May 22, 2015

Long suffering opponents of ‘too big to fail’ will feel they have had something to celebrate this year as elements of the Bank Recovery and Resolution Directive (BRRD) begin to take effect. The Directive seeks to sink the notion that systematically important institutions are categorically ‘too big to fail’. Given the events of 2008 this may sound promising; however, concerns exist regarding the value of the Directive, the protection it provides and the costs it imposes.

The Tools of Recovery and Resolution

The Directive provides common powers to national authorities to prevent bank crises and resolve failed institutions in an orderly fashion, thereby, minimising taxpayers’ exposure and preventing contagion.

EU credit institutions and investment firms are required to produce recovery plans (often referred to as “Living Will’s”), containing actions to be implemented during a period of financial stress, with the objective of returning the institution to a viable state. Furthermore, responsible authorities must generate individual resolution plans for the swift and orderly winding up of an institution, should it prove irrecoverable, while preserving its systematically important economic functions. Resolution authorities have been provided with the following tools:

  • Bail-In Tool – permits debt owed by financial institutions to be written down and converted to equity (effective 1 January 2016 at the latest)
  • Sales of Business Tool – permits the sale of the business, in whole or in part, without shareholder consent (effective 1 January 2015)
  • Bridge Institution Tool – allows for the creation of a new entity capable of continuing the critical economic functions conducted by the failed business (effective 1 January 2015)
  • Asset Separation Tool – allows for the separation of illiquid and high risk assets into another independent vehicle or ‘bad bank’ (effective 1 January 2015)
  • Resolution Funds – consisting of industry contributions and intended to cover some of the costs associated with resolution (target level must be reach by 1 January 2024)

Intended or Unintended Consequences?

Compliance will have consequences for in-scope institutions and creditors alike. There are indications that affected institutions have begun to re-examine the purpose of each business and place greater focus on core, and more robustly capitalised, activities. A high level of engagement with senior stakeholders and regulators will be required, while resources will have to be committed on an on-going basis as all plans must be reviewed annually, increasing costs.

Affected institutions also risk regulators using their powers to remove impediments to recovery and resolution. These powers enable regulators to, for example, remove Board or Managing Directors, change the business plan and alter the legal or operational structure of the institution, presenting significant operational and reputational risk to the business. Institutions must provide their annual contribution to the resolution fund determined by reference to the covered deposits they hold. This will come at a cost with flow on effects for borrowers and the markets alike.

The BRRD provides regulators with significant discretion as to when the bail-in tool may be exercised leaving creditors uncertain as to when and in what circumstances their debt may be written down or converted to equity. It has also been suggested that the minimum requirement for own funds and eligible liabilities (MREL), which must be set aside for use during a bail-in, will have consequences on the market, encouraging more secured and short term lending. What effect this has on the availability and price of capital to ins-scope institutions is yet to become clear.

Despite its promise, the BRRD will not become effective in its entirety for some time. In particular, the resolution funds are not scheduled to reach the mandated capital requirement until 2024. Whether the reserves within the funds will be sufficient in the event of a systematic crisis or a major participant exiting the market in a destabilising fashion has been strongly contested.

Fail to Plan or Plan to Fail

The costs and difficulties associated with predicting the nature of future economic crisis makes it questionable whether such planning is a misguided attempt to prepare for a black swan event. While it may be reasonable to require systematically important institutions to take steps, such as the withholding of capital, to mitigate against the consequences of such an event; asking them to identify future threats and plan against them arguably amounts to a purely academic exercise which in practice may not be prove realistic or achievable but will inevitably come at a cost.

ong suffering opponents of ‘too big to fail’ will feel they have had something to celebrate this year as elements of the Bank Recovery and Resolution Directive (BRRD) begin to take effect. The Directive seeks to sink the notion that systematically important institutions are categorically ‘too big to fail’. Given the events of 2008 this may sound promising; however, concerns exist regarding the value of the Directive, the protection it provides and the costs it imposes.