Resolution of banks and creditor participation

Note on resolution of banks and creditor participation (bail-in)

In response to experiences in the 2008 financial crisis, many states adopted rules and regulations according to which banks

in danger of default can be duly resolved without any contribution by the tax payer being necessary in future.

This leads to shareholders and creditors of banks possibly having to participate in their losses in the event of a bank's resolution.

The objective is to facilitate the resolution or winding-up of a bank without the use of public funding.

The European Union has adopted the following legal acts in this regard:

  • the Bank Recovery and Resolution Directive ("BRRD") and
  • the regulation establishing uniform rules and a uniform procedure for the resolution of credit

institutions and certain investment firms in the framework of a Single Resolution Mechanism

and a Single Bank Resolution Fund (the "SRM Regulation").

The BRRD provides, inter alia, for each EU member state to establish a national resolution authority

endowed with certain rights for resolution and recovery of credit institutions. These measures may

have an adverse impact on shareholders and creditors of banks.

The exact design and configuration of measures at national level that may be taken by the resolution

authorities may differ with regard to details. Below we explain the possible resolution actions using

Germany as an example. The resolution processes of other, in particular non-European countries, may

likewise differ and can be even stricter in design.

When can I be affected?

You can be affected if you are a shareholder or creditor of a bank, i.e. if you hold financial instruments issued by the bank in question (e.g. equities, bonds or certificates) or if you hold any contractual receivables against the bank (e.g. individual transactions under the Master Agreement for Financial Derivatives Transactions). The securities that you as a customer arrange for your bank to keep in a securities account on your behalf and which were not issued by the bank in charge of the securities account are not the subject matter of a resolution action against the bank in question. In the event of resolution of the bank managing the securities account, your ownership rights to such financial instruments in the securities account will remain unaffected.


Who is the resolution authority?

In order to facilitate due and proper resolution in the event of crises, resolution authorities have been created. The resolution authority responsible for the bank is authorised to order resolution actions to be carried out if certain conditions for resolution are met.

The Single Resolution Board ("SRB") and the Federal Market Stabilisation Authority ("FMSA", German: “Bundesanstalt für Finanzmarktstabilisierung) are the competent resolution authorities in Germany. For simplification reasons, no distinctions are made between the SRB and the FMSA below.


In what cases will a bank resolution or creditor participation take place?

The resolution authority may order certain resolution actions if the following conditions for resolution are fulfilled:

  • The bank affected is threatened in its existence as a going concern. This assessment is made
    according to statutory parameters and will apply, for example, if the bank is no longer able,
    owing to losses sustained, to meet the statutory requirements for admission as a credit
  • There is no prospect of averting the bank's default by means of alternative private sector
    measures or other measures of the supervisory authorities.
  • The measure is required in the public interest, i.e. it is necessary and proportionate and
    liquidation within the scope of regular insolvency proceedings is no equivalent alternative.


What measures can the resolution authority adopt?

If all conditions for resolution apply, then the resolution authority can adopt extensive resolution actions – already prior to insolvency – that may have an adverse impact on the bank's shareholders and creditors:

  • The so called bail-in tool (also referred to as creditor participation): the resolution authority
    may write down financial instruments of, and receivables from, the bank either wholly or in
    part or convert them into equity capital (shares or other instruments of ownership) in order to
    stabilise the bank in this way.
  • The sale of business tool: in the process, shares, assets or liabilities of the bank under resolution
    are transferred to a certain acquirer, either wholly or in part. To the extent that shareholders
    and creditors are affected by the corporate sale, they will be dealing with another already
    existing institution as a new counterparty/debtor.
  • The bridge institution tool: the resolution authority may transfer shares in the bank or part or
    all of the bank's assets including its liabilities to what is termed a bridge institution. This may
    impair the ability of the bank to meet its payment and delivery obligations to its creditors and
    reduce the value of the shares in the bank.
  • The tool of transfer to an asset management company: in the process, assets, rights or
    obligations are transferred to an asset management company. In this way, assets are to be
    managed with the objective of maximising their value by the time of their sale or liquidation at
    a later date. As in the case of the sale of business tool, following a transfer a creditor will have
    a new debtor.

By means of an official order, the resolution authority can adjust the terms and conditions of the financial instruments issued by the bank as well as the existing receivables from it, e.g. the due date or interest rate may be modified at the creditor's expense. In addition, payment and delivery obligations may be modified, e.g. temporarily suspended. Moreover, termination and other contractual rights of the creditors arising from the financial instruments or receivables can likewise be temporarily suspended.


When will I as a creditor be affected by a bail-in?

Whether you as a creditor will be affected by the resolution action of the bail-in will depend on the reach of the measure ordered and on the class to which your financial instrument or your debt receivable is to be assigned. Within the scope of a bail-in, financial instruments and receivables are assigned to different classes and drawn on for liability according to a statutory ranking (referred to as a liability cascade).

The following principles apply as to whether the shareholders and creditors of the respective classes are concerned: only if a class of liabilities has been drawn on completely and this is not sufficient to compensate the losses to an adequate degree in order to stabilise the bank can the next class of liabilities in the liability cascade be written down or converted.

Certain types of financial instruments and debts receivables are excepted from bail-in instruments by statute. For instance, these are deposits covered by the statutory deposit guarantee system of up to EUR 100,000 and liabilities secured by assets (such as German mortgage bonds: Pfandbriefe). Liabilities to which the bail-in is applied are also referred to as eligible liabilities.

In the liability cascade of a bank domiciled in Germany, from 1 January 2017 the following classes
will need to be distinguished:

  1. First of all, the resolution actions will affect the Common Equity Tier 1 capital and, therefore,
    the bank's shareholders (i.e. holders of equities and other company shares).
  2. Next, claims will be made on the creditors of the Additional Tier 1 capital (holders of
    unsecured, unlimited subordinated bonds and undisclosed deposits with a conversion or writedown
    clause making them subordinate to instruments of supplementary or Tier 2 capital).
  3. This will be followed by the supplementary or Tier 2 capital being drawn on. This concerns
    creditors of subordinate liabilities (e.g. holders of subordinated loans).
  4. Next in the liability cascade are unsecured, subordinated financial instruments / receivables
    that do not meet the requirements of Additional Tier 1 capital or of the supplementary or Tier 2
  5. Next in the liability cascade are unsecured non-subordinated financial instruments and
    receivables ("Other unsecured financial instruments / receivables").
    (a) These comprise non-structured financial instruments / receivables such as

    • non-structured bearer notes (Inhaberschuldverschreibungen) , order notes(Orderschuldverschreibungen) and rights comparable to such debt instruments that are tradable in terms of their type on the capital market, and

    • Registered bonds (Namensschuldverschreibungen), promissory note loans (Schuldscheindarlehen) unless they qualify as deposits in class (6) or are excluded from the bail-in.

    These also include financial instruments and receivables where their extent of the interest payments depends exclusively on a fixed or variable reference interest rate.

    (b) This group also includes liabilities in the form of structured, unsecured, non-subordinated financial instruments and receivables ("Structured financial instruments / receivables").Within this liability stage, structured financial instruments / receivables are only drawn on after non-structured financial instruments / receivables have been dealt with. In the case of structured financial instruments and receivables (e.g. certificates on stock indices or receivables arising from derivatives), the extent of the repayment or interest payment depends on an uncertain future event or it is fulfilled other than in the form of a payment of money/cash settlement. These also include deposits greater than EUR 100,000 by enterprises that do not fall into class (6).
  6. Finally, deposits of private individuals, micro-companies, small and medium-sized enterprises
    may be claimed if they exceed the statutory deposit protection limit of EUR 100,000 ("Other

Accordingly, effective as of 1 January 2017 the following simplified liability sequence will be applicable (direction of arrow), with a lower class being drawn on to bear a loss only if its higher classes (beginning with Common Equity Tier 1 capital) are not sufficient to bear the loss in question:


What consequences could the resolution action have for me as a creditor?

If the resolution authority orders or adopts a measure in accordance with these rules, the creditor is not allowed, on account of this measure alone, to terminate the financial instruments and receivables or to exercise any other contractual rights in this regard. This shall apply as long as the bank meets its primary performance obligations under the terms and conditions of the financial instruments and receivables, including its payment and service obligations. If the resolution authority adopts the measures described above, a total loss of the capital invested by the shareholders and creditors will be possible. Shareholders and creditors of financial instruments and receivables can thus lose the purchase price paid for the acquisition of the financial instruments and receivables in full, plus any costs associated with the purchase. The mere possibility of resolution actions being ordered may render the sale of a financial instrument or receivable more difficult on the secondary market. This can mean that the shareholder and creditor can only sell the financial instrument or receivable subject to considerable discounts or mark-downs. Even in the case of existing repurchase obligations of the issuing bank, a sale of such financial instruments may lead to a substantial markdown. If a bank is liquidated, the shareholders and creditors must not incur greater losses than would have been incurred if the bank in question had been wound up under normal insolvency proceedings . If the liquidation measure nevertheless leads to a shareholder or creditor being in a worse position than would have been the case in regular insolvency proceedings of the bank, this will give rise to a claim for settlement of the shareholder or creditor against the fund set up for resolution purposes (restructuring fund or Single Resolution Fund, "SRF"). Should a claim for settlement arise against the SRF, there is a risk of any payments resulting from such claim being made at a considerably later date than would have been the case in due and proper fulfillment of contractual obligations by the bank.


Where can I obtain further particulars?

The German Federal Financial Supervisory Authority (German: “Bundesanstalt für Finanzdienstleistungsaufsicht”, "BaFin"), the FMSA and Deutsche Bundesbank have made information available on the resolution and liquidation rules and regulations applicable in Germany.
Details are available here, for instance:

FMSA, BaFin and Deutsche Bundesbank published a joint interpretation aid containing further notes on how money market instruments are to be determined and what debt instruments fall into the category of structured or non-structured financial instruments / claims in class (5)(a) or (5)(b):

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