On January 1, 2016, the European Union’s “bail-in” provisions went into effect. The bail-in provisions, authorized under the Bank Recovery and Resolution Directive (BRRD) and implemented by the Single Resolution Mechanism (SRM), provide for financial resolution of covered institutions by cancelling or reducing liabilities of a failing bank, or converting debt to equity, as a means of restoring a financial institution’s capital position. The bail-in provisions apply to obligations incurred as of January 1, 2016, and as such when covered institutions enter into transactions governed by non-European law, their contracts need to include a “contractual recognition provision” which gives notice of the bail-in liabilities and obtains acknowledgment by the other parties to the transaction. This would include typical loan market documentation governed by any U.S. state law, with a borrower being, perhaps, an atypical creditor. On April 10, 2016, HETA became the European Union’s first bank to be bailed-in pursuant to these provisions.

Brief Overview

Following the financial crisis, the European Union passed broad sweeping banking regulation known as the Single Rule Book. Among other things, the Single Rule Book establishes capital requirements for banks, ensures protection for depositors, and regulates the prevention and management of bank failures, through regulations and directives including the Bank Recovery and Resolution Directive. The Single Rule Book also serves as the foundation of the formation of a “Banking Union” for Eurozone member states and for other participating EU member states. The Banking Union is composed of: 1) the Single Supervisory Mechanism (SSM), which places the European Central Bank (ECB) as the central prudential supervisor of financial institutions in the euro area, 2) the Single Resolution Mechanism, whose purpose is to ensure an orderly mechanism for resolution with minimal cost to taxpayers, and 3) the European Deposit Insurance Scheme (EDIS), designed to provide uniform insurance coverage for all retail depositors in the Banking Union with an eye toward ensuring equal protection of deposits throughout the Banking Union regardless of the Member State where the deposit is located.

In the context of the Banking Union, the BRRD and the SRM are complementary; the BRRD provides uniform rules across the EU single market and the SRM sets out the institutional and funding architecture for applying those rules in Member States participating in the Banking Union. One of the primary goals of the BRRD (implemented through the SRM) is the orderly resolution of banks such that their critical functions are preserved, while the non-critical parts of the failed institution are wound down.

The main aims of bank resolution under the BRRD are to: 1) safeguard the continuity of essential banking operations, 2) protect depositors, client assets and public funds, 3) minimize risks to financial stability, and 4) avoid unnecessary destruction of value.

Under the BRRD, resolution authorities are able to exercise clear-cut measures when a bank meets the conditions for resolution: 1) it has reached a point of distress such that there are no realistic prospects of recovery over an appropriate timeframe, 2) all other private sector or supervisory intervention measures have proved insufficient to restore the bank to viability, and 3) winding up the institution under normal insolvency proceedings would risk prolonged uncertainty or financial instability and therefore resolving the bank would be better from a public interest perspective.

Bail-In

Under the BRRD, resolution authorities are granted broad power to: (i) effect private sector acquisitions (parts of the bank can be sold to one or more purchasers without the consent of shareholders); (ii) transfer business to a temporary structure (such as a "bridge bank") to preserve essential banking functions or facilitate continuous access to deposits; (iii) separate clean and toxic assets between “good” and “bad” banks through a partial transfer of assets and liabilities; and/or (iv) bail-in creditors.

The main aim of bail-in is to stabilize a failing bank so that its essential services can continue, without the need for a bail-out using public funds. A bail-in can take one of two forms.

Open Bank Resolution

In an “open bank resolution,” authorities seek to recapitalize a failing bank through the write-down of liabilities and/or converting liabilities to equity so that the bank can continue as a going concern. In theory, this gives authorities time to reorganize the bank or wind down parts of its business in an orderly manner. In the process, shareholders would be severely diluted or wiped out and management would be replaced. Meanwhile, creditors would endure a haircut as a result of the write-down or alternatively become shareholders of the failing bank.

Closed Bank Resolution

In a “closed bank resolution,” the bank is split in two, a good bank (or bridge bank) and a bad bank. The good bank-bridge bank is a newly created legal entity which continues to operate, while the old bad bank gets liquidated. Bank creditors that are not determined to be systemic are either left with the old bank and undergo losses as part of the liquidation or are transferred to the new bank either reducing their claims or converting them into equity. Shareholders and holders of other instruments of ownership may have their shares canceled, transferred, diluted, or partially canceled/transferred (a situation in which dilution is combined with cancellation or transfer without cancelling or transferring the instruments in full).

In exceptional circumstances of systemic stress, authorities may also provide public support instead of imposing losses in full on private creditors. However, such measures would only become available after the bank’s shareholders and creditors bear losses equivalent to 8% of the bank’s liabilities and would be subject to the applicable rules on State aid.