The European Unions draft crisis management directive will allow regulators to intervene early in troubled banks, and to force losses on senior bondholders as well as capital investors in order to avoid calling on public funds to wind up failing institutions.
EU member states must transpose the directive into national law by the end of 2014, according to the draft. But bail-in is likely to apply from 2018 onwards, giving the market a longer phase-in to the new regime than expected.
No debt will be protected or grandfathered under the new regime all senior debt outstanding after January 1, 2018, will be bail-inable. However, there is some scope for manoeuvre, says Gerald Podobnik, co-head of capital solutions, Europe, at Deutsche Bank.
"Some market participants seem to think this is already the final rule, which it is not," he says. "It needs to go through a trialogue similar to the process for CRR I and CRD IV. And it needs implementation via national law in all 27 EU member states. So there can be changes and permutations in the coming months."
Among the points that need to be firmed up is how much bail-inable debt banks must hold. The European Commission did not specify a level, but said it would be "appropriate" for institutions to hold 10% of their total liabilities in bail-inable instruments. The final level is expected to be left up to national regulators, however a move which some bankers say was the result of a last-minute, gargantuan lobbying effort against a pan-European level.
Not everyone is happy about the level of discretion left to individual jurisdictions, however. The crisis management directive was firm in saying creditor hierarchy should be respected, with no investor worse off than they would be in a normal insolvency. But some investors claim that depending on national interpretations of the directive, bail-in could be used as a tool to give banks a new lease of life rather than wind them down.
"The main point is that investors want to ensure that the point of non-viability is compatible with the point of failure that senior creditors are bailed in to facilitate a wind-down of a broken bank," says Rob Kendrick, senior credit analyst at Legal & General Investment Management. "That makes your risk profile worse than without bail-in, but similar to buying the senior debt of a non-financial corporate.
"Its still not clear whether that will happen, though regulators want to keep a large amount of discretion as to what that point is. You want to be certain that shareholders are wiped out, sub debt is wiped out, the management has been fired and there is no chance of cash going on bonuses and the like. You dont want the bank to have gone bust and then risen from the ashes straight away after having imposed losses on senior holders."
However, the conclusion of that debate is a secondary concern for capital structurers, who are already looking further ahead.
Building up a buffer of tier two capital is one way banks are already looking to placate senior bondholders rattled by bail-in, but Podobnik at Deutsche says there is scope for a new market to be created, one that could replace the tier three product that was abolished by Basel III.
"Generally, the concept of bail-in is dramatic suddenly senior will be able to absorb losses outside of a normal liquidation process. But its interesting they suggest you could issue a form of short term sub debt which would not be capital to protect senior. It opens up a new layer of quasi-capital."
What you need is a unionUltimately, however, bail-in is likely to end up being one small part of a much larger regulatory framework. Banking union, Europes new project, would involve sweeping changes such as one set of banking regulations for the entire region and a common depositor guarantee scheme (see separate article).The ECB is likely to take on a new supervisory role covering every bank in the eurozone, while the EBA would remain regulator for the EU. Bail-in may look radical for now, and the debate will doubtless reignite as the 2014 national implementation date draws closer. But it could end up being a first step towards the harmonisation of Europes banking sector.