Bail-in tool: a comparative analysis of the institutions' approaches

18 October 2013

Cover note
Disclaimer
This is a working paper produced by the services of the Commission. It does not represent a formal position of the Commission. The analysis relies on publicly available data but contains a series of assumptions which may or may not hold in practice.

Introduction
In the context of the trilogues on the Bank Recovery and Resolution Directive (BRRD), the European Parliament and Council have asked Commission services to provide a comparative analysis of the bail-in tool and its inter-relationship with resolution funds and state support under the ECON report and the Council General Approach. Requests have also been made to assess how the approaches would fare in a future crisis. This note provides an overview of how they would have worked in the past crisis had they been in place, and how they could fare in a crisis of similar magnitude today. Bail-in is a key resolution tool in the BRRD. It would allow to write-down debt owed by a bank to creditors or to convert it to equity. It could be used in the event of a failure of a systemic bank. By replicating how creditors would incur losses if the bank had gone bankrupt, it reduces the value and amount of liabilities of the failed bank. It thereby avoids taxpayers from having to provide funds to cover these liabilities, while allowing for the critical functions of the bank (e.g. deposit-taking, lending, operation of payment systems) to continue uninterrupted, either in a new entity such as a bridge bank or in the same, albeit significantly restructured franchise. Resolution funds are another key feature of the BRRD framework. They would be newly set-up funds built-up through regular payments by banks based on their size and risk-profile. Their main function would be to provide medium-term support such as loans or guarantees to help the resolved bank regain financial viability. In the Council General Approach, they have also been explicitly given a potential role to contribute funds in lieu of some creditors who would otherwise have been bailed-in. In the Commissions proposal this role is more implicit and available only as a last resort, namely when owners and creditors have already been written down and it would be necessary to help ensure successful resolution in a systemic scenario.

Assessment
Both the ECON and Council approaches protect depositors covered up to 100 000 EUR by Deposit Guarantee Schemes (DGS) from suffering any losses. Both also assume full loss absorption by capital instruments as per the Capital Requirements Regulation (CRR). They both reflect the Commissions proposal in this respect. Beyond this, the analysis confirms the strong inter-relationship between: (i) Which other liabilities in banks balance sheets can be bailed in if needed, i.e. are not excluded by way of outright or discretionary exclusions; and (ii) How much funding would be needed from resolution funds or from the public purse to compensate for liabilities excluded from bail-in. 2

In general, the more liabilities are subject to bail-in without exclusion, the less is needed from resolution funds or from the state. However, both the ECON and Council approaches introduce considerable flexibility to depart from comprehensive bail-in. This is intended to allow for contributions from resolution funds or the state to replace some creditors such as bond-holders or uncovered depositors from being bailed-in, notably to prevent and, if necessary, to manage a systemic crisis affecting the banking sector more broadly. The ECON report proposes to allow for state support immediately after loss absorption by capital instruments in such cases. It also gives, in all cases, preference to eligible depositors in the bail-in hierarchy and excludes the DGS from having to contribute at all (which would otherwise contribute an amount equal to what it would have suffered on behalf of covered depositors in a liquidation of the bank). The Council General Approach provides for flexibility to replace loss absorption by some senior creditors and potentially all eligible depositors with a contribution from resolution funds, provided that 8% of liabilities have already been bailed-in, and only up to 5% of total liabilities. It also gives preference to eligible deposits from natural persons and small businesses and, above these, super-preference to the DGS. The corollary of the ECON and Council approaches is the need for a bigger resolution fund (the state support provided for in the ECON report is assimilated here to funding from the resolution fund). Indeed, both approaches provide for bigger resolution funds than in the Commissions proposal, namely 3% and 1.3% of covered deposits in the ECON and Council approaches respectively. By contrast, the Commissions proposal as well as the subsequent choice to opt for preference for eligible depositors in the hierarchy of claims provided minimal flexibility to depart from the comprehensive bail-in of liability-holders. Recourse to resolution funds would also be lower. In the original proposal a comparatively larger share of the losses would have been incurred by eligible depositors and the DGS. With a preferred ranking for eligible depositors, i.e. all who are not excluded from coverage by DGS irrespective of the amount, losses would fall commensurately more on other un-preferred and unsecured senior creditors. The latter would be subordinated to eligible depositors and the DGS, who would only assume the burden of absorbing losses afterwards. When assessed against the aid to cover excessive losses and build capital buffer given to EU banks in the past crisis (473bn EUR from 2008 to 2012), all three approaches would, in the case of an average bank, have ensured sufficient loss-absorbing capacity through the write-down of capital instruments, bail-in and contributions from resolution funds. However, this conclusion rests on some notable assumptions. It assumes fully built-up or operational resolution funds, which will take time. Crucially, it also rests on the mutualisation of national resolution funds which could be deployed where needed in the EU. Otherwise, the results would only be valid for the losses that occur evenly across the EU, whereas clearly this has not been the case. This proposal by the Commission has so far not been endorsed by the Parliament or Council. Equally importantly, it assumes the availability of bail-in as a resolution tool, while this may not be the case until 2018. In the case of the ECON approach, it also assumes the ability of public finances to withstand replacing the resolution fund in a systemic crisis. Finally, differences in banks liability-structures can be decisive in whether the combination of bail-in and resolution funds 3

would suffice or whether exclusions for specific bank-liabilities, for derivatives say, would render the combination inadequate. Therefore, in a future crisis of similar magnitude to the past one, it cannot be foreseen with certainty whether all three approaches would work in all cases. However, what can be said is that most banks today appear to have enough capital and bail-in-able liabilities to withstand losses in non-extreme cases without resorting to resolution funds or state support. To cater for more extreme and asymmetric cases a single fund is instrumental in order to help ensure this. It may also be necessary to circumscribe the flexibility to replace liabilities with contributions from resolution funds or the state as provided in the Council and ECON approaches, as well as to strengthen the need to ensure sufficient bail-in-able liabilities as part of big banks Minimum Requirement for Eligible Liabilities (MREL) at all times. Finally, the calculation basis of MREL matters and it should be neutral as to types of banks. Excluding specific liabilities such as covered bonds and derivatives from counting toward MREL, as the ECON and Council approaches respectively do, could excessively incentivise banks to try to fund themselves via these instruments. For example, the exclusion of derivatives could excessively favour big trading banks and complicate efforts to ensure sufficient MREL for them.

Conclusion
Given the above considerations, co-legislators should aim to ensure adequate bail-in-able capacity at all times, and restrict the flexibility to depart from this to limited cases. It is also important to incentivise investors to exert discipline and improve certainty for them, and avoid unintended consequences such as spurring moral hazard by creating an excessively large resolution fund.

Annex. A comparative analysis of the institutions' approaches to bail-in

Annex. A comparative analysis of the institutions' approaches to bail-in ...................................... 5 1. Scope and sequence of bail-in................................................................................................. 7 2. Impact on bail-in capacity: assessment of approaches ........................................................... 9 2.1. Methodology used to cluster data for the liability structure of EU Banks ....................... 9 2.2. Overview of bail-in capacity in banks ............................................................................. 11 2.3. Impact of bail-in on a bank type: 25% loss scenario ...................................................... 14 2.4. Impact of bail-in on a bank type: 10% loss scenario ...................................................... 24 3. Back-testing: assessment of approaches .............................................................................. 32 3.1. Summary results from the back-testing exercise ........................................................... 32 3.2. Methodology for the back-testing exercise ................................................................... 33 3.3. The Council General Approach ....................................................................................... 34 3.4. The Commission proposal .............................................................................................. 37 3.5. The European Parliament's approach ............................................................................ 40 3.6. Deviation from the assumption of the symmetric crisis ................................................ 42 4. Minimum Loss Absorption Capacity: definitions and implications ....................................... 43 Appendix 1. Data used in the back-testing analysis .................................................................. 45

In view of trilogue discussions on the proposed Directive on Bank Recovery and Resolution (BRR)1, the European Parliament and Council have asked the Commission to provide a comparative analysis of the bail-in tool under the Commission proposal (COM), under the general approach adopted by the Council (CN) and under the approach put forward by the Parliaments ECON committee (EP). Bail-in is one of the key elements of the BRRD framework. It sets out the key principles and rules that should ensure that in the future, banks will bear the primary responsibility for their failures. This shall send a clear signal that while a bank failure may come as a surprise, dealing with its consequences should however be as clear and predictable as possible. The comparative analysis of the three approaches to bail-in presents: 1) The assessment of bail-in capacity under different approaches, including the impact per type of a bank; 2) The results of the back-testing exercise, i.e. how losses incurred so far during the current crisis would have been absorbed in individual banks by different liabilities' instruments and how much would have been left to absorb by deposit guarantee schemes and resolution funds or in their absence by public finances; 3) Impact of the three definitions on the level of minimum Loss Absorbing Capacity.

COM(2012) 280 final.

1. Scope and sequence of bail-in

All three approaches define to varying degrees what liabilities are able to bear losses and to what extent. This is achieved through a combination of mandatory and discretionary exclusions of certain liabilities from bail-in and through determination of the sequence in which those liabilities that will remain in scope will be bail-in-able. 1.1. Mandatory exclusions All three institutions widely agree to exclude covered and secured liabilities and deposits as well as some specific liabilities (to employees, commercial creditors, social security, etc). All three institutions exclude short term liabilities but scope differs: COM excludes all liabilities under 1 month, EP excludes all interbank and money market liabilities with the same 1 month original term and CN excludes interbank liabilities with original maturity less than 7 days and payment system liabilities with remaining maturity of 7 days. Only EP excludes the DGS as well as liabilities to DGS from bail-in. 1.2. Discretionary exclusions COM and EP exclude liabilities arising from derivatives when justified by the need to ensure inter alia continuation of critical or core functions or financial stability. CN does not propose any specific derogation for derivative liabilities. Both CN and EP allow banks under certain extreme circumstances to exclude fully or partially any type of eligible liability. CN however requires banks to respect no-creditor-worse-off principle if losses that would fall on excluded liabilities are to be absorbed by those nonexcluded ones. Should there be still some losses remaining afterwards, banks are allowed to resort to Resolution Fund for a maximum of 5% of total assets under the condition that banks absorb losses up to a minimum of 8% of their total assets. EP also in extreme crisis situations allows for state support to replace eligible liabilities. 1.3. Bail-in sequence COM amended approach provides for a preference in the bail-in hierarchy to the DGS as well as to all depositors that are not excluded. Non-excluded deposits of banks or other institutions remain pari-passu with senior unsecured debt. CN also gives preference to DGS which has super-senior status above preferred depositors such as SMEs and retail. The same preference as SMEs deposits is awarded to liabilities of EIB. In addition to EP exclusion of DGS (subrogating to covered depositors) in bail-in, it gives all other depositors, including those of credit institutions, senior status to other senior unsecured liabilities.

Figure 1.1. Bail-in sequence under the institutions' approaches

2. Impact on bail-in capacity: assessment of approaches

2.1. Methodology used to cluster data for the liability structure of EU Banks
The ideal data for an accurate exercise is not publicly available. In general, bank disclosures on the liability structure are not sufficiently granular. There are not disclosures distinguishing between creditors that will be subject to EU regulation and those who will be subject to third countries one. This is especially relevant for banks with stand-alone subsidiaries outside the EU. Moreover, the split between senior unsecured and secured debt data is not disclosed in consolidated annual reports, nor are disclosed the maturity of unsecured senior debt and the interbank deposits. Furthermore, the amount of covered deposits and SME and retail noninsured deposits is not individually disclosed on a regular basis. The amount of Repurchase agreements in the liability part is not reported either. To overcome these constraints a mix of public data from 3 different data sources has been used. Senior unsecured debt is reported in private databases such as Bloomberg and Dealogic. Adjustments to reconcile these sources have been made in order to reconcile with banks annual reports. The Repurchase agreements data is taken from Standard & Poors. Three key assumptions have been made on deposits structure, first, interbank deposits under 7 days will be 66% and deposit under 1 month will be 85% of the total interbank deposits2. Secondly, 50% of customer deposits are assumed to be covered by the DGS (based on an average of the survey of the European Commission in 2010). Thirdly, deposits of SMEs and individual persons above 100.000 EUR are assumed to be 25% of deposit from the public. The overall assumption is that all the banks have the same above mentioned proportions. In any case the outcome of these assumptions seems to be in line with industry reports.3 Raw data on banks' balance sheets comes from 45 EU banks for the end of 2012, with an aggregated total assets of almost 28 EUR trillion (ranking from 24 EUR bn to 2042 EUR bn total assets) and make up around 70% of total banking assets in the Union4. The different liabilities types and their specific sources are: Total Equity (Source: Annual Report), Subordinated Debt (Source: Annual Report), Senior debt Unsecured of which less than 1 Month (Source: Bloomberg DDIS Screen) of which more than 1 Month (Annual reports minus Bloomberg DDIS Screen), Total Deposits(Source: Annual Report), Deposits by credit institutions (Source: Annual Report), Deposits and borrowings from the public (Source: Annual Report), Derivative Liabilities (Source: Annual Report), Repurchase agreements (Source: S&P) and Senior debt Secured (Source: Bloomberg DDIS Screen). In order to analyse the impacts of the three bail-in approaches on different types of banks, balance sheets of the 45 EU banks have been put together into 4 groups based on their key characteristics. The first group are big banks (25) and the other one are medium to small types
2

ECB April 2012 : Changes in bank financing patterns, http://www.ecb.europa.eu/pub/pdf/other/changesinbankfinancingpatterns201204en.pdf

3

Autonomus, July 2013: European Banks Bail-in modest progress Source: ECB, DGS 2010 Survey, European Commission elaborations

of banks (20). Big banks in the group of 25 are those that have more than 300 billion EUR of total assets on their balance sheet. The rest of them have been allocated to the group of medium banks. Secondly, we have created two more groups of banks based on whether their source of funding comes from whole-sale markets or from deposits. On the basis of these additional criteria we have created two more groups of banks: Big banks-market and Big banksretail. Market oriented banks (9 out of 25) in our sample are those that whose ratio of derivative liabilities over total assets is higher than 15%. Retail oriented banks (13 out of 25) are then those whose ratio of customer deposits over total assets is higher than 30%. Medium banks in this sample are biased towards those which disclose all the relevant data to pursue the analysis, normally this might mean the more solvent ones. Table 2.1. Liability structure per type of bank (EUR m, 2012YE)
Average Banks Total Assets Total Equity Subordinated Debt Senior Unsecured debt >1 Month Senior Unsecured debt < 1 Month (discret. exempt. COM) Deposits of credit institutions Deposits of credit institutions >7days-CN * Deposits of credit institutions > 1Month-EP, COM* Deposits and borrowings from the public Deposits from public non insured and not SME/retail**,*** DGS** SME/retail deposits*** Derivative Liabilities (discret. exempt.) REPOs-Exempted Senior debt Secured-Exempted Other non fin liabilities-Exempted Total 619,250 27,705 9,490 42,652 12,606 60,790 20,669 9,118 196,689 49,172 98,345 49,172 97,340 35,146 39,598 97,233 619,250 Big Banks 979,564 46,887 16,046 62,706 22,509 94,632 32,175 14,195 342,876 85,719 171,438 85,719 171,579 62,077 57,161 103,091 979,564 Medium Banks 8,457 2,460 27,943 369 33,727 11,467 5,059 45,456 11,364 22,728 11,364 9,757 5,489 26,279 8,920 Big Banks- Big BanksMarket Retail 778,651 45,836 16,347 55,301 21,929 71,298 24,241 10,695 354,508 88,627 177,254 88,627 64,176 34,690 44,099 70,467 778,651 52,848 17,528 64,849 25,724 145,725 49,546 21,859 338,269 84,567 169,134 84,567 362,424 111,507 70,311 178,716 168,857 1,367,900

168,857 1,367,900

Source: see section 2.1 Table 2.2. Liability structure per type of bank (% of Total Assets, 2012YE)
Average Banks Total Assets ( m) Total Equity Subordinated Debt Senior Unsecured debt >1 Month Senior Unsecured debt < 1 Month (discret. exempt. COM) Deposits of credit institutions Deposits of credit institutions >7days-CN * Deposits of credit institutions > 1Month-EP, COM* Deposits and borrowings from the public Deposits from public non insured and not SME/retail**,*** DGS** SME/retail deposits*** Derivative Liabilities (discret. exempt.) REPOs-Exempted Senior debt Secured-Exempted Other non fin liabilities-Exempted Total 619,250 4.5% 1.5% 6.9% 2.0% 9.8% 3.3% 1.5% 31.8% 7.9% 15.9% 7.9% 15.7% 5.7% 6.4% 15.7% 100.0% Big Banks 979,564 4.8% 1.6% 6.4% 2.3% 9.7% 3.3% 1.4% 35.0% 8.8% 17.5% 8.8% 17.5% 6.3% 5.8% 10.5% 100.0% Medium Banks 5.0% 1.5% 16.5% 0.2% 20.0% 6.8% 3.0% 26.9% 6.7% 13.5% 6.7% 5.8% 3.3% 15.6% 5.3% 100.0% Big Banks- Big BanksMarket Retail 778,651 5.9% 2.1% 7.1% 2.8% 9.2% 3.1% 1.4% 45.5% 11.4% 22.8% 11.4% 8.2% 4.5% 5.7% 9.0% 100.0% 3.9% 1.3% 4.7% 1.9% 10.7% 3.6% 1.6% 24.7% 6.2% 12.4% 6.2% 26.5% 8.2% 5.1% 13.1% 100.0%

168,857 1,367,900

Source: see section 2.1 10

2.2. Overview of bail-in capacity in banks

Table 2.3 together with Figure 2.1 depict the maximum bail-in capacity the four groups of banks would have on average when applying the three approaches as regards the resulting bail-in capacity and sequence of bail-in. If there would be no use of resolution fund to absorb losses for some excluded liabilities, then both COM5 and CN approach (without recourse to any flexibility) would leave banks with nearly about 50% of their liabilities eligible for bail-in (including the DGS substituting for covered deposits) whereas under the EP approach (under non-systemic scenario) the capacity would be only about 30% on average for the sample of 45 banks, primarily due to the exclusion of covered deposits from bail-in. COM and EP approach appear to have comparable levels of the bail-in buffer across the four bank types in a range of 11%-26% (COM) and 12%-23% (EP) before one would need to bail-in preferred deposits. CN approach at this stage appears to generate on average 10 percentage points more bail-in-able liabilities than COM and EP across the four bank types in a range of 22%-37%. This is largely explained by a substantial share of non-preferred customer deposits and by the shorter thresholds as regards maturities of deposits of credit institutions and other senior unsecured debt. Moreover, it should be kept in mind that the loss-absorption capacity of the CN approach would increase further thanks to the possible contribution of resolution fund of up to 5% (of the total assets) and possibly even more before the losses would have to be absorbed by preferred deposits. Overall, based on average losses experienced during the financial crisis, it appears that in a vast majority of cases banks in the sample would have enough capacity on their balance sheets to absorb the amount of losses and recapitalize, except for the EP crisis scenario, which would limit the bail-in buffer only to capital and its instruments.

COM amended approach that provides for depositor preference

11

Table 2.3. Overview of bail-in capacity

Number of banks in a sample Total Equity (EP systemic) Subordinated Debt EP, COM, CN COM, EP, CN senior unsecured > 1M CN, EP senior unsecured < 1M COM deposits non-preferred CN deposits non-preferred EP deposits non-preferred COM capital, unsecured and deposits CN capital, unsecured and deposits EP capital, unsecured qnd deposits European Medium Big Bank - Big Bank Big Banks Banks Banks market retail (25) (45) (20) (9) (13) 4.5% 1.5% 6.0% 7% 2% 1% 11% 0% 14% 26% 15% 32% 8% 16% 17% 46% 50% 32% 54% 50% 68% 96% 4.8% 1.6% 6.4% 6% 2% 1% 12% 0% 14% 27% 15% 35% 9% 18% 19% 49% 53% 34% 51% 47% 66% 95% 5.0% 1.5% 6.5% 17% 0% 3% 14% 0% 26% 37% 23% 27% 7% 13% 16% 53% 57% 40% 47% 43% 60% 95% 3.9% 1.3% 5.1% 5% 2% 2% 10% 0% 11% 22% 12% 25% 6% 12% 14% 36% 40% 26% 64% 60% 74% 96% 5.9% 2.1% 8.0% 7% 3% 1% 15% 0% 16% 32% 18% 46% 11% 23% 24% 62% 67% 42% 38% 33% 58% 94%

Equity + Sub Debt Capital buffer

Senior unsecured + nonpreferred deposits

Buffer before preferred deposits

COM preferred deposits CN preferred deposits (SMEs, retail) Prefered deposits CN preferred DGS EP preferred deposits Total bail-in-able liabilities COM Total capacity incl Preferred CN Total capacity incl Preferred including preferred EP1 Total capacity incl Preferred deposits COM exclusions CN exclusions EP exclusions EP(systemic) exclusions

Total liabilities excluded

Source: Based on average liability structure of banks presented in Tables 2.1 and 2.2

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CONFIDENTIAL Figure 2.1. Bail-in sequence

CONFIDENTIAL 13

2.3. Impact of bail-in on a bank type: 25% loss scenario

This section provides an assessment of how each approach is able to deal with huge losses on individual bank per type of the bank on the basis of the currently observed average liabilities structure. For the simulation exercise a threshold of 25% of losses, including recapitalisation needs, has been chosen. 4 out of 32 banks (12.5%) in the back-testing analysis (see Annex 1) had higher losses, whereas 28 banks (87.5%) had lower losses. 2.3.1. Bail-in: average big bank vs medium size bank Medium/small banks have on average slightly more capital and subordinated debt than an average big bank. The biggest difference between their liabilities structures arises from the unsecured senior debt, which medium banks have more than double compared to big banks. This difference impacts the sequence in which individual classes of liabilities would absorb losses for each approach given 25% loss scenario. Under the CN approaches, 5% of flexibility would be sufficient not to reach deposits in medium/small banks, whereas for big banks this would require a resolution fund to contribute with a total of 5.9% of total assets of the bank under resolution (see Figure 2.4 and 2.6). CN 0% flexibility in both an average big and medium bank would avoid the recourse to RFs and DGSs. Under EP systemic crisis scenario, the contribution from RFs to both big and small/medium banks is substantial respectively, 20.2% and 20% of total assets. In EP's non-systemic crisis, uncovered depositors would have to contribute on average 9.1% of total assets to the resolution of big banks, but only 1.5% in small/medium size bank. The big differences in average total assets for these two types of banks (big bank: 1 EUR trillion vs medium: 170 EUR billion) translates into big differences in the absolute amounts of loss absorption. In CN general approach, the resolution fund would need to contribute to a big bank on average up to 60 EUR billion, depending on the flexibility pursued. For medium banks this would be on average 8 EUR billion. In the same vein, uncovered deposits would have to contribute only 0.7% (7 EUR billion) under CN approach with higher flexibility than 5% whereas with limited 5% flexibility depositors would be haircut by about 1.6% or 16 EUR billion in a big bank. Under the EP non-systemic bail-in, uncovered depositors would need to contribute on average 9.1% (90 EUR billion) in a big bank failure and only 1.5% (2.5 EUR billion) in a medium/small bank failure. The EP non-systemic crisis scenario is very similar to CN 0% flexibility scenario. Both would likely avoid the use of RFs and DGSs. Under the EP systemic crisis scenario, depositors would not be haircut. However the resolution fund would need to contribute on average nearly 200 EUR billion for a big bank, in comparison to 34 EUR billion for a medium bank.

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Table 2.4. 25% loss absorption in an average big bank (% of total assets)
6

Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

0% flexibility

Capital Subordinated debt Senior debt7 RFs Senior debt Uncovered customer deposits8 Covered deposits / DGS RFs Total

4.8% 1.6% 3.4% 0.0% 0.0% 7.6% 7.6% 0.0% 25.0%

4.8% 1.6% 7.9% 0.0% 0.0% 5.4% 5.4% 0.0% 25.0%

4.8% 1.6% 0.9% 5.0% 11.1% 0.7% 0.0% 0.9% 25.0%

4.8% 1.6% 0.9% 5.0% 11.1% 1.6% 0.0% 0.0% 25.0%

4.8% 1.6% 10.7% 0.0% 0.0% 7.9% 0.0% 0.0% 25.0%

4.8% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 20.2% 25.0%

4.8% 1.6% 9.5% 0.0% 0.0% 9.1% 0.0% 0.0% 25.0%

Table 2.5. 25% loss absorption in an average big bank (EUR, bn) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total
6

47,019 15,673 33,378 0 0 74,410 74,410 0 244,891

47,019 15,673 76,896 0 0 52,652 52,652 0 244,891

47,019 15,673 9,058 48,978 108,294 6,615 0 9,253 244,891

47,019 15,673 9,058 48,978 108,294 15,869 0 0 244,891

47,019 15,673 105,294 0 0 76,905 0 0 244,891

47,019 0 0 0 0 0 0 197,872 244,891

47,019 15,673 92,642 0 0 89,556 0 0 244,891

Under CN 5% and >5% flexibility it has been assumed that intervention from RF excluded non-preferred eligible customer deposits from bail-in.
7

Including also bail-inable deposits of credit institutions The ratio between uncovered and covered customer deposits has been assumed to be 1

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Table 2.6. 25% loss absorption in an average medium size bank (% of total assets) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

5.0% 1.5% 7.8% 0.0% 0.0% 5.4% 5.4% 0.0% 25.0%

5.0% 1.5% 18.5% 0.0% 0.0% 0.0% 0.0% 0.0% 25.0%

5.0% 1.5% 1.2% 5.0% 12.0% 0.3% 0.0% 0.0% 25.0%

5.0% 1.5% 1.2% 5.0% 12.0% 0.3% 0.0% 0.0% 25.0%

5.0% 1.5% 14.4% 0.0% 0.0% 4.1% 0.0% 0.0% 25.0%

5.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 20.0% 25.0%

5.0% 1.5% 17.0% 0.0% 0.0% 1.5% 0.0% 0.0% 25.0%

Table 2.7. 25% loss absorption in an average medium size bank (EUR, bn) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

8,443 2,533 13,123 0 0 9,058 9,058 0 42,214

8,443 2,533 31,239 0 0 0 0 0 42,214

8,443 2,533 1,969 8,443 20,263 564 0 0 42,214

8,443 2,533 1,969 8,443 20,263 564 0 0 42,214

8,443 2,533 24,282 0 0 6,957 0 0 42,214

8,443 0 0 0 0 0 0 33,771 42,214

8,443 2,533 28,753 0 0 2,485 0 0 42,214

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2.3.2 Bail-in: big retail vs big wholesale banks Big retail banks have on average more capital, more subordinated debt as well as more senior unsecured debt (around 50% more) than big wholesale banks. In addition, there are considerable differences as to the share of derivatives and deposits they have on the balance sheet which then considerably impact the sequence in which individual classes of liabilities would absorb losses for each approach given 25% loss scenario. Under all three CN approaches big retail banks have already 8% of loss absorption covered by capital and subordinated debt, whereas big wholesale banks would need in addition to bail-in part of the senior unsecured debt before the resolution fund can be used. For big retail banks 5% of flexibility would be sufficient not to reach deposits. On the contrary, for big wholesale banks the contribution of 8.5% of total assets from resolution fund would be required (see Figure 2.8 and 2.10). Under EP systemic crisis scenario, the difference as regards the use of the resolution fund is material 2% of total assets more in big wholesale banks. Moreover, in EPs non-systemic crisis scenario, the contribution to bail-in by uncovered depositors at big retail banks would on average be a half of the contribution in big wholesale banks (6.7% vs 11.7%). The difference in total assets for these two types of big banks (retail bank: 780 EUR billion vs wholesale bank: 1.37 EUR trillion) translates into rather big absolute amounts of loss-absorption. In CN general approach, the resolution fund would need to contribute to a resolution of a big wholesale bank up to 117 EUR billion (8.5% of total assets), depending on the flexibility pursued. For big retail banks this would amount to 39 EUR billion. In the same vein, uncovered depositors in a big retail bank would under both CN approaches that allow for flexibility to use RF (5% or above 5% of banks total assets) not suffer any losses but uncovered deposits in big wholesale bank would be haircut between 14 EU billion and 63 EUR billion depending on the flexibility pursued. 0% flexibility scenario would double the contribution by uncovered deposits further to 131 EUR billion, but would avoid the use of resolution funds for loss absorption in big wholesale banks. Under the EP systemic crisis scenario, depositors would not be impacted. However, resolution funds would need to contribute on average 289 EUR billion in a wholesale bank, in comparison to 149 EUR billion in a big retail bank. The EP non-systemic crisis scenario is very similar to CN 0% flexibility scenario. Both would likely avoid the use of RFs and DGSs and contributions of senior unsecured debt and uncovered deposits would not differ substantially between these two types of banks up to 2%. Under the EP approach uncovered depositors would need to contribute to loss absorption on average 160 EUR billion in a big wholesale bank and 52 EUR billion in a big retail bank.

17

Table 2.8. 25% loss absorption in an average big wholesale bank (% of total assets) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

3.9% 1.3% 4.0% 0.0% 0.0% 7.9% 7.9% 0.0% 25.0%

3.9% 1.3% 6.3% 0.0% 0.0% 6.8% 6.8% 0.0% 25.0%

3.9% 1.3% 1.7% 5.0% 8.5% 1.1% 0.0% 3.5% 25.0%

3.9% 1.3% 1.7% 5.0% 8.5% 4.6% 0.0% 0.0% 25.0%

3.9% 1.3% 10.2% 0.0% 0.0% 9.6% 0.0% 0.0% 25.0%

3.9% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 21.1% 25.0%

3.9% 1.3% 8.1% 0.0% 0.0% 11.7% 0.0% 0.0% 25.0%

Table 2.9. 25% loss absorption in an average big wholesale bank (EUR bn) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

53,348 17,783 55,007 0 0 107,919 107,919 0 341,975

53,348 17,783 86,178 0 0 92,333 92,333 0 341,975

53,348 17,783 23,868 68,395 115,931 14,433 0 48,217 341,975

53,348 17,783 23,868 68,395 115,931 62,650 0 0 341,975

53,348 17,783 139,526 0 0 131,318 0 0 341,975

53,348 0 0 0 0 0 0 288,627 341,975

53,348 17,783 110,976 0 0 159,868 0 0 341,975

18

Table 2.10. 25% loss absorption in an average big retail bank (% of total assets) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

5.9% 2.1% 2.7% 0.0% 0.0% 7.2% 7.2% 0.0% 25.0%

5.9% 2.1% 8.5% 0.0% 0.0% 4.3% 4.3% 0.0% 25.0%

5.9% 2.1% 0.0% 5.0% 12.0% 0.0% 0.0% 0.0% 25.0%

5.9% 2.1% 0.0% 5.0% 12.0% 0.0% 0.0% 0.0% 25.0%

5.9% 2.1% 9.1% 0.0% 0.0% 7.9% 0.0% 0.0% 25.0%

5.9% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 19.1% 25.0%

5.9% 2.1% 10.3% 0.0% 0.0% 6.7% 0.0% 0.0% 25.0%

Table 2.11. 25% loss absorption in an average big retail bank (EUR bn) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

45,940 16,352 20,766 0 0 55,802 55,802 0 194,663

45,940 16,352 65,952 0 0 33,209 33,209 0 194,663

45,940 16,352 0 38,933 93,438 0 0 0 194,663

45,940 16,352 0 38,933 93,438 0 0 0 194,663

45,940 16,352 70,609 0 0 61,762 0 0 194,663

45,940 0 0 0 0 0 0 148,722 194,663

45,940 16,352 80,225 0 0 52,145 0 0 194,663

19

Figure 2.2. 25% loss absorption under the Commission's approach (no depositor preference).

Figure 2.3. 25% loss absorption under the Commission's approach (WITH depositor preference).

20

Figure 2.4. 25% loss absorption under the Council approach (MORE THAN 5% flexibility).

Figure 2.5. 25% loss absorption under the Council approach (5% flexibility).

21

Figure 2.6. 25% loss absorption under the Council approach (0% flexibility).

Figure 2.7. 25% loss absorption under the European Parliament's approach (systemic crisis scenario).

22

Figure 2.8. 25% loss absorption under the European Parliament's approach (NON-systemic crisis scenario).

23

2.4. Impact of bail-in on a bank type: 10% loss scenario

Table 2.12. 10% loss absorption in an average big bank (% of total assets) Council General Approach9
>5% Flexibility 5% Flexibility 0% flexibility

Commission proposal
NO depositor preference WITH depositor preference

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt10 RFs Senior debt Uncovered customer deposits11 Covered deposits / DGS RFs

4.8% 1.6% 0.7% 0.0% 0.0% 1.5% 1.5% 0.0%

4.8% 1.6% 3.6% 0.0% 0.0% 0.0% 0.0% 0.0%

4.8% 1.6% 0.9% 2.0% 0.0% 0.7% 0.0% 0.0%

4.8% 1.6% 0.9% 2.0% 0.0% 0.7% 0.0% 0.0% 10.0%

4.8% 1.6% 2.1% 0.0% 0.0% 1.5% 0.0% 0.0% 10.0%

4.8% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 5.2% 10.0%

4.8% 1.6% 3.6% 0.0% 0.0% 0.0% 0.0% 0.0% 10.0%

Total 10.0% 10.0% 10.0% Table 2.13. 10% loss absorption in an average big bank (EUR, bn) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

47,019 15,673 6,460 0 0 14,402 14,402 0 97,956

47,019 15,673 35,264 0 0 0 0 0 97,956

47,019 15,673 9,058 19,591 0 6,615 0 0 97,956

47,019 15,673 9,058 19,591 0 6,615 0 0 97,956

47,019 15,673 20,379 0 0 14,885 0 0 97,956

47,019 0 0 0 0 0 0 50,937 97,956

47,019 15,673 35,264 0 0 0 0 0 97,956

Under CN 5% and >5% flexibility it has been assumed that intervention from RF excluded non-preferred eligible customer deposits from bail-in.
10

Including also bail-inable deposits of credit institutions The ratio between uncovered and covered customer deposits has been assumed to be 1

11

24

Table 2.14. 10% loss absorption in an average medium size bank (% of total assets) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

5.0% 1.5% 1.5% 0.0% 0.0% 1.0% 1.0% 0.0% 10.0%

5.0% 1.5% 3.5% 0.0% 0.0% 0.0% 0.0% 0.0% 10.0%

5.0% 1.5% 1.2% 2.0% 0.0% 0.3% 0.0% 0.0% 10.0%

5.0% 1.5% 1.2% 2.0% 0.0% 0.3% 0.0% 0.0% 10.0%

5.0% 1.5% 2.7% 0.0% 0.0% 0.8% 0.0% 0.0% 10.0%

5.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 5.0% 10.0%

5.0% 1.5% 3.5% 0.0% 0.0% 0.0% 0.0% 0.0% 10.0%

Table 2.15. 10% loss absorption in an average medium size bank (EUR, bn) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

8,443 2,533 2,483 0 0 1,714 1,714 0 16,886

8,443 2,533 5,910 0 0 0 0 0 16,886

8,443 2,533 1,969 3,377 0 564 0 0 16,886

8,443 2,533 1,969 3,377 0 564 0 0 16,886

8,443 2,533 4,594 0 0 1,316 0 0 16,886

8,443 0 0 0 0 0 0 8,443 16,886

8,443 2,533 5,910 0 0 0 0 0 16,886

25

Table 2.16. 10% loss absorption in an average big wholesale bank (% of total assets) European Parliament (ECON) report
Systemic crisis NO systemic crisis

Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

3.9% 1.3% 1.0% 0.0% 0.0% 1.9% 1.9% 0.0% 10.0%

3.9% 1.3% 4.8% 0.0% 0.0% 0.0% 0.0% 0.0% 10.0%

3.9% 1.3% 1.7% 2.0% 0.0% 1.1% 0.0% 0.0% 10.0%

3.9% 1.3% 1.7% 2.0% 0.0% 1.1% 0.0% 0.0% 10.0%

3.9% 1.3% 3.0% 0.0% 0.0% 1.8% 0.0% 0.0% 10.0%

3.9% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 6.1% 10.0%

3.9% 1.3% 4.8% 0.0% 0.0% 0.0% 0.0% 0.0% 10.0%

Table 2.17. 10% loss absorption in an average big wholesale bank (EUR bn) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

53,348 17,783 13,335 0 0 26,162 26,162 0 136,790

53,348 17,783 65,659 0 0 0 0 0 136,790

53,348 17,783 23,868 27,358 0 14,433 0 0 136,790

53,348 17,783 23,868 27,358 0 14,433 0 0 136,790

53,348 17,783 40,917 0 0 24,742 0 0 136,790

53,348 0 0 0 0 0 0 83,442 136,790

53,348 17,783 65,659 0 0 0 0 0 136,790

26

Table 2.18. 10% loss absorption in an average big retail bank (% of total assets) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

5.9% 2.1% 0.3% 0.0% 0.0% 0.8% 0.8% 0.0% 10.0%

5.9% 2.1% 2.0% 0.0% 0.0% 0.0% 0.0% 0.0% 10.0%

5.9% 2.1% 0.0% 2.0% 0.0% 0.0% 0.0% 0.0% 10.0%

5.9% 2.1% 0.0% 2.0% 0.0% 0.0% 0.0% 0.0% 10.0%

5.9% 2.1% 1.1% 0.0% 0.0% 0.9% 0.0% 0.0% 10.0%

5.9% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 4.1% 10.0%

5.9% 2.1% 2.0% 0.0% 0.0% 0.0% 0.0% 0.0% 10.0%

Table 2.19. 10% loss absorption in an average big retail bank (EUR bn) Commission proposal
NO depositor preference WITH depositor preference

Council General Approach

>5% Flexibility 5% Flexibility 0% flexibility

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Capital Subordinated debt Senior debt RFs Senior debt Uncovered customer deposits Covered deposits / DGS RFs Total

45,940 16,352 2,443 0 0 6,565 6,565 0 77,865

45,940 16,352 15,573 0 0 0 0 0 77,865

45,940 16,352 0 15,573 0 0 0 0 77,865

45,940 16,352 0 15,573 0 0 0 0 77,865

45,940 16,352 8,307 0 0 7,266 0 0 77,865

45,940 0 0 0 0 0 0 31,925 77,865

45,940 16,352 15,573 0 0 0 0 0 77,865

27

Figure 2.9. 10% loss absorption under the Commission's approach (no depositor preference).

Figure 2.10. 10% loss absorption under the Commission's approach (WITH depositor preference).

28

Figure 2.11. 10% loss absorption under the Council approach (MORE THAN 5% flexibility).

Figure 2.12. 10% loss absorption under the Council approach (5% flexibility).

29

Figure 2.13. 10% loss absorption under the Council approach (0% flexibility).

Figure 2.14. 10% loss absorption under the European Parliament's approach (systemic crisis scenario).

30

Figure 2.15. 10% loss absorption under the European Parliament's approach (NON-systemic crisis scenario).

31

3. Back-testing: assessment of approaches

3.1. Summary results from the back-testing exercise
Table 3.1. Summary results from the back-testing exercise Commission proposal
NO depositor preference WITH depositor preference

European Parliament (ECON) report

Systemic crisis NO systemic crisis

Council General Approach

>5% Flexibility 5% Flexibility 0% Flexibility

Capital; EUR bn (% of total losses) Subordinated debt; EUR bn (% of total losses) Senior unsecured debt12; EUR bn (% of total losses) Uncovered eligible deposits13 14; EUR bn (% of total losses) Covered deposits / DGSs; EUR bn (% of total losses) RFs; EUR bn (% of total losses) TOTAL state aid (recapitalisation and asset relief measures) Minimum DGSs with full bail-in (% covered deposits) Minimum RFs with full bail-in (% covered deposits) Minimum RFs + DGSs with full bail-in (% covered deposits) Minimum RFs + DGSs with partial bail-in (% covered deposits) Minimum DGSs + RFs foreseen in the approach

316 (67%) 56 (12%) 21 (4%) 40 (8%) 40 (8%) 0.06 (0.01%) 473 40 (0.6%) 0.06 (0.001%) 40 (0.6%) 101 (1.45%) 1%

316 (67%) 56 (12%) 60 (13%) 20 (4%) 20 (4%) 0.06 (0.01%) 473 20 (0.3%) 0.06 (0.001%) 20 (0.3%) 101 (1.45%) 1%

316 (67%) 0 0 0 0 157 (33%) 473

316 (67%) 56 (12%) 65 (14%) 34 (7%) 0 2 (0.4%) 473

316 (67%) 56 (12%) 33 (7%) 10 (2%) 0 57 (12%) 473

316 (67%) 56 (12%) 33 (7%) 36 (7%) 2 (0.4%) 29 (6%) 473 2 (0.02%) 29 (0.42%) 31 (0.45%) 101 (1.45%) 1.3%

316 (67%) 56 (12%) 52 (11%) 47 (10%) 2 (0.4%) 0 473 2 (0.02%) 0 2 (0.02%) 101 (1.45%) 1.3%

0 157 (2.3%) 157 (2.3%) 157 (2.3%) 3%

0 2 (0.02%) 2 (0.02%) 101 (1.45%) 3%

0 57 (0.82%) 57 (0.82%) 101 (1.45%) 1.3%

12 13

Including also bail-in able deposits of credit institutions including EIB loans to banks (in CN approach), being parri passu with non-preferred customer deposits; on the basis the available data, EIB loans to banks were assumed to be equal to 0.43% of total assets in each bank included in the analysis 14 Non-preferred eligible deposits under the CN approach are pari passu with the deposits of credit institutions and other senior unsecured debt.

32

3.2. Methodology for the back-testing exercise

The analysis is built upon the losses, including recapitalisation needs, that 32 European banks from 11 Member States (see Appendix 1) incurred individually since the outset of the crisis and shows how these losses would have been absorbed by bail-in-able liabilities and the other financing arrangements under the approaches of the Council, of the Commission and of the European Parliament. Back-testing these approaches on the banks' loss absorption aims to provide an insight on the effectiveness of each approach in tackling a future crisis of a similar magnitude and with a similar loss distribution pattern in the banking sector. As far as the data for the losses is concerned, due to the presence of bail-outs by Governments, the financial statements of the banks could not be used to estimate the full amount of losses. Therefore, the amounts of State aid in terms of recapitalisation and asset relief interventions used for these banks have been taken as a proxy of the losses, including recapitalisation needs. The state aid provided in the form of liquidity support or guarantees are not subject to the back-testing analysis. The data used in the analysis refers to the state aid used by 26 banks within the period 2008-2011 and covers 85% of all asset relief and recapitalisation measures granted to the sector over those 4 years. It should however be noted that, due to the absence of comparable data, the analysis does not include yet state aid provided to European banks in 2012 and 2013. However, given the large scale restructuring of banks taking place currently in Spain, and in order to obtain more informative conclusions of the analysis it has been decided to also include 6 Spanish banks for which the amounts of approved state aid by 2012 were only available (see Appendix 1 for a list of individual banks). Figure 3.1. State aid in terms of recapitalisation or asset relief measures received by 32 European banks in the current financial crisis (% of total assets)

33

Table 3.2. The size of average liabilities items found currently in European banks and relevant for the back-testing exercise Over total assets 2012YE Total Equity Subordinated Debt Senior Unsecured debt >1 Month Senior Unsecured debt <=1 Month (relevant for EP and Council approaches only) Deposits of credit institutions >7 days (relevant for the Council approach)
Of which EIB loans

4.5% 1.5% 6.9% 2.0% 3.34%

0.43%

Deposits of credit institutions >1 Month (relevant for the EP and Commission approaches) Eligible customer deposits: Uncovered non-preferred deposits Uncovered deposits from SME/retail Deposits covered by DGS Source: see Table 2.2 in section 2.1

1.47%

7.94% 7.94% 15.88%

It has been assumed that, given one of the approaches had been in place at the time the resolution decisions on these banks had to be taken, banks would have had the liabilities structure similar to the one currently observed in existing banks, which already, at least partially, takes into account the future application of the bail-in tools. Table 3.2 indicates the estimated size of liabilities' items relevant for the assessment of the different approaches. Since, under all three approaches, derivatives would be bailed in on a net basis when subject to a netting agreement, and due to the ability to only observe gross positions in banks balance sheets, for the moment we assume that derivatives are excluded from bail-in. This assumption represents a lower bound on the loss absorption capacity of derivatives, which however would be normally small when considering net exposure as compared to gross exposures. Given that the analysis covers EU-27 banks, the assessment and comparison of approaches (in sections 3.3 3.5) focuses on the amount to be absorbed by all national financial arrangements jointly. Looking at financing arrangements in each Member State would have led to different results (see section 3.6 below).

3.3. The Council General Approach

The Council General Approach provides incentives for banks to obtain the buffer of at least 8% of total assets (total liabilities, including own funds). Only after the "contribution to loss absorption and recapitalisation equal to an amount not less than 8% of the total liabilities" the resolution financing arrangement is allowed to intervene in the loss absorption. Table 3.3 below shows how the past losses compare with the thresholds set by the Council General Approach. Figures 3.2 3.4 below show that if bail-in rules had been present during the crisis, the losses would have been absorbed and recapitalisation needs would have been satisfied exclusively by

34

banks themselves in 2/3 of banks under the Council 5% or more flexibility scenarios in all except 1 bank under the Council 0% scenario, where DGS would have been required to intervene. Table 3.3 indicated that the contribution from the resolution financing arrangements (RF) increases with the flexibility provided. 0% flexibility scenario would have not required the use of resolution funds. 5% RF contribution would have been used to further absorb 29 EUR billion (6% of total losses) in the EU. The allocation of remaining losses in 6 banks would have depended on resolution authorities' decisions to exclude or not customer deposits from bail-in, which would have had repercussions also on the use of deposit guarantee schemes (DGSs) (table 3.3 and figures 3.2 3.4). Table 3.3. Back-testing: loss absorption under the Council General Approach Scenario > 5% flexibility; 5% flexibility; Loss absorption by instruments in EUR bn (% of total EUR bn (% of total EUR bn (% of state aid) losses) losses) 372 372 Capital and subordinated debt (79%) (79%) Senior unsecured debt15 before 15 15 5% contribution (3%) (3%) Non-preferred eligible deposits 10 10 before 5% contribution (2%) (2%) 29 29 RF 5% contribution (6%) (6%) Senior unsecured debt after 5% 18 18 contribution (4%) (4%) 15 Non-preferred eligible deposits16 0 (3%) Preferred deposits of SMEs and 11 0 natural persons (2%) 2 Covered deposits / DGSs 0 (0.4%) 27 RFs for remaining losses 0 (6%) TOTAL state aid (recapitalisation 473 473 and asset relief measures) (100%) (100%) Minimum DGSs (% covered 2 0 deposits) (0.02%) Minimum RFs (% covered 57 29 deposits) (0.82%) (0.42%) Minimum RFs + DGSs (% covered 57 31 deposits) (0.82%) (0.45%) Minimum DGSs + RFs foreseen in 1.3% 1.3% the approach (% cov. Dep.)
15

0% flexibility; EUR bn (% of total losses) 372 (79%) 52 (11%) 0 0 0 37 (8%) 10 (2%) 2 (0.4%) 0 473 (100%) 2 (0.02%) 0 2 (0.02%) 1.3%

Including also bail-inable deposits of credit institutions

16

Non-preferred eligible deposits under the CN approach are pari passu with the deposits of credit institutions and other senior unsecured debt.

35

Figure 3.2. Back-testing: loss absorption implied by the Council General Approach with more than 5% of flexibility (assuming the exclusion of customer deposits from the bail-in)

Figure 3.3. Back-testing: loss absorption implied by the Council General Approach with 5% flexibility (no exclusion of customer deposits from the bail-in)

36

Figure 3.4. Back-testing: loss absorption implied by the Council General Approach with 0% of flexibility (no use of RF until all bail-inable liabilities including uncovered depositors have been bail-ed in)

3.4. The Commission proposal

With respect to the Commission proposal, the back-testing exercise focuses on two scenarios. The first scenario deals with the initial Commission proposal, which does not foresee depositor preference rules, while the second scenario introduces depositor preference to the Commission proposal (table 3.4). While loss absorption by capital and subordinated debt instruments would have been the same in both scenarios 372 EUR billion (79% of total losses), the loss allocation between the deposits and senior unsecured debt instruments would have been different. Only deposits being pari passu with senior unsecured instruments would have limited the loss to senior debt holders to 21 EUR billion, whereas depositor preference would have tripled their loss to 60 EUR billion. On the contrary, under pari passu treatment of customer deposits, uncovered depositors and DGSs would have absorbed 80 EUR billion, while depositor preference would have halved this amount to 40 EUR billion. Finally, RFs can intervene in the absorption of the remaining losses if there are no more bail-inable liabilities left.

37

Table 3.4. Back-testing: loss absorption under the Commission approach Scenario Initial Commission proposal (no Commission proposal assuming Loss absorption by instruments in EUR bn (% of state aid) Capital and subordinated debt Senior unsecured debt17 Uncovered eligible deposits Covered deposits / DGSs RFs TOTAL state aid (recapitalisation and asset relief measures) The use of DGSs and RFs in the back-testing exercise The minimum amount of financial arrangements (DGSs + RFs) foreseen in the approach depositor preference); EUR bn (% of total losses) 372 (79%) 21 (4%) 40 (8%) 40 (8%) 0.06 (0.01%) 473 (100%) 40 (0.6%) 1% depositor preference; EUR bn (% of total losses) 372 (79%) 60 (13%) 20 (4%) 20 (4%) 0.06 (0.01%) 473 (100%) 20 (0.3%) 1%

Figures 3.5 and 3.6 below present the graphical illustration of loss absorption under two scenarios of the Commission proposal.

17

Including also bail-in able deposits of credit institutions

38

Figure 3.5. Back-testing: loss absorption under the Commission proposal: NO depositor preference

Figure 3.6. Back-testing: loss absorption under the Commission proposal: WITH depositor preference

39

3.5. The European Parliament's approach

Back-testing of the European Parliament's (ECON) approach focuses on two scenarios (table 3.5). The first scenario assumes a systemic crisis, whereby government stabilisation tools will be used and only capital related instruments could be bailed-in. Another alternative scenario deals with a nonsystemic crisis which assumes depositor preference and excludes covered deposits from bail-in. The systemic crisis scenario allowed under the European Parliament's approach would have limited the use of banks' liabilities in loss absorption to capital instruments only, thereby limiting loss absorption by banks to 67% of total losses (316 EUR billion). The remaining loss of 157 EUR billion would have had to be incurred by RFs and would have amounted to 2.3% of covered deposits held in the EU banking system. On the contrary, in the non-systemic risk scenario with depositor preference, hardly any resources would have been required from RFs and DGSs (2 EUR billion or 0.02% of covered deposits). Table 3.5. Back-testing: loss absorption the European Parliament's (ECON) approach Scenario /// Loss absorption by instruments Systemic crisis Non-systemic crisis in EUR bn (% of state aid) Capital and capital related 316 316 instruments (67%) (67%) Subordinated debt 56 0 (12%) Senior unsecured debt18 65 0 (14%) Uncovered eligible deposits 34 0 (7%) Covered deposits / DGSs 0 0 RFs 157 2 (33%) (0.4%) TOTAL state aid 473 473 (recapitalisation and asset (100%) (100%) relief measures) Minimum DGSs (% covered 0 0 deposits) Minimum RFs (% covered 157 2 deposits) (2.3%) (0.02%) Minimum RFs + DGSs (% 157 2 covered deposits) (2.3%) (0.02%) The minimum amount of financial arrangements (DGSs + 3% 3% RFs) foreseen in the approach (% covered deposits) Figures 3.7 and 3.8 below present the graphical illustration of loss absorption under two scenarios of the European Parliament's approach.
18

Including also bail-in able deposits of credit institutions

40

Figure 3.7. Back-testing: loss absorption under European Parliament's approach: systemic crisis scenario

Figure 3.8. Back-testing: loss absorption under European Parliament's approach: no systemic crisis scenario

41

3.6. Deviation from the assumption of the symmetric crisis

The analysis above focused on real loss examples from the whole Union. Consequently, the estimation of the needs for financial arrangements has been estimated taking into account the whole Union area. Given that the Directive will be implemented by each Member State and individual financial arrangements are isolated from each other (i.e. there exist no mutualisation of losses between the financial arrangements), the results discussed in the previous sections are only valid in a fully symmetric crisis19, where the losses are distributed evenly between individual Member States in proportion to the size of their banking sector. This is an important assumption since the deviations from this assumption would require much higher amounts in the national financial arrangements than the ones discussed above. As seen in the current crisis, a failure of one big bank can hardly be tackled by bail-in tools and national resolution financial arrangements. Only pan-European financial arrangements would have prevented the recourse to the public money. Due to the geographical asymmetry of the crisis, even if the national resolution financial arrangements and deposit guarantee schemes had been fully prefunded, in none of the approaches Ireland would have avoided the public support. The financing arrangements would have had to be set at the levels going far beyond the level estimated under these approaches in order to avoid the recourse to the public finances. The Anglo Irish Bank and INBS required 38.2 EUR billion of state aid20, primarily in terms of capital injections; even after 8% loss absorption by capital and other instruments, the remaining aid would have accounted to 21% of covered deposits21.

19

Where bank losses are distributed evenly between Member States in proportion to the size of their respective banking sectors.
20

State aid, in terms of recapitalisation and asset relief measures, used between 2008 and 2011. Source: Commission services.
21

Source: European Commission, ECB, DGS Survey 2010, European Commission elaborations

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4. Minimum Loss Absorption Capacity: definitions and implications

Overview of the approaches Under all three approaches banks are required to maintain certain minimum of LAC, which is composed of banks own funds and a portion of other liabilities selected from the eligible liabilities pool. Minimum LAC should serve as the very first buffer that has real and immediate loss absorbing capacity. One should be able to trust the presence of LAC if an institution fails. The following three features determine the actual composition, size and of the LAC. (i) Required quality of liabilities in the LAC: COM requires certain loss absorbing features that would guarantee immediate bail-in only to certain subordinated liabilities that dont fall under the definition of Additional Tier 1 or Tier 2 instruments. Other eligible liabilities can thus be added to the LAC without any specific criteria as to their maturity, ownership, etc. CN approach on the other hand extends the loss-absorbing features to be fulfilled also by other eligible liabilities, however at the same time it excludes deposits, derivative liabilities from the scope of the LAC. (ii) Level and basis of assessment of the minimum LAC: The basis for determining the appropriate minimum level of LAC differs under the three approaches in the following way: COM: LAC = own funds + eligible liabilities / (total liabilities) CN: LAC = own funds + eligible liabilities / (total liabilities + own funds - derivative liabilities) EP: LAC = own funds + eligible liabilities / (total liabilities - covered bonds). Assessment of the approaches CN approach appears to ensure the easiest implementation and mobilization of the liabilities that are part of the LAC as they all need to have certain quality features to ensure bail-in success. Should the LAC be only composed of own funds and subordinated liabilities, then the COM approach would be on par with CN especially since both approaches require the liabilities to have remaining maturity of at least 1 year. However, if banks under the COM approach include other types of eligible liabilities to LAC (e.g. senior unsecured, derivatives or deposits), it may later prove impossible for whatever reason (time, complexity) to bail them in. In addition, what matter in an equal way is the way how the LAC should be determined. The three approaches differ as to the basis/denominator against which the authorities should determine the sufficient amount of LAC. In particular CN and EP exclude specific type of liabilities from the denominator. This endangers the level playing field across the varying banking models and could promote more risk taking and moral hazard. - In this vain, the CN approach appears to be more in favour of bigger trading banks who could disregard their derivative liabilities when assessing the minimum amount of LAC. 43

- EP approach creates similar result however for different types of banks. Excluding covered bonds from the basis that should be used to determine loss absorbing capacity of a bank creates incentives for unlimited asset encumbrance. Total assets is the most appropriate basis on which to determine the LAC for a bank. Losses arise and impact the whole of the asset side of a bank, regardless of what is being assumed is one or the other banks perceived riskiness. CN approach would be preferred if derivatives were not excluded from the baseline or COM approach should the basis include own funds. Table 2.6 shows the level of min LAC levels different types of banks would have under the three approaches to calculate the minimum level thereof. If the 8% of eligible liabilities over total assets is taken as a benchmark, it is evident that depending on the varying levels of denominator due to exclusions some banks would need to hold much less LAC in absolute value than others. Table 4.1. Comparison of the MREL (minimum LAC) under the three approaches
European Banks (45) 8% Big Banks (25) 8% Medium Big Banks - Big Banks banks market retail (20) (9) (13) 8% 8% 8%

2012YE COM: LAC = own funds + eligible liabilities / (total assets - own funds) CN: LAC = own funds + eligible liabilities / (total assets - derivative liabilities) EP: LAC = own funds + eligible liabilities / (total assets - own funds - covered bonds).

7.64% 6.72% 7.24%

7.62% 6.58% 7.28%

7.60% 7.51% 6.27%

7.69% 5.84% 7.38%

7.56% 7.41% 7.10%

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Appendix 1. Data used in the back-testing analysis22

Reference year for balance sheet 2008 2008 2009 2008 2008 2008 2008 2008 2008 2008 2008 2008 2011 2010 2011 2011 2011 2011 2011 2011 2008 2009 2008 2009 2008 2008 2008 2008 2008 2008 2008 2008 Total assets; EUR billion 37.4 55.8 41.2 28.6 355 974 288 420 208 422 448 625 227.6 30.431 70.8 22.5 29.3 77.00 72.2 312.3 651 13.3 101.32 197 3.369 367.7 287 1332 125 2219 436 104.3

Bank Kommunalkredit VAG BAWAG Ethias KBC Group Fortis WestLB Hypo Real Estate HSH BayernLB LBBW Commerzbank NordLB ATEBank CAM Banco Valencia UNIMM Catalunya Banc NCG Banco BFA Dexia INBS Anglo Irish Bank Bank of Ireland Parex ABN Amro/Fortis Netherlands AEGON ING SNS Reaal RBS Lloyds Northern Rock

Country AT AT AT BE BE BE DE DE DE DE DE DE DE EL ES ES ES ES ES ES FR/BE IE IE IE LV NL NL NL NL UK UK UK

22

Source: European Commission, ECB, European Commission elaborations

45