On 18 April 2023, the European Commission presented a comprehensive proposal for reforming the legal framework for bank resolution and deposit insurance which would apply to the European Union and in particular to the Eurozone. The reform proposal focuses in particular on the resolution of medium-sized and smaller banks and on allowing the use of the funds of deposit guarantee schemes for funding the orderly market exit for failing banks and shielding depositors in banking crises, such as by transferring them from an ailing bank to a healthy one.

Although the timing and substantive thrust of the EU reform proposal appears to coincide with the ongoing crisis among US regional banks and the events regarding Credit Suisse, the underlying cause and motives for the reform proposal are unrelated to these current developments. Instead, the Commission intends to address what it perceives as shortcomings of the existing EU bank resolution framework that have become apparent over the last decade since its inception in 2014.

Reasons for reform proposal

The European Commission gives the following main reasons for its reform proposal:

  • Notwithstanding the progress achieved since 2014, bank resolution has been rarely applied, especially within the Banking Union, i.e. the Eurozone.
  • To date, many failing banks of a smaller or medium size have been dealt with under national resolution regimes often involving the use of taxpayer money (bailouts) instead of the industry-funded safety nets, such as the Single Resolution Fund (SRF) in the Banking Union that so far has been unused in resolution. This goes against the intention of the EU bank resolution framework that was set up after the global financial crisis which involved a major paradigm shift from bailout to bail-in.
  • The EU bank resolution framework did not fully deliver on key overarching objectives, notably facilitating the functioning of the EU single market in banking by ensuring a level playing field, handling cross-border and domestic crises and minimizing recourse to taxpayer money. The reasons are mainly due to misaligned incentives in choosing the right tool to manage failing banks, leading to the non-application of the harmonized resolution framework, in favor of other (national) avenues.
  • In the view of the Commission, this is in particular due to (i) the broad discretion in the public interest assessment by the resolution authorities, (ii) difficulties in accessing funding in resolution without imposing losses on depositors, and (iii) easier access to funding outside of resolution. As the Commission sees it following this path raises risks of fragmentation and suboptimal outcomes in managing banks’ failures, in particular those of smaller and medium-sized banks.

The analysis of the Commission is corroborated by the case law of the decisions of the Single Resolution Board (SRB) published on the SRB’s website:

  • There have been indeed only a few resolution cases decided by the SRB so far. More often than not the SRB has decided to abstain from ordering a resolution and has referred the matter to the national authorities.
  • In all cases where the SRB decided not to intervene, it based its decision on the so-called “public interest assessment” by determining that the relevant banks had only a regional relevance but were not systemically relevant for the national or European financial market as required by the current EU bank resolution framework.

Components of reform package

The package proposed by the Commission comprises the following legislative proposals:

  • A Directive amending the Bank Recovery and Resolution Directive (BRRD) for the European Union;
  • A Regulation amending the Single Resolution Mechanism Regulation (SRMR) for the Eurozone;
  • A Directive amending the Deposit Guarantee Scheme Directive (DGSD);
  • A Directive (the so-called “daisy chain amendments”) amending the BRRD and the SRMR with respect to the methods for the indirect subscription of instruments for meeting a credit institution’s loss absorbency requirements.

In addition, the Commission published a comprehensive assessment of the operation of the Single Supervisory Mechanism (SSM) within the European Union.

In parallel, the Commission is carrying out an evaluation of its State aid framework for banks which is expected to be completed in the first quarter of 2024.

Overview of key substantive proposals

The EU proposes to address the shortcomings of the existing resolution framework in particular through the following key substantive changes:

  • Expanding the scope of resolution by modifying the public interest assessment to include also banks of only regional relevance;
  • Further amending the public interest test that makes it clearer that taxpayer money should not be relied upon while industry-funded safety nets (resolution funds, deposit guarantee schemes (DGS)) should be more easily tapped in resolution proceedings;
  • Amending the public interest assessment by tilting the balance in favor of resolution by allowing national insolvency proceedings only if they achieve the resolution objectives better than resolution (and not only when they would do so to the same extent – as under the current bank resolution framework);
  • Allowing easier access for the resolution authority to DGS funds for the resolution of medium-sized and smaller banks to finance the resolution tools of sale of business or transfer to bridge banks which are typically more suitable for this category of banks which are primarily financed with deposits;
  • Modifying the ranking of creditor claims in insolvency and ensuring a general depositor preference with a single-tier depositor preference, with the aim to enable the use of DGS funds to contribute to the funding of resolution measures, i.e. in case of sale of business, bridge bank or bail-in scenarios as opposed to the payout of covered deposits in insolvency proceedings;
  • Clarifying the early intervention framework by removing overlaps between early intervention by bank resolution authorities and supervisory measures by bank supervisory authorities, providing more legal certainty on the applicable conditions and facilitating cooperation between these authorities with the aim to ensure a timely triggering of resolution;
  • Describing in more detail and narrowing the scope of application of “precautionary recapitalization” measures where extraordinary public financial support is allowed on an exceptional basis by stressing that such precautionary recapitalization should only be temporary in nature and should only be permitted in cases of external shocks but not for helping banks with a weak business model;
  • Requiring member states that in those cases where the public interest assessment is not met and national procedures apply that the relevant bank is indeed wound up by having its bank license withdrawn and insolvency proceedings opened so that the failing bank exits the market within a reasonable timeframe;
  • Amending the rules for minimum requirements for own funds and eligible liabilities (MREL) so they better take into account resolution strategies other than a bail-in, i.e. the sale of business or bridge bank tool which applies typically in the case of smaller or medium-sized banks.

Easier use of DGS funds in resolution

In particular, the proposals of the Commission for allowing easier access to DGS funds in resolution procedures (with a focus on medium-sized and smaller banks) warrant a closer look:

A fundamental principle of the current bank resolution framework is that funding in resolution should be first and foremost provided by the bank’s internal resources (its capital and other liabilities), which are used to cover its losses. These can be complemented by external sources of funding, namely (1) the resolution financing arrangements such as the Single Resolution Fund (but only after 8% of the capital and liabilities of the bank have been used to cover its losses) and (2) the DGS funds (in lieu of covered depositors up to the amount of losses that they would have suffered in resolution). For certain smaller and mid-sized banks, especially those primarily financed with deposits, it can be very difficult to meet these requirements to access industry-financed external funding without bailing in deposits above the coverage level and those excluded from coverage which could lead to widespread contagion and financial instability, exacerbating the risks of broader banks runs, and thereby also have serious adverse impacts on the real economy.

Therefore, to enhance the application of transfer tools in resolution for smaller or medium-sized banks that will exit the market, the Commission proposes that the DGS funds can be used to support transfer transactions that include covered deposits, and, under certain conditions, also eligible deposits beyond the coverage level and deposits excluded from the DGS guarantee. The DGS contribution should cover part of or the entire difference between the value of the deposits transferred to a buyer or to a bridge institution and the value of the transferred assets. However, the amount of the DGS contribution may not exceed any shortfall in the value of the assets of the institution under resolution transferred to the buyer or the bridge institution in comparison to the value of the transferred deposits and liabilities with the same or a higher priority ranking in insolvency than those deposits. This is to ensure that the contribution of the DGS is only used for the purposes of depositor protection, where appropriate, and not for the protection of creditors that rank below deposits in insolvency.

In order to allow access to resolution financing arrangements where necessary for the implementation of a transfer strategy, the Commission proposes that the DGS contributions in resolution should count towards the 8% total liabilities and own funds (TLOF) requirement for accessing the resolution financing arrangement. If the contribution made by shareholders and creditors of the institution under resolution through reductions, write-down or conversion of their liabilities, summed with the contribution made by the DGS amounts to at least 8% of the institution’s total liabilities including own funds, it will be possible for the resolution authority to use the resolution financing arrangement to finance the resolution action, which must lead to the failing institution’s exit from the market.

Changes to depositor preference

The proposed changes to depositor preference are closely linked to the above proposals on the use of DGS funds:

Under current law, the BRRD creates a three-tier depositor preference in the hierarchy of claims. It provides that covered deposits and DGS claims must have a so-called ‘super-preference’ in the creditor ranking in the insolvency laws in each Member State relative to non-covered preferred deposits (the part of eligible deposits from natural persons and SMEs exceeding the coverage level of EUR 100 000). The latter must rank above the claims of ordinary unsecured creditors.

The BRRD is presently silent on the ranking of the remaining deposits, that is, non-covered non-preferred (i.e., corporate non-SME deposits exceeding the coverage level of EUR 100,000) and excluded deposits (which, under the current framework include deposits of public authorities, financial sector entities and pension funds). In most Member States, the non-covered non-preferred deposits rank in insolvency alongside ordinary unsecured claims, including senior debt instruments eligible for MREL, while in a minority of Member States, they already rank above ordinary unsecured claims.

The super-preference of the DGS in the current framework (i.e., its rank above claims of depositors that are not covered) impacts the results of the least cost test in a way that the DGS funds can almost never be used outside the payout of covered deposits in insolvency because the DGS would expect a full or very high recovery of the resources used to reimburse covered deposits.

To facilitate the use of the DGS in resolution where this is necessary to maintain financial stability and protect depositors, as well as to remove impediments to resolution, the Commission proposes to introduce a general depositor preference with a single-tiered ranking. This would be achieved thanks to two modifications. First, the legal preference in the insolvency laws of Member States required by BRRD relative to ordinary unsecured claims is extended to include all deposits. This entails that all deposits, including eligible deposits of large corporates and excluded deposits, rank above ordinary unsecured claims. Second, the relative ranking between the different categories of deposits is replaced by a single-tier depositor preference, where the super-preference of the DGS/covered deposits is removed, and where all deposits rank pari passu (i.e., at the same level amongst themselves) and above ordinary unsecured claims.

The Commission points out in its impact assessment that a single-tier depositor preference would not impinge on the protection currently enjoyed by covered depositors, who are always insured under the DGSD in case their accounts become unavailable and are mandatorily excluded from bearing losses in resolution under the BRRD. In the view of the Commission, the higher preferred ranking of the DGS claims instead seems to protect the banking industry, which pays contributions to the DGS. Nevertheless, the Commission argues that the higher priority of the DGS does not necessarily lead to a less frequent need for replenishment of the DGS given that the result of this higher priority would be more frequent use of DGS resources for payout than for transfer strategies in resolution.

In comparison to the current status quo, the reform package of the Commission aims to enable cheaper, more cost-efficient alternative uses of the DGS in resolution, when compared to the cost of DGS payout in insolvency, to support a transfer of assets and liabilities (including deposits) followed by the market exit of the failing institution.

First reactions

Pursuant to recent press reports the reform proposal has met with a mixed response among EU member states and within the financial community. While France and Spain appear to be in favor of the reform package, the finance ministers of Germany, Austria and the Czech Republic have strongly criticized the proposal at a recent meeting of the finance ministers of the EU member states (Ecofin). In particular, the plan to tap the various national deposit guarantee schemes more frequently in the event of a crisis is met with skepticism. Institutional protection systems (IPS) from five EU member states (Germany, Austria, Italy, Poland and Spain) have jointly published a note of protest. Within these member states IPS are able to provide preventive financial support financed by contributions of the member banks in order to help institutions that are in a financial crisis. Since the institutional protection schemes of the German saving banks and state-owned banks and of the German cooperative banks are clearly dominant in terms of size in comparison to the much smaller schemes in Austria, Italy, Poland and Spain, some participants hold the view that the concerns raised against the reform proposal are in essence special requests of the German financial industry.

Next steps

The Commission is expected to allow for a consultation period on the proposed legislative package. Thereafter, the reform package will be discussed with the European Parliament and the Council. These discussions may result in amendments to the legislative package.

Pursuant to the Commission’s proposal the amendments to the BRRD and SRMR will apply 18 months and the amendments to the DGSD would apply 24 months after the entry into force of the reform package.