The European Bail-in Tool is too Complex and MREL Won’t Remedy its Shortcomings

I recently published two related working papers that scrutinize the effectiveness of the bail-in tool in the European bank resolution framework. I find that the regime, even after the prospected implementation of the Standard for Total Loss Absorbing Capacity (TLAC) adopted by the Financial Stability Board (FSB), will miss a critical policy objective. Market discipline that could emanate from risk-sensitive pricing of bank capital will remain suboptimal.

In the first paper, Too Complex to Work: A Critical Assessment of the Bail-In Tool Under the European Bank Recovery and Resolution Regime, I argue that for the bail-in tool to generate adequate market discipline, sophisticated investors in bail-in capital must be able to predict the likelihood and extent of their loss-bearing with reasonable certainty ex ante. Unfortunately, this main precondition for an efficient bail-in regime is not met under the European framework. The main reason lies in the embeddedness of the BRRD’s bail-in tool in the much broader resolution process. This entails ample discretion for the authorities involved also in forcing private sector involvement (PSI) in a bank’s failure. Moreover, the idea that nearly all positions on the liability-side of a bank’s balance sheet can be bailed-in is misguided, because it entails an impenetrable set of exceptions that further complicates the projection of precise bail-in results for investors. I illustrate these points by looking closely at the determination of the trigger event for bail-in and the particulars of the application of the bail-in tool in resolution, specifically, the selection of the bail-in tool from the resolution tool-box, the choice of specific bail-in consequences, the exemptions of certain liabilities from bail-in, and the general limits on PSI. I also show that the uncertainty surrounding the prediction of the result of PSI from an investor’s perspective is exacerbated where resolution authorities face the failure of a complex corporate structure. This is especially the case when operations of the banking group stretch across borders. Finally, I synthesize the prior analysis and put forward an alternative regulatory approach. The regulatory framework should disentangle private sector loss-bearing, as a precondition for effective bank resolution, as much as possible from the broader resolution process. To achieve this, not only a pre-failure trigger for bail-in but also a strict concentration of PSI in instruments that fall under the minimum requirements for own funds and eligible liabilities (MREL) are preferable.

In the second paper, Why MREL Won’t Help Much, I show that MREL, which is supposed to provide for a sufficiently large layer of high-quality, easy-to-bail-in liabilities, is—both in its current form and after the projected reform to implement the FSB’s TLAC standard—insufficient to remedy the shortcomings of the BRRD’s bail-in tool. Echoing the general concerns I voice against the European bail-in regime, the main problem is that the specifications for MREL are also highly detailed and discretionary and thus alleviate the predicament of investors in bail-in debt (at best) insignificantly. The architects of the European bank resolution framework overemphasized the principle of proportionality and indulged in regulatory fine-tuning also with regard to MREL. The highly complicated interplay of competent and resolution authorities in setting and adjusting MREL levels makes investors’ task akin to a 30-day weather forecast. Quite importantly, given the character of typical MREL instruments as non-runnable long-term debt, even if investors were able to gauge the relevant risk of PSI in a bank’s failure correctly at the time of purchase, subsequent adjustments of MREL prescriptions by competent or resolution authorities change the risk profile of the pertinent instruments. Original pricing decisions may prove inadequate, i.e. investors purchased bail-in capital at either too low or too high prices. Therefore, pricing decisions cannot instill adequate market discipline. The paper fleshes out this assessment in an in-depth analysis of the quantitative and qualitative specifications for MREL and the respective determinants in (cross-border) banking groups.

Tobias Tröger is Professor of Private Law, Trade and Business Law, Jurisprudence, at the Goethe University, Frankfurt.