Training on Forecasting, February 6–7

Bail-in to rescue Russian banks

ACRA Senior Director Kirill Lukashuk on statutory solutions for the new proposal by the Ministry of Finance

If the MinFin proposal is implemented, the banking system can soon acquire a new institutionalized financial resolution tool, that is bail-in, which provides for conversion of liabilities into equity. Despite the fact that this tool has been already used in several cases (resolution of Tavricheski Bank and of Fundservicebank), these cases can be accounted for by the close ties between the major creditors and the banks rather than by the full scale use of this financial resolution tool. The main purpose of the bail-in is to protect tax-payers from taking the hit of bank failure (bank rescues funded by the Bank of Russia and/or of the Deposit Insurance Agency) and transfer resolution costs to creditors of failing banks. The efficiency of this tool will enhance not only the banking sector stability, but also the budget performance and trust in the financial system in general.

The news is important for the investors (primarily bank bondholders), as the new tool implementation will raise the issue about the repayment level of their funds if the issuing bank fails. At the same time there are a lot of issues that corporate bank customers will have to deal with: the new tool implementation may lead to tightening of their risk management policy related to cash allocation in credit institutions.

Concern about the cost, which the government has to pay to rescue banks, was particularly deep during the financial crisis in 2008-2009. According to the Financial Stability Board research (Historical Losses and Recapitalization Needs, 2015), rescue program of 13 global banks (including Bear Stearns, Citigroup, Commerzbank) in 2008-2010 costed the governments approximately 21% of their assets (equal to billions of US dollars) and this is only in terms of in direct recapitalization. The gravity of the issue is also tangible in the Russian financial system: bank resolution costed more than Rub 1.4 trillion. Taking into account the regulator’s strong policy this figure is likely to grow.  

Alongside other measures to reduce costs of government-funded rescues, as well as to solve a “too big to fail” dilemma, the international regulators came up with a special tool that will make creditors bear costs of financially unsustainable banks’ resolution (bail-in). This tool became part of the general approach, which aims at increasing the bank’s loss-absorbing and recapitalization capacity. In the US this approach was introduced already at the end of 2013 (described in the Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy (SPOE), a notice by the Federal Deposit Insurance Corporation (FDIC)). The global principles, that is “Principles on Loss-absorbing and Recapitalization Capacity of G-SIBs in Resolution & Total Loss-absorbing Capacity (TLAC) Term Sheet”, were published in November 2015; a year

before the Board published key requirements to the regulatory framework of bank failure prevention.

In Russia bailing-in is not regulated by any law, and its introduction will lead to major changes in the banking and bankruptcy law. There will be several crucial issues.

1. Banks involved. Shall the tool be used only for systemically important financial institutions the list of which shall be provided by the Bank of Russia, or for the banking system on the whole? The first way provides for better transparency in solving “too big to fail” issue, while investors in certain types of debt instruments get a message that they will not be solely exposed to the bank’s financial instability risk and that this risk will be at least shared with them. The second way is less difficult as far as logistics is concerned, for example, there will be no issue related to classifying the bank debt instruments subject to write-down if the bank is excluded from the list of systemically important banks. However, it will increase funding needs of the system in general. If deposit holders understand that their deposits may be bailed-in, they will be less eager to keep money on deposit.

2. Types of financial instruments which may be bailed-in. Creditors will benefit from description of core features of such instruments according to their term, structure and type of holder. Liabilities that are conventionally included in scope of the bail-in tool are uninsured naked debentures exceeding one year. As far as macroeconomic stability is concerned, an important issue arises whether bail-in of such instruments may lead to systemic stress in another economic sector where holders of such instruments are concentrated. In this case the budget burden will only increase.

3. Requirements to new shareholders. Acquisition of more than 10% of the bank shares is subject to prior approval by the Bank of Russia which sets forth eligibility criteria and credit standing criteria to the purchaser. In bail-in the list of the bank’s potential shareholders may contain companies, which do not meet the regulator’s criteria. Efficient functioning of the new tool requires resolution of this conflict. 

4. Powers of the Deposit Insurance Agency and/or the Bank of Russia. The Bank of Russia and/or the Deposit Insurance Agency should have the necessary powers to bail-in, so they could timely restore financial sustainability and operational activity of the failing entity.

5. Disclosure of information on the hierarchy of the bank’s liabilities. Taking into account the existing variety of debt instruments issued by banks, with the emerge of additional type of liabilities subject to bail-in it may become more complicated to determine the order in which liabilities absorb losses in resolution. Disclosure of a complete list of instruments, formed using such factors as subordination order and potentially bail-in or write-down option, will serve a positive sign for creditors (investors). In order to make the bank’s financial standing more transparent, it is advisable to disclose the amount of liabilities that may be bailed-in in their financial statements.

The statutory bail-in procedure may fundamentally impact the bank’s debt instruments credit rating, having diverse pressure on rating of instruments that are exposed to bail-in or fall out of the scope of this tool. As a result, the significant amount of liabilities subject to bail-in may serve as a supporting factor for the credit rating of the financial institution itself.

Generally, we suppose that introduction of the bail-in tool in the Russian banking practice will have a positive influence on the financial stability and lead to redistributing of risks among different types of banks liabilities holders. A more precise evaluation can be made after publishing of the legislation draft.

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