16.2 Creditor Bail-ins by Regulators
16.2.3 Other Potential Obstacles to Bail-In
Regulators also face an array of practical obstacles similar to those confronted in the case of contingent capital. First, the impact on investor appetite of subjecting the debt of
financial institutions to the risk of automatic conversion at the discretion of regulators is unknown, but it could be significant. The Financial Times reported the results of a
customer survey by JPMorgan showing that one quarter of senior bondholders have indicated they would refuse to purchase instruments subject to bail-in risk.48 This could raise average bank borrowing costs by 0.87 percent.49 European banks’ issuance of senior debt that can be subject to a bail-in is at its lowest in a decade as of mid-2013.50 During September and October of 2014, European banks issued 14.5 billion euros of senior debt, down from 27 billion issued over that same period in 2013.51
Bail-in eligibility is also likely to impact the ratings and capital treatment of implicated instruments. In 2011, Moody’s Investors Service cautioned that it would consider
downgrades of junior bank debt subject to bail-in;52 in February 2014, S&P issued a similar warning.53 S&P followed through on its threat in August 2014, when the rating agency downgraded three Austrian banks, specifically citing new bail-in legislation that
“indicates reduced predictability of extraordinary government support for systematically important banks, and for banks’ hybrid capital instruments and grandfathered debt, than we previously envisaged.”54
Second, the mechanics governing conversion must be designed and articulated.55 If the
“trigger” controlling when bail-in takes place is a pure function of regulatory discretion (rather than premising it on capital- or market-based variables), then at the very least regulators must define prospectively under what circumstances bail-in will occur (and which liabilities will be included or exempted from its sweep). This is the subject of considerable disagreement among advocates for the solution.56 Many of the putative advantages of bail-in, for example, automating resolution, minimizing regulatory intervention, and promoting uniformity in reorganizational outcomes, all in a
nondisruptive manner,57 require investors to know ex ante which claims will bear these costs and under what circumstances, but many market participants echo doubts that certainty in this connection can be achieved.58
Third, bail-in may entail replacing the failed institution’s old management with new management that commands the confidence of the market place following reorganization.
This means that new managers may have to be found and installed before a bail-in can be completed, delaying the process. Completing a bail-in would furthermore involve a
change of control that placed former debt holders into equity ownership of the failed institution. These debt holders may, however, be disqualified by regulators from the ownership of banking institutions under US law, for example, hedge funds or private equity firms.
The fourth major practical shortcoming of creditor bail-in is jurisdictional. To
encompass a meaningful portion of the international financial system, a bail-in regime will need to be coordinated with insolvency laws and resolution procedures applicable in
multiple national jurisdictions so that bail-ins can take place on a cross-border basis without violating or otherwise interfering with local laws.59 This is crucial when large financial institutions with multinational operations are subjected to bail-ins during a crisis. These institutions—arguably the most complex in the financial system—are widely regarded as most in need of an efficient alternative to current resolution regimes. Cross- border resolution through bail-in is likely to be much more difficult outside of formal resolution—developing cross-border cooperation is primarily focused today on resolution within bankruptcy. Given the major obstacles to achieving coordinated bail-in policies in the near future, one could require new debt instruments issued by financial institutions to incorporate private contract terms authorizing conversion to equity upon a trigger signal from regulators of a specified country, as the Basel Committee and others such as Bates and Gleeson (2011) have suggested.60 Under this alternative creditors would
contract to apply the law of the bail-in jurisdiction in advance, so that conflicts of law and among local regulators would be minimized. In the variant of this approach outlined by Bates and Gleeson, a financial institution incorporated in a bail-in regime would be required by the law of that jurisdiction to contract ex ante with any creditors whose claims could potentially arise in a non–bail-in jurisdiction to submit to the effect of a bail-in if one were to occur.61
However appealing it may be in principle, “contracting” for cross-border bail-in presents daunting challenges in practice. Success depends, among other things, on where the long- term debt of large, complex financial institutions is issued and held, and at what level of the corporate structure. The paradigmatic case imagined by Bates and Gleeson
contemplates one-company institutions where all subsidiaries are of a parent bank (though potentially with creditors in different jurisdictions) governed by bail-in rules applicable to all creditors. If all bailable debt were indeed issued at and held at the parent bank holding company level in a single jurisdiction, it might be relatively straightforward to require the institution to contract for uniform bail-in terms from all creditors.
However, most large institutions hold debt at dozens or even hundreds of local subsidiaries in multiple jurisdictions (even if originally it was issued at the holding company level but then transferred downstream to those subsidiaries). Under these conditions, the contractual solution is unlikely to work. Lehman Brothers, for example, operated 433 subsidiaries in 20 different countries prior to its failure.62 Many subsidiaries were subject to local regulation including capital. Local regulators responsible for
managing the capital levels of local bank subsidiaries are unlikely to allow conversion of subsidiary-level debt for the purpose of restoring the consolidated capital ratio at the holding company-level in a different jurisdiction, or to uphold or even permit contract terms to require that such local debt be subject to the control of foreign regulators.
Even for regulators bailing-in a financial institution that is organizationally confined to a single jurisdiction, the challenge of coordinating the conversion of debt instruments outstanding across many different bank subsidiaries so that all of these subsidiaries, in addition to the parent holding company, are adequately (but not over-) capitalized after the bail-in, will be formidable. Contracting for bail-in of complex multinational financial institutions thus presents both a “vertical” problem (coordinating bail-in between the
holding company and its bank subsidiaries) and a “horizontal” one (coordinating bail-in of debt in different jurisdictions). Furthermore relying on contract to streamline bail-in would transform it into a form of contingent capital, sacrificing its functionality as a
substitute for formal resolution procedures by requiring that the major terms controlling conversion be stipulated in advance if it were to be acceptable in multiple jurisdictions.63
Bail-ins outside of resolution have significant problems, some of which can be addressed in a more formal resolution procedure. We now turn to the new Orderly Liquidation Authority, the new formal US framework for dealing with certain nonbank SIFIs including bank holding companies.
Notes
1. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back from the edge 7 (Aug. 2010), available at http://www.afme.eu/WorkArea/DownloadAsset.aspx?
id=197.
2. Id.
3. Id.
4. Id.; see, for example, Christopher Culp, Contingent capital: Integrating corporate financing and risk management decisions, 15 J. Appl. Corp. Fin. 46 (Spring 2002), available at http://www.rmcsinc.com/articles/JACF151.pdf (surveying forms of
contingent capital); Russ Banham, Just-in-case capital, CFO Magazine, (Jun. 1, 2001), available at http://www.cfo.com/article.cfm/2996186/c_2984346/?f=archives;
Gallagher Polyn, Swiss re strikes $150 million contingent capital deal, Risk.net (Mar. 1, 2002), available at http://www.risk.net/risk-magazine/news/1503664/swiss-re-
strikes-usd150-million-contingent-capital-deal.
5. See LaSalle re-signs $100 million contingent capital program, Business Wire (Aug. 5, 1997), available at
http://findarticles.com/p/articles/mi_m0EIN/is_1997_August_5/ai_19650965; Joe Niedzielski, Aon-LaSalle re-post $100M package, Nat’l Underwriter Prop. Casualty (Aug. 6, 1997), available at
http://www.propertycasualty360.com/1997/08/06/aonlasalle-re-post-100m-package.
6. See, for example, Mark Flannery, No pain, no gain: Effecting market discipline via
reverse convertible debentures, in Capital Adequacy Beyond Basel: Banking, Securities and Insurance (Hal S. Scott, ed., 2005) (proposing reverse convertible debentures for large financial institutions convertible based on pre-established market capital ratios as a mitigant against the costs of financial distress); John Coffee Jr., Bail-ins versus bail-outs: Using contingent capital to mitigate systemic risk (Columbia Univ. Center for Law Econ. Studies, Working Paper 380, Oct. 2010), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1675015 (proposing contingent capital convertible into senior preferred stock).
7. See Christopher Thompson, Chinese banks issue most coco bonds, Fin. Times (Feb. 11, 2015), available at http://www.ft.com/intl/cms/s/0/5a99b804-b135-11e4-9331-
00144feab7de.html#axzz3Xt778fnQ.
8. Id.
9. Id.
10. Lynn Strongin Dodds, Hybrid securities revolution is here to stay, Investment &
Pensions Europe (Apr. 2015), available at http://www.ipe.com/reports/hybrid- securities-revolution-is-here-to-stay/10007298.fullarticle.
11. See supra Part II.B.1.a.
12. Simpson Thatcher, Federal Reserve adopts final U.S. bank capital standards under Basel III 8 (Jul. 8, 2013), available at
http://www.simpsonthacher.com/google_file.cfm?
TrackedFile=4B46116601DDE2D896B179&TrackedFolder=585C1D235281AED9B6A07D5F9F9478AB5A90188899 13. Fin. Stability Oversight Council, Report to Congress on Study of a Contingent Capital
Requirement for Certain Nonbank Financial Companies and Bank Holding Companies 19 (Jul. 2012).
14. Daniel Tarullo, Governor, Fed. Res. Bd. of Governors, Speech at the Peterson Institute for International Economics: Evaluating progress in regulatory reforms to promote financial stability (May 2013), available at
http://www.federalreserve.gov/newsevents/speech/tarullo20130503a.htm.
15. Swiss Fin. Mkt. Supervisory Auth., Addressing “too big to fail”: The Swiss SIFI policy 12 (Jun. 23, 2011), available at
http://www.finma.ch/e/finma/publikationen/Documents/be-swiss-SIFI-policy-june- 2011-summary-20110624-e.pdf.
16. Id. FINMA’s planned “Swiss finish” effectively amounts to a tier I common ratio of 10 percent of RWA, 3 percent of RWA in high trigger CoCos, and 6 percent of RWA in low trigger CoCos.
17. Basel Comm. on Banking Supervision, Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability 1 (Aug. 2010), available at
http://www.bis.org/publ/bcbs174.pdf.
18. Id. at 9.
19. William Dudley, President and CEO, Fed. Res. Bank of New York, Remarks at the Institute of International Bankers Membership Luncheon: Some lessons from the
crisis (Oct. 13, 2009), available at
http://www.newyorkfed.org/newsevents/speeches/2009/dud091013.html; see also Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back from the edge 5 (Aug. 2010), available at
http://www.afme.eu/WorkArea/DownloadAsset.aspx?id=197 (noting that contingent capital “could serve as a bridge between the prudential benefits of higher capital levels and the negative growth consequences of increased capital requirements”).
20. Basel Comm. on Banking Supervision, Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability 1, 9 (Aug. 2010), available at
http://www.bis.org/publ/bcbs174.pdf.
21. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back From the edge 7 (Aug. 2010), available at
http://www.afme.eu/WorkArea/DownloadAsset.aspx?id=197.
22A. T. Berg and C. Kaserer, Does Contingent Capital Induce Excessive Risk Taking, 24 J.
of Financial Intermediation 356 (2015).
22. Id.
23. Jennifer Hughes, Rabobank warns of “dangerous” bail-ins, Fin. Times (Nov. 8, 2010).
24. Helene Durand, After-market mars UBS bank capital first, Reuters (Feb. 17, 2012), available at http://www.reuters.com/article/2012/02/17/ubs-tier-
idUSL5E8DG50E20120217.
25. See Basel Comm. on Banking Supervision, International convergence of capital measurement and capital Sstandards 4–7, 14–16 (1998) (defining tier II capital as undisclosed reserves, asset revaluation reserves, general loan-loss reserves, hybrid capital instruments, and subordinated debt).
26. Simon Nixon, Lloyds banking on contingent capital for escape, Wall St. J. (Nov. 2, 2009), available at http://online.wsj.com/article/SB125713423970322203.html; Basel Comm. on Banking Supervision, Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability 1, 11–12 (Aug. 2010), available at
http://www.bis.org/publ/bcbs174.pdf.
27. Simon Nixon, Lloyds banking on contingent capital for escape, Wall St. J. (Nov. 2, 2009), available at http://online.wsj.com/article/SB125713423970322203.html; Basel Comm. on Banking Supervision, Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability 1, 11–12 (Aug. 2010), available at
http://www.bis.org/publ/bcbs174.pdf.; see also Alex Monro, New Basel proposals threaten bank sub debt, investors warn, Risk.net (Aug. 26, 2010), available at
http://www.risk.net/credit/news/1729774/new-basel-proposals-threaten-bank-sub- debt-investors-warn.
28. See, for example, Tracy Alloway, Adventures in hybrid debt, fixed income fund edition, FT.com/Alphaville (Sep. 9, 2009), available at
http://ftalphaville.ft.com/blog/2009/09/09/70851/adventures-in-hybrid-debt-fixed- income-fund-edition/.
29. Basel Comm. on Banking Supervision, Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability 1, 5–6 (Aug. 2010), available at http://www.bis.org/publ/bcbs174.pdf.
30. Id. at 12.
31. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back from the edge 8 (Aug. 2010), available at
http://www.afme.eu/WorkArea/DownloadAsset.aspx?id=197.
32. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back From the edge 9 (Aug. 2010), available at
http://www.afme.eu/WorkArea/DownloadAsset.aspx?id=197.; Basel Comm. on Banking Supervision, Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability 1, 12 (Aug. 2010), available at
http://www.bis.org/publ/bcbs174.pdf.
33. Oliver Hart and Luigi Zingales, Curbing risk on Wall Street 20, 26 Nat’l Aff. (Spring 2010), available at http://www.nationalaffairs.com/publications/detail/curbing-risk- on-wall-street (outlining a framework for protecting systemically relevant debt
through the use of a cushion of loss-absorbing subordinated debt). Hart and Zingales propose using the CDS pricing on this subordinated debt as a proxy for measuring the market’s estimate of the risk of the issuer and a signal to regulators for when
intervention is necessary. See also Barbara Rehm, A shot at redemption for credit–
default swaps, Am. Banker (Jan. 20, 2011); Laura Chiaramonte and Barbara Casu, Are CDS Sspreads a good proxy of bank risk? Evidence from the financial crisis 29 (2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1666793 (concluding that CDS spreads provide good evidence of bank riskiness based on their strong
relationship with bank balance sheet ratios through the financial crisis of 2007–2009).
34. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back From the edge 9 (Aug. 2010), available at
http://www.afme.eu/WorkArea/DownloadAsset.aspx?id=197.
35. See generally Nicholas Beale, David G. Rand, Heather Battey, Karen Croxson, Robert M. May, and Martin A. Nowak, Individual versus systemic risk and the regulator’s dilemma, Proc. Nat’l Acad. Sci. USA (2011), available at
www.pnas.org/cgi/doi/10.1073/pnas.1105882108 (“[T]he regulator faces a dilemma:
should she allow banks to maximize individual stability, or should she require some specified degree of differentiation for the sake of greater system stability? In banking, as in many other settings, choices that may be optimal for the individual actors may be
costly for the system as a whole, creating excessive systemic fragility.”).
36. Kathryn Chen, Michael Fleming, John Jackson, Ada Li, and Asani Sarkar, An analysis of CDS transactions: Implications for public reporting 3 (Fed. Res. Bank of New York, Staff Report 517, Sep. 2011), available at
http://newyorkfed.org/research/staff_reports/sr517.pdf.
37. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back from the edge 6 (Aug. 2010), available at
http://www.afme.eu/WorkArea/DownloadAsset.aspx?id=197.
38. See, for example, id. at 12–15 (comparing bail-ins to a “pre-pack recapitalisation”);
Adam Bradbery, Bondholders face a push to impose bank bail-ins, Wall St. J. (Aug. 25, 2010), available at
http://online.wsj.com/article/SB10001424052748703447004575449440499780022.html 39. See Chris Bates and Simon Gleeson, Legal aspects of bank bail-ins 5–6 (May 2011),
available at
http://www.cliffordchance.com/publicationviews/publications/2011/05/legal_aspects_ofbankbail- ins.html (comparing and distinguishing creditor bail-in with contingent capital).
40. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back from the edge 5, 11 (Aug. 2010), available at
http://www.afme.eu/WorkArea/DownloadAsset.aspx?id=197; see also Chris Bates and Simon Gleeson, Legal aspects of bank bail-ins 5–6 (May 2011), available at
http://www.cliffordchance.com/publicationviews/publications/2011/05/legal_aspects_ofbankbail- ins.html (comparing and distinguishing creditor bail-in with contingent capital).
41. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back from the edge 5 (Aug. 2010) (distinguishing contingent capital from creditor bail-in, noting that the former is “a recovery (rather than resolution) tool that serves to replenish a firm’s capital by converting a [specific class of] debt instrument to equity … well before a firm becomes distressed”); see also Wilson Ervin, Presentation at Harvard Europe–
US Symposium, Cross Border Resolution Panel 11 (Mar. 2011), available at http://www.law.harvard.edu/programs/about/pifs/symposia/europe/2011- europe/panelist-presentations/ervin.pdf.
42. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back from the edge 12–14 (Aug. 2010); Thomas Huertas, Vice Chairman, Comm. of Eur. Banking Supervisor and Director, Banking Sector, Fin. Servs. Auth. (UK), Routes to resolution:
Bridge Bank and bail-ins 4–9 (draft for discussion) (describing two related methods of bail-in, by write-down or conversion).
43. Paul Lee, The source-of-strength doctrine: Revered and revisited—Part I, 129 Bank.
Law J. 771, 771–772 (2012).
44. 11 USC §362 (2006).
45. See 11 USC §362(a)(4)-(7) (2006) (staying, inter alia, creation and enforcement of liens against debtor, collections of claims against debtor, and “setoff[s] of any debt owing to debtor” against other claims); id. at §§555, 556, 559, and 560 (exempting securities and commodities contracts and swap and repurchase agreements from the coverage of Section 362).
46. Inst. of Int’l Fin., The Net Cumulative Economic Impact of Banking Sector Regulation: Some New Perspectives (Washington, DC, 2010).
47. See also OLA discussion in Part II.B.2.
48. Jennifer Hughes and Brooke Masters, The debt net, Fin. Times (Feb. 21, 2011).
49. Id.
50. Christopher Thompson, Senior bank debt issues slump to decade low, Fin. Times (Jun. 16, 2013).
51. Alice Gledhill, Bail-in of senior European bank debt not fully priced in, Reuters (Oct.
31, 2014), available at http://www.reuters.com/article/2014/10/31/banks-debt- idUSL6N0SF34W20141031.
52. Jennifer Hughes, Junior debt in line for Moody’s downgrade, Fin. Times (Feb. 14, 2011), available at http://www.ft.com/cms/s/0/b4edd888-386e-11e0-959c-
00144feabdc0.html#axzz1EnpiUy3Y.
53. Martin Arnold, S&P warns of higher risk in bank bail-in bonds, Fin. Times (Feb. 6, 2014).
54. Edward Taylor (ed. David Goodman), Update 1-S&P downgrades three Austrian banks on bail-in uncertainty, Reuters (Aug. 13, 2014), available at
http://www.reuters.com/article/2014/08/13/austrianbanks-ratings- idUSL6N0QJ4P020140813.
55. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back From the edge 11–13 (Aug. 2010).
56. See, for example, Paul Calello and Wilson Ervin, From bail-out to bail-in, The Economist (Jan. 28, 2010). Calello and Ervin of Credit Suisse would have applied a bail-in to enable Lehman Brothers to circumvent bankruptcy, while others would restrict use of the policy to situations in which a federal bailout was unnecessary.
57. Ass’n for Fin. Mkts. in Eur., The systemic safety net: Pulling failing firms back From the edge 21 (Aug. 2010); Wilson Ervin, Presentation at Harvard Europe–US
Symposium, Cross Border Resolution Panel 9 (Mar. 2011), available at
http://www.law.harvard.edu/programs/about/pifs/symposia/europe/2011-