Vol 11 (2014) - Issue 2

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Bail-in: The New Tool in the Resolution Box?

Introduction
There has been substantial international debate and co-operation to try to establish a co-ordinated path to deal with failing financial institutions, in particular those which may be systemically significant either within their national economy or globally. The collapse of a systemically significant institution has serious knock-on effects on local and international economies, and governments and regulators have considered ways to limit these risks.
The first steps to effect this came with the development of resolution tools and regimes. This article deals with the most recent of those tools: the bail-in procedure, as being implemented in the UK.

Background
The financial crisis identified two principal sources of problems. Firstly, deposit takers such as the large UK retail bank, Northern Rock, needed to be dealt with swiftly to avoid depositor panic, potentially spiralling into civil unrest. Secondly, following the collapse of Lehman Brothers, it became clear that market disruption and client asset issues could not be dealt with satisfactorily. These issues produced, respectively, the Banking Act 2009 and the Special Administration Regime for Investment Banks which came into force in 2011.
The Banking Act provided for three types of resolution tool:
– Private sector purchaser – a separate institution would purchase some or all of the assets and liabilities of the failed institution. Depending on the exact terms of the purchase, either the remainder of the failed institution would be required to supply all necessary services to ensure that the purchaser could manage the business effectively; or the purchaser would be required to supply sufficient services that the rump of the failed institution could be wound down efficiently. Of the three initial resolution tools, this is regarded as the preferable route.
– Bridge bank – the business of the failed institution is transferred to a company wholly owned by the Bank of England. This may be used where there is no immediate possibility of a private sector purchase (at an acceptable price), and where it is necessary to build a stable platform prior to effecting such a sale.
– Temporary public ownership – the shares of the failed institution would be transferred to a company wholly owned by the Government in order to provide a stable platform to restructure prior to sale. This is regarded as the least attractive option, given the risk to public funds.

As part of the discussions taking place at national, European Union and G20 levels, a new tool has been added: bail-in. Bail-in has been introduced in the UK, ahead of, but intended to be consistent with, European Union proposals, in the Financial Services (Banking Reform) Act 2013 ('BRA').
An effective bail-in regime is extremely important for a sovereign, not least as an implicit guarantee of its banks’ liabilities may affect the sovereign’s credit rating. Consequently, many other jurisdictions are also considering resolution regimes incorporating bail-in, including the European Union member states, Switzerland, the USA, and most recently Hong Kong.

Bail-in – fundamental concepts
Bail-in can be simply described as the write-off or massive dilution of existing equity and the forced conversion of debt to equity in order to re-capitalise the failing institution to a level where it will be able to function normally. Conversion is intended to restore not just balance sheet solvency (i.e. a zero or surplus position of assets over liabilities) but also to restore capital adequacy levels to the required level.