The impact of the bail-in on banking services and bank funding

by Vincenzo Troiano and Gregorio Consoli

Abstract: This paper examines the main implications for bank services and bank funding that arise from the introduction of the Bank Recovery and Resolution Directive (BRRD) and the bail-in rules in Italy. The paper addresses the functioning of the minimum requirements for own funds and eligible liabilities (MREL) and analyzes the potential impact on banks’ funding criteria and which new products, such as covered bonds, could benefit from the introduction of the new rules. Furthermore, the analysis covers the approach to risk represented by the bail-in rules and implications for the structuring and subsequent offer of financial instruments that will be subject to the risk of conversion or write-down. We also describe the changing approach of the regulators to the assessment of the complexity of financial instruments consequent on the additional risks inherent in financial instruments that are subject the new rules. Finally, the paper addresses the impacts of the BRRD on the rules of product governance set forth in the MiFID II Directive, especially with regard to rules of conduct and distribution strategy with which issuers will need to comply. The paper also addresses the additional duties of disclosure and the duty of fairness that arise from the introduction of the new rules.

 Summary: 1. Introduction. Structure of the paper. – 2. The development of new products. – 3. The nature of instruments eligible for bail-in. Risk and complexity. – 4. The establishment of the relationship between issuer and distributor of instruments eligible for bail-in. – 5. The rules of conduct for the offer and the distribution of instruments eligible for bail-in towards costumers. – 6. Conclusion.

1. The focus of the paper is to examine the main implications for banking and lending businesses deriving from the introduction in the Italian legislation of the bail-in mechanism.

We start with an analysis of the incentives that the bail-in mechanism creates, and later evaluate the ways in which this new mechanism has been incorporated into the pre-existing legal framework applicable to the financial sector, which is highly regulated, segmented and fragmented, reflecting the varying degrees of protection required by the spectrum of end-users of financial services and products.

The main issues are as follows:

Firstly, the structuring of new instruments that may be subject to bail-in mechanisms. Important under this head are the governance procedures of issuers with regard to the creation and structuring of new products, understanding how they interact with the design of resolution and recovery plans and, more generally, with a bank’s general funding requirements. The jurisdiction of issuance of the product and nature of the issuer are also key.

Secondly, the relationship between the issuer and distributor of products eligible for bail-in. In this area, we need to examine, in particular, the product governance mechanisms for the construction of the reference target and for the transmission of information on the characteristics of the instruments, also bearing in mind the rules on the responsibility of the manufacturer and distributor in light of the legal framework in place and, most importantly, the principles discernible from the MiFID II directive;

Thirdly, actual and prospective conduct rules for the offer and distribution of eligible products to customers in terms of both disclosure by and to customers, application of rules of appropriateness and suitability, methods of execution of the relevant services. Retail customers pose particular concerns with regard to consumer protection laws and conflicts of interest where the distributor and issuer are the same entity (so-called “self-placement”) in the light of best execution obligations.

2. Examining the architecture of the BRRD as transposed by Italian Legislative Decree No. 180 of 2015 there is a significant incentive to create new products to which the bail-in legal framework will apply, especially in order to protect funding tools with a higher seniority. On the opposite, it is expected that the introduction of the BRRD will also lead to an increase in funding products, such as covered bonds, that are exempt from the application of bail in rules.

We refer to the implications deriving from the way the mechanism of the minimum requirements for own funds and eligible liabilities (referred to as the MREL) works. Under art. 50 of Legislative Decree 180, banks must meet minimum level of eligible liabilities for bail-in, at both individual company and group levels in order for the bail-in rules to work and thereby permit so-called “internal resolution” (where the legal conditions are met). The individual company level is set by the Bank of Italy, in consultation with the ECB (where the latter is the competent authority), and focuses on the primary need to ensure that in the event of bail-in the bank has sufficient liabilities to absorb losses, to ensure that the amount of Tier 1 Common Equity required for authorization to engage in banking activities is met, and to generate sufficient market confidence.

The Bank of Italy is also responsible for determining the characteristics of the liabilities that are taken into account for purposes of the requirement and for the calculation methods; the calculation of liabilities regulated by the law of a third party country are governed by specific rules.

This represents a considerable operating restriction: the introduction of potential bail-in mechanisms gives rise to a perceived increased risk associated with the subscription of instruments eligible for such treatment under the legal framework. Clearly, the risk-return expectations are greater with more risky securities and, therefore, may result in an increased cost of funding via such instruments. However, it should be borne in mind that banks ultimately do not have the freedom to devise funding policies that minimise the use of instruments eligible for bail-in since, quite to the contrary, it is precisely the need to meet the continuing requirement in question that effectively renders mandatory the issuance of such instruments.

Verification of whether the MREL for bail-in has been met rests with the resolution authority at the time of the preparation and updating of the individual or consolidated resolution plan of the issuer. Art. 102 of Legislative Decree 180, which sets out the transitional regime for resolution plans, expressly requires that such plans contain an indication of the MREL for bail-in and the deadline, if any, by which such requirement will be met. Yet more important is the provision which allows for the activation of powers and measures for the removal of impediments to resolution at the time of preparation of resolution plans by allowing the Bank of Italy, as the resolution authority, to order a bank to issue eligible liabilities in order to meet the MREL for bail-in (art. 16, 2.c).

It is very significant the impact that the MREL legal framework has on the funding dynamics of a bank and the policies that the bank has to put in place at the operational level in order to comply with the new legal architecture whose purpose is the preparation of the resolution or, prior to that, the recovery, of the relevant business. We should highlight the interaction between resolution and recovery plans: it would be surprising if the formulation of the recovery plans, in particular as to their composition, and the activation of capitalization instruments eligible for bail-in were completely detached from the needs to reach a resolution which, as mentioned, may even entitle the authority to require the issuance of such instruments.

Beyond such operational limitations, issuers remain entitled to seek to minimize the effects of debt instruments (with respect to the portion of funding that exceeds the minimum requirement) in terms of perceived risk/cost of the issuance, in particular where they operate within groups or conglomerates or multi-jurisdictional entities.

In addition to the need to seek new funding products to be included within the category of protected products, the following considerations would appear relevant: within groups, the need for full centralization of treasury operations with respect to non-bank business should be reconsidered, especially with regard to companies in which significant minority stakes are held. It may make sense for such companies to use direct forms of fundraising in the market as they would not be eligible for the application of the legal framework on bail-ins (see art. 2, Legislative Decree 180). Similarly, in conglomerates, it should be considered whether insurance related funding should be re-assessed, since the provisions on bail-in will not apply. Other considerations apply with regard to the issuance of funding products by entities located in different jurisdictions or subject to non-Italian governing laws. Generally speaking, the issuance by non-Italian entities of banking groups would be irrelevant for purposes of the application of the legal framework, since the scope of application of the provisions is extended to cover the entire banking group, and therefore the geographic location of the issuer would be irrelevant. However, as for the matter of the law governing the financial instrument issued, the provisions on the contractual recognition of the bail-in come into play. Indeed, when a liability eligible for bail-in is governed by the law of a third party country (meaning a country outside the European Union), banks must include in the agreement a clause pursuant to which the creditor acknowledges that the liability is eligible for a possible bail-in ordered by the Bank of Italy and agrees to accept and incur the effects of the same. In any event the clause is considered included by law in the agreement, and any non-conforming clauses that may be inserted by the parties are replaced, without any liability arising as a result of the absence of such clause. Such clause applies only to liabilities arising after January 1, 2016. Art. 59 of the Legislative Decree 180 also stipulates that the bail-in applies and is of binding effect on parties subject to the legal framework even where the above mentioned clause is absent or present but ineffective. This is a provision that remains rather opaque as to its ultimate scope of application, since while it is stipulated the definitive application of the bail-in to the bank, the ineffectiveness or absence of a clause that recognizes such effects continues to fall within the debtor-creditor relationships governed by the law of a third party country.

From a further, related, standpoint (again linked to the incentives created by the legal provisions of bail-in) the instruments falling outside the scope of application of the legal framework in question include liabilities owed to banks and SIM that are not part of the group of the entity the subject of resolution having a duration shorter than seven days (art. 49.1.f-e Legislative Decree). This is a provision which, according to the intentions of the European lawmakers, aims to reduce the risk of systemic contagion deriving from the resolution of an entity (recital 70 of the BRRD): the need to protect the financial system prevails over concerns regarding the uniform treatment of creditors of an entity subject to resolution measures. The same provision, which is now part of the legal framework, may also lead to the activation of forms of cross funding between third party institutions, for short-term maturities which are not subject to the restrictions of the bail-in, triggering operating solutions which perhaps today are seen as unprecedented, but certainly encouraged and fostered by the application of these legal provisions.

On the other hand, the implementation of the BRRD may lead to the expansion of new products, such as secured liabilities and covered bonds, that are exempt from the application of the new resolution tools introduced by the Directive. In particular, given that these instruments are protected from bail- in (up to the secured amount) and from the other resolution tools, such as the asset separation tool and the bridge institution tool, banks could find an interest in identifying secured liabilities to be offered to the more risk-adverse portion of their clients’ base, developing a new market for such securities.

3. Any further analysis concerning the structuring and offering of financial instruments falling under the scope of application of the bail-in provisions requires a number of preliminary high-level considerations.

The eligibility of an instrument for bail-in gives rise to a structural characteristic of riskiness of such instrument, if issued by a party subject to the provisions of the BRRD. It is not a decision for the issuer, which does not even have formal control over the events that may give rise to the application of the bail-in provisions. This is perhaps the reason why the provisions of recital no. 81 pursuant to which the fact that instruments must be written-down or converted by the authorities in the circumstances envisaged under the Directive must be acknowledged in clauses that govern the instrument (and also in the related disclosure documentation) were not included in the provisions implementing the Directive (with regard to instruments governed by Italian law). Consequently, it is even possible that market practice will tend toward the failure to indicate such circumstance expressly in the contractual documentation (other than the disclosure documentation) that governs their issuance (obviously with the exception of instruments that are governed by a third party country, since in such case the provision on the contractual acknowledgment of the bail-in would apply). Similarly to the issuance of any financial instrument, whether it be an equity or debt instrument, the contractual provisions are supplemented – if not exempted subject to the limits of the possibility for exemption – by the provisions of law that govern the specific instrument. For those financial instruments falling under the scope of application of the bail-in provisions, the effects that the provisions in question allow for would apply directly and not indirectly.

Another matter altogether is that of disclosure: it is obvious that the risk factors related to the investment in such assets must include clear disclosure that the bail-in provisions may apply (where the relevant conditions are met), which would give rise to a possible conversion or reduction/cancellation of the value of the instrument.

Eligibility for bail-in is a structural element that translates into a risk. Such risk may be more or less remote, depending upon the current and prospective situation of the issuer, but it remains a risk.

Another matter, apart from risk, is that of the complexity of a financial instrument. There may in fact be instruments that are simple as to their structure but high risk and, on the other hand, instruments that might be very complex as to their structure, but low risk. Often, complexity is associated with risk, which often leads to confusion between conclusions formulated on complex securities and those formulated on high risk securities, almost as if high risk implies complexity.

In the case of the bail-in, the structural characteristic we discussed above may be associated with instruments which may also be complex or with instruments that are not complex. Let us imagine, with regard to this latter case, a situation of senior unsecured plain vanilla bonds issued by banks: they are not complex at all, their risk associated with the bail-in derives from the initial and prospective quality of the issuer’s creditworthiness. In any event, risk is not correlated with complexity (which is absent in this case). We are fully aware that CONSOB, in the Q&A related to the Notice on the distribution of complex products, indicated that perpetual plain vanilla bonds are to be included in this category due to the difficulty in understanding the risks associated with them, “also due to the possibility of underestimating the factor of uncertainty in the restitution of principal”. In our case, however, the risk of bail-in derives from the application of a provision of law the contents (or at least the principles) of which are clear, and which has and will continue to receive wide publicity as to its impact on the general public (as well as upon customers of intermediaries). This may have the effect of neutralizing criticism, that bail-in is unknown or poorly understood, even in the short time since its introduction. It may be that it is less easy to assess the risk of default of an issuer, and to understand exactly what the MREL is and, therefore, the number of eligible liabilities for bail-in, but these are aspects related, in reality, to the issuer’s class of risk which is similar in nature, regardless of the security in which one is considering investing.

Let us take the opposite example: Italian covered bonds are usually fixed rate plain vanilla covered bonds guaranteed by a pool of assets. However, the pool of assets is segregated via market standard securitization techniques in a special purpose vehicle which, in turn, would issue a guarantee in favour of the bondholders. One could argue that the complexity of the techniques used to segregate the assets would qualify the instrument itself as “complex”; however the underlying bank obligation and the higher degree of comfort (from a credit perspective) renders the instrument much lower risk and, as such, it should receive a more favourable treatment than ordinary bonds from a product governance perspective.

In any event, we are of the view that any assessment as to the type of instruments eligible for bail-in as complex instruments or equivalent must be carried out on an individual, ad hoc basis for each instrument and must be applied uniformly in each jurisdiction of the European Union.

Each instrument must be assessed individually, since one cannot assume that the risk of bail-in may of itself constitute an element that worsens the rules of the offer, regardless of any considerations regarding the structure of the instrument. Such assessment must be carried out uniformly among the various jurisdictions, otherwise there would be a fragmentation of regimes that would inevitably result in a distortion of the rules of competition governing the funding of banks and the supply of financial services across the various countries. ESMA should analyze how and whether the characteristic of being eligible for bail-in would translate into a qualification as ‘complex’ for instruments possessing such characteristics, as was expressly indicated to be the case, for example, in relation to Contingent Convertible Bonds (eligible, under the new prudential legal framework, as Additional Tier 1).

At this point we would raise another general query, for simplicity of analysis, in relation to senior plain vanilla bank bonds, to which the bail-in regime also applies: Does the fact that the bail-in regime applies to them impact upon their nature as debt and funding instruments? We believe we must answer this query in the negative: the instruments continue to be debt instruments and are clearly funding instruments, and an obligation to repay continues to bind the issuer. Strictly speaking, Italian secondary legislation maintains that repayment obligation subsists even where it depends, as to its timing and amount, upon objective parameters, including those relating to the economic performance of the issuer. In our case, however, the law grants to the resolution authority the power to activate bail-in measures under certain circumstances established by regulatory provisions, the application of which requires the exercise of a somehow discretion, although of a technical nature. However, we do not believe that this circumstance leads to the conclusion that the nature of the instruments in question or their fundamental characteristics have changed.

If this is correct, secured liabilities should be granted the same regulatory treatment granted to ordinary plain vanilla bank bonds in a pre-bail-in scenario, if not an even more favourable treatment than could be justified by the low risk of the instrument.

4.  The general rules relating to the creation of new financial products modelled to reflect the needs of target customers clearly also apply to the structuring of products falling under the legal framework governing bail-ins.

We are referring, obviously, to the rules on product governance, set forth in the MiFID II Directive, but already in many respects in force following the domestic implementation of ESMA’s opinion (we refer, in particular, to the opinion issued in March 2014 on Structured Retail Products – Good practices for product governance arrangements) through Consob interventions on the matter (in particular, the Notice on the distribution of complex financial products to retail customers issued in December 2014). On the basis of this regulatory framework, investment firms that create financial instruments to be offered for sale to customers must adopt, exercise and control an approval process for every financial instrument and for every material change to existing financial instruments, prior to their commercialization or distribution to customers.

In particular, the process of approving the product must specify for each financial instrument the relevant reference market of end customers within the relevant category of customers and ensure that all risks specifically pertaining to such target customers have been analyzed and that the proposed distribution strategy is consistent with such target market.

The investment firm must moreover regularly re-assess the financial instruments offered or commercialized by it, taking into account events that may have a material effect on the potential risks for the target market, in order to assess, as a minimum, whether the financial instrument continues to meet the needs of the target market and whether the proposed distribution strategy continues to be appropriate.

These issues are also relevant in cases in which the issuer and the distributor are different entities: indeed, investment firm issuers must provide distributors with all necessary information relating to the financial instrument and to the procedures for approving them, including relating to its target market. In turn, investment firms that offer or recommend financial instruments that are not directly created by them, must take appropriate measures in order to obtain the above-mentioned relevant information and to understand the characteristics and identified target market of each financial instrument.

The rules referred to above, in addition to being important from an organizational standpoint, as regards internal mechanisms and information flows, are also relevant in terms of the rules of conduct to be followed by the intermediaries in question.

Indeed, it is envisaged that investment firms that create financial instruments for distribution to customers must ensure that such products are designed to meet the needs of a given reference market of final customers identified within the relevant customer category and that the distribution strategy for the financial instruments is compatible with the target market. In particular, the investment firm must have full knowledge of the financial instruments offered or recommended and assess their compatibility for the customers to which it provides investment services, taking into account the reference market of those end customers and ensuring that the financial instruments are offered or recommended solely where this is in the customer’s interest.

These general principles have a significant impact on instruments which present features of particular risk due to the fact that they may not carry an entitlement to receive repayment of some or all of the principal, or may be converted into equity upon the occurrence of certain events (such as those that permit the resolution of the entity). In these cases the firm must carry a very in-depth assessment, in terms of overall governance, in order to ascertain that the needs of the target customers are met where it purchases an instrument having such characteristics.

5.  As noted, the possibility that the instruments issued by entities subject to the provisions on the resolution of entities may be subject to the rules on bail-in represents a further risk of such instruments, different therefore with respect to securities of the same type issued by entities falling outside the scope of application of the above-mentioned legal framework.

Clearly, it follows that there is a need to highlight this particular circumstance throughout the entire supply chain of the offer and distribution of products of this type.

We referred above to product governance rules, including the rules concerning the information on the product that must be provided by parties that later sell or offer the products. We will now briefly mention the additional applicable rules of conduct which should apply.

We would, first of all, distinguish between duties of disclosure and duties of fairness in performing investment services.

Requirements of transparency. As for newly issued products, prospectuses will be required to highlight the specific risk that the instrument may be subject to the bail-in provisions. A similar risk warning will have to be included in the summary note, since the information in question is intended to be qualified as key information, for the purposes of the assessment of the risk related to the investment in instruments of such type. Even simplified prospectuses within the meaning set forth in art. 34-ter of Consob Regulation no. 11971/1999 (Issuer Regulation) must contain an express indication of the risks related to the applicability of the bail-in provisions. We are of the view that the supervening application of the bail-in provisions represent a new material fact capable of impacting the assessment of the relevant products, meaning that it would be necessary to draft a supplement to the prospectus pursuant to art. 94.7, of the Italian Consolidated Financial Law.

Rules of conduct. Under this head fall the rules of transparency and fairness in the supply of investment services. First of all, the rules of product disclosure will apply, with particular reference to the requirements of art. 31 of the Consob Regulation no. 16190/2007 (Regulation on Intermediaries) on the description of the nature and the risks inherent in the financial instrument in question. Sufficient detail must be provided so as to enable the customer to make informed investment decisions. The fact that the security is subject to bail-in is certainly a key information in terms of the characteristics of and risks inherent in the instrument. An indication of the risk of loss, including the possible total loss of the investment will also have to be provided, obviously stating that such risk will only arise where the criteria for the application of the resolution regime are met.

As for the rules of fairness, let us first of raise the obvious consideration that the execution only regime requires the definitive solution on the fact that a product is eligible for bail-in does not necessarily mean that such financial instruments are complex, otherwise at present the rules issued by Consob for the distribution of this type of products through the notice published at the end of 2014, as well as the ESMA guidance on the sale of complex products, would apply.

As for the rules on information provided by customers on their knowledge and experience relevant to the type of instruments, specific requests will be included aimed at verifying the customer’s awareness of the specific risk associated with the instrument, as an instrument subject to the bail-in provisions.

6. In conclusion, the legal framework governing bail-ins will have a significant impact on the entire chain of production from the structuring to distribution and funding of financial instruments. This is in addition to the obvious impact of the market’s perception of the risks associated with instruments issued by entities subject to such framework –being, first and foremost, banks and companies belonging to banking groups. The impact will be felt both in terms of the general structuring of funding policies, to which organizational safeguards of product governance are related, and also to the consequent rules of transparency and conduct applicable to the offer and distribution of the products, especially where the target market is retail. The qualification of products eligible for bail-in as complex financial products would have a significant impact on the considerations raised above.

Vincenzo Troiano is Full professor of Financial Markets and Intermediaries Regulation in the Department of Economics of the University of Perugia. He is a member of the Consultative Working Group of the ESMA’s IPISC and a partner at Chiomenti Studio Legale.

Gregorio Consoli, Ph.D in Business Law, L.U.I.S.S. Guido Carli University, Rome. He is a Partner of the Banking and Finance Department at Chiomenti Studio Legale.

Although this paper is the result of a joint reflection of the authors, Vincenzo Troiano wrote the paragraphs 1, 3, 6 and Gregorio Consoli wrote the paragraphs 2, 4, 5.