It follows that a way must be found to resolve systemically important institutions in an orderly manner. These are institutions that play a critical role in ensuring financial stability due to their size, interconnectedness or business activities. The aim is to support the critical functions, at least temporarily, in order to avoid contagion within the financial system and real economy. This is impossible under the regular insolvency proceedings, which also pose the threat of affecting confidence on the market, leading to the destruction of assets.

Advantage of orderly resolution

An orderly resolution offers the advantage of supporting the failing bank's critical functions and separating them from the non-critical ones. To this end, the institution itself, or a bridge bank to which such functions are transferred, must be recapitalised. This needs to happen quickly in order to restore market confidence. The recapitalisation and separation of functions usually take place over a weekend in order to ensure that a functioning bank with enough capital is there when the markets reopen the following Monday.

To this end, apart from the regulatory capital, there is a need for an additional capital layer which can be drawn on during a resolution to absorb losses and recapitalise the institution. This is why the European Union created the minimum requirement for own funds and eligible liabilities (MREL), which are laid down in the European Bank Recovery and Resolution Directive (BRRD), for all institutions. Germany transposed the BRRD with the German Recovery and Resolution Act (Sanierungs- und Abwicklungsgesetz – SAG).

The Financial Stability Board (FSB) introduced a globally applicable minimum standard for a better total loss-absorbing capacity (TLAC) for global systemically important institutions, which sets out even stricter requirements for the quality of the additional capital.

Converting liabilities

The MREL and TLAC require an institution to maintain, in addition to its own funds, enough liabilities that may be written off or converted into equity if the institution fails. In this way, losses beyond the regulatory capital can be covered. Moreover, this is also a way to recapitalise the institution or a bridge institution in order to then resolve it in an orderly manner.

The possibility to convert liabilities into equity was introduced in the EU with the BRRD in the form of a bail-in.

Risks of bail-in

A bail-in needs to be practicable in addition to being legally possible. It must be executable within the short period of time available, the "resolution weekend". The devil is in the detail. Take the example of derivatives and structured bonds: as they are based on complex contracts, the short period of time is hardly enough to assess the liabilities and balance-sheet offsetting items to the extent necessary prior to any bail-in. In addition, a bail-in may only be applied to liabilities whose conversion does not pose contagion or systemic risks of its own. Such risks may occur, for instance, during a bail-in of sight deposits of large companies. Big firms often use such deposits to manage their liquidity. Converting liabilities into equity may cause significant damage and cause a chain reaction in the financial system and real economy.

It is, therefore, reasonable to initially leave out liabilities carrying such difficulties and risks during a bail-in. They should be used only after the other liabilities have proven insufficient for loss-coverage and recapitalisation.

Priority of liabilities

In this context, the resolution authority faces a further problem: the above-mentioned liabilities as well as others that may prove problematic during a bail-in are, in the light of the current insolvency regulations, equal in ranking to those liabilities that lend themselves to be used in a bail-in. Among the latter are long-term unsecured debt instruments such as bonds, registered bonds and promissory note loans (Schuldscheindarlehen) as long as they do not include a derivative element.

However, the pari passu principle laid down in the BRRD and SAG requires liabilities with equal ranking to participate in a bail-in to an equal extent. Nevertheless, the resolution authority may allow exceptions in special cases. Consequently, the much more problematic issue is a possible breach of another principle laid down in the BRRD and SAG, namely that no creditor is to be worse off as a result of the resolution than they would be in regular insolvency proceedings (no creditor worse off – NCWO).

However, if creditors who hold long-term unsecured debt instruments and are equal in ranking according to insolvency law find themselves ranked senior in a bail-in for the above-mentioned reasons, they might suffer greater losses than in insolvency proceedings. Even though they would then have claims for damages which, in accordance with the BRRD and SAG, would have to be satisfied by the Single Resolution Fund, this would lead to the depletion of resources necessary for the resolution of institutions.

New legal provisions

This is why, following BaFin's proposal, the legislators issued the German Resolution Mechanism Act (Abwicklungsmechanismusgesetz – AbwMechG)), which, among other topics changed the ranking of liabilities in the case of bank insolvency proceedings by amending section 46f of the German Banking Act (KWG). Within the category of non-subordinated creditors within the meaning of section 38 of the German Insolvency Statute (InsO), from 1 January 2017 on, those liabilities that are ineligible for a bail-in will be met first. The liabilities particularly eligible for a bail-in – the above-mentioned long-term unsecured debt instruments – are to be satisfied only afterwards. However, these remain senior to the liabilities described in section 39 of the InsO, in particular contractual subordinated debt instruments.

Thanks to the new provisions, liabilities eligible for bail-in and liabilities ineligible for bail-in will be treated the same in insolvency proceedings as they would in a resolution. Consequently, the NCWO principle will remain intact. The resolution of banks will become significantly easier.

Priority ranking for insolvency proceedings

Priority ranking for insolvency proceedings

BaFin

Infringement of existing rights

As the intention is to improve institutions' resolvability immediately, this regulation will also apply to long-term unsecured debt instruments already issued. This, however, is not without problems as the provisions infringe existing rights of creditors. The new priority ranking did not exist at the time of issuance and so was not taken into account in the issue price. Treating other liabilities as senior might, for instance, retroactively increase the requirements for regulatory capital to be held for investments in such debt securities – for example for institutions that hold such debt securities.

However, infringing the rights of creditors is allowed if other legal interests, for instance resolvability and financial stability, are given a higher priority. In addition, major rating agencies have announced that they do not intend to downgrade these debt securities as a result of the new regulation. According to the agencies, the most important factor in rating a security is its probability of default, which remains unchanged – a judgement that may play a role in assessing whether higher own funds requirements would be justified.

Retail investors at no disadvantage

Critics see the fact that derivatives and structured capital instruments will now be senior to simple bonds under insolvency law as favouring speculative institutional investors at the expense of retail investors. However, this argument does not hold water as retail investors do not hold a lot of long-term unsecured debt instruments. At the same time, a large proportion of structured bonds, which due to their derivative character will now be treated as priority, are made up of index certificates which are very popular with retail investors. Also, this group of investors already enjoys preferential treatment anyway, due to the seniority of their deposits enshrined in insolvency law. The national deposit guarantee scheme is required to refund covered deposits up to EUR 100,000. In addition, retail investors' deposits are repaid before other liabilities out of the insolvency estate, as long as it lasts. This seniority was already established by the BRRD and its transposition in section 46f of the KWG.

After all, with the new provisions the legislators have only enshrined in law what is likely to happen during a resolution anyway, which is that complex liabilities as well as those with high contagion risks are excluded from bail-in. The SAG and the European Regulation on the Single Resolution Mechanism (SRM) within the eurozone (SRM Regulation) provide for some liabilities to be excluded from bail-in in general (section 91 (2) of the SAG and Article 27(3) of the SRM Regulation) or, in individual cases, be excluded by the resolution authority (section 92 of the SAG and Article 27(5) of the SRM Regulation). In this way, the resolution authority may avoid infringing the pari passu principle, but not the risk of breaching the NCWO principle. Now, however, that risk will be almost excluded with the new legal provisions.

Eligibility

It is still unclear, though, what impact the senior treatment of other liabilities will have on the eligibility of long-term unsecured debt instruments of German banks. The guidelines of the European Central Bank (ECB) on eligibility exclude the possibility of debt instruments being subordinated to other debt instruments issued by the same issuer. At first glance, this suggests that long-term unsecured debt instruments of German banks may no longer be eligible.

A second glance, though, reveals the argument for eligibility. This is because the position of long-term unsecured debt instruments in the hierarchy under insolvency law does not change. They continue to be ranked directly above subordinated liabilities under section 39 of the InsO. However, the non-subordinated (senior) liabilities class (section 38 of the InsO) is now divided into ineligible liabilities that are to be treated as priority and long-term unsecured debt instruments that are to be met afterwards. While the latter therefore show a higher loss given default in the case of insolvency, the ECB could consider a higher valuation haircut for refinancing operations instead of depriving them of eligibility out of hand.