European & Best Practice Bank Resolution Mechanisms: An Assessment and Recommendations for Policy and Legal Reforms

Discussion Report – Warsaw, Oct. 2011

John D. PollnerLead Financial OfficerFinancial Sector ProgramsEurope & Central Asia RegionWorld Bank

Lessons from the Financial Crisis

A severe lack of flexibility in handling bank failures without massive state intervention (e.g.: Northern Rock).

The report reviews major country practices in bank resolution as well as the new European proposals set forth by the EU Commission.

Purpose of report is for policy makers to reform bank insolvency legislation in line with EC proposals while identifying design gaps.

The European Commission Proposals:Added Flexibility for dealing with Bank

Failures They span modernized

resolution tools including: (a) sale of an institution (or parts) without shareholder consent, (b) a bridge bank before a final buyer is identified, (c) asset separation tool to split off good assets and bad assets, (d) debt write down, bail in and COCOs tools, (e) use of deposit insurance funds for gaps in resolution financing, subject to least cost criteria.

The working assumption that ordinary/traditional bank insolvency procedures should be used before applying new resolution mechanisms.

Working assumption that debt to equity conversions should be a last resort. Does this makes sense for SIFIs as these could be a first cushion given difficulty to ‘absorb’ SIFIs?

Working assumption that it will be difficult to establish a harmonized EU solution. Should the rules for resolution not be highly matched across the EU to avoid intra-EU reg. ‘arbitrage’?

Some issues in the EC Proposals

The report discusses the existing legislation in some key Western plus selected Eastern European countries as well as the U.S. and Canada where P&A tools fully implemented.

New reforms show that Germany, the U.K. and Spain have modernized features. The U.S. and Canada have used several instruments already. The Czech Republic is somewhat advanced. Poland and others need further legal reforms.

The U.S. legislation (Dodd-Frank) adds non-bank systemic institutions as also being subject to resolution and/or bail in mechanisms.

Country Comparisons

Several EU Countries Still have Gaps

An identified sole authority to conduct resolution is not well assigned/identified under the proposals.

Powers to sell parts or a whole of a failing institution without shareholder consent remain a problem.

Bridge bank options as well as good bank / bad bank options still not specified in several country laws.

Debt reduction/conversion tools not explicitly stated. Resolution is the new insolvency process in essence. There should not be a separate phase or another insolvency law. Resolution will also allow a final end-stage of liquidation for residual assets that cannot be absorbed.

A key gap in Poland’s and many country laws as well as the EC proposals, pertains to the definition of insolvency.

For banks, insolvency should not be economic insolvency (negative net worth) as that is too late for effective intervention.

A capital adequacy ratio below the minimum (regulatory insolvency) or other weaknesses should be an early criterion for intervention & considering resolution actions.

Intervention Triggers and Rights

Resolution laws should clarify that breach of “regulatory insolvency” is equivalent to breaching the conditions for having a banking license.

In such a context, once regulatory insolvency is breached, bank directors, management and shareholders should have rights suspended.

This allows resolution to proceed efficiently and avoid the acceleration of losses.

Rights under Regulatory Insolvency

Legal Tools and Financial Tools

Besides the several resolution mechanisms, the reality is that in crisis situations there may not be many buyers of a failed bank’s assets. Leave as ‘open bank’ to find solutions for 5-20 days.

Once ‘voluntary buyer’ options are exhausted, the authorities should formally revoke the failed bank’s operating license to conduct a forced resolution (as a closed bank) or other mechanism.

Whether voluntary or forced,

resolutions need more burden

sharing financial instruments.

Packaging loan portfolios into several securitized bonds for transfer to several sound banks ready to absorb them along with matching deposits.

Where banks do not wish additional loan portfolios, use “loan servicing banks” to collect on loans with a % success fee, but loans not on their balance sheets.

Pre-establish and define the hierarchy of creditor rights a priori.

After using least cost criteria, define

operating procedure for the residual

asset(s) liquidation phase.

Additional Financial Instruments to Ease Asset Transfers

Hierarchy of “Creditors”

FIRST ORDER

a. Technical/Legal Assistance given for bank asset/liability separation process

b. Private Depositors, starting with Insuredc. Cash obligations such as

withheld salaries, external commerce contracts due, overdue salaries, payments for

delivered work

SECOND ORDERCredits from Central Bank (can also be put under “first order”)

THIRD ORDERa. Public sector deposits

b. Other obligations/credit/capital support from Governmentc. External financial intermediaries/ other creditors

d. Tax obligations

FOURTH ORDERShareholders

Summary of Resolution Principles

Resolution transactions need to demonstrate that they minimize costs/losses to the State and deposit insurance fund versus payouts to insured depositors.

Whether a bank stays open or closed, assets are treated as viable to maintain and preserve value.

Following the above, the principle is that bank insolvency should preserve assets and not liquidate unless this is the last resort (more costly) option.

Summary Resolution Principles, continued

The principle that breach of regulatory capital suspends shareholder rights and allows resolution.

Priority first given to preserve all deposits via the voluntary assumption by potential buyers.

Failing this, a license revocation for other options: good/bad bank, forced mergers/acquisitions.

For SIFIs, the early use of debt write downs, COCOs and bail-ins to increase capital as a first resort, so as to preserve the institution as break-up is unfeasible.