What Are The Consequences Of Bank Bail-Ins For European Stakeholders And How Customers Can Minimize Risk And Maximize Payout?
An In-Depth Investigation into the Working Methods of Financial Institutions, the Risks Of Banking and the Consequences for Customers
Bank failures are rare but can have a serious impact on customers and society. Confidence in the financial system is required to keep the economy going. This is difficult to achieve when financial institutions that are interconnected make opaque products for unaware customers, facilitating the risk of contagion.
Previous studies show abstract descriptions of economic theory but lack an ethnographic study of bankers, their regulators, the financial industry and the customers. Ethical concerns are discussed but there is limited deeper scrutiny of the practical use of derivatives, exotic structured products and associated risk taking by the market players.
This dissertation assesses whether regulation and the bail-in tool minimize risk for individual customers and what customers can do themselves to avoid losing their money. The research identifies the gap between theory and the day-to-day practice as perceived by customers and justifies the conclusions by comparing secondary research with an extensive questionnaire and case studies.
The key findings are categorized under three main pillars: the regulatory framework, customer perception, and the process of prevention and repression. Case studies indicate that an attack on the Bank Recovery Resolution Directive has not been successful, and that legal procedures could have potential when they are filed for gross negligence or deception; Bank customers whose assets have been downgraded after a resolution, blame the regulator for their losses but take no action to prevent a resolution to re-occur; and, the BRRD provides a swift resolution with improved payment rates.
The global financial crisis which began in 2007 revealed fundamental structural weaknesses in the financial industry that may well have remained otherwise hidden. Examples include: excessive risk taking, a remuneration and bonus framework based on quantity over quality, unnecessary oblique and over-complex structured products, manipulated balance sheets, insufficient loss absorbing coverage, and unclear valuations by credit rating agencies. The result was a global financial meltdown. Rescue missions around the globe by different governments, funded in the main, by the tax payer was necessary to prevent financial institutions from bankruptcy and naturally resulted in public outrage as well as a loss of faith (The Economist, 2017).
To ensure market discipline was restored and give assurances that if such circumstances occurred again, it would not be tax payers encumbered by a subsequent bail-out for the affected financial institutions, measures were taken. The policy implemented was known as Basel III (Basel Committee on Banking Supervision, 2010a). The guidelines were thus: the minimum tier 1 capital requirement, where the banks’ capital conservation buffer was reached, would be incrementally increased to 8,5% in 2019. Another measure to prevent future tumult was the total loss absorbing capacity equivalent to 18% of risk weight assets that systemic banks needed to have by 2022 (Mendicino, et al., 2017).
Financial institutions play a pivotal role in society. They control the flow of funds into the real economy, ensuring economic growth and as corollary, improve employment prospects. Availability of capital for lending purpose is influenced by defaults on loans and the possibilities to convert commercial paper into cash. Non-performing loans are problematic for the potential of financial institutions to offer new loans when securitization is limited by valuation of the loan portfolio and regulation (Kara, et al., 2017).
Most financial institutions are complex and interconnected so a collapse may contribute to a domino effect and at the very minimum may adversely affect other entities. For example, a situation akin to that which Lehman Brothers in 2007 (Fox, 2009), could trigger another global financial crisis. The risk of contagion to other financial institutions therefore must be mitigated. Bank runs, where customers rapidly withdraw cash funds from their account creating liquidity and solvency challenges, should be avoided and deposit protection schemes that offer bank customers a deposit guarantee, allay customer exposure and promotes consumer faith and confidence must be implemented.
In a further response to the financial crisis, European regulators introduced the Banking Recovery and Resolution Directive (Lintner, P. et al., 2017), which provided EU member states with a procedure and tools for efficient and effective management to ultimately avoid another banking crisis or limit its consequences if a bank failed.
Banks and financial institutions founder for a combination of reasons. The most obvious reasons for bank exposure and failure are; lack of liquidity, a bank run and rogue trading. Also, fraud and failure to comply with anti-money laundering regulation has become a growing concern. Smaller banks like Banca Privada d’Andorra, FBME Bank and ABLV Bank, were closed by regulators following investigations by the United States Treasury Department which concluded that they were institutions of primary money laundering concern (FinCEN, 2018) and were therefore excluded from transacting in US Dollars. Customers were caught unaware as all three banks had no liquidity or solvability challenges, leaving them with the assumption that fraud or money laundering had occurred.
The aim for regulators is to orderly resolve the banks problems while simultaneously limiting damages for depositors, shareholders and other stakeholders (European Commission, 2014). Regulatory solutions are divided into three main categories; a sale or closure of (a part of) the bank, the winding up of the bank, or nationalization via a bailout.
Where a bail out is organized by regulators and funded with tax payer money, mandatory creditor participation (Tröger, 2015) via a bail-in the issue for the bank itself and its customers. The objective of a bail-in is to systematically tackle the financial challenges of the troubled bank through consolidation of its debt and to then, potentially reopen the bank under new ownership and management.
One of the consequences of a bail-in is that the creditor hierarchy determines the maximum payout per customer group (Bank of England, 2014). Oftentimes, the failure of a bank is triggered by a lack of liquidity or poor risk management. When a resolution decree is announced by a regulator, it is likely that a part of the account balance or investment must be set down or converted into equity to restore solvency. The pre-funded deposit guarantee scheme provides customers with swift access to a secured maximum amount. The guarantee scheme takes a priority position in an insolvency procedure, further limiting the possibility for customers to recover the surplus above the guaranteed amount.
The main concern for customers who experience a bail-in is the loss of their money, caused by the lack of forthcoming knowledge on the issue which contributes to the limited preparations made to protect their wealth. As became apparent in Cyprus during the crisis of 2012-2013, the exposure of banks into a few leveraged and high-risk markets triggered a problematic situation that almost led to the bankruptcy of the entire country (Demetriades, 2012). Emergency Liquidity Assistance was the last resort and Laiki Bank was shut down. Financial restructuring was operationalised at Bank of Cyprus where troubled assets and risky securities were placed in a separate entity, a bad bank (Martini et al., 2009), to avoid contamination of the healthy parts of Bank of Cyprus. The restructuring plan resulted in a permanent reduction of the value of uninsured account balances – also referred to as ‘haircuts’ (European Central Bank, 2016), on many customer accounts.
Features of a bail-in are that shareholders and unsecured creditors participate in the losses of the bank and potentially convert their unsecured account balance into equity in order to restore solvency. The creditor hierarchy (Bank of England, 2014) is another concern that needs further examination. In liquidation procedures, fixed charge holders, tax authorities and government claims take primacy- followed by liquidators. Ordinary preferential creditors, the deposit protection scheme and employees with claims from labor are third in line. Next are the preferential creditors, e.g. depositors with excess funds of 100.000 Euro. Unsecured senior creditors, subordinated creditors and shareholders end the continuum. The BRRD follows a limitative three step hierarchy, from senior unsecured liabilities, to subordinated debt, to shareholder equity and debt (Jennings-Mares, 2017). The creditor hierarchy reveals the inadequacies of a bail-in for customers; a weak capital adequacy leaves qualified depositors, subordinated creditors and shareholders only with a guaranteed sum under the deposit protection scheme.
The legal and regulatory framework is complex. Customers of a failing bank are unlikely to be aware of the potential hazards, yet, consequences of a bank failure can be devastating for those very customers and shareholders. A lack of access to the bank account, a potential hair cut on the deposit and a substantial decrease of the share price of the financial institution are all realistic scenarios.
As we see in the next chapter, most academic study has a focus on theoretical aspects of risk and regulation. The view from the perspective of the depositor, is underexamined in academic studies of risk management. Therefore, the methodology used triangulates using case studies and customer surveys to complement the data under analysis.
In view of the above, this study aims to contribute to the understanding of bank failures and the bail-in as a resolution strategy. It considers two core questions:
- How customers can best protect themselves against bank failure?
- What are they able to do to maximize their pay-out in the event of a bail-in?
Before practical questions can be answered a review of the existing literature on bank regulation is necessary. The outcome of the research is used to create an informative blueprint for bank customers that enables them to take appropriate action when they choose a bank; plan to diversify their wealth management source- which can mitigate losses if their bank is at risk. The study analyses the legal framework and regulatory solutions; explores different bank failures; and further investigates the customer perception to find evidence for their relative knowledge on the subject.
The research objectives relate to regulation and resolution; customer perception and protection; prevention and repression of the devaluation of wealth due to bank failure. This study answers the questions:
- What happens when a bank is placed under resolution?
- How much depreciation of wealth should depositors expect when their bank fails?
- What do customers need to do for themselves to claim their (insured) account balance?
It further examines whether regular customers can safeguard a priority position before any challenges might occur. The hypothesis is that customers are largely unaware of the procedures of banking and those for bank failure specifically.
The different chapters follow an explicit structure from current literature and research to the research methodology used that leads to conclusions and recommendations. The existing literature reveals a strong theoretic foundation of regulation and resolution but lacks the customer’s perspective. Driven by the research objective, that is focused towards the creditor, the research methodology combines primary and secondary data to eventually answer the research questions. The evaluation of the findings includes case studies to compare theory with recent events and enables profound analysis to come to conclusions and recommendations.
2. Literature review
Previous research on bank failures, bailouts and bail-ins was mainly conducted by central banks, regulators, universities and organizations like the Bank of International Settlements, BIS, the Financial Stability Board, FSB, and the Centre for Economic Policy Research, CEPR, among others. This study builds a logical sequence of events from operational banking to regulation; bank failure and resolution, and eventually tests theory with summaries of case studies of failing banks from the last decade. Customer perception and experience to identify the gap between theory and actions from regulators from one side and customers left wanting on the other side is also analysed.
Avgouleas and Goodhart assert that (2016), contemporary studies should concentrate on banks’ mismatch between assets and liabilities. Armour (2001) adds another category that triggers bank failures: cash flow insolvency i.e. issues concerning the banks’ tendency to engage in peripheral activities facilitating miscalculations that ultimately call for bail-ins when substantial losses have been made. Recent bank closures reveal a mismatch between developed regulation and the implementation of new rules by financial institutions, specifically in the areas of risk management, compliance, fraud and money laundering. The idea that bank failures are the exclusive result of liquidity challenges is anachronistic. The Bank Recovery and Resolution Directive, BRRD, designates four legal prerequisites to indicate a financial institution is failing or likely to fail, FOLTF. Three of these requirements relate to the financial state of the bank; balance sheet insolvency; cash flow insolvency; and the requirement of public financial support (Freudenthaler and Lintner, 2017). The final opportunity to designate a financial institution as FOLTF is whether the continuation or withdrawal of authorization is justified. Regulators need to have significant substantiation of their claims to place a bank under resolution when authorization is at stake.
2.2 How banks operate
Commercial banks take deposits and make loans with these deposits; they borrow short and lend long (Cecchetti, 2007a). Additionally, banks facilitate financial transactions and sell products from other financial institutions for a fee. Over time, banks found solutions to accelerate their profitability with fractional reserve lending, leverage techniques, securitization, borrowing from other banks and indirectly via quantitative easing programs. The shadow banking market, where actors are not covered under the regular banking regulations, played an additional crucial role in funding for commercial banks because of their involvement in the facilitation of credit throughout the global financial system.
A fractional reserve system allows commercial banks to keep a part of the funds that are entrusted to them as a reserve that is readily available, while lending out the bulk of their funds, irrespective of their obligation to repay the funds entrusted to them, to the extent that they are due on demand (Federal Reserve Bank of Atlanta, 2011). Fractional reserve lending was compared with the credit or money multiplier by Philips (1920), explained by Keynes (1930) as a way where only banks can create deposits in its books allowing the customer to use this deposit. More recently this has been clarified by Stiglitz and Walsh (1993) who postulated that fractional reserve banking seems to conjure something out of nothing. The fractional reservice system is a much-debated subject – Bagus, et al (2016) support the idea, while Huerta de Soto (2006) criticizes the use of a system that lacks true legal underpinnings. Others like Rothbard (1963) argue that banks are already and always will be insolvent.
Financial institutions intentionally take advantage of the difference between long term deposits and short-term borrowings. The Net Present Value, (NPV), calculates the value of future cash flow- the difference between the present value of capital inflow and the present value of capital outflow. Discounting is an important part and an oft utilised calculation model in large transactions. The value of money today differs from the value in the future. Non-linearity is a mathematical model based on hypotheses resulting in unpredictable scenarios that can differ per transaction. The discount also determines a part of the profitability of a transaction, where the perceived value of the underlying asset is considered higher than the purchase price.
Leverage is a technique of borrowing capital with the intent of making a profit (Gambacorta and Karmakar, 2016). Through using margin accounts, capital is borrowed to invest in financial instruments. Interest payments over the borrowed capital must be honoured. In a bull market, where overall positive results are measured, the return on investment is based on the borrowed capital, and therefore is exponentially high. Interest payments on the borrowed capital are of no concern in a bull market. The opposite of a bull market is the bear market, where negative considerations trigger the depreciation of financial instruments. The lack of a profit and the gap between the borrowed capital and the value of the investment can encourage the lender to request for margin calls or redeem the loan. If the total loss absorbing capacity of the financial institution is not at risk, a leveraged investment in a bear market has an impact on the profitability, but not the viability of the firm.
Financial institutions can bundle loans or other securities. Such a package of securities is appraised by a credit rating agency and resold to other investors. The process of creating bundled packages of securities is called securitization (Bessis, 2011) and enables financial institutions to sell a financial product to a customer, bundle this contract with other contracts in a financial instrument, sell this financial instrument to an investor, and then restart this process from the beginning again. The advantage of bundled packages of securities is that different risk factors, like default risk, can be spread over multiple different investment units. The global financial crisis revealed that the credit rating agencies responsible for the valuation of the securitized financial instruments were aligned with the very financial institutions offering these very same instruments. This is a clear conflict of interest that could influence the rating of the financial instrument. The combination of complex financial instruments with unclear and manipulated ratings can leave unaware and vulnerable investors with unexpected consequences.
To minimise risk, financial institutions use a variety of hedging techniques to mitigate potential losses. Derivatives, such as; forwards; options; futures and swaps, allow the parties to control the market price risk of the underlying asset by agreeing on a future outcome in a contract. Collateralized debt obligations; CDO, mortgage backed securities; and credit default swaps; CDS, are all derived from debt, where the financial instrument can act as a funding mechanism or an insurance policy for the default risk on a portfolio of debt; where failure of collateralized debt obligations is covered by credit default swaps (Longstaff, 2010). Derivatives are also used in high risk, speculative investment products like, binary options, warrants, and the contract for difference, CFD. They can be traded at the exchange as exchange-traded derivatives, ETD, or directly, via two parties, known as over-the-counter transactions, OTC.
Repurchase agreements, also referred to as repo transactions, cover the sale, and at a future date, the repurchase of these same securities (Bessis, 2011). The future date of the repurchase of the securities can be fixed in a term purchase agreement, or open in a demand repo. The value of the underlying securities fluctuates; therefore, the duration of a repo contract determines the amount of risk of the transaction. Since the transaction transfers ownership of the securities for a fixed term in return for capital, the balance sheet of the seller, who receives cash for the sale, is manipulated. This adjustment leads to an oblique purview of the creditworthiness of the seller in the repo transaction. Investors can maximize their liquidity, protect their principal and gain a competitive market return, while the transaction provides repo dealers with a return on investment. Lehman Brothers reveals the most notorious example of a firm using a repo transaction to obscure the true financial situation of an investment bank. The subsequent collapse of Lehman Brothers triggered a global financial crisis (Bernanke, 2017).
The performance-based bonus culture for bankers has been a protracted point of discussion -where large rewards upon closure of a contract are given, without responsibility for situations when markets dive, or investments become void. If there is causal link between risk taking and external deposit protection, it leaves a clear footprint seen in the laissez-faire ethical attitude of bankers towards excessive risk taking. It is little wonder as a higher sales volume, corresponds to a higher sales commission. This is especially true when the employer is ‘too big to fail’. Notwithstanding if such a failure does occur it can trigger a systemic financial crisis, resulting in rescue missions are expediently operationalised to save the bank from its collapse.
International banking is complex. The global trading landscape expects financial institutions to engage in cross border activities. To facilitate transactions in another country, financial institutions need to comply with international regulations and often need access to local representation. Local representation is executed by a ‘correspondent bank’, assisting in international money transfers and the provision of access to local financial markets abroad.
2.3 The capital structure of banks
Fractional reserve banking enables financial institutions to lend out deposits to other customers without holding collateral for all deposits (FRB Atlanta, 2011). To avoid the situation where all deposits are used for commercial purposes, banks are required to hold minimal reserves based on a percentage of their risk weight assets, long-term borrowings and unsecured, subordinated short term loans. Not all the banks’ assets contain the same risk, hence the reason for central banks to ascertain the value of assets according to risk. The reserves of a bank are divided into three different ‘Tiers’. Shareholder equity and retained earnings are part of the core equity, which is termed Tier 1 capital. The intention is to measure the financial health of a bank and reduce insolvency risk. Tier 2 capital includes long-term bank debt and Tier 3- subordinated short-term loans.
|Tier 1||Shareholder capital & retained earnings||Core capital||Total capital|
|Tier 2||Long-term borrowing, reserves, provisions, subordinated bank debt||Supplementary capital|
|Tier 3||Tier 2 + short-term subordinated loans||Tertiary capital|
Figure 1. Bank reserve capital
Credit risk describes the risk on defaults on loans by borrowers, and includes alongside the default risk, counterparty risk, mitigation risk, exposure risk and loss given default (Bessis, 2011). Credit worthiness is the main factor used to calculate risk-weight assets. The less risk, the lower the percentage. Different loans are evaluated by their percentages to come to the total risk-weight assets. The Capital Adequacy Ratio, CAR, is a percentage of the weighted credit exposure of a bank that measures the risk of insolvency due to excessive losses. CAR is calculated with the following formula:
|CAR =||Tier 1 + Tier 2|
The loss absorbing capacity of a bank refers to the position where losses do not push capital below the minimal required regulatory capital to avoid insolvency and which can result in recapitalisation of the bank or even resolution (Bank for International Settlements, 2015). Total loss absorbing capacity requirements are crucial for global systemic financial institutions, who are ‘too big to fail’, because the threat of failure for such a bank can have repercussions on the global economy and eventually down the line the local taxpayer. Specifically, the leverage ratios, that look at the ability of banks to meet their financial obligations, need to be monitored as it reveals the equity and debt positions of the bank to fund its operations.
Like most companies, banks are during the incorporation stage funded by their shareholders. Regulatory requirements to start a bank have evolved over time. Shareholder equity, which is the net value of the bank, is calculated as total assets minus total liabilities. In case of winding up, the shareholder equity can be paid to preferential creditors after all other sources of income are exhausted. When the banks liquidity and assets are monetized and paid to the preferential creditors the remaining shareholder equity can be then paid to the shareholders.
Most transactions of banks are visible on their balance sheet. This contains the bank’s assets: such as loans to customers; trading assets; property and central bank deposits; liabilities; customer deposits; debt; trading liabilities and loans from the central bank; and equity. Off-balance sheet items are ‘hidden’ assets or liabilities for a bank (Almazan, et al, 2015). The underlying asset is owned by a third party but utilised by the bank. Securitized loans, specific operational lease arrangements and CDO’s are examples of such off-balance sheet items. Accounting standards, examples being, US GAAP and IFRS, and the Basel II accord on bank supervision, address off-balance sheet activities in the notes of their financial statements or as part of the leverage ratio exposure.
2.4 Risk, regulation and the legal framework
Risk in financial institutions is derived from various sources. Financial stress in financial institutions can be the result of systemic and global influences, micro economic choices, or internal affairs. Risk based regulation combines assumptions of future possibilities with experiences from the past. A close examination of recent bank failures, such as Northern Rock, Icesave and Laiki Bank revealed serious exposures to bad debt and subprime mortgages through weak funding models, excessive leverage and resulted in inadequate capital and insufficient liquidity buffers. Regulators developed reform packages that included increased bank capital and an improvement of the quality of loss absorbing capital (Magnus, et al., 2017).
Another point of weakness for financial institutions, exposed during the global financial crisis, is the danger a failure can have for other market players and eventually the economic system, due to their size and interconnectedness with other banks. The largest banks and insurers were classified as Systemically Important Financial Institutions, SIFI, with more regulatory requirements, increased capital buffers and advanced stress testing to periodically review the stability of the institution (Anwar, 2012).
Financial institutions and regulators always need to find a balance between protection of the financial system and economic growth. Over time the global financial and economic interests enlarged. The definition of money laundering for example, altered from direct illegal qualifications to all actions that allow undeclared capital into a local economy (Hopton, 2009). The current definition of money laundering makes compliance for financial institutions a time consuming and complex task to address. FinTech, the overall description of technical innovation in the financial industry, brings new challenges to traditional financial institutions in relation to compliance and cybercrime. Innovation does not replace regular operational risk factors like credit risk and counterparty risk -he total risk environment expands with new and different challenges.
The starting point of current regulation is capital adequacy (Basel, 2010b). The Basel Committee on Banking Supervision implemented several accords on banking regulation and supervision over the years. It subdivided recommendations on regulation into three pillars (Magnus, et al., 2017) which address minimum capital requirements, supervisory review and market discipline. Basel recommendations can be implemented and enforced on national levels by the central bank. The pillars in figure 2 reveal the definition of minimal capital requirements and show the improvements made for the local regulator to monitor internal risk management procedures of the banks under their supervision. This promotes an active role for the bank itself.
|Capital||Quality and level, capital conservation buffer, countercyclical buffer, capital loss absorption|
|Risk coverage||Securitisations, bank exposures to central counterparties, trading book, counterparty credit risk|
|Leverage||Leverage ratio, off-balance sheet exposure|
|Risk management||Risk management processes|
|Supervision||Firm-wide governance, stress testing|
|Market discipline||Disclosure of the banks’ risk exposure|
Figure 2. Basel pillar structure on regulation
Central banks are responsible for managing the currency of their country, the interest rates and the value of monetary assets in a local economy, while protecting the domestic financial system. Such protection is executed by regulating the financial sector via supervision of the commercial banking system. Central banks provide licenses to credit institutions and allow branches and representative offices to operate in their country (European Central Bank, 2017). European rules acknowledge a single banking license issued by one of the member states of the EU as a point of entry in any EU country. The mutual recognition of supervisory systems enables credit institutions to access the system of correspondent banks and even open branches in other EU member states. Local central banks can set additional requirements for credit institutions to operate in their country.
From the purview of the EU, a banking union provides a uniform, collective framework for financial services that enables the same rules in the EU to safeguard confidence in the stability of financial institutions active in the EU (European Commission, 2015). The global financial crisis that emerged in 2008 revealed significant fissures in the foundations of the global financial system and this triggered a reformation and instituting of the ‘level playing field’ of financial institutions in Europe. The European Banking Union was formed to migrate specific domestic responsibilities of central banks to an EU authority. A single rulebook for financial services in the EU was established under the Banking Union, containing the Single Supervisory Mechanism and the Single Resolution Mechanism.
The Single Resolution Board (SRB, 2018) acts as the pan-European resolution authority that ensures the orderly resolution of a failing bank and simultaneously minimising impact for the real economy and local public finances. Participants in the SRB are representatives of the ECB, the European Commission and the national authorities. The SRB works closely with the European Banking Authority, EBA, and aims to promote financial and economic stability in the EU. The EBA is a powerful authority that can overrule a central bank when it fails to properly regulate the financial institutions under its control. It is responsible for the functioning and integrity of the financial markets, which includes the stability of the financial system in the EU. Furthermore, the EBA executes in collaboration with the European Systemic Risk Board, ESRB, the stress test exercise in Europe (EBA, 2018). The goal of the stress test is to assess if financial institutions can cope with specific negative market developments and to what extent the risk of contagion will impact on other financial institutions negatively.
The Single Supervisory Mechanism, SSM, allows the European Central Bank, ECB, to monitor the financial stability of financial institutions in EU member states. The regulations under which the SSM operates aim to contribute to the safety and integrity of credit institutions in Europe and the stability of the financial system. Due to its wide remit, the SSM acts uniform over all member states and can identify contagion across the industry and intervene where appropriate. Credit rating agencies played a significant role leading up to the global financial crisis (Gaillard, 2013). The business model of rating and assessment institutes, where market players appoint the rating agency to identify their own risk profile, creates a conflict of interest. Therefore, the importance of external credit assessment institutes, ECAI, should be reduced and their operational mandate must change (Committee of European Banking Supervisors, 2018).
Alongside the SSM, the Single Resolution Mechanism, SRM, provides the member states uniform rules and procedures for resolution of financial institutions (Tröger, 2015). The main objective of a resolution is to limit damages for the real economy and taxpayers. The rules for recovery are discussed in the Bank Recovery and Resolution Directive (BRRD, 2017) which describes the steps that need to be taken when a financial institution is in difficulties and a recovery and resolution process needs to be started. The main objectives of the BRRD are to remove obstacles that prevent an orderly resolution; implement early intervention measures to prevent a crisis; provide tools to manage a failure of the bank, enforcing loss absorption by creditors and shareholders (while the bank does not have to shut down permanently); limit government support, where last resort is a final remedy; resolution funding by bank contributions; and cooperation between member states to prevent contagion. Michaelides (2016) argues in his overview of the resolution via public support and bail-in of Bank of Cyprus and Laiki that timely intervention is critical to avoid a capital outflow and restore stability. The BRRD has four tools at its disposal to ensure an orderly process. These tools are the bail-in tool; the sale of business tool; the bridge institution tool; and the asset separation tool.
A bail-in is defined by Lintner and Lincoln (2016) as a write down and conversion of the assets of a creditor, and its opposite is a public bail-out or private loss absorption by creditors. Jennings-Mares (2017) describes the bail-in tool as the ‘statutory imposition of losses on liabilities of a financial institution where such liabilities are not designed, by their terms, to absorb such losses outside of an insolvency procedure’. Both definitions concretize the importance of a closed circuit to limit the risk of contagion. Shareholders and creditors of a failing bank bear the first losses of the bank in a bail-in situation. Loss absorption is achieved by the conversion of liabilities in a common equity instrument or devaluation of the assets which can result in a total write off the liability.
The main advantages of a bail-in situation are the swift measures taken to avoid definitive closure of the bank and the exclusion of tax payers from the resolution procedure (Dewatripont, 2014). Not all creditors of a bank can participate in a bail-in procedure. Insolvency law can prioritize specific creditors in case of default, hence the rationale for such liabilities to be excluded from the bail-in procedure. For example, covered deposits under deposit guarantee schemes, DGS, are excluded from the bail-in process.
The DGS itself gets a prioritized claim towards the bank in liquidation. Deposits exceeding the insured amount of 100.000 Euro and other secured liabilities can also potentially be part of the bail-in. Other circumstances under which liabilities can be excluded from a bail-in relate to timeframes; the viability of the bank and its core business units; the risk of contagion; and when the bail-in of a liability leads to a situation where other claims become subordinated and so receive an unequal share or normal regular insolvency proceedings. This is also known as the ‘no creditor worse off than under liquidation’ or NCWOL principle.
A bail-in tool can be used as an ‘open bank bail-in’, where the bank is recapitalized to absorb all losses and is safeguarded for another year of operation (Bank of England, 2015). The other option for the bail-in tool is the conversion of customer deposits into equity, claims or debt instruments to be transferred to an asset separation tool or bridge institution. The holders of the new equity instruments benefit from the proceeds of the asset separation or bridge institution. The main objective of the BRRD is to limit damages of failure and prevent the definitive closure of the bank. If there is a realistic possibility that the bank can resume its orderly operations, tier 1 equity capital can be amplified by the emission of shares in the bank via a resolution financing arrangement or government support. Also, unsecured debt instruments can strengthen the bank’s tier 2 capital. The choice between a capital injection of debt or equity lies in the corresponding risk involved. Value of equity can fluctuate and depends on the overall worth of the bank, where debt is, ceteris paribus, always the same amount.
The priority for regular customers of a bank under resolution is to regain swift access to their account balance. To maintain customer confidence in the financial institution and prevent stress or a bank run (where customers massively withdraw the deposits from their accounts) the deposit guarantee scheme, DGS, can pay to qualified depositors a maximum of 100.000 Euro (European Commission, 2014). Payment of the insured funds takes place within seven working days after the claim is successfully filed in compliance with the rules of the national resolution authority (NRA).
A regulator relies on the NCWOL principle to determine if normal insolvency proceedings or a bail-in takes effect. A creditor hierarchy defines the treatment and position specific customers of the bank get during the liquidation procedures. The BRRD distinguishes in a matter of priority between senior unsecured liabilities, subordinated debt, and tier 1 equity and tier 2 debt. During a bail-in procedure, senior unsecured liabilities, such as the DGS scheme, unsecured deposits of natural persons and small- and medium enterprises that exceed the insured level of 100.000 Euro, senior (secured) debt, and other uncovered deposits, have a priority position and receive the first pro-rata payment from the total assets of the bank. After the settlement of the first group of creditors, holders of subordinated debt, also referred to as junior creditors, receive payment. The reserve or supplementary capital of the bank that is merged in tier 1 equity, additional tier 1, AT1, instruments, and tier 2 debt, like reserves, hybrid instruments and subordinated debt, are positioned third in the bail-in hierarchy. AT1 and tier 2 instruments fall under the Write Down or Conversion of Capital, WDCC, and can be written down or converted in common equity tier 1, CET1, capital to ensure enough loss absorption capital during the resolution. Before WDCC takes place, CET1 instruments must be written down.
Advance payments are made to qualifying depositors via the DGS and is paid out shortly after the resolution. The remaining creditors hold unsecured debt instruments. The payment sequence is outlined in figure 3, below. Tier 1 capital and other existing shares are cancelled or transferred to bailed-in creditors, giving the existing shareholders of the bank a potential haircut on their property. Shareholders can object against the conversion of their shares in favour of senior creditors by challenging the action based on the right to property. Objections in any court of law can delay further resolution procedures (Directive 2014/59/EU, 2014).
|Advance payment:||Bail-in creditor hierarchy:|
|Deposit Guarantee Scheme (DGS)||First: DGS advance payment claim|
|Second: Senior unsecured liabilities|
|Third: Subordinated debt|
|Fourth: Tier 1 equity & Tier 2 debt|
Figure 3. Bail-in payment sequence
One of the most effective tools for a regulator is the sale of business tool that entails the sale of business units, or the complete bank with or even without the consent of the shareholders of the troubled bank (European Banking Authority, 2014a). The expropriation and sale of the business unit or bank is based on a fair, prudent and realistic price, to maximize the potential for the involved stakeholders. Proceeds of the sale are designated to the resolution proceedings or the shareholders. The sale of business tool can benefit depositors and restore access to their account balance when the shielded business unit contains the deposits. Private capital controls can be implemented to avoid a run on the bank.
The bridge institution tool, or bridge bank, fulfils the temporary need of capital provisioning to maintain the critical functions of the bank when it fails. Share transfer and property transfer to the bridge institution are the main instruments of a bridge bank, where the critical functions of the bank remain untouched. The bridge institution is a separate entity, owned by the state; the resolution financing arrangement or public authorities (Lazcano, 2017) to avoid a conflict of interest with the controlling entity over the bridge bank – the resolution authority.
Since the bridge institution is an interim solution, and established over a two-year period, a diligent valuation of the losses, assets and liabilities of the bank is required (Willey, et al, 2018). Due to the purpose of the bridge institution, losses are not transferred but are absorbed in advance via a bail-in or financed via the issuance of new debt. At the end of the two-year lifecycle the bridge institution is terminated. Profits made in the business unit during this period are paid out to the shareholders or returned to the failing bank.
An asset separation tool is also known as a ‘bad bank’ (European Banking Authority, 2014b). Its purpose is to hold the distressed assets of the failing bank. Often non-performing loans, NPL, and investments that must be penned are placed in the asset separation tool. The aim of the asset separation tool is to remove the toxic assets from the balance sheet of the bank and place these assets in an asset management vehicle (AMV) with its strict guidelines and under special management scrutiny. The goal of the AMV is to maximize the potential of the distressed assets and liabilities in an organized and measured way. Customized encouragement of debtors to resume their payment plan or new payment agreements can limit damages and are easier to achieve via specialized business units inside the bank. Similar to the bridge institution tool, the asset separation tool has a temporary existence and aims to protect the critical functions of the bank.
Although the SRM is comprehensive in case of challenges that relate to the solvency of financial institutions, it lacks an all-embracing solution for financial institutions that are subject to closure due to failure to comply with anti-money laundering, regulation, sanction violations, fraud or rogue trading. Systemic banks like Credit Suisse ($ 2.6 Bn), HSBC ($ 1.9 Bn) and UBS ($ 1.2 Bn) have been fined by US regulators for respectively tax evasion, money laundering and Libor rate manipulation (Ahmed, 2014). For Banca Privada d’Andorra, FBME Bank and ABLV Bank alleged violations of international money laundering regulation triggered a forced resolution. Deutsche Bank and Credit Suisse agreed on substantial settlements with the U.S. Department of Justice for their role in the creation and sale of toxic mortgage backed securities.
Since 2014, the European Central Bank, ECB, supervises the appointment of the management of credit institutions and financial holding companies that operate in the EU based on their theoretical banking- and practical experience. These fit and proper assessments include the factors: experience, reputation, and conflicts of interest assessment, as well as the time commitment to perform direct duties inside the credit institutions and collective suitability by internal self-regulation and ongoing governance (European Central Bank, 2017). The results of the assessment are the foundation of the ECB decision on the appointment of the member of the management. The potential member would be deemed fit and proper and can include a recommendation, condition or obligation; or not qualified determination. The fit and proper assessment is also part of the bail-in procedures where change of control in the bank is required after it is acknowledged that stability and confidence has been restored.
It is important to acknowledge that the aim of resolution is not to wind up the financial institution, the intention is to orderly resolve the financial challenges of the bank with minimum exposure to the bank, its customers, the taxpayer and the real economy. A bank failure can have devastating financial consequences for customers, shareholders and staff members. Only when there is no future for the financial institution, a definitive closure takes place.
Due to the impact that a bank failure can potentially have for depositors and shareholders, this study uses data derived from three different categories. Secondary sources provide a background and theoretical substantiation; case studies on various bank failures disclose the practical challenges and identify the losses for customers; and a questionnaire completed by 50 bank customers who experienced losses due to a bank resolution. Each category reveals specific key points that enable the researcher to formulate a conclusion.
The main concern of this study is whether the academic theory on bank failures corresponds with real world scenarios. The understanding of the mechanics of commercial banks and other players in the shadow banking sector, regulation and resolution, previous banking crises, bailouts and the bail-in tool are examined. The study relies on previous academic research: working papers, industry journals and the legal framework. The outcome of the study is to identify and potentially reduce the gap between prevention by regulation and the negative consequences suffered by the customer through the clear and expeditious provision of information.
3.2 Case studies
A case study is an empirical investigation where different examined situations provide a means of interpreting the topic under review in a practical setting. The objective of the case studies for this research was to identify overlap in outcome of resolution and a bail-in situation (Saunders et al, 2009). The data for the case studies came from different sources and included secondary sources such as the textbook ‘Cyprus and the financial crisis’ (Demetriades, 2012), publications like ‘The Novo Banco debacle and the rule of Law in Europe’(Hale 2018), ‘Iceland’s financial crisis in an international perspective’ (Halldorsson and Zoega, 2010), and ‘State aid NN 70/2007’ (European Commission, 2007) and directives and guidelines including the ‘Bank recovery and resolution’ (2014) framework by the European Commission. The choice for these specific sources was derived from the answer’s respondents gave to the questionnaire, and the feasibility for indemnification of losses via a court case. The case studies aim to find options and opportunities for further recovery.
The case studies on nine different bank failures during recent years showed that regulation and customer perception are disparate. Attempting to answer the research question without referral to these case studies would have provided only theoretical perspectives, rather than practical solutions.
3.3 Secondary research
Secondary data is acquired from databases and used for further investigation purposes (Mooi and Sarstedt, 2011). Existing material – reports, industry journals, regulatory frameworks and books contain valuable views on bank failures. The main advantage of secondary data is that it was collected and researched by others. The outcome of other studies creates a framework to compare own findings and make relevant and grounded conclusions. The challenge of using secondary data is that errors and inaccuracies of the data can be adopted in further studies.
Data used for this study contained the news release from the Financial Crimes Enforcement Network (FinCEN, 2018) on ABLV Bank, the EFTA court judgement on compensation for Icesave depositors (2013), reports such as ‘The credit crisis around the globe’ (Beltratti and Stulz, 2012), ‘Financial crises are not going away’ (Cecchetti, 2007), and ‘The road to financial stability’ (Cecchetti, 2015), the textbook ‘Risk management in banking’ (Bessis, 2011), and European regulatory publications ‘EU-wide stress testing’ (EBA, 2018), and ‘What are haircuts?’ (European Central Bank, 2016).
The literature review included in this study provides the researcher an understanding and enables him to utilize multimethod analysis on a combination of new sources, historical data and direct experience. As such, the analysis will reflect further on the content already discussed in chapter 2 in view of any findings from the primary data, along with any new secondary data that may come to light as part of additional analysis.
4. Results and Discussion
The questionnaire used for this study was focussed towards 50 bank customers who experienced a recent bank failure. They confirmed initial observations orally and revealed that the closure of the bank came unexpectedly for depositors. As Merler (2016a) argues in her case study on the resolution of four small Italian banks via a bridge bank and asset management vehicle to avoid a full bail-in, some Italian retail customers took subordinated debt positions due to the tax advantage on interest on bonds, while being unaware of the risk associated with such products. In effect the result is a conflation of bondholder status with depositor status.
Following Cecchetti (2007b) regulation responded to the crises to prevent similar events from recurring. Financial innovators though, will always scrutinize the financial system for its weakest points, while simultaneously trying to locate the minimal effective balance between risk and regulatory requirements, and consequently finding a route to minimizing their core capital. Regulation incrementally moves towards the understanding of any underlying vulnerabilities and the recognition of patterns that may lead to a financial crisis (Reinhart and Rogoff, 2009).
The Basel accords aim to ensure that financial institutions can survive unexpected financial crises. Such extreme circumstances bolster the argument of Cecchetti on regulation and, for example, the Basel accords providing a supplementary regulatory framework that anticipates problems and has in place readily accessible possible mitigations. Cornford (2009) argues that the first Basel accord lacked satisfactory guidelines for securitization and leveraged risk exposures. The global financial crisis became disruptive because of deregulation, securitization and the changes in the real estate and mortgage industry. The second Basel accord focused on capital-based regulation and relied on the credit rating agencies. This allowed the banks to calculate the Pillar 1 capital requirements with their own internal models (Goldstein, 2008).
Basel III aimed to improve the quantity and quality of required Tier 1 capital and decrease bank leverage to ultimately reduce contagion of the financial system and systemic risk exposure. Small businesses and retail customers use financing for spending purposes. A reduction of loans due to heavier capital requirements can hinder economic growth. Improved regulation and enhanced capital requirements that include deposit insurance provide a stronger fundament but can trigger a multiplication effect as well. Although deposit protection provides security for retail customers of a bank, Demirgüç-Kunt and Kane conclude in their study on deposit insurance around the globe (2002) that deposit insurance may help to develop a robust financial system only in the short term. The long-term consequences though, are more likely to undermine market discipline. Beltratti and Stulz (2012) enhanced the vision of the Basel accord and conclude that ‘large banks with more Tier 1 capital, more deposits and less funding fragility perform better’.
As discussed in the previous chapter, a bank resolution should only address the direct stakeholders of the failing bank in a self-contained environment. This means that depositors and shareholders bear all the potential losses and devaluations of capital in the process. Michaelides (2016) explains that in Cyprus the NPL ratio was high due to the large number of customers that had deposits and loans at the same bank. The value of deposits was downgraded but the total value of the loans remained intact. In the perception of the customers this was unfair resulting in a negative attitude towards strategic loan defaults policies (Guiso, et al, 2013). In 2017 the NPL ratio in Cyprus was higher than the country’s GDP (Georghadji, 2017) putting extra pressure on customers and banks for gradually writing off more of the NPL’s.
Felton and Reinhart (2008) argue that a bank fails due to the unavailability of liquid capital to continue meeting the needs of the customers when large numbers of customers withdraw their deposit simultaneously. The main cause of bank failures therefore is a mismatch between short term liabilities against long term investments. Funding and matching is crucial to avoid bank failures by liquidity and solvency challenges. Depending on the base point of the study, there can be various reasons for a bank to fail. The main reasons for failure relate to non-performing loans; excessive risk taking; regulatory issues; fraud; funding issues, and contagion.
4.2 Case study and analysis
To explore possibilities for legal action, the insurance requirements for banks were investigated. Furthermore, 9 banks that experienced difficulties that may have added to the global financial crisis, so were reviewed. Banks in different countries were chosen to compare the varying degrees of success when implementing BRRD into national legislation. All banks experienced a heavy downgrade of their value and customers lost money in the process. Specifically, due to the factor of customers losing money because of external actions was investigated.
Financial institutions implement a variety of risk management tools to mitigate devaluation of their assets, substantial investment loss and overall default risk. Nevertheless, not all risk can be eliminated and in the aftermath of the global financial crisis several banks failed. Regulation aims to limit damages for all stakeholders, but the bail-in tools went a step further and failed shareholders by converting the bank’s core capital into shares for bailed-in creditors (Lintner, 2016). The bail-in tool is the key resolution tool provided for in the BRRD. The BRRD is a framework for the applying of orderly resolution strategies in the European Union and aims to indemnify the state and provides alternatives for bank failure.
The BRRD provides guidelines for recovery and resolution plans and early intervention using resolution tools (Single Resolution Board, 2018). Individual member states were required to implement the BRRD guidelines into their national laws by January 2016. The main objective of the BRRD is to safeguard the financial system and avoid systemic crises by limiting state-aid and forcing shareholders and creditors of the bank to bear the costs of the failure by writing off or writing down the principal amount of the liability or through converting debt into equity.
The level playing field in the payment industry is subject to evolution as technological innovations progress. Traditional financial institutions have a banking license to engage in a variety of payment solutions and credit facilities. The Payment Service Directive, PSD2, opened the market for third party payment service providers that have only a limited and protected work area- it is possible to transact without a banking license. PSD2 broadened the scope of the payment industry and created new challenges.
Evidence that regulators wanted to involve different market players in default risk of financial institutions was seen through the enactment of new requirements for consumer protection in the PSD2 with its requirement to hold liability or indemnity insurance. As of September 2014, intermediaries involved in credit agreements for consumers relating to residential immovable property (European Banking Authority, 2014c) are required to hedge the risk of liability via a professional indemnity insurance, PII. To understand the scope of this requirement, a definition of a credit intermediary is essential. A report by Europe Economics on Credit Intermediaries in the Internal Market (2009) defines the credit intermediary as the individual or firm that facilitates access to third party credit, which excludes direct provision of its own funds for external credit purposes.
The Central Bank of Ireland considers the professional indemnity insurance cover the most prudent consumer protection safeguard (2015) and requires intermediaries in the insurance industry to hold such an insurance policy. MiFID stands for the Markets for Financial Instruments Directive. It provides harmonised regulation for investment services in the European Economic Area and attempts to safeguard customer rights while empowering the open market. MiFID triggered the European Securities and Markets authority to formulate regulatory technical standards to ensure that customers are treated fairly; that offers are transparent, and that products match the needs and wants of the client (London Economics, 2010). Bank customers who feel misrepresentations have been made or had unfair treatment can contact the financial institution, submit an official complaint or reach out to the financial ombudsman. An exact loss can only be appraised when all other means of recovery are exhausted. In this way, liability claims to an individual, intermediary or a financial institution can be enforced in court after the resolution procedures have concluded. Out of court settlements however, can be agreed upon at any moment, where the amount of damages has been agreed.
Institutional and regulatory overview in the financial industry is contained in a hierarchical framework – from international standards, to EU law that includes BRRD, SRM regulation, SRF and ESM, EU guidelines, to national insolvency laws where the standards are implemented as of 2016 (Lintner, 2015). The result is that the legal framework for a bank failure is supported by national and European law. Unfair treatment can therefore be questioned in both domestic and European courts. Since the year 2013, several bank customers have turned to the courts to challenge the outcome of the forced resolution of their bank.
4.2.1 ABN AMRO, Fortis, Royal Bank of Scotland – The Netherlands
Although under current regulation a bail-out of a financial institution is not desirable, it is not impossible to involve taxpayer input in the resolution of a bank. When the consortium of ABN AMRO NV, Fortis and the Royal Bank of Scotland in the Netherlands required government support in 2008, the Dutch taxpayer had to contribute. NL Financial Investments, NLFI, (a special purpose vehicle incorporated by the Dutch state to manage the shares of nationalized financial institutions in the Netherlands) formulated three conditions for exit via the ‘Intention to Float’-This was achieved through strategically and incrementally selling the shares in ABN AMRO NV they received, in return for their financial support. At the time of the IPO of ABN AMRO NV, the price was set at 17,75 Euro per certificate. Over time, NLFI decreased its interest in ABN AMRO NV and sold certificates for higher prices, potentially creating a positive return of investment for the Dutch state. Indirectly the government support to a troubled bank via a bail-out could be profitable when the financial institution has stability and positive prospects (NL Financial Investments, 2017).
4.2.2 Andelskassen – Denmark
The global financial crisis infected the financial industry in Denmark. The risk of further contagion concerned the government and in response five bank packages were adopted to encourage consolidation and restructuring. The resolution took place via a bridge bank and bail-in that included uninsured depositors. The bank packages included state guarantees, capital injections, liquidity support and incentives to promote small business funding. When the resolution decree was issued on the 5th of October 2015, the central bank immediately announced its control of Andelskassen. A bridge bank was established, and an interim valuation was prepared to test the NCWOL principle (Andersen, et al, 2016). No litigation procedures were initiated by creditors of Andelskassen who saw their claims being written down, making the Andelskassen resolution a model for other member states.
4.2.3 Heta – Austria
The nationalization of the Hypo Group Alpe Adria in Austria was the first case-study scrutinised – it is a resolution via an asset management vehicle: Heta. The bail-in decision imposed a haircut on senior debt of 54% (Lincoln & Lintner, 2016) when the asset management vehicle could not pay its debt and a provisional valuation report concluded that Heta was failing. The resolution was approved by the Financial Market Authority in Austria based on the FOLTF and public interest test. It concluded that the resolution of Heta guaranteed financial market stability, protected tax payers and enabled a bail-in for creditors, and thereof followed the European resolution regime. NCWOL calculations (FSB, 2017) via an independent appraisal showed a hypothetical insolvency scenario in favour of bail-in over liquidation. Several customers submitted the case to the Constitutional Court in Austria because of a violation of the fundamental right to property and the infringement of the ‘pari passu’ principle. The court confirmed that the resolution and restructuring was in the public interest and the haircut was justified. The right to property and a claim to the pari passu principle were rejected because there was a tangible distinction between normal creditors and junior creditors (VfGH, 2015).
4.2.4 Bank of Cyprus and Laiki Bank – Cyprus
Bank of Cyprus and Cyprus Popular Bank, also known as Laiki Bank, were the largest banking groups in Cyprus in 2013. A combination of a low-tax regime, an accommodating attitude towards foreign capital and its geographical location close by the Balkans and Middle East, (whilst part of the EU) attracted deposit inflow from several countries (Dübel, 2013). The expansion of the activities to Greece and the acquisition of Cyprus Popular Bank by the Marfin Investment Group led to unfettered growth.
A report by Alvarez and Marshall (2013) commissioned by the Central Bank of Cyprus revealed that earlier inspections of Laiki Bank showed evidence of significant irregularities and mismanagement. A financial crisis in Cyprus fomented and the banking sector was heavily hit. The exposure to Greek sovereign debt and poor risk management in the domestic market triggered a downfall (Demetriades, 2012). The ECB granted short term funding via Emergency Liquidity Assistance to the Central Bank of Cyprus, who in turn provided liquidity to Bank of Cyprus and Laiki Bank against enough collateral. The downward spiral accelerated and within a few weeks, Bank of Cyprus and Laiki Bank became insolvent. A resultant resolution and restructuring plan that included bail-in of uninsured depositors, was installed.
The Memorandum of Understanding (IMF, 2013) to restore financial, economic and social stability in Cyprus assigned the banking sector concerns and public debt as the two main challenges to solve. Foreign assets from Greece were sold to Piraeus Bank. Via a purchase and assumption procedure (IMF, 2013) the Cypriot assets of Laiki Bank were taken over at fair value by Bank of Cyprus. Uninsured deposits stayed in the legacy company and Laiki was resolved with full contribution by shareholders, bondholders and uninsured depositors. Uninsured deposits were written off, but loans made to these same depositors sometimes were off-set, but still continued to exist. Strategic loan defaults climbed to 150% of GDP (Michaelides, 2016). Capital controls had to prevent a rapid outflow of cash to other countries (Michaelides and Orphanides, 2016).
There was public outrage and several court cases were filed. The Nicosia district court referred staff members of Laiki Bank in Greece to the criminal court on charges of mismanagement. In the Greek Supreme Court two Laiki bankers were charged with market manipulation and presenting false and misleading information. Two other senior bankers were also charged for conspiracy to defraud and false accounting. In the Limassol District Court depositors with loans and deposits argued that their legal right to off-set was not calculated correctly. Greek investors felt discriminated against when their claims were written-off, while public institutions in Cyprus were prioritized. They filed their claims with the International Centre for Settlement of Investment Disputes – the tribunal of the World Bank.
4.2.5 Landsbanki and Icesave – Iceland
Although Iceland is not part of the European Union, it is part of the European Single Market and participates in the European Economic Area. Iceland was the first country affected by the global financial crisis and its systemic failure ranked third in the greatest bankruptcies in the world (Halldórsson and Zoega, 2010).
The respondents to the questionnaire for this study agreed when they stated that the collapse of the online savings bank Icesave was an alarm call and they further believe that the tenet, ‘savings accounts represent no risk’ is an anachronism. Landsbanki, a systemically important financial institution in Iceland, launched a brand called Icesave to acquire capital used by Landsbanki to fund highly leveraged debt (Rao and Cohn, 2008). The savings accounts offered above market returns and were so successful that a highly leveraged mismatch between deposits in banks and the reserves at the central bank resulted (Rannsóknarnefnd Alþingis, 2008).
Icesave had many customers in the United Kingdom and The Netherlands. After the failure of the bank, the deposit guarantee scheme had to cover the deposits. Iceland could not guarantee the deposit insurance payments and the Netherlands and United Kingdom covered the repayment of insured deposits to its citizens and tried to recover their advances with the Icelandic state. The governments of The Netherlands, United Kingdom and Iceland agreed on repayment of the advances but after a referendum was held, the Icelandic population rejected the bills. The case was submitted to the EFTA court which handles disputes relating to the European Economic Area and the infringement of the EEA laws. The ruling of the EFTA court (2013) was in favour of Iceland and the claims from The Netherlands and United Kingdom were forwarded to the Landsbanki receivership.
4.2.6 Northern Rock – United Kingdom
Northern Rock was one of the first banks affected by the global financial crisis where retail customers started a run on the bank, queuing for ATM’s and branches (Bruni and Llewellyn, 2009). The bank run itself was mainly a reaction to negative stories in the media, – liquidity challenges already began before, when short-term funding and interbank lending suddenly halted. To tap into new funding options, Northern Rock issued long-term liabilities, such as securitized notes and covered bonds. The real run on the bank began with a structural outflow of wholesale funds when maturing loans were not renewed and deposits withdrawn. Northern Rock received a capital injection from the Bank of England and was later nationalized (European Commission, 2007).
The bank had enough long-term assets but experienced short-term liquidity challenges. The first action of the Bank of England was to guarantee secured deposits. The nationalization split the bank in Northern Rock Asset Management, containing the loans and mortgages, derivatives and several wholesale deposits, and Northern Rock plc, holding the retail and wholesale deposits. The share price of the bank at the moment of nationalization was low and shareholders and bondholders objected due to failure of fair valuation of the share price.
Legal action was taken by shareholders against the UK government, regulators and other stakeholders who influenced the nationalization. The Royal Courts of Justice, Court of Appeal, Commercial Court and the Upper Tribunal ordered on parts of Northern Rock operational procedures.
4.2.7 Novo Banco – Portugal
Banco Esperito Santo SA, one of the systemic banks in Portugal, was placed under resolution by the central bank of Portugal (Banco de Portugal, 2014). A bridge bank, Novo Banco S.A., was formed with an equity capital injection by the resolution fund. Banco Esperito Santo experienced consolidated losses, a downgrade of the banks’ rating by a credit rating agency, cash flow challenges and liquidity shortfall. The worsened situation was a threat to the economy and the bank requested Emergency Liquidity Assistance.
That fact that central banks need to learn to adapt to changes in resolution becomes apparent following analysis of the transfer of bond liabilities from NOVO Banco back to Banco Espirito Santo to protect local investors at the expense of foreign bond holders. The bonds were asset linked liabilities of Novo Banco and diminished in value after the retransfer to Banco Espirito Santo due to the lack of collateral (Hale, 2018). The central bank of Portugal handpicked five out of forty similar Novo Bonds based on their value and retransferred these to Banco Espirito Santo. The high valued bonds were owned by two Hedge Funds, one of which took the central bank of Portugal to court based on the lack of equal treatment- the pari passu principle. A preliminary suspension to transfer the bonds to Banco Esperito Santo was ordered by the Portugese court whilst deliberations continued a final definitive decision. The argument put forward by the central bank of Portugal was these were measures justifying the retransfer of bonds to Banco Espirito Santo and that most significant bonds were issued under foreign law and therefore excluded from the bail-in (Mesnard, 2016). The ultimate solution for all stakeholders lies in the protection of small investors while ensuring equal treatment to other bondholders with an equal credit rank. The Portugese court is yet to decide if this is a feasible and appropriate policy.
4.2.8 SNS Reaal NV – The Netherlands
Like the case of Andelskassen in Denmark, where claims of subordinated and unsecured creditors were written down to zero, the Dutch ministry of finance expropriated shares from SNS Reaal NV. The Dutch state nationalized the holding company and bailed-in all subordinated debt. The risk associated with the real estate portfolio could not justify a takeover and EU competition law prevented the efforts for recapitalization by the Dutch state and other banks. The financial structure of the SNS group was unstable and this made it impossible to implement the bridge instrument or asset separation tool. The holding company was financed externally, while equity stakes in the SNS subsidiaries were funded by the holding company (Haentjes, 2016).
The resolution package for SNS Reaal combined nationalization with a bail-in and included shares, hybrid capital injections and a subordinated debt write-off (Dübel, 2013). Eventually, senior bondholders received full compensation, while shareholders and holders of subordinated debt received no payments as their claim for compensation had a monetary value of zero. As Dübel (2013) argues, secured debt was paid out but early intervention through swapping debt for equity would have limited loss participation of subordinated debt.
The Dutch administrative court, the Enterprise Chamber of the Amsterdam Court of Appeal, the Dutch Supreme Court, and the European Court of Human Rights all received complaints and cases were brought forward based on curtailing of civil rights; the treatment of subordinated debt; the immediate threat of financial stability; the zero-compensation figure and the expropriation. Most of the complaints were rejected but the Supreme Court ordered that compensation must be calculated by an independent third party and the compensation for expropriation should be based on hypothetical scenarios of a sale of the bank on the open market or alternatively the bank activities should fully resume.
4.2.9 Slovenia banking crisis – Slovenia
Slovenian banks were exposed to substantial corporate borrowings and wholesale financing. The global financial crisis made capital acquisition difficult and limited the funding possibilities. Simultaneously, the economy slowed down and the corporate non-performing loan portfolios at domestic banks grew (Mavko and Nyberg, 2016). Several banks in Slovenia could not pass the new regulatory capital requirements, failed the asset quality review and stress test, and had to be recapitalized or resolved. The Bank Asset Management Company, BAMC, was incorporated by the Republic of Slovenia to facilitate the restructuring of systemic financial institutions. Distressed assets of systemic banks were transferred to the BAMC
The resolution strategy was taken to the Slovenian Constitutional Court by subordinated creditors who had to write-off their subordinated claims, on the grounds of interference with private property rights. The Constitutional Court requested assistance and a preliminary ruling from the Court of Justice of the European Union. The European Court approved the right to enforce burden sharing on private investors, as this did not infringe the fundamental right to property.
4.2.10 Case study conclusions
Respondents to the survey used in this study want to take legal proceedings against the government or central bank for their role in the resolution decree. All reviewed case studies have one common element; the court approves the bail-in as a resolution strategy to limit damages for the real economy. This information is crucial to formulate appropriate solutions to the research question because victims want indemnification but tend to focus on the agent least vulnerable to litigation and this renders them with little prospect for success.
4.3 Settlement structures
The winding down of a financial institution can take place in four ways: special administration; receivership; liquidation or resolution. To determine the most effective and efficient route to return of customer funds, a comparison of the different strategies is recommended.
Following Lintner (2015), restructuring is needed expeditiously so business continues while losses are imposed on shareholders and creditors. However, in a traditional liquidation, such a procedure is problematic due to the difficulties of combining of loss absorption by shareholders and creditors and continuing with the essential banking operations which protect the bank from definitive closure. During the initial stage of the resolution a special administrator takes over control of the bank, and the bank management is replaced. Shareholder rights are suspended but purchase and assumption can happen with the approval of the shareholders. The tasks of the special administrator are intended to facilitate the stabilization or resolution of the bank.
When a bank is liquidated the remaining assets are sold in the best interest of the customers whilst the bank is wound down. The procedures for liquidation under national insolvency laws are not in line with European resolution based on the differences in the definition of critical functions and public interest (Merler, 2018). Resolution should be an exception for winding down the bank, because of the potential infringement of property rights, and the fact that it remains is a last resort when regular solvency proceedings have not met with European requirements.
Before answers can be presented to address the research questions, a brief appreciation of human responses as a change in risk perception is needed to help creditors understand the pitfalls of banking.
4.4.1 Regulatory actions
Persaud argues in ‘Why bank risk models failed?’ (2008) that regulatory and fiscal mechanisms can avoid crises when more consideration is given to ethical principles. Overload of regulation can slow down economic growth. But conversely, regulation is consumer freedom where providing adequate information allows consumers to make informed decisions. The European Parliament attempts to proffer guidance to the consumer with their online legislative train schedule (European Parliament, 2018) and so information is available, yet none of the respondents to the questionnaire appreciated the impact a bank failure could have.
The Basel accords, the BRRD and national regulation try to protect the financial system and safeguard the real economy. This is in the best interest of the customers of a bank and therefore further regulations will be enacted over time. The NCWOL principle that is part of the BRRD is an example of regulatory action adopted to maximize customer payments.
Non-performing loans are a concern in recent years and could further damage the global economy. The risk associated with an industry-funded NPL guarantee scheme, which Italy operated contained the provision of Atlas bank bail-out fund where the participating banks act as a shareholder of last resort, contributes to systemic risk exposure (Merler, 2016b). Hence, the argument of Merler (2018) to create one EU solvency law to prevent that creditors receiving a priority position over tax payers.
4.4.2 Bank risk management
Above all, the Basel III accord encourages financial institutions to raise their loss absorbing capacity. The question is though if this is an adequate measure and can it prevent the next systemic financial crisis. Profitability and risk avoiding behaviour did not correspond prior to the collapse of the financial system.
Equity providers such as shareholders and subordinated or convertible bondholders are most at risk during a bail-in. Although the exact risk depends on the financial position and capital buffer of the bank, historical events show that a downgrade of the value of subordinated debt is realistic. The argument that deposit protection encourages excessive risk taking is discussed above. The idea that banking services or savings accounts should be free is outdated. Financial institutions can sell clients insurance products that insure against the risk of default. Such an insurance should be structured with minimal risk to absorb losses resulted from a systemic crisis. In the United States, the Federal Deposit Insurance Corporation offers a guarantee on bank deposit up to 250.000 USD and some banks voluntarily participate in private industry-funded insurance funds that cover the deposits above the FDIC limit.
4.4.3 Prevention by the consumer
Knowledge and understanding are the foundation of an appropriate and considered approach. To determine risk, customers need to understand the difference between secured and subordinated debt. When the risk is known, decisions can be made to hedge such risk. Hedging of risk can easily be done via diversification. Deposit protection sees legal entities as separate claimants. The easiest way to qualify for deposit protection is to open a bank account with different banks, or by incorporating an asset protection company. The customer should be informed before incorporating such a company that deposit guarantee schemes do not cover (public) investment firms, pension schemes or financial holding companies.
More complex ways to prevent losses in a bank failure relate to derivates or similar products. An opportunity for the insurance industry lies in the facilitation of a personal insurance policy that protects subordinated debt in banks for individual customers. Since the value of an account balance fluctuates, premiums for such a policy must be based on the actual account balance values. To avoid that the underwriter defaults during a systemic crisis, the insurance could follow a similar model as the traditional life insurance with account balance protection over guaranteed payment, rather than that of a credit default swap. The basis of insurance is the assumption an event might occur and the quantification of the extent of failure and whether the insurance covers such a failure. These are factors which go toward determining the premium.
The disadvantage of an additional and private insurance that could protect depositors from losing more than the insured amount under a DGS may bring forth unintended consequences. (Cecchetti). Ignorance of ethical considerations risks reducing bank solvency if it ignores the possibility of excessive risk taking. This can further impinge upon the real economy, increasing financial fragility and limiting financial development (Demirgüç-Kunt and Kane, 2002).
4.4.4 Repression by the depositor
When a bank fails- stabilization or resolution is announced and the deposit guarantee scheme is triggered. The claim filing process is explained by the domestic central bank and often involves an administrative procedure to verify the legitimacy of the deposit insurance payment. Upon approval, within 7 to 20 days the insured payment is made. Customers with an account balance exceeding the insured deposit, or with other subordinated claims either must wait for the decision by the resolution authority on the activation of a bail-in or restart scenario, or can, in some EU member states, take matters in their own hands by taking legal action to enforce a right that has been denied.
The right to property in the EU and the rules of conduct commercial banks must follow, allow banks to seize a deposit at the same institution to cover a loan from the same client that is in default. The set-off is a different concept than offsetting, which is strictly used for accounting and reporting purposes. The terms set-off, offset and netting are often used to describe the same transaction but differ in the legal sense. Banks have assets and sometimes these are held by a third party, and a customer has a claim towards the bank. The assets of the bank that are held at an external securities account or even a correspondent account is not part of the agreement the customer has with the bank, however, they can be set-off against each other. An offset can only take place before the NCWOL test is executed because it can potentially create an unethical priority position for individual customers.
When no curtailing action is taken by the customer, the bail-in or liquidation pays out an equal share to creditors based on the creditor hierarchy after shareholder equity is converted. Once the procedure terminates and the exact loss is determined, a claim of liability can be issued against the relevant agent.
The survey and observation resulted in a need for further investigation into the workings of resolution and the bail-in tool. We see discrepancies between national insolvency law and the BRRD. These should be further aligned and harmonised to avoid the risk of taxpayer intervention in cases without systemic risk exposure (Weber and Groendahl, 2017).
To evaluate the advantages and disadvantages of different out of court procedures and settlements that limit damages for the stakeholders involved, it is essential to consider different techniques to resolve the resolution decree triggered after the failure of a bank.
Seeing the recent minefield that emerged for the customers when smaller banks were forced to shut down their operations due to money laundering allegations, it can be conclude that regulatory changes and the implementation of improved KYC procedures take longer than anticipated for smaller market players. Reform is needed to avoid a capital inflow of undesirable money into local economies.
The following schematic view shows the practical resolution scheme that aids customers in navigating the resolution decree after the deposit guarantee scheme paid out the insured deposits. At the end of the resolution, when all funds are distributed, victims can take the agent at fault to court and file a claim. The outcome of such a court case does not guarantee indemnification because shareholders are often in a similar situation to creditors; they have both received a haircut on their assets.
|Step 1: Resolution -> FOLTF, public interest test|
|Step 2: Activation of the Deposit Guarantee Scheme|
|Step 3: NCWOL test -> bail-in or liquidation|
|Step 3a: Bail-in:||Step 3b: Liquidation:|
|BRRD, National insolvency law & banking low||National insolvency law & banking law|
|Open bank bail-in, bridge instrument, asset separation tool||State aid (bail-out)|
|Sale of business tool||Creditor hierarchy: national insolvency law|
|Creditor hierarchy: BRRD|
|Haircut: exact loss is determined||Haircut: exact loss is determined|
|Step 4: Claim of liability|
Figure 5. Practical resolution scheme
5. Conclusions, limitations and recommendations
This study sought to answer the following questions:
- How customers can best protect themselves against bank failure?
- What are they able to do to maximize their pay-out in the event of a bail-in?
During the research phase some unexpected issues came to light. Although customers are aware of risk factors and potential hazards, acting upon them to mitigate unfavorable outcomes were not forthcoming. A mind-set change is required as to where to place savings, and specifically where large quantities of money can be deposited.
Other questions that occurred at the beginning of this study were:
- What happens when a bank is placed under resolution?
- How much depreciation of wealth should depositors expect when their bank fails?
- What do customers need to do themselves in order to claim their (insured) account balance?
The assumption at the inception of this study was that customers are unaware, regarding understanding of complex financial products and the mechanics of a bank failures; the risk involved and the outcome of a liquidation under the BRRD. As Koenig argues (in an interview taken for Bloomberg) that Weber and Groendahl (2017) give an example from the Italian rescue mission for Banca Popolare di Vicenza SpA and Veneto Banca SpA, where customers were left uninformed of the credit risk of bonds. Customer perception of risk resulted in high exposure to subordinated debt and eventually the Italian government had to intervene and provided state aid.
The most significant concern gauged from this study is that, although regulators aim to prevent bank failure, people look for information post hoc. Current customers in the midst of the experience can provide a cautionary tale for future customers. Complex subjects should be explained in layman terms to avoid misunderstandings. Regulators and central banks have been accused of fomenting circumstances that led to several crises incurring substantial financial losses for depositors.
Conversely it was held by several courts around Europe, including the High Court, that the actions of the different regulators did precisely the opposite and prevented a collapse of the complete financial system. When events can have such devastating consequences, governments and the European Union have a moral and practical governance obligation towards its citizens to provide information and ensure access to it. The European Parliament made a promising initial start with their initiative of the legislative train which is discussed in chapter 4.6.1 of this study.
5.1 How can customers best protect themselves against bank failure?
Protection should be considered at the prospect of unforeseen negative circumstances occurring. This is the core limitation of this study because depositors in general acted after the problem occurred. Measures could have been taken such as use of derivatives to hedge risk or diversify funds over different legal entities at various banks that participate in a deposit protection scheme. Though these do not entirely protect from failure it would limit the extent of depreciation.
Personal risk management starts with an understanding of the differences in the value of bank capital. Secured debt are deposits covered under a deposit guarantee scheme. Bonds and investments are subordinated but seem to occupy a place of more regard than the mere shareholders in the bank. Therefore, risk mitigation to avoid bank failure should include a strategy to place secured investments.
5.2 What are they able to do to maximize their pay-out in the event of a bail-in?
Deposit protection schemes in the European Union cover deposits up to 100.000 Euro. This is designated the covered or insured amount. Deposits above 100.000 Euro are unsecured liabilities and can be recovered via a bail-in. Before the bail-in is approved, a set-off is a serious option when assets of the bank are in a country where the right to offset is amended in its banking law.
5.3 What happens when a bank is placed under resolution?
First, a special administrator is appointed. The duties of the administrator are to maintain customer confidence and prevent legal action against the bank so that an orderly resolution or liquidation can begin. During the resolution a bank offers limited services that may include capital controls to avoid a run on the liquidity of the bank. When the bank cannot resume its normal operations, the deposit guarantee scheme is activated. Following the activation of the deposit guarantee scheme, other options are to: liquidate the bank; wind down the damaged parts of the bank or liquidate the complete entity. The sale of business tool, bridge instrument and asset separation tool are all interim solutions to maintain working order till a permanent solution is determined.
5.4 How much depreciation of wealth should depositors expect when their bank fails?
The NCWOL calculation commissioned by the resolution authority, states creditors should not be worse off than in a liquidation procedure, has exact figures from the bank to calculate hypothetical scenarios. However, one can estimate a pay-out based on the creditor hierarchy as discussed in chapter 2.4. First, qualified depositors are entitled to deposit insurance of up to 100.000 Euro. Tier 1 equity and tier 2 debt are converted into equity to calculate the pay-out percentages where senior liabilities are preferential. This means that customers with a surplus on their account above the insured balance via the deposit guarantee scheme, receive the next payment from the liquidation proceeds under bail-in.
5.5 What do customers need to do themselves to claim their (insured) account balance?
The Central Bank announces the resolution decree on their website and in the state journal. The deposit guarantee scheme is triggered to compensate qualified depositors up to 100.000 Euro. The Central Bank can appoint a third party to manage the administration and verification procedures for the payment of the insured funds. In general depositors need to present a valid identification document and, if the depositor is a company, recent company documents to ensure the insured payments are made to the correct company. The receiver of the insured funds must be the exact same legal entity holding the deposit with the bank.
5.6 Limitations and recommendations
The progression of this study revealed methodological and analytical limitations. Conflicts between prudent supervision and deregulation to stimulate economic growth tend to migrate risk from corporate institutions to individual customers. The gap between pre-existing data and the outcome of the analysis of customer experiences uncovered a lack of understanding by bank customers of the risk exposure of the current financial system. This level of understanding of bank depositors of the financial system is yet to be given adequate attention in academic research.
The bail-in tool is a relatively new remedy for regulators to limit the damages of bank failure. Academic theory and customer experience are based on relatively few examples of failure. This means that the lack of reliable data influences the analysis of customer responses. Future research therefore should include a wider audience of experiential experts from different areas of study.
Artificial intelligence, the FinTech industry and ever improving anti-money laundering regulation continues to change the legal framework in the financial industry. Another limitation of this study is that regulatory changes can have a severe impact and so research on bank failure should include in-depth analysis of differences in national solvency laws in the EU member states.
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