When a bank is in distress, one thing has definitely got out of balance: its balance sheet. In normal circumstances, a balance sheet is, well, balanced. The assets side and liabilities side are of the same size. If an institution is overindebted, however, something has occurred that normally shouldn’t happen. One side of the T-account – the one containing all the institution’s liabilities – is greater than the other, which holds its assets. However, this is not the end of the institution concerned but merely the beginning of the resolution process.

Such a resolution in accordance with the German Recovery and Resolution Act (Sanierungs- und Abwicklungsgesetz – SAG) and the SRM Regulation has not yet been undertaken in Germany. As the country’s national resolution authority, however, BaFin has been preparing for precisely this eventuality since 2018. In a crisis, BaFin would first cancel the institution’s instruments of ownership, which include, for instance, its shares. It would then write down its liabilities in accordance with their insolvency ranking until the assets and liabilities sides of the T-account were back in balance, i.e. were the same size again. Although the overindebtedness would now have been fixed, this would not be enough. Ultimately, the long-term survival of the institution or parts thereof – particularly its critical functions – must be ensured.

For that purpose, the institution now has to be recapitalised, meaning that new instruments of ownership are created by converting liabilities into shares. The institution should then be back in a position to continue its critical functions, and trust in the institution and the financial market should be restored. This would be the ideal course of events in a resolution scheme of this kind, known as a “bail-in”, where shareholders and creditors bear the losses (see info box “Bail-in: a legal perspective”) instead of having the government and tax payers foot the bill (a “bail-out”).

The bail-in is the most important resolution tool in a resolution authority’s tool box. As a general rule, it forms part of every resolution strategy and can be combined with other resolution tools (see info box “Options for resolution”).

The preparation of a bail-in concerns both the resolution authority and the decision-makers at the institutions involved. The authority’s tasks include calculating the write-down and conversion percentages and preparing the administrative act regarding the write-down of liabilities and their conversion into shares.

Amongst other things, the institutions must provide the resolution authority with data relevant to the valuation, conduct an internal impact analysis and execute the bail-in on a technical level in the end.

Cooperation between the resolution authority and the institutions is key to a successful resolution measure: in a crisis situation, everything hinges on automated processes and being able to access information more or less at the touch of a button. This is underpinned by BaFin’s Circulars and Guidance Notices on bail-in implementation (see info box “Groups of addressees”).

Initial versions from 2019

In February 2019, BaFin published a Circular setting out minimum requirements that institutions must meet in order to be deemed resolvable by means of a bail-in. This circular mainly covered the information to be provided and the technical resources and organisational structure of the institutions. These Minimum requirements for implementing a bail-in (Mindestanforderungen zur Umsetzbarkeit des Bail-in – MaBail-in, see expert article on the BaFin website dated 18 March 2019) were followed six months later by the Guidance Notice on external bail-in execution (Merkblatt zur externen Bail-in-Implementierung, see External implementation of a bail-in – step by step on the BaFin website dated 20 September 2019), which focused more closely on the interaction with financial market infrastructures. In an ideal scenario, the overall process for the external implementation of a bail-in is split into 20 operational steps and lasts five working days.

Supplementing the MaBail-in Circular

The first round of amendments is now under way. BaFin will hold consultations on the second version of its MaBail-in until 16 December 2020. Amongst other things, the MaBail-in regulates the data acquisition on the liabilities side. Unlike its first version from 4 July 2019, which initially focused only on liabilities up to and including the senior non-preferred insolvency class,¹ the new version now includes all liabilities eligible for bail-in as a general rule. This is also valid for other liabilities that, although in principle excluded from a bail-in under the law, can also include components eligible for bail-in as at the effective date of the resolution, such as secured liabilities.

Contingent liabilities such as liabilities from legal disputes are still excluded. By contrast, data must be captured on derivatives, securities financing transactions and structured debt instruments.

To enable institutions to handle the extended scope of this information without using up excessive resources, BaFin has added a proportionality component: the Circular allows institutions to restrict the information that they provide to specific insolvency classes. In exceptional cases, it might for instance be sufficient to provide information only on liabilities up to and including the senior non-preferred insolvency class, provided that the institution meets the respective economic requirements. BaFin also added new data points in the MaBail-in, so that it could also supplement its Guidance Notice on external bail-in execution.

Supplementing the Guidance Notice on external bail-in execution

BaFin is also consulting its Guidance Notice on external bail-in execution, and feedback can be provided until 15 January 2021. The first version of the Guidance Notice, published on 1 October 2019, focused initially on a default case scenario. At the pre-conversion stage, for instance, it only considered stock corporations with bearer shares, assumed bonds would only be denominated in euros and was restricted to the activities of the following financial market infrastructures: Clearstream Banking, WM Datenservice and the Frankfurt Stock Exchange.

The second version of the Guidance Notice now extends the focus with regard to procedural and technical terms to cover institutions of all legal forms and all classes of shares, and takes into account foreign-currency bonds. Whereas the discontinuation and suspension of trading previously only covered the regulated market on the Frankfurt Stock Exchange, the new version also covers the suspension of trading on regulated and non-regulated markets of regional exchanges, such as the Stuttgart Stock Exchange.

Previously, the Guidance Notice also assumed that the conversion process at a stock corporation would not modify the class of shares. All that was necessary in order to admit the new shares of the same class to the regulated market was a notification on the features of the new shares from the resolution authority. The “simplified listing application” in the new version now covers all additional scenarios. Besides the class of shares, for instance, the institution’s legal form or stock market listing can change after the resolution process.

What else is new? Unlike the first version, the one currently being consulted includes the option of suspending payments – i.e. for a limited time – during the technical implementation phase. The new version also incorporates pool factor reduction.

Relationship to the MaValuation Circular

Another Circular consulted in 2020 was the one on Minimum requirements for information systems to provide information for valuations in the context of resolution (MaValuation) (Mindestanforderungen an Informationssysteme zur Bereitstellung von Informationen für Bewertungen im Rahmen einer Abwicklung – MaBewertung, see expert article on the BaFin website dated 15 September 2020). This Circular sets out specific requirements for the type of information required for the valuations to be performed in the context of a resolution. It answers the question of what information the institutions must provide for this purpose. Designed to be proportionate, the MaValuation follows a two-step approach: whilst step I looks mainly at existing internal and external standard reports as well as documentation from the bank, in step II BaFin will require a data model from the institutions. Although the current MaValuation does not yet cover step II, there is a close relationship between the MaValuation and the MaBail-in: without valuation results, there can be no bail-in.

As the new version of the MaBail-in extends the data requested to include all liabilities eligible for bail-in, the role of the MaValuation is becoming even more important. This is because the valuers are no longer just responsible for determining the losses, net asset values and recapitalisation requirements of the institution to be resolved: depending on the specific case, they are now also, for example, required to establish bail-in values for structured and/or partially secured instruments and to assess close-out amounts for derivatives and securities financing transactions.

Outlook

The present consultation on the second version of the MaBail-in will not be the last. BaFin is also planning to additionally include internal loss absorption and unrecognised uncertain liabilities in future versions.

In the future, the Guidance Notice on external bail-in execution will look at incorporating the international central securities depositories – Clearstream Banking Luxembourg and Euroclear Bank.

Although the first version of the MaValuation will not be published until January 2021 after the consultation has been completed, the second version is already on the horizon. When it is published, the above-mentioned step II will introduce detailed data requirements alongside an equally detailed data model. In connection with this BaFin will open a dialogue with the institutions in 2021.

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