EU proposals for enhancing the EU resolution regime for medium-sized and smaller banks.

The European Commission published proposals for the reform of the EU bank crisis management and deposit insurance (CMDI) framework, on 18 April 2023, with a focus on medium-sized and smaller banks.

After the Global Financial Crisis (GFC) in 2007-8, the EU adopted a number of measures to harmonize and improve the tools for dealing with bank crises in its member countries, while protecting European depositors, known as the European CMDI framework. ?These consist of three EU?legislative texts acting together with relevant European national legislation: the Bank Recovery and Resolution Directive (BRRD – Directive 2014/59/EU), the Single Resolution Mechanism Regulation (SRMR – Regulation (EU) 806/2014), and the Deposit Guarantee Schemes Directive (DGSD – Directive 2014/49/EU).

EU Member States asked the European Commission to take action a year ago to further strengthen the system, to enable action to be taken for all banks, whatever their size. So whilst the European Commission’s review of the CDMI had been underway for some time, it was only published last week.?At its accompanying press conference, the European Commission’s Vice President Dombrovskis noted that "recent failures of some US and Swiss banks and resulting stress in the international banking sector are just a reminder of why we need a strong functioning system to deal with all banks whatever the size when they get into trouble".

Under the CMDI framework, a bank resolution occurs at the point where the authorities determine that a bank is failing or likely to fail (FOLTF), that there is no other supervisory or private sector intervention that can restore the institution to viability within a short timeframe and that normal insolvency proceedings would cause financial instability while having an impact on the public interest.

The European Commission is now seeking to expand the EU’s regime for failing banks to catch more mid-sized lenders, including changing the rules so those banks can tap a rainy-day fund, the Banking Union’s Single Resolution Fund to finance their exit from the market; and enabling EU countries to use Deposit Guarantee Schemes (DGS) — which protect deposits up to €100,000 — upfront, to provide ‘bridge funding’, rather than having recourse to taxpayers’ money and negative consequences on financial stability, and depositor protection.

The European Commission’s proposals include:

(i) Broadening the scope of resolution through a revision of the public interest assessment

?·??????Amending the criteria for the public interest test by having regard to ‘regional’ in addition to ‘national’ when assessing the impact of the disturbance of their discontinuation to the real economy or to financial stability;

and

·??????Clarifying and harmonizing the approach to perform the ‘least cost test’, which determines by which maximum amount a DGS may intervene outside playout, to finance preventive, resolution and alternative measures.

(ii) Strengthening the cooperation between EU supervisors and EU resolution authorities

·??????Providing legal clarification of early warning of FoLTF to facilitate prompter recognition by involved authorities on when a bank needs to be resolved, e.g., immediately after it is recognized that they cannot find a white knight, which should be cheaper in the long term from the perspectives of the depositors and the wider economy.

?(iii)??Amending the hierarchy of claims in insolvency and creating a single depositor preference??

·??????Enhancement of and harmonizing the protection of depositors by introducing a general depositor preference with a single-tiered ranking through two key changes:

o??All deposits to have equal ranking for treatment under insolvency; and

o??All deposits to be treated equally for depositor preference, i.e., all deposits rank pari passu (i.e., at the same level amongst themselves) and above ordinary unsecured claims;

·??????Extending depositor protection to public entities (i.e., hospitals, schools, municipalities), as well as client money deposited in certain types of client funds (i.e., by investment companies, payment institutions, e-money institutions). Also, protection of temporary high balances on bank accounts more than €100,000 linked to specific life events (such as inheritance or insurance indemnities).

Potential impact of the proposed changes

Will it change how banks are rated??

The proposed change to the hierarchy of claims, by enhancing the group of depositor preference preferences, may change how Credit Rating Agencies rate the hierarchy of a bank’s liabilities, and hence potentially impact banks’ overall ratings.

So who pays?

Whilst the European Commission may be seeking to mitigate the need to use the public purse with its proposals, larger banks may be concerned that they would be expected to step in to assist the bolstering of the adequacy of the funding levels for both Deposit Guarantee Schemes and Resolution Funds, were they now to be also used to provide bridging finance to failing banks.

Minimal change to Minimum Requirement for own Funds and Eligible Liabilities (MREL)?

Under the BRRD, resolution authorities set – on a bank-by-bank basis - a minimum requirement for own funds and eligible liabilities (‘MREL’).?MREL is the minimum amount of equity and unsecured debt based on the amount of risk it takes, which would be used to bail the bank in if it is to be resolved. ?The aims of MREL regime are similar to those of the Total loss absorbing capacity (TLAC) standard developed by the Financial Stability Board (FSB). Further, from 2024, banks will have to disclose their MREL requirement set by their supervisor and whether they have reached it. ??

Under its proposals, it would appear that the European Commission remains committed to the MREL principle. It has proposed only a small clarification of the legal basis for MREL for transfer strategies, that, when setting the MREL for leaving the market, it should be proportionate to the circumstances for its proposed use.?

No change to the level of depositor protection coverage

The European Commission has not proposed to change the level of coverage, as set out in the DGSD, for all EU eligible depositors, i.e. it remains at €100,000 per depositor and bank.

So what happens next?

The Commission’s legislative package is now due to be discussed by the European Parliament and Council.?It is envisaged that these negotiations may take around two years, given the controversial nature of some, such as changes to the hierarchy of claims, and funding of DGS.

Moreover, it remains to be seen as to whether further changes are proposed for the regime, in light of the recent collapses of SVB and Credit Suisse.

If you would like to discuss the EU bank crisis management and deposit insurance (CMDI) regime in more detail and how EY can provide practical support in this area, please do not hesitate to contact.

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Disclaimer: The views reflected in this article are the author and do not necessarily reflect the views of the global EY organisation or its member firms.?