Vol 8 (2011) - Issue 3

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Germany’s Special Resolution Regime for Failing Banks

Introduction

Banks, in their capacity as financial intermediaries, act at the very centre of modern economies. Their potential insolvency should therefore be considered unique. Indeed a bank’s insolvency may affect the stability of the economy as a whole, thus creating vast externalities. The financial crisis of 2008-9 and the insolvency of Lehman Brothers are prime examples of this destabilising effect. Both events have demonstrated the shortcomings of corporate insolvency regimes in relation to the insolvency of banks. This results from the fact that corporate insolvency regimes are built upon principles that do not fully take into account the distinctive features behind a bank’s insolvency. Firstly, there is a difference in objectives. Corporate insolvency law seeks to achieve equal ('pari passu') treatment of creditors and maximisation of the assets of the debtor in the interest of general creditors. By contrast, the main aim in bank insolvency proceedings is the protection of the underlying financial system. Other important considerations include prompt payment to depositors and minimising costs to deposit insurance funds. Secondly, creditors can be more active in general insolvency proceedings as compared to bank insolvency proceedings. While in the former, creditors can initiate the proceedings and act individually or collectively through creditor committees, in the latter, the power to commence and, to a certain extent, govern the proceedings typically lies with the regulator. Thirdly, the general triggers usually associated with corporate insolvencies may be considered inappropriate for banks. In this regard, definitions of insolvency vacillate between cash-flow ('commercial') and balance-sheet ('absolute') criteria. In relation to banks, however, the widely held view is that insolvency proceedings should commence at an earlier stage since, by the time a bank has already defaulted on any deposit liabilities, it will probably be too late for an orderly resolution. On the other hand, the balance sheet may not provide an accurate picture of the true depth of the accumulated losses since loan portfolios tend to deteriorate rapidly in bad times.

German parliament has learned these lessons during the financial crisis. On 1 January 2011, after two years of drafting work, the Restructuring Act 20114 (the 'Act') came into force. Along with amendments to the German Banking Act,5 the Act establishes a special resolution regime for banks in distress with a view not only to protecting the stability of the financial system,6 but also enhancing public confidence in the stability of the financial system while protecting depositors.