Creditor Priority in European Bank Insolvency Law

The global financial crisis saw several European states ‘bailing out’ banks. Consequently, bank creditors mostly escaped unscathed. This highlighted the need for a legal framework that makes it possible to impose losses on a failing bank’s creditors without disrupting the financial system. The EU’s response was the Bank Recovery and Resolution Directive (BRRD) of 2014. The directive requires Member States to adopt bank resolution frameworks, thereby partially harmonizing the diverse approaches to bank insolvency previously found in national laws. The general insolvency frameworks employed for handling most company failures are thus deemed inapt for safeguarding financial stability.

Any insolvency framework requires rules concerning creditor priority—ie how losses are to be shared among creditors. In Creditor Priority in European Bank Insolvency Law (Hart Publishing 2023), I study the framework for creditor priority resulting from the BRRD and other EU legal acts of relevance for bank failures, such as the Settlement Finality Directive (SFD) and the Financial Collateral Directive (FCD). This represents the first comprehensive study of EU requirements on creditor priority in bank insolvency law, here understood as comprising both the bank resolution frameworks to be used when in the public interest and the national frameworks for winding up insolvent banks whose failure does not necessitate such resolution.

The book shows how creditor priority in bank insolvency law differs from general frameworks in several respects. First, EU directives adopted around the turn of the millennium—FCD and SFD—require Member States to disapply most limits for giving secured creditors absolute priority to the collateralised assets in insolvency proceedings insofar as the secured debts relate to certain financial markets transactions or payment and securities settlement. Among other things, the directives require the disapplication of certain transaction avoidance provisions and provisions reserving parts of the value of collateralised assets for unsecured creditors. Second, unlike what may be the case under some general insolvency law frameworks, bank-specific priority rules affecting loss distribution among unsecured creditors tend to favour those extending short-term credit. Finally, the bank-specific regime contains features that lack a counterpart in general regimes. The public authority in charge of resolving a bank has discretion to deviate from the generally applicable creditor hierarchy on an ad hoc basis if deemed necessary to preserve financial stability. Furthermore, this resolution authority may, using so-called MREL-requirements, request that a bank’s financing be partly in the form of equity instruments or subordinated debt. As banks have incentives to meet such requirements with subordinated debt (as such financing is deemed to entail lower costs than equity), the power to adjust the MREL-requirement effectively enables resolution authorities to influence the distribution of losses among bank creditors.

What explains these special features? It is helpful to first consider the two features that characterise creditor priority under the national general insolvency frameworks, three of which—English, German and Norwegian law—are examined in the book. First, as it is generally possible to grant security that remains effective in insolvency proceedings, companies may decide that certain creditors shall have prioritized recourse to the collateralised assets. This possibility broadly conforms with the implications of two different theoretical arguments, namely that it improves companies’ ex ante access to financing and that it is implied by the company’s right to dispose of its property. Secondly, the value remaining after any secured debts have been paid is as a main rule shared rateably by unsecured creditors, with some jurisdictions giving creditors deemed in need of special protection priority ahead of other unsecured creditors.

While the rationales for the two main aspects of creditor priority in general insolvency law are different, a common trait is that they are motivated by concerns for companies and their creditors—ie those directly affected by a company’s failure.

By contrast, financial stability—a public good—motivates the special approach to creditor priority in bank insolvency law. The idea is that creditor priority affects the risk of a failing bank’s problems spreading to other parts of the financial system. The book argues that different approaches to this link can be traced over time. Earlier directives—FCD and SFD—aimed to expand the possibilities for granting security interests for liabilities resulting from certain financial contracts and participation in settlement systems. The concern was that a bank’s default could lead to direct contagion in the financial system—ie a ‘domino reaction’ among its creditors. Removing barriers for using security to give certain creditors priority ahead of others was thus intended to give interbank creditors means to protect themselves.

Conversely, BRRD’s priority rules are more oriented towards reducing the risk that failures occur in the first place. Such a policy seeks to reduce the risk of indirect contagion caused by a distressed bank’s disorderly selling of financial assets in a scramble for liquidity. Moreover, BRRD’s approach is to a larger degree prescriptive than that of FCD and SFD: BRRD does not limit itself to facilitating risk-reduction while leaving to banks and their creditors to make use of these possibilities. Importantly, resolution authorities are empowered to influence loss distribution: both ex ante (MREL) and ex post (ad hoc decisions). The approach to creditor priority in bank insolvency law has thus evolved over time, and underlying this evolution is less trust in the ability of market participants to secure an optimal creditor hierarchy if left to their own devices.

The book argues that this evolution parallels a trend in EU banking regulation—in particular, within capital requirements—towards a regulatory approach of ‘technocratic fine-tuning’. This kind of regulation has three attributes. First, the regulatory output is complex in the sense that banks are increasingly subject to individual requirements tailored to their specific characteristics, which are intended to vary over time. Second, the regulatory output is increasingly determined through case-by-case decisions by administrative authorities, as opposed to legislation or other generally applicable rules. Third, while the exercise of the powers of these authorities is ostensibly constrained by numerous conditions, these are often worded in vague terms. If combined with deferential standards to judicial review of ‘complex economic assessments’ the result may be that the limits are significantly less binding than they first appear. If so, the relevant authorities may de facto enjoy a large degree of discretion concerning issues with distributional implications. The book argues that while this approach brings about benefits, eg ensuring that regulatory requirements faced by individual banks are proportionate, the attainment of these benefits could conflict with certain conceptions of the rule of law and democratic legitimacy.

Sjur Swensen Ellingsæter is Associate Professor at BI Norwegian Business School, Department of Law and Governance.