SUERF's Berg, Lind: Why there is no need to stray from the original ideas behind the Bank Recovery and Resolution Directive
05 April 2023
The BRRD was revised in 2019 (BRRD2) and the Commission has announced that they are working on a new directive, the Crisis Management and Deposit Insurance Directive (CMDI).
The idea behind the Bank Recovery and Resolution Directive (BRRD) was to let creditors pay for bank failures and not let bankers land on a tax payer with the associated risk of a doom loop, where banks drag countries down. Unfortunately, many supervisors have been hesitant in their support for the BRRD and in particular on imposing losses on bank creditors. In the banking union, the Single Resolution Board (SRB) has sent banks on to national authorities, who have decided to use national liquidation procedures; often another term for bail out.
The BRRD was revised in 2019 (BRRD2) and the Commission has announced that they are working on a new directive, the Crisis Management and Deposit Insurance Directive (CMDI). BRRD2 in some respects steps back from the original ideas behind the BRRD by either making it more difficult to bail-in creditors or strengthening incentives to procrastinate instead of undertaking prompt corrective action. It is important that the CMDI does not do the same.
The purpose of this paper is to show that in most instances the BRRD would work as intended with a bail-in of senior unsecured claims, but with a fairly limited bail-in. A limited bail-in that reflects the risk premium that investors receive on senior debt and the likelihood of a bail-in. The prompter corrective action is taken, the less losses to senior unsecured claims. Therefore, prompt corrective action is also a good way to minimize contagion.
The basic idea of the Bank Recovery and Resolution Directive (BRRD)
When a bank fails somebody has to pick up the bill. On the one hand you have the shareholders, the various forms of subordinated creditors, the senior unsecured claims, and the depositors that are not guaranteed by the deposit insurance fund. On the other hand, you have the general public in various disguises; the tax payer, resolution funds and the deposit insurance fund.
Historically in the EU, the choice was for the shareholders and then the tax payer to pick up the bill, but with the BRRD the intention was to shift the bill from the tax payer to the creditors. The argument was both necessity and fairness. Necessity because governments could not afford to pay and fairness because creditors had received an above risk free rate on their claims. In addition, this would give the creditors incentives to monitor the banks they had claims on and charge a risk premium that reflected the risk. The latter would give the bank an incentive to limit its risk taking.
1,2
The BRRD contained one notable exception to shifting the risk to creditors. The BRRD introduced resolution funds (Single Resolution Fund (SRF) or national). These funds can contribute up to 5 percent of total liabilities and own funds (TLOF) in terms of absorption of losses on the condition that 8 percent of TLOF had been written down or converted into new capital. More on the precise mechanism shortly. However, the bottom line is that the resolution fund is an insurance with a decent excess payment and limited coverage. In other words, an insurance designed to avoid the worst of moral hazard.
You can ask, why can we not handle banks through the standard bankruptcy procedure like any other company. The answer is that depositors, including unguaranteed depositors, needs access to their deposits – or most of them – in order to make the payments that are crucial for their day to day business and the economy at large. And on a good day, they should also have access to their credit facilities, which many use to make payments.
3 They cannot wait the 10 years or more that a bankruptcy process takes. However, they can afford a small haircut, and that is even more true for senior debt holders, to cover the deficit in the failing bank’s balance sheet.
The smart idea in the BRRD is that it takes the liquidity problem out of a bank failure, but still lets the creditors pay. It does so by the resolution authorities making a qualified conservative estimate of the funds required to repair the hole in the bank’s balance sheet.
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