## _sdn1203

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---

### Executive Summary — Overview and definition
- Large-scale government support of financial institutions deemed too big or too important to fail has been costly and potentially increased moral hazard.
- Reform initiatives at national and international levels have expanded resolution powers and tools to protect taxpayers and reduce TBTF risks.
- Bail-in defined: statutory power of a resolution authority to restructure the liabilities of a distressed financial institution by writing down its unsecured debt and/or converting it to equity.
- Statutory bail-in aims to achieve a prompt recapitalization and restructuring on a going-concern basis without public-fund recapitalization (except liquidity backstop).
- This paper studies:
  - the effectiveness of bail-in in restoring viability,
  - potential risks when bail-in is activated,
  - and proposes design features to mitigate these risks.

### Main conclusions and findings
- As a going-concern form of resolution, bail-in could:
  - mitigate systemic risks associated with disorderly liquidations,
  - reduce deleveraging pressures,
  - preserve asset values.
- Market perception risk:
  - If bail-in is perceived as a sign of insolvency it could trigger runs by short-term creditors and worsen liquidity problems.
  - Ideally, bail-in should be activated when a capital infusion is expected to restore viability, with official liquidity support as a backstop.
- Bail-in is not a panacea:
  - Should supplement, not replace, other resolution tools that allow for orderly closure of a failed institution.

### Introduction and rationale; systemic failure channels
- Purpose of bail-in:
  - Reduce likelihood of government bail-out by ensuring shareholders and creditors bear losses.
  - Minimize systemic risks by restoring confidence, reducing fire sales, and preserving going-concern value.
  - Achieve effective cross-border resolutions.
- Systemic failure channels:
  - Direct counterparty risks and high demand for collateral (margin).
  - Liquidity risks and fire-sale effects depressing asset prices and raising margin demands.
  - Contagion risks from panic spreading to other institutions.
- Problem context:
  - Government-funded rescues have been costly and increased TBTF risks.
  - Shadow banking remains under-regulated and contributed to systemic risk.

### Definition and relationship to contingent capital (CoCos)
- Bail-in:
  - Statutory power to restructure liabilities of a distressed SIFI by converting and/or writing down unsecured debt on a “going concern basis.”
  - SIFI remains open as an ongoing legal entity; goal is to eliminate insolvency risk by restoring capital without public funds (except liquidity backstop).
- Contrast with CoCos:
  - CoCos are contractual private instruments that convert or write down on predetermined triggers.
  - Bail-in is statutory and can eliminate/dilute shareholders and write down or convert contractual contingent capital, subordinated debt, and unsecured senior debt in that order.
  - Complementary use: contingent capital as first line, bail-in for remaining distress.

### Key design principles and triggers
- Triggers:
  - Should be consistent with other resolution tools.
  - Set at the point when a firm would have breached regulatory minima but before balance-sheet insolvency.
- Scope and transparency:
  - Scope limited to (i) elimination of existing equity shares as a precondition for bail-in; and (ii) conversion and haircut to subordinated and unsecured senior debt.
  - Debt restructuring should respect order of priorities applicable in liquidation.
- Management and governance:
  - Resolution authority should have power to change bank management in resolution.
- Cross-border and intra-group issues:
  - Framework must address bail-in of debt issued by an entity within a larger banking group and cross-border operations.

### Legal framework and creditor safeguards
- Necessity of a clear legal framework to balance private rights and public policy interest in financial stability.
- Creditor consent and protections:
  - Debt restructuring ideally not subject to creditor consent.
  - A “no creditor worse off” test may be introduced to safeguard creditors’ and shareholders’ interests.
- Group and cross-border mechanisms must be provided for issues arising from group structures and cross-border effects.

### Capital contribution mechanics and shareholder effects
- New capital sources:
  - Debt conversion and/or issuance of new equity, with elimination or significant dilution of pre-bail-in shareholders.
- Safeguards for new shareholders:
  - Suitability checks for new shareholders.
  - Possible measures such as a floor price for debt/equity conversion to reduce risk of a “death spiral” in share prices.

### Market and contagion mitigants
- Issuance and encumbrance limits:
  - Minimum requirements on banks for issuing unsecured debt or limits on encumbrance of assets may be necessary to reassure markets and forestall runs.
- Contagion risk measures:
  - Measures to mitigate contagion to other systemic institutions, e.g., limiting cross-holding of unsecured senior debt.
- Liquidity backstop:
  - Bail-in should be accompanied by a government liquidity backstop to mitigate short-term funding stresses.

### Simple numerical illustration of bail-in effects
- Starting balance sheet (in billions of U.S. dollars):
  - Assets: 100
    - Cash & other fixed assets: 5
    - Securities & short-term investment: 45
    - Loans & other long-term investment: 50
  - Liabilities: 90
    - Deposits: 50
    - Repos & other short-term borrowing: 20
    - Long-term unsecured debt: 20
  - Equity: 10
- After write-down of $10 billion in long-term assets:
  - Assets: 90
    - Loans & other long-term investment: 40
  - Liabilities: 90 (unchanged)
    - Long-term unsecured debt: 20
  - Equity: 0
- After recapitalization under bail-in (restoring equity to 10):
  - Assets: 90
  - Liabilities: 80
    - Long-term unsecured debt: 10
  - Equity: 10
- Example mechanics:
  - Restoring the equity position to $10 billion by converting 50 percent of unsecured senior debt into equity.
  - Pre-restructuring shares are written off; deposits, repos, and short-term funding are not affected; restructured senior debt holders become shareholders.

### Policy trade-offs and operational considerations
- Benefits:
  - Private-sector recapitalization alternative to taxpayer-funded rescues.
  - Can reduce runs on repos and short-term funding by ensuring bail-in capital absorbs losses.
  - Reduces need for assisted mergers and potential further concentration of financial institutions.
- Risks:
  - Triggering bail-in could signal nonviability and, absent confidence in recapitalization, provoke runs.
  - Roll-over risk of long-term debt could increase.
- Implementation elements:
  - Bail-in should be part of a comprehensive special resolution regime with a going-concern form of proceeding (e.g., “official administration”), appointment of an administrator, and powers to design restructuring or prepare for orderly liquidation.
  - Framework should consider impacts on short-term creditors and include mitigating measures.

### Procedural elements (Section VII) — triggers, judicial role, and creditor approval
- Overall objective:
  - Empower resolution authority with a flexible toolkit to determine when legal thresholds for resolution are met and how best to resolve the bank.
- Triggers — approaches and trade-offs:
  - Insolvency-related triggers:
    - Trigger when close to balance-sheet or cash-flow insolvency.
    - Principal argument: bail-in substantially interferes with stakeholder rights and therefore should only be possible when the bank is insolvent.
    - Disadvantage: may be too late to restore viability.
  - Pre-insolvency triggers:
    - Trigger earlier, e.g., when official administration may be initiated.
    - May be based on qualitative triggers or quantitative triggers such as capital adequacy ratios falling below levels (e.g., below 50 percent or 75 percent of the norm).
    - Advantages: allow prompt and effective response.
    - Disadvantages: legal questions on position of senior creditors and potential compensation needs.
    - Note: in early pre-insolvency cases senior creditors should not face outright haircuts but only debt-to-equity conversion so pre-insolvency shareholders are diluted rather than benefiting from creditor haircuts.
  - Recommended design:
    - Trigger close to but before balance-sheet insolvency.
    - Use combination of quantitative and qualitative assessments.
    - Discretionary but not arbitrary initiation by resolution authority.
- Role of judiciary:
  - Minimize courts’ role to allow quick action by technical officials.
  - Decisions by banking authorities subject to prior approval and follow-up judicial review that cannot reverse the resolution but can review legality and award damages.
- Creditor approval and cross-border recognition:
  - Quick decisive action argues against creditor approval procedures common in corporate insolvency.
  - Eliminating creditor consent must be safeguarded to survive legal challenge and support cross-border recognition.
- Additional tests:
  - Authorities might be required to be assured bail-in is most likely to restore viability.
  - Bail-in might be subject to a “no creditor worse off” test.

### Substantive design elements, group issues, and cross-border challenges
- Characterization:
  - Bail-in should be characterized as an “insolvency proceeding” where possible to justify interference with stakeholder rights and aid cross-border effectiveness.
- Scope of liabilities subject to bail-in:
  - Only subordinated and senior unsecured debt should be subject to bail-in.
  - Exclude insured/guaranteed deposits, secured debt (including covered bonds), and repurchase agreements.
  - Consider carving out some senior unsecured debt (e.g., inter-bank deposits, payments, clearing, securities settlement obligations, some trade-finance obligations) due to systemic importance.
- Order of loss absorption:
  - Losses attributed in liquidation order: pre-restructuring equity first (including post-conversion contingent capital), then subordinated debt, then unsecured senior creditors.
- Recapitalization and shareholder issues:
  - New capital may come from converting part of haircut-adjusted debt and/or issuing new equity, diluting pre-restructuring shareholders.
  - Company law must not impede recapitalization (e.g., via rigid preemption rights).
  - Process to restore private control must be specified.
  - New shareholders subject to supervisory suitability scrutiny; early regulatory action recommended to avoid forced sales.
  - Some institutional investors (e.g., hedge funds) could be prohibited from owning equity stakes; alternatives such as trust funds could be considered.
- Contract continuity and close-out:
  - Legislation should prohibit contractual counterparties from terminating solely because bail-in invoked (terminations for actual default remain permissible).
  - Close attention to cross-default clauses to avoid contagion.
- Liquidity and official support:
  - Bail-in may need to be coupled with official liquidity assistance and possibly official guarantees for some debt.
  - Government financing provided during restructuring should receive priority if the bank subsequently fails.
- Group-specific and cross-border implications:
  - Restructuring implemented on a legal-entity-specific basis, with home-country authorities leading.
  - Statutory bail-in powers could, in principle, apply to all liabilities including those governed by foreign law, governed by lex fori concursus.
  - Subsidiary-specific bail-in could de-group a bank and destabilize parent/group.
  - Consider allowing resolution authority to convert claims against a subsidiary into the parent’s equity or restructure related entities’ debt—significant departures from entity-specific regimes.
- Cross-border recognition approaches:
  - Contractual approach: include provisions in new debt instruments to give effect to home-authority restructurings (applies only to new debt).
  - Legislative approach: enact laws recognizing home authority bail-in powers (direct recognition or parallel measures).
  - IMF coordination framework: encourage recognition where the home framework meets “core coordination standards.”

### Comparisons with other resolution tools (P&A and bridge bank)
- Objectives:
  - Bail-in: recapitalize distressed SIFI by mandatory debt restructuring and prevent insolvency-related runs.
  - P&A and bridge-bank: ensure orderly closure and preserve going-concern value; bridge banks provide temporary solutions pending private purchasers.
- Advantages of bail-in:
  - Does not require finding purchasers (useful for very large SIFIs).
  - Potentially avoids value destruction from fire sales.
  - Likely lower execution risks and fewer foreign-law contracts restructured compared with transfers under P&A.
- Limitations of bail-in:
  - Does not directly address problem assets and loss-making business lines; P&A can leave problem assets in receivership.
  - Unknown asset impairment levels may undermine investor confidence—desirability of over-capitalizing to cover hard-to-predict losses.
  - Contingent liabilities, off-balance-sheet liabilities, and litigation may remain with the open entity and need to be paid in the ordinary course.

### Potential market risks and mitigating measures
- Market perception and run risk:
  - Perception of non-viability could trigger runs and contagion; perception of restored viability can enhance confidence.
- Impact on funding costs:
  - Bail-in reduces or eliminates implicit TBTF subsidy, likely increasing banks’ funding costs.
  - Senior ratings expected to be adjusted downwards; removal of ratings uplift may result in average downgrade of senior unsecured debt.
  - Example: JP Morgan estimates percentage of EU banks shifting to non-investment grade would increase from 2 percent to 33 percent (Henriques, 2011).
  - At end-2010, 10 out of 33 of the largest international banks were refinancing themselves as if they were rated at speculative levels.
  - Removing the government “put” may reduce correlation between senior bank and government spreads.
- Effects on liability structure:
  - Higher marginal cost of debt could reduce debt’s share of total liabilities; banks might increase capital or shift to short-term and secured borrowing (e.g., covered bonds).
  - Covered bonds are cheaper and protect investors via collateral but can undermine unsecured creditor positions and bail-in efficacy by encumbering high-quality assets.
  - Consider imposing minimum unsecured debt requirements or limits on asset encumbrance.
  - Since 2009, many countries updated or adopted covered bond laws; several advanced countries (Australia, Italy, Netherlands, United Kingdom, and the United States) have introduced asset encumbrance limits.
- Contagion and cross-holdings:
  - Large shares of senior debt held by financial institutions declined from close to 20 percent on average in 2007 to 17 percent in 2010 for Euro area banks, and from 15 percent to 12.5 percent for U.S. banks over the same interval.
  - Insurance companies hold bank bonds accounting for 20 to 30 percent of their investment portfolios and up to three times their capital.
  - Regulators should assess effects of bail-in on other banks’ balance sheets and consider regulating investment in unsecured senior debt issued by SIFIs.
- Mitigating measures:
  - Restrictions or quantitative limits on cross-holdings of bail-in instruments with timely monitoring.
  - Convergence of supervisory criteria and triggers across jurisdictions.
  - Frequent and transparent disclosure and communication by SIFIs and authorities.
  - Effective resolution planning and up-to-date recovery and resolution plans.
  - Statutory bail-in considered within a comprehensive framework including effective supervision to prevent failures.

### Conclusions and key design recommendations
- Role of bail-in:
  - Additional and complementary statutory resolution tool to recapitalize distressed SIFIs via mandatory debt restructuring and avoid operational/legal complexities of P&A transfers.
  - By restoring viability, bail-in can reduce pressure to post collateral, minimize liquidity risks, and prevent runs by short-term creditors.
- Key design elements:
  - Scope: Limit statutory power to (i) eliminating or diluting existing shareholders; and (ii) writing down or converting, in the order, contractual contingent capital, subordinated debt, and unsecured senior debt; accompany with authority to change bank management.
  - Triggers: Align with other resolution tools; set at point when institution would have breached regulatory minima but before balance-sheet insolvency; use transparent and predictable criteria (quantitative and qualitative).
  - Pre-positioned unsecured liabilities: Require banks or holding companies to maintain a minimum amount of unsecured liabilities subject to bail-in to reassure markets.
  - Liquidity backing: Couple bail-in with adequate official liquidity assistance to fund outflows and compensate for temporary market access loss.
  - Comprehensive framework: Include effective supervision, an overall resolution framework, and up-to-date recovery and resolution plans.
  - Appropriate use: Use statutory bail-in where a capital infusion is likely to restore viability; avoid use where it would simply delay inevitable failure.

*Source: _sdn1203 - Executive Summary*

### Executive Summary ......................................................................................................

### _sdn1203 - Executive Summary

### Overview: context and definition
- Large-scale government support of the financial institutions deemed too big or too important to fail during the recent crisis has been costly and has potentially increased moral hazard.
- To protect taxpayers from exposure to bank losses and to reduce the risks posed by too-big-to-fail (TBTF), various reform initiatives have been undertaken at both national and international levels, including expanding resolution powers and tools.
- Bail-in is a statutory power of a resolution authority (as opposed to contractual arrangements, such as contingent capital requirements) to restructure the liabilities of a distressed financial institution by writing down its unsecured debt and/or converting it to equity.
- The statutory bail-in power is intended to achieve a prompt recapitalization and restructuring of the distressed institution.
- This paper studies:
  - the effectiveness of bail-in in restoring the viability of distressed institutions,
  - potential risks when a bail-in power is activated,
  - and proposes design features to mitigate these risks.

### Main conclusions and findings
- 1. As a going-concern form of resolution, bail-in could mitigate the systemic risks associated with disorderly liquidations, reduce deleveraging pressures, and preserve asset values that might otherwise be lost in a liquidation.
  - With a credible threat of stock elimination or dilution by debt conversion and assumption of management by resolution authorities, financial institutions may be incentivized to raise capital or restructure debt voluntarily before the triggering of the bail-in power.
- 2. However, if the use of a bail-in power is perceived by the market as a sign of the concerned institution’s insolvency, it could trigger a run by short-term creditors and aggravate the institution’s liquidity problem.
  - Ideally, therefore, bail-in should be activated when a capital infusion is expected to restore a distressed financial institution to viability, with official liquidity support as a backstop until the bank is stabilized.
- 3. Bail-in is not a panacea and should be considered as one element of a comprehensive solution to the TBTF problem.
  - It should supplement, not replace, other resolution tools that would allow for an orderly closure of a failed institution.

*Source: _sdn1203 - Executive Summary*

### 4.      Most importantly, the bail-in framework needs to be carefully designed to ensure its

### _sdn1203 - 4.      Most importantly, the bail-in framework needs to be carefully designed to ensure its

### Introduction and Rationale
- Purpose of bail-in:
  - Reduce likelihood of government bail-out by ensuring shareholders and creditors bear losses.
  - Minimize systemic risks by restoring confidence, reducing fire sales and disorderly liquidations, and preserving going-concern value.
  - Achieve effective cross-border resolutions.
- Systemic failure channels identified:
  - Direct counterparty risks and high demand for collateral (margin).
  - Liquidity risks and fire-sale effects depressing asset prices and raising margin demands.
  - Contagion risks from panic spreading to other institutions.
- Problem context:
  - Government-funded rescues have been costly and increased too-big-to-fail risks.
  - Shadow banking remains under-regulated and contributed to systemic risk.

### Definition and Concept of Bail-in
- Bail-in defined:
  - Statutory power to restructure liabilities of a distressed SIFI by converting and/or writing down unsecured debt on a “going concern basis.”
  - SIFI remains open as an ongoing legal entity; goal is to eliminate insolvency risk by restoring capital without public funds (except liquidity backstop).
- Distinction from contractual contingent capital (CoCos):
  - CoCos: private contracts that automatically convert or write down on predetermined triggers.
  - Bail-in: statutory power that can eliminate/dilute existing shareholders and write down or convert contractual contingent capital, subordinated debt, and unsecured senior debt in that order.
  - Complementary use: contingent capital as first line, bail-in for remaining distress.

### Key Design Principles and Triggers
- Triggers:
  - Should be consistent with other resolution tools.
  - Set at the point when a firm would have breached regulatory minima but before balance-sheet insolvency.
- Scope and transparency:
  - Scope should be limited to:
    - (i) elimination of existing equity shares as a precondition for a bail-in; and
    - (ii) conversion and haircut to subordinated and unsecured senior debt.
  - Debt restructuring should respect order of priorities applicable in liquidation.
- Management and governance:
  - Resolution authority should have power to change bank management in resolution.
- Cross-border and intra-group issues:
  - Framework must address bail-in of debt issued by an entity within a larger banking group and cross-border operations.

### Legal Framework and Creditor Safeguards
- Necessity:
  - A clear and coherent legal framework is essential to balance private rights and public policy interest in financial stability.
- Creditor consent and protections:
  - Debt restructuring ideally not subject to creditor consent.
  - A “no creditor worse off” test may be introduced to safeguard creditors’ and shareholders’ interests.
- Group and cross-border mechanisms:
  - Legal design must provide mechanisms for issues arising from group structures and cross-border effects.

### Capital Contribution Mechanics and Shareholder Effects
- Sources of new capital:
  - Debt conversion and/or issuance of new equity, with elimination or significant dilution of pre-bail-in shareholders.
- Safeguards for new shareholders:
  - Mechanisms to ensure suitability of new shareholders.
  - Possible measures such as a floor price for debt/equity conversion to reduce risk of a “death spiral” in share prices.

### Market and Contagion Mitigants
- Issuance and encumbrance limits:
  - May be necessary to impose minimum requirements on banks for issuing unsecured debt or set limits on encumbrance of assets.
  - Purpose: reassure market that bail-in would suffice to recapitalize distressed institution, forestall runs by short-term creditors, and avert downward share price spirals.
- Contagion risk measures:
  - Include measures to mitigate contagion risks to other systemic financial institutions, e.g., limiting cross-holding of unsecured senior debt.
- Liquidity backstop:
  - Bail-in should be accompanied by a government liquidity backstop to mitigate short-term funding stresses.

### Simple Numerical Illustration of Bail-in Effects (as provided)
- Starting balance sheet (in billions of U.S. dollars):
  - Assets: 100
    - Cash & other fixed assets: 5
    - Securities & short-term investment: 45
    - Loans & other long-term investment: 50
  - Liabilities: 90
    - Deposits: 50
    - Repos & other short-term borrowing: 20
    - Long-term unsecured debt: 20
  - Equity: 10
- After write-down of $10 billion in long-term assets:
  - Assets: 90
    - Loans & other long-term investment: 40
  - Liabilities: 90 (unchanged)
    - Long-term unsecured debt: 20
  - Equity: 0
- After recapitalization under bail-in (restoring equity to 10):
  - Assets: 90
  - Liabilities: 80
    - Long-term unsecured debt: 10
  - Equity: 10
- Example mechanics:
  - Restoring the equity position to $10 billion by converting 50 percent of unsecured senior debt into equity.
  - Pre-restructuring shares are written off; deposits, repos, and short-term funding are not affected; restructured senior debt holders become shareholders.

### Policy Trade-offs and Operational Considerations
- Benefits:
  - Provides private-sector recapitalization alternative to taxpayer-funded rescues.
  - Can reduce runs on repos and short-term funding by ensuring bail-in capital absorbs losses.
  - Reduces need for assisted mergers and potential further concentration of financial institutions.
- Risks:
  - Triggering bail-in could signal nonviability and in absence of confidence in recapitalization, could provoke runs.
  - Roll-over risk of long-term debt could increase.
- Implementation elements:
  - Bail-in should be part of a comprehensive special resolution regime with a going-concern form of proceeding (e.g., “official administration”), appointment of an administrator, and powers to design restructuring or prepare for orderly liquidation.
  - Framework should consider potential impacts on short-term creditors and include mitigating measures.

*Source: IMF staff discussion in the provided PDF chapter.*

### Section VII.

### Section VII.

### A. Procedural Elements — Overview and Objectives
- Overall goal: empower the resolution authority with a flexible toolkit to determine when a bank meets legal thresholds for initiating resolution proceedings and how best to resolve the bank, taking all facts and circumstances into account.
- Triggers for bail-in power should be consistent with those used for other resolution tools.
- Determination of bail-in triggers must balance legal certainty and early intervention to maximize the likelihood of restoring a distressed financial institution’s viability.
- Minimize uncertainty from discretionary use of bail-in power by making intervention criteria as transparent and predictable as possible.
- To the extent consistent with maintaining orderly market conditions, disclosure concerning remedial measures against a troubled institution (up until the point of intervention) may enhance certainty.

### Triggers for Bail-in — Approaches and Trade-offs
- Insolvency-related triggers
  - Trigger point: when a financial institution is close to being either balance-sheet or cash-flow insolvent.
  - Principal argument for this approach: bail-in substantially interferes with stakeholder rights and therefore should only be possible when the bank is insolvent and in danger of liquidation.
  - Key disadvantage: may be too late for bail-in to achieve its purpose of restoring the bank to viability.
- Pre-insolvency triggers
  - Trigger point: earlier than insolvency, for example, when official administration may itself be initiated.
  - Official administration is generally triggered by either qualitative triggers (e.g., repeated breach of regulatory standards) or quantitative triggers, such as capital adequacy ratios falling below a certain level (e.g., below 50 percent or 75 percent of the norm).
  - In some countries, a “public interest” finding may also be required.
  - Advantages: generally allow for a prompt and effective response to a bank’s difficulties.
  - Disadvantages: in some legal systems, pre-solvency triggers could raise legal questions as to the position of senior creditors relative to other stakeholders (including shareholders), official interference with contractual rights, and non-discrimination, which may require compensation to debt holders that are adversely affected.
  - Additional note: pre-insolvency shareholders should not inappropriately benefit from haircuts on creditors. Therefore, in case of early pre-insolvency triggers where losses may not be large enough to eliminate shareholders completely, senior creditors should not be subject to outright haircuts but only to debt-to-equity conversion, so that the pre-insolvency shareholders are diluted.
- Recommended trigger design
  - It may be appropriate for the trigger for the bail-in power to apply at a point that is close to but before the institution is balance-sheet insolvent.
  - Trigger could be based on a combination of quantitative and qualitative assessments, such as a combination of a breach of regulatory minima (e.g., minimum capital adequacy ratio) and concerns about the distressed institution’s liquidity problems.
  - Triggers should be discretionary but not arbitrary; resolution authority should initiate bail-in only when trigger criteria are met.

### Role of the Judiciary and Decision-Making Processes
- Argument for minimizing the role of the courts given the need to act quickly and to vest restructuring decisions in officials with the necessary technical expertise.
- Suggested approach: decisions taken by the banking authorities (for example, by the official administrator), subject to prior approval of the supervisory or resolution agencies and follow-up judicial review.
- Follow-up judicial review should:
  - Not be able to reverse the resolution.
  - Be limited to review of the legality of the action and the awarding of damages as a remedy.

### Creditor Approval, Cross-border Recognition, and Legal Safeguards
- Need for quick and decisive action in the interest of financial stability argues against incorporating a procedure for creditor approval in the bail-in framework, despite creditor approval being typical in corporate insolvency debt restructurings.
- Care should be taken to ensure that eliminating creditor consent will survive legal challenge in the relevant jurisdiction and will not undermine the ability to achieve cross-border recognition of bail-in as an appropriate insolvency or reorganization proceeding.

### Additional Tests and Protections
- Consideration of additional tests before implementing bail-in:
  - Authorities might only be permitted to proceed with bail-in if they (or another competent authority) were assured that bail-in was most likely to restore a distressed bank to viability.
  - Bail-in might also be subject to a “no creditor worse off” test.
- Where restructuring is not subject to creditor consent, mechanisms (such as the “no creditor worse off” test) can provide protections and a basis for compensation where appropriate.

*Source: _sdn1203 - Section VII.*

### introduction of such a requirement would provide important safeguards for the interests of

### _sdn1203 - introduction of such a requirement would provide important safeguards for the interests of

### Substantive design elements
- Characterization:
  - Bail-in should be characterized by official administrations as an “insolvency proceeding” where possible to justify interference with stakeholder rights and improve cross-border effectiveness, while recognizing tension in jurisdictions that seek to keep banks open as a going concern.
- Scope of liabilities subject to bail-in:
  - Only subordinated and senior unsecured debt should be subject to bail-in.
  - Insured/guaranteed deposits, secured debt (including covered bonds), and repurchase agreements should be excluded from restructuring.
  - Consider carving out some types of senior unsecured debt (for example, inter-bank deposits, payments, clearing and securities settlement system obligations, and arguably some trade-finance obligations) because of systemic or strategic importance.
  - Legal concerns could be addressed by creating different classes for unsecured creditors or by providing compensation to creditors made worse off than in liquidation.
- Order of loss absorption:
  - Losses should be attributed in liquidation order: first to pre-restructuring equity (including post-conversion contingent capital), then to subordinated debt outstanding at the time of restructuring, and only thereafter to unsecured senior creditors.
- Recapitalization and shareholder issues:
  - New capital required after equity reduction may come from converting part of haircut-adjusted debt into equity and/or issuing new equity leading to significant dilution of pre-restructuring shareholders.
  - Company law must not impede recapitalization (e.g., via rigid preemption rights or procedural requirements).
  - The legal framework must specify the process for restoring the bank to private control once bail-in is completed.
  - New shareholders must pass supervisory suitability scrutiny; early regulatory action to write down equity within a timeframe that avoids forced sales is recommended.
  - Certain institutional investors (such as hedge funds) could be prohibited from owning equity stakes; alternative ownership structures (for example, trust funds) could be considered.
- Contract continuity and close-out:
  - Legislation should prohibit contractual counterparties from terminating agreements solely because bail-in powers have been invoked (terminations for actual default remain permissible).
  - Close attention to cross-default clauses in standard financial contracts is necessary to avoid contagion across group components.
- Liquidity and official support:
  - Bail-in may need to be coupled with adequate official liquidity assistance.
  - Official guarantees for some debt may be necessary to stem outflows; government financing provided during debt restructuring should receive priority treatment if the bank subsequently fails.

### Group issues and cross-border challenges
- Principles assumed for analysis:
  - Restructuring implemented on a legal-entity-specific basis.
  - Home-country authorities would initiate, approve, and implement the restructuring process.
  - Statutory bail-in powers could, in principle, apply to all liabilities of the ailing bank, including liabilities “held” abroad and claims governed by foreign laws (foreign lex contractus).
  - The process of debt restructuring would be governed by the law of the home country (lex fori concursus).
- Entity-specific implications:
  - A subsidiary-specific bail-in could “de-group” a bank by wiping out the parent’s equity in the subsidiary and could destabilize the parent/group.
  - If a SIFI was funded through intra-group borrowing, restructuring only the funded entity’s liabilities may leave funding conduits or guarantors destabilized.
- Possible departures from entity-specific approach:
  - Consider allowing resolution authority to:
    - Convert claims held against a subsidiary subject to bail-in into the parent’s equity in the subsidiary; or
    - Restructure the debt of related entities that provide funding to the bank subject to bail-in.
  - Such approaches would constitute significant legal and policy departures from traditional entity-specific regimes.
- Cross-border effectiveness mechanisms and limitations:
  - Recognition mechanisms include choice-of-law rules, comity, and statutory frameworks (e.g., UNCITRAL model law on cross-border insolvency or the EU Winding-up Directive).
  - Statutory bail-in is more likely to be effective in other jurisdictions if the home proceeding is an insolvency or insolvency-related reorganization regime.
  - Host jurisdictions may resist recognition if local ring-fencing or territorial insolvency proceedings are initiated against a branch.
- Two approaches to increase cross-border recognition:
  - Contractual approach: ensure newly issued debt instruments incorporate provisions that give effect to restructurings imposed by home authorities (consensual element; applies only to new debt).
  - Legislative approach: ensure jurisdictions enact legislation recognizing bail-in powers implemented by home authorities (direct recognition of home authority orders or issuance of parallel/protective measures).
- IMF coordination framework:
  - The IMF has proposed an approach encouraging countries to recognize bank-resolution measures implemented in another country provided the home framework meets certain “core coordination standards,” including harmonization of national resolution tools and effective prudential supervision.

### Comparisons with other resolution tools (P&A and bridge bank)
- Objectives:
  - Bail-in: primarily to restore viability of a distressed financial institution by recapitalization through mandatory debt restructuring and prevent insolvency-related runs.
  - P&A and bridge-bank powers: ensure orderly closure of a failed institution and preserve going-concern value; bridge banks provide temporary solutions pending private purchasers.
- Advantages of bail-in:
  - Does not require finding purchasers (useful for very large SIFIs).
  - Potentially avoids value destruction from fire sales.
  - Likely lower execution risks: fewer contracts governed by foreign law are restructured compared with transfers under P&A, and less pre-resolution legal due diligence is required.
  - Because issued debt will likely be governed by relatively few jurisdictions, achieving cross-border effectiveness may be more straightforward than for P&A.
- Limitations of bail-in:
  - Does not directly address problem assets and loss-making business lines; P&A can leave problem assets in receivership.
  - Unknown level of asset impairment may undermine investor confidence—desirability of over-capitalizing the bank to cover hard-to-predict losses.
  - Contingent liabilities, off-balance-sheet liabilities, and litigation may remain with the open entity and need to be paid in the ordinary course of business; in P&A these can be left to receivership.
  - Transition arrangements needed for regulatory approval of new shareholders and orderly placement or trust of shareholder interests when approvals are not obtained.

### Potential market risks and mitigating measures
- Market perception and run risk:
  - If bail-in is perceived as a sign of non-viability, it could trigger runs by various creditors and contagion.
  - If perceived as restoring viability, it can enhance investor confidence and reinforce financial stability.
- Impact on funding costs:
  - Bail-in reduces or eliminates the implicit too-big-to-fail subsidy to SIFIs, likely increasing banks’ funding costs.
  - Banks’ senior ratings are expected to be adjusted downwards to reflect loss of government guarantees; removal of ratings uplift may result in average downgrade of senior unsecured debt.
  - Example: JP Morgan estimates the percentage of EU banks shifting to non-investment grade would increase from 2 percent to 33 percent (Henriques, 2011).
  - At end-2010, 10 out of 33 of the largest international banks were refinancing themselves as if they were rated at speculative levels.
  - Removing the government “put” may reduce correlation between senior bank and government spreads.
- Effects on liability structure:
  - Higher marginal cost of debt could reduce debt’s share of total liabilities; banks might increase capital or shift to short-term and secured borrowing (e.g., covered bonds).
  - Covered bonds are cheaper for issuers and protect investors via collateral, but they can undermine unsecured creditor positions and the efficacy of bail-in and deposit insurance by encumbering high-quality assets.
  - Consider imposing minimum requirements upfront for banks to maintain unsecured debt as a percentage of total liabilities, or limits on asset encumbrance.
  - Since 2009, many countries updated or adopted covered bond laws; several advanced countries (Australia, Italy, Netherlands, United Kingdom, and the United States) have introduced asset encumbrance limits.
- Contagion and cross-holdings:
  - Large shares of senior debt are held by financial institutions (declining from close to 20 percent on average in 2007 to 17 percent in 2010 for Euro area banks, and from 15 percent to 12.5 percent for U.S. banks over the same interval).
  - Insurance companies hold bank bonds accounting for 20 to 30 percent of their investment portfolios and up to three times their capital.
  - Regulators should preliminarily assess potential effects of bail-in on balance sheets of other banks and consider regulating investment in unsecured senior debt issued by SIFIs.
- Mitigating measures:
  - Restrictions or quantitative limits on cross-holdings of bail-in instruments with timely monitoring by authorities.
  - Convergence of supervisory criteria and triggers for bail-in across jurisdictions.
  - Frequent and transparent disclosure and communication by SIFIs and authorities.
  - Effective resolution planning and up-to-date recovery and resolution plans.
  - Statutory bail-in should be considered within a comprehensive framework including effective supervision to prevent failures and an effective overall resolution framework.

### Conclusions and key design recommendations
- Role of bail-in:
  - Bail-in is an additional and complementary statutory resolution tool to recapitalize distressed SIFIs via mandatory debt restructuring and avoid operational/legal complexities of transfers under P&A transactions.
  - By restoring viability, bail-in can reduce pressure to post collateral (for example, against repo contracts), minimize liquidity risks, and prevent runs by short-term creditors.
- Key design elements for effective bail-in frameworks:
  - Scope: Limit statutory power to (i) eliminating or diluting existing shareholders; and (ii) writing down or converting, in the following order, any contractual contingent capital instruments, subordinated debt, and unsecured senior debt, accompanied by the power of the resolution authority to change bank management.
  - Triggers: Align triggers for bail-in with those used for other resolution tools and set them at the point when an institution would have breached regulatory minima but before balance-sheet insolvency; use transparent and predictable intervention criteria (combination of quantitative and qualitative assessments).
  - Pre-positioned unsecured liabilities: It may be necessary to require banks or bank holding companies to maintain a minimum amount of unsecured liabilities (as a percentage of total liabilities) subject to bail-in to reassure markets that bail-in can recapitalize the institution.
  - Liquidity backing: Bail-in may need to be coupled with adequate official liquidity assistance to fund potential outflows and compensate for temporary loss of market access.
  - Comprehensive framework: Bail-in must be part of a comprehensive framework that includes effective supervision, an effective overall resolution framework, and up-to-date recovery and resolution plans.
  - Appropriate use: Statutory bail-in should be used where a capital infusion is likely to restore viability (for example, institution has a decent business model and good risk-management systems); otherwise bail-in could simply delay inevitable failure.

*Italic: Source — _sdn1203 - introduction of such a requirement would provide important safeguards for the interests of (IMF PDF content).*

### REFERENCES

### _sdn1203 - REFERENCES

### Academic articles and books
- Acharya, Viral, Hyun S. Shin, and Tanju Yorulmazer, 2011, “Crisis Resolution and Bank Liquidity.” Review of Financial Studies, Vol. 24, No. 6, pp. 2166-2205.
- Adrian, Tobias, and H. Shin, 2010, “The Changing Nature of Financial Intermediation and the Financial Crisis of 2007-2009,” Annual Review of Economics, No. 2, pp. 603-18.
- Brunnermeier, Markus, 2009, “Deciphering the Liquidity and Credit Crunch 2007–08,” Journal of Economic Perspectives, Vol. 23, No. 1, pp. 77–100.
- Diamond, Douglas, and Philip Dybvig, 1983, “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy, Vol. 91, No. 5, pp. 401-19.
- Duffie, Darrell, 2010, How Big Banks Fail and What to Do About It? Princeton: Princeton University Press.
- Gorton, Gary, and Andrew Metrick, 2010a, “Securitized Banking and the Run on Repo,” Journal of Financial Economics, forthcoming.
- Gorton, Gary, and Andrew Metrick, 2010b, “Regulating the Shadow Banking System,” Brookings Papers on Economic Activity, forthcoming.
- Shleifer, Andrei., and R. Vishny, 2011 (winter), “Fire Sales in Finance and Macroeconomics,” Journal of Economic Perspectives, Vol. 25, No. 1, pp. 29–48.
- Tirole, Jean, 2006, Theory of Corporate Finance (Princeton and Oxford: Princeton University Press).

### Regulatory frameworks, standards, and official consultative documents
- Basel Committee on Banking Supervision (BCBS), 2010a, “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems,” December (Basel: Bank for International Settlements).
- Basel Committee on Banking Supervision (BCBS), 2010b, “Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Nonviability,” BCBS Consultative Document, August (Basel: Bank for International Settlements).
- European Commission, 2011, “Technical Details of a Possible EU Framework for Bank Recovery and Resolution,” DG Internal Market and Services Working Document, January 6 (Luxembourg).
- Financial Stability Board (FSB), 2011a, “Effective Resolution of Systemically Important Financial Institutions: Recommendations and Timelines,” FSB Consultative Document, July 19 (Basel: Bank for International Settlements).
- Financial Stability Board (FSB), 2011b, “Key Attributes of Effective Resolution Regimes for Financial Institutions,” FSB Consultative Document, October (Basel: Bank for International Settlements).
- Independent Commission on Banking (U.K.), 2011, Final Report and Recommendations, September (London).
- Federal Deposit Insurance Corporation (FDIC), 2011, “The Orderly Liquidation of Lehman Brothers Holding Inc. under the Dodd-Frank Act,” FDIC Quarterly, Vol. 5, No. 2.
- European Covered Bond Council (ECBC), 2011, European Covered Bond Fact Book. (Brussels).
- Rawcliffe, Gerry, and D. Weinfurter, 2010, “Resolution Regimes and the Future of Bank Support,” Fitch Ratings, Global Special Report, December.
- Henriques, Roberto, 2011, “The Great Bank Downgrade: What Bail-In Regimes Mean for Senior Ratings?” JP Morgan Chase Europe Credit Research, January 7.

### Policy analysis, proposals, and working papers
- Acharya, Viral, T. Cooley, M. Richardson, and I. Walter, 2010, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Hoboken, NJ: John Wiley & Sons).
- Calomiris, Charles, 2011, “An Incentive-Robust Program for Financial Reform” February, independently published on the web and available at www.hertig.ethz.ch/Calomiris_Analytical_2011.pdf
- Chance, Clifford, 2011, “Legal Aspects of Bank Bail-ins”, unpublished briefing note for clients, April.
- Huertas, Thomas, 2011, “Barriers to Resolution,” draft for discussion, London School of Economics Workshop on Bail-ins, March.
- Summe, Kimberly, 2011, “An Examination of Lehman Brothers’ Derivative Portfolio Post-Bankruptcy and Whether Dodd-Frank Would Have Made any Difference,” (mimeo), Hoover Institution, Stanford University.
- Viñals, José, J. Fiechter, C. Pazarbasioglu, L. Kodres, A. Narain, and M. Moretti, 2010, “Shaping the New Financial System,” IMF Staff Position Note No. SPN/10/15 (Washington: International Monetary Fund), October.
- Pazarbasioglu, Ceyla, J. Zhou, V. Le Lesle, and M. Moore, 2011, “Contingent Capital: Economic Rationale and Design Features,” IMF Staff Position Note No. SDN/11/01 (Washington: International Monetary Fund), January.
- Ötker-Robe, Inci, Aditya Narain, Anna Ilyina, and Jay Surti, 2011, “The Too-Important-to-Fail Conundrum: Impossible to Ignore and Difficult to Resolve,” IMF Staff Position Note No. SDN/11/02 (Washington).

### Institutional and technical guidance
- Hagan, S., 1999, Orderly and Effective Insolvency Procedures (Washington: International Monetary Fund).
- International Monetary Fund, 2010, “Resolution of Cross-Border Banks—A Proposed Framework for Enhanced Coordination,” June (Washington).
- Brunnermeier, Markus, 2009, “Deciphering the Liquidity and Credit Crunch 2007–08,” Journal of Economic Perspectives, Vol. 23, No. 1, pp. 77–100.

*Source: _sdn1203 - REFERENCES*

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