Legal Aspects of Bank Bail-Ins - Clifford Chance

Legal Aspects of Bank Bail-Ins

Sea of ChangeRegulatory reforms to 2012 and beyond

Why consider bail-ins?................................................ 4

Bail-in vs subordinated capitalvs contingent capital ................................................... 5

Bail-in vs resolution .................................................... 6

How does a bail in work? ........................................... 7

Impact on pricing of debt............................................ 10

Legal structure – making bail-ins effective................... 12

The hybrid approach .................................................. 13

Scope of bail-in ......................................................... 13

Group issues ............................................................. 15

Other issues .............................................................. 17

The limits of bail-ins ................................................... 19

Road to resolution ..................................................... 20cont

ents

Clifford Chance Contacts

Chris BatesPartner, LondonT: +44 20 7006 1041 E: [email protected]

Simon GleesonPartner, LondonT: +44 20 7006 4979 E: [email protected]

3Legal Aspects of Bank Bail-Ins May 2011

© Clifford Chance LLP, May 2011

Legal Aspects of Bank Bail-Ins AbstractThe aim of the bail-in proposal is that governments should have an alternative optionto taxpayer-funded rescues of systemic banks. It operates through a mechanismwhereby an insufficiently solvent bank can be returned to balance sheet stability bywriting down not only the claims of its subordinated creditors but also some of itssenior creditors; converting their claims to equity. To be effective, the mechanismshould be “hybrid”, in that the terms of the relevant instruments should provide for thebail-in to operate through private contract, but the power to trigger the bail-in and todetermine the extent of write-down and the resulting compensation should be vestedin the relevant public authority.

The primary objective of bail-in is toenable the relevant institution to avoid asudden and disorderly liquidation byenabling it to continue in business as agoing concern until it can berestructured or run down. This avoidsthe significant destruction of value whichresults from a “sudden stop” insolvency,reduces contagion within the financialsystem and potentially preserves criticalfunctions. It is particularly attractive inrespect of institutions or groups whosebusiness are too complex or toointernational to be capable of beingdisintegrated into a “good bank”/“badbank” model in the relatively short spaceof time required if the good bank is tocontinue in business withoutgovernment support.

The application of bail-in techniqueswithin banking groups requires carefulthought, and should be addressed byregulators as part of the “living will”analysis. There may be some groupstructures in which bail-in techniqueswould be inappropriate or wouldproduce perverse results.

The primary weakness of a bail-in as abank restructuring tool is that although it

renders the firm creditworthy, it providesno new cash. Thus in order to survivethe firm must not only be creditworthy,but credibly creditworthy to at least itscentral bank, and preferably to the

market as a whole. It is therefore likelythat bail-in will require statutory backingin order to convince counterparties tocontinue dealing with it post-reconstruction.

Why consider bail-in?The purpose of a bank bail-in regime is toprovide a mechanism to return aninsufficiently solvent bank to balancesheet stability at the expense of some ofits creditors without the necessity forexternal capital injection – or, moresimply, an end to taxpayer-funded bankbailouts. Taxpayers have been forced tobail out banks because there was noother practical option. The aim of the bail-in proposal is to create that option, andto ensure that taxpayers are never againcompelled by circumstances to rescuebanks or at least, if they are, thatsubordinated and some senior creditorscan be forced to take losses andcontribute to the resolution beforetaxpayers funds are put at risk.

The starting point for the analysis istherefore to understand why it was thattaxpayers were in fact compelled to bailout banks. In a modern economy largebanks perform services which arevaluable to society, and allowing asignificant bank to cease to operatewould inflict significant damage on theeconomy and on society. Thus, where alarge bank has suffered a loss greaterthan the amount of its capital, theunappealing choice for government is torecapitalise the bank out of taxpayers’funds, thereby preventing that damage,or to see society suffer a much greaterloss as the bank ceases to operate.

It may be asked why it should be somuch harder to deal with an insolventbank than with any other sort of insolventbusiness, which are dealt with in theirthousands every month without causingequivalent societal damage. The generalissues which arise in considering a bankfailure are not significantly different fromthose which arise on the failure of any

other socially significant enterprise. In thecontext of ordinary corporate insolvency ithas been agreed for some time that thesocietal costs of winding up a productiveenterprise are significantly greater thanthose of recapitalising it and allowing it tocontinue in business, and insolvency lawhas been developed over many years tominimise this societal damage by creatingregimes (the UK administrationproceedings, or the US Chapter 11regime) which permit the insolventcompany to continue trading for a periodwhile a buyer can be found for thebusiness as a going concern or while itsdebts are restructured under thesupervision of the court. Put simply,sudden stop liquidation creates massivevalue destruction – as the Lehmanexample demonstrated. However, theordinary Administration/Chapter 11regimes do not work for banks. A bank isnot like an ordinary commercial company,in that although an ordinary commercialcompany can continue to trade whilst ininsolvency, a bank cannot, since no-onewould voluntarily deal with an insolventbank. An insolvent bank cannot tradeeven for a short period while its debts arerestructured. Simply put, the essence ofbanking is solvency, and an insolventbank is by definition not a going concern.

The challenge, therefore, in dealing withbanks, is to create a mechanism whichdelivers the same broad outcomes as theinsolvency process but which can beexecuted quickly, outside insolvencylegislation and without triggering a formalinsolvency process. Bank resolutionregimes are in this regard best regardedas specialised insolvency regimes forbanks – once a resolution has beencommenced, the bank is dead and theissue is how parts of it may be salvagedintact. The success of traditional bank

resolution tools depend on the ease withwhich the bank can be dismembered andthe good parts separated from the badso that the good parts can continue as agoing concern under new ownership.Bail-ins also aim to avoid the need forformal insolvency proceedings, but byrestructuring the bank’s balance sheetand ensuring the continued survival of theinstitution without immediatedismemberment. To this extent, bail-insare another kind of resolution tool which,like temporary public ownership,preserves the institution as a whole as agoing concern and imposes losses onshareholders and creditors, but withoutthe explicit or implicit commitment offurther public support that publicownership implies.

The idea of bail-in, although initiallygreeted by regulators and marketparticipants with some scepticism, hasrecently gained ground. Regulators arefamiliar with the concept of banks issuingdebt which is described as being capableof supporting the bank through itsdifficulties, and tiers three, two andinnovative tier one capital have all beenrecognised as providing this utility tosome extent. It is therefore not toodifficult for them to accept the propositionthat making some senior debt (andsubordinated debt) capable of beingwritten down in some contexts wouldhave a beneficial effect on the stability ofbanks. The most broad-ranging recentstatement in this regard was theEuropean Commission’s “Workingdocument on the technical details of apossible EU framework for bank recoveryand resolution” published on 6 January20111 which proposes extending nationalresolution regimes to include a “debtwrite down tool” capable of being used towrite down specified senior and

Legal Aspects of Bank Bail-Ins May 2011

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1 Available at http://ec.europa.eu/internal_market/consultations/docs/2011/crisis_management/consultation_paper_en.pdf


http://ec.europa.eu/internal_market/consultations/docs/2011/crisis_management/consultation_paper_en.pdf

subordinated obligations of a bank orbank holding company and mooting twoalternative frameworks under which abroader or narrower class of senior debtwould be exposed to losses.

As noted below, bail-ins are not apanacea. In particular, the effect of thebail-in mechanism is to allocate some ofthe losses incurred by a financialinstitution to its senior creditors. If thosesenior creditors are themselves financialinstitutions, then this could achieve littlemore than the transmission of contagionthrough the system. A properly designedbail-in regime will minimise this risk byexcluding from the scope of bail-in thetransaction types which transmit lossdirectly between system participants(deposits, transaction payments, swapsand others), but since financial institutionsmay be senior creditors in other financialinstitutions in a number of ways, it cannoteliminate it.

The optimal environment for a bail-in towork would be in circumstances where asystemically important institution failed forreasons idiosyncratic to itself or itsbusiness model, and where theremainder of the financial systemremained stable. When dealing with anentire financial system subjected to asubstantial exogenous shock affectingmany different business models, the likelyusefulness of a bail-in approach would bea direct function of the amount of cross-holding of debt within that system – ifbail-in debt was substantially owned byother banks, then bail-in could increasesystemic risk; whereas if bail-in debt werepredominantly held by end investors, thenbail-in could substantially reducesystemic risk. The trend amongstregulators (particularly through the BaselIII proposals) is to penalise inter-bank

holdings of debt and, in particular,holdings of other banks’ capitalinstruments, and the market appears tobe moving towards an environmentwhere the majority of long-term bankdebt is held outside the banking system -this should increase the appeal toregulators of bail-in as a tool for dealingwith bank failure.

Bail-in vs subordinatedcapital vs contingentcapitalThe idea that banks should be able tosubordinate some of their debt in order toenhance their solvency ratios has beenaround for many decades. These havetaken various forms including innovativehybrid subordinated capital (qualifying astier 1 capital), perpetual subordinateddebt (upper tier 2) or term subordinated(lower tier 2). However regulatorsobjected – and events proved – thatalthough this subordination would havehad the effect of protecting depositors inan insolvency, it provided no benefitwhere a bank was in difficulty butliquidation was not a real option. Inparticular, where taxpayers’ funds mightbe needed to support an entity as agoing concern, taxpayers could end upbailing out subordinated debtholdersalong with senior creditors andsubordinated debt might also impederesolution options such as the sale of thewhole entity to a purchaser.

Accordingly, just seven days after theissue of the European Commission’sconsultation on debt write downs, theBasel Committee issued a statementthat, under the new Basel III regime,neither subordinated debt instrumentsnor preference shares would count ascapital unless either the terms andconditions of the instruments contain aprovision that requires them, at the optionof the relevant regulator, to be written offor converted into common equity at thetrigger point of non-viability or the bank’shome state has laws which require thatdebt to be written off at that trigger pointor otherwise require those instruments tofully absorb loss before taxpayers areexposed to loss. The trigger point iswhen the regulator determines either thatthe firm cannot continue in businesswithout an injection of public capital orthat the firm will be required to take awrite-off which would result in itsbecoming unviable.2 Thus, theseproposals, in common with more generalbail-in proposals, envisage thatsubordinated debt at least must beexposed to loss at a “gone concern” (ornear “gone concern”) trigger point, in orderto facilitate a “going concern” outcome.

The increased focus on the loss-absorbency of banks has also led to thedevelopment of new instruments that arecapable of absorbing losses on a goingconcern basis, by being written down orconverting into equity at a trigger point



“Taxpayers have been forced to bail out banks becausethere was no other practical option. The aim of the bail-inproposal is to create that option, and to ensure thattaxpayers are never again compelled by circumstancesto rescue banks...”

2 See the Basel press release of 13 January 2011 at http://www.bis.org/press/p110113.pdf. This articulates the policy which was consulted on in its “Proposal to ensure theloss absorbency of regulatory capital at the point of non-viability” – BCBS 174 of August 2010 at http://www.bis.org/publ/bcbs174.pdf

http://www.bis.org/press/p110113.pdf

which is intended to be long before thepoint of non-viability. These contingentconvertible or contingent capital bondsaim to restore the health of a bank byeither converting the debt into equity orwriting down the outstanding amount ofthe debt - thus creating additional coretier 1 capital - at a trigger point generallyset by reference to the issuer’s capitalratio falling below a level set at a pointwell above the point at which the bankwill be in real crisis.3 The intention is thatthese instruments should count towardsincreased regulatory measures of loss-absorbency, such as the new “Swissfinish” requirements which envisage largeSwiss banks having levels of loss-absorbing capital well above the Basel IIIminimum standards, the potential newrequirements that may be developed bythe Basel Committee or other nationalregulators for systemically importantfinancial institutions (SIFIs) or the stresstests applied to test the resilience ofbanks to severe adverse marketdevelopments.

It is therefore clear that there is a greatdeal of similarity between contingentcapital and bail-in eligible debt. Both are,in effect, debt instruments that have thecapacity to create or restore a bank’score equity capital at a defined triggerpoint, to secure a going concernoutcome for the institution as a whole.Both can take the form of either senior orsubordinated debt and both could berequired to be converted or written downin whole or in part as needed to achievetheir ends.

There are, however, three principaldifferences between the two. First,contingent capital is based on a “goingconcern” trigger, in contrast to the “goneconcern” (or near “gone concern”) trigger

envisaged by bail-in proposals. Secondly,for that reason, contingent capital can bestructured with an objectively definedtrigger point and a pre-definedconversion or write-down mechanism,which requires no regulatory interventionto achieve its outcome and no (orminimal) exercise of discretion by thebank’s board. In contrast, a bail-in istriggered at a point of non-viability whichinevitably requires an exercise ofregulatory discretion. At least for bail-insof senior debt, there will also need to bediscretion exercised by regulators as tothe quantum of the debt that is subject toconversion or write down and, in thecase of conversion, the quantum ofshares issued in exchange. Thirdly, as aresult of the two previous features,contingent capital can more readily bestructured on a wholly contractual basis,where, as discussed below, bail-inproposals (at least for senior debt) arelikely to require the backing of a statutoryregime empowering regulators to take thenecessary actions and to deal withconsequential issues, such as thecancellation or dilution of existing equityand the overriding of events of default.

Bail-in vs resolution Bank rescue – whether by insolvency orthrough specialised resolution regimes -is harder than it sounds. The essence ofa corporate restructuring is that it isessential to keep the business goingwhilst its finances are restructured, andthis in practice means that tradecreditors must continue to be paid whilstfinancial creditors are restructured. A

loss has been incurred, and that loss istoo great to be discharged over time outof the ordinary revenues of the business.The question is therefore one of howthat loss should be distributed – whoshould bear it, and in what proportions.Causing trade creditors to bear it willterminate the businesses supplier andcustomer relationships and cause it tobe wound up. Preserving the business,therefore, involves allocating the lossesto financial creditors.

The problem that arises in translating thisconcept into the financial sphere is thatfor a bank the distinction betweentrading and financial creditors is more orless meaningless – all creditors of a bankare providers of finance andcounterparties to financial transactions.Thus having decided to restructure thebank, the primary problem is to decidewhich creditors should accept whatquantity of loss.

To complicate matters further, banks existin an industry in which viability ismeasured minute to minute. In manybusinesses it is possible for a business tosuspend its activities for days or evenweeks without doing irreparable damageto its commercial success. However if abank ceases to function even for a periodmeasured in minutes, its viability as abusiness is gone. A successful bankrescue is therefore one which can becompletely effected in a period in whichthe bank is closed for business -classically between the close of businessin the US on Friday evening and openingof business in Tokyo on Monday morning,or around 50 hours.

The classical bank resolution mechanisminvolves transferring assets (usually goodloans) and liabilities (usually retail and



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“Existing debt restructuringregimes just don’t workfor banks.”

3 At the time of writing there have only been a small number of such issues, notably by Lloyds in 2009, Rabobank in 2010 and 2011 and Credit Suisse in 2011.

corporate deposits) into a “good bank” (a“bridge bank”) in such a fashion that thebridge bank remains solvent (and can bewound down and sold at a later stage) orto a rival purchaser. The remainder(including ownership of the good bank)will be left in the initial institution - nowthe “bad bank” - which is likely to be verybad indeed. The residual creditors of thebad bank will generally be entitled towhat enterprise value may be securedfrom the sale of the ownership of thegood bank (or the sale to the purchaser)and the realisation proceeds of any(usually illiquid and often toxic) assetsleft in the bad bank, but are likely to beleft short.

This approach has been tried and testedaround the world, and in particular is theusual modus operandi of the US FederalDeposit Insurance Corporation, whichmay have more experience of managingbank failures than any other organisation.However, it is a tried and testedtechnique in the context of smaller orprimarily domestic retail-financed banks,whose structures are generallystraightforward and whose funding isnon-complex. The difficulty in using thistechnique in other circumstances is thatthe more complex the business of theinstitution the harder it is to perform thedivision of assets into “good” and “bad”.This difficulty is then magnified manytimes over if the institution has significantassets or liabilities governed by foreignlaw or held through foreign branches orsubsidiaries, which are subject to theirown investor protection or regulatoryregime and in the case of overseassubsidiaries with creditors of their own.There is therefore a point at which aninstitution becomes simply too large or

too complex to divide into a “good” and a“bad” bank in the 50 available hours. Thispoint is well below the size of anyinstitution which could reasonably beconsidered systemically significant.Resolution planning (“living wills”) canincrease the confidence of regulators thatthese techniques can be used, but theusefulness of the bail-in option is that itcan provide a more credible, readilyunderstood alternative.

Alternatively, the simplest way to effect abank resolution is to arrange for thewhole bank to be acquired by a solventpurchaser with sufficient resources tosustain it (although such transactionsmay be subsequently criticised as leadingto over-concentration in the market).However even if potential purchasersexist for the insolvent bank, the problemwhich may well have to be faced is thatthere is a tremendous difference betweenknowing that a bank is in trouble andknowing exactly the extent of the troublethat the bank is in. Rescue purchasesmay simply have the effect of imperillingthe stability of the rescuer, and in suchcases the usefulness of the existence of abail-in option may be considerable.

How does a bail in work?Bail-in, by definition, is a process whichapplies to some but not all of the seniorcreditors of an institution, since some of

these will be the very creditors whom theprocess is designed to protected. Chiefamongst these are depositors, althoughbanks have for some time had depositorprotection schemes in place to addresssuch issues.4 However, for the reasonsgiven above, if the bank is to bepreserved as a going concern its “tradecreditors” - payment services customers,short term creditors, securities andtrading exposures, etc. - must bepreserved intact, and for the purposes ofillustration it can be assumed that thebail-in process will be applied to the long-term investment creditors of the bank –loosely, bondholders and holders ofsubordinated debt.

The essence of “bail-in” is the idea thatsome senior creditors of a bank should,in certain circumstances, have part oftheir claim against the bank written downin wholly or in part, after the write downof lower ranking subordinated claims andequity. Such senior creditors may receivenew shares in the bank, but subordinatedcreditors may have their claims simplyextinguished.

As shown in the example below, a fullspectrum bank might have total assets of€1 trillion financed by (inter alia) €50bn ofshareholders equity, €20bn ofsubordinated debt and €200bn of seniordebt securities. Thus applying a haircut of



“Bail-ins aim to avoid the need for formal insolvencyproceedings, but to restructure the bank’s balance sheetand to ensure the continued survival of the institutionwithout the need to dismember the bank by the use ofconventional resolution tools.”

4 However depositor protection is in some respects a misnomer, since what is also sought to be protected is payment accounts and other facilities. Individual depositors didnot queue outside branches of Northern Rock only because they believed they were exposed to credit risk (because of the self-insured portion of their claim under the UK’sthen deposit-protection scheme), many of them queued because an insured deposit balance which cannot be withdrawn is useless for most of the ordinary purposes forwhich we keep money in a bank.

40% to the senior debt securities wouldbe more than sufficient to restore thegroup’s equity capital and to replace itssubordinated debt with equity, assumingthat the group’s losses burn throughthese layers of protection. This isequivalent to having funded the groupwith €50bn of equity, €20bn of

subordinated debt, €80bn of contingentor other capital securities and €120bn ofordinary senior debt. The advantage ofthe bail-in structure is that in extremis thewhole €200bn would be available forconversion or write down, whereas in thecontingent capital structure this amount islimited to €80bn.

It is interesting to compare this outcometo the outcome of a resolution regimeinvolving the creation of a bridge bank toprotect retail depositors. In resolution apart of the bank will be “saved” into agood bank, but the remainder will haveto be either sold or will disappear ascounterparties cease to do business



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Example – Bank A (before)

Assume:n Unexpected accounting loss of €80bn

n In a liquidation

• all senior creditors rank pari passu

• senior creditors would recover 70 cents in the euro

• i.e. total liquidation losses of €349bn

– €50bn share capital +

– €20bn subordinated debt +

– €930bn senior liabilities x 30% = €279bn

n Therefore, in a liquidation, total recoveries of:

• Holders of eligible senior debt = €140bn (i.e. 30% loss)

• Holders of shares and sub debt = €0 (i.e. 100% loss)

Assets: €1,000bn

Liabilities:

Eligible senior debt* €200bn

Retail deposits €300bn

Other senior liabilities €430bn

Subordinated debt €20bn

Share capital €50bn

Total €1,000bn

* Senior debt eligible for bail-in

Example – Bank A (after bail-in)

Assets:Previous total €1,000bnAccounting loss (€80bn)Revised total €920bn

Liabilities:Residual eligible debt €120bnRetail deposits €300bnOther senior liabilities €430bnShare capital €70bnTotal €920bn

Bail-in:n Eliminate €80bn loss by:

• Cancelling share capital + subordinated debt (total €70bn)

• Writing down eligible debt by €10bn

n Recapitalise bank by:

• Converting €70bn of eligible debt into equity

Total recoveries:n Holders of eligible senior debt now hold €70bn (shares) +

€120bn (residual debt) = €190bn book value (5% loss)

n Previous holders of shares and subordinated debt = €0 (100% loss)

Note to table:- The imponderable in the above is the increased loss on liquidation – this illustration has been created by assuming that the liquidation loss which occurred inthe Lehman case is typical.

with the bank and – if possible – closeout against it. Thus we would expect thevalue destruction in the “bad” bank tobe comparable to that which would berealised on an insolvency. In addition,the losses of senior creditors are inprinciple increased as a result of theireffective subordination to otherwise paripassu depositors, unless they areprotected by a regime which guaranteesthat no pre-resolution creditor will beworse off as a result of the resolutionthan they would have been in aliquidation or other insolvencyproceeding of the bank. The results arealso illustrated below.

One of the most interesting issues whicharises out of this example is theassumption that equity is extinguished ina bail-in. In principle, this is clearly right –a bail-in conducted without a cram-downof existing equity holders would result inthose equity holders receiving a windfall

profit. The conversion of contingentcapital, by contrast, involves the creationof new equity which ranks pari passuwith the existing equity (although it mayheavily dilute it). The implicit sequencingis therefore:

1. subordinated or contingent capital iswritten off and converted in full toequity;

2. bail-in is triggered, and existing sharecapital (old and new) is written off; and

3. new equity is issued to the holders ofthe bailed-in senior bonds.

It probably goes without saying that inorder to have any confidence in this

system regulators would need a power torequire that a bank maintain at least aspecified minimum proportion of its seniorfinancing in the form of either contingentcapital or bail-in eligible debt or somecombination of the two (although therequirement could also be met by equityor bail-in eligible subordinated debt). Aneffective bail-in regime depends on theauthorities having the “fire power” to dealwith extreme levels of unexpected loss.The determination of the level andappropriate combination should be madeby regulators as part of the “living will”review process.


“Although contingent capital and bail-ins aim to secure agoing concern outcome for the bank as an institution,contingent capital is based on a “going concern” trigger,in contrast to the “gone concern” (or near “goneconcern”) trigger envisaged by the bail-in proposals.”


Example – Bank A (after resolution)

Residual Bank A (after)Assets: †Original 1,000bnLiquidation losses (€349bn)Transferred to bridge bank (€330bn)Bridge bank equity €30bnTotal residual assets €351bn

Residual senior liabilities:Eligible senior debt €200bnOther liabilities €430bnTotal €630bn

Resolution methodn Assume resolution by creation of a bridge bank

n Bank A transfers to bridge bank:

• €300bn of retail deposits

• €330bn of “good” assets to back deposits and capitalisebridge bank

Saving for deposit protection fund* = €300bn x 30% = €90bn

Total recoveries:n Senior creditors recover €351bn/€630bn = 56%

n If “no creditor worse off” rule, deposit protection/resolution fundcontributes €90bn

n After contribution, senior creditors recover: (€351bn +€90bn)/€680bn = 70%

n Other stakeholders recover €0 (100% loss)

Bridge bank (after)Assets: €330bn

Liabilities:Deposits €300bnCapital €30bnTotal €330bn

Notes: * Assumes all retail deposits insured and 70% recovery in liquidation† Assumes that losses in resolution are the same as liquidation losses and

that residual Bank A receives benefit of equity in bridge bank

Requiring a larger volume of bail-ineligible debt reduces the percentage hair-cut that will be applied to eligible seniorcreditors and eliminating the claims ofequity holders and issuing new shares tobailed-in bondholders also reduces theiroverall losses. Those losses are likely tobe further reduced, as compared withliquidation or other resolution outcomes,as bail-in preserves the institution as agoing concern and avoids at least someof the losses that would otherwisecrystallise during an insolvency orresolution process. However, theobjective of bail-in is not primarily toreduce the losses of creditors. Theprimary aim of a bail-in is to recapitalisethe relevant institution, and it is argued insome quarters that ensuring thatcreditors do suffer significant losses is an

appropriate and necessary part of theprocess, whose development willenhance market discipline.

Impact on pricingof debtAn objection which is sometimes raisedto bail-in capital is that because thepulling of the bail-in trigger and thequantum of the resulting write-down orconversion are in the discretion of theregulator, it would not be possible forholders of bail-in eligible debt to makeany meaningful pre-estimate of their riskof loss. This, it is argued, would makesuch debt difficult or impossible to priceon the market. Although there issomething in this, it is possible byanalysing the likely structure of a bail-in

regime to draw some useful conclusionswhich may assist the pricing process.

Contingent capital instruments generallyhave defined trigger andconversion/write-down mechanismsspecified in the terms of the instrument,whereas the triggering of a bail-in and theresulting conversion/write-down are atthe regulator’s discretion. However,holders of senior bonds issued by UKbanks subject to resolution underBanking Act 2009 already face a similarrisk. The Act allows the authorities totrigger resolution based on subjectivedeterminations of non-viability and totransfer at their discretion a variablequantity of valuable assets out of thefailing bank in such a way as to reducethe assets available to meet the claims ofresidual senior creditors (or to expropriatebond-holders as part of the sale of thebank to a commercial purchaser ortemporary public ownership). This hasnot affected the market’s ability to pricethese bonds. This may be becausedealers and investors have made thesimplifying assumptions that the makingof a resolution order under the 2009 Actis functionally equivalent to default – thatis, that such an order would be madeonly where the institution would otherwisehave defaulted – and that the “no creditorworse off” and compensation safeguardsin the Act ensure that their loss in aresolution would be no worse than in adisorderly liquidation. Thus, the existenceof the Act may not have affected theirfundamental calculation as to theprobability of the issuer defaulting or theirloss given default.

The same is broadly true for bail-in – thefact of a bond being bail-in eligible shouldonly be material to pricing if theprobability of a bail-in is significantlydifferent from the probability of a defaultabsent bail-in or if the creditors’ loss on a



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“There is a point at which an institution becomes simplytoo large or too complex to divide into a “good” and a“bad” bank in the 50 hours typically available.”

bail-in would exceed their loss givendefault by other means. If an institutionwere permitted to operate using only theminimum tier 1 regulatory capital andrelied on a bail-in to cover all of its otherrisks, the chance of bail-in occurringwould clearly be significant, and thisphenomenon might well be observed.However, any bail-in regime would alsoneed to ensure that institutions maintainsufficient regulatory capital to satisfyregulators, plus a balance of contingentcapital sufficient to cover the residual riskof unexpected losses. The risk coveredby the bail-in debt would therefore be therisk that the losses suffered by theinstitution would exceed both expectedand unexpected loss. In principle this is a“tail” risk, of a kind which is not generallyreflected in pricing.

A bail-in regime does concentrate anyloss (not absorbed by equity orsubordinated debt) on a sub-set of seniorcreditors, whereas resolution regimes canspread losses across a wider group, e.g.where only deposit claims are transferredto a bridge bank, leaving all other seniorcreditors to suffer losses equally.Realistically, however, the increasedlosses resulting from a liquidation or thedismembering of an institution in aresolution are likely to outweigh theserisks – in most cases investors in bail-ineligible debt are likely to be better off thanunder the alternatives of insolvency or theuse of other resolution tools - andinvestors should in any event analysetheir likely loss in resolution on a worstcase outcome. In addition, the EuropeanCommission proposes that the “nocreditor worse off” safeguard shouldapply equally to the use of the debt writedown tool, which should mean that thelikely loss given default on bail-in is atleast no worse than the loss given defaulton other resolution outcomes.

There is a further concern. Since thepower to require a bail-in will necessarilyinvolve an element of discretion on thepart of the relevant authority, the price ofbail-in eligible debt would rise if it wereperceived that the regulator were mindedto exercise that power in circumstancesin which the institution would not havedefaulted. This is a behavioural matter,and as such very difficult to model –although the impact could be mitigated ifregulators were prepared to give broadguidance as to in what circumstancesthey would ordinarily expect to use theirbail-in power.

However, a more fundamental issue isthe possibility that the market has notpriced the potential adverse impact ofexisting resolution regimes intooutstanding subordinated or, moreimportantly, senior bank debt, on thebasis that the existing regimes are notperceived to present a credible threat ofimposing losses on bondholders,precisely because of the difficulties ofusing resolution tools that require thedismembering of a large, internationalsystemically important institution.Therefore, it is possible that theintroduction of a bail-in regime might beperceived as significantly altering theprobability of default, because it wouldbe easier for the authorities to use bail-inpowers than their existing resolutionpowers. In the UK, that might beshortsighted, because the Banking Actprovides the authorities with additionalresolution tools that can be used to

impose losses on some bondholderswithout dismembering the institution (byexpropriation of securities using thetemporary public ownership and sale toa commercial purchaser tools, althoughthe difficulties of imposing losses onholders of non-UK law governed bondswould be a constraint). However, evenputting that aside, this argumentsuggests that any impact on pricingwould result from the removal orweakening of the implicit sovereignguarantee for systemically importantbanks, and the removal of this guarantee(and the subsidy to the cost of bankfunding) is the one of the key objectivesof the proposals for a bail-in regime.

Finally, there are concerns that asignificant number of current investors inbank senior or subordinated debt wouldbe unable to buy bail-in eligible debtbecause their investment mandatesrestrict their ability to purchase debtwhich is convertible into equity and thatthe resulting restricted market for bail-ineligible debt will drive up funding costs.This could be a particular issue if a bail-in regime is structured based on the useof contractual conversion clauses indebt issues. However, the risk ofultimate conversion into equity is a riskwhich is taken by every senior creditorof any corporate issuer which can besubjected to a Chapter 11 or similarrestructuring regime under whichcreditors can be required to exchangetheir claims for equity without theirconsent. These regimes do not seem to



“The essence of “bail-in” is the idea that some seniorcreditors of a bank should, in certain circumstances,have part of their claim against the bank written down inwholly or in part, after the write down of lower ranking,subordinated claims.”

restrict investor appetite for senior debt.This suggests that a statutory bail-inregime which is clearly seen as a form ofcompulsory debt restructuring would beless likely to restrict investor demand. Itmay also be possible to reduce theimpact of investor mandate concerns bybuilding in a trust or similar mechanismunder which debtholders can elect notto receive shares but to have them soldfor their benefit. Nevertheless, in onerespect, there is likely to be a morerestricted investor base in the future forbail-in eligible senior debt than currentsenior bank debt, as bank regulators areraising the capital charges for exposuresto other banks and could decide to treata bank’s holding of bail-in eligible seniordebt of another bank as the holding ofanother bank’s capital instruments whichmay be required to be deducted fromcore tier 1 capital under the new BaselIII regime.

Legal structure – makingbail-ins effectiveA bail-in regime will be useless unless it isimmediately accepted by the bank’scustomers and counterparties as legallyeffective. A bail-in, by itself, is purely anaccounting adjustment. Its usefulness liesin the fact that by writing off debt it

improves the creditworthiness of the bankconcerned to a stage where it canaccess the money markets and raiseliquidity. In order to achieve this objective,providers of liquidity must be left with nogrounds to doubt that the write-off isimmediately effective and cannot becredibly challenged.

Achieving this level of legal certaintyrequires a surprisingly large amount oflegal analysis. In a situation where thebank and all the relevant creditors werelocated in a single jurisdiction, simplelegislation in that jurisdiction wouldsuffice. However this is not – and willnever be - the case for any bank whosefailure would give rise to significantsystemic concern. The challenge istherefore to construct a legal solutionwhich employs a variety of legaltechniques to achieve a robust outcomewithout falling into impossible demandsfor global harmonisation of bankresolution legislation.

It might be possible in some jurisdictions– including possibly the UK - to create abail-in regime entirely by private contractby including the relevant provisions indebt instruments issued by the entityand in the constitution of that entity.However, this would give rise to someinteresting legal conundrums, since theissuer would be seeking to create debtson terms allowing the debtor, at itsdiscretion, to eliminate all or part of thedebt and to replace that debt with newshares. Even if this were possible, itseems unlikely that it would beacceptable to those creditors or theentity’s shareholders that such a regimecould be operated by the board of therelevant company entirely in itsdiscretion, and even more unlikely that,in the context of the modern law on

directors liability, any board of directorswould in practice be prepared toexercise such a discretion. Thus even ifthe regime were based entirely onprivate law, it seems likely that thecontractual provisions would need to bestructured so that the initiation of thebail-in is triggered by an external act ofan appropriate regulator or other publicbody and to ensure that any discretionabout the extent of any necessary write-down or any compensatory issue ofequity is also exercised by theauthorities rather than the board. Thiswould almost certainly create proceduraland technical difficulties for publicauthorities, who in many cases wouldperceive unacceptable risks to actingpursuant to private rights rather thanpublic obligations.

An alternative approach would be toprovide for bail-in by legislation. Bail-inbacked by legislation has a number ofappealing aspects – in many jurisdictionslegislation will be necessary to deal withcompany law issues, and legislativebacking would clearly underpin marketconfidence in the robustness of a bail-in.However legislation is an imperfectsolution for all but the smallest banks,since for the majority of banks asignificant portion of their senior debt islikely to be governed by laws other thanthat of their place of incorporation – forexample most large continental Europeanbanks are likely to have bonds governedby English or New York law.

The problem which arises in this case isknown to English lawyers as the “Metliss”problem. In National Bank of Greece vMetliss5, the English courts decided thatwhere a Greek bank owed money underbonds governed by English law, a Greekstatute passed for the purpose of varying



12

“It is argued in somequarters that ensuring thatcreditors do suffersignificant losses is anappropriate and necessarypart of the process, whosedevelopment will enhancemarket discipline.”

5 National Bank of Greece and Athens S.A. v Metliss [1958] A.C. 509

liability on the bonds would not berecognised by the English courts, since –at its simplest – you cannot vary Englishlegal rights by Greek statute. Thisprinciple would almost certainly beapplied by the courts of most jurisdictions– thus, if the contractual obligations of aUK bank were varied by UK law, there isa significant risk that the variation wouldnot be effective as against holders ofNew York law governed bonds. Therecent litigation commenced in New Yorkby Fir Tree Capital against Anglo IrishBank Corporation is an example of acreditor seeking to rely on rights underNew York law governed documentationalleged to conflict with the exercise ofresolution powers, in this case thoseconferred on the Irish authorities by theIrish Credit Institutions (Stabilisation)Act 2010.

It is important not to overstate Metliss. Inparticular, the EU proposals would, ifenacted, produce a regime in which abail-in or write-down effected by the lawof one member state would berecognised by the laws of other memberstates. In addition, courts are in somecases prepared to recognisecompromises of creditors rights arisingunder the laws of other jurisdictions.However such recognition in practicetends to be confined to formal insolvencyproceedings, and predicated on theassumption that a similar process wouldbe possible under the domestic law ofthe court concerned. Thus, although apurely statutory regime might be effectivein a world where all major financial

jurisdictions had broadly equivalentdomestic bail-in regimes, it would not beeffective at any time prior to that.

The hybrid approachThe conclusion from this seems to bethat the most robust approach wouldbe a hybrid approach. The structure ofsuch an approach would be that thebank should, in its country ofincorporation, be subject to a statutoryregime whose effect would be torecognise the bail-in in national law. Thislaw should automatically apply the bail-in terms to any bail-in eligible creditorwhose claim arose under the law of thatjurisdiction. The bank would then berequired to ensure that for any bail-ineligible creditor whose claims weregoverned by any other law, it should berequired to include in the agreementwith that creditor a term to the effectthat the creditor agreed to be bound byany bail-in effected under the law of theplace of incorporation as if their rightsunder the agreement were governed bythat law, and to obtain legal opinionsthat the term would be recognisedunder the applicable law of theagreement.

This hybrid approach would ensure thatthe most important part of the bail-in –the reduction of existing creditor claimson the bank concerned – would belegally robust and effective. However, inorder to fully accomplish a bail-in youneed to do three broad legal jobs. Oneis to write down the relevant senior debt.

The second is to issue new equity to thewritten-down debt-holders. The third isto cram down the existing equity. Boththe second and the third may alsorequire legislative change in the countryof incorporation of the bank.

As regards the creation of new equity,there may well be national company lawrules about new equity issuance whichrequire to be observed. In somejurisdictions it may be possible toaddress these through amendment tothe constitution of the companyconcerned, but in others statutorychange may be required.

Cram-down is more problematic. Thecancellation of equity may run into issuesof protection of property rights in caseswhere it is not certain that the existingequity is completely valueless – althoughconventionally a cram-down should beaccompanied by the issue of warrants ofsome description to the former ordinaryshareholders such that the holders ofthese warrants would be entitled tosome participation in the recovery of theentity but only after the holders of thebail-in shares had been appropriatelycompensated. Again, in somejurisdictions this will require legislationin order to amend existing companylaw concepts.

Scope of bail-inThe question of legal effectiveness isfrequently confused with the question ofthe scope of the bail-in itself. The reasonfor this is that when considering bail-inregimes, an apposition is sometimesposed between a “targeted” regime,under which the bail-in is only possiblefor certain pre-designated exposures, anda “comprehensive” regime, in which thebail-in is extended to all senior creditorssubject to a closed list of exceptions6. Itshould be clear from the foregoing that a



“The fact of a bond being bail-in eligible should only bematerial to pricing if the probability of a bail-in issignificantly different from the probability of a defaultabsent bail-in or if the creditors’ loss on a bail-in wouldexceed their loss given default by other means.”

“comprehensive” regime would be legallyineffective for any institution whose debtwas not entirely subject to the laws of thecountry of its home state regulator. Sinceit would in practice be impossible torequire a global institution to enter into allof its financial contracts under the law ofits place of incorporation, the next-bestoperative solution would be to require thebank as a matter of regulation to includein all of its relevant contracts languagewhich would give effect to the bail-in. Atthis point the distinction between the“targeted” regime and the“comprehensive” regime disappears - inboth cases the mechanism by which thebail-in is effected is the inclusion oflanguage in the documentation creatingthe relevant exposure, and the principalremaining distinction is the means bywhich the scope is defined.

Consideration of this exposes anotherissue regarding a “comprehensive” bail-inregime. It is accepted that not allcreditors should be bailed-in - in additionto the “trade” creditors who would haveto be preserved, there would clearly beother classes of contracts - purchase ofgoods, occupation of real estate, unpaidsalaries, outsourcing fees and manyothers - which would also have to beoutside the scope of the regime. Thelegal difficulties which would be causedfor banks by the existence of acontinuing obligation to consider everycontract entered into across the bankagainst this issue would be considerable,and the legal uncertainties raised by thequestion of whether the bank hadcorrectly categorised the exposureswhich it had entered into would result inlegal uncertainty affecting the bail-out asa whole - an outcome which would betoxic for the success of the bail-outwhen required.

Consideration of the “targeted” approach,however, immediately flushes anotherlegal Chimera - the idea that creditorscould “contract out of bail-in”. This isclearly true (it is true of all creditors in allpossible structures) - the question iswhether it is a problem, and the answerto the question of whether it is a problemdepends on the way in which bail-in isapproached by regulators.

In the context of any bail-in arrangement,it is clear that certain creditors must becapable of being excluded from thepossibility of bail-in (secured creditors arean obvious example). It is thereforeessential for the institution concerned tobe able to say clearly to any creditorwhether or not it will be caught by a bail-in possibility. Since the factors whichdrive that determination must bemechanical and predictable, it will alwaysbe possible for any claim to be takenoutside the scope of bail-in. The issue isnot the fact that this is possible – it isinevitable – but the question of whetherthe fact of the possibility weakens thereliance which the regulator would seekto place on the bail-in mechanism.

In order to answer this we need to thinkabout the bail-in mechanism from theperspective of the regulator. In general,we expect regulators to determine theirapproach to bail-in capital levels in thecontext of a “living will” analysis.Regulators should assess the questionof whether:

(a) there is sufficient existing equitycapital to meet anticipated losses

(b) there is sufficient contingent capitalavailable to meet unanticipated orcrisis losses, and

(c) in the event of a catastrophicunexpected losses, there is sufficient

bail-in eligible debt available to avoidthe necessity for a government bail-out.

This process should yield a quantifiablerequirement for the institution concernedto maintain a specified amount of bail-indebt - defined as capital containingcontractual provisions by which theholder agrees to have his obligationwritten down or partially converted on thedetermination of the relevant authorityunder its legislative powers. If theinstitution does not maintain sufficientbail-in eligible debt (i.e. permits too manycounterparties to contract out of bail-in)the required amount of contingent capitalor equity would simply be increasedproportionately. However if the institutiondoes have sufficient bail-in eligible debt tosatisfy the regulator, there is no reason toassume that the regulator should carewhether new creditors fall inside oroutside this scope. Since it should beassumed that it will be clear to allcreditors how much of the institutionstotal debt is bail-in eligible and how muchis not, an institution which sought toreduce the amount of its debt which wasbail-in eligible would be expected tosuffer a significant increase in its cost offunding from its remaining bail-in-abledebt, and, of course, vice versa. Thusprovided that the institution maintainedsufficient bail-in debt to satisfy itsregulator, there is no reason for concernabout “contracting out”. Indeed, theflexibility to issue additional non-bail-ineligible senior debt – which is theremaining distinction between thecomprehensive and the targetedapproach – may be a source of strength.It allows additional senior funding,presumably at lower cost, in normal timesand, in times of stress when it may notbe possible to issue further bail-in eligibledebt because of the increased risk of



14

6 These are the labels adopted in the European Commission discussion document referenced in note 1 above

loss, would allow the institution tocontinue to access the capital marketswithout the need to create a furthercategory of super-senior creditors ordebtor in possession financing.

Group issuesThus far we have considered the bail-in ofa bank. However most large banks aremembers of groups, and it is frequentlythe case that in a bank group there is anunregulated bank holding companyabove the bank.

In the case illustrated in fig. 1, if the bail-in were to be conducted at the bank

level the effect of the bail-in would be tobreak the group structure (since the bankwould cease to be a subsidiary of theholding company) – and would be likelyto push the holding company intoinsolvency (since its shares wouldbecome deferred and its dividend flowfrom the regulated bank would cease).This problem clearly would not arise ifthe senior borrowing were primarily atthe holding company level. However

practices vary amongst banks as towhether funding is (a) raised at theholding company level anddownstreamed, (b) raised at the level ofthe bank itself or (c) raised at both levels.This it is impossible to make any generalassumption as to where in the groupbail-in eligible debt will be raised.

This means that the structure of any bail-in must be adapted to the specific caseof the bank group concerned. This canbe most easily understood by consideringthe case of the slightly more complexbank group illustrated in fig. 2.

In this case, the group has creditorsat multiple levels and within multiplelegal entities.

The starting point for consideration of thissituation should be the fact that it isdesirable for both the group and for itsregulator that creditors should be clearwhich parts of the group they areexposed to. Creditors of the holdingcompany will clearly consider themselvesexposed to the group as a whole, andcreditors of the booking vehicle willconsider themselves exposed – in creditterms at least - solely exposed to thatbooking vehicle. However for the Asiansubsidiary bank, for example, thequestion of whether that bank would, indifficulty, be able to or entitled to callupon the resources of the remainder ofthe group would have to be determinedas part of the living will process. It wouldclearly be open to the bank group tostructure itself on the basis that all of itscomponents were interdependent, and ifthis were the case then the logicalconclusion would be that any bail-in of



“Providers of liquidity must be left with no grounds todoubt that the write-off is immediately effective andcannot be credibly challenged.”

Seniorcreditors

BankOther GroupEntities

Bank Holding Company

Fig. 1

Seniorcreditors

Fig. 2

Senior creditors

CreditEnhancedBookingVehicle

Bank(Asia)

Bank Holding Company(UK)

OtherEntities(various)

Bank(UK)

any creditor across the group shouldprovide for the issue of new shares in theholding company. This would result increditors of a solvent part of the groupbecoming exposed to the insolvency ofother parts of the group, but it is likelythat in the absence of formal ring-fencingarrangements (such as are found aroundcredit enhanced vehicles) this would betheir ordinary expectation in any event. Bycontrast, where it is part of the resolutionplan that a particular group member besegregated from exposure to theremainder of the group (perhaps so that itcould be easily sold off to raise finance),this should also be recognised in the bail-in structure.

What all of this comes down to is nothingmore complex than that the bail-instructure should reflect the existingstructure of the group and theexpectations of creditors as to theircounterparty exposures. This is neitherunreasonable nor overly challenging, andcertainly does not represent aninsuperable barrier to the establishmentof bail-in regimes, at least where the bankholding company and the entities issuingbail-in eligible debt are incorporated inthe same country. The position is morechallenging where the group has a moresubsidiarised structure containing largeentities issuing debt that are notincorporated in the same country as thebank holding company, as the localregulator will not have direct powers overthe holding company to implement thebail-in. However, it should also beaccepted that there will be some group

structures which render the operation ofa comprehensive bail-in regime difficult oreffectively impossible. Again, this is not afundamental objection to the adoption ofa bail-in approach by regulators for thosegroups for whom bail-in is possible andat present most large banking groupswith a bank holding company structurehave their bank holding companyincorporated in the same jurisdiction astheir principal banking entities. It alsopotentially aligns the interests ofregulators in effective resolution planningwith the interests of banks in operatingintegrated legal entities operatinginternationally through branches ratherthan subsidiaries.

However, cross-border issues should notmean that it is impossible to implement abail-in in a case where the troubled bankor its bank holding company also hastroubled foreign subsidiaries. In manycases, those subsidiaries will havesignificant intra-group borrowings fromtheir parent bank or bank holdingcompany due to the downstreaming offunding raised at the group level. Thebail-in of debt at the level of the bank orbank holding company should createenough capital so that it has capacity towrite off or convert those loans to itssubsidiaries into equity in thosesubsidiaries, enabling their recapitalisationas part of the overall process, even if thelocal regulator does not have an effectiveresolution regime. This may have theresult of bailing out the creditors of thosesubsidiaries, effectively at the expense ofthe parent’s creditors, but this may be a

better overall outcome than letting thosesubsidiaries go into liquidation. Inaddition, if local regulators have a localresolution regime with correspondingpowers, there should be ways in whichthe group’s lead regulator and the localregulators can coordinate the exercise oftheir powers to produce an appropriateresult, without the need (outside the EU)for complex international treaties whichcould take many years to negotiate.

A bail-in of an integrated bank groupwould therefore require senior creditorsof a bank subsidiary to be issued withnew shares in the bank holdingcompany rather than the bank itself.The write off of the bail-in eligible debtwould create capital reserves in thesubsidiary. The issue of the shares inthe holding company does notnecessarily require any intermediatestep of requiring the subsidiary to issueadditional shares or debt to its parentcompany, but the mechanics woulddepend on local corporate lawsensibilities. There is no reason whythis should not be done by statute, andif the bank and the holding companyare established in the same jurisdictiona legislative solution in that jurisdictionshould be capable of being crafted.

In the context of groups, it is alsoimportant to note that a consistentpolicy would be required as regardsintra-group debt. The question ofwhether intra-group debt should betreated differently from any other debt inthe context of a bail-in is notstraightforward. However it is by nomeans clear that it is necessary toresolve these on a single global basis asopposed to a case-by-case basis - theoptimum solution would seem to be thatthis issue should be addressed betweenindividual banks and their lead regulatorsas part of the “living wills” discussion.



16

“An apposition is sometimes posed between a “targeted”regime, under which the bail-in is only possible for certainpre-designated exposures, and a “comprehensive”regime, in which the bail-in is extended to all seniorcreditors subject to a closed list of exceptions.”

Again, this may be easier to accomplishin the “targeted” approach where bankscontinue to be able to issue senior debtwhich is not bail-in eligible alongsidebail-in eligible debt.

Other issuesApplicability of existing insolvencyco-ordination mechanismsThere are a number of international co-ordination measures currently in forcewhich enable corporate restructuringproceedings under the law of one state tobe upheld and enforced in the courts ofother states. The most important of theseare the EU Credit Institutions Winding UpDirective (WUD) and the UNCITRAL modellaw on cross-border insolvency.7

It would be nice to be able to concludethat one or other of these mechanismwould enable immediate cross-borderrecognition of bail-ins in multiplejurisdictions. Sadly nothing is this simple.The UNCITRAL convention generallydoes not apply to banks (although itwould generally apply to reorganisation ofbank holding companies), and it is notentirely clear that a partially contractually-based bail-in would fall within thedefinition of “reorganisation measures”within the meaning of WUD.

The point, however, is that there areexisting international measures currently inforce which, if slightly varied, would provideexactly the robust platform necessary forcross-border recognition of bail-ins.

Creditor safeguardsThe laws of most jurisdictions have theeffect that people may not be arbitrarilydeprived of their property withoutappropriate safeguards and/or judicialprocess8. For this reason it is important toensure that the bail-in mechanismadopted contains appropriate provisionsto ensure that the rights of creditorsare protected.

The contractual element of the proposedhybrid bail-in structure goes a long waytowards addressing this issue - if aperson contracts in particular terms andthe rights arising under that contract areenforced against them, they do notgenerally have a public law remedy evenwhere the person enforcing the rights isthe government. However, there isequally no question that under the hybridmodel the person making thedetermination that the creditor should bebailed-in is the regulator, and thedetermination of the extent to whichthose creditor’s claims are reduced is inthe regulator’s discretion.

This poses a challenge. The essence of abail-in is that it should be capable ofbeing completed over a week-end (orappropriately short period of marketclosure). There is therefore no scope forcreditor or shareholder votes, public court

hearings or public consultation, and verylittle for judicial or political control of thebail-in process.

The approach adopted to this problem inthe UK under the Banking Act 2009 wasthe embedding of the “no creditor worseoff” principle” in the legislation. The effectof this is that if the result of governmentaction is that any creditor receives ademonstrably lower return than theywould have done had the bankproceeded to disorderly liquidation, theyshould be compensated by thegovernment.9 This approach relieves thenecessity for procedural safeguards in therestructuring process by reference to anobligation to compensate in the event ofmisappropriation.

This is not, however, the only effectiveapproach in this context. It would bequite possible to convene an emergencypanel of – say – bankruptcy judges toreview the restructuring proposals of therelevant resolution authority10. Alternativemechanisms could involve the“recruitment” of a representative creditorinto the process in order to negotiate onbehalf of his fellows, or theestablishment of guidelines by publicauthorities. The key issue is simply thatsome safeguard mechanism is likely tobe required in most jurisdictions in order



“A bail-in of an integrated bank group would thereforerequire senior creditors of a bank subsidiary to be issuedwith new shares in the bank holding company ratherthan the bank itself.”

7 Since WUD applies across the EU and UNCITRAL has been implemented in Australia, Canada, Great Britain, Japan, New Zealand Poland, South Korea, South Africa andthe United States of America, these cover a large proportion of the relevant bank groups.

8 For example, the 5th Amendment to the US constitution provides that no person should be deprived of property without due process of law. Protocol 1 Art 1 to the EuropeanConvention on Human Rights provides that also enshrines the right to “peaceful enjoyment of possessions,” although also recognizes that this right can be constrained. No oneshould be deprived of property “except in the public interest and subject to the conditions provided for by law.”

9 However, in the UK, the government can in effect draw on the deposit protection scheme (to the extent that the resolution actions result in the scheme saving having to pay outto depositors the compensation that would have been payable in a liquidation), which in turn recovers the money from the banking industry in general.

10 This is broadly the approach adopted in the US, although it should be noted that the relevant judges do not review the substantive fairness of the proposals, but only considerwhether they relevant decisions have been arrived at in accordance with the precepts of public law and satisfy a basic standard of reasonableness.

to ensure that legal protections ofproperty rights are respected.

However, the operation of bail-in regimesin the context of group structures requiresa more careful analysis of the safeguardsfor other stakeholders. For example, in acase where only one banking subsidiaryof the holding company is on the verge ofinsolvency and the bank holding companyhas other viable and valuable subsidiaries,it could be perceived as disproportionateto cancel the claims of existingshareholders in the holding company. Ifthe banking subsidiary had gone intoliquidation, their shares might still havehad significant value because of the valueof those other subsidiaries. In thosecircumstances, the appropriate result maybe to compensate the holders of bail-ineligible debt issued by the bankingsubsidiary with shares representing a partof the enlarged share capital of theholding company but to leave the claimsof the existing shareholders intact, albeitdiluted by the new equity. What thisillustrates is a “no stakeholder worse off”variant of the European Commission’sgeneral safeguard for resolution toolsdiscussed above. It also illustrates that,while the write down of bail-in eligible debtmust be immediate to be effective, it maybe necessary to delay the issue of newequity and the determination of the rightsof shareholders to a later date, when therelative interests can be determined (andin the meantime for trading in the sharesto be suspended).

Ownership caps

If a bail-in regime involves the conversionof debt into equity, whether in a bank orits holding company, it is likely to benecessary to include provisions whichallow the regulator to cap the amount ofan individual shareholding that would beacquired by a single creditor or group ofrelated creditors (and to convert theexcess into a claim on the eventualproceeds of disposal of the shares). Largebanking groups have regulatedsubsidiaries around the world and it couldundermine the effectiveness of the bail-inif, for example, the bail-in were to result ina single creditor acquiring in excess of a10% shareholding in the bank holdingcompany if ordinarily that would triggerprior filing or approval requirements in thebank’s home jurisdiction or otherjurisdictions where regulated groupcompanies operate (which might alsoresult in possible sanctions against thelocal regulated entities by local regulators).

Events of defaultPhilosophically, the function of a bail-in isno different from that of any othercorporate restructuring – it is to imposelosses upon the financial creditors whilstallowing trading to continue. For a bank,in order for normal business to continue,it is important that counterparties in thatbusiness should not be affected. Part ofthe problem, of course, is that it isconsiderably harder to draw a bright linebetween financial creditors and tradecreditors for a bank that it is for a tradingcompany. However, another verysignificant element is that tradingcreditors generally include “event of

default” language in their agreements withthe bank, the effect of which is to givecounterparties the right to terminate theagreement, for example if a bank’sregulator institutes proceedings against itseeking relief under “any bankruptcy orinsolvency law or other similar lawaffecting creditors’ rights”. The institutionof a statutory or quasi-statutory bail-in islikely to have the effect of triggering theseclauses and terminating (or at leastproviding creditors with an option toterminate) trading agreement.11 Thetriggering of such clauses could beheavily value-destroying for the remainingbusiness of the bank.

The simplest approach to this issue isthat adopted in the US bankconservatorship and bankruptcyprovisions, which in broad terms providethat no contractual event of default canbe effective if it is triggered as a result ofthe conservatorship. An alternative (andpossibly more nuanced) approach isadopted in sections 22 and 38 of the UKBanking Act 2009, which provide that inthe event of a resolution being effected,the authorities can specify that the ordereffecting the resolution will not trigger anumber of broadly defined event ofdefault, termination or other similarprovisions in any agreement to which thebank or its subsidiaries are party.

In the context of a bail-in such provisionscould be incorporated in the relevantnational law of the place of incorporationof the bank. However this would give riseto significant conflict of law issues.Imagine a UK bank which has enteredinto trading arrangements with derivativescounterparties in Australia governed byNew York law. The bank is bailed in. Thefact that UK law provides that the event



18

“The triggering of event of default clauses could beheavily value-destroying for the remaining business ofthe bank.”

11 A bail-in operating on a purely contractual basis would probably not trigger such clauses, since the exercise of private contractual rights would almost certainly not constitutea restructuring.

of default provisions of the New York lawagreement are not triggered would be ofno relevance under New York law and itis hard to see an Australian or New Yorkcourt being prepared to take cognisanceof the UK Act in this respect. However, acounter-argument would be that creditorshad entered into their agreements in theknowledge of the existence of theprovision and should be treated as havingimplicitly agreed to it.

The issue could be addressed byrequiring the bank to include a specificexclusion of bail-ins in its documentation.However a rule which required the bankto include a particular provision in everyagreement into which it entered would beextremely difficult to implement.

In general banks control the events ofdefault which operate against them intheir normal business. As a result, themost significant issue in this regard islikely to arise in the context of derivativeand other trading documentation, whereevents of default are likely to beconsiderably more widely drawn. In thecontext of the global adoption of a bail-inarchitecture supported by nationallegislation in major jurisdictions, it doesseem likely that an industry initiative toamend standard terms in thesedocuments would be the mostappropriate way to minimise this risk. Inaddition, resolution planning shouldidentify cases where there are otheragreements whose termination may betriggered by a bail-in or other resolutionaction and where the consequences

could materially adversely affectimplementation of the resolution tools sothat they can be addressed by individualnegotiation or other mitigation action.

Finally, it should be noted that the effectof an event of default is in general to givethe non-defaulting counterparty thechoice to terminate the relevant contractif he so desires. If the bail-in is effectiveand the bailed-in form has immediateaccess to new liquidity as a result of it,the likelihood may well be thatcounterparties would not choose toterminate profitable business relationshipseven if they acquired the right to do so. Inthis regard it may well be that therobustness of the bail-in is itself theanswer to the problem.

Transition to a bail-in regimeThe European Commission’s proposalsare that any bail-in regime should only beimplemented in a way that applies tofuture issues of debt, so that existing debtwould remain unaffected by the regime.This is in part a pragmatic response. Thehybrid approach discussed above canonly be implemented with respect to newdebt, since it requires the inclusion ofcontractual provisions in the debtinstruments recognising the authorities’powers to bail in the debt. However, it isalso a recognition that discussions aboutextending the regime to existing debtcould themselves have a destabilisingeffect on markets which is likely to becounter-productive, even if existing debtmay be exposed to similar risks of loss asa result of the application of otherresolution tools.

Even with a significant cushion of equityand contingent capital, it may be difficultfor a bank to issue its first tranche of bail-in eligible debt as this tranche will beperceived to be exposed to the fullamount of any excess unexpected loss.

There may need to be phase-inarrangements where explicit thresholdsare set for each bank, so that the bail-inpowers only become exercisable after thebank’s total issuance of bail-in eligibledebt exceeds those thresholds.

The limits of bail-ins Bail-ins are not a panacea, and will notproduce a zero-failure environment forbanks. Recapitalisation only works forgood businesses with bad balancesheets - businesses which arefundamentally bad will not be and shouldnot be bailed in, but will be left to aresolution regime in the ordinary way. It isalso perfectly possible for a bail-in to fail- if the initial assessment of the extent ofthe losses of an institution is sufficientlyadrift, the amount of new capital createdby the bail-in may be insufficient tosupport the business. Possibly moreimportantly, a bailed-in bank will onlysurvive if counterparties, creditors andcustomers believe that the institution isnow robust. Leaving aside uncertaintiesas to the legal robustness of the bail-out(which should be largely eliminated bythe use of the hybrid method andappropriate safeguards), it will beimportant that the market be satisfiedthat the institution has enough capital forits needs, and in response to theregulators assurance that this is now thecase the market might not unreasonablyrespond “yes, but that is what you saidlast time”. It has been suggested thatthis problem could be addressed bycreating an equivalent of “debtor-in-possession” financing which could beused in such cases, whereby a bailed-ininstitution could contract on terms thatnew creditors were senior to existingcreditors. However this proposal isoutside the scope of this paper.

The most significant obstacle to the



“Bail-ins are not apanacea, and will notproduce a zero-failureenvironment for banks.”



20

use of bail-ins, however, is that at theend of the day a bail-in is simply amechanism for allocating an existingloss. It will only be possible to use it toallocate such losses to the bankscreditors if the bank’s creditors aresufficiently robust to absorb that loss. Ina systemic crisis, where all systemicinstitutions are simultaneously at riskdue to external circumstances, a bail-incould be counter-productive, sendingcascades of default across the system.However, even in this case bail-in ispreferable to “sudden stop” liquidation,since this would increase the lossesrealised within the system and thereforeincrease the damage to the system –thus no matter how bad the overallsystemic problem, it will always be thecase that a bail-in response will bepreferable to a liquidation response.However, if at he end of the day theentire system is unstable thenrearranging exposures within the systemwill not help it.

The road to resolutionThe bail-in proposals clearly merit furtherstudy. The European Commission’s paper

has clearly sparked considerable interestamong regulators and banks, not leastbecause it may offer a more completeanswer to the existential challenge posedby the “too big (or important) to fail”question for large systemically importantbanks, without the need for extensiverestructuring to separate out economicallycritical functions into separately resolvablesubsidiaries (as is threatened, for example,by some of the proposals underconsideration by the UK IndependentBanking Commission). Indeed, there arelikely to be positive advantages for theeffectiveness of bail-ins if the bankconducts most of its operations through asingle large banking entity which is theprimary (or only) issuer of bail-in eligibledebt in the group.

However, there are still many issues thatrequire further work. In particular, there isstill uncertainty about the marketacceptability of bail-in eligible debt whichneeds further testing in the context of amore fully developed design framework.There is also further work to be donearound the prioritisation of resolutionoptions, in particular whether bail-inshould be a first or last resort tool, and

making bail-in options work in a groupcontext. These factors alone mean that itis unlikely that an appropriately markettested package of proposals could beincluded in the EU legislative proposal oncrisis management scheduled for thesummer of 2011. Pushing to catch thisparticular legislative sailing time with aninadequately developed proposal riskssinking the legislative ship. It is particularlyimportant to take care in the processgiven that the US is unlikely to be able tolegislate in a similar way. It is unlikely to bepossible to amend the Dodd-Frank Act inany significant way, given the currentmake-up of Congress following the mid-term elections. Therefore, whatever the EUdoes it will have to do on its own andargues in favour of taking a measuredapproach to building the consensusaround the proposals.

© Clifford Chance LLP, May 2011.

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Legal Aspects of Bank Bail-Ins - Clifford Chance

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