UK: UK Government Consults On New Rules To Recapitalise Small Banks In Resolution – What Does This Mean For Potential Buyers Of Distressed UK Banks?

What is the government proposing?

• The UK government ("HM Treasury") has launched a Consultation setting out its proposals to amend the UK special resolution regime ("SRR") to direct that the UK depositor guarantee scheme is used to fund the resolution of small non-systemic banks, building societies and other financial institutions falling within scope of the SRR (each a "bank").
• The proposal is for the UK depositor protection guarantee scheme (the "Financial Services Compensation Scheme" or "FSCS") to provide funding to recapitalise failing small banks, where these banks are placed into resolution (or orderly wind-down) rather than insolvency. The FSCS is currently the vehicle through which eligible depositors are repaid on any failure of a UK deposit taking bank. The funding proposed under the consultation will be raised by additional levies placed on UK deposit taking banks. In short, the Bank of England will recover the costs of resolving and recapitalising small banks by recouping those costs from the deposit taking banking sector as a whole. By placing these costs on the banking sector, it mitigates the risk of taxpayer funds being utilised to resolve small banks and eases the exit of a small bank from a bridge bank to facilitate a sale to a third party purchaser.

• Small banks, in this context, are those banks which are not required to hold certain loss absorbing capital (known as "MREL"). MREL is bank capital, above minimum capital requirements, which is bailed-in to enable a failing bank to be recapitalised. Certain small banks in the UK are not required to hold MREL as the expectation (prior to the collapse of Silicon Valley Bank in March 2023) was that small banks would be resolved through a modified insolvency process (the "Bank Insolvency Procedure") rather than through the use of resolution powers (i.e. a bail in strategy, the sale of the bank to a third party purchaser or holding the bank in a bridge bank). The successful sale of Silicon Valley Bank has demonstrated the efficacy of using resolution as a tool to resolve smaller banks rather than the Bank Insolvency Procedure.
• Requiring small banks to raise MREL or otherwise increasing their regulatory capital requirements to fund recapitalisation in resolution is not an option. HM Treasury's view is that "[i]n practice, small banks have very limited or no access to capital markets to issue MREL-eligible debt to investors and would therefore need to meet MREL requirements with equity. Requiring such firms, in effect, to maintain higher equity capital ratios, would impose disproportionate costs on small firms, and in turn have a negative impact on competition. Building up a prefund, financed by levies on the banking sector, would in aggregate be less costly to the sector as a whole than imposing individual MREL-type requirements on small banks".

How will the costs of resolving the small banks be allocated?

• Once the failing bank's shareholders and any capital has been written down, funds would be made available to cover:
  • the costs of recapitalising the failed bank;
  • the costs of operating any bridge bank (in which the failing bank is held pending a sale or orderly wind down); and
  • HM Treasury and the Bank of England's costs (include legal and other professional advisor costs) in relation to the resolution.

The FSCS would be required to make such funds available at the Bank of England's direction. It is anticipated that the current overall cap of the FSCS would remain the same.

• HM Treasury's preferred approach would involve the FSCS providing funds through an ex-post levy on the banking sector (levied on the entire deposit taking class of banks). Legislation would be required to expand both the FSCS's statutory functions and its levy-raising powers. The FSCS's annual levy limit for the deposit-taking class would continue to be set by the PRA based on their assessment of what is affordable for the sector.
• The new mechanism would not necessarily be used in all cases of small bank failure. In many cases, the Bank Insolvency Procedure may continue to be used, where it is appropriate to do so, taking into account the statutory resolution objectives.

How does this impact potential purchasers interested in acquiring small banks which are in resolution?

• It is important to understand which failing small banks will be out of scope. The new mechanism would not be used to recapitalise the failure of credit unions since the SRR does not apply to these firms. Equally, UK branches of offshore banks are also out of scope. HM Treasury has clarified that the "new mechanism would similarly not be used to manage the failure of a third-country branch operating in the UK. This is because the responsibility for resolving such a firm ultimately lies with the relevant home resolution authority". None of this will impact existing legislative arrangements under which UK depositors of credit unions and third country branches benefit from the protection from the FSCS in resolution for eligible deposits up to £85,000.
• The expectation is that this new funding mechanism will predominately be used where the small bank is required to be placed in a bridge bank (controlled by the Bank of England) prior to a sale to a third party purchaser. This is because this is the scenario most likely to give rise to the use of taxpayer funds.
• Where the bridge bank stabilisation option has been deployed, the bank in resolution may be sold to a buyer. Any proceeds from the sale to the private sector buyer would be applied in accordance with the provisions of a "resolution fund order" made by HM Treasury. HM Treasury expects that any such order would provide for the proceeds of the sale to meet: (i) any compensation costs arising from the transfer; and (ii) the expenses of HM Treasury and the Bank of England (to the extent not met from FSCS funds). Where any monies remain, HM Treasury expects that they would be paid to the FSCS to offset future levies or repay the banks contributing to the FSCS.
• The consultation also provides for changes to the pre-conditions for resolution financing made available to a failing bank. Specifically, there are two conditions set out in the SRR Code of Practice which state that: (i) "[r]esolution financing arrangements may only be used....... where the shareholders and creditors of the failing institution have made a contribution equal in value to at least 8% of the liabilities of the institution". This is known as the "8% rule" and "[t]he contribution of the resolution financing arrangements may not exceed an amount equal to 5% of the liabilities of the institution". This is known as the "5% rule". Small banks are not required to hold MREL. Consequently, they are unlikely to satisfy the 8% rule and 5% rule. HM Treasury's view is that "these conditions are therefore not appropriate for the cohort of firms for which the new mechanism is expected to be used, and applying these conditions when the new mechanism is used is likely to prevent it from being deployed effectively."

The effect of the above changes is to provide more certainty on funding and recapitalisation of small banks in resolution. This will enable the Bank of England as resolution authority to consider the use of resolution tools (such as the sale of a business to a third party or transfer to a bridge bank) where the Bank Insolvency Procedure does not achieve the resolution objectives – providing further acquisition opportunities for potential buyers.

The ultimate aim of the proposals under consultation is to ensure that the costs of small bank failures are borne first by shareholders and certain creditors and then by the UK banking sector, rather than taxpayers. The consultation closes on 7 March 2024.

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