You know, there’s never a dull moment when one reports on the regulatory states’ endless and so often fruitless and wrong-headed tinkering with the global economy. So now… let’s talk bail-in. The bail-in regime, which was adopted by all European Union countries (other than Poland) and implemented on January 1, 2016 (European Economic Area (EEA) members Norway, Iceland and Lichtenstein are required to adopt the regime by December 31, 2016), permits European financial regulators to “bail-in” a failing institution by cancelling, writing-down, or converting into equity certain of the institution’s unsecured liabilities. Affected institutions must include a contractual recognition clause in its non-European-law governed contracts, so that all counterparties acknowledge that the institution’s liabilities are potentially subject to bail-in and agree to be bound by them.
The bail-in regime is intended to provide European regulators with a way to recapitalize troubled financial institutions at no cost to taxpayers. Like much of the regulatory apparatus that has been imposed on the market, the rule is long on lofty sounding goals birthed from a primeval soup of jejune macro-economic certitudes, ideology and practical politics and short on the operationalize bit: Will it really work as intended in the real world?
The Bail-In Rule will require changes in virtually all contracts (including loan documents, swap agreements, repos, etc., etc.) of any bank which is established inside the EEA, if the contract is not governed by EEA member country law. To be clear, this rule doesn’t just profess to apply to transactions in the EEA, but transactions throughout the world where a designated bail-in bank is a counterparty.
What type of undertakings would be subject to the ability of the European regulators, to disregard, remake or breach a contract? Any of them which are unsecured. Where the rubber most particularly hits the road in CRE lending is with future advance components, revolving lines of credit, swaps, hedges and repurchase and securities contract agreements. Does it mean that the buyer bank in a repo need not return the collateral? I guess it could if the regulator viewed the counterparty as holding only a chose in action. (But it’s secured lending, right? Maybe. But maybe not to a Belgian regulator.) But hey, you get stock in an effectively insolvent financial institution. So what’s wrong with that?
In the past several months, many major European banks have instructed counsel around the world, including North America, to insert bail-in provisions in their documents. These provisions come in a couple of flavors, the most common one is one that is provided by the LSTA and a copy of that isattached to this commentary. It’s sort of startling, isn’t it? How are those powers triggered, how much discretion does the prudential regulator have? Does the counterparty have any rights to, I don’t know, get something other than common equity? Most nationally recognized counsel are already carving out the bail-in provision from their enforceability opinions because it is very hard, no make that impossible, to sort how exactly the provisions would actually work.
A couple of big ticket observations: Maybe this is much to do about nothing. It’s not going to happen until a major bank is taken into the European version of conservatorship or receivership and, if we learned nothing else over the past several years, the Europeans usually find a way to avoid that final denouncement, the final reel of the movie and the European banks seem to somehow stumble along with support either from the institutions of the EC or from their national sovereign protectors. So maybe it never happens.
Is the bail-in concept any worse than the rights that a counterparty would have under the United States Bankruptcy Code or under the FDIC’s resolution powers? If your counterparty goes castors up here in America, the Bankruptcy Code is going to have a lot of rights to modify and adjust its contractual obligations. United States Bankruptcy Courts have broad equitable powers to reject executory contracts, and a seller under a repurchase facility would likely be considered an unsecured creditor of the bankrupt counterparty. If it’s a bank, the prudential regulators can step in, with even broader powers to repudiate contracts (not limited to executory contracts) that are considered burdensome, or which are determined to promote the orderly administration of an institutions affairs. But at least all those counterparties remain creditors, senior to the insolvent entities’ equity.
The European regulators’ “Write-Down and Conversion Powers” appear on their face to be broader than the FDIC receivership powers, which are generally limited to liquidation and distribution of assets according to statutory priorities and are aimed at maximizing net returns for creditors. The bail-in regime provides regulators with the flexibility to convert unsecured creditors’ into equity and vary certain terms of the underlying liabilities (the FDIC is limited to repudiation of contracts), such as interest rates and maturity, with a view towards continuing the institution as a going concern or smoothly transitioning to a successor institution. That really is different.
And finally, did the masters of the universe who, while thinking great macro-prudential thoughts, give any consideration to the extent this may disrupt commercial arrangements, reduce the efficient operations of the capital markets and reduce the flow of capital which is necessary to support global economies? Did anyone try to measure and weigh risks and rewards? Look at the scale and weigh the benefits and burdens? I don’t think so. There is a conservation of matter sort of rule in the regulatory version of the universe. Rules that change existing business relationships and upset existing contractual patterns are not without consequence and cost. The Bail-In Rule will make transactions less commercially certain and hence increase the cost of doing business and decrease the efficiency in which business is conducted and it is going to cause even more growth in the compliance regimes of all covered institutions. Was any of that measured against the theoretical benefit of all this regulatory sturm und drang? I get the basic concept of protecting European taxpayers from the cost of restructuring a bank, but doesn’t this feel a lot more like protecting voters and politically adept domestic constituencies? It’s a nifty idea if one’s a tenured professor wearing the tweeds, but somehow it feels ill thought through in a real world context and it feels more a part of the ongoing populist, anti-bank, anti-business narrative which so many politicians have embraced.
So, let’s bail! Bail in or Bail out, it’s just another notch on the regulatory pistol grip, a head fake to distract the unwashed that the governments will not do the hard work of fixing the system. It is another escapist notion to take the place of real reform, on behalf of a polity bereft of both good ideas and the conviction necessary to fix what’s broken. So the lawyers will beaver away and we’ll all stand by to see how the world of real transactional activity assesses and values the risks and burdens of this new regulatory regime. It fixes nothing, but perhaps it only does modest harm. Nothing’s new.