Crisi bancarie
Aprile 2016

A modern resolution tool to TBTF

Estremi per la citazione:

A. Fantuzzi, A modern resolution tool to TBTF, in Riv. dir. banc., dirittobancario.it, 20, 2016

ISSN: 2279–9737
Rivista di Diritto Bancario

Foreword

The 2007-2009 crisis brought a severe destabilization in the financial system and thecrisis showed us the failure of market discipline and the government responses exacerbated this problem by confirming the idea that some financial institution were too big tofail.

Before the crisis the only choice for a government in front of the failure of a systemically important institution was to bail-out the institution or to initiate a bankruptcy proceeding.

Due to the disruptive effect of these two approaches, international and regional institutions responded to the need of a more resilient financial system. The initiatives designed to make the resolution of a systemically important financial institution less costly have been focusing on adopting common resolution tools such as impose losses on equity and debt holders, restructuring their operations, maintaining critical functions. These common points come under the name of bail-in or conversion of debt into equity.

This paper examines the different approaches undertaken by the United Stated and the European Union and the strictly linked jurisdictional and practical issues.

 

1. Bail-in tool

Banks are by nature vulnerable to sudden failures in times of economic distress and this is because they rely on the maturity transformation[1]. Through this type of business, banks take deposits and other short-term assets, to finance long-term assets. This modelpermits to connect lenders who have fund to invest with borrowers who needfunds[2].

In the balance sheet of a systemically important bank[3], financial liabilities play a key role. These liabilities include bank deposits, derivative contracts, insurance policies and repos. Financial liabilities are those whose value is impaired by the insolvency process. Value is destroyed by insolvency, but at the same time insolvency must mitigate this destruction. It is then important that some special liabilities, financial liabilities, are protected because they are not simply claims against future incomes. Bank deposits are also a source of liquidity, whilst derivatives or repos shift risks. Liquidity and risk shifting are functions valuable themselves, which must be preserved.

Financial liabilities are contracts in which credit risk is incidental. The creditor is not primarily an investor, who pays now to get more later. This type of investor wants liquidity, or insurance, or other types of risk shifting. To a financial firm, the proceeds of a financial liability are used as a form of credit, being considered as a product of a firm.

Modern financial markets are highly complex system of financial institutions with a degree of interdependence and interconnections. Financial institutions are connected through exposure on the asset side[4] of the balance sheet, but also on the liability side trough funding relationships. Financial institutions are subject to runs on their liabilities. Bank deposits and financial contracts are liquid by nature, and so always subject to potential run[5]. Liability interconnectedness becomes a problem when the failure of one institution causes the cessation of asset purchases (repos, commercial papers etc) sold by another financial institutions and it impacts the ability of these institutions to fund their operations[6].

The linkages between financial institution introduce the possibility of a systemic failure; when a shock leads a bank to fail, this failure will reduce the amount of common liquidity available to the whole system.

Contagion occurs when a run at one institution or some other events induces short-term creditors of other institutions to run, including financial institutions that are adequately capitalized and may have not any linkage to the same set of problematic risk exposure[7].

Measures to limit contagion and systemic risk have been considered of top priority. Capital and liquidity requirements, as well as resolution procedures, are designed to achieve the same goal: to impose losses on debt and equity holders, in order to avoid other bail-outs[8]. International efforts concentrated in several directions: (i) capital requirements designed to enable financial institutions to incur losses without failing[9]; (ii) liquidity requirements that ensure the existence of high-quality assets that can be sold or pledged as collateral to meet unexpected outflows[10]; (iii) ex post resolution procedures that impose losses on shareholders and creditors[11].

It is commonly accepted that adequate levels of capital and liquidity are necessary but cannot prevent an individual financial institution from failing. Despite the limits of capital requirements, these increased requirements provide a line of defense against that risk, since stronger banks can withstand common external shocks.

The concern that remain is the risk that a correlated negative shock causes the failure of other financial institutions simultaneously.

2. Bail-in concept and the meaning of capital

Effective resolution regimes are essential to avoid the ‘too big to fail’ problem and maximize creditor recoveries, but resolution procedures that affect short-term creditors are unlikely to counteract their run. The protection of short-term creditors is essential in a perspective of systemic risk regulation[12].

Bail-in potentially is a powerful tool that can make banks “safe to fail”[13], reducing the social costs and the disruption to markets that insolvency and liquidation could cause. Bail-in refers to a set of techniques that aim at forcing creditors of financial institutions to absorb losses that the institution has occurred by converting or reducing certain of their liabilities for new equity, restoring a financial institution’s pool of available capital and reducing its leverage in a period of stress[14]. In fact, if a bank fails, the resolution authority would write down or convert into equity some or all of the instruments subject to bail-in in response to a regulatory determination, without putting the bank into formal administration[15]. Bail-in is intended to recapitalize a bank swiftly without the value destruction that could derive from a judicial or administrative reorganization[16]. Furthermore, the bail-in tool can be used to keep the bank as a going concern avoiding disruptive consequences in the financial market.

Bail-in is a credible alternative to administrative proceedings because it subordinates non-financial liabilities (bonded debt) from financial liabilities. As Joseph Sommer says, this transforms the meaning of capital, because usually junior liabilities should protect senior liabilities. In bail-in, bonded debt works as equity, because it represents a layer of defense against the loss of value of financial liabilities, and in light of that all non-financial liabilities are capital[17].

There are several preconditions to the success of it: (i) there has to be enough back-up capital[18] available to bail-in. It should be sufficient to replace the minimum required common equity of thebankruptcy; (ii) the losses that holders of bail-in-able debt would suffer have to imposes in a manner consistent with strict seniority[19]; (iii) it must be capable of a quickimplementation, especially through the use of resolution plans[20]; (iv) it should preserve the bank as a going concern. It implies that it should not trigger any close out on derivative contracts or cross-default that are not subject tobail-ins; (v) it may need to be reinforced through liquidity[21] from the central bank; because it may not restore immediately market confidence, it may need to be supplemented by aid of the centralbank.

After the bail-in tool has been used the resolution authority would decide how to wind down the institution as a going concern. This could lead to a rehabilitation of the institution, a wind down of one or more business lines, the creation ofa bridge bank or the transfer of its deposits to a third party.

The result of bail-in should be a bank with a clean (i.e. one with no losses to be taken) and strong (i.e. one with an equity capital ratio above minimum requirements) balancesheet.

The goals of bail-in differs depending on the jurisdiction[22]. In the USA the process through which bail-in takes form is the single point of entry strategy under Title II of the Dodd-Frank Act. This means that activating bail-in under Title II aims at providing with sufficient capital the subsidiaries that were subject to the parent holding company that went under liquidation.

European Union is reluctant to bail-out and it requires, under Bank Recovery and Resolution Directive, that creditors must be the prior participants in meeting the costs of bank resolution. This means that bail- in will be triggered in both situations where the bank remains a going concern and the bail- in is used to recapitalize the bank (open bank bail-in process) or the bank as a gone concern is subject to the exercise of the resolution powers (closed bank bail-in process). This differs from the Dodd Frank's approach which deals only with the closed bank option.

3. US Response- Single Point of Entry

Systemically important banks are conglomerates and not unitary entities. The main issue is how to reorganize the liabilities of these institutions without touching their financial debt. This sort of debt exists in different entities, located in different countries. This configuration can create serious problem of coordination, which could be difficult to achieve.

The Bank Holding Company Act encourages the parent company of a financial entity to organize as a Holding company[23]. In such structure, the parent does not rely on financial liabilities, as opposed to its subsidiaries. The parent represents the cheapest source of funding in the organization, therefore, it can down-stream debt to the subsidiaries. The debt of the parent is subordinated to the debt of its subsidiaries, therefore creditors if a solvent subsidiary will be repaid in full, even if the parent is insolvent. It is clear that reorganization involves only a single entity, one jurisdiction, one set of rules.

The Dodd Frank Act[24] created the Orderly Liquidation Authority[25] (OLA), a new regime for receivership of non-bank financial companies “whose failure would pose serious adverse effects on the financial stability of the United States”[26]. The Orderly Liquidation Authority is meant to provide an alternative to bankruptcy proceedings. However, bankruptcy remains the preferred resolution procedure despite the new resolution regime[27]. Orderly liquidation authority can be invoked if an institution is found to be a “financial company”[28] and certain distress financial findings are made. The first finding is that the financial institution is “in default or in danger of default”, which means that a firm is insolvent or unable to pay its debts as they come due in the ordinary course of its business or in danger of becoming such. The second finding is that reorganization or liquidation of the company under Bankruptcy code would create a serious adverse effects on financial stability of the US, and that Orderly liquidation authority instead would avoid or mitigate thoseeffects.

Despite the benefits that this new procedure could provide to regulators and financial companies, its use has been contentious because of critics moved towards its effectiveness. Its application is not sure, because Title II of Dodd-Frank Act requires regulators to liquidate any institution they take over, and this clearly is a disincentive to invoke it[29]. Furthermore, Title II does not force regulators to intervene in a timely fashion. The main criticism to Orderly Liquidation Authority stems from the fact that it mya not protect short-term creditors from loss, consequently this will not solve the contagion problem.[30]

The uncertainty of an institution to fall under Title II, and whether short-term creditors will be protected if the institution would actually be resolved under Orderly Liquidation Authority, will determine a run from these creditors before such determinations are made[31].

If liquidation was the only option under title II, regulators would be reluctant to invoke it. In 2013 Federal Deposit Insurance Corporation developed a more promising strategy for implementing Title II, known as the “Single Point of Entry[32]” (SPOE). Single point of entry strategy would recapitalize a troubled systemically important bank rather than liquidating it[33]. This strategy has gained such a recognition around the world, that is fair to say that it is the leading strategy for solving the Too Big To Fail problem for global systemically important banks with centralized structures and a sufficient amount of combined capital, long-term unsecured debt, and other loss-absorbing resources at the top-tierparent.

In determining this strategy, the Federal Deposit Insurance Corporation stated that it would hold shareholders, debt holders and culpable management accountable for the failure of the firm; it would provide stability to the financial markets by allowing vital linkages among the critical subsidiaries of the firm to remain intact and preserving the continuity of services between the firm and financial markets that are necessary for the uninterrupted operation of the payment and clearing systems.[34]

In the event of financial distress, the Federal Deposit Insurance Corporation would commence a receivership action against Topco, while leaving the subsidiaries of the holding company solvent, in a going concern perspective. If a subsidiary suffers large losses (losses exceeding a subsidiary’s equity) that render the parent company insolvent, under the single point of entry, a new “bridge financial company” would be created where to transfer the assets of Topco, in particular its equity interest in its subsidiaries, and a limited amount of liabilities of the failed holding company. The equity, subordinate debt and senior unsecured debt of the failed company would be left behind as claims on receivership to absorb losses that caused resolution. The subsidiary’s excess losses are covered and its solvency is restored by writing down and converting into equity as much as is needed of the intragroup debt. The amount of losses which creditors and shareholders of Topco will suffer is in accordance with their priority. If losses are to be borne by Topco creditors, this requires the parent company to maintain a certain amount of bonds (TLAC) that can be bailed-in to cover losses. The holders of these bonds will become the new owners of the bridge Topco. This approach should reassure depositors and other short-term creditors of the operating subsidiaries of the financial stability of the subsidiary itself[35]. The restructuring would occur primarily at the holding company level, with liquidity and capital down-streamed to affiliates.

By contrast, a Multiple Point of Entry would put each subsidiary under receivership and as consequence of this, they will face obstacles in conducting their day-to-day operations[36].

By leaving behind unsecured liabilities and stockholders equity in the receivership, assets transferred to the bridge company will exceed its liabilities, resulting in a well-capitalized holding company. As a result, the new bridge company with significant assets of the parent holding company and fewer liabilities will be in a good position to borrow money from the private market, that will be downstream to the failing subsidiary in form of equity.If the customary sources are unavailable from the market, the Federal Reserve's discount window, from Section 13(3) of the Federal Reserve Act, the Federal Deposit Insurance Corporation might provide temporary secured loans from the Orderly Liquidation Fund to the bridge, by borrowing money from the Treasury[37].

4. Advantages and Disadvantages of SPOE

The process is a fast one, indeed it should occur in a weekend. The process is quick and the benefits are evident in a situation where only the Holding Company fails but its critical operating subsidiaries are restored to sound financial condition by private sector capital. Since everything happens at the parent level, the complexity of the conglomerate should not be a problem if subsidiaries are safe. The source of destructive “runs” by uninsured depositors, short-term creditors, meaning all the derivative instruments, are issued at the subsidiary level, and so it comes that when single point of entry is invoked, only the holding company level would be put under receivership, avoiding a risk of run. Losses would be borne solely byshareholdersandcreditorsoftheholdingcompany,sincecreditobligationsofthe holding company are long-term[38]. After the recapitalization of the subsidiaries by debt relief, the aggregate value is preserved, but there will be classes of claimants, each demanding their new share of equity. The process of equity distribution is not an easy task and it may require some time. The distribution of equity is the end of the legal process, but not the end of the whole process because the new entity may have a new and strong balance sheet, but it may not have a strong business. Bail-in then requires other than enough parental debt to fill the capital shortfall, must restore confidence in the market. As for this, liquidity backstop[39] is necessary as is cooperation of foreign regulators.

International cooperation is a complex step, but in the single point of entry strategy the scope of cooperation is limited. A recognized merit of this approach, compared to the opposite MPE, is that it addresses the global consequences of a failure by limiting the consequences of default to the US holding company. Foreign subsidiaries will be insulated and will continue to operate[40] and foreign regulators must keep its subsidiaries out of insolvency proceedings. Bail-in shifts all the pain to the home country, and it aligns the cross-border incentives as long as all the subsidiaries are safe[41].

Finally, the single point of entry approach reduces moral hazard at the parent level[42] because the bridge company cannot be recapitalized using taxpayers’ money. At the same time though, this process can create ambiguous incentives, encouraging a shift of liabilities from the parent company to the subsidiaries, but the solution has been found in mandatory debt[43]. A more prominent issue is how to avoid moral hazard at the subsidiary level, and here scholars are debating over it[44].

The Federal Deposit Insurance Corporation would not impose a loss on subsidiaries' creditors unless and until the parent's unsecured debt is converted into equity. With a lower risk of loss, the subsidiary creditors would have less incentive to monitor the activities of thesubsidiaries.

The single point of entry presupposes a certain corporate structure[45]. A critical feature for the success of single point of entry is a top level holding company whose assets consists primary of equity and intra-company debt claims in its operating subsidiaries[46]. That is to assume that the corporate group has clear dividing lines among different constituent legal entities, and that the parent's company creditors can monitor the group's risk-taking activities as well as the subsidiaries' creditorscan.

But reality might be different because a group structure might not have clear dividing lines among different legal entities and because holding company's creditors may not be functional equivalents of the subsidiaries' creditors in terms of monitoring capacity[47].

5. EU Response

Under the Bank Recovery and Resolution Directive[48], the European Union has expressly recognized single pint of entry as a resolution strategy, but due to the differences within the EU, it has stated the necessity for an openness to a diversity of resolution approaches, including a multiple point of entry.

The new resolution regime in Europe derives from different circumstances, peculiar to the Eurozone. National governments took decisions to bail-out financial institutions, while EU was playing a secondary role, principally reviewing bail-outs through the “state aid” criteria. National regulators showed forbearance towards their own banks, with the aim of protecting them. Banking assets have been a multiple of some national budgets as the financial crisis developed into the European sovereign debt crisis. It became clear that some countries’ balance sheets were not large enough to rescue their own banks. The perceived interdependence of sovereign and bank creditworthiness created a downward spiral of weak banks. Thus the most effective resolution regime is necessary to break this link between sovereign and banks.

The bail-in[49] approach is intended to counter the dual threat of systemic disruption and sovereign over indebtedness. It is based on the penalty principle, namely, that the costs of bank failures are shifted to where they best belong: bank shareholders and creditors. Namely, bail-in replaces the public subsidy with private penalty[50] or with private insurance4 forcing banks to internalize the cost of risks, which they assume. The Bank Recovery and Resolution Directive requires the prior participation of bank creditors in meeting the costs of bank resolution.

Nonetheless, the Bank Recovery and Resolution Directive does not rule out the possibility of injection of public funds subject to strict conditions of Article 37(10), 57 and 58 of the Directive, and which must be approved by the EU Commission in accordance with the state aid framework of Article 107 TFUE[51].

Yet, the legal entity by entity approach raises its own difficulties. In fact, in case of non European groups, resolution colleges will have to coordinate operations, but a bail-in decision has distributional consequences. So in certain circumstances, it can create a lack of confidence in the banking system of a Member State or even disagreement can arise as to which entity/subsidiary to bail-in. The preferred solution would be a group entity resolution and concentrate all losses to the group entity based in the Eurozone.

6. Implementation of Bail-in

While Orderly Liquidation Authority provides for the liquidation of a bank holding company, it implements a single point of entry strategy to leave the subsidiaries going concern. On the other hand, European Union adopted an ‘open bail-in’ that aims at recapitalizing the ailing bank and keep it as a going concern.

It is essential to be aware that the BRRD, unlike the OLA, allows the use of the bail-in also before the financial institution has been placed into insolvency proceeding. The tool can be used when an institution is still a going concern but meets the conditions seen in Art.32 and 33 of the Directive. In this circumstances the main goal of bail-in is to restore the ability of the covered company to comply with the conditions for authorization, to carry on its any day to day activities, to maintain market confidence[52]. Implementing the bail-in tool is permitted only if there is a reasonable expectation that the covered company will be restored to financialsoundness[53].

When[54] to trigger bail-in is important, taking also into account the requirements of early intervention. If the supervisor trigger bail-in too early, it may be necessary other rounds of bail-in, if losses are not fully revealed; if bail-in is used at a later stage instead, there is a risk of run of bank creditors who do not bail-inable debt.

The Bank Recovery and Resolution Directive provides for numerous scenarios that may apply to a bank in difficulties to continue its operations. Bail-in mechanism in principle should be applied at the ‘point of non-viability[55]’ of a bank and the business of a bank must be considered gone concern, but there are many references in the Directive that suggest for an application of bail-in in a ‘going concern’ situation[56].

The first instrument regulators can adopt in a going concern logic is provided under article 59 of the Directive. The write down of capital instruments is not meant to be a resolution tool, but it works as an ancillary tool or a tool that can be exercised outside any resolution measures. It looks very similar to the bail-in tool, as long as debt instruments can be either written down or converted into equity. A clear distinction with bail-in appears in a group context. While on bail-in, the Directive follows a clear entity-by-entity approach, this principle is loosened regarding the write-down instrument. Because article 59(4) rules that the point of non viability refers not only to a single institution but rather to the group itself.

The bail-in tool gives the authorities the power to write-down all equity and subordinated debt and to write down or convert senior liabilities to equity[57]. More specifically, resolution authorities have the power to: reduce to zero the nominal amount of shares and cancel them; reduce to zero the outstanding principal amount of eligible liabilities; convert eligible liabilities into ordinary shares; cancel debt instruments; require an institution under resolution to issue new equity or other capital instruments; amend or alter the maturity of debt instruments or amend the amount of interest payable; close out and terminate financial contracts and haircut amounts owing by the debtor for the purposes of applying the bail-in tool to liabilities arising from derivatives[58]. These powers may be used to (i) recapitalize an institution in order to restore its viability to comply with the conditions for authorization and to carry on the activities; or (ii) convert to equity or reduce the principal amount of debt transferred to a bridge institution, a private sector buyer or an asset management vehicle[59].

Bail-in applies to all liabilities of an institution that are not excluded[60]. Liabilities excluded are: deposit guaranteed up to the amount of the guarantee (Eur.100.000); secured liabilities, including covered bonds; liabilities arising from the holding of client assets or client money or from the institution acting as fiduciary; short-term liabilities with an original maturity of less than seven days; certain liabilities owed to employees, commercial and trade creditors, and tax and social security claims[61][62].

The delineation of the scope of bail-in indicates that all unsecured debt with an original maturity of seven days or more will be bail-inable. The main loophole derives from the special rules that apply to derivatives[63], liabilities arising from repos, other title transfer collateral agreements and short-term debt. In order to prevent banks to from holding only exempt debts, there is a need to establish a minimum requirement for eligible liabilities.

Art. 45 of the Directive provides that member states shall ensure that institutions meet a minimum requirement for own funds and eligible liabilities expressed as a percentage of the total liabilities and own funds of the institution[64]. Resolution authorities are tasked with determining the minimum requirement on an individual basis for each institution based in certain factors like size, the funding model and the risk profile. This surplus of capital will protect creditors, but at the same time it will affect the strength and the credit quality of the financial institution and consequently affects all of its existing creditors. The optimum level at which the minimums are to be set should be proportionate to the risk of the institution or the composition of the funding of the institution[65]. The European approach in the Total Loss Absorbing Capacity Consultative Document reveals a source of uncertainty in the prepositioning of loss absorbing instruments in the various subsidiaries of the bank, so as to assure that eligible liabilities are enough to recapitalize subsidiaries as necessary to support resolution[66]. The European approach to resolution is commonly recognized by a multiple point of entry, a process that ad hoc but more chaotic than a Single Point of Entry. A multiple point of entry may be an optimum strategy for banking groups that operate in different regions, with little integration among them, so that it is possible to address any of these units singularly and separately during a crisis. Multiple point of entry looks suitable for financial companies with a decentralized structure, which does not reflect the European banking system.

In order to apply the bail-in tool, resolution authorities must first establish the aggregate amount of the eligible liabilities that should be reduced or converted[67]. When resolution authorities exercise the write down or conversion power, they shall dot it in accordance with the priority of claims under normal insolvency proceedings.

Bail-in should work up the liability structure of the bank in reverse order of seniority. The losses must be allocated proportionally between shares or other eligible liabilities of the same priority by reducing their principal amount pro rata[68]. If bail-in of capital instruments is not necessary to recapitalize the bank, bail-in will have to proceed further up the liability latter, so that deposits and derivatives could potentially be bailed-in. But this measure could affect the aim of preserving the continuity of the bank, so attention must be paid to assure that banks hold enough investor obligations.

7. Conclusion

An optimal resolution mechanism should address the Too Big To Fail problem on two fronts. First it should impose losses on those responsible for the failure of the institutions and, secondly, it should minimize the effect of resolution on the whole financial system.

Large systemically important banks operate in a complex and highly interconnected market, thereforeresolution authorities necessitate strong resolution powers to be exercised in a timely fashion. The power and speed to take and implement a strategy is important because assets of financial institution fluctuate in value in a very short period of time, depending on market's variations and confidence[69]. Moreover, speed of resolution/recapitalization (albeit at the expense of flexibility) is one of the reasons for the popularity of bail-in among regulators. Yet, there is a concrete doubt whether the adoption of bail-in regimes would lead to earlier regulatory intervention than under the bailout regimes. McAndrews and others[70] express the legal concerns that imposing potentially large losses on private creditors could postpone resolution, perhaps until the last possible minute. By then the liabilities needed to be written down could extend beyond HoldCo’s bail-in-able debt, interfering with short-term credit and deposits. When implementing bail-in or other resolution tools, resolution authorities must take into account also stability[71] and certainty[72]. The former prevents creditors and counterparties from a run that could destabilize the balance sheet of the firm in resolution, while the latter should help creditors during the implementation of the resolution strategy in order not to create panic in the financial market.

The write down powers can work efficiently where (i) the bank has sufficient subordinated term debt to absorb asset losses without impairing deposits and other short term credit; and (ii) the bank has an organizational structure that permits such a debt conversion without putting core subsidiaries/branches into bankruptcy. These requirements referred to the structure of banking, which need to be imposed if necessary. The observation that arise from looking at Europe and United States is that banking groups diverge between the two regimes. In Europe banks are usually organized on the model of “universal banking”.[73] The typical American “holding company” model is not popular in Europe, but regulations can change with different and relevant incentives[74]. Indeed, Swiss regulators were the first banks among Europe banks to change their structure into a holding company, to make the banking group more resolvable[75][76].




[1] Maturity transformation identifies a model where banks collect demandable deposits as well as raise funds in short term capital markets (short-term liabilities) and invest these funds in long-term assets (long-term liabilities). See Allen F., Carletti E., 2014, “The role of banks in financial systems”, In A. Berger, P. Molyneux, J. Wilson (eds),Oxford Handbook of Banking, Oxford University Press, 2009, 32–57

[2] The risk entailed in the maturity transformation are two: first, the bank cannot sell easily illiquid and long-term assets, so when it is forced to sale to obtain liquidity it will incur in a “fire sale”; secondly, because a financial institution is heavily leveraged, it means that it is subject to a liquidity run that can cause insolvency[2]. In the event of an economic shock, lenders might withdraw their money (liquidity run), spreading this fear among other creditors of other institutions.

[3] Systemically important financial institutions or SIFIs are large banks whose failure could pose a systemic risk to the whole financial market. These institutions are defined systemically important based on three aspects: size, interconnectedness and substitutability.

[4] The asset side also becomes illiquid in time of stress. Therefore, asset liquidity dries up when a financial institution needs liquidity. Tradable assets generally are not liquid; they are so because of legal rules and market conventions.

[5] Diamond D., Dybvig P., 1983, “Bank runs, deposit insurance, and liquidity”, 91 Journal Pol. Econ. 401. A ‘run’ is: “Banks are able to transform illiquid assets by offering liabilities with a different, smoother pattern of returns over time than the illiquid assets offer. These contracts have multiple equilibria. If confidence is maintained, there can be efficient risk sharing, because in that equilibrium a withdrawal will indicate that a depositor should withdraw under optimal risk sharing. If agents panic, there is a bank run[,] and incentives are distorted. In that equilibrium, everyone rushes in to withdraw their deposits before the bank gives out all of its assets. The bank must liquidate all its assets, even if not all depositors withdraw, because liquidated assets are sold at a loss”.

[6] Economic theory explained the effects of interbank lending. See Douglas G., Allen F., 2000, “Financial contagion”, 108 Journal Pol. Econ.1,4; Freixas X., Rochet J-C., 2000, “Systemic risk, interbank relations, and liquidity provision by the Central Bank”, 32 J. Money, Credit & Banking.

[7] See Scott, 2011, “How to improve five important areas of financial regulation” In “Rules for growth: promoting innovation and growth through legal reform, 113,114.

[8] A tax payer bailout is an injection of public money into an otherwise insolvent institution that imposes at least some losses on parties other than the non public shareholders and creditors of the firm.

[9] Basel Committee on Banking Supervision, “Basel III: A global regulatory framework for more resilient banks and banking systems”, June 2011.

[10] Liquidity coverage ratio (LCR) and Net stable funding ratio (NSFR). See note 10.

[11] See Financial Stability Board, “Key Attributes of Effective Resolution Regimes for Financial Institutions”, 15 October 2014.

[12] An efficient resolution regime, as prospected by international standards, should regulate the treatment of qualified financial contracts. Contracts against a financial institution, such as derivatives, swaps etc. are highly subject to market conditions, and in this case to the initiation of a resolution process towards a bank. The counterparties of these contracts will usually terminate/net-out their contracts upon the initiation of a resolution process, causing a potential fire sale and destruction of value in the market.

[13] Huertas T., 2014, “Safe to Fail”, Plagrave MacMillan; see also Zhou J. et al., “From bail-out to bail-in: mandatory debt restructuring of systemic financial institutions”, April 24,2012, IMF discussion paper.

[14] Bate C., Gleeson S., 2011, “Legal aspects of bank bail-ins”, Clifford Chance.

[15] Ass’n for Fin. Mkts. in Eur. (AFME), The Systemic Safety Net: Pulling Failing Firms Back From the Edge 7 (Aug. 2010), http://www.afme.eu/WorkArea/DownloadAsset.aspx?id=197; Capizzi A., Capiello S., “Prime considerazioni sullo strumento del bail-in: la conversion forzosa del debito in capitale”, http://www.academia.edu/15672199/Prime_considerazioni_sullo_strumento_de...

[16] Essentially, bail-in provisions mean that a pre-planned contract replaces a bankruptcy proceeding, giving more certainty on the sufficiency of funds needed to rescue a failing institution, and facilitating recapitalization.

[17] Sommer J., 2014, “Why bail-in? And how!”, FRBNY Economic Policy Review.

[18] Banks must have enough liabilities with loss-absorbing capacity (TLAC). The FSB envisaged that TLAC should consist of instruments that can be written down or converted into equity in case of resolution. Thus capital instruments and long-term unsecured debt are the components of this tool. Banks must at all times have enough liabilities to absorb losses. Setting a minimum TLAC seeks two objectives: (i) to avoid the need for a bail-out; (ii) recapitalize the failed institution at a level that promotes market confidence and facilitate an efficient implementation of the resolution strategy.

[19] A condition that bail-in needs to respect in order to be effectively implemented is the creditor hierarchy, which contains two other principles such as the no creditor worse off principle and the same treatment to the equally positioned creditors. For a detailed description of the allocation of losses in an insolvency regime see Hupkes E.,

[20] Living wills play an important role in resolution strategies. They are “plans or strategies to be developed by specified large complex financial institutions for winding down the operation if and when they become insolvent with minimum disruption both to themselves and to the economy”. See Hupkens E., 2012, “Living wills: an international perspective” In “Bank recovery and resolution directive: Europe’s solution for too big to fail?”, ILF series; Avgouleas E. et al., 2013, “Bank resolution plans as a catalyst for global financial reform”, Journal of Fin. Stab., Vol.9

[21] Recapitalizing the bank in resolution is necessary but not sufficient to stabilize the institution. Continuity of operations can only be assured if the bank has an access to adequate liquidity. Collateral is key in the liquidity management, because any liquidity provider would require that this is done on a collateralized basis.

[22] Avgouleas E. and Goodhart C., 2015, “Critical Reflections on Bank Bail-ins”, Journal of Financial Regulation, vol.00, no. 0 , pp.1-27

[23] Bank holding company act was enacted in 1956. The parent company usually do not hold financial liabilities.

[24] Dodd Frank Wall Street reform and consumer protection, Pub.L.111-230, H.R.4173

[25] Cohen T.H., 2011, “Orderly Liquidation Authority: a New Insolvency Regime to Address Systemic Risk”, University of Richmond L.R., vol.45,pp.1143-1229

[26] Dodd-Frank Act, sec.203.

[27] Bankruptcy should be the preferred method to resolve a financial institution. Indeed, resolution plans will necessarily include bankruptcy among the resolution methods. The discipline of living wills requires commercial firms to pre-commit to their treatment in bankruptcy. Also under Title II, OLA, resolution under the Bankruptcy code should continue to be the main tool to resolve a failing institution, however if OLA is invoked, it will displace bankruptcy.

[28] Financial companies include not only bank holding companies but any nonbank financial company designated by the FSOC as a systemically important financial institution, as well as any other company that is predominantly engaged in financial activities.

[29] Kupiec P.H., 2015, “Is Dodd Frank Orderly Liquidation Authority necessary to fix Too-Big-To-Fail?”, American Enterprise Institute.

[30] Scott H., 2014, “Interconnectedness and contagion”, Working Paper, Committee on Capital Markets Regulation.

[31] Id.

[32] On the SPOE strategy in detail, see Bovenzi J., Guynn R., Jackson T., 2013, “Too Big To Fail: The path to a solution” In Baily N. and Taylor J.B. “Across the Great Divide”, HooverPress; The Clearing House, 2013, “Ending TBTF: Title II of the Dodd Frank Act and the Approach of Single Point of Entry Private Sector Recapitalization of a Failed Financial Company”, Banking Brief White PaperSeries.

[33 ]SPOE strategy is equivalent to Chapter 11 of the Bankruptcy code, where the essential aim is the reorganization of a company; for a comparison between Title II (SPOE) and bankruptcy see SkeelD.,2014,“Single Point of Entry and the Bankruptcy Alternative” In Baily N. and Taylor J.B. “Across the Great Divide”, Hoover Press.

[34] Federal Register/ Vol.78, No.243/ Wednesday, December18, 2013/Notices.

[35] For a detailed description of the process see FDIC-BoE Joint Paper, “Resolving globally active, systemically important, financial institutions”, 10 December 2012; The Clearing House, 2013, “Ending TBTF: Title II of the Dodd Frank Act and the approach of Single Point of Entry private sector recapitalization of a failed financial company”, Banking White Papers.

[36] For a general description of the SPE and MPE strategy see Davies P., 2015, “Resolution of cross-border groups”, In “Research handbook on crisis management in the banking sector”, Edward Elgar publishing.

[37] All the advance made by the FDIC trough the OLF are fully secured trough the pledge of the assets of the bridge company and its subsidiaries. If the assets of the bridge company, it subsidiaries, and the receivership are insufficient to repay fully the OLF, the receiver would impose risk-based assessments on financial companies.

[38] A consequence of initiation of bail-in is also an automatic anti ipso facto provision that voids cross-default clauses keyed to the resolution of the parent company. Furthermore, as stated in Dodd Frank Act, sec.210(c)(8)(F), derivatives shall not originate a fire sale of assets. If the assets' price fall, other institutions that hold the same asset would see the value of their assets fall as well. The SPOE can avert this fire sale by putting the derivative on a stay until 5.00 p.m. the day after the FDIC is appointed as receiver. If the receivertransfers those contracts to the new bridge company, counterparties cannot exercise their liquidation and foreclosurerights.

[39] The FDIC's paper notes that their liquidity and capital pressures would be alleviated trough intercompany loans from the recapitalized parent. By providing liquidity and preventing termination of contracts, the FDIC would allow the subsidiaries to operate without obstacles.

[40] As the FDIC-BoE joint paper conclude: “It should be stressed that a key advantage of a whole group, single point of entry approach is that it avoids the need to commence separate territorial and entity-focused insolvency proceedings, which could be disruptive, difficult to coordinate, and would depend on the satisfaction of a large number of preconditions in terms of structure and operations of the group for successful execution”.

[41] See FDIC-BoE Joint Paper, “Resolving globally active, systemically important, financial institutions”, 10 December 2012.

[42] The fact that unsecured creditors absorb part of the losses is a significant fact from an incentive perspective. Usually creditors are risk adverse in comparison with shareholders, but the creditors' risk-taking disappears if they know that the institution will be bailed out and if the cost of monitoring risky activities is too high. If the government shifts the cost from taxpayers to creditors, the creditors would be exposed to the risk of reckless debtor investments. This exposure would incentivize creditors to monitor risky activities, aligning the interests of society with the interests of the financial institution.

[43] The problem stems from the fact that single point of entry relies heavily on the assumption that unsecured liabilities of the parent company will be sufficient to cover the losses of the financial group. However, if financial institutions were left to their own devices, they might hold very little long-term debt at the parent level in order to undermine the implementation of the single point of entry approach. Because long-term at the holding company is subject to write -down, it may become more costly and subsidiary debt comparatively cheap. Regulators are aware of this incentive and they responded by mandating that SIFI holding companies hold acertain amount of long-term debt. In November 30, 2015 FED issued a proposal on the use of TLAC. See Federal Reserve System, “Total loss-absorbing capacity, Long-term debt, and Clean holding company requirements for systemically important US bank holding companies and Intermediate holding companies of systemically foreign banking organizations; Regulatory capital deduction for investments in certain unsecured debt of systemically important US bank holding companies; Proposed Rule”, Federal Register, Vol. 80, No.229, 30 November 2015.

[44] Skeel D., 2014, “Single Point of Entry and the Bankruptcy Alternative” In Baily N. and Taylor J.B. “ Across the Great Divide”, Hoover Press.

[45] See Jin K-Y., 2105, “How to eat an elephant: Corporate group structure, of systemically important financial institutions, Orderly Liquidation Authority, and Single Point of Entry Resolution”, Yale L.J., Vol.124, No.5.

[46] The structure of holding companies facilitates a resolution strategy like single point of entry. The path of United States to the holding company structure is a consequence of the exclusion of banks from financial services as securities underwriting and other investment activities by the Glass-Steagall Act. See Banking Act of 1933.

[47] See note 41.

[48] Directive 2014/59/EU of the European Parliament and of the Council; see Schelo S., 2015, “Bank Recovery and Resolution”, WoltersKluwer

[49] See Bart P.M.J., 2014, “Bail-in mechanism in the Bank Recovery and Resolution Directive”, Netherlands Association for comparative and international Insolvency Law; and also Ferrarini G., Busch D., 2015, “European Banking Union”, Oxford press

[50] Huertas T., 2013, ‘The Case for Bail-ins’ In Dombret A. and Kenadjian S.,” The Bank Recovery and Resolution Directive”, ILF series, De Gruyter.

[51] BRRD, Recital 57.

[52] For a description of objectives and principles of the EU resolution process see Binder J-H., “Resolution: Concept, Requirements and Tools”, Bank Resolution: The European Regime, Oxford University Press, 2015/2016,forthcoming; also Thole C., 2014, “Bank crisis management and resolution- Core features of the Bank recovery and resolution directive”, http://ssrn.com/abstract=2469807

[53 ]BRRDart.43(3).

[54] Timing is essential for bail-in to be efficient. There are generally two types of trigger for bail-in: (i) an insolvency related trigger, which works when a bank is close to be balance sheet insolvent; (ii) and a pre-insolvency trigger, which activates at an early stage, such as the breach of the capital ratio. Considering both thresholds, the perfect time to trigger bail-in is at a point close but before a bank is balance sheet insolvent and all its equity is wiped out. See Preamble to Bank Recovery and Resolution Directive.

[55] The Point of Non Viability (PONV) is reached when a bank is failing or likely to fail and there is no reasonable prospect that any private sector measure could save the bank. BRRD, Art.42.

[56] Recital 68 of the BRRD: “In order to ensure that resolution authorities have the necessary flexibility to allocate losses to creditors in a range of circumstances, it is appropriate that those authorities be able to apply the bail-in tool both where the objective is to resolve the failing institution as a going concern if there is a realistic prospect that the institution’s viability may be restored, and where systemically important services are transferred to a bridge institution and the residual part of the institution ceases to operate and is wound up”.

[57] BRRD art.43.

[58] BBRD art.43(1), 63(1).

[59] BRRD, Art.43(2).

[60] The European legislation is modeled on a “carve-out approach”, as opposed to a “waterfall approach”. Both extend bail-in beyond capital instruments, but the former extends bail-in throughout the entire liability structure of the bank but creates carve-outs for certain obligations. The latter instead creates a further class of instruments subject to bail-in at the point of intervention.

[61] BRRD, Art.44(2).

[62] The exclusion of certain liabilities from the scope of bail-in may constitute a deviation from the ranking of creditors under national insolvency laws, where insured depositors, short-term creditors and trade creditors are ranked pari passu with general unsecured creditors.

[63] BRRD, Art. 49. To the extent that they are not excluded from the application of the bail-in tool, they may be bailed

in only after closing them out.

[64] BRRDart.45(1).

[65] BRRD, Art.45.

[66] FSB, “Adequacy of Loss-Absorbing Capacity of Global Systemically Important banks in Resolution- Consultative Document”, 10 November 2014.

[67] BRRD art.50. The issue is how to combine the setting of the conversion rate with (i) the NCWO principle and (ii) the priority of claims in the national insolvency laws. The Directive sets the ‘fair balance’ at the counterfactual insolvency value which take into account the insolvency recovery rate. The conversion ratio will definitely lead to controversies, and this is the point where judicial review becomes relevant. The Directive is silent on this point. It just states that the Member States have the duty to ensure a swift implementation of the resolution tool and however Art.85 of the BRRD provides for a right to appeal, this may be limited and may not stop the write down from becomingeffective.

[68] BRRD art.48(2).

[69] ‘Speed’ should be guaranteed by living wills and the power to enforce the resolution tools. It is widely discretionary in both regimes, American and European, where resolution authorities are provided with wide discretion in terms of when to establish that a firm is no longer viable and which resolution tool to use.

[70] McAndrews J. and others, ‘What Makes Large Bank Failures so Messy and What to Do about It?’ 20 Federal Reserve Bank of New York, Econ Pol Rev.

[71] ‘Stability’ should be granted by the power to put derivative contracts on stay and exclude them from the application of bail-in.

[72] ‘Certainty’ reflects two fundamental principles: the creditor hierarchy and the no credit worse off principle. The respect of those two principles is essential to the implementation of bail-in.

[73] See Canals J., 1997, “Universal banking: International comparisons and theoretical perspectives”, Oxford Press; Gleeson S., 2012, “Legal aspect of bail-ins”, LSE Financial markets group paper series; Gordon J., Ringe W-G., 2014, “Bank resolution in the European Banking Union: A transatlantic perspective on what it would take”, Oxford Legal Research paper series, No. 18

[74] The European Union has a Proposed Structural Measures Regulation under deliberation, which considers whether to adopt a form of the US ‘Volcker Rule’ to limit proprietary trading by large credit institutions. See Proposal for a Regulation of the European Parliament and of the Council on structural measures improving the resilience of EU credit institutions, COM (2014) 43 Final 2014/0020 (COD) 29 January 2014.

[75] FINMA, “Resolution of global systemically important banks”, 7 August 2013.

[76] Jeffrey Gordon and Wolf-George Ringe argue for single point of entry to be a more efficient resolution methodology than multiple point of entry. Single point of entry has several advantage: (i) it makes resolution more transparent and credible; (ii) it works better in a cross-border situation facilitating a regulatory solution by one resolution authority; (iii) it ensures that the subsidiaries keep operating, thus avoiding destructive runs that can cause fire sale liquidations, negative asset valuation and other knock-on effects.