Europe: Bail-in delay hits EU resolution authority plans

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By:
Louise Bowman
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Regional resolution legislation put back; Calls for bad banks grow

Michel Barnier’s recent decision to delay implementation of the EU bank resolution framework was a pragmatic reaction to the virulent rejection of proposed bail-in language by fixed-income buyers. Originally slated for summer 2011, this legislation missed another deadline in November and looks unlikely to appear soon.

It has already been a long time coming. The EU framework for bank resolution was mooted by the World Bank as long ago as early 2010.

In a speech in March of that year, then IMF chief Dominique Strauss-Kahn said: "What I think is needed is a European Resolution Authority armed with the mandate and the tools to deal cost-effectively with failing cross-border banks – an ex ante solution to the problems that currently hamper cooperation in crisis situations, rather than an ex post one. It should be part of an integrated system of crisis prevention, crisis management, crisis resolution and depositor protection."

He added that: "To be robust, such a system needs access to financing and a fiscal back-up mechanism for any net resolution costs." That’s easy to say, but now that bail-in legislation has proved so contentious such a European Resolution Authority (ERA) looks as far away as ever.

Three things

This resolution legislation needs to do three things: create a harmonized EU regime for crisis prevention, bank recovery and resolution; harmonize bank insolvency regimes; and create an integrated resolution regime – an ERA – by 2014.

The delay in bail-in implementation means that this timetable will inevitably now be pushed back too. But insolvency experts argue that despite the breathing time that the three-year LTRO has given struggling eurozone banks, the need for effective resolution legislation is acute.

Nils Melngailis, managing director at restructuring experts Alvarez & Marsal in London

Nils Melngailis, Alvarez & Marsal

"The ECB has eased immediate liquidity issues but at the cost of potentially distorting the market," says Nils Melngailis, managing director at restructuring experts Alvarez & Marsal in London. "This means that a number of European banks will now need more capital and to accelerate their restructuring plans."

It is sobering to reflect that when the Irish banking sector collapsed the country had no national resolution legislation in place at all. But resolution is not a national problem and cannot be tackled just at a national level.

"When you have different resolution frameworks they all start out trying to do the same thing but end up getting bogged down by domestic issues," says Ajay Rawal, who works with Melngailis at A&M as a senior director. "A resolution framework can work in Europe – the anti-trust framework applies on a Europe-wide level, so a resolution framework can too."

The European Commission issued a consultation paper on the draft legislation in late 2010 and again in late 2011, but there is a sense that as many European lenders edge towards the precipice, wrangling over bail-in language might stymie a framework that needs to be in place as a matter of urgency.

Resolution mechanism

"The primary work is to introduce a bank resolution regime that works across borders. This must be designed in a manner which protects taxpayers far more effectively," explains Pádraig Ó Ríordáin, partner at law firm Arthur Cox in Dublin and member of ILEG, the group of insolvency experts advising the European Commission on the Bank Resolution Framework. Ó Ríordáin advised the Irish Government throughout Ireland’s banking crisis.

The biggest challenge facing any resolution authority is how to deal with bad-bank assets. Ireland’s National Asset Management Agency (Nama) is the only such authority to have been set up so far, but calls are growing for other countries to follow suit, particularly Spain.

"Banks are trying to rebuild themselves, and they can’t do this if they and their depositors have to worry about recoveries in non-core," says Melngailis.

"Until there is a fiscal solution, in many European countries their banking markets will be distressed and inactive for years to come," he continues. "If there are ways to support the banks and get their non-performing assets off the balance sheet and without burdening them then this should be done. Proper legislation can be drawn up to achieve this that could allow the restructuring to occur without short-term hits to the balance sheet."

This process is envisaged in the draft legislation, which encompasses the establishment of a bridge bank in the event of the orderly wind-down of a lending institution. But questions remain as to how that process will work for institutions with activities across and outside the region, and indeed the thorny issue of the price at which assets would be transferred.

"Banks could follow the Northern Rock model and move the good assets to a clean bank essentially at book value, or transfer non-performing assets to a special vehicle as in the case of Nama," says Rawal. "Under either type of restructuring, state aid rules must be observed to ensure that existing shareholders share the burden, which can affect the method for valuing the loans to be transferred. One of the biggest barriers to restructuring is the ability to transfer borrowers to another entity," he continues. "For example, you might be able to transfer economic risk but not the legal claim over the assets. This could be addressed by European legislation."

Daunting task

Any pan-European laws will be tough to enforce in a crisis. They face a daunting task in that they will essentially be overlaid on top of national regulations and their adoption is at the discretion of national regulators.

"The success of a European resolution framework will depend upon how well and consistently any European level directive is adopted by national jurisdictions," says Jeremy Jennings-Mares, partner at law firm Morrison and Foerster in London. "Although resolution actions will be triggered by banks’ home member state authorities, good coordination between different regulators will be vital. There will be a general obligation of member states to cooperate with action taken by others, but there will be safeguards built in that mean the situation will be less clear-cut. So there will be the potential for a messy situation where there is complete disagreement between the different member states affected by a bank’s resolution."

No shortage of assets
Size of non-core and non-performing assets in the EU
Source: Deloitte

So far the only real test case for this process is Nama. Ó Ríordáin at Arthur Cox was involved in advising the institution and believes that "a bad bank can be one part of the solution. In Ireland it has worked well because we had a concentration of distressed assets in development land – the market could not evaluate the impact of these assets on the banks’ balance sheets, so we transferred them to Nama, which can work them out over a 10-year period. There is no doubt that the state can carry distressed assets for much longer than the banks can as it is should be able to fund more cheaply than the banks."

Ó Ríordáin says that only time will tell whether or not Nama will make a profit. How would the Irish banks be doing if they still had these assets on their books? "It is hard to see them being in their current shape if that was the case. A bad bank provides stability and certainty, even if the cost of transferring the assets depletes the capital of the banks in the short term."

Given the well-flagged difficulties that might result from a conflict between the EU and domestic resolution legislation, could there be a case for examining a pan-European bad bank? The logistics of such an exercise are daunting.

"Setting up an effective bank resolution mechanism on a pan-European basis would be a challenging undertaking," says Ó Ríordáin. "Each situation is different. In Ireland there was very little sovereign debt on bank balance sheets, the problem assets were primarily development property — a specific asset class. Setting up Nama and bringing the assets to one place helps us to work out entire estates of development land even where individual loans in that estate were originated by different banks."

Each bank has its own unique array of problem assets, many of which may not be suited to a Nama-style solution. A pan-European asset management company (AMC) also amplifies questions over how such a mechanism would operate.

In both Iceland and Ireland the transfer of assets out of distressed banks involved some form of indirect subsidy, which would be political suicide in the current environment.

Quid pro quo

"This raises very big macroeconomic questions about market operation and taxpayer subsidization," says Greg Campbell, a restructuring partner at Gibson, Dunn & Crutcher in London. "Would it essentially be a bottomless pit of taxpayer money? To work in practice, the assets to be acquired need to be valued fairly and transparently. It makes no economic sense for taxpayers to subsidize banks through overpaying for impaired assets, especially when the perception is that some banks are using the proceeds to rebuild their own capital ratios rather than injecting liquidity into the market through new lending – there has to be quid pro quo."

Campbell says, however, that a pan-European asset management entity could conceptually be established.

"There is no reason one could not structure an AMC along the lines of the EBRD, for example, owned by states but essentially ‘opt in’," Campbell says. "Using the political and legislative toolbox of the European Union to create a eurozone AMC is a possibility, but the elephant in the room is the state of the union and its future. An opt-in approach could be more achievable."

Certainly any pan-European resolution framework – as and when it emerges – needs to address the question of how non-performing and non-core assets on the balance sheet of a failing bank are dealt with in the event that an ordinary liquidation is not possible.

Rawal at Alvarez & Marsal argues that a bad bank is the answer but only with certain caveats in place.

"Creating a bad bank is the right thing to do only if you can afford to crystallize the losses," he says. "You can end up creating a monster. It takes time to get your arms around the problem – exiting and minimizing losses is a long-term undertaking that can take seven, 10, 15 years. But if you can do it and do it properly it makes sense."