Who Should Hold Bail-Inable Debt and How Can Regulators Police Holding Restrictions Effectively?

In a few days, the European Commission will propose amendments to the EU bank crisis management and deposit insurance (CMDI) framework. Against this background, in our recent working paper, we analyse the demand side preconditions for the effective application of the bail-in tool and focus on the retail challenge for bank resolution, that is, the impending disincentive of resolution authorities and politicians to impose losses on vulnerable retail investors that ultimately jeopardizes the credibility of the bail-in tool and the market discipline it is supposed to instil.

Bail-in is the primary regulatory response to the Global Financial Crisis, aiming to re-instil market discipline in the financial sector. The tool imposes losses on creditors by writing down and converting liabilities to offset losses and recapitalize failing banks. In an ideal scenario, the critical functions of troubled institutions (eg, lending, deposit-taking, and payment services) are not impaired and taxpayers are not required to provide funds to cover losses. Thus, a bail-in should undo implicit government guarantees and create desirable incentives for the holders of capital and debt instruments to adequately price bank risk and closely monitor institutions' investment behaviour. In our paper, we scrutinize the demand-side prerequisites for the efficient application of the bail-in tool in bank resolution and whether the European CMDI framework ensures that these prerequisites are met.

We first show that market discipline in the banking sector will only follow if three distinct yet intertwined conditions are met. Debt holders need to display at least three features:

1. the ability and be in the position to both monitor banks' risk-taking and exert meaningful control on banks' lending operations; 2. the capacity to bear losses; and 3. the belief that they will share the costs in a bank failure. 

The demand-side prerequisites are crucial for efficiently applying the bail-in tool in resolution. Suppose debt holders are retail investors or small firms that lack those features. In that case, the social implications of imposing losses on them may lead resolution authorities and politicians to refrain from involving these bank creditors in a bank resolution. In turn, if investors rationally expect resolution authorities to behave inconsistently over time and bail out bank equity and debt holders despite earlier vows to involve them in bank resolution, the pricing and monitoring incentives that the crisis management framework seeks to invigorate will vanish. Therefore, an efficient CMDI framework should ensure only suitable investors hold bail-inable debt. 

The Bank Recovery and Resolution Directive (BRRD) initially did not address the demand-side preconditions and only laid down the loss-attribution sequence based on the ranking of the affected liabilities (BRRD, art 48). In the first applications of the CMDI framework in Italy and other jurisdictions, retail investors incurred losses in resolution alongside seasoned institutional investors and asset managers. The subsequent public outcry amplified decision-makers' inclination to spare retail investors and small firms in resolution. Although the CMDI framework expressly bans unconditional government support to banks in distress, its substantive rules and institutional design leave ample space for the injection of public funds in managing bank crises (within or outside the perimeter of the BRRD). In sum, the many shortcomings of the CMDI frustrated optimal incentives for bail-inable creditors and the bail-in tool failed to interrupt the link between banks and sovereigns. Instead of bailing out banks, governments bailed out retail investors and small firms.

Neither art. 44a of the BRRD, introduced by the 2019 Banking Package, nor the amended Markets in Financial Instruments Directive 2014 (MiFID II) rules are appropriate to prevent mis-selling of bail-inable capital (‘minimum requirement for own funds and eligible liabilities’ or ‘MREL’ instruments) to unsuitable retail customers. Such rules and provisions fail to counter the fundamental incentive problem for banks that cannot place their bail-inable debt on markets. These banks face an existential conflict of interests that makes them effectively sanction-proof. Consequently, we propose how the CMDI framework can achieve its policy objectives and ensure that retail investors without sufficient loss-bearing capacity do not acquire bail-inable debt. In particular, debt instruments most likely to absorb losses in resolution should have a high minimum denomination and banks should not be allowed to place such securities among their clients.

Moreover, the regulatory framework should allow suitable (retail) investors to assess and price the risk they incur correctly. A critical factor in achieving this goal is to make resolution outcomes as predictable as possible. This target demands that resolution authorities' discretion be limited, which in turn requires, among other things, that the differences in the burden-sharing requirements in resolution and liquidation be levelled.

Irene Mecatti is Senior Lecturer and Adjunct Professor of Business and European Banking Law at Siena University, Department of Law.

Tobias H. Tröger is Professor of Private Law, Commercial and Business Law, Jurisprudence at Goethe-University Frankfurt and Director of the Cluster Law and Finance at Leibniz Institute for Financial Research SAFE.