A look at the recent restructuring of the Co-operative Bank and EU proposals for mandatory reform

The Co-operative Bank announced in mid-June that it would need to carry out a forced listing of £300m new shares on the London Stock Exchange to fill a capital hole of around £1.5bn. Co-op's difficulties are said to have been triggered by mounting losses at Britannia Building Society - which Co-Op acquired in 2009 - that were highlighted when the bank failed to follow through on its planned acquisition of 632 Lloyds branches in February this year.

The bank's restructuring deal will tackle £1.3bn of group debt which will include a "bail-in" of the group's junior bondholders, who will be offered an unspecified number of new shares and bonds when Co-op lists on the stock market.

Retail investors hold about 5% of the group's subordinated debt, much of which was acquired before the Britannia merger.  They are now being asked to support the bank voluntarily by giving up bonds in exchange for new bonds and shares (potentially suffering at least a 30% discount on the exchange - although the details of the package and the price levels will not become clear until October when the exchange offer is due to take place).  The restructuring exercise will not affect residential mortgages and deposit accounts, and is expected to raise £1bn of fresh capital for the bank this year.

"Bail-in" is becoming a buzz word as national regulators attempt to redistribute the burden of bank bailouts from taxpayers to the bank's own stakeholders.  The Co-op restructuring follows examples of European bail-ins, including Ireland's Anglo Irish bank.  Banks in Cyprus recently took the step of requiring not only junior bondholders but also senior bondholders and - highly controversially - depositors to accept losses.

The European Commission continues to work on proposals for an EU recovery and resolution framework through the draft Recovery and Resolution Directive (RRD) for entities coming within the scope of the Capital Requirements Directive (2006/48/EC and 2006/49/EC)(CRD).  The CRD covers investment firms and credit institutions, which in the UK context includes banks and building societies.

The aim of the RRD is to harmonise the powers and options of member states to tackle bank distress at an early stage, and to prevent the costs being passed on to taxpayers, as had been the case following the financial crisis in 2007/2008 when banks deemed "too big to fail" were bailed out by member states.  By passing more responsibility to the banks to manage their affairs with their own stakeholders, it is also hoped that the RRD will discourage the excessive risk-taking that is cited as having been a key contributory factor in the many of the high profile failures.

What is a bail-in?

A "bail-in" is a debt write-down tool used to recapitalise a corporate entity internally, under which equity and subordinated debt can be written off and/or converted into a form of equity claim.   It is used when an entity reaches a point of non-viability, and imposes the losses on its direct stakeholders rather than needing to rely on external support (for example by way of a government bailout) or failing by way of an insolvency procedure.

Under the RRD, bail-ins are intended to be used by "resolution authorities" - who will have legal and regulatory powers conferred on them in order to supervise the banks and other entities covered by the CRD - to determine when those entities have reached the point of non-viability.  We anticipate the PRA will be the designated resolution authority in the UK for these purposes, but confirmation is awaited. Bail-ins can be used either when a bank continues as a going concern, to adjust losses and recapitalise, or in an orderly wind-down.

When a resolution authority determines that bail-in is appropriate, it will appoint an administrator to compile a business reorganisation plan to implement the bail-in and other restoration measures within a reasonable timescale of up to 2 years.  It would be expected that - in accordance with general company law and insolvency principles as to the priority of debt and equity - shareholders' claims would be the first to be extinguished before subordinated creditors, followed by senior creditors, although resolution authorities may have the ability to reorganise and convert different classes of claims depending on the level of residual capital.  All banks will be obliged to maintain a prescribed level of debt (for example equity and bonds) which would be available to be released/converted as part of the bail-in process.  The prescribed level will be determined by the regulation authority and will take into account the nature of the bank and its risk profile in order to ensure there is sufficient debt to enable a bail-in (as opposed to a bailout by taxpayers) to take place.

Resolution authorities' powers to bail-in the bank's liabilities will be subject to specified exclusions, although the extent of these and the discretion of member states to determine these generally or in a given case remains subject to debate at the time of writing.  Exclusions central to the RRD are likely to encompass secured liabilities, guaranteed deposits, and liabilities arising from holding client assets/money any other fiduciary relationships.

Current status

The Commission published a discussion paper on 30 March 2012 which focused on its bail-in proposals and formed the basis of discussions held in April 2012 with key stakeholders.  It is intended that the RRD be finalised and member states to implement the RRD measures by the end of 2014, and apply provision on bail-ins from 1 January 2018.

At the time of writing in late June 2013, discussions in the Council of the EU continue around the design of the bail-in tool in order to strike an appropriate balance between harmonisation and flexibility, deciding essentially how much discretion national authorities will be allowed in the distribution of losses between different classes of creditor.

It remains to be seen whether bail-ins continue to increase in popularity as a voluntary measure - as in the case of Co-op - in anticipation of a compulsory regime overseen by national authorities being implemented in the next 5 or so years.  Of the tools being considered at local, national and global level, it is clear that bail-ins have the potential to reduce "contagion", and in particular the economic disruption caused by public sector bailouts of banks, and they are part of a compelling attempt to call banks to account for their own activities by forcing them to plan ahead in uncertain times.

But the Co-op's plan has already angered the Co-op's retail bondholders who will suffer significant  losses on their investments and several hundred have signed up to a campaign to fight for a "fairer deal."