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Making the European bank failure management framework suitable for mid-sized banks requires facilitating sale-of-business transactions by ensuring both adequate financial support from the deposit insurance fund and the availability of sufficient assets that could be transferred to an acquirer.

Under the current financial cap, support by deposit insurers is limited by the costs (net of recoveries) they would incur if paying out covered deposits in a bank liquidation. That crucially depends on the ranking of deposit insurance fund claims in the creditor hierarchy. The ability to transfer sufficient assets is directly linked to the minimum requirement for eligible liabilities (MREL).

As a minimum, MREL should aim to help close the expected gap between transferred liabilities and assets, after considering the available support from the deposit insurer.

Consequently, calibrations should be based on the prevailing status for deposit insurance fund claims in insolvency and on a structured assessment of three key factors: (i) the estimated (franchise) value of banks' assets; (ii) the proportion of transferred liabilities which are not covered by the deposit insurance fund; and (iii) the liquidation procedure's ability to preserve banks' asset values.

1. Introduction

There is by now broad consensus that the most suitable approach for dealing with the failure of most midsized banks is through sale-of-business (SoB) strategies that imply market exit after the transfer of the failing bank’s sensitive liabilities (such as deposits)2 to a suitable acquirer. Other resolution strategies are often inappropriate for those banks. In particular, the application of the regular insolvency procedures involving piecemeal liquidation – which are often inefficient – can give rise to significant value destruction and contagion. At the same time, resolution strategies that rely primarily on the writedown or conversion into equity of banks’ liabilities (open bank bail-in) is also often inappropriate for mid-sized banks. Those banks’ business models cannot easily accommodate the issuance of large amounts of liabilities (other than deposits) that could be loss-absorbing in resolution (Restoy (2018)). The success of SoB strategies crucially depends on the availability of sufficient funding. In an SoB transaction, acquirers receive a failing bank’s assets as compensation for assuming liabilities. Yet, for failing commercial banks with a large deposit base, the value of transferable assets is often lower than the volume of deposits. When this is the case, SoB can only work if there is external financial support. In the United States, that support is regularly provided by the deposit insurance fund (DIF) subject to the (least-cost) condition that this option is less expensive for the DIF than paying out covered deposits if the failing bank is liquidated (FDIC (2017)) DIF support for SoB transactions is also available in the European Union. 3 That support is limited to the cost to the DIF of paying out covered deposits if the bank had been liquidated. In practice, that financial cap is substantially more restrictive than the least-cost constraint in the US because of the different ranking of covered deposits in insolvency. In the US, deposits covered by the DIF rank pari passu with uncovered deposits; however, in the EU covered deposits (and, therefore, DIF claims after paying them out) are “super-preferred” over non-covered deposits. Consequently, the DIF claims on the liquidating bank are better protected in the EU, and the DIF would expect to recover more of its costs. As a result, the net cost for the European DIF of paying out deposits would be smaller and the financial cap for any support for SoB transactions will be commensurately lower. That de facto makes the DIF unable to provide meaningful support for SoB transactions in the EU. Following several contributions made over the last few years,4 the European Commission (EC) has put forward a legislative proposal to facilitate, among other objectives, the funding of SoB strategies (EC (2023)). This proposal amends the EU crisis management and deposit insurance framework, and is referred to hereafter as the “CMDI proposal”. A key element of the proposal is to replace the superpreference of covered deposits with a general depositor preference rule which would give DIF claims and uncovered deposits the same ranking in insolvency procedures. 5 The additional DIF funding facilitated by this reform aims to make an SoB strategy a realistic alternative to open bank bail-in for banks that cannot issue large amounts of gone-concern capital instruments. However, a key question remaining is how much loss-absorbing capacity should still be required. The Single Resolution Board (SRB), in accordance with the legislative revisions introduced by the 2019 banking package, 6 has introduced some corrective factors for MREL for banks with an SoB strategy. MREL would still have to be calculated as the sum of a loss absorption amount (LAA) and a recapitalisation amount (RCA) as in the case of banks following an open bank bail-in strategy. Yet, as a way to recognise the lower capital needs for failing banks exiting the market, the recapitalisation amount (RCA) component for SoB banks could be adjusted downwards by a minimum of 15% and a maximum of 25%. 7 In selecting the precise adjustment, the SRB uses “criteria that capture the marketability and capital needs of the resolved entity” (SRB (2023)). The EC CMDI proposal also contains general provisions aimed at providing a legal basis for establishing the RCA amount of MREL for banks with an SoB preferred strategy seeking “a proportionate and consistent application”. 8 While those general criteria are certainly all relevant, there is as yet no clear framework to establish the actual MREL for SoB banks. In particular, neither the current nor the proposed provisions on setting MREL take into account the DIF contribution. Moreover, a calibration of MREL on the basis of discounts from what would have been required for an open bank bail-in strategy does not fully capture the specific role that MREL plays in SoB transactions. By definition, MREL instruments should be able to absorb losses in resolution. When an SoB is performed, those liabilities are not transferred to the acquirer but rather are written down (in a whole bank transfer) or left behind in a residual entity that will be liquidated (in partial transfers). Therefore, the larger the MREL that can absorb losses, the larger the amount of assets that can be transferred relative to the (sensitive) transferred liabilities. In other words, while less is needed than for an open bank bail-in strategy, MREL still plays a key role – together with the aid provided by the DIF – in ensuring the feasibility of an SoB strategy. Indeed, in the US, where no formal MREL-type obligations currently exist for small and medium-sized banks, there are already plans to introduce (bail-in-able) longer-term debt requirements for banks with more than $100 billion in assets in order to facilitate SoB transactions (Gruenberg (2023)). Moreover, it could be argued that a reasonable volume of bail-in-able liabilities could generally provide incentives for adequate bank management regardless of banks’ preferred resolution strategy and reduce the need of any external support when they fail. Naturally, while an appropriate calibration of MREL might significantly facilitate SoB transactions, it cannot by itself guarantee successful implementation of that resolution strategy. Both external (market) conditions and the specific characteristics of the failing bank would always affect the likelihood of finding a sound buyer and, therefore, the suitability of SoB as a preferred resolution strategy. Beyond MREL, a bank’s resolution plan can contain other requirements, such as internal reorganisations or adjustments to its balance sheet structure, to support the feasibility of an SoB strategy when the bank fails. Moreover, when resolution plans contain a combination of different resolution tools, MREL should be adjusted accordingly. In any event, once SoB is identified as the preferred strategy, the calibration of MREL should primarily target the expected gap between the value of the transferred liabilities (eg deposits) and the sum of the value of the transferred assets and the support provided by the DIF. That gap would depend on factors such as the composition of the balance sheet (including the proportion of insured to uninsured deposits), the value of the franchise for the acquirer and elements affecting the efficiency of the liquidation procedures. The latter enter the equation as they have an impact on the cost that the DIF would face in a liquidation counterfactual and, therefore, on the maximum amount it would be able to contribute to support the SoB transaction. Following that approach, this paper provides a relatively simple analytical framework that helps to facilitate the calibration of MREL for banks with an SoB resolution strategy. The rest of the paper is organised as follows. Section 2 presents the analytical setup leading to the determination of MREL as a function of bank-specific and more structural characteristics. Section 3 offers some illustrative calibrations. Section 4 concludes.

2. The analytical framework

The problem The exercise considers a bank for which the competent authority has approved a resolution plan with a preferred SoB resolution strategy. That strategy consists of transferring, when resolution is triggered, all deposits9 to a suitable acquirer. The acquirer will assume those deposits and in exchange receive the failing bank’s assets as well as, if needed and feasible, cash support from the DIF. The transaction would only be feasible if the sum of the expected value of transferred assets and the available DIF support exceeds the volume of assumed deposits. The relation between transferable assets and assumed liabilities would be determined by the availability in the failing bank’s balance sheet of sufficient loss-absorbing liabilities that would not be transferred to the acquirer. Those liabilities would be directly written down or remain in the residual entity that would be wound up after the execution of the SoB transaction. The maximum support the DIF is allowed to provide is the net cost of paying out covered deposits in a piecemeal liquidation under the applicable insolvency regime (the financial cap). That financial cap will therefore depend on the ranking of DIF claims in the insolvency procedures. The competent authority should determine, given the available DIF support, the lowest possible level of gone-concern capital that the bank should be required to hold in order to be able to transfer sufficient assets to the acquirer for it to assume all the failing bank’s deposits. 10 That amount should depend on the expected value of the assets held by the bank when failing as well as on the composition of liabilities – ie the ratio between covered and uncovered deposits – as the latter affects the financial cap for DIF support, depending on the prevailing hierarchy of DIF claims in insolvency. Note that the concept of gone-concern capital is not identical to MREL. The former would be composed of those loss-absorbing liabilities that would remain on the balance sheet after the bank is declared failing or likely to fail. The latter also includes going-concern capital able to absorb losses before resolution. Within the current two-component framework for MREL determination, MREL for SoB banks could be approximated by the sum of (going-concern) minimum regulatory capital (the current LAA component) and the gone-concern capital requirements derived from the exercise (a new RCA amount). The setup Suppose a failing bank whose assets have an accounting value (net of asset-backed and other preferred claims)11 of A. Those assets are funded by deposits (D) and gone-concern capital (K). 12 Part of the deposits are covered (CD) and the rest (ND) are not covered by the DIF. Therefore A = CD + ND + K. We assume, for simplicity, that all deposits and assets would be transferred to the acquirer under the SoB transaction. The acquirer will also receive cash support from the DIF with a maximum amount of MS. When valuing the bank’s assets, the acquirer applies a haircut to their accounting value. The acquirer will assume the deposits only if the sum of the value of the transferred assets and the support received from the DIF exceeds the volume of transferred deposits. Thus, the transaction would only be feasible if: ℎ𝐴𝐴 − 𝐷𝐷 + 𝑀𝑀𝑀𝑀 ≥ 0, where h is the value preservation proportion of the accounting value of the assets for the acquirer (or franchise value). Given a specific amount of deposits (D), an estimate of the franchise value parameter (h), and the maximum available DIF support (MS), the authority could derive the minimum amount of loss-absorbing liabilities (K) that would need to be available in order to be able to transfer sufficient assets (D+K) to the acquirer. Replacing A by its counterparts and rearranging terms permits the required gone-concern capital to be expressed as: 𝐾𝐾 ≥ 1 − ℎ ℎ 𝐷𝐷 − 𝑀𝑀𝑀𝑀 ℎ . (1) Therefore, quite intuitively, required gone-concern capital would depend positively on the amount of transferred deposits and negatively on the available DIF support and on the acquirer’s valuation of the assets. Maximum DIF support Following Restoy et al (2020), the financial cap (the maximum net cost for the DIF in liquidation) depends on the hierarchy of liabilities in the applicable liquidation framework. In particular, it depends on whether DIF-covered deposits – and, therefore, DIF claims in liquidation – rank senior to non-covered deposits and thus are super-preferred (SP) or rank pari passu as in a general deposit preference regime (GP). In the SP case, the DIF would be entitled to receive the proceeds of the liquidation of all assets before all other unsecured creditors if needed to compensate for paying out covered deposits. In the GP case, the proceedings of asset liquidation must be shared pro rata between the DIF and holders of non-covered deposits. Denoting by m (𝑚𝑚 < ℎ) the proportion of the assets’ accounting value that would be preserved in piecemeal liquidation, the net cost of paying out deposits in liquidation under super-preference of covered deposits (𝑀𝑀𝑀𝑀𝑆𝑆𝑆𝑆) would be: 𝑀𝑀𝑀𝑀𝑆𝑆𝑆𝑆 = max(0, 𝐶𝐶𝐶𝐶 − 𝑚𝑚𝑚𝑚), (2) since the DIF would only suffer costs if the cash obtained from the liquidation of assets is below the amount required for paying out covered deposits. In the GP case, the net cost for the DIF in liquidation (𝑀𝑀𝑀𝑀𝐺𝐺𝐺𝐺) would be 𝑀𝑀𝑀𝑀𝐺𝐺𝐺𝐺 = max(0, 𝐶𝐶𝐶𝐶 − 𝑚𝑚′𝐴𝐴), (3) where m’ ≡ 𝑚𝑚 𝐶𝐶𝐶𝐶/(𝐶𝐶𝐶𝐶 + 𝑁𝑁𝑁𝑁). Therefore, as 𝑚𝑚′ ≤ 𝑚𝑚, the financial cap for the DIF would be tighter under SP than under GP as long as the failing bank holds non-covered deposits. Since A = D + K, in both regimes the maximum support available correlates negatively with the amount of gone-concern capital. For a given volume of deposits, losses for the DIF in liquidation (the financial cap) will be lower the larger the volume of junior liabilities. In other words, by increasing the required volume of bail-in-able liabilities, the scope for DIF support in SoB transactions would be smaller. Minimum gone-concern capital Putting together equations (1), (2) and (3), we can derive expressions for minimum gone-concern capital under the SP and GP regimes. 6 Under the SP regime, in the absence of DIF support (𝑀𝑀𝑀𝑀𝑆𝑆𝑆𝑆 = 0 in (2)), the ratio of going-concern capital to deposits satisfies: 𝐾𝐾 𝐷𝐷 ≥ 1 − ℎ ℎ . If there is DIF support (𝑀𝑀𝑀𝑀𝑆𝑆𝑆𝑆 = 𝐶𝐶𝐶𝐶 − 𝑚𝑚𝑚𝑚 > 0 in (2)) minimum K / D can be expressed as 𝐾𝐾 𝐷𝐷 ≥ 1 ℎ − 𝑚𝑚 𝑁𝑁𝑁𝑁 𝐷𝐷 − 1. As required gone-concern capital would need to be larger when there is no DIF support, minimum requirements under the SP regime (𝐾𝐾𝑆𝑆𝑆𝑆) should satisfy: 𝐾𝐾𝑆𝑆𝑆𝑆 𝐷𝐷 ≥ min � 1 ℎ − 𝑚𝑚 𝑁𝑁𝑁𝑁 𝐷𝐷 − 1, 1 − ℎ ℎ � . (4) Expression (4) shows that minimum gone-concern capital requirements depend crucially on three parameters which reflect the valuation of the bank’s assets for the acquirer as well as the size of the expected DIF support, if any. Those parameters are the franchise value coefficient in SoB (h), the proportion of covered deposits over total deposits, and the value preservation coefficient in liquidation (m). The higher the valuation of assets by the acquirer, the less assets required to facilitate the transaction and, therefore, the lower the amount of loss-absorbing liabilities that could be left behind for liquidation that the bank needs to hold. In addition, the larger the proportion of non-covered deposits over total deposits, the lower the support from the DIF as a proportion of transferred liabilities and the larger the need to transfer assets to the acquirer. That can only be achieved by holding more loss-absorbing liabilities. Finally, the larger the value preservation in liquidation, the lower the costs for the DIF in liquidation (thus tightening the financial cap) and, therefore, the higher the need to transfer assets (and therefore the amount of loss-absorbing liabilities required). Under the GP regime, minimum gone-concern capital requirements could analogously be expressed as: 𝐾𝐾𝐺𝐺𝐺𝐺 𝐷𝐷 ≥ min � 1 ℎ − 𝑚𝑚′ 𝑁𝑁𝑁𝑁 𝐷𝐷 − 1, 1 − ℎ ℎ � , (5) where 𝑚𝑚′ = 𝑚𝑚 𝐶𝐶𝐶𝐶 𝐷𝐷. The difference between 𝐾𝐾𝑆𝑆𝑆𝑆 and 𝐾𝐾𝐺𝐺𝐺𝐺 is just that, under the GP regime, the value preservation coefficient in liquidation appears weighted by the proportion of covered deposits over total deposits, since the proceedings from asset sales should be shared by all deposit holders. This makes the costs for the DIF in liquidation larger and, therefore, increases the support that the DIF can provide for SoB. As a consequence, in relation to SP, GP reduces the amount of assets that need to be transferred under SoB and therefore, there is less need for gone-concern capital. According to (4) and (5), when the ratio of non-covered deposits is low there is no need for goneconcern capital to support the SoB transaction (ie minimum K / D becomes zero or negative). The reason is that in such a case, the costs for the acquirer of assuming deposits could be largely offset by the DIF support as its losses for paying out covered deposits in liquidation would be large. In the limit, with zero non-covered deposits, there would be no need to transfer assets (K = – D and A = 0)) since, in that case, the DIF would be exposed to a cost for paying out covered deposits in liquidation that would be exactly equal to the liabilities assumed by the acquirer. In that case, the DIF could fully compensate by itself the acquirer’s costs of assuming all deposits, thereby making the transaction feasible. In the calibrations below, 7 whenever (4) and (5) yield a negative value for minimum gone-concern capital we assume K = 0. We then adjust DIF support (MS) downward accordingly by setting A = D in expressions (2) and (3).

5. Conclusions

The operationalisation of SoB transactions for the resolution of mid-sized banks requires adequate compensation for suitable acquirers which take over a failing bank’s sensitive liabilities (mainly deposits). That compensation should primarily be provided by the transfer of sufficient assets and the provision of external support. The former would depend on the availability of sufficient gone-concern capital that would be written down or remain in the residual entity, thereby making it possible to transfer more assets than liabilities. According to CMDI, the latter would primarily be provided by the DIF while satisfying its financial cap. This paper shows that under a regime such as the current EU one, in which DIF claims are superpreferred over other deposits in insolvency, there is essentially little or no scope for the DIF to support SoB transactions. By contrast, under a general deposit preference rule (like the one prevailing in the US or the one recently included in the EC CMDI proposal) there are suitable combinations of DIF support and gone-concern capital requirements that could effectively facilitate SoB transactions. Accordingly, MREL requirements for banks with a preferred SoB resolution strategy should be primarily calibrated to make the operation feasible by helping acquirers to obtain sufficient value in the transaction, including the expected DIF support. The framework presented in this paper shows that it is possible to develop a structured methodology to perform that task by combining the assessment of three key factors: (i) the estimated franchise value of the failing bank; (ii) the proportion of covered deposits over all liabilities (eg total deposits) that are planned to be transferred in resolution; and (iii) the prevailing bank liquidation regime’s ability to preserve failing banks’ asset value. Naturally, MREL determination is only one aspect of resolution planning. The proposed framework also confirms that, beyond an adequate determination for MREL, the efficacy of SoB resolution strategies would be significantly enhanced by promoting robust franchise values – implying eg accurate accounting – and avoiding excessive reliance by SoB banks on non-covered deposits. In doing that, the SoB transactions would more easily become feasible while respecting the financial cap for DIF support and keeping MREL at affordable levels.