At the sudden trend of banking failures and consequent economic depression globally between 2008 and 2009, the Banking Union sought to encourage comprehensive and effective arrangements to deal with failing banks at national level and cooperative arrangements to tackle cross-border banking failures in the European Union. This led to the Bank Recovery and Resolution Directive in 2014.
The Bank Recovery and Resolution Directive (BRRD), a framework for the recovery and resolution of credit institutions and investment forms which came in force on the 2nd July, 2014 was adopted on the 15th of May, 2014 by the European Parliament and Council of the European Union (the Council).
The BRRD included rules to set up a national resolution fund that must be established by each EU country in other to ensure an orderly resolution of failing banks and required that all financial institutions contribute to these funds. Contributions are however calculated based on the institution’s size and risk profile.
BRRD, one part of the Single Rulebook together with rules on capital and liquidity requirements and on deposit guarantee schemes (DGS) now ensures a unified regulatory framework in financial institutions in the EU.
The Single Rulebook is the term used for the set of legislative texts that all financial institutions in the EU must comply with and on which Banking Union depends.
EU and the BRRD
The Banking Union was created by the European Union in 2012 in response to the “Euro zone Crisis”. The European Union is a political and economic union of 27 Member States that are located primarily in Europe. It is worthy to note that not all countries in Europe are Member States of the European Union.
The EU developed an internal single market through a standardized system of laws that apply in all Member States in matters where members have agreed to act as one.
Banking Union in the European Union was the vehicle used to transfer responsibility for banking policy from the national to the EU level in several countries of the European Union. The motivation for Banking Union was the fragility of numerous banks in the Euro zone, and the bank credit-sovereign credit vicious circle.
The Single Resolution Mechanism (SRM), a pillar of the Banking Union centrally implements the Single Rulebook’s Bank Recovery and Resolution Directive (BRRD) in participating Member States
Generally, if a failing bank cannot pay its depositors, a bank panic might ensue in which depositors run on the bank in an attempt to get their money back. This can make the situation worse for the failing bank, by shrinking its liquid assets as depositors withdraw them from the bank. And when a bank is short of liquidity, it would be less willing to lend money to firms and consumers. Consequently, firms would reduce investment and employ fewer workers. And where there is a significant fall in investment levels, there is slower economic growth and higher unemployment. A financial crisis.
The Bank Recovery and Resolution Directive was a response to a financial crisis. Generally, a bank resolution occurs when authorities determine that a failing bank cannot go through normal insolvency proceedings without harming public interest and causing financial instability and this was already the case in the European Union.
This financial crisis, which began in US subprime mortgage market in 2007 had spread quickly globally because of the high inter connectivity of the financial sector. It had very strong effects across the globe including in Europe.
The European debt crisis also referred to as “Euro area” or “Euro zone” made apparent a lack of clarity about how to handle a distressed banking sector, and serious shortcomings in the tools available to deal with failing banks without interrupting the provision of systemically critical functions to customers and the economy at large. The severe shortcomings in the institutional framework of the European Union (EU) in general, and in the Economic and Monetary Union (EMU) was revealed.
Fiscal interventions were undertaken by governments worldwide to restore financial stability and keep the markets calm but banks continued to fail and require capital injections to restore market confidence. But, a negative feedback loop between banks and sovereigns, i.e. the link between sovereign debt and bank debt, impaired a coordinated centralized response to the financial crisis in the EU. The increasing risk of fragmentation in the EU banking market also risked undermining the single market for financial services and impairing the effective transmission of monetary policy to the real economy throughout the euro area.
The effects of the crisis spilled over from banks to the real economy. The main cause was found in the nexus between (domestic) bank risk and sovereign risk as earlier stated.
The BRRD procedure
The BRRD regulates four key elements in response to this financial crisis and envisaged bank failures:
- The preparation and prevention of resolution via recovery and resolution planning.
- The taking of early intervention measure by the supervisor.
- The application of resolution tools and powers in the case of an actual bank failure.
- The cooperation and coordination between national authorities.
Five resolution tools are provided for under the BRRD in regulating these four elements. Named after the elements they control, there is the: Bail-in tool; Sale of business tool; Asset separation tool; Bridge institution tool; and, as a last resort having tried all of the above to no avail the Government stabilization tool.
The resolution authority is given all the above powers and tools for use in achieving the objectives of resolution. It is assumed that the powers are applied as a “bundle”, called resolution tools, which may be used individually or in any combination on a case-by-case basis (with exception to the asset separation tool, which may only be applied together with another resolution tool).
The Bail-in tool allows the resolution authority to allocate incurred losses to the owners and debt holders of the institution. With this, the interests of existing shareholders are cancelled, diluted, or transferred, and the claims of unsecured creditors are written down and/or converted into equity to recapitalize the firm. Depositors with eligible deposits of up to € 100.000 are exempted from a bail-in while senior debt holders must be bailed-in before any other depositors.
The Sale of Business tool allows for fast transfer of financial instructions of the institution under resolution to a purchaser “on commercial terms”.
The Bridge Institution tool allows for a temporary transfer of financial instruments to a “publicly owned” bridge bank in order to maintain critical functions of the problem bank.
The Asset Separation tool allows for “impaired” assets, rights and liabilities to be transferred to a “publicly owned” asset management vehicle, also known as a “bad bank”. This causes value improving workout of assets and avoids possible value destruction caused by fire sale under liquidation.
Finally, the Government Stabilization tools may be used as a last resort in very exceptional situations of systemic crisis and after having exploited all the resolution tools. This works with the resolution authority seeking funding from the government by way of temporary public ownership or public equity support. This tool is not technically a resolution tool.
Other powers are provided for in Article 63 of the BRRD and as may be entrusted by Member States. The use of tools thereof must be consistent with the resolution principles and objectives, especially that of non-interference with the effective resolution of cross-border groups.
The BRRD does not specify scope and nature of a moratorium. Banks have to bail-in bank creditors before public funds can be used for rescuing an institution. These (limited) new source of resolution funding have been self-funded by the industry and have had wider impact on costs of funding for the markets and borrowers. Bank capital instruments not governed under EU law must include a legally enforceable clause, indicating the instrument could be used for bail-in purpose and applied to existing liabilities, or only new liabilities. Applied retroactively, banks and creditors may need to renegotiate instruments, resulting in increased compliance costs and possibly impacting costs of funding.
Recently, the European Commission has been working to improve the prudential rules in the EU to ensure growth and financial stability with the aim of ensuring that the rules are proportional to risk and consistent prudential objectives and financial stability are preserved.
On 23 November 2016 the European Commission proposed amendments to the BRRD. The amendments include measures that will further strengthen the European resolution framework and the ability of relevant authorities to achieve resolution outcomes that are effective in safeguarding financial stability and public funds.
There were proposals for a directive amending the BRRD as regards the ranking of unsecured debt instruments in insolvency hierarchy, for a directive amending the BRRD on loss absorption and recapitalization capacity of credit institutions and investment firms.
And on 16 April 2019, the European Parliament endorsed the final agreement on a comprehensive set of reforms proposed by the Commission to strengthen further resilience and reliability of EU banks, including the BRRD.