On April 18, the European Commission announced its legislative proposal to update the EU's CMDI framework. The update takes on board the lessons of bank failures since the introduction of the first Bank Recovery and Resolution Directive (BRRD). Originally, the Commission had intended a broad range of measures to complete the EU banking union, including EDIS as its third pillar. However, the Eurogroup (which comprises member states' finance ministers) narrowed the ambition in June 2022 and requested that the Commission table proposals that solely focus on the CMDI framework. With its proposals, the Commission is answering this request. The legislative process that involves the European Council and European Parliament will now start.

Across three core legislative elements, the proposal addresses four interrelated priorities:

• Broader application of resolution tools to smaller banks, aided by a clarified and harmonized public interest assessment;
• Harmonized and wider use of national deposit guarantee schemes (DGS) in resolution, including to support funding and facilitate access to resolution funds;
• Clarified early intervention framework to provide legal certainty, ensure timely triggering of resolution, and avoid extraordinary public support to failed banks; and
• Widened scope of depositor protection to include public entities, albeit with no changes proposed to the €100,000 coverage limit (outside of exceptions granted for specific life events).

The proposal seeks to optimize, rather than overhaul, the framework introduced though the BRRD in 2014. Still, it envisages some quite radical changes. This includes the introduction of general depositor preference, which would subordinate senior preferred debt to all deposits, and rerank all deposits pari passu--in contrast to the current three-tier hierarchy. Among other things, the proposal would enable EU resolution authorities to use "purchase and assumption" (P&A) transactions more readily for failed smaller banks and DGS funds more flexibly. Both are already tried and tested practices of the Federal Deposit Insurance Corporation (FDIC) in the U.S. It could also help to ease future contagion issues to the extent that it reduces the risk that uninsured depositors are subject to delayed or partial repayment.

The proposal remains subject to change before it becomes legislation--a process that could complete later in 2023. While the Commission already received suggestions from key policymakers and regulators as it formulated the proposal, parts of it appear potentially controversial among key decision-makers--not least the potential removal of DGS' super-seniority.

As we recently commented, we still see resolution as the most likely course of action if a systemic EU bank were to fail (see "Crisis Management Observations From Recent European And U.S. Banking Sector Volatility," published April 19, 2023). We see the CMDI framework more as a toolbox of options that could be applied under the specific circumstances of a bank failure, rather than a prescriptive formula. Nevertheless, our ratings on EU banks are informed by the content of the framework and how we expect it to be applied. We will consider the potential for any associated rating implications as the proposal moves toward final legislation and implementation. At this time, we make the following observations:

• We are unlikely to change our assessment that government support for failed and failing EU banks is uncertain.
• The creation of general depositor preference does not, in and of itself, imply rating changes.
• The hierarchical separation of senior preferred debt from uninsured deposits could incentivize a reduction in subordinated MREL (minimum requirement for own funds and eligible liabilities), and so ALAC.
• The changes might lead in some circumstances to more EU banks gaining ALAC uplift in their issuer credit ratings (ICRs).
• A changed hierarchy for deposits could imply a widening of the types of liabilities addressed by our resolution counterparty ratings (RCRs) in EU banking systems.
• EU banking systems will remain predominantly national in nature, and our ratings therefore continue to recognize how the strength of national banking systems influences banks' individual credit strength.

The CMDI Review Identifies Areas To Enhance The Current EU Framework

Implemented since 2015, the EU's BRRD led to a radical step-up in public authorities' ability to avoid or limit government solvency support for failing or failed banks. It also sought to reset market expectations about the likelihood of previous bank bailouts reoccurring. In the decade since the global financial crisis and European sovereign debt crisis, the region's banks have made huge preparations to enhance their resolvability--a process that will be largely complete by 2024. In that time, a series of small and midsize banks have failed across the EU. Each failure had its own specific circumstances, and some resolution tools (like bail-in) remain unused. By 2020, though, it became clear to the resolution authorities, policymakers, and other market observers that there was significant scope for improvement in the framework to address the following challenges:

An incomplete banking union

• Despite making good headway in reducing legacy nonperforming loans since 2017, progress toward a complete union is limited by a complex web of interlinked initiatives that are technically and politically difficult. A recent example is the stalled proposals to deliver a European deposit insurance scheme.

Recurring cases of government support for distressed EU banks

This reflects the recurring use of public funds for failed and failing banks since the implementation of the original BRRD, and has occurred because:

• Authorities have been able to determine that a recapitalization is precautionary even under severe bank distress;
• Authorities appear reluctant to bail-in depositors given financial stability concerns, which may also impact their willingness to bail-in senior preferred creditors that rank pari passu;
• The lack of generalized depositor preference makes it challenging to use resolution funds without bailing in depositors, especially for midsize banks that haven't built sufficient subordinated buffers; and
• National insolvency frameworks differ in the availability of stabilization and intervention tools. In certain instances, it has been possible for governments to provide state aid under such insolvency procedures.

Inconsistency across EU jurisdictions

• Causes include differing national insolvency frameworks in terms of the availability of regulatory tools, and divergences between the "failing" or "likely to fail" (FOLTF) concepts in the BRRD and the diverging conditions to withdraw a banking license under national law; specifically, in applying prospective versus retrospective concepts of what constitutes a failure.

Potential unpredictability

• Causes include divergent interpretations of the public interest assessment (PIA)--the gateway to resolution tools--across jurisdictions, as well as diverging creditor hierarchies, or variability in state aid decisions.

Complex decision-making

• This can impede effective resolution, particularly cross-border resolution, for example because of the differing national insolvency laws and DGS rules.

Aside from EDIS, which remains stalled, the CMDI proposal could remedy many of the above complexities and obstacles, and deliver an improvement in the consistency of resolution actions.

Re-Ranking Of Deposits And DGS Standing Is Central To The Proposal, Political Discussion, And Potential Rating Implications

As we noted in "Crisis Management Observations From Recent European And U.S. Banking Sector Volatility," European regulators have long recognized that:

• It is not only large banks, but also many smaller and midsize ones, that can pose potential financial stability risks if they fail.
• The bail-in of uninsured deposits, while permissible under the BRRD, could cause financial instability.

The rewording of the PIA will make it easier for authorities to justify the use of resolution tools for more of these smaller banks, as opposed to just putting them into liquidation. Indeed, the definition of critical functions--the existence and continuity of which being key determinants of public interest in resolving the banks--will be clarified to include a reference to "national or regional level".

In addition, the proposal aims to substantially enhance the body of funds that can be used in resolution by allowing more flexible use of DGS to ensure a bank under resolution can exit the market. Indeed, in such market exit cases, it will now be possible--when necessary to protect financial stability and subject to a least cost test--to use DGS funds as a bridge to meet the 8% threshold which remains a pre-condition to access resolution funds. Resolution funds cannot be used to help recapitalize banks unless 8% of the failing bank's total liabilities (including own funds) have already been absorbed, which is a high threshold. The Single Resolution Fund (SRF), for example, is well funded and poised to meet its target of 1% of covered deposits, which is about €80 billion by end-2023.

To unlock the use of DGS funds in practice, the Commission proposes to remove the current DGS' "super-preference" in the hierarchy of claims. Its existence is the main reason why, until now, DGS funds can almost never be used outside a payout of covered deposits in insolvency--because this payout is the action that is very likely to pose least cost to the DGS. By removing this DGS' super-preference, i.e., subordinating its claim in the creditor hierarchy, the new proposals make it more likely that the "least cost" test would be met and DGS funds could be used in resolution.

Taken together, this is likely to mean that EU resolution authorities could now undertake FDIC-style P&A transactions (selling books of assets and liabilities to other banks) on more banks and aided where necessary by funding from DGS. The use of other resolution tools, such as bail-in, could remain reserved for larger, more complex banks that pose the most serious risk to financial stability.

The proposal goes further on deposits. Several EU countries--including Greece, Italy, and Portugal--already introduced a general depositor preference that "seniorizes" (that is, ranks senior in payment right) even uninsured deposits from corporates and financial institutions above many other senior preferred liabilities, not least bonds. The Commission now proposes to extend this measure across the bloc at the same time as removing the DGS' super-preference--henceforth all deposits would rank pari passu (see chart 1). This change was necessary to address the current "no creditor worse off" (NCWO) constraint that could impede a resolution authority from bailing-in senior preferred bonds while leaving pari passu uninsured deposits untouched.

Chart 1

Taken together, the use of DGS funding and the seniorization of uninsured deposits should further reduce the likelihood that authorities need to bail-in uninsured deposits and so should help reduce contagion risk. At first sight the removal of the DGS' super-preference increases the exposure of the banking industry as it would have to replenish depleted DGS funds over time. However, the Commission argues that the industry would not be materially more exposed since the expanded use of P&A transactions (i.e., the asset transfer resolution tool) would better avoid the cost for a DGS if the failed bank is simply liquidated.

How The Proposal Could Affect Ratings

Observation #1: Government support for failed and failing banks would very likely remain uncertain in the EU

Since 2015, we have seen the prospect of extraordinary government solvency support for banks as uncertain in the EU. Support isn't impossible, in our view, but we find the prospect so unlikely that we do not assume it in the analytical base case that supports our ratings on commercial banks. That said, taxpayer-funded extraordinary support has remained a periodic--if less typical--feature in the EU, notably such as that extended to Monte Paschi di Siena and the "liquidation aid" to Banca Popolare di Vicenza and Veneto Banca. If the Commission draft proposals achieve the policymakers' intended aim of enhancing the credibility and efficacy of resolution and further constricting the ability of governments to provide solvency support to failed or failing banks, this seems to reinforce the message that the EU has moved away from bailouts of old.

Observation #2: The creation of general depositor preference does not, in and of itself, imply rating changes

This change would be unlikely to affect our ratings on EU banks directly because we do not see it meaningfully changing banks' ability and willingness to service senior preferred debt and other senior unsecured obligations. Although the recovery prospects for senior preferred bonds may decline, our bank ratings reflect the likelihood of default and do not assess loss-given default (see "Extending Depositor Preference To All Depositors Would Not Trigger Rating Changes On Spanish Banks," published on Nov. 25, 2020).

Observation #3: The hierarchical separation of senior preferred debt from uninsured deposits could incentivize banks to reduce subordinated MREL, and so ALAC

While the proposal would not necessarily require a recalibration of banks' MREL, the creation of general depositor preference would seniorize these confidence-sensitive and often systemically relevant liabilities above senior preferred debt--as is already the case in countries such as Greece, Italy, and Portugal. This isolation of senior preferred debt (and ability to bail it in without touching deposits) is one reason why many banks in these jurisdictions have no MREL subordination requirement--they are free to fill their MREL buffer with senior preferred debt if they wish. By contrast, we observe a markedly different approach in other EU jurisdictions, mainly in the north--such as in Germany, France, and Sweden--where these deposits currently rank pari passu with senior preferred debt. These jurisdictions tend to insist on substantial, if not total, subordination of MREL instruments to senior preferred claims, even if EU regulation does not require this.

Banks' thin buffers of subordinated debt in countries like Italy, Greece, and Portugal are a key reason why our ICRs on systemic banks in these jurisdictions do not benefit from ALAC uplift, even when we see the intended resolution strategy as potentially supportive of timely payment to these creditors (see chart 2).

Chart 2

It remains a long-range issue, but there is a possibility that, over time, regulators in other countries might reduce the subordination requirement for banks in their jurisdiction. Particularly with spreads having widened, there is a meaningful chance that the banks may choose to increase their senior preferred buffer to the detriment of the subordination debt buffer. This would imply a reduction in their ALAC buffer and so, possibly, exert negative pressure on the level of their RCR and ICR (see chart 3).

We note also that the proposal envisages harmonization of MREL requirements for banks that would likely be subject to transfer strategies (such as sale of business). This would, for example, allow regulators to recognize that divested assets would not need to be recapitalized by the failed bank's creditors. As a result, MREL requirements for these banks could reduce, and so also their ALAC buffers.

Chart 3

Observation #4: The changes might lead in some circumstances to more EU banks gaining ALAC uplift in their ICRs

In the past two years we have continued to assign new RCRs and add ALAC uplift to more European bank ratings as their resolution and debt issuance plans became clearer, and not only with respect to the largest banks--see "The Improving Resolvability Of Europe's Midsize Banks Offers Greater Protection To Senior Creditors," published Dec. 7, 2022. However, our ratings assess the risk of banks being able to make timely and full payment of relevant obligations. This means that we only uplift our ICRs for ALAC (and assign RCRs) if we see the intended resolution strategy as likely to reduce default risk for these senior obligations--the presence of a large subordinated buffer alone is insufficient. As a result, European banks with ALAC uplift tend to be sizable institutions that would be targeted for open bank bail-in resolution or a sale of business (share transfer).

When implemented, the proposal could result in more banks--particularly important subregional players--being targeted for resolution, with the expectation that they then build a larger MREL buffer and make other preparations to enhance resolvability. However, this does not necessarily mean that significantly more banks would gain ALAC uplift in their ICRs. For example, we would expect that most of these banks newly targeted for resolution would be subject to the asset transfer tool (i.e., a P&A transaction) at the point of failure, which could leave some senior preferred obligations behind in the failed bank. Furthermore, it's unclear whether these banks would build substantial subordinated buffers that support ALAC uplift.

Observation #5: A changed hierarchy for deposits could imply a widening of the types of liabilities addressed by our RCRs

RCRs reflect our opinion of the relative default risk of a bank's certain senior liabilities (RCR liabilities) that may be protected from default should the bank be subject to a resolution process. As a result, RCRs only apply if:

• The bank operates in a jurisdiction where we assess the resolution framework to be effective; and
• We assess that, if the bank became nonviable, it would likely be subject to a resolution process that would support the full and timely payment of RCR liabilities.

Differences in bail-in legislation across the major jurisdictions mean that the universe of RCR liabilities differs among them. We have published jurisdictional assessments for each country where we assign RCRs to financial institutions. In Europe, we currently maintain a narrow classification of RCR liabilities, limited to liabilities that are explicitly specified in law as being excluded from bail-in.

Although the deposits would henceforth rank equally in liquidation, we do not see insured deposits as less protected from default risk under the proposal--the wider use of resolution powers may mean that DGS payouts are needed less often. More importantly, though, the seniorization of uninsured deposits and potential mobilization of DGS funds may increase the likelihood of this class of liabilities continuing to be paid on time and in full. If we were to see default risk on uninsured deposits as having become reliably and substantially differentiated relative to that of ICR-level senior preferred liabilities, we could include uninsured deposits within the liabilities addressed by our RCRs. In theory, we would determine this on a jurisdiction-by-jurisdiction basis, but the harmonization of the hierarchy across the EU would imply a comparable outcome across the bloc.

That said, we would not position an RCR above a bank's ICR unless we believe that the bank has a meaningful layer of senior preferred liabilities that would help to absorb losses in resolution and could therefore better protect its RCR liabilities from default. The decision to position a bank's RCR above its ICR would therefore remain subject to case-by-case review of a bank's liability structure.

Observation #6: Our ratings continue to recognize that the strength of national banking systems influences banks' credit strength

European banks are heterogenous in their business models, and our ratings acknowledge this--as well as their differing levels of balance sheet strength, profitability, risk appetite, and other important features. However, the starting point for rating banks is our banking industry country risk assessment (BICRA), which, even in the banking union, retains a strong influence of national-level economic and industry strengths and weaknesses, including market structure.

The Commission's proposal cites an interesting observation from the European Central Bank that "every Member State has at least one medium-sized or smaller bank for which a reimbursement of covered deposits would fully deplete the national DGS". We also note that in many of the previous cases of small and midsize bank failures in Europe, it's the larger local banks that have, where needed, been part of the solution. We saw this most recently in Poland where the largest banks stepped up to contribute equity to a deal that allowed failed Getin Noble to be resolved with the assistance of the resolution fund. And in Germany, all commercial banks will have to replenish the DGS after payouts arising from the failures of Wirecard Bank and Greensill Bank. Confidence and financial stability are critical to banks, and where we see inherent weaknesses in a system, this will continue to affect bank ratings through BICRAs. Where crystallized costs emerge, such as an obligation to replenish a DGS, then this would also inform our assessment of a bank's future profitability. While EDIS could help to diversify these contagion risks in the banking union, particularly for more concentrated banking systems, it remains a seemingly distant prospect.

Related Research

• Crisis Management Observations From Recent European And U.S. Banking Sector Volatility, April 19, 2023
• The Improving Resolvability Of Europe's Midsize Banks Offers Greater Protection To Senior Creditors, Dec. 7, 2022
• The Resolution Story For Europe's Banks: The Final Push To Resolvability, Sept. 30, 2022
• The Resolution Story For Europe's Banks: More Resolvability, Consistency, Credibility, Oct. 5, 2021
• Extending Depositor Preference To All Depositors Would Not Trigger Rating Changes On Spanish Banks, Nov. 25, 2020
• What's Next For Resolution Counterparty Ratings?, March 2, 2020
• Continued Bank Bail-Outs Stretch The Credibility Of Europe’s Resolution Framework, Feb. 26, 2020