EBF response to EBA consultation paper on draft guidelines on the rate of conversion of debt to equity in bail-in

06 February 2015

Determining conversion rates is closely related to valuation and the treatment of shareholders in bail-in. Conversion rates therefore cannot be treated in isolation.

The general principles of a) No Creditor Worse Off than in Liquidation (NCWOL)) and b) respecting the creditor hierarchy when applying bail-in seem to be adequate and undisputable. However, outcomes of the application of these principles in practice are not intuitively obvious. For bail-in to be a credible instrument, more clarity and transparency should be provided to all parties involved and in particular to investors about the effects of bail-in and (potential) NCWOL.

In EBF’sview, based on simple numerical examples, conversion rates are no more and no less than the resultant and logical consequence of application of the principles of NCWOL and respecting the creditor hierarchy. They are not pre-determined or calculated ratios to be applied.

Conversion rates can be calculated in various ways: a) Based on pre-resolution values i.e. before losses have been absorbed or based on values after losses have been fully absorbed, and b) based on accounting value or based on economic value. The draft guidelines however do not provide a strict definition of conversion rates.

EBF’s understanding of the required steps to determine the conversion rates is as follows:

• Loss absorption: losses will be absorbed according to the creditor hierarchy, starting with the shareholders. Affected shareholders and creditors will in principle not be compensated for absorbing losses (similar to an insolvency situation)
• Recapitalisation: remaining creditors will be converted into equity according to the hierarchy, in principle on a EUR for EUR basis (1 equity for 1 debt) regardless of the ranking of the creditor (based on accounting / prudential rules)
• NCWOL: to determine (potential) NCWOL the economic/market value (see EBA/CP/2014/38 on valuation) of the new shares that creditors have received has to be compared with the value of what creditors would have received in a liquidation scenario
• Conversion rates: if a creditor is worse off than it would have been in a liquidation scenario, conversion rates could be adjusted to compensate

This requires the following input:

• Losses and recapitalization levels will have to be known
• At least 3 types of valuations will have to be made which requires numerous data but also assumptions, in particular with respect to the hypothetical liquidation scenario

As it will take time to gather all data and do all calculations, it seems likely that conversion rates determined during the resolution weekend will have to be adjusted afterwards. Given all uncertainties, a temporary buffer, as suggested in the Draft RTS on valuation (EBA/CP/2014/38) could be helpful. However, this would raise additional issues:

• Should the buffer be taken as a loss or as an extra temporary recapitalization buffer? How does this affect (potential) NCWOL and conversion rates?
• How will any non-utilised parts of the buffer be (re-)distributed over creditors?

Even if above mentioned operational and timing issues can be solved, some unresolved issues remain. NCWOL can occur at a total level as well as at an individual creditor class level:

• If the total economic value is higher than the total liquidation value, some creditors may still be worse off than in liquidation. As the total economic value is higher this would mean that other creditors are (much) better off. Potential NCWOL could be solved by transferring value from the (much) better off creditors to the worse off creditors by setting conversion rates such that all creditors receive at least a value that equals liquidation value
• Even if total economic value is higher than total liquidation value and all creditors are better off, there might be reason to transfer value from one creditor class to another to “avoid setting conversion rates which disproportionately benefit a particular class of creditors”

Full response

© EBF