Everybody knows that, logically, banks can fail. Few expect them to.
Silicon Valley Bank (SVB), the U.S.’s 16th largest bank, was closed on 10 March 2023, and the Federal Deposit Insurance Corporation (FDIC) appointed as receiver. Signature Bank, New York, NY was closed on 12 March 2023 and again the FDIC was appointed as receiver. In the evening of 12 March 2023, the U.S. Department of the Treasury, the Federal Reserve, and FDIC released a joint statement announcing that all depositors of SVB and Signature Bank would have access to all of their deposits (including deposits that were not FDIC-insured). US Treasury Secretary Janet Yellen has indicated that similar actions could be warranted if smaller institutions suffer deposit runs, although she appears to have ruled out blanket protection of all deposits. On 13 March 2023, in an exercise of its powers under the Banking Act 2009, the Bank of England announced the acquisition of SVBUK by HSBC. And over the following eight days we saw the deterioration of Credit Suisse, culminating in the announcement that on 19 March 2023 UBS had agreed to acquire it for CHF3bn.
In this article we will look at some of the issues that should be considered when a deposit-taking bank regulated in the UK or the EU gets into financial difficulties. We have split the piece into the following segments, which you can navigate to by using the contents list on the right hand side of the article: a general introduction to resolution, practical issues relevant to all, and then practical issues from the viewpoint of a corporate depositor, a corporate borrower, a co-lender in a syndicate, a hedging counterparty, a holder of subordinated debt and a shareholder.
What is bank resolution?
A number of readers will remember the banking crisis that started in 2007 and became known as the Global Financial Crisis, or GFC. This saw (amongst other events) the collapse of Lehman Brothers, the nationalisation of Hypo Real Estate, the bail-out of Dexia by France, Belgium and Luxembourg, the rescue takeover of HBOS by Lloyds Banking Group and the melt-down of Iceland’s main banks. Government funds were used to support or “bail out” distressed banks to an unprecedented extent.
Global regulators resolved that never again should tax payers’ money be used to bail-out banks that found themselves in financial difficulties. There should be an end to the concept of “too big to fail”.
Recognising that bank insolvency can pose a systemic risk to the wider economy, in 2014 Directive 2014/59 of the European Parliament and of the council establishing a framework for the recovery and resolution of credit institutions and investment firms – better known as the BRRD – came into effect, requiring EU Member States to introduce a special resolution regime (SRR) into national legislation1. The SRR would provide the resolution authorities (RAs) with pre-insolvency tools to deal with banks in financial difficulties. In the UK, the requirements of the BRRD were mainly implemented through the Banking Act 2009 and, importantly, the UK SRR has remained largely unchanged post-Brexit.
The SRR consists of five pre-insolvency resolution tools which can only be exercised once certain conditions have been satisfied. The main conditions are that the RAs are satisfied that the bank is failing or is likely to fail and it is not reasonably likely that action other than under the SRR will be taken in time to rescue the bank, and that exercise of the power is necessary having regard to the public interest.
The resolution tools are:
- transfer of the bank or all or any part of its business to a private sector purchaser;
- transfer of the bank or all or any part of its business to a bridge bank (being a vehicle wholly or partially owned by the national authorities and set up to hold the assets and liabilities of the bank in resolution);
- transfer of all or any part of the banks’ business to an asset management vehicle;
- the bail-in option; and
- (in the UK) transfer of the bank to temporary public sector ownership.
In the UK, there are also two special insolvency procedures for banks: the Bank Insolvency Procedure which is akin to liquidation, and the Bank Administration Procedure which can be used where part of the bank’s business has been transferred to a private sector purchaser, a bridge bank or an asset management vehicle. Certain EU Member States have introduced special insolvency procedures for banks, but generally banks will simply enter the insolvency proceedings available to corporates generally. This article does not consider bank insolvency procedures.
In certain conditions, including where the RAs are satisfied that the resolution conditions are satisfied and they’ve decided to exercise a resolution power, as a first step the RAs must undertake a write down or conversion of capital instruments (the Mandatory Conversion). This Mandatory Conversion process involves:
- the cancellation, transfer or dilution of Common Equity Tier 1 (CET1) instruments;
- the reduction, writing off or conversion into CET1 instruments of Additional Tier 1 instruments (AT1) to the extent required to achieve the SRR objectives; and
- the reduction, writing off or conversion into CET1 instrument of Tier 2 instruments (T2) to the extent required to achieve the SRR objectives where the action taken in relation to AT1 was insufficient.
The cancellation, transfer, write-down and conversion under the BRRD (or the Banking Act 2009 in the UK) has to follow a strict hierarchy, as set out above, so equity is cancelled or transferred before any write down or conversion of AT1 or T2 instruments can take place, and AT1 instruments must be written down or converted before any action can be taken in relation to T2 instruments.
Mandatory Conversion is different from the bail-in option, even though they may both involve the write down or conversion of capital instruments. Under the bail-in option, the RAs must first write down or convert CET1, AT1 and T2 instruments as described above, but can then turn to other subordinated debt, and then any other liability that the bank may owe, other than certain excluded liabilities such as protected deposits or secured liabilities. Those liabilities can be written down in full or in part or converted into equity and the liability (or the agreement under which the liability arose) can be varied or suspended.
The recent agreement by UBS to acquire Credit Suisse (CS) (which (subject to expedited regulatory approval) is expected to close by the end of 2023) was accompanied by an instruction by FINMA to CS requiring CS to write down its AT1 instruments to zero (in contrast to the return that shareholders will receive on their equity). The statement from FINMA on 23 March 2023 clarified that the write-down of CS’s AT1 Instruments to zero was achieved not through the pre-resolution write-down of equity or capital instruments, but rather through the write-down mechanism contained in the contractual terms of the AT1 bonds and pursuant to emergency legislation under which, inter alia, FINMA was authorised to order CS to write down AT1 instruments. Swiftly after the announcement that the CS AT1 instruments were being written down in full, statements were published by EU and UK regulators confirming the creditor hierarchy in resolution as set out above - but the actions by the Swiss regulators have nonetheless caused consternation in the market.
Viewpoints - all
- Whoever you are – depositor, borrower, creditor, shareholder - check who your contract counterparty is. Is it a UK bank, an EU bank, a local branch of an non-EU / UK bank etc? The identity of your contractual counterparty may well determine which resolution regime will apply and what protections you might have. A borrower from SVBUK, for example, may be in a different position to a borrower from SVBUS.
- Consider asking significant counterparties where their funds are held – whilst one step removed from dealing with a distressed bank, it can be important to see whether someone you rely on is themselves at risk of liquidity issues if their main bank or funder becomes distressed.
- The Ernest Hemingway quote “How did you go bankrupt? Two ways: gradually and then suddenly” may be overused but remains accurate nonetheless. Bank resolution can happen very quickly, probably over a weekend – as was the case with SVBUK. It is essential to get your house in order in advance as there may be few warning signs before a bank enters resolution, and little time to do anything once it has.
Viewpoints - corporate depositor
The issues at SVB in the US and the UK, the failure of Signature Bank and the current market fluctuations in bank stocks will be making depositors think carefully about where their money is kept.
Is my money protected?
in the EU and the UK, under national implementation of the requirements of the Deposit Guarantee Schemes Directive (2014/49/EU) and the Investor Compensation Schemes Directive (97/9/EC), accounts with credit balances of up to £85,000 / €100,000 (and joint accounts with a credit balance of up to £170,000 / €200,000) are protected (or “eligible”), meaning that if the bank is deemed unable for the time being to repay eligible deposits because of its financial status, a fund (being the Financial Services Compensation Scheme (FSCS) in the UK) will pay out eligible depositors up to the guaranteed amount. The fund will then claim directly against the bank. However:
payments will not be made immediately and a certain period of waiting is likely (the Directive requires payment within 10 business days of a determination that the bank is deemed unable to repay eligible deposits, although that period will reduce over time and by the start of 2024 the period will be 7 business days);
- while the guarantee limit may offer significant protection to retail depositors, it is unlikely to provide much comfort to large corporates which may hold many multiples of the protected amount in their accounts. It is unclear whether EU or UK authorities would take steps similar to those taken in the US following the collapse of SVBUS to guarantee all deposits, whatever their level, if the level of depositor withdrawals continues to be high at some banks;
- deposits made by certain financial services firms are not eligible for protection.
- in the event of a bank insolvency, certain depositors are given secondary preferential status (meaning they rank ahead of the bank’s ordinary creditors) for any deposit above the national caps referred to above. However, they will still rank behind the cost of the insolvency process and any higher-ranking preferential creditors.
- eligible deposits cannot be bailed in by the RAs but can be transferred under one of the resolution tools (for example to a private sector purchaser or to a bridge bank).
- Can I access my account while a bank is in resolution? The payment suspension that can be imposed by the RAs for a limited period doesn’t apply to eligible deposits. However, it is likely that access will be restricted, at least initially, so there may be a period of time when your deposits cannot be accessed.
- What happens if my account is transferred to another bank? The transfer powers under the SRR are very wide but there are certain protections (for example for set-off, netting and security rights) which are beyond the scope of this note. At least initially, the terms applicable to your account will not change and you will be able to access the account once held by the new bank in the same way. Keep in mind, however, that the new bank may want to change the terms of the account and may be able to do so unilaterally, so review all communications from the new bank carefully.
- Practical advice:
- Monitor (to the extent possible) the financial health of any institution which holds your money;
- For structured transactions, ensure that payments are made directly to a secure bank account or that commingling risk is sufficiently collateralised. It is not ideal for payments to be made into an insolvent originator account for long periods so check whether the transaction provide for an account to which customer payments can be made and. If not, how long will it take to establish such an account and the process for notifying relevant parties;
Consider having accounts at more than one institution. Whilst administratively more burdensome, not putting all of your eggs in one basket has a number of benefits:
Accounts are already open should you want to move funds from one bank to another quickly;
Funds will still be available to you should one of your banks become distressed, which will help with liquidity at least in the short term;
Having a relationship with another bank may make it easier to discuss short term funding needs if required.
However, check your banking documentation – some banks require you to keep all deposits with them as a condition of any lending which may make opening accounts elsewhere difficult.
Viewpoints - corporate borrower
These are some of the points to consider if your lender is a stressed bank:
- The bank’s distress does not relieve you as borrower from your obligations under the loan agreement. All scheduled payments (including commitment and other fees) should continue to be made on time, in accordance with your loan documentation (although, in relation to syndicated loans, see the points below on “Defaulting Lenders” and “Impaired Agents”). Failure to comply with your contractual obligations may well entitle the lender to take action such as making demand for repayment of the loan or imposing default interest.
If your loan facility is not fully drawn, then:
If it is a bilateral loan, it is likely that the bank will not comply with any further drawdown request;
- If it is a syndicated loan then, again subject to what we say below on Defaulting Lenders, the remaining lenders in the syndicate will usually be contractually required to provide their portion of further drawdowns, but are unlikely to be under any obligation to make up any shortfall if a lender fails to make available its portion of the requested loan;
As a reaction to the GFC, changes were made to the LMA leveraged finance syndicated Facilities Agreements to address issues posed by “Defaulting Lenders” and “Impaired Agents”. These provisions are not contained in all LMA agreements (for example the investment grade documents), although the parties may agree to include equivalent provisions during negotiation:
In brief, a Defaulting Lender is defined as one which fails to fund its portion of a loan, or rescinds or repudiates a Finance Document. A lender will also be a Defaulting Lender if it suffers an Insolvency Event.
“Insolvency Event” is widely defined and includes an inability to pay debts, or the taking of any action under the SRR. However, national legislation implementing the BRRD in EU Member States (and the Banking Act 2009 in the UK) provides that anything in a contract which means the contract terms are or can be terminated, modified or replaced upon the taking of any action under the SRR is ineffective if the bank continues to perform its substantive obligations under the contract. Because of that, unless it qualifies as a Defaulting Lender under one of the other limbs of the definition, a bank which continues to perform its obligations cannot be treated as a Defaulting Lender even if it enters resolution.
Whilst a lender is a Defaulting Lender its rights change and a range of options becomes available to the borrower and other syndicate lenders including:
the cessation of any commitment fee on the Defaulting Lender’s undrawn commitment;
- cancellation of the Defaulting Lender’s undrawn commitment. The agreement may also allow the borrower to bring in another lender to take on the Defaulting Lender’s cancelled commitment;
- the terming out of the Defaulting Lender’s participations in any outstanding revolving facility loans – in other w ords, the repayment date of the amounts owing to the Defaulting Lender are extended, potentially to the final repayment date of the facility, so the revolving facility effectively becomes a term loan;
- the disenfranchisement of the Defaulting Lender in respect of any undrawn commitment – meaning the Defaulting Lender will only be able to vote in relation to its drawn and not undrawn commitments;
- the ability to exclude a Defaulting Lender’s drawn commitments for the purposes of calculating whether the relevant percentage of votes has been received to approve a request, if the Defaulting Lender fails to respond within a specified period (a “snooze you lose” approach);
- the borrower may, at any time a lender has become and continues to be a Defaulting Lender require that Defaulting Lender to transfer its rights and obligations under the agreement, including if required its undrawn commitments (a “yank the bank” approach);
- the Agent is able to disclose the identity of the Defaulting Lender upon request.
- Many Facilities Agreements post-GFC include a “cashless” rollover of an RCF loan where the maturing RCF loan is being refinanced by a new loan in the same currency and to the same borrower. This reduces significantly the risk that a lender in financial distress won’t – or won’t be able to – fund its portion of a new drawing.
The Impaired Agent concept was introduced to protect borrowers and lenders against the risk that the Agent may get into financial difficulties. An Impaired Agent is one which fails to make a payment under the Finance Documents, or which is a Defaulting Lender or in respect of which an Insolvency Event occurs:
Whilst impaired, the Agent can be replaced, payments can be made by the lenders directly to the borrowers (and vice versa) and communications can take place directly between the parties rather than having to go through the Agent.
- Practical points
- It is better to continue to perform your obligations under the documentation. Failure to do so could result in the repayment of the loan being demanded, default interest imposed and any security enforced.
- Check your loan documentation. Does it contain the Defaulting Lender / Impaired Agent / cashless rollover provisions, and how are they drafted? If not, is there an opportunity to introduce something now? If the loan is a bilateral RCF, does it allow for cashless rollovers?
- Remember that if the distressed bank or its business is transferred, it is no longer in resolution, the Insolvency Event may no longer be continuing and the Defaulting Lender provisions may cease to apply. If you do want to take advantage of the Defaulting Lender provisions you may need to act quickly so make sure you know what rights you have well in advance.
- If your document has Impaired Agent provisions, is your Agent complying with the information requirements and providing you with lender details on a monthly basis? If the details only have to be provided on request, request that information if there is a concern about the financial stability of the Agent. A document which allows dealings between the parties direct rather than through the Agent is of little benefit if you don’t know who or what the parties, or their payment details, are and it is better to have that information ahead of any distress event.
- Loans can be transferred to a new lender as part of the resolution process. A new lender may try to change the terms of the loan – but whether the lender can force through revised terms will depend on the terms of the documentation. Early communication with your new lender is the best approach.
- If your loan is transferred to a new lender, is there any impact on areas such as tax? Will you have to gross-up payments, and is there anything in the loan agreement which might assist?
- As with deposits, consider whether you should have funding lines with more than one lender to ensure continued liquidity if one bank becomes distressed. This is particularly important in the case of facilities such as overdrafts or other working capital facilities which are needed for day to day trading. Check your existing documentation to see whether there are any restrictions on incurring additional financial indebtedness and what is permitted.
- Many loan agreements expressly exclude rights of set-off, meaning that you will not be able to set off amounts owing to you by the bank (such as a deposit) against amounts that you owe to the bank. However, it is worth checking the terms of the documentation to see if that is the case as contractual set-off can increase eventual recoveries. In the UK, the position changes once insolvency set-off applies as the setting off of mutual debits and credits is mandatory. Different rules will apply if the bank is regulated in or subject to a resolution process in another jurisdiction – seek advice.
- The distress of a syndicate bank is unlikely to be an event of default under your loan agreement. Accordingly, bank distress should not result in your loan being accelerated or any security being enforced. However, keep in mind that it is likely to take longer to get a response from a distressed bank, particularly one which is in resolution. If consents, waivers or releases are required (for example, on any refinancing) you should take that additional time requirement into account.
Viewpoints - co-lender in a syndicate
The distress of a syndicate member can be almost as concerning for co-lenders as it is for the borrower. Many of the points referred to above, such as the Defaulting Lender and Impaired Agent points, are also relevant for co-lenders. However, the following are also relevant:
- co-lenders should check any indemnities that have been provided to administrative parties such as the Agent or Security Agent, or to an LC Issuing Bank. Is each lender responsible for part only of the indemnity, corresponding to its share of the commitments, or are the indemnities given on a joint and several basis? If the latter, then where a lender fails to pay its share of the indemnity, the other lenders will be required to make up any shortfall. Even if each lender is only responsible for a portion of any indemnity, the recipient of the indemnity may seek confirmation from the non-Defaulting Lenders that they will keep that person whole in the event of any loss – so in practice lenders may well find themselves having to cover any shortfall.
- as noted above, loan participations can be transferred as part of the resolution process. Consent / consultation requirements under the loan agreement can be ignored by the RAs. It is possible that you may find yourself in a syndicate with a lender who in normal circumstances would not be an eligible lender under the terms of the loan agreement. If that happens, you may want to check the transfer provisions to see if you can transfer your debt and exit the arrangement.
- documentation tends not to cater expressly for the position where a Security Agent / Security Trustee becomes distressed or enters resolution. It is likely that there will be resignation and replacement provisions that can be operated but keep in mind that assistance from the distressed bank may be slow at best and possibly limited, which could make the process or replacing the Security Agent difficult. Ensure that where the Security Agent is replaced, all necessary steps are taken in each relevant jurisdiction to ensure the security is transferred effectively and the transfer perfected (for example by making relevant filings in asset registries).
Viewpoints - bank as hedging counterparty
There are several points to consider if your hedging counterparty with whom you have outstanding OTC derivatives transactions under an ISDA Master Agreement is in distress.
- Under the ISDA Master Agreement, there are a number of Events of Default and Termination Events that may be relevant, including Bankruptcy or Failure to Pay. This could include where a party has become insolvent, is unable to pay its debts or where it has instituted any insolvency or bankruptcy proceedings.
- Where an Event of Default has occurred and is continuing, the non-defaulting party may designate an Early Termination Date in respect of any outstanding OTC derivative transactions. Any payment obligations under the ISDA Master Agreement are subject to the condition precedent in section 2(a)(iiii) of the ISDA Master Agreement that no Event of Default or Potential Event of Default has occurred and is continuing and that no Early Termination Date has occurred or been designated.
By suspending the obligation of the non-defaulting party to pay any amounts which may be owed under the ISDA Master Agreement, section 2(a)(iii) protects the non-defaulting party from the additional credit risk involved in performing its own obligations whilst the defaulting counterparty is unable to meet its own obligations. The High Court of England and Wales recently clarified2 that the insolvency Events of Default relate to factual events or states of affairs. The decision also provided clarity as to the extent to which and for how long a party can rely on this condition precedent to payment contained in the ISDA framework documentation where the other party is subject to an event of default (click here to read our article on this case).
However, as with loan agreements, national legislation implementing the BRRD in EU Member States (and the Banking Act 2009 in the UK) provides that anything in a contract which means the contractual terms are or can be terminated, modified or replaced upon the taking of any action under the SRR is ineffective if the bank continues to perform its substantive obligations under the contract. Accordingly, absent any other applicable Events of Default or Termination Events, the non-defaulting party would not be able to withhold performance, terminate or close-out simply because the bank has entered resolution.
- If the bank counterparty fails to perform its substantive obligations under the derivatives transactions, the restriction referred to above will not apply and the non-defaulting party can take actions such as withholding payment obligations.
- Check the terms of your derivatives documentation. What rights will you be able to exercise if your bank counterparty enters resolution and what rights may be overridden where the bank continues to perform its substantive obligations?
- Continue to perform your obligations under the ISDA Master Agreement and any Confirmations to ensure you do not become the defaulting party;
- If you are able to withhold performance, bear in mind that the ability to withhold performance will only exist for so long as the event of default is “continuing”. Following the court decision referred to above, it is likely that if the bank ceases to be in resolution and is, for example, transferred to a private sector purchaser, the right to withhold performance will cease. Ensure you remain aware of whether the bank is in resolution or not, so that you don’t inadvertently become a defaulting party once resolution is ended.
Viewpoints - holder of AT1 / T2 / subordinated debt
The position is likely to be different depending on whether the bank is in resolution or not.
National legislation implementing the BRRD (and the Banking Act 2009 in the UK) states that as a precursor to resolution action by the RAs, CET1 instruments must be transferred or cancelled before ATI or T2 instruments are written down or converted, and ATI instruments must be converted or written down before action is taken in relation to T2 instruments. This write down and conversion power can also be exercised by the RAs independently of resolution action provided the conditions for resolution have been met. This order in which losses must be borne – first by CET1, then AT1 and then T2 - is the creditor hierarchy in resolution.
Compensation may be payable based upon principle that no creditor should be worse off (NCWO) where a bank is in resolution than it would be in an insolvency.
- Actions to write down or convert these capital instruments can be taken without the consent or co-operation of the holders, and the RAs can override any restrictions on transfer.
- While the BRRD provides for the cancellation or transfer of CET1 and the write-down or cancellation of AT1 and T2 instruments once the conditions to resolution have been met, Regulation 2013/575 on prudential requirements for credit institutions and investment firms (the capital requirements regulation, or CRR) requires that AT1 instruments contain a contractual conversion provision under which the AT1 instruments will be converted to equity or reduced or cancelled when a trigger point is reached. The trigger point will occur when the CET1 ratio of the bank falls below either 5.125 % or a higher level determined by the bank. Additional trigger events can be included, as appears to have been the case with CS. In many cases, it is likely that the contractual trigger point will be reached before the conditions to resolution have been met.
- Where AT1 instruments are contractually converted into equity, it is still open to the RAs should resolution action subsequently be required, then to cancel or transfer the equity into which the AT1 instruments have been converted.
- The CRR does not require a cancellation or transfer of CET1 prior to conversion or write-down of AT1 instruments, nor does the CRR contemplate compensation being paid to holders of AT1 instruments which are converted
- The terms of all AT1 instruments should be checked carefully and a note made of the events which might trigger a conversion or write-down of the debt instrument. How wide are those triggers – are they similar to those in the CS AT1 instruments or are they more in line with the trigger required under CRR?
- Don’t underestimate the willingness of national legislators to implement emergency legislation if by doing so a bank might be rescued, or prevented from entering resolution, and financial stability protected. In the UK, the ring-fencing legislation was permanently amended to allow the HSBC ring-fenced bank to acquire SVBUK and provide financial support. In Switzerland, the Federal Council enacted the Emergency Ordinance on Additional Liquidity Assistance Loans and the Granting of Federal Default Guarantees for Liquidity Assistance Loans by the Swiss National Bank to Systemically Important Banks. As well as providing the legal framework for the provision of considerable liquidity support to CS, the Ordinance also authorised FINMA to order CS to write down AT1 instruments.
Viewpoints - shareholders
Prior to the exercise of one of the resolution options, the RAs are required to write down equity in the bank. In the resolution creditor hierarchy in the EU and the UK, shareholders are the first to suffer loss. Examples of this in action include the merger in 2017 of Banco Popular Español SA with Santander (under which the SRB3 wrote down the ordinary shares and AT1 instruments issued by BPE, converted T2 instruments into shares and transferred those shares to Santander) and in 2023 the acquisition by HSBC of Silicon Valley Bank UK (under which the UK RAs wrote down the AT1 and T2 instruments to zero and sold the share for £1).
Shares can also be transferred under the resolution tools without the consent or any involvement of the shareholder – again, as evidenced by the acquisition of SVBUK by HSBC.
Shareholders may be entitled to compensation under the NCWO principle referred to above.
There have been comparisons drawn between what is currently happening to the banking sector and the issues that arose in the banking market during the GFC. However, notwithstanding recent turmoil, the sector is still better positioned than it was in 2008, with better documentation, better supervision, stronger capital requirements, higher liquidity requirements and specific tools available for resolution. That said, improvements can always be made. We have already seen press reports that the EU will accelerate proposed changes under which capital and liquidity requirements will be amended to implement more fully Basel III. The UK authorities are reportedly thinking again about whether to relax certain elements of bank regulation. And it will be interesting to see what approach the US takes, as it has already agreed to stand behind all deposits at certain banks. Only time will tell whether the SRR is indeed fit for purpose. It is certainly being tested at the moment!