4 Bank failing or likely to fail

If it becomes clear that a bank is unable to restore its financial position and any early intervention measures taken by a regulator are insufficient to resolve its underlying difficulties, the bank moves into a final stage.

The two key options available at this point are resolution or insolvency. Resolution typically involves an orderly transfer, restructuring or winding-down of the bank, intended to preserve the value of the bank’s business and minimise disruption to the financial markets. Insolvency involves a less orderly process, typically more value-destructive and outside the regulator’s control once it has started. The regulator’s choice of option is crucial.

Its choice is likely to depend on the perceived systemic risk and market disruption expected to arise from the bank’s failure. It will weigh up the bank’s systemic significance and the risk posed by its failure, taking into account the key services such as payment facilities which it provides and the number of its retail depositors. The regulator would also take into account the reasons for the bank’s failure, as any suggestion of fraud or material mis-reporting of assets/liabilities would impede resolution.

If the regulator decides a bank merits resolution, its next steps will depend on the resolution tools available to it and the bank’s operational and debt structure. Ideally the bank’s retail and systemically important operations would be ring-fenced, its debt instruments would be issued by a different entity to that running the ring-fenced operations (so there is a “single point of entry”, ideally at a holding company level) and that debt could be bailed in. This would allow the bank’s balance sheet to be restructured without impacting those key operations and, if necessary, they could be transferred quickly to a third party or bridge bank.

4.1 Resolution

The starting point for considering bank resolution is to identify whether there is a legislative framework providing bank resolution tools and, if so, what those tools are, the decision-making process for using them and the availability of a resolution plan for the bank. If the bank has a resolution plan in place, this should be checked to identify which options are suitable in the circumstances.

Most major European jurisdictions have national legislation providing at least some bank resolution tools. On 1 January 2015 the EU position will become more harmonised when the majority of the BRRD comes into force although, as implementation may vary between states, the possibility of local differences between resolution regimes across the EU will remain.

Under the BRRD, resolution should be initiated when the relevant authorities determine that a bank is failing or is likely to fail and resolution measures would prevent such failure within a reasonable timeframe. A bank will be considered to be failing or likely to fail when it is in breach of the requirements for continuing authorisation, its assets are less than its liabilities, it is unable to pay its debts as they fall due or it requires extraordinary public support. The authorities’ key objectives will be preserving the systemically important part of the bank’s business, protecting depositors, ensuring continuity of core services and preventing market disruption.

This may be achieved by a rapid transfer of part of the bank’s business to a commercial purchaser. Most statutory

23 Restoring confidence. The changing European banking landscape

Box 17: Resolution plans: at a glance

Overview Resolution authorities are required to prepare bank resolution plans specifying the options for resolving a bank in a range of scenarios. This must identify how resolution tools will be applied and how continuity of critical functions will be preserved.

Banks’ involvement Banks will need to work closely with the resolution authority in preparing the plan. They will provide information such as organisation structure, critical operations, core business lines and wide-ranking operational details.

Group resolution plan The resolution plan will be for the group as a whole. It must specify measures for the resolution of (i) the EU parent undertaking, (ii) each subsidiary and (iii) each financial holding entity.

Initial plan National resolution authorities will set date for submission of initial plan.

Updates to plan Plans are required to be updated (i) at least annually or (ii) after a material change to the bank’s structure, business or financial position.

A bank’s suitability for resolution will depend on its systemic significance, the risk posed by its failure, the extent of its retail deposit base and the reasons for its failure.

Pedro Siza Vieira Managing Partner – PortugalLinklaters – Portugal

bank resolution regimes include a sale of business tool. Under the BRRD, this tool enables resolution authorities to make such a sale, on commercial terms and in accordance with EU state aid rules, without shareholder approval or compliance with otherwise applicable procedural requirements.

Where a rapid transfer is not achievable or desirable, the authorities may establish a “good bank/bad bank” structure. This will involve an intensive initial phase in which the bank’s key retail and systematically important operations are transferred to a separate legal entity - the “good bank”. Resolution tools typically provide protections to ensure that set-off, netting and security rights are not prejudiced by this separation process. The “good bank” must be adequately capitalised and have sufficient liquidity to permit withdrawals by depositors. Funding options include the use of any statutory depositor protection scheme, an industry-financed restructuring fund established for such a purpose or transferring to the “good bank” assets with an estimated realisable value in excess of the liabilities which it is assuming.

An alternative mechanism to achieve this is to transfer impaired/problem assets to an asset management vehicle, using an asset separation mechanism. Under the BRRD, this tool is not intended to be used in isolation, to minimise the risk of moral hazard. The business, assets and liabilities contained in the “bad bank” after the transfer would typically be managed with a view to maximising their value over time, through sales or work-outs. The “bad bank” could emerge from this process as a going concern, but is more likely to be liquidated once value has been extracted.

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Box 18: Resolution decision-making process under the SRM

Approach Commission in relation to state aid or SRF aid,

if relevant

Start

12hrs

24hrs

32hrs

SRB adopts resolution scheme and immediately transmits it to the Commission

ECB and/or SRB determine conditions to resolution exist

Commission endorses scheme

Commission objects to discretionary

aspects of scheme

Commission sends scheme to the Council, recommending modification to SRF amount

proposed in scheme or objection to resolution on public interest grounds

Council may approve or object to Commission’s

recommendations to modify scheme

SRB transmits scheme to relevant national resolution authorities for implementation, including obtaining any state aid

Council may object to resolution on public interest

grounds

Option 1 Option 2 Option 3

SRB must modify scheme in accordance with Commission and/or Council requirements

Bank must be wound up under

national law

The Single Resolution Mechanism introduces centralised decision-making for bank resolution, augmenting the harmonised EU legislative framework under the Bank Recovery and Resolution Directive.

Etienne Dessy Counsel – Banking and Capital MarketsLinklaters – Belgium

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The success of any “good bank/bad bank” division will depend on the bank’s information systems providing accurate data about the business being transferred. This may be difficult where a business crosses multiple legal entities in a complex group structure. The “good bank” will need to use any third party information technology and other services previously used by the bank. Any contractual termination rights exercisable by the bank’s counterparties by reference to bank resolution, and any legislative overlay imposing a moratorium upon those rights, will require analysis.

If the “good bank” cannot be sold immediately, it may be transferred to a “bridge bank”, typically state owned, to ensure its business and operations have been fully severed from the bad bank. The bridge bank may later sell the good bank to a third party in more favourable market conditions.

Decisions to enter bank resolution are currently taken by a bank’s national supervisor. This remains the case after the BRRD is implemented, but changes on 1 January 2016 when the SRM comes into force. This provides a mechanism for centralised decision-making to resolve banks using the SRB. Box 18 shows the decision-making process for entering resolution under the SRM, using a strict maximum 32 hour timetable.

4.2 Insolvency

If the regulator decides to allow the bank to go into insolvency, the process is likely to be disorderly, with insolvency officials forced to make fast, pressured decisions based on limited information. Exactly what happens at this point depends on various key factors. These include an assessment of the viability of any part of the bank’s business and any potential purchaser of it, the nature and geographical scope of the bank’s business, the extent to which the regulator allows the bank to continue operating during the insolvency process and whether local insolvency legislation contains bank-specific provisions. The eventual outcome for stakeholders is likely to be considerably worse where such legislation is untested or not tailored to banks.

While these factors may result in very different outcomes for the failing bank, key practical steps can be taken to preserve value for stakeholders and limit market disruption. These differ depending on whether the bank is a retail or investment bank.

When news breaks of a retail bank’s insolvency, the initial focus will be dealing with concerned members of the public. An effective communications system should be established quickly, using the bank’s website and potentially its branch network and internet banking platform to give customers clear advice. The key message where the bank’s retail banking business cannot be continued (as occurred when the Bank of

Lithuania revoked the licence of Bankas Snoras AB in 2011 and had it declared bankrupt) is that the first €100,000 of their savings are not at risk as they are protected by the relevant statutory depositor protection scheme. Additionally, the bank should provide information on how to receive payment under that scheme. If liquidity permits, limited cash ATM withdrawals may be advisable, given the potential consequences of denying customers access to cash pending receipt of such payments.

One important operational issue to address at an early stage is whether the bank’s branches should open, if only to allow staff to provide information to customers, or whether it would be unsafe to do so given prevailing sentiment. An associated question is whether certain customers should be allowed access to recover safety deposit box items.

The bank’s insolvency officials will need to make other key operational decisions, balancing their statutory duties against a desire to avoid market disruption. Policies for the treatment of cheques, overdrafts and debit/credit cards will be required, as will a mechanism to allow customers to withdraw identified securities from securities custody accounts. The operation of any internet banking platform should be addressed, including setting up barriers to prevent electronic transfers from accounts. The bank’s commercial lending should be considered, particularly where it is acting as facility or security agent or a borrower could still submit a drawdown request.

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Box 19: State aid: key recent changes

Use of state aid If a bank fails the comprehensive assessment and cannot achieve the required remediation actions in the market, the relevant state may need to intervene, assisting the bank to return to viability or, where this is not possible, supporting its liquidation in an orderly fashion. This will require consideration of the state aid regime.

Key changes to the state aid regime The 2013 European Commission (“Commission”) Banking State Aid Communication came into force on 1 August 2013 and requires a bank to work out a sound plan for its restructuring or orderly winding down before it can receive state recapitalisation or asset protection measures. Previously, state aid was granted before a bank submitted its restructuring plan.

Under the new rules, if the Commission considers that recourse to state aid could reasonably have been averted through appropriate management, the bank will typically be required to replace its CEO and potentially other board members. The new rules also cap total remuneration for so long as the bank is under restructuring or relying on state support and raise the minimum requirements for burden-sharing by investors. For example, all capital generating measures, including converting junior debt, are required to be exhausted before state aid is granted. Finally, the new rules introduce behavioural restrictions intended to prevent the outflow of funds from the bank.

Range of compensatory measures To address concerns that state aid may distort competition, the Commission has developed an arsenal of compensatory measures. Those typically imposed include structural measures (such as divestment of subsidiaries, branches, portfolios of customers or business units), quasi-structural measures (such as balance sheet reductions or acquisition bans for a specified period) or behavioural measures (such as prohibitions on advertising a bank’s receipt of state support or paying dividends). Compensatory measures are tailored to a bank’s individual circumstances. Most restructuring aid approvals (around 80%) include an obligation to divest assets or activities.

Recent changes to the state aid regime require a bank to submit its restructuring plan before it may receive state aid and allow the European Commission to impose a range of compensatory measures.

Christian Ahlborn Partner – Competition/AntitrustLinklaters – UK

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Bank insolvency is likely to be in a worst case scenario. Limiting market disruption and preserving value for stakeholders will be among the supervisors’ main objectives.

David Ereira Partner – Banking/R&ILinklaters – UK

Arrangements to continue key IT and other services must be made. Finally, it will be essential to identify, retain and motivate the bank’s key staff with detailed knowledge of the bank’s business.

Once the initial stabilisation phase is under way, the focus will typically shift, concentrating on maximising and realising any remaining value in the bank’s business. This process may include establishing the bank’s post insolvency contractual position, assessing the marketability of its branch network and disposing of any loan portfolio or online banking platform.

Many of these issues apply equally to an investment bank. In each case, the insolvency official will need to establish the bank’s liquidity position quickly, preserve its assets and deal with employees and creditors. There are, however, key differences between the two, not least as a bank that was primarily an investment bank would not typically hold significant retail deposits.

One key initial decision to be made when an investment bank goes into an insolvency process, assuming that any necessary regulatory authorisations have not been withdrawn, is whether to allow it to continue any profitable business lines, potentially with a view to a sale, or whether all operations should be terminated immediately.

Depending on the nature of the bank’s business, policies may also have to be devised at an early stage for handling pending/failed trades and for identifying and valuing over-the-counter derivative contracts. To give a sense of scale, in the case of Lehman Brothers International Europe, it is estimated that there were 839,000 pending/failed trades and 130,000 OTC derivative contracts.

Once the initial position has been stabilised, the two main priorities will typically be to identify and return client monies/assets and to maximise recoveries from the bank’s own “house” assets and trading book. This process will be more difficult if the bank has not complied fully with applicable client money rules and not segregated cash and securities, or has held client assets as custodian, but with the contractual right to deal with and substitute those assets, potentially resulting in a customer losing its proprietary right over them. The question of whether or not a client has a proprietary interest in an identified and recoverable client asset assumes critical significance at a time when the absence of such an interest would leave it with an unsecured claim of uncertain value against the bank.

Where large amounts are at stake or the bank has issued complex financial products, there may be a significant amount of litigation during the insolvency process, as stakeholders seek to establish their exact rights. This can result in considerable delays in the recovery and repayment process.

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