23 April 2012

AFME's response to the EU discussion paper on debt write down

AFME sees two key issues for designing bail‐in properly:

1. It should be flexible: firms using bail‐in should not be subject to a minimum amount requirement nor restricted to where a bail‐in could occur in their structure; and
2. with the exception of deposit guarantee schemes and deposits not covered by any such scheme, which AFME's members continue to consider, in principle, all unsecured liabilities should be bail-in-able, including derivatives, so that a wide range of situations can be addressed. As a matter of practice, however, it can be expected that certain classes of liabilities, including derivatives, might need to be excluded to make bail‐in more practical and efficient and avoid systemic disruptions.

Flexibility

A bail in will likely not work for firms that are largely funded by deposits with little to no capital markets funding. Deposits are the bank’s equivalent to a company’s customers – they are their lifeblood. Without them, there is no business. If they are compromised in a recap they will likely leave the firm (even where reimbursed by a DGS). Deposit funded institutions may be more appropriately resolved by using a bridge to run off the good assets (loans) and transferring the deposits to a solvent institution. UK banks Northern Rock, Bradford & Bingley and Dunfermline are cases in point. A Lehman, on the other hand, could have been recapitalised (bailed in).

The difficulty with establishing a minimum amount is finding a level appropriate for all firms. It needs to be incumbent upon each firm to show its investors that the firm is resolvable. A firm employing bail‐in will need to persuade its senior investors that it has sufficient capital. This will inform their pricing dialogue, as it should.

Another problem of a minimum amount is it risks creating an artificial trigger for signalling systemic distress that may in reality be unwarranted. A firm may be distressed before – or after – the trigger is breached.

Firms should be permitted to establish bail‐in plans at the place in their structure that makes the most sense for them. In most cases this will be at the holding company level but not in all. In cross-border situations, concerns that a subsidiary may not be supported by a parent can be dealt with in group resolution plans and firm‐specific cooperation agreements. These plans will be supplemented by a variety of corporate law techniques to upstream or downstream funds or equitise intercompany debt. The key is that these plans are simple and easy to implement.

Derivatives

AFME recommends that derivatives be included within the scope of the authorities’ bail‐in powers. As a practical matter, however, derivatives counterparties are a firm’s trade  creditors. Bailing them in could push up the cost of prudent hedging activity and lead to  further demands for collateral in circumstances where supply is scarce. These concerns leave AFME to conclude that while it should be legally possible to bail in derivatives, AFME doesn’t envision that it would be necessary or practical in all but extraordinary circumstances.

Full paper

© AFME