EU Bank Deposits Over €100,000 Are At Risk If A Bank Fails

What happens if an EU Bank Fails? Can depositors lose their money? Who is protected?

With the recent banking turmoil in the US and in Switzerland I have been asked a few times what would happen if an EU bank got into difficulty and would bank account funds be at risk.

For largely political reasons following the global financial crisis there is strong sentiment in some EU countries that, unlike the recent resolutions in the US, taxpayers should not be on the hook if a bank fails.

The Bank Recovery and Resolution Directive (BRRD) (Directive 2014/59/EU) harmonised rules to prevent and manage crises at banks and investment firms throughout Europe.

The BRRD rulebook is designed to allow orderly crisis management that is more effective and uses private sector resources to buffer the impact on an economy and saving taxpayers’ money.

The financial crisis showed that many EU countries had inadequate tools for managing banking crises, especially for intermediaries with complex organizational structures and a dense network of relations with other financial operators.

To stop a crisis at one bank from spreading uncontrollably, significant public interventions were necessary to safeguard the financial system and the economy but would also involve high costs for States and even jeopardised public financial stability. In addition, it was very hard to coordinate the interventions of the national authorities to deal with the problems of intermediaries operating in more than one country.

What is a bank resolution?

A bank resolution is a restructuring process managed by independent authorities – resolution authorities – that, by using the tools and powers now available under the BRRD, aims to avoid interruption of essential services (for example, deposits and payments), restore the viability of the healthy part of the bank, and liquidate the remaining parts.

When is a bank subject to resolution?

The resolution authorities can place a bank under resolution if all these conditions are met:

• the bank is failing or is likely to fail when, for example, as a result of losses, it has entirely written off its capital or significantly reduced it;
• the authorities are convinced that alternative, private measures (such as capital increases) or supervisory action cannot take effect quickly enough to keep the bank from failing;
• the normal insolvency proceedings would not safeguard the stability of the system, protect depositors and customers or ensure the continuation of critical financial services, so that resolution is required in the public interest.

The resolution tools

The resolution authorities can:

• sell a part of the business to a private buyer;
• transfer assets and liabilities temporarily to a ‘bridge bank’ established and managed by the authorities to continue performing critical functions, with a view to their subsequent sale on the market;
• transfer non-performing loans to a vehicle (‘bad bank’) that will manage their liquidation in a reasonable timeframe,
• apply a ‘bail-in’, i.e. write down equity and other liabilities and convert them into shares to absorb the losses and recapitalize the existing bank or a new bank able to perform the critical functions.

Bail-in

A bail-in is a tool that enables the resolution authorities to write down the value of the shares and reduce some claims payable or convert them into shares to absorb the losses and recapitalise a bank, to restore capital adequacy and maintain market confidence.
The shareholders and creditors cannot, under any circumstances, be required to suffer greater losses than they would incur under normal insolvency proceedings.

What is excluded from a bail-in?

All the following liabilities are excluded from the scope of application. They cannot be written down or converted into shares:

• deposits protected under the deposit guarantee scheme, i.e. of up to €100,000;
• secured liabilities, including covered bonds and other guaranteed instruments;
• liabilities resulting from the holding of customers’ goods or in virtue of a relationship of trust, for example the contents of safe deposit boxes or securities held in a special account;
• interbank liabilities (except those within the same banking group) with an original maturity of less than 7 days;
• liabilities deriving from participation in payment systems with a residual maturity of less than 7 days;
• debts to employees, commercial payables and tax liabilities, provided that they are privileged under bankruptcy law.

Liabilities that have not been expressly excluded can be included in a bail-in.

However, in exceptional circumstances, such as when the bail-in entails a risk for financial stability or jeopardizes critical functions, the authorities may, at their discretion, exclude other liabilities as well. These exclusions are subject to limits and conditions and must be approved by the European Commission. Losses that have not been absorbed by the creditors can be transferred, at the discretion of the authorities, to the Single Resolution Fund, which can intervene up to a ceiling of 5 per cent of total liabilities, provided that a minimum bail-in of 8 per cent of total liabilities has been applied.

What about bank deposits?

Bail-ins are applied according to a ranking where those investing in the riskiest financial instruments will be the first to absorb any losses or have their claims converted into equity. Only when all the resources in the highest-risk category have been deployed can the next category be involved.

Shareholders are sacrificed as the value of their shares is written off. Next, when reducing the value of the shares to zero does not fully cover the losses, the assets of some classes of creditors may be written down or converted into equity to recapitalise the bank.

For example, the holders of bank bonds could find that they have been converted into equity and/or their claim is devalued, but only if the resources of the shareholders and those holding subordinated debt securities (i.e. the riskiest assets) are insufficient to cover the losses and recapitalise the bank, and even then only if an authority has decided not to exercise its discretionary power to exclude this kind of credit in order to prevent contagion and to safeguard financial stability.

For bail-ins, creditors are placed in the following order of priority:

1. Shareholders
2. Holders of other capital instruments
3. Other subordinated creditors
4. Unsecured creditors
5. Individuals and small businesses for the part of their deposits above €100,000 and
6. The deposit guarantee fund, which contributes to the bail-in in the place of guaranteed depositors.

EU legislation (BRRD) takes the approach to bail-ins whereby measures must also be applicable to instruments issued prior to the enactment of the legislation and already in the possession of investors. Accordingly, investors must pay very close attention to the risks attaching to certain kinds of investment.

Retail customers who intend to buy bank securities should first be offered certificates of deposit covered by the Deposit Guarantee Fund instead of bonds, which are subject to bail-in. At the same time, banks must reserve the instruments other than deposits, especially subordinated debt instruments, which come right after shares in absorbing losses, for more expert investors.

Banks must provide timely information to their customers. The information must be provided in great detail at the time of placement of securities issues.

How are depositors protected?

Deposits up to €100,000, which are protected under the Deposit Guarantee Fund, are expressly excluded from bail-ins. This protection applies, for example, to current accounts, savings books, and certificates of deposit covered by the Fund, but it does not apply to other forms of investment, such as the bank’s bonds.

The portion of households’ and small businesses’ deposits above €100,000 also get preferential treatment. These deposits only sustain a loss if all the instruments with a lower insolvency ranking are insufficient to cover the losses and restore capital adequacy.

Retail deposits above €100,000 can also be excluded from the bail-in on a discretionary basis, in order to prevent the risk of contagion and maintain financial stability, on condition that the bail-in has involved at least 8 per cent of total liabilities.