Not just another clause for banks to add to their contracts, the compulsory inclusion of references to new bail-in powers in certain contracts will focus customers' minds on the ability of resolution authorities to diminish the value of those contracts or even cancel them. But which contracts are included and what should the clause say? Pending the publication of final rules, Rosali Pretorius and Tom Harkus look at some of the key issues.

Summary

Firms to which the new UK rules apply (Covered Firms) include all UK banks and building societies. For certain of its unsecured liabilities, a Covered Firm must include wording in the relevant contract if it is governed by a non-EEA law (e.g. New York or Swiss law). The wording recognises, and binds their counterparties to, the Bank of England's (BoE) ability to write down, convert, amend and even cancel the Covered Firm’s liabilities under the contract, using its new bail-in powers. ("Bail-in" refers to a resolution mechanism that requires existing creditors to bear some or all of the economic burden. It contrasts with a "bail-out", which describes a resolution through the injection of new external credit, often from taxpayers.)

Bail-in

The Banking Recovery and Resolution Directive (BRRD) is an EU directive which grants powers to resolution authorities to step in if a bank or other relevant firm has "failed" or is likely to "fail" and it is not reasonably likely that any other action will be taken to prevent it from failing. This will likely, but not necessarily, be after a recovery plan has failed. The BoE is the UK's resolution authority.

The BoE's main resolution tools are its abilities to:

  • sell the Covered Firm;
  • transfer all or some of the assets or functions to a bridge bank for onward sale to another institution;
  • transfer non-performing assets into an asset management vehicle (the Asset Segregation Tool); and
  • bail in certain assets as described above.

Resolution authorities can use any combination of these tools provided they do not use the Asset Segregation Tool in isolation. The key objective is to avoid a "too-big-to-fail" scenario. In the event of a failure of a large financial institution, the regulators want critical functions of the institution and the financial system to continue without widespread contagion. They want to avoid taxpayers propping up the financial system whilst protecting client assets and protected deposits.

What contracts are affected and when do we need to update them?

In force now

Certain Covered Firms, excluding mixed financial holding companies, should already be including bail-in wording in certain contracts issued/entered into from 19 February 2015 where they are governed by the law of a non-EEA jurisdiction. This is currently limited to contracts setting out the terms of the Covered Firm's liabilities under transferable debt securities or instruments, or additional Tier 1 or Tier 2 instruments, provided they are not excluded. Excluded liabilities include secured liabilities, liabilities relating to client assets and protected deposits.

Liabilities arising out of the following are therefore currently caught:

  • unsecured bonds (provided they are transferable);
  • uncollateralised commodity warehousing; and
  • commercial paper, bills of exchange, bankers' acceptances and deposit certificates (unless they are not negotiable).

Where other products, such as letters of credit or loans, include the above items, e.g. a bill of exchange, then these would also be caught.

From 1 January 2016

The scope will expand dramatically from 1 January 2016 to include the following liabilities of a Covered Firm:

  • unsecured loans;
  • guarantees;
  • letters of credit;
  • net liabilities from derivative transactions (assuming netting is operative, this applies to the termination amount only);
  • commercial paper, bills of exchange, bankers' acceptances and deposit certificates (whether or not they are negotiable); and
  • non-transferable bonds.

This list is not exhaustive but gives an indication of the breadth of instruments that are caught.

The BRRD tasked the European Banking Authority (EBA) with setting out the detail of what liabilities are excluded from the bail-in powers. EBA has published draft technical standards (RTS) for consultation, and the final draft RTS are expected imminently, by 3 July 2015. While it is clear that EBA cannot extend the exclusions available under the BRRD, various industry associations are lobbying EBA not to narrow them. There is a concern that if they do, the new rules could apply to contracts under which Covered Firms have a liability to advance loans, as well as contracts under which the Covered Firm incurs or may incur debt.

What should the clauses say?

The RTS will set out the details of what bail-in clauses should say. PRA, however, opted to implement the rules early for certain contracts. For contracts currently affected, PRA expects Covered Firms to generally follow the draft RTS as guidance. However, note that such contracts may need to be updated once the RTS are finalised.

Which entities does this affect other than UK banks and building societies?

The UK rules apply to all CRR firms (as defined in the Combined Handbook) and qualifying parent undertakings of CRR firms. As a result, UK subsidiaries of non-UK banks will be caught directly by the PRA rules. UK branches of non-EEA foreign banks will also be subject to certain bail-in powers whereas branches of relevant EEA financial institutions will be subject to their home state's resolution powers. The BRRD is EEA-wide so other EEA financial institutions will be bound by similar rules being introduced in their home jurisdiction.

Devil in the detail

How do I deal with liabilities that are only partially secured?

The unsecured portion of a liability is subject to bail-in powers. So the contractual recognition of bail-in should be included in agreements governing these contracts where they are governed by the laws of a non-EEA jurisdiction.

What if the liability was fully secured but the value of the security has since fallen?

This is unclear and we expect EBA to deal with this point in its final draft RTS.

Are insurance companies caught by the BRRD?

Insurance companies are not caught by the BRRD. However, Solvency II proposes similar rules to systemically significant or critical insurers in the UK and such insurers will need to be aware of these rules when they become clearer.

Will creditors be worse off?

One of the principles of bail-in is that it should not leave creditors worse off than they would have been in a liquidation. This is clearly a difficult maxim to fulfil but ultimately resolution authorities will have to weigh up what they think unsecured creditors would likely get in a liquidation against the amount they would get if they exercised their bail-in powers.

What happens if an agreement entered into before the rules were effective is amended?

The rules apply to liabilities that were issued, entered into or arose after the specified dates. It is unclear at what point a new liability will arise and the RTS may clarify this.

How do we deal with undocumented liabilities, such as those created by law?

The draft RTS published for consultation are silent on these liabilities and we wait to see if the final draft RTS will provide clarity.

What is the significance of contractual stays?

This only relates to derivatives prior to close-out and gives resolution authorities time to consider bail-in powers before parties can terminate their derivative contracts. The detail is beyond the scope of this article but PRA is consulting on rules and ISDA has published a protocol for counterparties to sign up to.