Institute for Financial Law

3 March 2011

INSTITUTE FOR FINANCIAL LAW

OF

RADBOUD UNIVERSITY NIJMEGEN, THE NETHERLANDS

Response to the consultation on Technical Details of a Possible EU Framework

for Bank recovery and Resolution

(DG Internal Market and Services Working Document)

1.  Introduction

The Institute For Financial Law (the Institute) is a fully independent think tank of the Radboud University in Nijmegen. It is active in the financial sector; it enables and enhances research in financial law, it organises graduate and post graduate educational courses, and it publishes books and organises seminars on topics of financial law. The activities of the Institute cover public and administrative law, civil law and criminal law aspects of financial law. A list of professors, fellows and sponsors of the Institute is attached to this Report as an Appendix.

The Institute is pleased to provide a response to the consultation initiated by the DG Internal Market and Services on a possible framework for bank recovery and resolution. The Institute considers this an important initiative. Given the relative size of the Dutch financial sector and the importance of the Dutch financial institutions both domestically and internationally, the Netherlands has a particular interest in the subject of this consultation.

This is an independent Report, and the views expressed in this Report are the independent views of the Institute. These views do not necessarily align with those of the Dutch Ministry of Finance, the Dutch Central Bank, the Authority for the Financial Markets or any of the sponsors of the Institute. The Report was submitted in draft form to the sponsors of the Institute, and where deemed appropriate by its authors, the views of these sponsors are reflected in the Report.

The Institute is a legal think tank, and accordingly this Report will not address non legal issues (e.g., financial, commercial and cost factors). This Report will only address Question Boxes where we believe our views may be helpful.

Many of the issues raised by the DG Internal Market and Services raise rather complex issues of law, including complex issues of private international law. Many of these issues merit an independent legal analysis. This Report does not undertake such analysis but is confined to making hopefully helpful more generalised comments; however, it does attempt to identify where such analysis would be needed.

The Institute would welcome and seriously take into consideration any mandate to provide such analysis or to help providing such analysis.

2.  General comments

The Institute makes the following more general comments in relation to the subjects covered in the Working Document:

(a)  The credit crisis in its current form is unique in its scope and severity. However, looking back over the past three decades or so, major systemic meltdowns in the developed world have been relatively infrequent. This factor, together with the factor that the shape or scope of a future credit crisis appears to be difficult to predict, should be taken into account when weighing the benefits and disadvantages of the various regulatory solutions that are being put forward. The Institute agrees with the need for a EU framework for recovery and resolution of financial institutions active in the international banking sector, but believes that we need to guard against overreaction that may be to the unnecessary detriment of stakeholders such as capital and liquidity providers and other financiers of the financial sector.

(b)  We also believe that it is advisable to guard against overly ambitious regulation at the EU level. We suspect that it is better to have less comprehensive but practically workable solutions rather than devising an ambitious all encompassing solution of which the practical feasibility is in doubt. The question arises in this context, whether the rules envisaged by the Working Document should apply across the board, or only to institutions that are systemically important on a cross-border level, leaving other institutions to reside under the existing legal frameworks. We think a limited scope is preferable, but then of course the question arises who determines that scope. It may well be that this determination should be made by the EBA in consultation with the member-state(s) where the institution concerned has its corporate seat and/or principally operational.

We note that it must be recognised that risk is an inherent element of the financial sector; attempts to eliminate or overly reduce risks in the financial sector by unnecessarily strict regulation could seriously jeopardise further development in terms of innovation and product offerings in the financial sector. This may have an impact on the economy as a whole.

We also believe that predictability in the functioning of crisis management is a key requirement to avoid unnecessary disturbance of the financial markets and the economy generally. A crucial element in this is a harmonised approach to crisis management within the EU and (ideally) also beyond its borders. Within the EU, this includes harmonisation of the triggers for the different phases of the crisis management framework and the tools that can be applied in each phase.

We note in this respect that it will be difficult to find a harmonised approach that effectively works without agreement on burden-sharing. If there is no consensus on this, the Institute believes there is a real risk that national considerations will in practice prevail over an internationally effective European resolution framework.

(c)  In line with our previous comments, it is of fundamental importance that a EU framework is coordinated with the US framework and is given as much international (i.e. beyond the boundaries of the EEA) acceptance as is practically achievable. This includes in particular a coordinated approach to the triggers for supervisory powers and tools in the various phases of the crisis management framework. The Institute realises of course that this is a tall order (to say the least), but express recognition of this fact should be given prominent attention in the process of setting up the EU framework.

(d)  Within the framework, the issue of prevalence of the various supervisory authorities involved in a bank failure (supervisory authorities at a EU level, at the home country level, at the host country level) is a complex and divisive issue. A bank in one member state not having systemic importance status may have a subsidiary in another member state that does have that status. It cannot be acceptable to the supervisory authorities of the latter member state to have to submit to the powers of the former member state's supervisory authorities. The Institute believes that prevalence of home member state supervision with ample coordination requirements is probably overall the best principled approach to this difficult dilemma.

(e)  The Institute believes that we should be reluctant to upset the checks and balances relating to creditors' rights that have been developed over the years in the context of bankruptcy law. Bankruptcy laws and in particular the "waterfall of priorities" that these laws impose, have wide variance in the different EU member-states, and it is definitely imperative to achieve a much wider harmonisation than the Winding Up Directive[1] now does. At the same time, however, we must be very careful in analysing the direct and indirect effects that wider discretionary powers of the national and supra-national supervisory authorities might be given, and in assessing whether the resulting interventions as regards third party property rights are commensurate and defensible when weighed against the benefits to be achieved. Intervention in third party property rights should obviously be limited to what is unavoidably necessary.

(f)  The Institute notes that the harmonisation referred to in (e) above is necessitated not just by general considerations, but also by a particular feature of the Winding Up Directive which may entail that national bank insolvency rules will "proliferate" across the European Union. Measures taken by one member-state in relation to a bank insolvency in that member-state, will be effective throughout the Community, according to Article 3 subsection 2 of the Directive. This for instance means that if under a national bank insolvency rule debt obligations can be written off, this will have EU wide effect, therefore arguably also in relation to the international bond markets.[2] This issue needs to be resolved.

(g)  Wherever third party property rights are negatively affected by intervention, adequate compensation techniques should be established. A rule of thumb is that third parties that are the owners or ultimate beneficiaries of the institution in question should only have a compensation right on a fully subordinated basis, but non affiliated third parties should be able to rely on equitable compensation schemes that assure, to the extent practically possible, that in a pre-insolvency situation full compensation of losses actually suffered is achievable and that in a resolution situation, no further losses should be suffered than would have been the case if ordinary insolvency proceedings had been followed. The compensation issue is undoubtedly one of the trickiest issues on the table.

(h)  It is imperative that intervention by the supervisory authorities should be possible without any immediate interference by interested parties. Interested parties' interference jeopardises the speed and effectiveness of intervention. Arguments on legality and proportionality of intervention should only be allowed ex post facto, but this heavily underscores the need for adequate and fair compensation techniques. Undeniably unchallengeable intervention rights for the supervisory authorities deprive interested third parties of an otherwise legitimate remedy, and this deprivation is defensible because the maintenance of the financial infrastructure in a jurisdiction is (at least arguably) of greater public interest than the preservation of third party rights – but at the same time it is only acceptable if balanced by fair and equitable compensation.

(i)  In the determination of the extent of powers to be granted to supervisory authorities to prevent or mitigate bank failures, it will be crucial to gain a thorough understanding of how banks fund their activities, both in terms of equity and debt capital (and intermediate (synthetic) forms of capital), and how intervention rights would affect the ability of banks to secure continued funding at realistic pricing levels and the appetite of financiers to respond to capital calls. The funding of bank activities is hugely complex and varied. We have the impression that insufficient attention is given to these issues in the "Technical Details" document produced by the DG Internal Market and Services.

(j)  In connection with (i), we suspect that, particularly in the current state of the bond markets and capital markets generally, there will be little or no sympathy for the notion that write downs or conversions in to ordinary share capital can be statutorily imposed on any debt instruments other than instruments whose T&Cs already legally provide for such write down or conversion. If this is correct, it would effectively mean that the legal position of current bondholders must be maintained.

(k)  In particular with respect to the preparatory measures and the early intervention phase, private sector solutions should have prevalence over the tools provided by the framework and private sector solutions should, where possible, be promoted by the framework.

(l)  In connection with (k), sufficient reliance should be given to “regular” supervision. A strong and effective crisis management framework should be an ultimate resort toolbox for supervisors and should not be used more generally as an addition to the regular supervisory tools available under the relevant domestic law.

(m)  We believe that restraint should be exercised to grant resolution tools in the "Preparatory and Preventive Phase" in the context of the EU framework over and above the tools available under the "regular" national supervision regime. Banks have an understandable and legitimate reluctance to permit the supervisory authorities to force banks, as it were over the heads of their management, to take measures of strategic impact in these early phases. Perhaps the applicable rules of proportionality would address the concerns of the banks on this point, but a fine balance in the regulations will ideally have to be found to appease these concerns.

(n)  The EU Framework should recognise the unique characteristics, in terms of their capital structure and organisational structure, of cooperative banks. The "Technical Details" document produced by the DG Internal Market and Services focuses largely on banks with stock exchange quoted share capital; however, the said characteristics of cooperative banks should be taken more specifically into account.

(o)  The EU Framework should recognise and absorb important developments that are meanwhile taking place in the market, such as the issuance of "coco's" by financial institutions (Rabobank, Lloyds, CS). These developments should not be jeopardised.

The "bail in proposals" as contained in the Annex to the Consultation Paper are currently at a very generalised level and lack in detail in many respects. The proposals raise significant issues, including in relation to creditor rankings and recoveries in insolvencies. They may also affect banks' costs of funding, and hence the cost of borrowing for bank customers.

These proposals clearly need to be aligned to Basel III and -- to the extent practically feasible – to the US framework in relation to bank capitalisation requirements. We would think this latter objective will be rather difficult to achieve.

We have in this Report below given a few comments on the "bail-in" proposals, but this is clearly a highly complex subject matter that requires significantly more thought and assessment.

(p)  We note finally that it is probably recommendable that in respect of each resolution measure that the EU Framework envisages a cost/benefit analysis is carried out, however difficult it may prove to be to arrive at economically dependable conclusions.

3.  Question Box 1

The question whether investment firms should be subject to the EU Framework is not easy to answer. There may be good arguments to exclude them altogether; one such argument is that that would create much greater clarity of scope of the EU framework and of the functions and responsibilities of the supervisory authorities who have to implement the EU Framework. Another argument could be that as a matter of principle the EU framework is complex to such a large extent that it makes sense only to apply it to systemic relevant financial institutions. See also our general comment under 2 sub (b) above.

In any case, if investment firms are included, we agree with the approach of the European Commission that this only should be necessary to the extent the failure of these investment firms might risk financial stability on a substantial cross-border level. Generally, this is indeed less apparent for investment firms than it is for banks. As the Commission rightly points out, the majority of investment firms are unlikely to be systemically relevant and their failure could well be dealt with under normal insolvency proceedings.