter, there is no doubt that bail-in within resolution is one of the

most powerful resolution tools provided to resolution authorities. Therefore, a critical evaluation should be

conducted to give an equal balance and a full analysis of this incredibly powerful resolution mechanism.

7.1 Bail-In and the Principle of Proportionality Based on the Human Rights Perspective

Resolution authorities exercise intervention powers when they bail in unsecured and uninsured

creditor claims to absorb the losses of a distressed bank by writing down or converting these claims

wholly or partly into equity. When such intervention powers are triggered, they inevitably raise juridical

questions regarding the balance between the property rights of private corporations, private investors,

relevant stakeholders of the corporations and public interests of the state.112

The right to property is a fundamental right which is protected in the European Convention for the

Protection of Human Rights and Fundamental Freedoms signed in Rome on 4 November 1950. The right

to property is contained in Article 1 of the First Protocol of the Convention.

Article 1 – Protection of property provides that:

‘Every natural or legal person is entitled to the peaceful enjoyment of his possessions. No one

shall be deprived of his possessions except in the public interest and subject to the conditions provided for

by law and by the general principles of international law.

The preceding provisions shall not, however, in any way impair the right of a State to enforce such laws as

it deems necessary to control the use of property in accordance with the general interest or to secure the

payment of taxes or other contributions or penalties.’113

The European Court of Human Rights (ECtHR) assessed under its settle-case law that Article 1 of

the first Protocol comprises three distinction rules:

The first rule, set out in the first sentence of the first paragraph, is of a general nature and

enunciates the principle of the peaceful enjoyment of property; the second rule, contained in the second

sentence of the first paragraph, covers deprivation of possessions and subjects it to certain conditions; the

third rule, stated in the second paragraph, recognizes that the Contracting States are entitled, amongst

other things, to control use of property in accordance with the general interest [...]. The three rules are not,

however, 'distinct' in the sense of being unconnected. The second and third rules are concerned with

108

The Comptroller and Auditor General, ‘Maintaining Financial Stability Across the United Kingdom’s Banking

System’ 4 December 2009 (National Audit Office, London 2009) 8 109

Julia Black, ‘Managing the Financial Crisis – The Constitutional Dimension’ (n 107) 36-38 110

Julia Black, ‘Managing the Financial Crisis – The Constitutional Dimension’ (n 107) 38 111

Thomas F Huertas, ‘The Case For Bail-ins’ (n 76) 167-169 112

Charles Randell, ‘Triggers For Bank Resolution’ (n 43) 109 113

Protocol to the Convention for the Protection of Human Rights and Fundamental Freedoms as amended by

Protocol No. 11 Paris, 20.III.1952

23

particular instances of interference with the right to peaceful enjoyment of property and should therefore

be construed in the light of the general principle enunciated in the first rule.114

Article 1 will be applied when interference with property of a natural or legal person occurs. The

term ‘possession’ in this Article has a relatively broad definition. The European Court of Human Rights

tends to accept that ‘possessions’ are equivalent to ‘vested rights’115

The European Commission on

Human Rights (the Commission)116

recognized that claim may constitute possessions within the meaning

of Article 1 of the Protocol in the decision A., B., C., and D. v. the United Kingdom. And within this same

decision, the Commission recognized that shares constituted possessions. 117

A later decision of the

Commission in 1978 also recognized that a debt can constitute a possession for a creditor.118

The Commission further observed that a person can be ‘deprived’ of his right to property when he

loses the influence and power of a shareholder over a company in which he owns shares as decided in the

Company S. and T. v. Sweden 1986 as follows:

[A] company share is a complex thing. It certifies that the holder possesses a share in a company

together with the corresponding rights. This is not only an indirect claim on company assets but also that

other rights, especially voting rights and the right to influence the company, may follow the share.119

Shares of shareholders and debts of creditors are, therefore, protected under Article 1 of the First

Protocol against deprivation and certain forms of state control and interference.120

This means that a

deprivation of natural or legal person property rights by a state must satisfy judicial due process

guarantees121

and respect the concept of proportionality.122

In the Sporrong and Lönnroth v. Sweden case, the ECtHR ruled that the burden on a person when

he is deprived of the right to property is excessive and, therefore, upset the concept of proportionality

when ‘the fair balance which should be struck between the protection of the right of property and the

requirements of the general interest’123

is not satisfied. ‘The search for this balance is inherent in the whole

of the Convention and is also reflected in the structure of Article 1 (P1-1).’124

The ECtHR highlighted the notion of the ‘fair balance’ in the Sporrong and Lönnroth v. Sweden

case by referring to the ‘means chosen to achieve the aim’ in the James and others v. the United Kingdom

as follows:

114

Beyeler v Italy ECHR 2000-01 115

Laurent Sermet, ‘The European Convention on the Human Rights and Property Right’ (Human Rights files No.11

rev. Council of Europe Publishing 1999) 11 116

The system for human rights adjudication under the Convention for the Protection of Human Rights and

Fundamental Freedoms was substantially reformed by the Member States with the coming into force of Protocol

No.11. This ceased the European Commission for Human Rights’ functions and transferred them to the Court in

1998. See Aidan O'Neill QC, ‘Reform of the European Court of Human Rights – A Proposal’ (UK Supreme Court

Blog, 24 March 2011) <http://ukscblog.com/reform-of-the-european-court-on-human-rights-a-proposal/> accessed

15 October 2014 117

A, B, C, and D v UK (1967) 23 CD 66 118

AB and Company AS v Germany (1978) 14 DR 159 119

(1986) 50 DR 121 120

See Sovtransavto Holding v Ukraine (2002) ECHR 2002-VII; Eva Hüpkes, ‘Special Bank Resolution and

Shareholders’ Rights: Balancing Competing Interests’ (2009) 17 Journal of Finance Regulation and Compliance 277 121

Eva Hüpkes, ‘Special Bank Resolution and Shareholders’ Rights: Balancing Competing Interests’ (2009) 17

Journal of Finance Regulation and Compliance 277, 281 122

Laurent Sermet, ‘The European Convention on the Human Rights and Property Right’ (n 115) 32-36 123

(1982) Series A no 52, para 69 124

(1982) Series A no 52, para 69 (n 123)

http://ukscblog.com/reform-of-the-european-court-on-human-rights-a-proposal/

24

‘Not only must a measure depriving a person of his property pursue, on the facts as well as in

principle, a legitimate aim "in the public interest", but there must also be a reasonable relationship of

proportionality between the means employed and the aim sought to be realized. […] The Court considers

that a measure must be both appropriate for achieving its aim and not disproportionate thereto. 125

’

When resolution authorities exercise bail-in powers as a measure to resolve a distressed bank, they

have to carefully employ these powers in the manner that respect legal conditions of the proportionality

concept.126

Since a clear expression of resolution objectives and a certainty in the period of time when

bail-in powers should be triggered are crucial for the successful implementation of bail-in regime in both

pre-insolvency and insolvency-related triggers127

, these contingents could raise challenges concerning the

exercise of bail-in powers for the resolution authorities. Due to the fact that it is practically impossible to

address in advance the definite conditions and circumstances in which bail-in powers will be triggered.128

If the resolution authorities decide to trigger bail-ins at an early stage, the full amount of losses might be

underestimated and this could lead to successive rounds of bail-ins in the future.129

Consequently,

employing these resolution powers, which deprives shareholders and creditors’ property rights, might be

considered to be excessive if the principle of proportionality is not conformed.130

7.2 The Constraint of Bail-Ins on Certain Causes of Failures

There is criticism that bail-ins would be effective to resolve a distressed bank and superior to the

case of liquidation only in circumstances where systemically important institutions failed on an

idiosyncratic cause of failure, such as on the ground of fraud or due to its problematic business model, and

on the condition that other financial institutions in the markets remain stable.131

In other words, bail-in

might not be an appropriate mechanism to deal with the situation where more than one systemically

important bank is failing on the cause of financial difficulties that simultaneously erode balance sheets of

multiple banks.

When confronted with an entire financial system distress affecting a great number of banks, a

bail-in approach could become complicated. If bail-inable liabilities are predominantly hold by end

investors, bailing in these end investors to absorb losses could considerably minimize systemic risk.132

However, this is rarely the case in the financial system, since banks use a wide range of financial

instruments to fund themselves. These financial instruments include both retail and wholesale sources.

The prevalent wholesale sources of banks’ funding are inter-bank loans and other short term debts such as

125

(1986) Series A no. 98, para 50 126

Eva Hüpkes, ‘Special Bank Resolution and Shareholders’ Rights: Balancing Competing Interests’ (n 121) 127

See Chapter 1 section 3.3 128

Eva Hüpkes, ‘Special Bank Resolution and Shareholders’ Rights: Balancing Competing Interests’ (n 121) 287 129

Emilios Avgouleas and Charles A Goodhart, ‘A Critical Evaluation of Bail-In as a Bank Recapitalisation

Mechanism’ (2014) Centre for Economic Policy Research Discussion Paper No. 10065,

< http://www2.law.ed.ac.uk/file_download/publications/2_274_acriticalevaluationofbailinasabankrecapi.pdf>

accessed 15 October 2014, 11-12 130

Sporrong and Lönnroth v. Sweden (1982) Series A no 52, para 69; Laurent Sermet, ‘The European Convention on

the Human Rights and Property Right’ (Human Rights files No.11 rev. Council of Europe Publishing 1999); Eva

Hüpkes, ‘Special Bank Resolution and Shareholders’ Rights: Balancing Competing Interests’ (2009) 17 Journal of

Finance Regulation and Compliance 277 131

Clifford Chance, ‘Legal Aspects of Bank Bail-ins’ (Sea of Change – Regulatory Reforms to 2012 and Beyond,

May 2011) <http://www.cliffordchance.com/briefings/2011/05/legal_aspects_ofbankbail-ins.html> accessed 1

October 2014, 6; Emilios Avgouleas and Charles A Goodhart, ‘A Critical Evaluation of Bail-In as a Bank

Recapitalisation Mechanism’ (2014) Centre for Economic Policy Research Discussion Paper No. 10065,

< http://www2.law.ed.ac.uk/file_download/publications/2_274_acriticalevaluationofbailinasabankrecapi.pdf>

accessed 15 October 2014, 10 132

Clifford Chance, ‘Legal Aspects of Bank Bail-ins’ (n 103) 6

http://www2.law.ed.ac.uk/file_download/publications/2_274_acriticalevaluationofbailinasabankrecapi.pdf


25

repurchase agreements (repos), commercial paper and certificates of deposit,133

which can be wholly or

partly subject to bail-in when the predetermined bail-in conditions are met.134

The holder of these bank’s

funding instruments includes broad classes of investors. In the case of commercial paper for example, the

most prevalent holders are money market mutual funds, followed by the foreign sector and then by other

mutual funds that are not money market mutual funds. Other financial institutions that also share some

part of ownership in commercial paper are non-financial corporations, commercial banks, insurance

companies and pension funds.135

When these unsecured or uninsured creditors of a systemic bank are

bailed in to absorb losses from the bank’s failures, it might be as well as shifting the burden to bear losses

from taxpayers in the bailout scenarios to other banks, insurance companies, pensioners and mutual

funds.136

Bail-ins in such a scenario could constitute systemic risk in the financial system.137

This

unanticipated bail-in scenario would bring panic to the investors and might cause them to fire-sale their

assets which would result in a sudden deterioration in asset values and make the banking system become

even more vulnerable.138

An argument is therefore made on this basis that exercising bail-in powers is

unsuitable in the circumstances when banks, pension funds or investors like hedge funds are the holders of

bail-inable liabilities.139

7.3 Bail-Ins and the Changing in Banks’ Funding Models

When investors are aware that their investments in banks’ liabilities could risk the probability of

being haired cut or written down, if the conditions that will allow resolution authorities to trigger bail-in

powers are fulfilled, they would then find a way to exclude themselves from the scope of a potential bail-

in powers unless they are comfort with the return after being bailed in. Banks themselves would also seek

a strategy to help exempting their creditors from the debt write-down tool. They would try to develop

funding structures that will provide them with greater leeway not to be under bail-in within resolution.

Consequently, this could lead to unanticipated market distortions and the possibility for regulatory

arbitrage. In order to avoid these unfavorable circumstances, the exact scope of the bail-in powers is

therefore an important element. However, compared to the preciseness of the trigger points of bail-in

demonstrated early,140

trying to capture an exhaustive list of the transactions that banks conclude with

133

Adrian van Rixtel and Gabriele Gasperini, ‘Financial Crises and Bank Funding: Recent Experience in the Euro

Area’ (2013) BIS Working Paper Monetary and Economic Department Bank for International Settlements No 406, 1

<http://www.bis.org /publ/work406.htm> accessed 16 October 2014 134

Elin Eliasson and others, ‘The Bail-In Tool from a Swedish Perspective’ (2014) 2 Sveriges Riksbank Economic

Review < http://www.riksbank.se/Documents/Rapporter/POV/2014/2014_2/rap_pov_artikel_2_1400918_eng.pdf>

accessed 16 October 2014 135

Tobias Adrian, ‘The Federal Reserve’s Commercial Paper Funding Facility’ (2010) Federal Reserve Bank of New

York Staff Reports no 423 < http://www.newyorkfed.org/research/staff_reports/sr423.html> accessed 16 October

2014, 8 136


Mechanism’ (n 129) 13 137

Clifford Chance, ‘Legal Aspects of Bank Bail-ins’ (n 103) 6 138

Avinash Persaud, ‘Bail-ins are No Better Than Fool’s Gold’ Financial Times (London, 21 October 2013)

<http://www.ft.com/intl/cms/s/0/686dfa94-27a7-11e3-8feb-00144feab7de.html?siteedition=intl#axzz3IOzCu15s>



Mechanism’ (2014) Centre for Economic Policy Research Discussion Paper No. 10065,

<http://www2.law.ed.ac.uk/file_download/publications/2_274_acriticalevaluationofbailinasabankrecapi.pdf>

accessed 15 October 2014; Avinash Persaud, ‘Bail-ins are No Better Than Fool’s Gold’ Financial Times

(London, 21 October 2013) <http://www.ft.com/intl/cms/s/0/686dfa94-27a7-11e3-8feb-00144feab7de.html?

siteedition= intl#axzz3IOzCu15s> accessed 16 October 2014 140

See Chapter 2 section 7.1

http://www.riksbank.se/Documents/Rapporter/POV/2014/2014_2/rap_pov_artikel_2_1400918_eng.pdf

http://www.newyorkfed.org/research/staff_reports/sr423.html


26

their customers to be covered by the bail-in mechanism would be very difficult, if not impossible for the

legislators.141

7.4 Bail-Ins’ Hurdles Concerning Their Legal Implementation and Governance

Another criticism regarding bail-in mechanism is placed on its complexity when it comes to real

implementation. Difficulties could occur in situations regarding the treatment of bail-in creditors. The

difficulties might be most predominant in the case where bailed-in creditors, whose claims are converted

into equity, receive new securities and become new shareholders of a distressed bank rather than having

their claims written off. The treatment of bailed-in creditors in this particular case is likely to be, as

observed by Emilios Avgouleas and Charles A Goodhart, ‘complex, time-consuming and litigation

intensive.’142

The step toward bail-in mechanism will also emphasizes the necessity of better information

disclosures to help investors assess the risk of bail-inable debts. Banks will need to focus their attention

more on providing their customers with the accurate information. The information should be up-to-date,

comprehensible and include the category of liabilities that may be eligible for bail-in and the order of

seniority or the hierarchy of claims of these bail-inable instruments.143

Without the accurate information regarding the bail-inable claims distributed to the investors,

resolution authorities might encounter with legal difficulties when they try to bail in those equity holders

or creditors to absorb the banks losses. A case concerning convertible bonds, called Valores bonds, issued

by Banco Santander, Spain’s largest lender144

and Europe’s biggest bank,145

can demonstrate an analogous

example for the possible legal difficulties. This case, according to Fernando Zunzunegui, head of

Zunzunegui Lawyers which representing Santander’s clients who invested in Valores bonds, ‘is without a

doubt the most important case in the history of Spain for the rights of bank clients’.146

Valores Bonds are retail saving products sold by Banco Santander to its clients in order to finance

its acquisition of part of ABN Amro in Spain. The bonds can be converted into Santander shares at a fix

price of €14 each. They offered a high 7.5 per cent interest rate in the first year of issuance. However, this

rate later fell to 2.75 per cent. The price of Santander shares have plummeted sharply since 2007 to a level

of slightly over €6 each. This means that investors in Valores Bonds, who are mostly savers, will lose

approximately a third of their original investment.147

The cases were brought to the Spanish court against Banco Santander for allegedly mis-selling

€7 billion of Valores bonds. The verdict was announced in March 2012 when the local court in Alicante

ruled that Santander had to return money to its clients suffering a loss on their investments. The court

reasoned that ‘the bank had sold €45,000 of the bonds without explaining its risks’.148

Recently in

February 2014, Spain’s stock market regulator, the Comisión Nacional del Mercado de Valores, imposed a

141

Standard & Poor’s, ‘How a Bail-In Tool Could Affect Our Ratings on EU Banks’ (Global Credit Portal Ratings

Direct, Standard & Poor’s 10 May 2012) 5 142


Mechanism’ (n 129) 13-14 143

Standard & Poor’s, ‘How a Bail-In Tool Could Affect Our Ratings on EU Banks’ (n 141) 4-5 144

‘Spain’s Biggest Lender Santander Fined €16.9 mn for Mis-Selling’ (18 February 2014) < http://rt.com/business/

santander-spain-banking-fine-553/> accessed 16 October 2014 145

Sarah Gordon, ‘Santander Succession Highlights Europe’s Planning Woes’ Financial Times (London, 24

September 2014) <http://www.ft.com/intl/cms/s/0/a941520e-42f0-11e4-9a58-00144feabdc0.html#axzz3IVMkHt

BZ> accessed 16 October 2014 146

Miles Johnson, ‘Santander Could Face More Mis-Selling Cases’ Financial Times (London, 8 March 2012)

<http://www.ft.com/intl/cms/s/0/349b1bf8-693e-11e1-9618-00144feabdc0.html#axzz3IVMkHtBZ> accessed 16

October 2014 147

Miles Johnson, ‘Santander Could Face More Mis-Selling Cases’ (n 146) 148

Miles Johnson, ‘Santander Could Face More Mis-Selling Cases’ (n 146)

http://rt.com/business/

http://www.ft.com/intl/cms/s/0/a941520e-42f0-11e4-9a58-00144feabdc0

27

fine of €1.69 million on Banco Santander for this mis-selling Valores scandal. The regulator said the bank

had committed a ‘very grave infraction’149

by failing to reveal the investors of its Valores bonds the

‘necessary information’.150

The Valores bonds is a landmark case that banks who issue bail-inable debts and resolution

authorities who are responsible for resolution action should be aware off. Compensation paid for a

successful litigation against banks or the decisions of resolution authorities would undermine the

enforceability and effectiveness of bail-in.151

A further discussion on how to strengthen statutory bail-in

powers particularly in cross-border situations with contractual provisions will be explained in chapter 4

section 1.1.152

149

Tobias Buck, ‘Santander Fined €16.9m Over Mis-Selling Scandal’ Financial Times (London, 17 February 2014)

< http://www.ft.com/intl/cms/s/0/afed86dc-97e6-11e3-ab60-00144feab7de.html?siteedition=intl#axzz3IVMkHtBZ>


Tobias Buck, ‘Santander Fined €16.9m Over Mis-Selling Scandal’ (n 149) 151

Financial Stability Board, ‘Cross-border Recognition of Resolution Action – Consultative Document’ September

2014 (Banks for International Settlements, Basel September 2014) 152

See Chapter 4 section 1.1

http://www.ft.com/intl/cms/s/0/afed86dc-97e6-11e3-ab60-00144feab7de.html?siteedition=intl#axzz3IVMkHtBZ

28

Chapter 3

1. The Move toward a Consolidating Economic and Monetary Union (EMU) within the EU

Banks provide many essential financial services to the economy.153

Most banks are closely

interconnected due to the interbank market. A run or a viability problem in one bank might endanger the

viability of other banks and could imperil the entire financial system. According to this specialty of banks,

most jurisdictions tend to manage bank insolvencies with administrative procedures instead of using

traditional court procedures. This is due to the fact that the administrative procedures provide the

possibility to preserve the critical and vital functions of the failing bank and retain customers’ confidence

in the banking system by containing the contagion effect of one bank’s failure to not spread to other

banks.154

Over the course of the crisis, the EU struggled with the problem that neither authorities nor banks

were appropriately prepared. Many member states had inadequate tools and powers to intervene, stabilize

and reorganize a distressed bank at an early stage. The only option that national authorities had in order to

preserve financial stability and contain systemic disruption was to use the taxpayers’ money to bail out

interdependent banks.155

The continuation of stress in sovereign and bank funding conditions have

necessitated member states to carry on granting state aid to address the negative effects bonded with the

financial and economic crisis. The Commission, during the period from 1 October 2008 to 1 October

2012, had made more than 350 decisions regarding state aid measures for the financial sector based on the

Article 107(3) (b) of the Treaty on the Functioning of the European Union (TFEU) in order to ‘remedy a

serious disturbance in the economy of a Member State’156

during the period from 1 October 2008

to 1 October 2012. The aid granted purely for recapitalization and impaired asset relief, which involves a

direct transfer of money from the national budget to the financial institution concerned, during the period

from 1 October 2007 to 31 December 2011, amounted to €441.9 billion or 3.5 per cent of EU GDP.157

This emphasizes the need for greater cross-border cooperation so that supervisors and other

resolution authorities can efficiently handle with banks operating across geographical borders of member

states. Not only does public financial intervention costs taxpayers excessive sums of money, but they also

put some member states’ public finances at risk. This budgetary support is unsustainable from a fiscal

rationale. Furthermore, the recent financial crisis had shoved the economies of the European member

states into a severe recession, with the shrink by 4.2 per cent or €0.7 trillion of the EU’s GDP in 2009.158

The Eurozone Summit and the European Council decided in June 2012 to establish a single

rulebook with an integrated financial framework.159

The single rulebook includes stronger prudential

requirements for banks, improved depositor protection and rules for managing failing banks in all

153


Stefano Micossi and others, ‘The New European Framework for Managing Bank Crises’ (CEPS Policy Brief no

304, 21 November 2013 Centre for European Studies 2013) 5 155

Commission, ‘Summary of the Impact Assessment Accompanying the document Proposal for a Directive of the

European Parliament and of the Council establishing a framework for the recovery and resolution of credit

institutions and investment firms and amending Council Directives 77/91/EEC and 82/891/EC, Directives

2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No

1093/2010’ (Commission Staff Working Document) COM (2012) 280 final 156

Consolidated Version of the Treaty on the Functioning of the European Union [2012] OJ C 326/47 Article 107 (3) 157

Commission, ‘Facts and figures on State aid in the EU Member States - 2012 Update – Accompanying the

document State aid Scoreboard 2012 Update Report on State aid granted by the EU Member States’ (Commission

Staff Working Document) COM(2012) 778 final, 27-29 158

Commission, ‘Summary of the Impact Assessment’ (n 155) 159

Herman Van Rompuy, ‘Towards A Genuine Economic and Monetary Union – Report by President of the

European Council’ (EUCO 120/12, 26 June 2012 European Council Brussels 2012) 3-4

29

financial actors in 28 member states across the EU.160

One of the central elements for an integrated

financial framework is to have an integrated supervision under a single European banking supervision

system to ensure the effective functioning of prudential rules, risk control and prevention of crisis in every

part of the EU. The aim of the single European banking supervision is to eliminate supervision

forbearance by national regulators by assigning the European level with ultimate responsibility in order to

create European wide equally effective supervision in diminishing the probability of bank failures.161

The Eurozone Summit and the European Council in 2012 also set an aim for an integrated

budgetary framework, particularly within the euro area. This is an essential step towards a fiscal union.

Effective mechanisms to revise unsustainable fiscal policies in each member state, the introduction of joint

and several sovereign liabilities would be a robust framework for budgetary discipline which should help

reducing moral hazard and concurrently promote responsibility and compliance.162

2. The Uniform Rules for Bank Resolution in the EU

The Council and the European Parliament have adopted the directive 2014/59/EU of 15 May 2014

establishing a framework for the recovery and resolution of credit institutions and investment firms (BRR

Directive)163

and the regulation (EU) No 806/2014 of 15 July 2014 establishing uniform rules and a

uniform procedure for the resolution of credit institutions and certain investment firms in the framework

of a Single Resolution Mechanism and a Single Resolution Fund (SRM Regulation)164

in order to

construct uniform rules of bank resolution within the EU. By reading the provisions in the BRR Directive

and the SRM Regulation, it is obvious that they strongly cooperate with each other.165

3. Crisis Management

According to the BRR Directive, banks crisis management within the European member states is

divided into three phases as follows166

:

1. Preparation phase, provided in Title II of the directive, is the phase where recovery and resolution

planning are to be drawn up.167

The Recovery plan is a plan that each institution needs to draw up containing measures that the

institution will use to restore its financial position after a significant deterioration of its financial

160

Internal Market and Services Directorate General, ‘Banking Union’ (3 October 2014) <http://ec.europa.eu/

internal_market/finances/banking-union/index_en.htm> accessed 17 October 2014 161


European Council’ (n 159) 3-5 162


European Council’ (n 159) 3-5 163

Council Directive 2014/59/EU of 15 May 2014 establishing a framework for the recovery and resolution of credit

institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC,

2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations

(EU) No 1093/2010 and (EU) No 648/2012 [2014] OJ L173/190 (BRR Directive) 164

Council Regulation (EU) No 806/2014 of 15 July 2014 establishing uniform rules and a uniform procedure for the

resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and

a Single Resolution Fund and amending Regulation (EU) No 1093/2010 [2014] OJ L 225/1 (SRM Regulation) 165

Council Directive 2014/59/EU of 15 May 2014 establishing a framework for the recovery and resolution of credit

institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC,

2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations

(EU) No 1093/2010 and (EU) No 648/2012 [2014] OJ L173/190; Council Regulation (EU) No 806/2014 of 15 July

2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain

investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Fund and amending

Regulation (EU) No 1093/2010 [2014] OJ L 225/1 166

The BRR Directive (n 163) 167

The BRR Directive (n 163) Article 4

http://ec.europa.eu/dgs/internal_market/index_en.htm

http://ec.europa.eu/%20internal_

http://ec.europa.eu/%20internal_

30

state. This recovery plan should be updated at least once a year or after there is a change to the

legal or organizational structure of the institution.168

The Resolution plan, on the other hand, is a plan to be drawn up by the resolution authorities in

order to set up resolution actions when the conditions for resolution of an institution are met. In

this plan, the resolution authorities should identify any material impediments that could occur

when trying to resolve an institution and outline relevant measures regarding how those

impediments could be dealt with.169

2. Early intervention phase, provided in Title III, concerns an institution’s infringements or its

probability to infringe, for example, capital or prudential requirements under the EU legislatives.

Early intervention can also take place when an institution’s financial situation, such as liquidity

situation, non-performing loans and concentration of exposures, is suddenly depreciated.170

In this

circumstance, the resolution authorities could employ early intervention measures to remove

senior management and management body of that institution.171

If the previous measure is

insufficient to improve the situation, resolution authorities may appoint one or more temporary

administrators to the institution.172

3. The resolution phase, which is the final phase, is provided in Title IV of the directive. The

resolution phase is the stage in which resolution authorities really apply resolution tools and

exercise the resolution powers. To justify which tools and powers should be used to resolve an

institution, resolution authorities shall take into account the resolution objectives.173

Those

objectives are:

‘(a) to ensure the continuity of critical functions;

(b) to avoid a significant adverse effect on the financial system, in particular by preventing

contagion, including to market infrastructures, and by maintaining market discipline;

(c) to protect public funds by minimizing reliance on extraordinary public financial support;

(d) to protect depositors covered by Directive 2014/49/EU and investors covered by Directive

97/9/EC;

(e) to protect client funds and client assets.’174

168

The BRR Directive (n 163) Article 5 169





The BRR Directive (n 163) Article 31(1) 174

The BRR Directive (n 163) Article 31(2)

31

4. Resolution Tools Provided in the BRR Directive

Resolution tools that the European member states need to equip their national resolution

authorities with are separated into four categories. They include the sale of business tool, the bridge

institution tool, the asset separation tool and the bail-in tool. Resolution authorities can apply these tools to

a distressed bank individually or integrally with other resolution tools.175

1. The sale of business tool is the power that allows resolution authorities to transfer all or any

assets, rights or liabilities and shares or other instruments of ownership issued by a bank under

resolution to a purchaser that is not a bridge institution. The ‘transfer’ under this tool can take

place without having to obtain the consent of the shareholders of the bank and without having

to comply with any procedural requirements under company or securities law.176

Sale of banks

business should be conducted in a manner that is open, transparent and non-discriminatory.

The rationale behind the transparency, openness and non-discrimination is to ensure that a fair

market price is paid.177

2. The bridge institution tool gives resolution authorities the power to transfer to a bridge

institution shares or other instruments of ownership and all or any assets, rights or liabilities of

one or more banks under resolution.178

The bridge institution must be a legal person that is

fully or partially owned by one or more public authorities and is structured for the purpose of

acquiring and holding the shares or other instruments of ownership issued by a bank or the

assets, rights and liabilities of one or more banks with the objective to preserving critical

functions of the banks concerned.179

3. The asset separation tool provides resolution authorities the power to transfer assets, rights or

liabilities of a bank or a bridge institution to one or more asset management vehicles.180

The

tool empowers resolution authorities to transfer underperforming or toxic assets to a separate

vehicle or a bad bank so that the authorities can clear the balance sheet of the failing bank.181

It also allows resolution authorities to separate essential functions of the bank from the non-

essential functions. The good and critical functions are then sold and transferred to another

entity (known as Purchase & Assumption) or to a bridge bank. The unessential part will go

175



Commission, ‘Communication from the Commission to the European Parliament, the Council, the European

Economic and Social Committee, the Committee of the Regions and the European Central Bank - An EU Framework

for Crisis Management in the Financial Sector’ COM(2010) 579 final 178






for Crisis Management in the Financial Sector’ (n 177)

32

into administration, break down and destruct.182

In summary, the aims to transfer assets to the

asset management vehicle are to maximize the assets value as well as to maintain the proper

functioning of the bank.183

4. The bail-in tool enables resolution authorities to recapitalize a bank that meets the conditions

for resolution in order to restore its ability to comply with the regulatory requirements for

authorization, to continue performing its services and to maintain market confidence in the

bank. Bail-in will permit the bank to carry on its operation, either temporary or permanently,

as a going concern entity.184

The resolution authorities are also entitled to convert into equity

or reduce the principle amount of claims or debts instruments that are already transferred

through the sale of business tool, the asset separation tool or a bridge institution in order to

provide capital for that bridge institution.185

The conditions for resolution that need to be fulfilled before resolution authorities can execute the

bail-in powers are provided under Article 32(1) of the BRR Directive.186

These conditions are distributed

into three clauses as follows:

(a) When it is determined by the competent authorities or the resolution authorities that a bank is

failing or is likely to fail.187

(b) There is no reasonable prospect that any other measures provided in the BRR Directive would

prevent the failure from happening within a reasonable period of time.188

(c) With respect to the public interest, a resolution is necessary.189

5. The Interpretation of Different Situations when a Bank shall be assessed as ‘Failing or Likely to

Fail’

5.1 When to Pull the Trigger?

A consideration should be taken in Article 32 (1) (a) regarding the term ‘failing or is likely to

fail’.190

The discussion with stakeholders on bail-in, which are member states (mostly minister of finance

and central bank), banking industry and legal experts, organized by the Commission in April 2012 is

182

Paul Tucker, ‘Resolution – A Progress Report’ (n 79) 183

The BRR Directive (n 163) Article 42(3), Article 42(5)(b) 184



for Crisis Management in the Financial Sector’ (n 177) 185


The BRR Directive (n 163) para (39) 187

The BRR Directive (n 163) Article 32(1)(a) 188

The BRR Directive (n 163) Article 32(1)(b) 189

The BRR Directive (n 163) Article 32(1)(c) 190

The BRR Directive (n 163) Article 32(1)(a)

33

concluded with the agreement that there should be only one possible trigger point for all resolution

tools.191

Most member states agreed that bail-in should be trigger at the point of non-viability, the same

way as other resolution tools are. The balance between legal certainty and the flexibility provided to

resolution authorities is a crucial aspect that needs to be determined. From the industry’s point of view,

banks’ concern is focused on the issue that providing resolution authorities’ flexibility could lead to the

possibility that the authorities discretionally interpret the point of trigger and, therefore, results in an

inconsistent practice. On the side of legal experts, lawyers opted for flexible and discretional triggers.192

They also made a thoughtful note that ‘requiring objective elements to support that the bank is failing

constrains too much authorities. There is always a subjective element in the assessment made.’193

Although the definitive point of trigger could not be agreed on during the period of discussion in

April 2012, there is a mostly preferred option. The preferred option will leave the assessment to be

decided by the authorities in a form of soft trigger. However, resolution authorities should pull the trigger

for bail-in only under the conditions that a bank is close to failure which means that it is likely to fail or it

has lost the ability to fulfill its authorization conditions and there is no other measure available to restore

its viability and the intervention is, therefore, necessary on the ground of public interest. Furthermore, the

unclear nature of soft triggers may be minimized if the authorities published their code of conduct in crisis

situations in order to give a guideline for relevant market participants.194

5.2 Guidelines on Failing or Likely to Fail for Banks

Article 32 (6) of the BRR Directive mandates the European Banking Authority (EBA) to issue

guidelines by 3 July 2015 regarding the interpretation concerning banking institutions on the term ‘failing

or likely to fail’ in different circumstances.195

The determination that a bank is failing or likely to fail is one of the three stipulations in Article

32(1) to justify whether a bank shall be placed in resolution phase or not.196

A general explanation of

circumstances in which a bank shall be deemed to be failing or likely to fail is provided in Article 32 (4)

of the BRR Directive related to the following aspects:

‘4. For the purposes of point (a) of paragraph 1, an institution shall be deemed to be failing or

likely to fail in one or more of the following circumstances:

191

Commission, ‘Impact Assessment Accompanying the document Proposal for a Directive of the European

Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and

investment firms’ (n 155) 40 192



investment firms’ (n 155) 193






investment firms and amending Council Directives’ (n 155) 39-40 195


The BRR Directive (n 163) Article 32(1); European Banking Authority, ‘Guidelines on the interpretation of the

different circumstances when an institution shall be considered as failing or likely to fail under Article 32(6) of

Directive 2014/59/EU’ (EBA/GL/2015/07 26 May 2015 European Banking Authority 2015)

34

(a) the institution infringes or there are objective elements to support a determination that the institution

will, in the near future, infringe the requirements for continuing authorization in a way that would justify

the withdrawal of the authorization by the competent authority including but not limited to because the

institution has incurred or is likely to incur losses that will deplete all or a significant amount of its own

funds;

(b) the assets of the institution are or there are objective elements to support a determination that the assets

of the institution will, in the near future, be less than its liabilities;

(c) the institution is or there are objective elements to support a determination that the institution will, in

the near future, be unable to pay its debts or other liabilities as they fall due;

(d) extraordinary public financial support is required except when, in order to remedy a serious

disturbance in the economy of a Member State and preserve financial stability, the extraordinary public

financial support takes any of the following forms:

(i) a State guarantee to back liquidity facilities provided by central banks according to the central

banks’ conditions;

(ii) a State guarantee of newly issued liabilities; or

(iii) an injection of own funds or purchase of capital instruments at prices and on terms that do not

confer an advantage upon the institution, where neither the circumstances referred to in point (a),

(b) or (c) of this paragraph nor the circumstances referred to in Article 59(3) are present at the

time the public support is granted.’197

Around one month before the deadline of the given timeframe, on 26 May 2015, the EBA issued the

final report of guidelines on the interpretation of the different circumstances under which an institution is

considered to be failing or likely to fail according to Article 32(6) of the BRR Directive.198

The criteria

outlined by the EBA in Title II of these guidelines for determining that a bank is failing or likely to fail

covers three areas.199

1. The capital position of a bank

This area is provided in Article 32(4)(a) and (b) of the BRR Directive.200

Under this criterion, the

competent authority and the resolution authority as the case may be should base their assessment on

objective elements. These elements include among other things the level and composition of own funds

held by a bank according to the EU required level of own funds,201

the result of an asset quality review

197


These Guidelines should be read in conjunction with other regulatory products developed by the EBA, and in

particular: the EBA regulatory technical standards developed pursuant to Article 81(1) of Directive 2014/59/EU,

specifying, among other things, the procedures, content and conditions related to the notification that an institution is

failing or likely to fail; the EBA guidelines on types of tests, reviews and exercises developed pursuant to Article

32(4)(d) of Directive 2014/59/EU; the EBA guidelines on triggers to apply early intervention measures developed

pursuant to Article 27(5) of Directive 2014/59/EU; the EBA regulatory technical standards on valuation developed

pursuant to Article 36 of Directive 2014/59/EU; the EBA guidelines on the common procedures and methodologies

for the SREP developed pursuant to Article 107 of Directive 2013/36/EU. 199

European Banking Authority, ‘Guidelines on the interpretation of the different circumstances when an institution

shall be considered as failing or likely to fail under Article 32(6) of Directive 2014/59/EU’ (EBA/GL/2015/07

26 May 2015 European Banking Authority 2015) 200


Council Regulation (EU) No 575/2013 of 26 June 2013 on prudential requirements for credit institutions and

investment firms and amending Regulation (EU) No 648/2012 [2013] OJ L 176 Article 92; Council Directive

2013/36/EU of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit

institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and

35

which indicates a significant decrease in asset value, a significant non–temporary increase in the cost of

funding and other market indicators signaling that the bank has insufficient assets to cover its liability.202

2. The liquidity position of a bank

This criteria corresponds with Article 32(4)(a) and (c) of the BRR Directive.203

The evaluation

concerning a bank’s liquidity position should be focused on the non-temporary increase in cost of funding

as well as unhealthy liquidity buffer of the bank and its unfavorable counterbalancing capacity. Other

objective elements including any indication that the bank is experiencing difficulties to fulfil its

obligations in payment, clearing and settlement systems or any developments that trend to severely impair

the bank’s reputation such as significant rating downgrades or the inability to renew funding also have to

be taken into account.204

3. Other requirement for processing authorization

In accordance with Article 32(4)(a) of the BRR Directive,205

this criterion concerned serious

weaknesses in the governance arrangements as well as operational capacity of an institution which

materially impair its reliability and capacity to provide banking services. The bank’s weaknesses in

governance arrangements include many elements. Some of these elements are: serious misstatements in

regulatory reporting or financial statements, the inability to make critical decisions due to a prolonged

deadlock in its managing body as well as material deficiencies - such as inadequate strategic planning and

major reputational depreciation – which can have a serious negative prudential impact on the bank. For

operational capacity, critical objective elements that should be considered in the assessment of whether a

bank is failing or likely to fail include among other things the bank’s inability to honor its obligation

towards its creditors and the constraints on conducting banking activities caused by its inability to make or

receive payments.206

Some further important remarks should be made regarding the justifications of failing or likely to

fail of a bank. The guidelines issued by the EBA are intended to assist the determination of competent

authorities and resolution authorities on objective elements regarding the possibility of failure of a bank.

However, the ultimate decision whether to employ resolution powers to intervene in a bank or not still

remains to the discretion of competent authorities and resolution authorities as the case may be. The

occurrence of a single objective element presented above should not be viewed as an indicator that a bank

is failing or likely to fail and, hence, not result automatically in the application of resolution tools. These

objective elements stated in the guidelines should not be considered as exhaustive criteria and it should

remain this way because it is unlikely, if not impossible, that the authorities will be able to identify all

crisis circumstances in advance. Moreover, the conclusion in an assessment that a bank is failing or likely

to fail does not in itself imply that other conditions to intervene in the bank using resolution powers are

also fulfilled. Resolution authorities and competent authorities still have to refer to other conditions in

Article 32 (1) (b) and (c). This means that besides judging the bank to be failing or likely to fail, there

2006/49/EC [2013] OJ L 176/338 Article 104(1)(a); European Banking Authority, ‘Guidelines on the interpretation

of the different circumstances when an institution shall be considered as failing or likely to fail under Article 32(6) of

Directive 2014/59/EU’ (EBA/GL/2015/07 26 May 2015 European Banking Authority 2015) 13 202


shall be considered as failing or likely to fail under Article 32(6) of Directive 2014/59/EU’ (n 199) 13-14 203

The BRR Directive (n 163) Article 32(4)(a), Article 32(4)(c) 204


shall be considered as failing or likely to fail under Article 32(6) of Directive 2014/59/EU’ (n 199) 15-16 205

The BRR Directive (n 163) Article 32(4)(a) 206


shall be considered as failing or likely to fail under Article 32(6) of Directive 2014/59/EU’ (n 199) 17-18

36

must be no other alternative measures available to remedy the situation within a reasonable time and with

respect to the public interest, the resolution process is necessary.207

6. Power to Exclude Certain Liabilities Subject to Bail-In of the Resolution Authorities

Banks’ liabilities - like covered deposits - are excluded from the scope of the write down or

conversion powers of bail-in tool.208

The current level of deposit guarantee in the EU is covered up to

€100,000 per depositor per bank. This means that the coverage level applies to accumulated amount of all

deposits of the same depositor held at the same bank regardless of the bank’s different operation brand

names. However, deposits of the same depositor held in different banks will all benefit from separate

guarantees.209

This implies that deposits that exceed the covered level may be subject to bail-in.210

However, article 44(3)(c) of the BRR Directive empowers resolution authorities in exceptional

circumstances to exclude or partially exclude eligible deposits from the application of the write-down or

conversion powers of the bail-in tool, providing that the exclusion is ‘strictly necessary and proportionate

to avoid giving rise to widespread contagion’.211

The power to exclude certain liabilities of the resolution

authorities also extends to those liabilities that might cause depreciation in value and result in higher

losses to be borne by other creditors.212

In addition to this, resolution authorities could also exercise the

exclusion power in order to preserve the continuity of critical functions and core business lines of the

failing bank, allowing it to continue key operations, services and transactions.213

Losses that have not been absorbed due to the exclusion of eligible liabilities described above

might receive a contribution from the resolution financing arrangement to cover the residual amount of

loss.214

However, the resolution financing arrangement may make a contribution in these circumstances

only after the shareholders and the holders of bail-inable instruments of the distressed bank under

resolution have contributed to loss absorption and recapitalization equal to an amount not less than 8 per

cent of the bank’s total liabilities.215

Moreover, the BRR Directive additionally limits the contribution of

the resolution financing arrangement to 5 per cent of the total liabilities.216

7. National Pre-Funded Resolution Fund According to the BRR Dirctive

In order to ensure the effective application of resolution tools and to make a contribution to the

failing bank under resolution in the case when its certain creditors are excluded from bail-in powers217

, the

BRR Directive mandates member states to establish financing arrangements. The directive sets the target

level of these arrangements to reach at least 1% of the amount of covered deposits of all banks operating

within the territorial of member states by 31 December 2024.218

The covered deposits at the end of 2012 in

207


shall be considered as failing or likely to fail under Article 32(6) of Directive 2014/59/EU’ (n 199) 3-7, 10-12 208

The BRR Directive (n 163) Article 44 (2) 209

European Commission, ‘Deposit Guarantee Schemes – Frequently Asked Questions’ (Memo, Brussels 15 April

2014) <http://europa.eu/rapid/press-release_MEMO-14-296_en.htm?locale=en> accessed 18 October 2014 210

The BRR Directive (n 163) Article 44 (2), Article 44 (3) (c) 211

The BRR Directive (n 163) Article 44 (3) (c) 212

The BRR Directive (n 163) Article 44 (3) (d) 213

The BRR Directive (n 163) Article 44 (3) (b) 214

The BRR Directive (n 163) Article 44 (4) (a) 215

The BRR Directive (n 163) Article 44 (5) (a) 216

The BRR Directive (n 163) Article 44 (5) (b) 217

The BRR Directive (n 163) Article 101 (1), Article 101 (1) (f) 218

The BRR Directive (n 163) Article 102 (1)

37

the EU, according to the data provided by the member states, aggregated to the amount of nearly €7,000

billion.219

The financing of these funds shall be contributed ex ante from the banks authorized in member

states at least annually.220

The pro rata to the amount of the banks’ liabilities adjusted in accordance with

the proportion to the risk profile of each bank will be used to calculate the actual amount that each bank

will has to contribute.221

The establishment of national resolution funds under the EU’s BRR Directive, aims to put an end

to the old bank bailouts’ paradigm which exposes taxpayers to hundreds of billions of euros to save failing

banks during crisis by requiring banks themselves to pay for the contributions of the funds.222

However,

there will be some changes under the framework of the banking union.223

The creation of a banking union is agreed on by the member states in June 2012. The banking

Union will promote centralized application of EU-wide rules for those banks within the euro area. The

banking union will make breaking the link between banks and sovereigns become possible. Distressed

banks should be resolved without recourse to taxpayers’ money and banks should be no longer ‘European

in life but national in death’224

because they will be supervised and managed by one single European

mechanism.225

In the banking union, these national resolution funds set up under the BRR Directive which came

into force on 15 January 2015,226

will be replaced by the single resolution fund.227

The single resolution

fund is set up under the SRM Regulation. The transfers of national banks’ contributions to the single

resolution fund228

began on 1 January 2016.229

This means that the national resolution funds will be

gradually pooled together to form a single resolution fund.230

On 21 May 2014, 26 EU’s member states have signed an inter-governmental agreement on the

transfer and mutualisation of contributions to the single resolution fund. Even though the UK and Sweden

219

European Commission, ‘Delegated Act on Ex-Ante Contributions to the Resolution Financing Arrangements

under the Bank Recovery and Resolution Directive (BRRD): Frequently Asked Questions’ (Memo, Brussels 21

October 2014) <http://europa.eu/rapid/press-release_MEMO-14-597_en.htm> accessed 23 October 2014 220



European Commission, ‘Finalising the Banking Union: European Parliament Backs Commission’s Proposals

(Single Resolution Mechanism, Bank Recovery and Resolution Directive, and Deposit Guarantee Schemes

Directive)’ (Statement, Brussels 15 April 2014) <http://europa.eu/rapid/press-release_STATEMENT-14-

119_en.htm> accessed 19 October 2014 223

European Commission, ‘Commission Adopts Detailed Rules on Contributions of Banks to Resolution Funds’

(Press Release, Brussels 21 October 2014) <http://europa.eu/rapid/press-release_IP-14-1181_en.htm> accessed 23

October 2014 224

European Commission, ‘Banking Union: Restoring Financial Stability in the Eurozone’ (Memo, Brussels 15 April

2014) <http://europa.eu/rapid/press-release_MEMO-14-294_en.htm> accessed 19 October 2014 225

European Commission, ‘Banking Union: Restoring Financial Stability in the Eurozone’ (n 224) 226


The SRM Regulation (n 164) Article 96 228

The SRM Regulation (n 164) Article 67 (1) 229

European Commission, ‘Commissioner Barnier Welcomes the Signature of the Intergovernmental Agreement

(IGA) on the Single Resolution Fund’ (Statement, Brussels 21 May 2014) < http://europa.eu/rapid/press-release_

STATEMENT-14-165_en.htm> accessed 19 October 2014 230


(n 223)

http://europa.eu/rapid/press-release_MEMO-14-597_en.htm

http://europa.eu/rapid/press-release_IP-14-1181_en.htm

http://europa.eu/rapid/press-release_MEMO-14-294_en.htm

http://europa.eu/rapid/press-release_%20STATEMENT-14-165_en.htm

http://europa.eu/rapid/press-release_%20STATEMENT-14-165_en.htm

38

have decided not to sign the inter-governmental agreement at this stage, they can opt to participate any

time in the future.231

8. The Single Resolution Fund

During the last financial crisis, one of the biggest problems faced by many member states of the

EU is the perilous circle called sovereign feedback loop. This dangerous feedback circle occurs from the

fact that European banks hold a large amount of European sovereign bonds without setting aside

regulatory capital to absorb potential losses since the bonds were considered as risk-free assets before the

eurozone crisis.232

In the time of volatility in sovereign debt markets, banks owning large quantity of

sovereign bonds are severely affected and governments’ solvency are threatened by theirs local banks

sequentially. The percentage of sovereigns – banks’ holdings nexus has increased over the two years since

October 2011. Spanish banks expanded government bond holdings as a proportion of their total assets

from 5 to 9.4 per cent. Italian banks increased their sovereign holdings from 6.4 to 10.3 per cent. In

Portugal the number rose from 4.6 to 7.8 per cent and in Slovenia from 7.8 to 10 per cent. The similar

pattern also happened with banks in Germany, France and Austria.233

In the preamble of the SRM Regulation, paragraph 19 explains the reasoning behind establishing a

single resolution fund as follows:

If the funding of resolution were to remain national in the longer term, the link between

sovereigns and the banking sector would not be fully broken, and investors would continue to establish

borrowing conditions according to the place of establishment of the banks rather than to their

creditworthiness. The Fund should help to ensure a uniform administrative practice in the financing of

resolution and to avoid the creation of obstacles for the exercise of fundamental freedoms or the distortion

of competition in the internal market due to divergent national practices.234

8.1 Financing of the Single Resolution Fund

The single resolution fund started on 1 January 2016 and it set the target level of the fund to reach

at least 1% of the amount of covered deposits of all banks authorized in the participating member states,235

which include 6,000 banks operating in the euro area.236

This is the same target level set for national

resolution funds in the BRR Directive.237

According to the European Commission, the target level of the

single resolution fund in number is €55 billion within the period of 8 years starting from its initial date.238

The administrator of this single resolution fund is the Single Resolution Board.239

231

European Commission, ‘Commissioner Barnier Welcomes the Signature of the Intergovernmental Agreement

(IGA) on the Single Resolution Fund’ (n 229) 232

Commission, ‘Facts and figures on State aid in the EU Member States - 2012 Update – Accompanying the

document State aid Scoreboard 2012 Update Report on State aid granted by the EU Member States’ (n 157) 28 233

Christopher Thompson, ‘Europe Banks Overexposed to Domestic Debt’ Financial Times (London, 23 December

2013) <http://www.ft.com/intl/cms/s/0/8290470c-6b17-11e3-8e33-00144feabdc0.html#axzz3JSCWpJQX>


The SRM Regulation (n 164) para 19 235

The SRM Regulation (n 164)Article 69 (1) 236

European Commission, ‘Banking Union: Restoring Financial Stability in the Eurozone’ (n 224) 237


(n 223); See also Chapter 3 section 7 238

European Commission, ‘Finalising the Banking Union: European Parliament Backs Commission’s Proposals

(Single Resolution Mechanism, Bank Recovery and Resolution Directive, and Deposit Guarantee Schemes

Directive)’ (n 222) 239

The SRM Regulation (n 164)Article 67 (3); European Commission, ‘Finalising the Banking Union: European

Parliament Backs Commission’s Proposals (Single Resolution Mechanism, Bank Recovery and Resolution Directive,

and Deposit Guarantee Schemes Directive)’ (n 222)

39

The financing of the single resolution fund will be ex ante contributions that should be raised at

least annually240

by the national resolution authorities.241

The calculation for the annual contributions for

each bank will be based on its pro rata amount of liabilities242

and its risk profile.243

The notion of

adjusting contributions in proportion to the risk profile of banks will comply with the delegated acts

adopted by the Commission under Article 103(7) of the BRR Directive.244

The Commission adopted a delegated act to calculate the contributions of banks to the national

resolution funds under the BRR Directive on 21 October 2014.245

The annual contributions, which reflect

the size of each bank, will be determined by the liabilities that a bank has. This is referred to as a basic

annual contribution. The annual contribution will then be adjusted in proportion to the risk profile of that

bank (additional risk adjustment) to reflect the risk level related to relevant activities of that bank.246

This

annual contribution implies with ‘the riskier a bank, the higher its contribution’ principle.247

There are four pillars for resolution authorities to assess the risk profile of a bank. Each pillar

contains different risk weight and various indicators as follows:248

(a) The ‘Risk exposure’ pillar has 50% risk weight. The indicators for this pillar constitutes of

own funds and eligible liabilities held by the bank in excess of the minimum requirement for own funds

and eligible liabilities 25%, leverage ratio: 25%, common equity tier 1 capital ratio: 25% and total risk

exposure divided by Total Assets: 25%.249

(b) The ‘Stability and variety of sources of funding’ pillar has 20% risk weight and each risk

indicator in this pillar has equal weight.250

(c) The ‘Importance of an institution to the stability of the financial system or economy’ pillar has

10% risk weight.251

240



The SRM Regulation (n 164)Article 70 (2) (a) 243

The SRM Regulation (n 164)Article 70 (2) (b) 244



(n 223) 246

Commission Delegated Regulation (EU) 2015/63 of 21 October 2014supplementing Directive

2014/59/EU of the European Parliament and of the Council with regard to ex ante contributions to

resolution financing arrangements [2015] OJ L11/44 para 5 247


under the Bank Recovery and Resolution Directive (BRRD): Frequently Asked Questions’ (n 219) 248

Commission Delegated Regulation (EU) 2015/63 of 21 October 2014 supplementing Directive


resolution financing arrangements (n 246) Article 7 249



resolution financing arrangements (n 246) Article 7(1)(a), Article 7(2) 250



resolution financing arrangements (n 246) Article 7(1)(b), Article 7(3) 251



resolution financing arrangements (n 246) Article 7(1)(c)

40

(d) The ‘Additional risk indicators to be determined by the resolution authority’ pillar has 20%

risk weight.252

The indicators in this pillar are trading activities and off-balance sheet exposures,

derivatives, complexity and resolvability: 45%, membership in an Institutional Protection Scheme: 45%;

and extent of previous extraordinary public financial support: 10%.253

Under the delegated act, the pillars and indicators will assist resolution authorities to be able to

calculate the precise amount that an individual bank has to contribute each year to its respective resolution

fund. In theory, as soon as the predetermined target of €55 billion is achieved, banks will then have to

contribute more only if the resources of the fund are exhausted.254

9. Member States Financing the Single Resolution Fund in Numbers

The estimation regarding how much banks in each member states would have to pay for the single

resolution fund calculated by the Financial Times suggests that France’s big banks would be the biggest

contributors to the fund. The Financial Times estimates that banks from France would have to contribute

around €17 billion over the period of 8 years set by the fund to reach its €55 billion target. The €17 billion

paid by France’s banks should represent around 30 per cent of the single resolution fund. The single

calculation approach might favor hundreds of small and medium sized banks in countries like Germany

and Spain. This is because the calculation adjustments could result in France sector including BNP

Paribas and Société Générale (both banks are listed as G-SIBs by the FSB as of 6 November 2014255

),

paying 70 per cent more than required under the EU regime for national resolution funds. German banks

would pay 9 per cent less with the single resolution fund regime and the contributions by Spanish banks

would be reduced to almost half of the previous amount. The Financial Times further estimates that

German banks would have to pay roughly €15 billion or about 27 per cent.256

This implies that around 90 per cent of the €55 billion target of the single resolution fund will be

received from large banks operating within the eurozone.257

Small banks, which have total asset worth less

than €1 billion and deposits equal to or less than €300 million,258

would have to contribute only 0.3 per

cent of the total amount of the single resolution fund even though they are liable to 1 per cent of the euro

area banking assets.259

Medium sized banks, which represent 14 per cent of assets, would have to pay 9.7

per cent to the fund.260

The European Commission considers this calculation approach to be proportionate

252

Commission Delegated Regulation (EU) 2015/63 of 21 October 2014 supplementing Directive 2014/59/EU of

the European Parliament and of the Council with regard to ex ante contributions to resolution financing

arrangements (n 246) Article 7(1)(d) 253



resolution financing arrangements (n 246) Article 7(4) 254



Financial Stability Board, ‘2014 Update of List of Global Systemically Important Banks (G-SIBs)’ (n 89) 256

Peter Spiegel and Alex Barker, ‘EU Leans on Big Banks to Finance Bailout Fund’ Financial Times (London, 21

October 2014) < http://www.ft.com/intl/cms/s/0/abc93c04-591f-11e4-a722-00144feab7de.html#axzz3JpgUwS8N>


Peter Spiegel and Alex Barker, ‘EU Leans on Big Banks to Finance Bailout Fund’ (n 256) 258



resolution financing arrangements (n 246) Article 10(6) 259

Peter Spiegel and Alex Barker, ‘EU Leans on Big Banks to Finance Bailout Fund’ Financial Times (London, 21

October 2014) <http://www.ft.com/intl/cms/s/0/abc93c04-591f-11e4-a722-00144feab7de.html#axzz4ALd6SqXt>

accessed 24 October 2014; European Commission, ‘Commission Adopts Detailed Rules on Contributions of Banks

to Resolution Funds’ (Press Release, Brussels 21 October 2014) <http://europa.eu/rapid/press-release_IP-14-

1181_en.htm> accessed 23 October 2014 260

Peter Spiegel and Alex Barker, ‘EU Leans on Big Banks to Finance Bailout Fund’ (n 256)

http://markets.ft.com/tearsheets/performance.asp?s=fr:BNP

http://markets.ft.com/tearsheets/performance.asp?s=fr:BNP

http://markets.ft.com/tearsheets/performance.asp?s=fr:GLE



41

and non-discriminatory261

arguing that large banks are more likely than small banks to seek resolution

funding.262

261




(n 223)

42

Chapter 4

1. How to Improve the Effectiveness of Bail-Ins

Two important things that resolution authorities in each jurisdiction need to do are to remove any

obstacles that could arise when bail-in powers are implemented in cross-border situations and to ensure

that banks operating in their territory hold adequate amount of loss absorbing instruments to absorb losses

in resolution and to avoid public funds being used to bail out distressed banks in the time of crisis.263

1.1 Contractual Approach to Promote Cross-Border Recognition by Including Debt Instruments of

Clauses into Financial Contracts

Cross-border recognition is essential to improve the proper functioning of bail-in powers when

bail-inable instruments that subject to resolution are governed by the laws of jurisdiction that are not the

same jurisdiction when the instruments are issued.264

Contractual recognition clauses could help promoting the cross-border enforceability of bail-in

and minimizing the risk that the exercise of statutory bail-in powers - such as write-down or convert into

equity by resolution authorities - would not be recognized in other jurisdictions.265

The FSB recommended each jurisdiction to include 5 key principles for recognition clauses in

bail-inable instruments to enhance the implementation of statutory bail-in powers in a cross-border

situation. These 5 key principle clauses are:

1. To contain a clear contractual provision that the holders of bail-inable instruments are agreed to be

bound by the terms of bail-in under the relevant resolution framework. The provision should also

include that other terms and conditions governing the bail-inable instruments may be overridden

to allow the validation of statutory bail-in powers. The purpose of these provisions is to attach the

enforceability and effectiveness of bail-in powers with a matter of contract law, rather than to rely

on extra-territorial consequence under the conflict of law rules. The FSB anticipated that national

courts would allow these contractual provisions to be enforced properly as long as they do not

contradict the public policy of that jurisdiction.266

2. To disclose the consequences of the potential effect under statutory bail-in to the debt instrument

holders in accordance with disclosure requirements that are applicable under the relevant

jurisdictions. The clarity of disclosure in manners that conform with applicable rules is crucial to

mitigate the likelihood of successful claims by debt holders who allege that they had been misled

when purchasing the bail-in able instruments. The case of investors being misled to purchase such

bonds as discussed in the second chapter may provide a better understanding of this key

263

Financial Stability Board, ‘Progress and Next Steps Towards Ending “Too-Big-To-Fail” (TBTF) – Report of the

Financial Stability Board to the G-20’ September 2013 (Banks for International Settlements, Basel September 2013) 264

Financial Stability Board, ‘Cross-border Recognition of Resolution Action – Consultative Document’ (n 151) 265

Financial Stability Board, ‘Cross-border Recognition of Resolution Action – Consultative Document’ (n 151) 266

Financial Stability Board, ‘Cross-border Recognition of Resolution Action – Consultative Document’ (n 151) 13-

14

43

principle.267

It is the FSB concerns that liabilities or other compensation arising from this kind of

litigation would impede the effectiveness of bail-in to recapitalize the bank.268

3. Recognition provisions should be drafted in contracts as general terms in order to ensure that they

will not contradict with the statutory bail-in regime. This implies that the contractual provisions

should give a clear demonstration that the terms of bail-in will ultimately be determined by the

resolution authorities and not by any conversion specified in the documentation of the bail-inable

instruments. The terms in the financial contracts should clearly establish and explain that the

mechanisms for conversion or write-down contained in the contract might be exercise separately

and differently from the statutory bail-in powers employed by the home resolution authorities.269

4. It might be necessary for banks to include specific consents or waivers of legal provisions

provided under the law of foreign jurisdiction that prevent amendments to bail-inable

documentation without receiving the consent of instrument holders.270

5. Relevant authorities should require banks to demonstrate that any statutory bail-in of debt

instruments governed under foreign laws would be enforceable in practice. This demonstration

can be done in form of an independent legal opinion. The legal opinion should provide a

confirmation rather than hypothetical opinion of the enforceability of the contractual provisions of

such bail-inable instruments under the specific governing law of foreign jurisdiction. If the legal

opinion includes limitations on enforceability of statutory bail-in powers, the legal advisor should

also provide further evaluation concerning the likelihood of its impact on any bail-in action.271

Within the EU, the Directive 2001/24/EC already provide the mutual recognition and enforcement in

all member states concerning the decisions to reorganize or wind up institutions having branches in

member states other than those in which they have their headquarters.272

The BRR Directive also requires some of these key principles recommended by the FSB to be

included in the terms of the contract governing bail-inable liabilities that banks issued in order to ensure

the effective implementation of bail-in powers when the law of a third-country is involved.273

One year after the publishing of a consultative document, the final text of the Principles for Cross-

border of Effectiveness of Resolution Actions was published by the FSB in the end of 2015.274

267


Financial Stability Board, ‘Cross-border Recognition of Resolution Action – Consultative Document’ (n 151) 14 269


Financial Stability Board, ‘Cross-border Recognition of Resolution Action – Consultative Document’ (n 151) 14-

15 271


Council Directive 2001/24/EC of 4 April 2001 on the reorganization and winding up of credit institutions [2001]

OJ L 125/15 273

The BRR Directive (n 163) Article 45 (5), Article 55 274

Financial Stability Board, ‘Principles for Cross-border Effectiveness of Resolution Actions’ (Banks for

International Settlements, Basel November 2015)

44

1.2 Sufficient Loss Absorbing Capacity of G-SIBs in Resolution

In September 2013, the FSB first introduced a proposal on the adequacy of loss absorbing capacity

for G-SIBs. It stressed that G-SIBs need to have sufficient resources to absorb losses in resolution in order

to avoid assistance from public funds through bailouts.275

Loss absorbing capacity is also important for

home and host authorities as well as for markets to trust that systemically important banks, which have

long been labeled as too-big-to-fail, can be resolved without the assistance of public funds. Moreover, it is

an essential requirement to preserve the continuity of critical functions of banks when they are being

restructured under the resolution regime.276

The FSB has set a new requirement for minimum total loss-absorbing capacity of G-SIBs to be

consisting of both a going concern and gone concern basis. The objective of the FSB is to create a

framework that is consistent with the Basel framework for capital requirement and to constitute

appropriate incentives for banks to structure themselves with good capital. This means that those

instruments that satisfy minimum regulatory capital requirements would also satisfy the common

minimum Pillar 1 total loss-absorbing capacity requirement set out by the FSB. The minimum Pillar 1 loss

absorbing capacity is planned to improve overall financial stability by ensuring that each G-SIB has an

adequate amount of loss absorbing capacity and can be resolved, if necessary, by resolution authorities in

an orderly manner without the support from taxpayers.277

Some specific criteria that financial instruments issued by G-SIBs must fulfill to be recognized as

having a total loss-absorbing capacity are the following: 278

1. Instruments such as credible ex ante commitments to recapitalize a G-SIB in resolution and

temporary resolution funding may be counted as bank’s Pillar 1 minimum loss absorbing

capacity. It should be noted that such commitments must be pre-funded by industry contributions

and they should facilitate an orderly resolution especially in providing the possibility to preserve

the continuity of the bank’s critical functions.

2. The eligible total loss-absorbing capacity must be unsecured.

3. Those liabilities are to be counted as loss absorbing capacity under the Pillar 1 must have

minimum remaining maturity of at least one year.

4. Some liabilities such as insured deposits, derivatives, liabilities that do not arise from contract e.g.

tax liabilities, liabilities that have preference over general senior unsecured creditors and

liabilities that are inappropriate to write down or convert into equity should not be included in

eligible total loss-absorbing capacity.

5. The eligible liabilities for the Pillar 1 should contain contractual trigger279

or be subject to a

statutory regime that permits resolution authorities to impose losses or convert them into equity

under resolution framework.

275

Financial Stability Board, ‘Progress and Next Step Towards Ending “Too-Big-To-Fail” (TBTF): Report of the

Financial Stability Board to the G-20’ (n 21) 5 276


Resolution – Consultative Document’ (n 30) 277


Resolution – Consultative Document’ (n 30) 6 278


Resolution – Consultative Document’ (n 30) 15-18

45

Apart from requiring G-SIBs to hold adequate total loss-absorbing capacity, it is as important to

disincentivize them not to hold loss absorbing liabilities issued by other G-SIBs in order to reduce the

contagion effect that could spread from one G-SIB to other systemically important banks.280

This proposal

is consistent with the previous publication of the FSB in July 2013, which suggests that loss absorbing

capacity should be held ‘in the right hands’.281

This means that loss absorbing capacity should not be

concentrated within other financial firms, insurance companies or pension funds to such an extent that the

attempt to resolve a bank by writing down their equity or liabilities could generate subsequent negative

impact on these holders and, therefore, create instability in the financial system.282

The draft for Pillar 1 total loss-absorbing capacity by the FSB is placed within the range of 16-20 per

cent of risk weight assets.283

However, the Financial Times reported that this percentage could be as high

as 25 per cent by the time the final requirement for extra capital buffers are in place.284

The EU has already established its own rules for a minimum loss absorbing capacity to promote the

effectiveness of statutory bail-in powers under the BRR Directive. However, the EU’s directive does not

use per cent of risk weight assets as in the FSB’s proposal to calculate this minimum amount. Instead, it

uses a percentage of the total liabilities and own funds of the bank for the calculation purpose.285

One of the criticisms of the total loss-absorbing capacity is that it would be difficult for lenders to

figure out how these criteria set out by the FSB should function in practice since there are some unsettled

aspects about them that still remain unclear. Another criticism refers to the involvement of relevant

countries. There is a complaint that these rules have been created within the US without the involvement

of the EU, although banks within the EU will later on be subject under these new standards.286

The interesting thing about this 16-20 per cent of Pillar 1 total loss-absorbing capacity is that it is

comparable to suggestions by Anat Admati and Martin Hellwig in their book called the Bankers’ New

Clothes (2013) that requires banks to hold equity of at least 20-30 per cent of their total assets, which is a

lot higher than the proposal in the Basel requirement.287

However Anat Admati and Martin Hellwig strongly believe that only equity would be able to make

the financial system safer and more stable and public support through bailouts will not be needed if banks

hold much higher equity.288

They criticized that regulators should not rely on some type of liabilities or

instruments which allow banks to not make payments if they incur losses as equity. They demonstrated

that these kinds of instruments were bailed out by the government along with depositors and other

279





Guidance on Developing Effective Resolution Strategies’ (n 29) 14 282


Guidance on Developing Effective Resolution Strategies’ (n 29) 14; See also Chapter 2 section 7.2 283

Financial Stability Board, Adequacy of Loss-Absorbing Capacity of Globally Systemically Important Banks in


Sam Fleming and others, ‘Banks Brace for New Regulatory Hurdle’ Financial Times (London, 7 November 2014)

<http://www.ft.com/intl/cms/s/0/42156e0a-64ea-11e4-ab2d-00144feabdc0.html> accessed 9 November 2014 285

The BRR Directive (n 163) para 79, Article 45 (1); Sam Fleming and others, ‘Banks Brace for New Regulatory

Hurdle’ Financial Times (London, 7 November 2014) <http://www.ft.com/intl/cms/s/0/42156e0a-64ea-11e4-ab2d-

00144feabdc0.html> accessed 9 November 2014 286

Sam Fleming and others, ‘Banks Brace for New Regulatory Hurdle’ (n 284) 287

Anat Admati and Martin Hellwig, The Bankers’ New Clothes – What’s Wrong with Banking and What to do

about It (Princeton University Press 2013) 178-79 288


about It (n 287) 179

46

creditors during the 2007-2009 financial crises in order to avoid another disorderly bank insolvency. They

also criticized that the conversion of such liabilities could be too complicated to be effective and it might

benefit some investors as well as putting others at risk. Their hypothesis is that bank’s managers might

undertake some actions to manipulate the point of trigger of these convertible instruments. Consequently,

such actions would create panic in the markets for these financial instruments. Therefore, Anat Admati

and Martin Hellwig ultimately concluded that regulators should only rely on equity to absorb losses in a

financial crisis.289

289


about It (n 287) 187-88

47

Conclusions As far as this research conducted, bail-in regime seems to be a move in the right direction. Bailing

out large and complex banks risks the continuation of moral hazard and the too-big-to-fail problem during

future crises.290

If shareholders and creditors have the wrong belief that they will be shielded from losses

in mind, they will not be incentivized to monitor the bank’s risk taking activities291

and market discipline

will not be able to work effectively in these circumstances.292

Arranging public funding to save banks

from their failures is also unfair for taxpayers, since they do not have the competence to monitor the risk-

taking behavior of banks.293

Most importantly, creditors and shareholders should not be rewarded from

their imprudent decisions on lending.294

The new regulatory and resolution regime should focus on allocating burden to bear losses to

banks’ stakeholders namely shareholders and creditors and protect taxpayers from the exposures.295

The

statutory bail-in regime should make this become possible without causing disruption to the financial

markets296

and allow a failing bank under resolution phase to continue performing its services to the

customers and honor its counterparty obligations as a going concern entity.297

However, one of the most important points that is not frequently mentioned in many researches is

that bail-ins also have some drawbacks. Regulators and resolution authorities should bear in mind that

bail-in regime is not a panacea.298

Several aspects regarding the when and how bail-in should be

implemented still remain unclear.

Paul Tucker, Deputy Governor for Financial Stability at the Bank of England, had said in 2012

regarding the trigger for resolution that, ‘the best way of thinking about it is that a firm should go into

resolution when its time is up – when Recovery strategies are exhausted, and the firm just will not be able

to reverse its decline into insolvency or lack of viability.’299

As presented in Chapter 3, there are some disagreements between the EU’s member states,

banking industry and legal experts about the point of trigger of bail-in powers.300

To strike the balance

between providing resolution authorities subjective element when making the assessment301

and to avoid

the issues of legal uncertainty302

is the next decisive step for regulators, resolution authorities and

competent authorities to undertake to decide the effectiveness of bail-in tool. This decision is undoubtedly

very hard to conclude, since it is unlikely, if not impossible, to address in advance the precise conditions

290

Eva Hüpkes, ‘Allocating Costs of Failure Resolution – Shaping Incentives and Reducing Moral Hazard’ in Rosa

M Lastra (ed), Cross-Border Bank Insolvency (Oxford University Press 2011) 104 291

Eva Hüpkes, ‘Allocating Costs of Failure Resolution – Shaping Incentives and Reducing Moral Hazard’ (n 290)

105 292


(n 96) 293

Benoît Cœuré, ‘The implications of bail-in rules for bank activity and stability’ (n 105) 294

Barry Eichengreen, ‘Bailing In the Private Sector: Burden Sharing in International Financial Crisis Management’

(n 12) 57-59 295

Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ (n 6) 3 296

Financial Stability Board, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ (n 6) 34 297

International Monetary Fund and the World Bank, ‘An Overview of the Legal, Institutional, and Regulatory

Framework for Bank Insolvency’ (n 54) 15, 35 298

James McAndrews and others, ‘What Makes Large Bank Failures So Messy and What to Do About It?’ (2014) 20

Federal Reserve Bank of New York Economic Policy Review 1, 13 299

Paul Tucker, ‘Resolution – A Progress Report’ (n 79) 300





Charles Randell, ‘Triggers For Bank Resolution’ (n 43)

48

and circumstances in which bail-in powers should be implemented.303

The final report of the guidelines

published by the EBA under Article 32(6) of the BRR Directive304

should be helpful for relevant

stakeholders to predict the way bail-ins should function. However, these EBA guidelines also clearly state

that competent authorities and resolution authorities have the ultimate decision, when to pull the bail-in

trigger.305

This implies that the uncertainty of bail-in regime will not be easily settled in the near future.

Another issue worth mentioning is that bail-in tool is only part of resolution mechanism. There are

other tools that can be used to solve a financial crisis as well. Relevant authorities should not feel obliged

to use bail-in powers to handle with bank failures. It is also not an objective of the FSB or the Key

Attributes to give bail-in a special status. A publication from the FSB responding to member countries

clearly explained that bail-in should be ‘one resolution option among others, available to resolution

authorities for use where it most appropriate in the particular circumstances, and would generally be

exercised in conjunction with other resolution measures.’306

According to these reasons, resolution

authorities should not commit themselves to implement any particular preferred resolution tool, including

bail-in, to resolve a failing bank. Making such commitment could limit the flexibility that is essential for

resolution authorities to act when a crisis occurs.307

There might be cases where public subsidy is necessary to stabilize the markets,308

relevant

authorities should always evaluate the likelihood of systemic risk that bail-in could create, moral hazard

and the benefits of public interest as a whole before deciding whether there should be a bailout or a bail-

in. Bail-in as well as other resolution tools should only be executed in a circumstance where it is most

likely to maintain financial stability in the market and economic situations at the point of failure of the

bank.309

Since it is nearly impossible to design a perfect tool to battle crises and different jurisdiction has

different economic concern,310

it is obviously not a bad thing to also be prepared with other mechanism.

One of the mechanisms mentioned in this paper is to require banks to hold higher equity. Anat Admati and

Martin Hellwig suggested that banks should hold at least 20-30 per cent equity of their total assets. This

should make banks become more stable and less vulnerable in the financial crisis.311

As discussed in Chapter 4 section 1.2 concerning sufficient loss absorbing capacity of G-SIBs, the

FSB purposes that major banks should at all-time hold Pillar 1 total loss-absorbing capacity between 16-

20 per cent of their risk weight assets. The total loss-absorbing capacity should ensure that these banks are

303

Eva Hüpkes, ‘Special Bank Resolution and Shareholders’ Rights: Balancing Competing Interests’ (n 121) 281 304



shall be considered as failing or likely to fail under Article 32(6) of Directive 2014/59/EU’ (n 199) 306

Financial Stability Board, ‘Effective Resolution of Systemic Important Financial Institutions: Overview of

Responses to the Public Consultation’ (n 22) 3 307




Institutions Recommendations and Timelines’ (n 4) 6-7 309



Commission, ‘Consultation on a Possible Recovery and Resolution Framework For Financial Institutions Other

Than Banks’ (working document of the Commission services for consultation) (n 44) 311


about It (n 287) 178-79

49

no longer too-big-to-fail and if they have to be resolved, the resolution action can take place in an orderly

manner.312

When connecting the proposals of Anat Admati and Martin Hellwig and and the FSB together,

one should be able to conclude that both equity and bail-inable instruments are equally important for

banks and also for the stability of the financial system. Equipping resolution authorities with appropriate

resolution tools such as bail-in is inadequate, if the failing bank does not have enough equity to be written

down and insufficient bail-inable debts to be converted into equity. If bail-in should help recapitalize the

bank to a balance sheet solvency stage, it may also be necessary to require banks to hold higher equity as

suggested by Anat Admati and Martin Hellwig to increase the robustness of the banks and prolong its time

of viability simultaneously. Moreover, it should be clear for every party involved that bail-inable

instruments, which the FSB will require major banks to issue in the coming future, should be considered

as a supplement - not a substitute - for bank regulatory equity requirements or macro prudential

regulations.313

312



James McAndrews and others, ‘What Makes Large Bank Failures So Messy and What to Do About It?’ (n 298)

14