Creditors in bank failure and bank liquidation are often left in the dark as to the realistic expectations of repayment. The assumption is that banks use the money of savers to make a profit. It is often forgotten that borrowers may default on their obligations. Another complication is that bank capital fluctuates in value and when converted into liquidity does not always correspond with the outstanding claims from creditors.

Bank liquidation is the final stage to dissolve a financial institution in distress. The failure of a bank may disrupt society and can have adverse effects on an economy. As such, central banks and financial regulators scrutinize bank failure from the very first moment. A resolution plan is then formulated to mitigate risk and limit damages for the stakeholders involved. Traditionally, banks fail for financial reasons, in essence they are unable to honor their obligations towards customers, investors and other creditors. In other peculiar circumstances, banks may fail for violations of international regulation. This mostly concerns matters of anti-money laundering and counter terrorism financing.

To maintain public confidence and limit damages, failing financial institutions must be resolved in an orderly manner. This means that creditors should regain access to at least part of their account balance fast, whilst the insured amount must be repaid to eligible depositors when it is determined that the failing financial institution is unable to make repayments to its creditors. These first two recovery mechanisms are straightforward, even though not every creditors qualifies for repayment under such schemes.

Prospects and expectations in bank liquidation

In general creditors of failing financial institutions wish to understand the mechanics of overall fund recovery to determine their chances of full repayment. Full repayment depends on the actual consolidated account or group liquidity. Bank failure is a financial issue and therefore results in liquidity challenges. For creditors with unsecured claims, or those with balances that exceed the insured limits, there is always risk of an asset write down involved. The scope of this account devaluation depends on several factors. Therefore, the applicability of the deposit protection scheme is of critical importance. Furthermore, and as explained in this article, asset and fund recovery has distinct and isolated stages that all have their own potential. Using them to their full potential often delivers the best prospects in overall bank liquidation.

Although financial challenges are the common reason for bank failure and bank liquidation, financial institutions can also be striped of their license by its responsible regulator. Stakeholders then take matters in their own hands to limit their damages. The result is that eventually financial challenges that justify a winding up will occur. However, the financial health of the bank could have been sufficient to repay most creditors on demand at the moment regulatory interference took place.

The answer to the question what the prospects and expectations in bank liquidation are for bank depositors and other creditors starts with an outline of the possibilities for asset and fund recovery. Since bank liquidation is only one singular part of the total recovery procedure, creditors should consider the other relevant options too so they can maximize repayment by not having to rely on one single repayment opportunity. Yet, since this question relates to bank liquidation, the creditor and insolvency hierarchy in liquidation must be examined to come to the appropriate conclusion.

General creditor hierarchy in liquidation

Bank liquidation and corporate liquidation have close similarities. Systemically important financial institutions are considered too big to fail and use their own regime. The European Bank Recovery and Resolution Directive (BRRD) applies to systemic banks and defines the most extensive framework to protect the financial system from the failure of systemic institutions.

Prior to the repayments to creditors are made, the special administrator or liquidator of the bank must evaluate the capital position of the bank. This contains Tier 1 (shareholder capital and retained earnings), Tier 2 (long term borrowing, reserves, provisions, and subordinated bank debt), and Tier 3 (additional Tier 2 plus short term subordinated loans). Creative bookkeeping allows the bank for example to value loans at the level when they were initially sold to the borrower. Depreciations by loan defaults are inapplicable for the real time valuation. As such, the capital position of the bank is often seen as an accounting value. When accounting values are monetized, the real value is generally lower which results in a depreciation of the repayment potential for creditors.

Once the banks assets are liquid, repayment can start. A general pool for repayment is formed. The special administrator or liquidator must ensure that payment is justified to the appropriate account holder. Therefore, creditors are asked to submit a proof of debt and a proof of claim. Without this information no repayment is made and the claim eventually become obsolete. Creditors must realize that once repayments start, the general pool of funds rapidly declines in value and late filing unsecured creditors may experience further losses.

The insolvency and creditor hierarchy in bank liquidation groups creditors according to the priority of their claim and repays prioritized claims before other claimants get their share from the general pool of funds available for distribution. Creditors per group are treated on an equal basis and once the group is paid in full, the next group follows. As such, the following hierarchy, with slight differences per jurisdiction, is in general used:

  • Group 1: Cost of the liquidation, employee benefits and late payments, tax claims, regulatory fines and penalties, and the DGS advance payment claim.
  • Group 2: Senior secured debt; general securities and fixed and floating charges.
  • Group 3: Unsecured liabilities; bank deposits.
  • Group 4: Subordinated debt; investments in commercial paper and unsecured bank investment products.
  • Group 5: Tier 1 equity & Tier 2 debt; shareholders.

Most visitors of this website are bank depositors. These are placed at the third position in the creditor hierarchy for bank liquidation and have a subordinated claim to the general pool of funds. The total available liquidity of the bank as a percentage of all claims therefore does not stand in relation with the final payment percentage to bank depositors. A write-down or ‘haircut’ of the deposit is most likely and shareholders will try everything they can to improve their position and regain access to a higher repayment than their designated group 5.