Banks provide vital services to citizens, businesses, and the economy at large.
In the past, because of the vital role played by banks, and in the absence of effective resolution regimes, authorities have often had to put up taxpayers' money to restore trust and avoid a contagion effect of failing banks on the real economy.
In view of the critical intermediary role that banks play in our economies, financial difficulties in banks need to be resolved in an orderly, quick and efficient manner, avoiding undue disruption to the bank's activities and to the rest of the financial system.
While for most banks this can be achieved through the normal insolvency proceedings applicable to any company in the market, some banks are too systemically important and interconnected to allow for their liquidation through a normal insolvency process.
Rather than relying on taxpayers to bail these banks out, a mechanism is needed to put an end to potential domino effects. It should allow public authorities to distribute losses to banks' shareholders and creditors – rather than on the taxpayers.
Resolution, also through its preventative effects, is essential to making banks safer and less likely to fail. In some cases, resolution rather than normal insolvency proceedings will be applied for banks when it is necessary, in the public interest, safeguards financial stability, and protects taxpayers. The new resolution regime increases financial stability.
There are four resolution tools:
- Sale of business - allows for the total or partial disposal of the entity’s assets or liabilities
- Bridge bank – parts or all of the business are transferred to a controlled temporary entity
- Asset separation – assets the liquidation of which could cause market disruption can be transferred to an asset management vehicle
- Bail-in – equity and debt can be written down, converted or bailed in, placing the burden on the shareholders and creditors of the bank, rather than on the public.
The bail-in tool
Bail-in is a key resolution tool provided for in the Bank Recovery and Resolution Directive (BRRD). It allows to write-down debt owed by a bank to creditors or to convert it into equity.
By replicating how creditors would incur losses if the bank had gone bankrupt, it reduces the value and amount of liabilities of the failed bank. It thereby protects taxpayers from having to provide funds to cover these liabilities, while allowing for the critical functions of the bank (e.g. deposit-taking, lending, operation of payment systems) to be uninterrupted.
The bail-in tool can be used to:
• recapitalise the institution under resolution to the extent necessary to restore its ability to comply with the conditions for its authorisation and so continue performing its authorised activities, and to sustain market confidence in the institution; or
• convert to equity, or reduce the principal amount of, claims or debt instruments that are transferred to a bridge institution (in order to provide capital for that bridge institution) or under the sale of business tool or asset separation tool.
Bail-Ins Versus Bail-Outs
Bail-outs occur when outside investors, such as a government, rescue a borrower by injecting money to help make debt payments. In the past, this helped save the companies from bankruptcy, with taxpayers assuming the risks associated with their inability to repay the loans.
A bail-in, on the other hand, occurs when the borrower's creditors are forced to bear some of the burden by having a portion of their debt written off. This approach eliminates some of the risk for taxpayers by forcing other creditors to share in the pain and suffering.
Resolution authorities must ensure resolution action in accordance with following principles:
• shareholders of the institution must bear the losses first
• creditors of the institution bear losses after the shareholders (in accordance with the priority of their claims under normal insolvency proceedings, except where expressly provided for otherwise in the BRRD)
• management and senior management of the institution are replaced (except where their retention is considered necessary to achieve the resolution objectives)
• creditors of the same class are treated in an equitable manner (except where otherwise provided)
• no creditor shall incur greater losses than they would have incurred under normal insolvency proceedings
• covered deposits are fully protected by the respective Deposit Guarantee Schemes.