During the financial crisis, failing credit institutions and investment firms presented a major problem. There were no adequate tools to deal effectively with the insolvency of an institution and there was no system in place to ensure that the customers of a failing bank would continue to have access to essential banking services. Many institutions had to be ‘bailed out’ using taxpayer’s money.
As a result, the EU regulatory structure was strengthened with the introduction of the European System of Financial Supervision (see our report here) and three major, and complementary, EU legislative packages were adopted: the BRRD, the recast Deposit Guarantee Scheme Directive (Directive 2014/49/EU) (DGSD II) and the Capital Requirements Directive (2013/36/EU) (CRD IV)/Capital Requirements Regulation (575/2013) (CRR).
Whilst the CRD/CRR strengthens the prudential requirements for, and the supervision of, banks and investment firms, the BRRD introduces systems to deal with an institution’s failure, and the DGSD II provides for better protection of depositors at failing banks (see our report on the new DGSD II here) and contributes to funding the resolution process under the BRRD.
For the Eurozone, the BRRD is an important step towards the “Banking Union” which involves the common or single application of EU requirements for Eurozone banks –
- The Single Supervisory Mechanism (SSM) under which the ECB becomes the supervisor of all 6,000 Eurozone banks. As a first step in this process, the ECB will (from November 2014) directly supervise the largest 130 (approx.) banks. It has conducted a ‘comprehensive assessment’ of their financial health, including an Asset Quality Review (AQR) and stress test. The results of this exercise were announced on 26 October.
For further information on the SSM see our article here.
- In addition to the development of Eurozone arrangements for deposit guarantee under DGSD II, a 'Single Resolution Mechanism' introduced under Regulation 806/2014 (see our report here) will apply the provisions of BRRD across the Eurozone.
In the UK, the Banking Act 2009 introduced the Special Resolution Regime (SRR) to deal with failing financial institutions. The Banking Act was subsequently amended by the Financial Services (Banking Reform) Act 2013 which included provisions which will deal with ring-fencing and bail in stabilisation powers - see below and our reports here and here.
Scope of the BRRD
The BRRD applies to all credit institutions and to, so called, ‘£730k investment firms’ as defined in CRR, as well as EU branches/subsidiaries of non-EU credit institutions and investment firms. The directive also applies to financial holding companies, mixed financial holding companies, mixed activity holding companies, and parent financial holding companies and their subsidiaries.
The directive makes provision for recovery and resolution proceedings as well as for early intervention. Each member state is required to designate a resolution authority which will have a number of important powers throughout resolution, including the power to write down and convert capital instruments. The competent authority of each member state is also given more powers and responsibilities including the ability to replace the management of a company as part of early intervention measures.
Delegated legislation will determine in detail how the provisions of the BRRD will take shape. The European Banking Authority (EBA) is required to publish a number of guidelines, regulatory technical standards and implementing technical standards by 3 July 2015. Some of these have already been produced and for others consultations have been published.
Recovery and resolution planning
The BRRD requires that each institution has a recovery plan and a resolution plan. The recovery plan is to outline recovery measures to be taken by an institution in order to restore its financial position following significant financial deterioration. The resolution plan, on the other hand, is for when recovery is no longer possible. The recovery plan must be updated, and the resolution plan must be reviewed, annually and also after any organisational or legal change to the institution’s structure.
The recovery plan
Institutions are able to draw up their own recovery plan and are also able to conduct most of the recovery proceedings themselves. This contrasts with the resolution plan, which must be drawn up by the resolution authority. Although drawn up by the institutions themselves, the competent authority will assess the recovery plans and direct the institution to make changes if the plan has ‘material deficiencies’.
EBA has already published draft RTS on the content of recovery plans and draft RTS on the assessment of recovery plans.
Institutions are required to ‘test’ their recovery plan by considering a range of scenarios including severe macroeconomic and financial stress. EBA has published guidelines and a consultation paper on the range of scenarios to be used.
When assessing the recovery plan, the competent authority and institution must agree on a set of indicators which should be included in the plan and which trigger certain recovery actions to take place. These indicators can be of quantitative or qualitative nature. EBA has published a consultation paper on draft guidelines specifying the minimum list of qualitative and quantitative indicators which firms should address.
The resolution plan
When preparing the resolution plan, the resolution authority must consult with the competent authority and with resolution authorities in other member states where the institution has significant branches. The institution is required to cooperate and provide the resolution authority with all necessary information.
Should the resolution authority come across any material impediments to resolvability when drafting the resolution plan, they must inform the institution in question, which is then required to take measures to remove them .The preparation of the resolution plan will be deferred until these issues are resolved. An impediment to resolvability could be, for example, that a group structure is too complex for easy resolution or perhaps that the retail deposit taking business is not sufficiently free standing for easy separation.
The resolution authority has a wide range of powers available to remove impediments (either directly or indirectly through the competent authority), should the measures proposed by an institution not be sufficient. This includes, but is not limited to requiring an institution to:
- revise any intragroup financing agreements
- change its legal or operational structures
- pest specific assets
- refrain from or limiting existing or proposed activities
- issue liabilities which are eligible for bail in or to take other steps to meet the minimum requirement for own fund and eligible liabilities (see below)
EBA has published a consultation paper on draft guidelines on the specification of measures to reduce or remove impediments to resolvability and the circumstances in which each measure may be applied.
Crisis Management & Supervisory Intervention
Should a financial institution shows signs of financial difficulties, competent authorities are able to intervene in order to prevent failure. Among other things, a competent authority can require an institution to:
- Change its business strategy
- Change its legal or operational structures
- Implement one or more of the arrangements or measures set out in the recovery plan
- Remove one or more members of the management body or senior management, should they be found unfit to fulfil their duties under CRD IV or MiFID II
- Convene a shareholder meeting and at such a meeting require certain conditions to be considered for adoption by the shareholders – if necessary the competent authority can convene such a meeting itself.
Under BRRD the intervention powers are available if an institution infringes the requirements of CRR, CRDIV, Title II of MiFID or any of Articles 3 to 7, 14 to 17, and 24, 25 and 26 of MiFIR. In addition the powers arise where the institution is likely, in the near future, to infringe these requirements due to a rapidly deteriorating condition including a deteriorating liquidity situation, an increasing level of leverage or non-performing loans or concentration of exposures (assessed on the basis of a set of triggers, which may include the institution’s own funds requirement plus 1,5 percentage points). EBA is to develop guidelines on the triggers for the use of the early intervention powers and has already published a consultation on this topic.
Should a competent authority determine that an institution’s financial condition is deteriorating, they must inform the resolution authority.
The competent authority is able (in addition to the powers above) to remove the senior management and management body or place the institution into administration where the intervention powers listed above are insufficient to deal with an institution experiencing significant financial deterioration or where there have been significant violations of law or regulation.
Intra-group financial support regime
BRRD introduces a new regime for intra-group financial support agreements for emergency funding. These agreements are not mandatory, but BRRD requires member states to remove any legal impediments to their operation. This regime does not restrict the provision of support outside such agreements.
The regime applies when entities within the same group enter into voluntary financial support agreements which provide for the provision of financial support from one entity to another should one of them meet the criteria for early intervention. (The agreement must be entered into while the entities are healthy i.e. before financial difficulties arise). The financial support stipulated in the agreement can take the form of a loan or the provision of guarantees or of assets for use as collateral. The agreement must be consistent with the conditions for financial support which are broadly outlined in BRRD, although EBA will draft RTS to further specify these in detail.
Financial support agreements within this regime are subject to review by the competent authorities, who can prohibit the conclusion of an agreement if it is not consistent with the conditions of financial support. Once the agreement has been authorised by the competent authorities, it must also be approved by the shareholders of the institution in question.
Group entities must make public whether or not they have entered into a group financial support agreement. If they have entered into such agreement, they must disclose a description of the general terms of such an agreement and the names of the group entities that are party to it. EBA will produce draft ITS specifying the form and content of such disclosure.
Write down or conversion of relevant capital instruments
The power to write down or convert capital instruments can be used by the resolution authority when using the resolution bail in tool (see below), but can also be used independently of resolution. In fact in most cases the BRRD requires resolution authorities to write down or convert relevant capital instruments into shares or other instruments of ownership before taking any resolution action. This includes situations when an institution has been deemed to be no longer viable, to be failing or likely to fail or when it is determined that the institution requires extraordinary public support. Only if there is no reasonable prospect that it would prevent an institution’s failure, can resolution be commenced without using the write down tool first.
Write down or conversion powers of relevant capital instruments are applied in accordance with priority of claims under normal insolvency proceedings.
‘Relevant capital instruments’ are:
- Additional Tier 1 instruments (meaning capital instruments that meet the conditions laid down in Article 52(1) of CRR);and
- Tier 2 instruments (meaning capital instruments or subordinated loans that meet the conditions laid down in Article 63 of CRR)
In addition, shares and other lower-ranking instruments of ownership must be cancelled, transferred to bailed-in creditors or diluted.
The extent of the write down required is not specified other than that it must meet the resolution objectives (see below). This is a rather vague test but it is unlikely to mean that an institution needs only to meet its minimum capital requirement. A number of factors can be taken into account to determine the appropriate level of write down, including the viability of the firm and the level of recapitalisation needed.
The BRRD contains a provision to ensure that ‘no shareholder or creditor is worse off’, i.e. that they do not incur greater losses than they would have if the institution was wound up under normal insolvency proceedings. Although this ‘safeguard’ is also referenced in the resolution principles, it appears that it only applies when a resolution tool is used – so it does not apply to the write down of relevant capital instruments exercised before and outside of resolution. It seems that this might act as an incentive for the use of these powers before/outside of resolution.
Resolution is governed by a set of nine principles and should achieve the following resolution objectives:
- Ensuring the continuity of critical functions
- Avoiding significant adverse effect on the financial system
- Protecting public funds
- Protecting depositors covered by DGSD II
- Protecting client funds and client assets.
The resolution authority is primarily responsible for resolution proceedings and has most of the powers in that respect. Unlike recovery proceedings, many proceedings under resolution include interfering with creditors’ or shareholders’ rights. According to the resolution principles, shareholders should bear the first losses, followed by creditors. Except when otherwise provided in the Directive, creditors of the same class should be treated in an equitable manner.
The principles also stipulate that natural and legal persons are to be ‘made liable for their responsibility for the failure of an institution’.
When is resolution action taken?
Resolution action is to be taken by the resolution authority when the following conditions are met:
a) the institution is failing or is likely to fail – this is determined by the competent authority, after consulting the resolution authority; and
b) there is no reasonable prospect that any alternative private sector measures or early intervention measures (including the write down or conversion of relevant capital instruments) would prevent failure; and
c) it is in the public interest to resolve the institution.
Before resolution action can be taken, an independent party should conduct a fair, prudent and realistic valuation of the assets and liabilities of the relevant institution, but in cases of urgency this can be done subsequently.
When an institution is placed in resolution, the resolution authority has the power to appoint a special manager who will replace the management body of that institution.
When is an institution failing or likely to fail?
BRRD sets out a number of circumstances in which an institution can be deemed to be failing or likely to fail.
- The institution infringes the requirements for continuing authorisation;
- The assets of the institution are less than its liabilities or are likely to be so in the near future;
- The institution is unable to pay its debts or in the near future is likely to be unable to do so;
- The institution requires extraordinary public financial support.
EBA has published a consultation paper on draft guidelines on the interpretation of the different circumstances when an institution should be considered as failing or likely to fail.
The resolution authority has four resolution tools:
- The sale of business tool
This tool allows the resolution authority to sell the institution or part of its business. This can be done without shareholders consent. Under the SRR, authorities in the UK have such powers already.
- The bridge institution tool
Resolution authorities are able to transfer shares, assets or liabilities of an institution to a bridge institution, which is wholly or partially owned by one or more public authorities. In the UK, this is already possible using the SRR.
- The asset separation tool
Resolution authorities are able to transfer shares, assets or liabilities to an asset management vehicle which is wholly or partially owned by one or more public authorities. There are currently no specific provisions for this tool in the UK.
Resolution authorities should use the tools and powers which best serve to achieve the resolution objectives and any resolution action taken should be in line with the nine general principles.
The bail in tool
The BRRD makes provisions for a broad-scope bail in tool. The bail in tool is used to minimise the effect that a failing institution has on the taxpayer. This is achieved by imposing an appropriate amount of loss on the shareholders and creditors of the failing institution. These are ‘bailed-in” by writing down, converting to equity or cancelling liabilities or rights as appropriate.
The following liabilities are excluded from bail in:
- Deposits covered by DGSD II
- Secured liabilities including covered bonds
- Liabilities arising out of holding client assets or client money (e.g. on behalf of UCITS or of AIFs)
- Liabilities stemming from the existence of a fiduciary relationship
- Liabilities to institutions with a maturity of less than seven days (unless these are to entities of the same group)
- Liabilities to employees regarding accrued salary, pension benefits or fixed remuneration
- Liabilities to tax and social security authorities
- Liabilities to deposit guarantee schemes arising from contributions due in accordance with DGSD II.
The resolution authority is able to exclude further liabilities should certain conditions be met.
The resolution authority must (using the valuation made before the institution was placed into resolution) make an assessment of the amount of bail-in that is required. This includes:
- the amount of eligible liabilities which must be written down so that the net asset value of the institution is equal to zero; and
- the amount of additional eligible liabilities that must then be converted into shares (or other capital instruments) in order to restore the Common Equity Tier 1 capital ratio.
‘Eligible liabilities’ are those which are not excluded from bail in and those that that do not qualify as Common Equity Tier 1, Additional Tier 1 or Tier 2.
Within one month of using the bail-in tool, a business reorganisation plan must be drawn up by the management or management body of the institution in question and submitted to the resolution authority.
This reorganisation plan should outline measures aiming to restore the long-term viability of the institution.
Sequence of write down
The sequence of write down and conversion under BRRD is as follows:
- Common Equity Tier 1
- Additional Tier 1
- The principal amount of Tier 2
- The principal amount of subordinated debt that is not Additional Tier 1 or Tier 2 capital in accordance with the hierarchy of claims in normal insolvency proceedings.
Should write down and conversion of the above not be sufficient to reach the amount required, write down will continue down the ranks of eligible liabilities in accordance with normal insolvency proceedings.
Treatment of shareholders
As shareholders should bear the first losses (see resolution principles above) the resolution authority can cancel existing shares or transfer shares to bailed-in creditors. Moreover, the resolution authority is also able to dilute the existing share capital as a result of converting relevant capital instruments or eligible liabilities into new shares.
Minimum requirement for eligible liabilities (MREL)
As part of the bail-in provisions, the BRRD specifies that firms must at all times maintain a sufficient amount of own funds and eligible liabilities which can be subject to write down and conversion. The resolution authority, after consultation with the competent authority, is responsible for quantifying the minimum requirement. If possible and appropriate, the resolution plan as drawn up by the resolution authority should quantify that minimum requirement. Should a liability be governed by third-country law, it must be clear whether the bail in power would be operative in regards to that liability. If this is not the case, the liability will not count towards fulfilling the minimum requirement for eligible liabilities.
BRRD gives a broad outline of criteria that should be considered when quantifying MREL, including the ability to resolve the institution by using the bail in tool. However EBA will draft RTS to specify the criteria for quantifying the MREL in more detail.
Resolution financing arrangements
Member states must put in place resolution financing arrangements, so that the required resolution tools and powers can be adequately used. These funds must be established (ex-ante) before they are required, so that they are immediately available when needed. There also needs to be a mechanism in place to provide additional ex-post financing if the ex-ante financing is not sufficient.
The Deposit Guarantee Scheme (DGS) funds should also be used to finance resolution, so that (and to that extent only) protected depositors continue to have access to their deposits. Any contribution from the DGS fund is subject to a cap equal to the amount of losses that the DGS would have been subject to if the institution would have been wound up under normal insolvency proceedings.
Treatment of groups
There are separate provisions dealing with the treatment of institutions which are part of a group. Although the requirements are broadly the same, the procedures and authorities involved differ. The treatment of groups under the BRRD is complicated and beyond the scope of this article.
When an institution becomes insolvent, its creditors are entitled to a claim on its residual assets. Insolvency proceedings usually prescribe a set hierarchy between those creditors. The BRRD introduces EU-wide changes to the ranking of deposits in this insolvency hierarchy. Accordingly, the following deposits rank ahead of unsecured and non-preferred creditors:
- Deposits that qualify for coverage under DGSDII but exceed the prescribed coverage level of €100 000; and
- Deposits that would be eligible for protection under DGDSII if they were not made through non EU-branches.
Covered deposits (eligible deposits in accordance with DGDSII of €100 000 or below) rank ahead of the deposits above and of unsecured, non-preferred creditors.
Further consultations, followed up by final guidelines, RTS and ITS are expected from the EBA by 3 July 2015. The BRRD must be implemented by 1 January 2015 - although the bail in provisions can be delayed until 1 January 2016.
Recovery and resolution in the UK
In the UK, the Special Resolution Regime (SRR), which was established under the Banking Act 2009 and came into force on 21 February 2009, already provides a mechanism for dealing with failing banks, building societies, investment firms and central counterparties. Under the SRR, a specially established Resolution Directorate at the Bank of England has a number of powers, including the ability to direct and accelerate a transfer of part, or all, of a failing bank’s business or take control of part, or all, of a failing bank’s business through a bridge bank owned and controlled by the Bank of England.
The Financial Services (Banking Reform) Act 2013 introduced further measures including ring-fencing – certain large UK banking groups must place certain deposit taking activities into ring-fenced bodies. The PRA has recently published a consultation paper CP19/14 looking at the implementation of the UK’s ring-fencing regime, which will take effect in 2019. For further reading on this, see our report here.
The Financial Services (Banking Reform) Act 2013 also introduced depositor preference in the UK, ranking FSCS eligible deposits (claims of up to £85 000) the same as preferential debt.
Implementation of the BRRD in the UK
The BRRD will apply to credit institutions (banks) and certain investment firms. About 230 of these investment firms (IFPRU 730k firms) are ‘sole regulated’ by the FCA (i.e. they are not regulated by PRA). The following consultation papers have been published:
- HM Treasury - ‘Transposition of the Bank Recovery and Resolution Directive’ (closed on 28 September) and an impact assessment on changes to UK legislation necessary to implement the BRRD into UK law
- PRA - CP13/14 Implementing the Bank Recovery and Resolution Directive (closed on 19 September)
- FCA - CP14/15 Recovery and Resolution Directive (closed on 1 October 2014)
- BoE - Approach to resolution (23 October 2014) explaining how it will resolve a failed firm. This approach document takes accounts of the developing UK regime for resolution and the BRRD and considers the BoE’s resolution toolkit and how this will be applied. It looks at three phases – stabilisation, restructuring and exit from resolution phase. This document was only released as this report was being completed and it has not therefore been addressed in detail here.
The Financial Services (Banking Reform) Act 2013 included a bail-in stabilisation option, which was based on the then draft bail-in tool contained in the BRRD. The UK’s bail-in stabilisation option has not been implemented. The government will now make amendments to the domestic legislation to bring it in line with the BRRD and plans to implement the legislation on 1 January 2015 (rather than awaiting the final implementation date a year later). However, according to the HMT consultation above, the government is considering whether to delay implementation of the MREL to 1st January 2016.
The Bank of England currently draws up resolution plans for banks and some investment firms. This informal arrangement will be put on a legal basis as part of BRDD implementation.
Changes to the new UK depositor preference regime are also to be made to bring it in line with the BRRD requirements above.
 critical functions’ means activities, services or operations the discontinuance of which is likely in one or more Member States, to lead to the disruption of services that are essential to the real economy or to disrupt financial stability due to the size, market share, external and internal interconnectedness, complexity or cross-border activities of an institution or group, with particular regard to the substitutability of those activities, services or operations; (BRRD Article 2 s1(35))
 If so provided by the member state, the resolution authority, after consulting the competent authority, may also make the assessment whether the institution is failing or not. For this purpose the resolution authority will need to have the necessary tools to make such an assessment, including access to relevant information.
 Defined in CRR