Consultation outcome

Bail-in powers implementation

Updated 12 December 2014

This was published under the 2010 to 2015 Conservative and Liberal Democrat coalition government

1. Introduction

The Special Resolution Regime (SRR) established in the Banking Act 2009 (“the Banking Act”) confers a number of resolution powers on the Bank of England and HM Treasury. The Financial Services (Banking Reform) Act 2013 (the 2013 Act) confers on the Bank of England a further option for the resolution for banks, building societies, investment firms, and certain banking group companies: the bail-in stabilisation option.

Since the financial crisis, a wide-ranging programme of financial sector reform has been underway at domestic, European and international levels. The government set up the Independent Commission on Banking (ICB), charged with considering structural and related non-structural reforms to the UK banking sector to promote financial stability and competition. It reported in 2011, and one of its key recommendations was the introduction of a bail-in tool. Bail-in powers were also recommended by the Parliamentary Commission on Banking Standards (PCBS) in its June 2013 report. The Financial Stability Board’s (FSB), ‘Key Attributes of Effective Resolution Regimes’ – endorsed by the G20 – has recommended that resolution regimes put in place a bail-in tool in order to improve the toolkit for dealing with the failure of large, globally systemic banks.

Bail-in involves shareholders of a failing institution being divested of their shares, and creditors of the institution having their claims cancelled or reduced to the extent necessary to restore the institution to financial viability. The shares can then be transferred to affected creditors, as appropriate, to provide compensation. Alternatively, where a suitable purchaser is identified, the shares may be transferred to them, with the creditors instead receiving, where appropriate, compensation in some other form.

Bail-in will help to ensure that shareholders and creditors of the failed institution, rather than the taxpayer, meet the costs of the failure. Bail-in will also ensure that the failed institution can continue to operate and provide essential services to its customers, by recapitalising it so that restructuring measures can then be implemented that address the cause of the failure. This will help to limit disruption to the institution’s customers and maintains public confidence in the banking system.

In order to complete the legislation and commence the bail-in powers in the 2013 Act, a number of pieces of secondary legislation are to be made. This paper invites comments on the following three statutory instruments:

1.1 The Building Societies (Bail-in) Order

This order will make provision under section 17 of the 2013 Act, to facilitate the exercise of the bail-in powers by the Bank of England to in relation to a building society. It makes the modifications necessary in order to reflect the different ownership model and corporate structure of building societies.

1.2 The Banking Act 2009 (Restriction of Special Bail-in Provision, etc.) Order

This order will make provisions under section 48P of the Banking Act 2009 (as inserted by the 2013 Act). It puts in place appropriate safeguards for certain financial arrangements – principally certain types of set-off arrangements and netting arrangements.

1.3 The Banking Act 2009 (Mandatory Compensation Arrangements Following Bail-in) Regulations

These Regulations will make provisions under section 60A of the Banking Act 2009 (as inserted by the 2013 Act). The Regulations will require certain compensation arrangements to be put in place following the exercise of the bail-in stabilisation option. In particular, they are designed to ensure that pre-resolution shareholders and creditors of the institution do not receive less favourable treatment than they would have received had the institution entered insolvency immediately before the initial exercise of the resolution powers (the “no shareholder or creditor worse off” compensation).

This consultation also seeks views on three other issues:

• a proposal to align the creditor hierarchies in insolvency for banks and building societies, through early transposition of the depositor preference provisions in the European Bank Recovery and Resolution Directive (BRRD) – see Section 4
• a proposal to implement changes to the Financial Collateral Arrangements Directive (FCAD) in what is currently Article 107 BRRD through amendments to the Financial Collateral Arrangement (No 2) Regulations 2003 (as amended) – see Section 5
• applying the bail-in tool to banking group companies – see Section 7

2. Background on bail-in

During the financial crisis, the UK government was forced to step in and provide billions of pounds in support to failing banks in order to maintain wider financial stability in the economy. The bail-in stabilisation option provides a new option through which the Bank of England will be able to resolve failing (or likely to fail) banks, building societies and investment firms and helps ensure that the costs such failures are borne by the shareholders and creditors of the firm, rather than taxpayers.

In other industries, when a business fails, it enters insolvency. Its creditors have a claim in that insolvency. How much they recover is determined by their position in the creditor hierarchy and the amount of losses in the firm (i.e. how much money there is available to pay creditors, and should creditors be paid in full, return to shareholders). For large banks and other large financial institutions, it is not in the public interest for them to enter insolvency due to the interconnectedness of the banking system (the insolvency of one bank can cause wide spread problems in financial markets) and the range of essential services they provide to customers and other industries. Disruption to these services could have serious repercussions for the economy.

Bail-in involves shareholders of a failing bank being divested of their shares and creditors having their claims cancelled or reduced to the extent necessary to restore the bank to financial viability. It recapitalises the institution by reducing the losses on its balance sheet. The shares can be transferred to the affected creditors as compensation, or the shares can be transferred to third party buyer with the creditors instead receiving, where appropriate, some other form of compensation.

The bail-in stabilisation option includes the power to cancel or modify the terms of contracts (the power to make “special bail-in provision”) in a resolution scenario in order to cancel, reduce or defer the liabilities of the bank under resolution. Liabilities can also be converted into different forms: for example, a debt instrument can be converted into an equity instrument.

Certain liabilities are excluded from the scope of the power to make special bail-in provisions (by section 48B(8) of the Banking Act). These are:

• liabilities representing protected deposits
• any liability, so far as it is secured
• liabilities that the bank has by virtue of holding client assets
• liabilities with an original maturity of less than 7 days owed by the bank to a credit institution or investment firm^{[footnote 1]}
• liabilities arising from participation in designated settlement systems and owed to such systems or to operators of, or participants in, such systems
• liabilities owed to central counterparties recognised by the European Securities and Markets Authority in accordance with Article 25 of Regulation (EU) 648/2012 (EMIR) of the European Parliament and the Council of 4 July 2012 on OTC derivatives, central counterparties and trade depositaries
• liabilities owed to an employee or former employee in relation to salary or other remuneration, except variable remuneration
• liabilities owed to an employee or former employee in relation to rights under a pension scheme, except rights to discretionary benefits
• liabilities owed to creditors arising from the provision to the bank of goods or services (other than financial services) that are critical to the daily functioning of its operations^{[footnote 2]}

A “protected deposit” is defined in section 48C as one which is covered by the FSCS, or equivalent deposit guarantee scheme, up to the coverage limit of that scheme.

Further details on the other classes of excluded liabilities can be found in section 48D of the Banking Act. In particular, a “designated settlement system” means a system designated in accordance with Directive 98/26/EC of the European Parliament and of the Council (the Settlement Finality Directive)^{[footnote 3]}.

2.1 The Bank Recovery and Resolution Directive (BRRD)

In December 2013, an agreement was reached between the Council and the European Parliament on the Bank Recovery and Resolution Directive (BRRD). This agreement is subject to technical finalisation and formal approval by the co-legislators – a process which is currently underway, and is expected to conclude by spring 2014.

The Directive will ensure that EU Member States have a harmonised minimum toolkit to deal with the failure of banks and investment firms. It includes a bail-in tool, similar in design to that included in the 2013 Act.

The BRRD will strengthen the EU financial system and make it less vulnerable to shocks and contagion. As such, the government strongly supports it and is committed to fully transposing the Directive by 1 January 2015. The government does not intend to take advantage of the option of delaying the application of the bail-in provisions until 2016.

The bail-in powers in the 2013 Act will require some minor modifications in order to fully transpose the BRRD requirements. However, the government is of the view that the amendments required will not change the fundamental characteristics of the bail-in tool.

The BRRD also includes provisions regarding the ranking of deposits in the insolvency hierarchy in what is currently Article 98A (subject to renumbering). It requires Member States to ensure that:

• eligible deposits – that is, deposits of any amount that qualify for protection under the Deposit Guarantee Scheme (in the UK, the Financial Services Compensation Scheme) – from natural persons and SMEs, have a higher priority ranking in insolvency than the claims of ordinary unsecured creditors
• covered deposits – that is, deposits that qualify for protection under the Deposit Guarantee Scheme, up to the coverage limit (in the UK, £85,000) shall have a higher priority ranking in insolvency than the part of eligible deposits from natural persons and SMEs that exceed the coverage limit

As outlined above, the government is seeking views in the consultation on the transposition of certain aspects of the BRRD. The government will consult on transposition of the remainder of the BRRD in due course.

3. Applying the bail-in power to building societies

As set out in the Coalition Agreement, the government is committed to promoting mutuals and fostering diversity in financial services. The government recognises that the mutual ownership model provides a valuable alternative to the company form. A diversity of types of financial institution is essential to provide the consumer choice and the competitive pressure that the UK needs to sustain a vibrant and effective financial sector.

Building societies are key players in the UK financial services landscape. Therefore, it is important that the impacts of financial reforms on the sector are fully considered. The government has made clear its intention to ensure that the bail-in stabilisation option can be used in relation to failing building societies in as similar way to banks as possible. However, due to the different structure and business models of building societies, certain technical modifications are needed so that bail-in can be made effective for building societies, once they satisfy the conditions for resolution under the special resolution regime.

Section 17 of the 2013 Act gives the Treasury the power to make an Order to facilitate the exercise of the bail-in powers by the Bank of England in relation to a building society. The 2013 Act specifies that, in particular, an Order may enable the Bank of England to cancel membership rights or shares in the building society, and to convert a building society into a company, or to transfer to business of the building society to a company for the purpose of enabling it to execute a bail-in. This would result in the demutualisation of the building society. This is consistent with Article 37 of the BRRD, which requires that Member States ensure that the resolution authority is able to change the legal form of an institution in the context of applying the bail-in tool.

3.1 Scope of the bail-in powers

In common with the rest of the SRR powers, the bail-in powers apply to all building societies. However, the conditions for exercising the bail-in power are listed in sections 7 and 8A of the 2009 Act. Section 8A states that the Bank of England may only do so if it is satisfied that “the exercise of the power is necessary, having regard to the public interest in:

• the stability of the financial systems of the United Kingdom
• the maintenance of public confidence in the stability of those systems
• the protection of depositors
• the protection of any client assets that may be affected

One of the basic principles of bail-in is that the original “owners” of the firm, i.e. those who were previously entitled to make decisions relating to the firm (including for example, the right to appoint the directors), and to enjoy the economic value generated by the firm should lose this interest as part of the bail-in. Although the status of building society members is not directly analogous to shareholders in a bank, they are the most direct comparison, and therefore demutualisation seems to fit with this principle.

This matches the consequences on insolvency because, had the bail-in powers not been exercised, the members would most likely have had no ongoing interest in the firm, or right to future earnings, since the firm would have entered insolvency.

Demutualisation also seems to be the most operationally straightforward way of achieving a result similar to that for banks. When creditors of a bank are bailed in, they will generally receive shares in the institution as compensation (where necessary). These shares will give them rights to influence the direction the firm takes, and to a share of future profits in a company with a profit motive.

Capital instruments in building societies grant a share of future profits in an institution without also granting power to direct management’s incentives to make a profit (as is the case with bank shares). They may also be difficult to trade, as there is a more limited market in such instruments. Therefore, converting debt instruments into building society capital instruments using the bail-in powers may result in the bailed-in creditors being in a worse position than they would have been in had the institution entered insolvency. This may result in a large compensation bill. The government does not consider this an acceptable outcome, since it would not meet the objective of ensuring that the costs of failure are met by the shareholders and creditors of the institutions involved.

Additionally, the government interprets Article 42 of the BRRD as requiring the “instruments of ownership” (in a building society’s case, the member shares) to be cancelled or transferred to bailed in creditors (or severely diluted if there is net positive value in the building society at the time of failure). Although this Order is not intended to implement the BRRD, the government believes that introducing an option here that may be inconsistent with the BRRD would not be appropriate.

Bail-in is a resolution tool, and will only be used under the strict conditions in sections 7 and 8A of the Banking Act. It may only be used where a society is failing or likely to fail to satisfy the threshold conditions, and there is no other action that can be taken by, or in respect of, the firm that would be reasonably likely to restore it to viability. In addition, it must be necessary in the public interest having regard to a clear set of objectives. For this reason, the choice being made at this point is not a choice between the society continuing under mutual ownership, or the demutualisation and bail-in of the firm – it is a choice between bail-in and disorderly failure of the firm. That failure may be damaging not just for the society and its members, but for the wider mutuals movement and the financial sector more generally.

A building society member is either a “shareholding member” (a person who holds a share, typically in the form of a savings account, in the society) or a “borrowing member” (an individual who is indebted to the society in respect of a loan which is secured on land). Like shareholders in a bank, certain classes of building society members have certain rights associated with membership of the society – particularly, the right to vote on certain decisions, and rights on the transfer or winding-up of the society. It is this element which will be cancelled by demutualisation. The government therefore proposes that shares in the society will be cancelled, and a deposit will be created in the new demutualised entity.

Questions: bail-in of building societies

Question 1	Do you agree that it is appropriate for members to lose control of a building society (i.e. a demutualisation) where a society enters resolution and the Bank of England considers use of the bail-in powers to be appropriate?
Question 2	Do you agree with the proposed approaches for demutualising a failing building society?
Question 3	Do you think that there are any circumstances where demutualisation would not be appropriate? If so, how could bail-in be made to work in these circumstances?

The Order inserts section 84A into the Banking Act, which provides for two possible approaches to demutualisation for the purposes of exercising the bail-in option in respect of a building society:

3.2 Conversion method

The building society is converted by operation of law (through the resolution instrument) to a public limited company, incorporated under the Companies Act 2006 (the Companies Act). The company would be treated for all purposes^{[footnote 4]} as the same person as the society (and would therefore continue to be authorised by the PRA at the point of conversion).

3.3 Transfer method

The assets, rights and liabilities of a building society are transferred to a public limited company. The company must be authorised by the PRA (with the consent of the FCA) at the point of transfer.

In order to effect the demutualisation, section 84A(4) provides that a resolution instrument which provides for demutualisation may cancel shares in the society, cancel membership rights and provide for the cancellation the society’s registration as a building society.

The instrument may convert shares in the society into deposits in the successor company, in order to ensure that members’ deposits are maintained and to respect the fact that covered deposits are an excluded liability, and therefore may not be affected by bail-in. It may also confer rights and impose liabilities in place of cancelled shares and membership rights.

At the point of demutualisation, the resolution instrument may provide that any “approved persons” under Part 5 of the Financial Services and Markets Act 2000 in the building society will be considered approved persons in relation to the successor company. This helps to ensure continuity of service. However, it is without prejudice to the powers of the FCA and the PRA to vary or withdrawal approvals.

Section 36 of the Banking Act 2009 relates to property transfer instruments, and allows the instrument to provide for a transfer to be treated as a succession, and for the transferee to be treated for any purpose connected with the transfer as the same person as the transferor. Section 37 provides that licences relating to anything transferred by a property transfer shall continue to have effect despite the transfer. To ensure the continuity of the business following demutualisation, section 84A allows the resolution instrument to contain any provision which could be included in a property transfer instrument by virtue of section 36(1) – (5) or 37 of the Banking Act.

3.4 Authorisation and naming of the new company

In order to continue the business of the building society, when utilising the transfer method, the company to which its business has been transferred will need to be authorised by the PRA, with the consent of the FCA. This will happen in a similar way to the existing approach to authorisation of the bridge bank – the regulators will assess the company (the “successor company”) taking into account the action being taken in relation to the bank under the SRR.

Additionally, following the transfer or conversion, the successor company will have to be renamed, in order to remove references to a building society, and to reflect the nature of its business (a bank). The word “bank” appears in the Company, Limited Liability Partnership and Business Names (Sensitive Words and Expressions) Regulations 2009 as a sensitive word – the Secretary of State (having consulted the FCA) must approve any company name in which it appears, and written confirmation of their consent must accompany any application to register a name including “bank”. Therefore, the FCA and Secretary of State will be approached before the Bank of England converts a building society into a company and includes the word “bank” in the company name, or the company to which the building society’s business has been transferred changes its name.

3.5 Details of the conversion method

The process for converting a building society into a company in order to exercise the bail-in power is outlined in the draft Order, which inserts new section 84B into the Banking Act.

Where the conversion method is being applied, the initial resolution instrument must include a copy of the new company’s memorandum and articles of association and the company’s proposed name. An application for registration of the company would be filed with the Registrar in the normal way, but in addition the resolution instrument would be filed with the Registrar. The Registrar would register the company in the usual way. The conversion of the society into the company takes effect on registration of the company under the Companies Act 2006.

For the initial conversion of the company, the Bank of England will have the power to nominate the officers and directors of the company. Any directors which remain in place after the conversion is effective will need approval from the PRA and/or FCA (as appropriate) in the usual way to perform controlled functions at the successor bank.

3.6 Bail-in of the new company

Following the demutualisation, through either the transfer or the conversion method, the “successor company” can then be bailed-in in the same way as other banks. The draft Order adds section 84D to the Banking Act, which modifies Part 1 of the Banking Act 2009 so that references to “bank” in the applicable provisions are in most cases read as references to the successor company rather than to the building society. Sections 84D(2) and (4) also modify the way in which Part 1 applies in the case of the bail-in of a building society.

In particular, references to securities issued by a specified bank in section 12A(4) are to be read as references to securities issued by the building society, or the successor company. This will allow a resolution instrument to provide for the transfer of securities that were issued by the building society, or are issued by the successor company in the course of the resolution. This will allow the Bank of England to write down or cancel any liabilities of the successor company, in order to recapitalise the bank and allow it to continue as a going concern, while maintaining access to core services throughout the resolution period.

Section 60A of the Banking Act permits the Treasury to make regulations about mandatory compensation arrangements to apply where shareholders and creditors are affected by a bail-in (see Section 6). Section 60B requires the Treasury to have regard to the desirability of ensuring that pre-resolution shareholders and creditors of a bank do not receive less favourable treatment than they would have received had the bank entered insolvency immediately before the initial resolution instrument came into effect.

It is hypothetically possible that, had the building society entered insolvency immediately prior to resolution, there would have been some residual value left in the society after all creditors’ claims had been satisfied. In these circumstances, the members of the building society may have been entitled to a share of the residual value, in accordance with the rules of the society. In this case, the members would be eligible for compensation if their actual position, following bail-in, was worse than the treatment they would have received in insolvency.

Section 84D(2) therefore provides that the references to the pre-resolution shareholders and creditors of a bank in section 60B are read as references to the persons who were shareholding members of the society (within the meaning of paragraph 5 of Schedule 2 to the Building Societies Act 1986) or were creditors of the society, immediately before the coming into effect of the first resolution instrument to be made with respect to the society.

3.7 Formation of a parent company

It is common for banks incorporated in the UK to have a parent company, in the form of a financial holding company. In contrast, building societies do not have a parent company. A building society must be at the top of any group structure to ensure that the principal of mutual ownership can be maintained.

As part of the demutualisation process in the event of bail-in, it may be desirable for the successor bank to have a structure similar to other banks operating in the UK. This also has the benefit of facilitating any future bail-ins (in the event that the successor bank entered difficulties at some point in the future) by allowing for bail-in of the holding company rather than the subsidiary operating company. The draft Order contains provisions which would allow the conversion method to involve conversion into a company owned by a parent undertaking. It also includes provision for the transfer of the business of a building society to a successor company owned by a parent undertaking. In both cases, section 84A(5) provides for the parent company to be wholly owned, at the outset, by the Bank of England, the bail-in administrator or a nominee of the Bank of England.

Section 84A(1)(b) permits the resolution instrument to contain provision for the purposes of or in connection with the creation of a parent/subsidiary structure. This power might, for example, be used to create an intra-group liability. Under section 84D(1)(b), special bail-in provision may relate to the successor company or the parent.

Section 48B is modified so that the power to modify, or change the form of a liability of the bank may include provision to replace a liability of any form of the building society with a security of any form or class of the parent undertaking. This would allow creditors of the building society to be bailed-in and given securities in the parent undertaking, rather than the successor bank, as means of compensation.

3.8 Other modifications

In addition to the modifications included in the consultation draft, consideration will be given to the need for further modifications to the law (in particular the Banking Act 2009, Building Societies Act 1986 and Companies Act 2006) in consequence of demutualisation in the bail-in context. For example, the government is considering whether it is desirable to include provision enabling (or maybe requiring) the registration of pre-existing building society charges under Part 25 of the Companies Act 2006. A possible model under consideration is that in section 859C of the Companies Act 2006 (companies acquiring property which is subject to an existing charge).

Particularly when the conversion method is followed, it may be difficult under existing arrangements for the successor bank to obtain a trading certificate under section 761 of the Companies Act 2006 from the moment of incorporation. It is therefore being considered whether modifications are needed to the requirements for making an application for a trading certificate (see section 762 of the Companies Act 2006), and whether there should be an exception, for a short period, to the prohibition on trading without a trading certificate provided that the requirements as to minimum share capital are met from incorporation.

Questions: bail-in of building societies

Question 4	Do you think that any other modifications (beyond those included in the draft Order) are required to ensure that the successor bank can be bailed-in effectively?
Question 5	Do you agree that it is desirable to allow the creation of a holding company structure for the successor bank?
Question 6	Does any special provision need to be made to deal with building societies where members have agreements in place to assign any windfall benefits to charitable organisations?

3.9 The future of the successor bank

The bail-in of a building society will result in a new bank, which has been recapitalised to an appropriate level. As is the case for banks which are subject to the bail-in stabilisation option, the Bank of England will have the ability to require the bail-in administrator, or one or more directors of the bank, to draw up a business reorganisation plan with respect to the bank. This may include measures to be taken in order to ensure the viability of the successor bank.

The successor bank will also have to ensure that it complies with the regulatory requirements on banks, which may in some cases include ring-fencing requirements. The government is exploring options to allow the successor bank time following demutualisation to make the necessary changes to comply with ring-fencing.

4. The creditor hierarchy

Savings in building society share accounts are currently subordinated to unsecured creditors, meaning that if the building society entered insolvency, those depositors would only be entitled to any recoveries after other creditors had been paid out in full.

The majority of members’ deposits would be excluded from the scope of the bail-in powers by virtue of section 48B(4) and (8) and 48Cof the Banking Act 2009 – however, any uninsured deposits could be subject to bail-in.

Section 48E of the Banking Act 2009 (as inserted by the 2013 Act) requires the Bank of England to address in a report any departures from the insolvency treatment principles, which state that bail-in should be consistent with treating all liabilities of the bank (or building society) in accordance with the priority that they would enjoy on liquidation; and that any creditors who would have equal priority on liquidation bear losses on an equal footing. Transposition of the BRRD will limit the flexibility available to the Bank of England.

Furthermore, the draft Banking Act 2009 (Mandatory Compensation Arrangements Following Bail-in) Regulations 2014, made under section 60A and considered in detail in Section 6 of this document, will ensure that any shareholding member or creditor who is left in a worse position by the bail-in than they would have been in had the building society entered insolvency will be entitled to have an assessment made of whether compensation is required under the “no shareholder or creditor worse off” principles.

Since share accounts are currently subordinated to creditors, it is highly unlikely that these creditors would have experienced losses in insolvency – since they would be entitled to receive their claims in full before depositors received any money. Therefore, if they were bailed-in and experienced losses, they would be entitled to significant compensation.

Therefore, the government is of the view that, in order to have a credible and effective bail-in tool for building societies that meets the Special Resolution Regime objectives, it is necessary to alter the creditor hierarchy of building societies.

This is consistent with the government’s statement in the discussion document “The Future of Building Societies”, published in July 2012, that consistency across banks and building societies is important for creating a level playing-field. That statement proposed to implement insured depositor preference for both banks and building societies, and take any other necessary steps to ensure consistency.

Since that discussion paper was published, the BRRD has been agreed and will require us to introduce a slightly different form of depositor preference. It will require a two tier preference, where:

• eligible deposits from natural persons and SMEs have a higher priority ranking in insolvency than the claims of ordinary unsecured creditors
• covered deposits have a higher priority ranking in insolvency than the part of eligible deposits from natural persons and SMEs that exceed the coverage limit

Covered deposits are defined as those that are protected by the FSCS, up to its limit of £85,000. Eligible deposits are defined as those which qualify for FSCS protection, without any limit on the amount (and deposits from such natural persons and SMEs that are made through foreign branches of EU institutions). Following these changes, if an individual had £100,000 deposited at a building society that is a member of the FSCS, £85,000 would be a “covered deposit” and have a higher priority ranking than the remaining £15,000 which in turn would have a higher ranking than ordinary unsecured creditors.

We anticipate that the Directive will come into force by May 2014. The transposition deadline is 1 January 2015.

In order to avoid making multiple changes to the creditor hierarchy, the government proposes transposing this particular element of the BRRD ahead of the transposition deadline – for both banks and building societies and to take any other steps necessary to align the creditor hierarchies of banks and building societies. This will avoid having to amend the insolvency hierarchy twice within six months. Successive amendments in quick succession are not helpful to industry and do not represent an appropriate use of Parliamentary time. It will also reduce the contingent liability of the FSCS, since its recoveries are likely to be higher in any subsequent insolvency.

Questions: depositor preference

Question 7

Do you agree that early transposition of the BRRD is the best approach for aligning creditor hierarchies, and ensuring that the bail-in tool is effective?

5. Safeguards for protected arrangements

Under section 48P of the Banking Act, the Treasury has the power to make an order restricting the exercise of the bail-in powers in relation to protected arrangements. This power can be used to ensure that the contractual protections provided by such arrangements are appropriately protected in bail-in.

“Protected arrangements” are security interests, title transfer collateral arrangements, set-off arrangements and netting arrangements.

The most significant safeguard for many protected arrangements is an exclusion from bail-in found in section 48B(8) of the Banking Act: resolution authorities may not bail in liabilities to the extent they are secured, or liabilities arising from participation in a designated settlement system, for example. This is discussed in more detail below.

5.1 The BRRD context

The draft Order is designed to implement the domestic powers introduced in the 2013 Act, not to transpose the BRRD. However, in designing the safeguards, the government is firmly of the view that, in order to provide market participants with certainty about the operation of the bail-in powers and to avoid making substantive changes in order to transpose the BRRD, the provisions here should be as consistent as possible with the BRRD.

The draft Order is consistent with the requirement under Article 44 of the BRRD that derivatives subject to netting arrangements should only be bailed-in on a net basis. Given that netting is critical to the operation of other types of financial contracts (such as stock lending and repo arrangements), the government believes that it is appropriate to require that all liabilities under certain other types of financial contract subject to set-off or netting may only be bailed-in on a net basis, together with certain master agreements. The government believes that it is appropriate to give these agreements this protection.

The government considers that this strikes an appropriate balance between ensuring adequate protections for these arrangements, while ensuring that a bail-in can be executed within a reasonable timeframe.

5.2 Security interests and certain other excluded liabilities

Section 48B of the Banking Act includes a list of “excluded liabilities”, and specifies that the power to make special bail-in provision cannot be exercised in such a way as to affect these liabilities. The list of excluded liabilities includes any liability, so far as it is secured (which includes title transfer security arrangements).

Given that these liabilities are excluded, so as to be unaffected by the exercise of the bail-in powers, the government considers that no further provision is required in the safeguards in relation to security interests.

Questions: safeguards for protected arrangements – security interests / other excluded liabilities

Question 8

Do you agree that the list of excluded liabilities provides sufficient protection for the holders of these liabilities, so that no further provision is necessary in this Order?

5.3 Set-off arrangements and netting arrangements

For the purposes of this draft Order, “netting arrangements” and “set-off arrangements” are defined in section 48P(2) as follows:

• “netting arrangements” means arrangements under which a number of claims or obligations can be converted into a net claim or obligation, and includes, in particular, “close-out” netting arrangements, under which actual or theoretical debts are calculated during the course of a contract for the purpose of enabling them to be set off against each other or to be converted into a net debt
• “set-off arrangements” means arrangements under which two or more debts, claims or obligations can be set off against each other

The draft Order provides a safeguard in respect of “protected liabilities” subject to set off and netting arrangements (including where set-off or netting takes place in the context of a title transfer collateral arrangement^{[footnote 5]}). The “protected liabilities” are defined in article 4(2) as those which relate to derivatives, certain types of financial contract or certain types of master agreement. The definition of derivatives in the BRRD is adopted and the definition of financial contracts is adapted in part from that included in the BRRD. In combination, these include certain options, futures, swaps and forwards; certain securities contracts (including repos) and commodities contracts of a financial nature (including repos). Master agreements for derivatives, financial contracts and the sale, purchase or delivery of currency are also within scope.

The draft Order provides that the Bank of England may not bail-in a protected liability. The Bank would first have to close-out the contract to create a net liability. The net liability could then be bailed-in, provided that it was not an “excluded liability” under section 48B(8). This is consistent with the treatment of such arrangements in insolvency.

For this purpose, where applicable, the Bank of England will close out the contracts which are subject to the bail-in tool and have not already been closed-out, prior to or at the time of the bail-in.

In order to close-out derivatives, financial contracts or qualifying master agreements subject to set-off or netting arrangements, it may be necessary to make special bail-in provision – for example, by using the power in section 48B(1)(c), which allows the Bank of England to provide that a contract under which the bank has a liability is to have effect as if a specified right has been exercised under it. Where a set-off or netting arrangement is in place, this power could be used to require the right to be converted into a net debt.

Therefore it is necessary to ensure that the Bank of England may exercise special bail-in provision in relation to protected liabilities in order to convert, or in connection with converting, the protected liability into the net debt, claim or obligation that would be due under the set-off or netting arrangements. This is specified in article 4(4) of the draft Order.

Following the conversion to a net claim, the net claim could therefore be bailed-in in the same way as the bank’s other liabilities, and respecting any other conditions – so, for example, a net liability would be excluded from bail-in so far as it was secured.

The PRA and FCA will be consulted by the Bank of England in accordance with the terms set out in the Banking Act, including on the exercise of its powers to make special bail-in provision.

Questions: safeguards for protected arrangements – set-off and netting arrangements

Question 9	Do you agree with limiting the scope of this safeguard to those “protected liabilities” defined in the draft Order?
Question 10	Do you agree with the definition of “financial contracts”?
Question 11	Do you agree that the Order should prevent special bail-in provision being made in respect of a protected liability subject to set-off or netting?

5.4 Termination rights

The Banking Act confers powers to restrict termination rights (and other similar rights), both for the bail-in option and for other stabilisation options. For bail-in, section 48M allows the Bank to require the resolution instrument to be disregarded in determining whether a default event provision applies^{[footnote 6]}. Special bail-in provision under section 48B also allows contracts to be modified, for the purpose of, or in connection with, reducing, deferring or cancelling a liability of the bank. For existing stabilisation options, the share transfer and property transfer powers contain equivalents to section 48M (in sections 22 and 38 respectively).

The provisions of sections 22, 38 and 48M cannot be used to override financial collateral agreements, which are protected by the Financial Collateral Arrangements Directive^{[footnote 7]} (“FCAD”), and which in broad terms must be allowed to take effect in accordance with their terms. This currently places a material restriction on the use of sections 22, 38 and 48M.

To be able to use the bail-in powers effectively, the Bank may need to be able to restrict the enforcement of financial collateral arrangements. Article 107 of the BRRD amends FCAD to allow for this. The government proposes to implement Article 107 ahead of the transposition deadline by amending the Financial Collateral Arrangements (No 2) Regulations 2003^{[footnote 8]}, which implement FCAD. The resolution authority will then be able to switch off relevant termination rights.

In consequence, no safeguard for termination rights is included in the draft Order. In order to give effect to the implementation of Article 107 of the BRRD, it will also be necessary to remove the safeguard for termination rights in article 9 of the Banking Act 2009 (Restriction of Partial Property Transfers) Order 2009 (“the 2009 Order”).

Questions: safeguards for protected arrangements – termination rights

Question 12

Do you agree with the proposal to amend the regulations implementing FCAD in advance of the BRRD transposition deadline, and to amend the Banking Act 2009 (Restriction of Partial Property Transfers) Order 2009 to ensure consistency?

5.5 Remedy for breaches

As is the case in the 2009 Order^{[footnote 9]}, it is important to ensure that appropriate remedies are in place for any breach of the safeguard.

Similar to the protections themselves, the remedies will have to appropriately balance the rights of the affected creditor, and the need to ensure that the bail-in is successful in restoring the firm to viability in a reasonable time period (such that it gives market participants confidence in the resolution).

The government believes that a remedy which made the resolution instrument “void” to the extent that it contravened the safeguard, would not provide sufficient certainty for other market participants and creditors of the bank – it could call the effectiveness of the bail-in into question.

Instead, the draft Order provides that, in the event of being notified that they have breached the safeguard, the Bank of England is required to remedy the contravention, either by providing the affected party with securities in the bank in resolution^{[footnote 10]} or by requiring the bank in resolution to pay moneys to the affected party.

Questions: safeguards for protected arrangements – remedy for breaches

Question 13

Do you consider the suggested remedy – that the Bank of England uses its powers in order to remedy the breach – is suitable?

5.6 “No Shareholder or Creditor Worse Off” compensation

In addition to the protections in the draft Order (under section 48P), all creditors of the institution under resolution will be covered by the “No Shareholder or Creditor Worse Off” safeguard put in place through regulations to be made under section 60A (considered below), which will provide a key safeguard.

Therefore, to the extent that any set-off arrangements or netting arrangements (whether contractual or statutory) would have been respected in the insolvency counterfactual, the holders of these arrangements would be able to rely on this in the establishing of their “insolvency treatment” for the purposes of establishing whether any “no shareholder or creditor worse off” compensation is appropriate.

5.7 Compatibility with EU law

The draft Order prohibits the making of special bail-in provision to the extent that it would contravene EU law. Although the exercise of the bail-in powers will always seek to be compatible with EU law in a way which would prevent this situation occurring, the government considers that it is appropriate to include a similar provision in the draft Order to that included in the 2009 Order, by expressly providing that the bail-in powers cannot be exercised in such a way as to contravene EU law.

6. ‘No Shareholder or Creditor Worse Off’ compensation

Following a resolution involving the making of special bail-in provision, the Treasury is required to put in place a compensation order specific to that particular resolution. When the bail-in option is used, this will be a bail-in compensation order (see sections 52A and 49(2A)). For a bridge bank resolution involving bail-in, this will be a resolution fund order (see sections 52 and 49(3)). These are referred to below as “resolution-specific compensation orders”.

Section 60A of the Banking Act gives the Treasury the power to make regulations about provisions that must be included in resolution-specific compensation orders. Section 60B requires the Treasury, when making these regulations, to have regard to the desirability of “ensuring that pre-resolution shareholders and creditors of a bank do not receive less favourable treatment than they would have received had the bank entered insolvency immediately before the coming into effect of the initial instrument” (the first instrument made by the Bank in the resolution).

The draft Regulations which accompany this consultation are modelled closely on The Banking Act 2009 (Third Party Compensation Arrangements for Partial Property Transfers) Regulations 2009 (the 2009 Regulations) which make provision about compensation following an exercise of the partial transfer powers in the Banking Act. Although broadly similar in approach, consequential amendments will be necessary to the 2009 Regulations in circumstances where a resolution involves both bail-in and a partial property transfer.

The Regulations apply whenever the Bank of England makes an instrument containing special bail-in provision (whether under the bail-in option through a resolution instrument under section 12A, or in conjunction with the bridge bank stabilisation option in accordance with section 44B(1) of the Act).

The government proposes that the Regulations specify a number of mandatory provisions which must be included in resolution-specific compensation orders. This is consistent with the approach taken in the 2009 Regulations.

6.1 Mandatory provisions – appointment of independent valuer

The government proposes to introduce a requirement that the resolution-specific compensation orders include a requirement to appoint an independent valuer. The independent valuer would be appointed to determine whether all relevant persons, a class of relevant persons or a particular relevant person should be paid compensation, and if so how much.

“Relevant persons” are defined as the pre-resolution shareholders and creditors of the institution, which are defined in section 60B(3) of the Banking Act as the persons who held securities issued by the institution, or were creditors of the institution, immediately before the coming into effect of the initial instrument.

6.2 Mandatory provisions – insolvency treatment and actual treatment

In order to determine whether any relevant person is entitled to compensation, the government proposes that the independent valuer be required to determine the treatment that person would have received had the institution subject to the relevant instrument entered insolvency immediately prior to the coming into effect of the initial instrument.

Regulation 8 permits the resolution-specific compensation order to specify the particular insolvency process (e.g. administration, liquidation) that the independent valuer should assess for the purposes of determining the insolvency treatment. Alternatively, the resolution-specific compensation order may require the independent valuer to determine what insolvency process it is likely that the banking institution would have entered.

In either case, regulation 9 requires the independent valuer to assume that the banking institution concerned would have entered into insolvency immediately before the coming into effect of the initial instrument, that neither the initial instrument nor any other instrument would have been made in respect of the firm, and that no financial assistance would have been provided by either the Bank of England or the Treasury.

The independent valuer would then be required to determine the “actual treatment” – that is, the treatment that the relevant persons have received, are receiving or are likely to receive. As part of a bail-in, shareholders or creditors may have received securities in the institution, which will have a value which should be taken into account for the purposes of determining the actual treatment.

The appropriate method for determining their value is likely to be dependent on the circumstances of the individual resolution.

Therefore, regulation 12 permits the relevant compensation order to include a requirement that, when determining the “actual treatment”, the valuer must assume that the relevant securities would have a value specified by that order, or a value calculated by reference to criteria specified in the order. This will allow the government to specify, in any individual circumstance, the appropriate value or methodologies for valuing securities issued as part of the bail-in. Where the relevant compensation order does not include such provision, the independent valuer may develop his own methodology.

The BRRD also provides that the EBA may develop regulatory technical standards in relation to the methodology for assessing the insolvency treatment and the actual treatment of creditors.

Questions: no creditor worse off – insolvency treatment and actual treatment

Question 14	Do you agree that the provisions relating to the assessment of the insolvency treatment should mirror, with the necessary differences, the existing provisions in the 2009 Regulations for partial property transfers?
Question 15	Do you agree that the Regulations should allow the relevant compensation order to specify the value of relevant securities, or the methodology (or methodologies) for determining value of relevant securities, in order to determine the actual treatment of pre-resolution shareholders and creditors?

6.3 Building societies

As described in Section 3, the government is of the opinion that the bail-in of a building society will normally involve its demutualisation. During the period of resolution, the Bank of England, bail-in administrator or other person nominated by the Bank of England may hold the shares in the successor bank prior to distribution to bailed-in creditors.

The original shareholding members and creditors of the building society will be considered the “relevant persons” for these purposes, and will therefore be entitled to assessment for compensation in the event that their actual treatment was less favourable than their insolvency treatment.

The insolvency treatment will be assessed on the basis that the building society had entered into insolvency immediately before the coming into effect of the initial instrument – and therefore before the demutualisation occurred.

Questions: no shareholder or creditor worse off – building societies

Question 16	Do you agree that, for building societies which are demutualised as part of the bail-in, the relevant persons are the shareholding members and creditors of the building society before the demutualisation occurs?
Question 17	Do you think that any additional provision is required to effectively apply the Regulations to building societies?

6.4 Group companies

Section 81BA of the Banking Act provides for the Bank of England to exercise the bail-in powers in respect of certain banking group companies if certain conditions are met. This therefore creates the possibility that shareholders and creditors of more than one company within a group will be affected by the resolution actions.

In the majority of these cases, the government anticipates resolution instruments in respect of multiple companies within a group would be made at the same time. However, it is not possible to entirely rule out the possibility that there may be circumstances where the bank (“B”) is first subject to a resolution instrument on one date, and another group company (“C”) is first subject to a resolution instrument on a later date.

In these circumstances, there is a question over whether the “pre-resolution shareholders and creditors” of C should refer to the persons who held securities issued C, or were creditors of C, immediately before the coming into effect of the earliest instrument (which only directly affected B) or those who held securities issued by C, or were creditors of C, immediately before the coming into effect of the later instrument, which was the first one that directly affected C.

The government considers that it is appropriate to follow the principles of insolvency, where, if a group fails, each individual company in the group is subject to its own insolvency procedure.

Therefore, the government proposes that, in these circumstances, the pre-resolution shareholders and creditors are the persons who held securities issued by the company in question, or were creditors of the company, immediately before the coming into effect of the first instrument that directly affected that company. These shareholders and creditors are therefore the relevant persons for the purposes of determining whether any compensation is necessary.

Questions: no creditor worse off – group companies

Question 18	Do you agree, where a company in the same group as a bank subject to bail-in is subject to a resolution instrument at a later date than the resolution instrument in respect of the bank, the pre-resolution shareholders and creditors of the group company should be those who are shareholders and creditors at the time the resolution instrument in respect of the group company is made?
Question 19	Do you consider that this approach could have any unintended consequences or cause problems for the resolution? If so, please give details of the risks and any suggestions on how to mitigate them.

6.5 Tax consequences of bail-in

The use of the bail-in tool has the potential to have tax consequences in relation to the pre-resolution shareholders and creditors of the resolved institution as well as the resolved institution itself. The government is considering the treatment of these tax consequences to ensure they are consistent with the general intentions of the tax system and would not unfairly advantage or disadvantage the affected parties.

7. Banking group companies

Section 81BA, as inserted by the 2013 Act, allows the Bank of England to exercise the bail-in power in respect of a banking group company (BGC) when specified conditions are met.

This is closely related to section 81B of the Banking Act 2009 (as inserted by the Financial Services Act 2012) which extends the private sector purchaser and bridge bank stabilisation powers to BGCs.

Section 81D defines a banking group company as an undertaking which is (or, but for the exercise of a stabilisation power, would be) in the same group as a bank. It also allows the Treasury to specify, by order, conditions that must be met for an undertaking to be a BGC. The Treasury consulted on a draft of this Order in a consultation paper entitled “Secondary Legislation for Non-Bank Resolution Regimes”, published in September 2013. This consultation closed on 22 November 2013.

This consultation did not consider the application of the bail-in powers to group companies, since it was published before the Bill which became the 2013 Act was amended to provide for the bail-in option. Nor did it reflect the requirements of the BRRD, which had not been agreed. However, the definition of BGCs in the order will apply to the bail-in stabilisation option by virtue of sections 81BA and 81D, and is therefore relevant to the implementation of the bail-in powers.

The government proposed in the consultation on the draft order that it will continue to maintain its position concerning the protection of capital market arrangements (subject to any changes required by the BRRD). Alongside the protection already in place in the existing safeguards order, entities that facilitate capital market arrangements, such as covered bond special purpose vehicles are excluded from being a “banking group company” for the purposes of the stabilisation powers unless they fall within the definition of an “investment firm” or a “financial institution”. The BRRD will require that all investment firms and financial institutions are within the scope of the stabilisation powers.

The government expects to proceed with laying the Banking Group Companies Order before the summer, in order to meet the policy objective of extending the private sector purchaser and bridge bank stabilisation options to banking group companies. The Order will also apply to the bail-in stabilisation option once those provisions are commenced, by virtue of section 81D.

The government is considering whether it is appropriate to amend the Order in due course so that it applies in a different way to the bail-in stabilisation option compared to the other stabilisation tools, and whether changes will be required to implement BRRD. In particular, the government is considering whether covered bond vehicles and securitisation companies, which will be excluded in their entirety from the other tools (unless they fall within the definition of an “investment firm” or a “financial institution”), should be within the scope of the bail-in power.

Secured liabilities would remain out of scope of the bail-in tool, by virtue of being excluded from bail-in under section 48B(8)(a). But covered bonds or other collateralised funding arrangements may not be fully collateralised at the point of failure. To the extent that under-collateralisation results in an unsecured liability of the failing firm and the covered bond vehicle, the government is considering whether that unsecured liability should be capable of being bailed-in.

It is not expected that these vehicles would have significant unsecured or uncollateralised exposures. However, if they do, then in insolvency or liquidation the creditors of those entities would have lost money. And having these vehicles in scope of the bail-in powers may prevent there being an incentive for firms to engage in under-collateralised off-balance sheet funding.

Therefore, the government is considering whether it is appropriate that, for the bail-in stabilisation option, these vehicles should be capable of being bailed in. For the avoidance of doubt, any secured liabilities they contain would continue to be excluded.

Questions: bail-in of banking group companies

Question 20

Should covered bond vehicles and securitisation vehicles that are not “financial institutions” or “investment firms” be within the scope of the bail-in stabilisation option?

1. Where the counterparty is not a banking group company in relation to the bank. ↩

2. Where the counterparty is not a banking group company in relation to the bank. ↩

3. As amended by Directives 2009/44/EC and 2010/78/EU. ↩

4. The successor company would no longer have to comply with the Building Societies Act 1986; it may also be subject to ring-fencing requirements under the Banking Reform Act 2013. ↩

5. To the extent that a liability is secured by a title transfer collateral arrangement, it is an excluded liability within the meaning of section 48B(8)(b) (see section 48D). ↩

6. Default event provision includes termination rights and a wide variety of analogous rights. Section 48M(1) provides that the definition in section 22 is adopted. ↩

7. Directive 2002/47/EC. ↩

8. The Banking Act 2009 (Restriction of Partial Property Transfers) Order 2009 (S.I. 2003/322). ↩

9. Where bail-in is used in conjunction with the bridge bank stabilisation option, the securities could also be securities issued by the bridge bank. ↩

10. Or the bridge bank, where special bail-in provision is made in conjunction with the bridge bank stabilisation option. ↩