Boštjan Jazbec: The bail-in tool and the challenges to its smooth
implementation
Address given by Mr Boštjan Jazbec, Governor of the Bank of Slovenia at the Executive
Seminar on Banking Resolution, Florence, on 14 July 2016.
* * *
It is a pleasure to be invited to talk on banking resolution to this distinguished gathering of
bank regulators, supervisors, central bank officials, bankers, and academics. The timing
could not be more opportune.
Banking resolution can be a messy business. Last week, criminal police from the Special
Prosecutor's Office raided the Bank of Slovenia and seized documents and information
related to banking resolution measures undertaken by the Bank of Slovenia and the
government in December 2013. The main focus of the investigation is the decision taken at
that time to use bail-in of subordinated instruments as one of the tools of banking resolution.
In 2014, the Slovenian Association of Small Shareholders filed several court cases against
the Bank of Slovenia and local banks, claiming that the subordinated instruments in rescued
banks should not have been erased. One of the cases has gone all the way to the European
Court of Justice after Slovenia's Constitutional Court referred it to the EU tribunal for
clarification. A ruling of the European Court on this case is expected early next week. The
court ruling may have serious ramifications for the efforts under way to establish an effective
Banking Union in Europe.
Considerable momentum has developed in favor of bail-in centered banking resolution. As
Andrew Gracie of the Bank of England has noted in a recent speech, a bail-in transaction is
at the heart of all the resolution plans drawn up in the Crisis Management Groups. In
addition, the European Banking Authority (EBA) has set standards on Minimum Requirement
for Own Funds and Eligible Liabilities (MREL) that banks should have to ensure adequate
loss absorbing capacity. The Slovene experience brings out the sensitivity of the bail-in tool
and the challenges to its smooth implementation. It would be important for the resolution
authorities to address these challenges upfront and find answers for them.
A key requirement would be to make bail-in legally enforceable by introducing all the
necessary legislation, thereby minimizing the possibility of litigation. An important associated
step is clear communication. Investors and shareholders will need to understand the risks to
which they are exposed by holding subordinated instruments, and holders should have clarity
on the order in which they would incur losses. However, it is doubtful if the ambiguities in the
resolution framework can be fully eliminated. A major challenge with every resolution is to
decide when to trigger resolution measures and what process of resolution to use. The
criteria for bank resolution are relatively vague and there are no mechanical formulas that tell
us exactly whether a bank needs to be resolved. Resolution frameworks (including the
BRRD) typically do not define trigger thresholds and specify solutions.
* * *
Let me now turn briefly to the developments in the banking sector in Slovenia during the
financial crisis and the specifics of resolution measures undertaken in December 2013.
The business models of Slovene banks before the financial crisis were based on heavy
funding on international financial market and aggressive lending to increase or retain market
share. As a result, the onset of the global financial crisis hit Slovene banks particularly hard.
The availability of foreign funding of Slovene banks shrank and funding costs increased. The
resulting liquidity crunch put a strain on corporate operations and an increasing number of
firms resorted to delayed or non-settlement of financial liabilities to banks. As the quality of
their loan portfolios deteriorated, banks were faced with higher loan impairment and
provisioning charges and a decline in capital adequacy relative to the requirements. Bank
profitability began a downward slide and moved into negative territory in 2010. All the
common bank profit indicators remained negative till 2014.
Matters came to a head in the second quarter of 2013 following the international bail-out of
Cyprus by the European Commission (EC), European Central Bank (ECB) and
International Monetary Fund (IMF). The contagion spread to Slovenia. Slovenia's
sovereign long-term debt was downgraded and the availability and cost of funding for banks
on wholesale markets came under further pressure. With the recognition that an international
bailout was looming for Slovenia as well in the absence of urgent measures to rescue and
restructure the banking system, a comprehensive review of the banking system
encompassing an asset quality review and stress tests was initiated in August 2013. The
review was conducted by four consulting firms under the supervision of a steering committee
comprising representatives of the Bank of Slovenia and Ministry of Finance and observers
from the European Commission (DG EcFin and DG Comp), European Central Bank and the
European Banking Authority.
The resolution measures undertaken on the basis of the results of the review included:
capital increases in three major banks with state aid and in five small banks via money from
private investors; transfer of non-performing claims to a special bank asset management
company; bail-in of subordinated instruments; and reorganization of activities to core
business with the aim of improving governance structure and risk management. In addition,
two small banks were put in the process of an orderly wind-down involving asset divestment
and phasing out of portfolios and activities over a three-year period. The total cost of the
rehabilitation of the banking system is estimated at around 8 to 10 percent of GDP. The
share of bail-in instruments in the total cost is close to 2 percent of GDP.
* * *
What can be said about the banking resolution process in Slovenia?
Like elsewhere in Europe, Slovenia did not have an effective banking resolution framework
during the crisis period. Response to the deteriorating health of the banks during the crisis
period was delayed, thereby increasing capital risk and the need for additional capital. On
occasions, in state-owned banks funding guarantees were provided by the government in
lieu of actual capital.
At the time of the banking resolution in Slovenia in December 2013, the BRRD was not in
effect and the decision on the establishment of a Single Resolution Mechanism was being
finalized. Still, the EC, ECB, and EBA did exercise considerable influence on the resolution
package. The national resolution authority and the three European institutions did not always
agree on the preliminary findings of the review. This gap had to be closed before the final
package could be crafted, since DG Comp is mandated with assessing the viability and the
restructuring plans of banks to which state aid is granted. It is therefore ironical that the Bank
of Slovenia is being investigated for alleged mishandling of data and inaccurate calculations
and the European Court is to issue a ruling on a case referred to it.
The legislation on many aspects of the resolution package, including the bail-in on
subordinated instruments, were in existence but were not consolidated. However, it would be
wrong to construe that holders of subordinated instruments did not know the risks that they
were exposed to.
* * *
What are the challenges looking ahead?
The world of Slovene banks is changing on account of institutional and regulatory changes
and the prevailing macroeconomic environment. In November 2014, the European Central
Bank assumed responsibility under the Single Supervisory Mechanism for supervising
8 banks in Slovenia accounting for more than two-thirds of the market share. The supervisory
culture will change under the new regime. The ECB will also inspect the business models of
banks. It is reasonable to expect that under the new supervisory regime the ECB will trigger
any decision on the need for banking resolution. Thereafter the decision to place a bank in
resolution would involve the SSM Board, the ECB Governing Council, possibly the SSM
Mediation Panel and the Board of the SRM. I apologize to those institutions that I forgot to
mention. Given the high political sensitivity of the elements to be included in a resolution
scheme, it is hard to contemplate how a binding decision on banking resolution could be
reached over a weekend.
In addition, prudential rules have been established for European banks that require putting in
place by specific dates new requirements on, among other things, quality and quantity of
capital (in the form of several layers of capital buffers), liquidity, leverage, and counterparty
risk. Building up capital buffers and meeting the Minimum Requirement for Own Funds and
Eligible Liabilities (MREL) will be challenging in an environment of low bank profitability. If
only for this reason, harmonization and transparency of resolution standards would help.
* * *
To conclude, I will finish with the same thought that I started my speech. Banking resolution
is a messy business.