Fitch: Retail Investors Present Challenge For EU Bank Resolution

Bank resolutions in the EU will still prove challenging even though the Bank Recovery and Resolution Directive (BRRD) came into full force on 1 January 2016, says Fitch Ratings. One key complication is that bank resolutions can force losses on retail investors in bank debt, which might be politically unacceptable and undermine retail investor confidence in the banking sector. However, the Single Resolution Mechanism (SRM), which implements BRRD in the eurozone and became fully operative on the same day, should ensure that politics are kept out of resolution decisions by curbing the powers of national resolution authorities.

The practice, common in some countries, notably Italy and Portugal, of selling bank bonds, primarily senior, to retail investors blurs the line between a government's responsibility to provide an appropriate level of protection for individuals' savings and investments and maintain domestic financial stability, and the need to implement BRRD. Bonds sold to retail investors are investments, rather than savings' deposits. Consequently, they are neither insured (unlike deposits up to EUR100,000) nor preferred to other senior creditors (unlike all retail deposits). Subordinated bonds that were sold to retail investors were bailed-in in some of the latest resolutions in Italy and Portugal.

Elke Konig, who chairs the Single Resolution Board, stresses that when a bank fails, market economy principles will be applied strictly and even retail investors must be held responsible for their investment decisions. Europe's supervisory authorities warned banks against "self-placement" of loss-bearing financial instruments to consumers in July 2014. But EU-wide regulation to prohibit the distribution of securities that could be bailed in to retail customers does not appear to be on the cards. Some jurisdictions, notably the UK, prohibit the practice.

We think a handful of bank resolutions were probably rushed through before end-2015 in Italy and Portugal to avoid application of the full bail-in aspect of BRRD. Some of these banks had retail investors, giving rise to complications. Senior bondholders and depositors were safeguarded in the resolution of four small failed Italian banks in November 2015. But subordinated debt was written down, some of which was held by retail investors. Jonathan Hill, the EU Commissioner for Financial Services, warned of the risk of selling 'inadequate products to the public' in the wake of these Italian write-offs.

Investigations are underway to determine whether securities were mis-sold and retail investors may receive some compensation, but this is likely to take time. Litigation related to the bail-in of legacy junior retail instruments at failed banks in Spain during the height of the latest financial crisis is ongoing.

In Portugal, the resolution of long-troubled Banif - Banco Internacional do Funchal - in December 2015 involved a split into a 'good' bank and liquidation of the remaining 'bad' bank. Equity and subordinated debt were left behind in the 'bad' bank. But Banif's subordinated debt had also been issued to retail investors and consumers and opposition parties will probably lobby against the decision.

To complicate matters, implementation of BRRD is being handled differently across the EU. For example, in Italy, deposits in excess of EUR100,000 not held by individuals and SMEs, and senior unsecured debt currently rank equally in liquidation and resolution, but there are proposals that they become preferred to senior debt from 2019. In Germany, deposits and counterparties will rank ahead of senior debt from 2017. Late last year, France outlined proposals for a new class of 'senior subordinated' debt, similar in principle to the 'tier 3' debt that can be issued by Spanish banks.

BRRD's bail-in tool requires shareholders, depositors, counterparties and debt holders to absorb losses equivalent to at least 8% of liabilities and own funds before public equity can be injected in a bank. Retail and SME deposits enjoy preference over larger corporate and institutional deposits, while insured deposits are excluded from bail-in.