EU Bank Insolvency Law Harmonization—What Next?

Prior to the COVID-19 crisis, the (further) harmonization of insolvency laws pertaining to credit institutions was firmly in the crosshairs of EU regulators and policy makers. The principal arguments were twofold: first, the complexities resulting from divergent national bank insolvency laws pose a challenge for the application and credibility of the EU resolution framework consisting of the EU-wide Bank Recovery and Resolution Directive (BRRD) and the Euro-zone’s Single Resolution Mechanism (SRM); and secondly, inadequate national insolvency law regimes invite national bailouts through generous State aid outside the resolution regime. In the wake of the COVID-19 crisis, the Commission has temporarily relaxed the State Aid framework. As a result, huge amounts have been mobilised, and will put a strain on national budgets for years to come. As a consequence, effective and efficient national bank insolvency regimes will be even more relevant when the COVID-19 crisis subsides.  In my recent paper, I argue that the EU crisis management framework could be improved by the extension of the BRRD resolution regime, from only covering financial institutions the failure of which is deemed to be systemically significant, to cover the failure of any credit institution.

BRRD and SRM have established a harmonized and partially integrated framework for the resolution of potentially any financially distressed credit institutions and certain investment firms, provided (i) the institution is failing or likely to fail; (ii) there is no reasonable prospect that failure could be prevented through alternative measures; and (iii) resolution action is necessary in the public interest. As an exception to domestic ‘normal insolvency proceedings,’ the BRRD/SRM resolution framework seeks to replicate the loss allocation principles of general insolvency law so as to curtail moral hazard and enhance market discipline; whilst at the same time providing a tailored administrative procedure with far-reaching powers to prevent the systemic implications of contagious knock-on effects. However, it imposes a minimum loss absorption requirement of shareholders and creditors of 8% of total liabilities.

Any decision to let losses lie where they fall hurts those called upon to contribute to loss absorption, invites public scrutiny, and is likely to generate litigation. Authorities have strong incentives to avoid politically inconvenient decisions and the conditions for resolution leave ample room for opting out of the BRRD’s minimum loss contribution requirement. The public interest test, in particular, constitutes the Achilles heel of the BRRD/SRM resolution framework. Relying on State aid to bailout institutions that have been referred to treatment under national bank insolvency procedures may significantly add to the unsustainable strain already put on (some) national budgets as a result of the COVID-19 measures.

Moreover, the complexity of the EU crisis management framework, consisting of the BRRD/SRM resolution regime, national bank insolvency law and State aid rules, makes it difficult for investors to appreciate the riskiness of their investments in any given case.

‘Internal complexity’ emanates from the interaction of the BRRD/SRM framework and applicable national insolvency law in a supporting role within resolution. Two issues are particularly pertinent: the liquidation of the residual entity under ‘normal insolvency proceedings’ where the viable parts of an institution have been transferred to a private sector purchaser or a bridge institution;  and the liquidation analysis on the basis of the ranking of different classes of creditors under national insolvency law mandated by the ‘no-creditor-worse-off’ principle. Remaining differences in the national orders of priority may have significant (re-)distributive effects. Ceteris paribus, a difference in the applicable law of otherwise identical institutions may have a direct impact on the costs of resolution, and the exposure of the relevant resolution funds and national deposit guarantee funds, and thus indirectly on national budgets.

‘External complexity’ concerns the interaction between the BRRD/SRM resolution framework, on the one hand, and national bank insolvency regimes as standalone default options, on the other. National bank insolvency laws differ in terms of the role and responsibilities of courts and regulatory authorities, the powers of office holders, the degree of creditor involvement, and the triggers for opening proceedings, as well as a myriad of substantive law issues. The availability of multiple procedures across and within Member States, combined with the division of responsibilities between Union and national levels, both institutionally and substantively, renders the crisis management framework overall exceedingly opaque for investors.

‘Internal complexity’ could be reduced through targeted harmonization of pertinent issues, notably creditor rankings and the initiation problem. However, dealing with the residual entity following the application of transfer tools, and the harmonization of bank insolvency law as a standalone default option requires a more comprehensive approach. A harmonized European bank insolvency law should not be limited to a liquidation tool but be able to accommodate restructuring and reorganization options in appropriate circumstances. An EU-level bank insolvency regime with broad administrative powers currently exists in form of the BRRD/SRM resolution framework for institutions that at the point of failure are deemed to be systemically important. Extending this regime to institutions of all shapes and sizes, by removing the public interest test as part of the resolution trigger, would prevent a further gaming of the system based on public interest considerations, enhance the credibility of the crisis management framework and protect national budgets, thereby reducing the bank-sovereign debt feedback loop.

Consequently, any institution regardless of its size and complexity would be subject to the resolution tools and powers provided for by the BRRD. Depending on a least-cost assessment, the institution could be restructured by transferring the viable parts to a private sector purchaser and liquidating the non-viable parts on the basis of the BRRD-implementing legislation; or the institution could be recapitalized through bail-in with financial support from resolution funds. Under the BRRD, resolution authorities already seem to have the powers necessary to effectively liquidate a failing institution. In addition to the removal of the public interest test, a number of further amendments would be necessary to make this solution viable. In particular, a sensible way around the 8% minimum loss contribution requirement has to be found for smaller institutions. This could take the form of an exemption based on a certain threshold below which the 8% minimum loss contribution does not apply.

Extending the BRRD/SRM resolution regime as envisaged would constitute an interference only with the property rights in existence at the time the transformation takes effect. Property rights that emerge thereafter would already be encumbered with the potential application of resolution tools and powers. For deposit taking institutions, the interference with pre-existing property rights could be justified, and removing the public interest test would actually benefit investors: creditors would be faced with a more aligned system of creditor rights as the new baseline and pricing uncertainty would be reduced.

Michael Schilllig is Professor of Law at the Dickson Poon School of Law, King’s College London