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Deposit Protection and Bail-in of Banking Institutions

The turbulent banking crisis in the Republic of Cyprus triggered disputes among the EU with regard to whether depositors should be protected from bail-ins or whether only deposit holders with accounts exceeding €100,000 should be subjected to losses through such resolution. Bail-in relates to a situation where the creditors of an institution facing bankruptcy are forced to bear some of the burden of the debt, by having part of their deposits written-off.

The first deal for the Republic reached on March 16, requested the imposition of a levy on all bank deposits in exchange for a €10 billion loan package. The indicated tax rate was 6.75% for insured deposits below €100,000 and 9.9% for uninsured deposits in excess of €100,000. This deal was rejected by the country’s House of Representatives. The agreed deal, which came one week later, spared insured depositors and instead wiped out all bondholders of Laiki and imposed massive losses on both Laiki’s and Bank of Cyprus’ uninsured depositors. This massive haircut was agreed in order to restructure the country’s two leading banking institutions, through the resolution of Laiki and the recapitalisation of BoC. The plan also provided for transferring Laiki’s insured deposits under €100,000, its loans and its €9 billion liabilities to the BoC.

A levy on deposits below €100,000, if enforced, would have been in conflict with EU legislation, which protects deposits up to that total. The relevant decrees are the 1994/19/EC and 2009/14/EC with regard to deposit-guarantee schemes, their coverage extent and payout. Hence, since December 2010, all EU countries are expected to protect deposits up to €100,000, adhering to the 2009 decree.

Deposit Guarantee Schemes (DGS) are formed to avert circumstances such as those now distressing Cyprus. The fundamental objective of DGS is to compensate a certain amount of funds to depositors whose bank became insolvent. These schemes are designed to safeguard a part of the deposit holders’ assets and to restrain them from making mass withdrawals from their credit institution, thereby preventing severe economic effects. A decision to impose a levy on insured deposits – which is a first in the history of EU – would jeopardise the institution of DGS. As Ronny Rehn, an analyst at Keefe, Bruyette & Woods in London, stated with regard to the issue, “This has broken the seal on guaranteed deposits. It won’t make it easier to reach an agreement on a guarantee scheme. In the meantime, if we get to another bailout stage the reaction of depositors could be more volatile. This precedent doesn’t help.” (Vaughan E. & Martinuzzi E., Cyprus Bank Tax Threatens European Deposit Guarantees Plan, Bloomberg.com {June 20, 2013})

EU proposal on bail-in

After the precedent in Cyprus, the Council of Europe and the EU Parliament are currently contemplating on the creation of a more secure legal framework for small deposit holders. Their suggestions revolve around the harmonisation and simplification of the schemes with regard to protected deposits, conduction of faster payouts and improvement of their financing.

The proposals under consideration entail that all credit institutions without exception should join a DGS. They also describe more explicitly what falls under the scope of deposits, denoting that it is only entirely repayable vehicles that can be reckoned as deposits. Most importantly, with the intention of ensuring that depositors are conscious of the risks involved, the schemes necessitate that prior to opening a deposit account, all depositors should sign a form indicating whether or not their deposits are guaranteed.

The proposals also require the coverage of deposits deriving from real estate dealings, as well as deposits relating to particular life events in excess of €100,000, provided that the duration of coverage is 12 months. What is more, the schemes proposed give EU member-states the discretion to form a separate system, apart from the DGS, to safeguard particular deposits for social purposes, pensions and deposits linked to real estate dealings for private residential reasons.

On May 20, 2013, the EU Parliament voted that, from 2016, large depositors in the EU member-states might face reductions on their deposits in the event of a failure of a banking institution. The programme voted was similar to the deal in Cyprus, where large depositors suffered losses to rescue the country from bankruptcy. The members of the Parliament voted in favour of the legislation that would give regulators authorisation to impose losses on depositors and take other measures during a bank rescue. Moreover, the verdict provides that:

  • Guaranteed deposits up to €100,000 would be excluded from the scope of any bail-in.
  • A banking institution would go into deposits in excess of €100,000 only in the event that it has used up all other remedies, such as bondholders and shareholders.
  • The law provides for the formation of national resolution funds financed by credit institutions. A number of policymakers suggested the creation of a Euro Zone-wide resolution fund and the EU Commission is anticipated to propose such a fund in the coming months.
  • Deposit holders would be categorised into reliable and risky. The bail-in tools would be adopted according to what grouping the depositor belongs to.

Since bail-in has been established as a desirable resolution strategy, DGS in Euro Zone member-states should be reinforced in order to be effectively used as a strong vehicle towards minimising the losses in the event of bank failures.

Conditions to apply in order to strengthen DGS

Deposit Guarantee Schemes require the adoption of several techniques in order to be effective during the bail-in of a failed bank. Where deposits are safeguarded by a DGS, there is no reason why they should not take losses, given that it is the DGS and not the depositor which will suffer the loss. Deposits above the DGS insurance level should be handled in the same fashion as any other senior creditor and take losses in the same way and to the same level. When a DGS performs its responsibilities in a timely manner, financial stability is maintained, insured depositors suffer no loss and in the event of formation of a bridge bank or a deposit transfer, no loss of continuity in access to their funds.

Extension of powers and authorities

Generally, insured depositors are safeguarded by DGS, which have the effect of transferring any loss that would otherwise be incurred by depositors through to the other banking institutions in the relevant banking system. It is thus imperative to all other contributors that the participation of the DGS in a bail-in is formed in such a way, that the funds of it are used in a fashion which reduces losses to its contributors. Therefore, DGS should not be limited only to paying compensation to depositors once default has occurred, but should be able to use its funds in collaboration with other parties to minimise the extent of the losses suffered. The authorities of the DGS’s managers should be extended to allow them to apply DGS funds in a way which promotes efficient resolution. Nevertheless, this involvement should be voluntary and only occur where its managers are content that acting in this way will minimize the liabilities of the contributors to the DGS.

Involvement in resolution pre-default

A DGS should be involved in the resolution process before a bank failure, based on the exposure that it would have after the failure. In bail-ins a DGS should thus be managed as if it was already subrogated to the claims of depositor holders, even though in theory that subrogation may not yet have occurred. Although it is in the discretion of its contributors to require that the DGS should only be used after a default, in practice they would be imprudent to do so. This is because the demolition of value pertaining to a formal insolvency would enlarge the loss which would be transmitted to those contributories through the DGS.

No creditor worse off than in liquidation

As soon as a mechanism has been deployed by which the DGS can decide whether it is permissible to contribute to a resolution, policymakers should find a way of calculating the extent to which the DGS can be asked to participate. In effect, this has to be done on a “no worse off than in liquidation” basis. Thus, the regulations pertaining to DGS should provide that when a bank calls upon the contribution of a DGS for bail-in purposes, the contribution cannot be larger than the payments that it would have had to assume to compensate depositors in the event that the bank become insolvent.

Introduction of deposit preference

Up to now, most liabilities of distressed institutions around the world have been deposit liabilities. Once depositor preference has been introduced, the constitution of a bank is likely to change, in a way that any creditor who is not a depositor will want to become an insured creditor. The fewer the uninsured creditors, the greater the risk to them, and thus the smaller the group of unsecured creditors is likely to be. The establishment of depositor preference on bail-in is possible to occur in a possibility that depositors will have to be bailed-in only in the absence of any other bail-in-able senior creditors and that they would be the first to be repaid in the event of insolvency.

Enhanced decision-taking and exposure assessment

To be able to ensure that a DGS can participate in a bail-in, there must be an enhanced element of decision-taking and exposure assessment by its managers. In practice, the DGS should be granted equity participation in return for a credit commitment and this must be voluntary for the DGS. The reason behind this is that the operation of any DGS is to wait for the bank to become insolvent and then to compensate depositors. If the DGS is to enhance its powers and offer more than that, it must determine whether participating in the resolution will result in a lower cost to it than paying out insurance after the event. This means that at a minimum the DGS must be able to analyse the proposal of intervening and accepting or challenging it on behalf of its members.

Formalisation of DGS at a global level

Collaboration mechanisms between national DGS with regard to cross-border deposit compensations should be formalized at a global level. The matter is that if the resources of the banking system in a country are incapable of satisfying the claims of overseas depositors, liability will be transferred to the country concerned. Governments though, are notoriously reluctant to spend local taxpayers’ money in compensating foreigners. The current proposals for reforming the EU DGS’ systems endeavor to square this circle by interlinking DGS. The proposals provide that branch depositors are to be compensated in the first instance by the DGS of the host state, which subsequently is to be repaid by the scheme in the home state.

Formalisation of interaction between DGS funds and resolution funds

In the same manner, the interaction between DGS resources and bank resolution resources should be formalized at a national and international level. The EU is currently testing the strengths of this suggestion, by trying to establish a degree of regulatory and supervisory overlap between DGS and resolution authorities.

Inadequate for systemic crises

The final point to make is that DGS are tools created to take in losses from a single bank failure that takes place within a solvent banking system. In a systemic crisis, a DGS may well turn from being part of the solution to being part of the problem, and in particular may become a channel for the transmission of systemic risk. In systemic failures, all participants of the financial system must work together in order to be effective. The burden of dealing with systemic crises should not be assumed only by the DGS, but also by the government.

Contact Michael Chambers & Co and learn everything you need to know about deposit guarantee schemes and bank resolution in Cyprus.

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