Since the high profile bail-outs of the financial crisis, regulators have taken steps to shift the financial burden of a failing firm from the taxpayer, onto shareholders and unsecured creditors. As such, the resolvability assessment framework (RAF) includes a greater focus on bail-ins as an integral resolution tool to allow firms to fail safely, without affecting wider financial stability. In the event of a banking resolution, the Bank of England (BoE) has developed a roadmap of activity, including the order of losses for shareholders and creditors for greater transparency.
The guide applies to banks and building societies, but the latter will follow slightly different rules due to their mutual structure. In the event of a bail-in, building societies must first be de-mutualised, then either be converted to a company or transfer all rights, assets, and liabilities to a company. Members’ ownership rights would be replaced by shares and distributed to bailed-in creditors. Depositors in the successor company would continue to be protected by the Financial Services Compensation Scheme, and the bail-in would follow the same structure as outlined below.
In a nutshell, during a bail-in a firm’s equity is written off and debts are written down to absorb losses. This is followed by recapitalisation, where the debtholders are issued equity and become shareholders. A bail-in will be conducted in four stages, as outlined below.
Figure 1: Structure of a bail-in.
First off, the BoE will assess if a firm meets resolution conditions. For the criteria to be met, the Prudential Regulatory Authority (PRA) must be confident that the firm is failing, or likely to fail, and the bank must be satisfied that:
Valuation in resolution will assess the above and the BoE will appoint an independent valuer to help review if the firm is failing, or likely to fail, by assessing all assets and liabilities and calculating the recapitalisation necessary. This will include an accounting value, an economic value and a liquidation or ‘gone concern’ value, which will be repeated throughout the resolution and bail-in process. The central bank will also gather further information from other authorities, prepare communication plans, assess any necessary changes to the firm’s leadership and consider the resolution liquidity framework.
The next step is to assess the instruments or liabilities that may be subject to a bail-in, which would ultimately be cancelled, diluted, written-down, transferred or be converted to equity if enacted. Each creditor will be issued with a certificate of entitlement (CE) giving them the right to potential compensation, often as equity shares, and no creditor should be worse off under a bail-in than a wind-down process. A hierarchy will be established for delivering against the CEs in the case of insolvency, but it’s important to note that some liabilities are legally excluded from a bail-in.
As the structure of the bail-in becomes clear, a resolution instrument must be prepared, which outlines the next steps across three standard templates. These will be tailored to meet the individual circumstances, including the bail-in mechanic or legal elements, the RAF statement of policy and international co-ordination. There will also be a degree of flexibility as the resolution tool has not yet been applied and the BoE may need to make adjustments to ensure its effectiveness. It’s also important to consider disclosure obligations under the Market Abuse Regulation, but the firm is not required to disclose inside information if it will prejudice the firm’s interests.
Ideally, the resolution will be co-ordinated over a weekend to reduce disruption. The BoE will announce the bail-in, specify the timeline, and appoint a bail-in administrator. The bail-in instrument will be established and published as soon as possible, outlining all instruments and liabilities to be included, and their treatment during resolution, which will largely dictate the structure of the bail-in. It will also include classification of CEs, treatment of coupons and principle payments for liabilities. It will also include arrangements for appointing the bail-in administrator, potentially reorganise directors, and specify the next steps for stakeholders.
On appointment, the bail-in administrator will draw up the reorganisation plan, liaise with the valuator, temporarily hold securities, exercise voting rights (where appropriate), and manage the firm’s business. Ultimately, the bail-in administrator will report to the BoE, and its exact role will be defined during the planning phase, but may act as part of the wider management team or more independently.
This period may last for six months or more, until the CEs for shares or other securities are exchanged, at which point control of the firm will be handed back to senior leadership. Next steps would be determined by the firm’s reorganisation plan, which will include the reasons for failure, the route to a sustainable business module, the ability to meet compliance expectations, and the resolution objectives. This can be created by the bail-in administrator or the firm itself, but it must be approved by the BoE, the PRA and the FCA.
While some elements of the business will be sold, or wound down, others can continue under a new structure. The terms for CE exchange will be completed after the final valuations, including exchange ratios, timescales, and the date for holders to redeem their CEs. In some cases, there may be a deferred bail-in, in which case the supplemental bail-in instrument will action any write-downs or cancellation of liabilities. This tool may also apply if the final valuations are higher than anticipated at the start of resolution.
The exchange ratio is the proportion of shares or compensation that CEs of each class represent, which will be calculated by the priority of liability payments under standard insolvency processes. Different financial instruments pre-resolution will be converted to different CE classes. For example, liabilities will become class C CEs, while Tier 2 and AT1 capital will become class B and A CEs respectively. CET1 capital will become shares. Each CE holder will be issued with a statement of beneficial ownership, which will expire if not submitted by the final exchange date. The bank will also provide onward transfer instruments, to allow shares or other securities to be transferred at a later date.
To exit resolution, the onward transfer instrument will transfer shares to bail-in creditors, who will gain the right to vote and contribute to the direction of the firm post bail-in. At this point, the bail-in administrator will retain voting rights for unclaimed shares, but will restore control of the firm to senior management. Any shares or securities not exchanged for CEs will be sold; similarly, any CE holders who have not yet exchanged them for shares will be eligible for the value of the sale of their unclaimed shares.
The firm will return to private control and any suspended listings or frozen instruments can resume. Although the bail-in will now be complete, elements of the firm’s reorganisation plan will be ongoing, including restructuring and post-resolution regulatory expectations from the PRA.
As bail-ins are the preferred resolution tool for larger firms, it’s essential for businesses to plan effectively, and both regulators and senior management need assurance that those plans are realistic. A senior manager must hold ultimate accountability for resolution assessments and associated activities.
Major UK banks, with the potential to cause the most harm to the financial system, must demonstrate that these plans are fit for purpose and report to the PRA, with a summary version publicly available. This report will include details of resolution planning testing, relevant governance processes, and operational continuity in resolution arrangements. Firms must also ensure they have appropriate processes, controls, systems in place to conduct valuations in resolution. This requires a significant amount of data, model testing and validation, and effective oversight.
As a highly technical area, firms need specialist resources to support banking resolution planning and to deliver robust assurance to maintain regulatory expectations.
For more guidance on bail-ins and banking resolution planning, get in touch with Paul Young.
