10.6092/issn.2531-6133/7664
This paper aims to address the role of subordinated liabilities within the newresolution framework resulting from the post-crisis reforms. In particular, this study starts from the resolution intervention of four Italian banks in November 2015. The legal analysis of that resolution is complemented by an empirical analysis of the determinants of subordinated debt issuances for Italian banks. From this set of evidence is possible to infer the desirability of a well-functioning and dynamic market for subordinated debt. On the other hand, what clearly emerges is the incompatibility between such a market and the new regulatory framework as it is. Therefore, the paper, given the compelling arguments showing the inefficiency of a pure mandatory bail-in mechanism for subordinated debt, proposes to complement it with a contractual clause to bail-in subordinated creditors, tailored on coco bonds model, in order to enhance certainty amongst the contractual parties.
application/pdf
2531-6133
7664
2
en
Edoardo Martino
University of Bologna Law Review
Subordinated Bonds
Subordinated Debt Under Bail-in Threat
Text.Serial.Journal
https://bolognalawreview.unibo.it/
2
Articles & Essays
2018-01-03
2018-01-03
2017-11-22
2018-12-14
252-299
UBLR
Edoardo Martino
2017
10.6092/issn.2531-6133/7664
252
Erasmus School of Law
2531-6133
2
Subordinated Bonds
en
299
Subordinated Debt Under Bail-in Threat
https://bolognalawreview.unibo.it/article/download/7664/7390
2
ARTICLES & ESSAYS                                                         https://doi.org/10.6092/issn.2531-6133/7664




                          Subordinated Debt Under Bail-in Threat


                                            EDOARDO MARTINO†



TABLE OF CONTENTS: 1. Introduction; 2. Bail-In, Debt and Creditor’s Treatment; 2.1.
Raising Capital in the Banking Industry; 2.2. B.R.R.D. and Creditor’s Treatment; 3. The
Italian Anecdotal Evidence; 3.1. The Narrative and Some Caveat; 3.2. The Market for
Subordinated Debt in the Italian Banking System; 4. Empirical Assessment of the
Determinants of Subordinated Debt; 4.1. Sample and Variables; 4.2. How to Understand
Decision on Subordinated Debt Issuance?; 4.3. Are There Reliable Determinants?; 4.4.
Policy Consequences; 5. Convertible Subordinated Bond: A Solution Though Contracts?;
5.1. Contractual Clause for Writing Down and Conversion: a Solving Problem Tool; 5.2.
Incentive Structure of Relevant Actors; 6. Conclusions; 7. Appendix.

ABSTRACT: This paper aims to address the role of subordinated liabilities within the new
resolution framework resulting from the post-crisis reforms.
In particular, this study starts from the resolution intervention of four Italian banks in
November 2015. The legal analysis of that resolution is complemented by an empirical
analysis of the determinants of subordinated debt issuances for Italian banks.
From this set of evidence is possible to infer the desirability of a well-functioning and
dynamic market for subordinated debt. On the other hand, what clearly emerges is the
incompatibility between such a market and the new regulatory framework as it is.
Therefore, the paper, given the compelling arguments showing the inefficiency of a
pure mandatory bail-in mechanism for subordinated debt, proposes to complement it
with a contractual clause to bail-in subordinated creditors, tailored on coco bonds
model, in order to enhance certainty amongst the contractual parties.


KEYWORDS: Law and Economics; Law and Finance; European Banking Union; Banking
Resolution; Subordinated Bonds




                                            UNIVERSITY OF BOLOGNA LAW REVIEW

                                                    ISSN 2531-6133

                                                     [VOL.2:2 2017]

           This article is released under the terms of Creative Commons Attribution 4.0 International License


                                                         252
                                                                 University of Bologna Law Review
                                                                                     [Vol.2:2 2017]
                                                                    https://doi.org/10.6092/issn.2531-6133/7664




         1. INTRODUCTION

After the global financial crisis in 2007 and the sovereign debt crisis in 2011,
the lack of a common regulatory framework for banking supervision and
resolution has been identified as one of the main drivers of European, and
especially the Eurozone, stagnation.

          The European policy maker reacted implementing the European
Banking Union (hereinafter E.B.U.)1 to enhance financial stability and make a
step forward towards a genuine economic and monetary union.2 The new E.B.U.
consists of three main pillars:3 a Single Supervisory Mechanism for the
Eurozone (hereinafter S.S.M.),4 a new Deposit Guarantee Scheme (hereinafter
D.G.S.)5 and a new framework for the resolution of distressed banks.6

          Within the resolution intervention, the bail-in tool attracted the
utmost attention of both media and scholars.7 A bank bail-in8 is a tool that the
Resolution Authority can employ once a resolution is triggered. The power to
write down (Article 63 (1)(e) B.R.R.D.) or convert into ordinary shares (Article
63 (1)(f) B.R.R.D.) eligible liabilities issued by the bank under resolution
constitute a bail-in. Therefore, a bail-in represents a balance sheet operation



†
  Edoardo Martino LL.M., Ph.D. Candidate in Law & Economics at Rotterdam Institute of Law and
Economics, Erasmus School of Law. The author is grateful to Dr. Jaroslaw Beldowski and Dr.
Wiktor Wojciechowski for their supervision on this work. Usual disclaimers apply.
1
  See the ‘Conclusions document’ of the European Council (28/29 June 2012).
2
  See HERMAN VAN ROMPUY, TOWARDS A GENUINE ECONOMIC AND MONETARY UNION (2012).
3
  See DANNY BUSH & GUIDO FERRARINI, EUROPEAN BANKING UNION (2015).
4
   Council Regulation 1024/2013 of 15 October 2013 conferring specific tasks on the European
Central Bank concerning policies relating to the prudential supervision of credit institutions, 2013
O.J. (L 287), 63.
5
  Directive 2014/49 of the European Parliament and of the Council of 16 April 2014, on deposit
guarantee schemes, 2014 O.J. (L 173), 149.
6
  Directive 2014/59, of the European Parliament and of the Council of 15 May 2014 Establishing a
Framework for the Recovery and Resolution of Credit Institutions and Investment Firms and
Amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC,
2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No
1093/2010 and (EU) No 648/2012, of the European Parliament and of the Council, 2014 O.J. (L173),
190, and – specifically for the Eurozone - Single Resolution Mechanism – Regulation 806/2014, of
the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a
uniform procedure for the resolution of credit institutions and certain investment firms in the
framework of a Single Resolution Mechanism and a Single Resolution Fund and amending
Regulation (EU) No 1093/2010, 2014 O.J. (L 225), 1.
7
  For a survey about the challenges stemming from bail-in, see Goodhart, Charles; Charles
Goodhart & Emilios Avgouleas, A Critical Evaluation Of Bail-Ins As Bank Recapitalisation Mechanisms,
SSRN, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2478647 (Aug. 12, 2014).
8
  See Paul Calello & Wilson Ervin, From bail-out to bail-in, THE ECONOMIST, Jan. 28, 2010.

                                               253
                                                                 University of Bologna Law Review
                                                                                     [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




to recapitalize and restore the viability of the distressed institution.9 In this
way, the State should not be “forced” to bail those banks out and,
consequently, would avoid burdening tax-payers with bank savings.10

        The specific objective of this paper is to address the consequences that
the new resolution tools have on subordinated liabilities market in a dynamic
perspective; meaning that the paper considers not only how the new regulation
affects a particular class of creditors, but also whether such new framework
incentivizes     a   shift   in   the   characteristic      of   subordinated             bonds         and
bondholders and the expected outcome of the whole process.

          This paper discusses the desirability of a developed market for
subordinated bonds and – at the same time – the inefficiency of a purely
mandatory debt conversion regime. Eventually, a contractual model tailored on
the contingent capital instrument is proposed to make all the actors involved
better-off.

          The structure of the paper is as follows: Section § 2 provides an
introduction to the banks’ financial structure and creditors’ safeguards in case
of bail-in, as disciplined in the Bank Recovery and Resolution Directive
(hereinafter B.R.R.D). Section § 3 analyzes an anecdotal evidence from Italy,
where the Bank of Italy, along with Ministry of Economic and Finance,
resolved four banks in November 2015. The key point of that resolution
intervention was, indeed, writing down the bank subordinated debt. Section §
4 tries to test empirically which are the determinants of subordinated debt,
using a sample of Italian banks and listed subordinated bonds. Finally, Section
§ 5 discusses the incentives for banks and bondholders to include in their
agreement a clause to convert and/or write-down the credit when a given
trigger event occurs (Section § 5).

        Throughout        this    paper     the     so-called     “Law         and       Economics”
methodology is widely applied. This basically means that the legal analysis
concerning bail-in and subordinated bond is closely tied to the analysis of

9
   See Simon Gleeson, Special Paper, Legal Aspects Of Bank Bail-Ins, 2012 LONDON SCH. ECON. FINAN.
MKT. GROUP PAPER SERIES ¶ SP205.
10
   During the 2007-08, crisis almost 37% of aggregate E.U. Member State GDP was spent to avoid
banks     failure. See    E.C.B.   Report    on     EU    Banking     Structures,  (Sept.   2010),
https://www.ecb.europa.eu/pub/pdf/other/eubankingstructures201009en.pdf?cd7ac9e5cf703dabf8
6f35ac0140f225.

                                              254
                                                                    University of Bologna Law Review
                                                                                        [Vol.2:2 2017]
                                                                       https://doi.org/10.6092/issn.2531-6133/7664




economic consequences of the legal framework,11 borrowing from basic
microeconomic theory and econometrics.




          2. BAIL-IN, DEBT AND CREDITOR’S TREATMENT

     2.1 RAISING CAPITAL IN THE BANKING INDUSTRY

Before starting any analysis of banks bail-in and its impact on subordinated
debt, it seems to be wise taking a step back and examining how banks raise
their capital, i.e.: how they make decisions concerning the source for funding
firm’s activities. In fact, the decisions about capital and debt structure are
going to be a crucial aspect of the paper.

         An intuitive division is usually drawn between debt and equity, anyhow
– given the large variety of debt and equity instrument available – the source
of funding can be better visualized as a vector ordered according to the loss
absorbency capacity of each particular financial instrument: clearly, pure
equity instruments have a higher loss absorbency capacity in case of failure
and debt tools have lower and lower capacity to absorb losses. From the
investor’s standpoint, a greater loss absorbing capacity means a higher risk
profile of the investment.

         For standard economic reasoning, in deciding its capital structure, each
firm strives to find a mix of different capital instruments which maximize the
difference between marginal cost and marginal benefit of capital (e.g.: tax
incentives, cash flow incentives).12

         The first issue that has to be highlighted is that a bank’s financial
structure has many peculiarities compared to non-financial corporations.
These can be explained by focusing on two aspects: the role of financial
structure for banking activity and the social cost of banks failure. Indeed, the
financial structure of banks is per se highly leveraged, as the core business of

11
   For an extensive introduction see ROBERT D. COOPER, LAW AND ECONOMICS (Pearson Education eds.,
6th ed. 2011). ; see also Louis Kaplow & Steven Shavell, Economic Analysis Of Law, in 3 HANDBOOK OF
PUBLIC ECONOMICS 1661-1784 (Martin Feldstein & A.J. Auerbach eds., 2002).
12
   See Jianping Zhou et al., From Bail-out to Bail-in: Mandatory Debt Restructuring Of Systemic Financial
Institutions, 12/03 INT’L MONETARY FOUND STAFF DISCUSSION NOTES, Apr. 24, 2012, at 21.

                                                  255
                                                                       University of Bologna Law Review
                                                                                           [Vol.2:2 2017]
                                                                          https://doi.org/10.6092/issn.2531-6133/7664




commercial banks is to transform short term lending (mostly deposits) into
long term borrowings. In other words, capital structure is part of what banks
do and not only the result of a strategy to raise funds.13 Moreover, since bank
activities have a systemic importance for economic stability,14 the social cost of
banks bankruptcy is by far more severe than for every other kind of
corporation.15

         Any policy suggestion has to carefully consider those two aspects in
making proposals to reform banks capital structure whose purpose is to
enhance the loss absorbency capacity of banks’ liabilities.

         After the global financial crisis, (too) high leverage in banks’ balance
sheets was intensively criticized, and several scholars proposed to set a
minimum requirement of equity far higher than the Basel III requirements.
The underlying assumption of most of those proposals is the belief that
gathering debt is not cheaper than raising equity.16 This position borrows from
Modigliani and Miller’s Indifference Propositions, according to which –
assuming “no cost of bankruptcy” and “perfect information” – the cost of
raising capital is independent of the debt/equity structure of the firm.17 The
departure from that proposition generates a huge stream of literature on
corporate finance which will be helpful later on, in the empirical analysis of
determinants of subordinated debt issues. In fact, the “no cost of bankruptcy”
and the “perfect information” assumptions, which represent the baseline of
the Modigliani and Miller’s model, turn to be rather unrealistic, especially for
the banking sector.

         Furthermore, increasing the share of equity in banks financial structure
cannot be considered a policy goal per se. In fact, the first-order purpose is to
enhance loss absorbency capacity of bank liabilities and, hence, make them
more resilient. Thus, in governing future financial crisis, the debt shall play a



13
   See Paul Davies, The Fall And Rise Of Debt: Bank Capital Regulation After The Crisis, 16 EUR. BUS. ORG. L.
REV., 491, 500 (2015).
14
   See Olivier Blanchard, Giovanni Dell’Arriccia & Paolo Mauro, Rethinking Macroeconomic Policy, 42
J.MONEY, CREDIT AND BANKING 199, 206 (2010).
15
   See, for instance MATEJ MARINC & RAZVAN VLAHU, THE ECONOMICS OF BANK BANKRUPTCY LAW (2011).
16
    See, e.g., ANAT ADMATI & MARTIN HELLWIG, THE BANKERS’ NEW CLOTHES: WHAT’S WRONG WITH
BANKING AND WHAT TO DO ABOUT IT (updated ed., 2014).
17
   See Franco Modigliani & Merton Howard Miller, The Cost Of Capital, Corporation Finance And The
Theory Of Investment, 48 THE AM. ECON. REV. 261-297 (1958).

                                                    256
                                                                 University of Bologna Law Review
                                                                                     [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




role in absorbing losses, and this can be considered the overarching policy goal
of the bail-in.18

        For what specifically concerns subordinated debtholders in banks, their
role was highly studied at the beginning of the millennium, during the
discussion preceding the Basel II agreement, as a tool to enhance bank’s
governance via market discipline mechanism.19 A certain consensus arose
around the fact that imposing market discipline via subordinated debt is
technically feasible, even though the market discipline mechanism was
disturbed by the implicit guarantee of the sovereign on domestic banks
solvency.

        Although those represent quite outdated evidence, they acquire a new
importance thinking that the new E.B.U. mainly aims to eliminate both the
implicit guarantee of domestic sovereignty and the “too big (or too complex,
international, important) to fail” policy. Therefore, considering that evidence
and the new European institutional framework, a considerable improvement in
market discipline mechanism via subordinated debt can be predicted, given the
greater incentives to fully internalize the costs (i.e.: risk) of subordinated
bonds,20 since subordinated bondholders are particularly prone to bear losses in
a resolution process.

        However, the bail-in tool goes far beyond the mere market discipline
mechanism, since it enhances and makes effective the loss absorbency capacity
of debt instruments21.

        On the other hand, the role of subordinated debt in the bail-in process
there are not straightforward answers, as well noted by Paul Davies:

          Whilst subordinated debt has survived a real-life performance which
          would have caused most teams to be relegated, its final role in bank
          capital is not yet absolutely clear. The FSB is the cheer-leader for
          subordinated debt in resolution […]. The Bank Recovery and

18
   Gleeson, supra note 9, at 267.
19
   See Andrea Sironi, Testing for Market discipline in the European Banking industry: evidence from
subordinated debt issues, 35 J. MONEY, CREDIT AND BANKING 443 (2003) ; see also Jürg M. Blum,
Subordinated debt, market discipline and banks’ risk taking, 26 J. BANKING & FIN. 1427 (2002).
20
   Zhou et al., supra note 12, at 20.
21
   See BASEL COMMITEE ON BANKING SUPERVISION, CONSULTATIVE DOCUMENT PROPOSAL TO ENSURE THE LOSS
ABSORBENCY OF REGULATORY CAPITAL AT THE POINT OF NON-VIABILITY (2010)
http://www.bis.org/publ/bcbs174.pdf.

                                               257
                                                                  University of Bologna Law Review
                                                                                      [Vol.2:2 2017]
                                                                     https://doi.org/10.6092/issn.2531-6133/7664




           Resolution    Directive    of   the    E.U.   requires    the     issuance         of
           subordinated debt to promote resolution but is circumspect on the
           actual proportion.22

The last remark about the importance of pricing internalization should be
devoted to the positive repercussions of reducing the spillover effect from
domestic banks to sovereign and vice versa. As incisively noticed by Paul
Tucker: “For banking risk, the genie is out of the bottle. If the risk is not priced
into bank bonds, it will be priced into government bonds. The people deserve
better”.23




     2.2 B.R.R.D. AND CREDITOR’S TREATMENT

The narrative and the policy goals that led to the B.R.R.D. and bail-in is
nowadays well known and a systemic introduction on the theme falls well
beyond the scope of this paper.24 Nevertheless, a brief introduction to the
principles on creditors’ treatment included in the B.R.R.D. is useful both to
concretize the theoretical statements made in § 2.1 and to introduce the
anecdotal evidence in § 3. Three main aspects are to be discussed: which are
the bail-in eligible creditors; what are their safeguards during the resolution
process and their role in capital regulation.

         The idea itself of the bail-in makes clear that the position of creditors
vis-à-vis the bank insiders and the resolution authorities represents one of the
key elements of the new framework.25

         To begin understanding the position of creditors under B.R.R.D., a good
starting point is the second part of the recital n. 67: the goal of creditors
involvement within the resolution process is to avoid moral hazard of – at
least big – creditors, giving incentives to engage in monitoring activities. This

22
   Davies, supra note 13, at 510.
23
    Paul Tucker, The resolution of financial institutions without taxpayer solvency support: Seven
retrospective clarifications and elaboration, CTR. FOR ECON. POL’Y RES. EUR. SUMMER SYMP. IN ECON.
THEORY, Jul. 3, 2014, at 1, 10.
24
   To have a good idea of what happened both from a policy and legal perspective see, FINANCIAL
STABILITY BOARD, KEY ATTRIBUTES OF EFFECTIVE RESOLUTION REGIMES FOR FINANCIAL INSTITUTIONS,. (2014);
Goodhart & Avgouleas, supra note 7; Thomas Conlon & John Cotter, Anatomy of a bail-in, 15 J. OF FIN.
STABILITY 257 (2014); Christos Hadjiemmanuil, Bank Stakeholders' Mandatory Contribution to
Resolution Financing: Principle and Ambiguities of Bail-In, 2015 EUR. CENT. BANK LEGAL CONF., 225.
25
   See Jens-Henrich Binder, The Position of Creditors Under the BRRD, BANK OF GREECE CTR. FOR CULTURE
(2016).

                                                 258
                                                               University of Bologna Law Review
                                                                                   [Vol.2:2 2017]
                                                                 https://doi.org/10.6092/issn.2531-6133/7664




rationale holds if and only if creditors are actually capable of monitoring
banking activities, i.e.: creditors with sufficient expertise.26

        Thus, in determining the classes of bail-in eligible liabilities, three
guidelines have to be considered: exclude debt holders that threaten the
systemic stability in case of write-down or conversion (the so-called runnable
liabilities); include debt holders that can successfully fulfill the monitoring
task; exempt particular classes of creditors that deserve to be protected for
other reasons.

        The B.R.R.D. normative strategy consists in granting a general and ex-
ante exemption from bail-in to specific groups of creditors (Article 44 (2)
B.R.R.D.) and allocate to the Resolution Authority the power to exempt on a
case-by-case assessment other liabilities that are theoretically bail-in eligible.
The purpose of this case-by-case assessment is to preserve the continuity of
critical activities of the resolving bank and avoid the risk of contagion (Article
44 (3) B.R.R.D.).

        In particular, a general ex-ante exemption has been granted to
depositors whose deposits are covered by the D.G.S. (deposit up to 100,000€);
secured liabilities (e.g.: covered bond); liabilities toward client for what
concern fiduciary custody of assets; short-term inter-bank operations;
wholesale short-term arrangements (e.g.: repos); liabilities toward workers
and retail creditors supplying good and services.

        Therefore, all the other liabilities fall within the scope of bail-in, i.e.:
the resolution authorities have the power to write off or convert them,
according to the safeguards of article 34 of the Directive:

        1) creditors bear losses after shareholders according to the order of
priority of their credits under classical insolvency procedure (Article 34 (1)(b));

        2) within each class, creditors are treated in an equitable manner
(Article 34 (1)(f));




26
   Cf On this instance GÖTZ, Martin R., et al. Should the marketing of subordinated debt be
restricted/different in one way or the other? What to do in the case of mis-selling? Goethe
University Frankfurt, Research Center SAFE-Sustainable Architecture for Finance in Europe, 2016.

                                             259
                                                                    University of Bologna Law Review
                                                                                        [Vol.2:2 2017]
                                                                       https://doi.org/10.6092/issn.2531-6133/7664




         3) creditors cannot bear higher losses than would have been incurred
under normal insolvency procedure (no creditor worse-off principle - Article
34 (1)(g)).

The application of the first two principles, apart from some ambiguities 27 and
difficulties in the coordination of likely divergent national legislations, appear
quite straightforward. On the other hand, the no-creditor-worse-off principle
(hereinafter N.C.W.O.) creates much more doubts and implementation issues.
Moreover, it is crucial to analyze this principle in order to understand what will
be the likely role of subordinated debt in the new institutional framework of
banks resolution.

         The N.C.W.O. principle asks the resolution authority to make a
counterfactual assessment, establishing (Article 74) the value of bailed-in
liabilities that would have resulted from the normal insolvency procedure. This
hypothetical value represents the minimum level of protection for creditors;28
but, as in all the cases, requires a difficult counterfactual assessment, thus
serious effectiveness concerns might arise.29

         These concerns, which are surely serious and well-grounded, can be
approached in a wholly different way, looking at the N.C.W.O. principle as a
substitute for the lack of ex-ante safeguards (vote, court hearing, public
consultation, etc.) for creditors.30 To better grasp the economic rationale of the
latter statement, the very first step is to transpose the N.C.W.O. protection into
the classic Law and Economic trade-off between “Property Rule” and
“Liability Rule”.31

         First of all, the underlying entitlement that N.C.W.O. principle wants to
grant shall be defined as follows: “In the B.R.R.D., bailed-in creditors are
entitled not to suffer higher losses compared to a liquidation scenario”;
therefore, the only relevant point to be answered is: how to enforce such an
entitlement? In this instance, the entitlement is not protected through an


27
   Hadjiemmanuil, supra note 24, at 225-248, 241-244.
28
   Binder, supra note 25, at 10.
29
   See George Jacobs & David Mitchell, The no-creditor-worse-off principle from a valuation perspective:
standing in the shoo of a hypothetical liquidator, 29 BUTTERWORTH’S J. INT’L BANKING AND FIN. L. (2014).
30
   Gleeson, supra note 9, at 265.
31
   See Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules and Inalienability: One
View of the Cathedral, 85 HARV. L REV. 1089 (1972).

                                                 260
                                                                University of Bologna Law Review
                                                                                    [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




absolute and ex-ante mechanism that prevents creditors to be worse-off,
which in Calabresi and Melamed taxonomy is called “property rule”.
Nevertheless, creditors are still protected through a different mechanism. In
fact, the N.C.W.O. principle acts as a blueprint that should guide the resolution
authority’s activities plus – and especially – as ex-post “liability rule” that
assure the compensation of creditors worse-off in the resolution process (as
provided by Article 75).

        Assuming a costless litigation procedure, the economic outcome
stemming from a property and liability rule will be equivalent for the creditors.
If the latter assumption is relaxed, the rationale behind such an institutional
design can be summarized as follows: bail-in represents a value-creating
process compared to the traditional insolvency procedure. In a nutshell, the
reduction in transaction costs overweight the positive cost of administrating
the Justice.

        Considering the time constraints under which a bail-in shall be applied
and the value of systemic stability, the approach of European regulator makes
a lot of sense from a social welfare standpoint.

        Finally, to properly grasp the role of debt – and thus creditors – in the
E.B.U. mechanism, a brief overview on financial structure regulation contained
in B.R.R.D. has to be presented.32 First of all, Article 45 B.R.R.D. provides that
institutions shall meet at all times a minimum requirement of bail-in eligible
liabilities (hereinafter M.R.E.L.).

        Article 45 § 4 lists the necessary characteristic to consider a liability as
eligible: be issued and entirely paid up; not deriving from infra-group
operation; have a remaining maturity of at least one year; not arising from a
derivative or a deposit covered by D.G.S.




32
   Anyhow, the core of the financial structure regulation is contained C.R.R./C.R.D. IV package
represents the European implementation of Basel III accords. ( For a survey of the main regulatory
features of C.R.R./C.R.D. IV), see Rainer Masera, CRR/CRD IV: the trees and the forest, SSRN,
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2418215; (On the possible overlaps and
inconsistencies between BRRD and CRR/CRD IV regulation) see Bart Joosen, Bail in Mechanisms in
the Bank Recovery and Resolution Directive, SSRN,
https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2511886.

                                              261
                                                                 University of Bologna Law Review
                                                                                     [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




In this instance, the approach of E.U. legislator appropriately departs from the
one-size-fits-all paradigm.33 Indeed, Article 45 (6) B.R.R.D. provides several
criteria to the resolution authorities to determine a specific M.R.E.L. for each
institution.34

        Another relevant piece of this complex puzzle is a document about Total
Loss Absorbency Capacity (hereinafter T.L.A.C.) for Systematically Important
Financial Institutions (hereinafter S.I.F.Is.), issued by Financial Stability Board
(2015). F.S.B. suggests setting a minimum fix requirement of bail-in eligible
liabilities between sixteen and twenty percent of risk-weighted assets
(hereinafter R.W.A. (Pillar 1) plus an adjunctive buffer to be determined on an
individual basis (Pillar 2).35

        Nonetheless, for what is here of interest, subordinated liabilities are
certainly part of eligible liabilities if the remaining maturity period is longer
than one year. At the same time, they can or cannot be part of the regulatory
capital (as Additional Tier 1 or Tier 2) depending on whether the tight Capital
Requirements Regulations (hereinafter C.R.R.) standards are fulfilled.

        The next section is going to apply this theoretical and normative
framework to an Italian case study of November 2015, when four medium-
small banks were resolved by the National Resolution Authority (i.e.: Bank of
Italy) and the role of subordinated debt was crucial.




33
   The one-size-fits-all approach is, instead, adopted by C.R.R./C.R.D. IV package in order to
establish a consistent internal market for banks. This approach has been widely criticized since it
artificially creates higher compliance costs for medium and small banks, favouring S.I.F.Is. which
can enjoy economies of scale.
34
   The European Banking Authority implemented a Draft Regulatory Technical Standards to
concretely implement such criteria, see EBA FINAL Draft Regulatory Technical Standards on
criteria for determining the minimum requirement for own funds and eligible liabilities under
Directive 2014/59/EU, EBA/RTS/2015/05, final (3 July 2015); see also EBA Interim report on MREL,
Report on implementation and design of the MREL framework, EBA-Op-2016-12, (19 July 2016).
The base to determine the bank specific requirement is the “own fund requirement” provided by
C.R.R. plus any additional requirement to hold own funds in excess. From this starting point, the
Resolution Authority can increase or even decrease the amount of M.R.E.L. considering the risk
profile, the business model and the funding model of each institution.
35
   The conformance period is not sure yet, but not before 2019. The application of T.L.A.C.
standards is consistent with M.R.E.L., even though in other instances, the minimum requirement
pursuing B.R.R.D. can substantially deviate from T.L.A.C. standards.


                                               262
                                                                    University of Bologna Law Review
                                                                                        [Vol.2:2 2017]
                                                                       https://doi.org/10.6092/issn.2531-6133/7664




         3. THE ITALIAN ANECDOTAL EVIDENCE

     3.1. THE NARRATIVE AND SOME CAVEATS

The 21st November 2015, the Bank of Italy resolved four Italian territorial
banks via “Sale of goods” tool to a bridge entity. The day after, the
bureaucratic process to establish the bridge banks was speeded up by the
government with the so-called “Bank Saving Decree” (D.L. n. 183/2015).

         The four resolved banks are Banca Marche, Banca Popolare dell’Etruria
e del Lazio, CariChieti and Cassa di Risparmio di Ferrara who together used to
hold 1% of national deposits36. Despite the size of these banks being rather
small, considering the structure of the Italian entrepreneurial system, their
viability of was crucial (see Agostino et al., 2011), since those are “territorial”
banks, coming from a history somehow related to cooperative credit.
Therefore, the stability and continuity of the credit lines toward S.M.Es. within
their geographical area assumed an importance far beyond the actual amount
of deposits or the size of their assets.

         The Bank of Italy, following the strategies arranged in the Resolution
Plans, created four bridge banks and transferred to them all the assets and
liabilities, except for equity and subordinated debt.37 A procedure for selling the
four bridge institutions has already started, and Bank of Italy is striving to
conclude it as soon as possible.

         On the other hand, for the sake of administrative efficient, only one
Asset Management Vehicle,38 which can be labeled as ‘Bad Bank’,39 has been
created, gathering all the equity and subordinated debt of the resolved banks



36
    See Lorenzo Stanghellini, The Implementation of the BRRD in Italy and its First Test: Policy
Implications, 2 J. FIN. REG. 157, 158 (2016); see also Donato Messineo, Il provvedimento «salva-
banche»: il trattamento di azionisti e creditori nella nuova disciplina delle crisi bancarie [The “Salva-
Banche” intervention: shareholders and creditors treatment in the new banking crisis framework],
36 QUADERNI COSTITUZIONALI 102 (2016).
37
   The Slovenian Supervisory Authority followed the same strategy in 2013. Recently E.C.J. ruled for
the legitimacy of bailing-in subordinated liabilities. See Case C-526/14, 19th July 2016.
38
   Directive 2014/59, of the European Parliament and of the Council of 15 May 2014 Establishing a
Framework for the Recovery and Resolution of Credit Institutions and Investment Firms and
Amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC,
2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU, and Regulations (EU) No
1093/2010 and (EU) No 648/2012, of the European Parliament and of the Council, 2014 O.J. (L173)
4, 5.
39
   Stanghellini, supra note 36, at 159.

                                                  263
                                                                     University of Bologna Law Review
                                                                                         [Vol.2:2 2017]
                                                                        https://doi.org/10.6092/issn.2531-6133/7664




on the liabilities side and some non-performing loan on the asset side.40 The
National Resolution Fund owes the capital of both good and bad banks.41 From
a balance sheet perspective, the situation of the former banks, the new bridge
banks, and the bad bank is summarized in Table 1.42




Table 1 – Balance-sheet situation for resolved Bank, 22nd November 2015.




40
   Given the systemic relevance of non performing loans in Italian Banking System, currently there
are proposals to make that “Bad Bank” the Italian systemic bad bank to cope with future possible
resolution interventions.
41
   The Asset Management Vehicle has been established by the National Resolution Fund, which
was – in turn – created few days before the resolution intervention, pursuant to Articles 45 and ff.
of the D.Lgs. n. 180/2015.
42
   BANK OF ITALY, Information about the crisis solution of Banca Marche, Banca Popolare dell’Etruria e
del Lazio, CariChieti and Cassa di Risparmio di Ferrara (Informazioni sulla soluzione delle crisi di Banca
Marche, Banca Popolare dell’Etruria e del Lazio, CariChieti e Cassa di Risparmio di Ferrara) (2015).

                                                  264
                                                                       University of Bologna Law Review
                                                                                           [Vol.2:2 2017]
                                                                          https://doi.org/10.6092/issn.2531-6133/7664




Therefore, Bank of Italy applied a de facto bail-in, even though the legal
instrument currently employed is different since the full-speed bail-in
regulation entered into force only on the 1st January 2016. Thus, the relevant
institutional framework is the 2013 Banking Communication on “burden
sharing”.43

         For some obscure reasons very little has been written on this argument
by Italian scholars so far.44 Hence, this paper also wants to try filling such a
gap. First of all, this resolution intervention dealt with the idiosyncratic crisis
of relatively small banking institutions, while – in the previous Section –the
importance of coping with a systemic crisis of S.I.F.Is. was stressed.

         The crisis came from serious mismanagements of all the four resolved
banks; indeed, all the four banks were already subjected to severe supervisory
intervention by the Bank of Italy. The only “systemic” aspect of the crisis is
the crucial role of non-performing loans, which represents one of the central
problems of Italian banking system. In fact, during the IV quarter of 2015, the
non-performing loans amount was approximately €350 billion, representing
almost the 20 % of total loans.45

         This contingency reflects and fosters many concerns around the actual
effectiveness of bail-in as an on-going concern: an excellent tool for mostly
idiosyncratic crisis, as substitute of liquidation; but presenting a high risk to be
useless or even harmful in case of resolution of big institutions in systemic
crisis.46

         Currently, there are no counterchecks, but it is reasonable to think that
the strategy of resolution authorities shall consist in “playing tough” with
small distressed institutions in the next couple of years to engender a credible
threat and furnish the right incentives to maintain banks viability. In a



43
    Commission Communication on the Application, from 1 August 2013 , of State Aid Rules to
Support Measures in Favour of Banks in the Context of the Financial Crisis ( ‘Banking
Communication’ ), 2013 O.J. (C 216) 1.
44
   See Antonella Antonucci, Fra Opacità E Regole Tossiche: Il Ruolo Degli Scenari Probabilistici. Scritto per
Il Convegno 'Salvataggio Bancario E Tutela Del Risparmio' [Between Opacity And Toxic Rules: The Role Of
Probabilistic scenarios. Written For The Conference'Banking Rescue And Saving Protection'], RIV .DIR.
BANC., Feb. 2016, at 1.; Stanghellini, supra note 36; Messineo, supra note 44.
45
   BANK OF ITALY, Statistical Bulletin – quarter 1. (2016).
46
   See Goodhart & Avgouleas, supra note 7, at 20; MCANDREWS, James, et al. What Makes Large Bank
Failures So Messy and What to Do about It?. Economic Policy Review, Forthcoming, 2014.

                                                    265
                                                                    University of Bologna Law Review
                                                                                        [Vol.2:2 2017]
                                                                       https://doi.org/10.6092/issn.2531-6133/7664




nutshell: the best bail-in for S.I.F.Is. is the bail-in that will never happen
because of the credible threat established by the regulatory framework itself.

         The resolution intervention has been costless for taxpayers so far since
the Resolution Fund provided the liquidity to guarantee the continuity of
critical activities, via an advance payment by Unicredit, Banca Intesa SanPaolo
e UbiBanca.47 Thus, the policy goal of avoiding taxpayers’ expenditures for
banks resolution seems to be – at least for the moment – achieved.

         As anticipated above, subordinated bonds played a crucial role: they
have been fully allocated to the bad bank as the offset for the non-performing
loans (see again Table 1). The Italian Resolution Authority (Resolution Unit of
Bank of Italy) publicly admitted that the operation intentionally took place in
the window between the B.R.R.D. transposition within the Italian legal system 48
and the 1st January 2016, when bail-in entered into force. So that, it was
possible to avoid both the standard atomistic liquidation and the use of the
“full bail-in tool”.49 The concerns about using bail-in arose from the fact that
under bail-in regime a substantial amount of non-subordinated debt should
have been written off. Thus, the political choice of the Resolution Authority,
along with Ministry of Economy and Finance, was to use subordinated debt as
a cushion to protect senior creditors.

         The transitory regime in part justifies and explains this approach:
people that invested in non-subordinated bond before the “burden-sharing”
document and the B.R.R.D. drafts were not able to fully internalize the risk of
the financial instruments they were buying because of the previous distorted
incentives on which they relied.50




47
   See BANK OF ITALY, Information about the crisis solution of Banca Marche, Banca Popolare
dell’Etruria e del Lazio, CariChieti and Cassa di Risparmio di Ferrara (Informazioni sulla soluzione
delle crisi di Banca Marche, Banca Popolare dell’Etruria e del Lazio, CariChieti e Cassa di
Risparmio di Ferrara) (2015).
48
   D.Lgs. n. 180/2015 and D.Lgs. n. 181/2015.
49
   See BARBAGALLO, Carmelo. Camera dei deputati – Indagine conoscitiva sul sistema bancario italiano.
Audizione di Carmelo Barbagallo. Capo del Dipartimento Vigilanza Bancaria e Finanziaria Banca d’Italia
[Italian Chamber of Deputies – Cognitive survey over Italian banking system. Hearing of Carmelo
Barbagallo. Chief of Banking and Financial Supervisory Department, Bank of Italy] (Dec. 9, 2015), p. 9.
50
   It is important to note that “Trust” is an informal institution that has a great importance in
social behaviors and, at the same time, is particularly troublesome and time-consuming to
generate in the society. See e.g., PINOTTI, Paolo. Trust and regulation: addressing a cultural bias. Bank
of Italy Temi di Discussione (Working Paper) No, 2009, 721.

                                                  266
                                                                   University of Bologna Law Review
                                                                                       [Vol.2:2 2017]
                                                                      https://doi.org/10.6092/issn.2531-6133/7664




Nonetheless, those arguments can be generalized, at least up to a certain
extent. In fact, there is a misalignment between bail-in eligible liabilities and
the loss absorbency capacity of each of them, as designed by C.R.R./C.R.D. IV
package. Thus, for resolution authorities writing down senior creditors claims
will never be an easy call51 and it is plausible that resolution policy will opt for
permanently using subordinated debt as a cushion even when the resolution
mechanism will work at full speed.

         Despite the protection of senior creditors, the resolution has been
greatly criticized. The widely perceived unfairness was mainly due to severe
mismanagement in the allocation of those financial instruments. For example,
resolved banks commonly asked their clients to subscribe subordinated bonds
to open or keep credit lines for SMEs,52 as an informal collateral, without
giving proper information about their risk profile, breaching de facto the
standards      established      by    Markets      in    Financial     Instruments              Directives
(hereinafter MiFID).53

         As current final episode of this narrative, the Italian government
provided for a reimbursement procedure for a portion of written-off debt
holders.54 The overall result of this refund operation consists of shifting a part
of the resolution burden from bank insiders to the banking system as a whole,
via the National Resolution Fund, realizing a sort of “private bail-out”
intervention. This aspect, together with the use of subordinated debt to protect
senior creditors, can give an idea of the future resolution policies.

         As was expected, the conclusion of the story after the completion of the
sale of the bridge institutions, will be that the new, viable, banks will not be
strictu sensu “territorial” anymore. In fact, three out of four banks have been
acquired by UBI Banca, while – at the time I am writing – there are still




51
   See Binder, supra note 25.
52
   On the risk of allocating debt to bank’s clients, even for the overall stability of the institution,
see Stanghellini, supra note 36, at 161.
53
   See for an extensive introduction about MiFID, JEAN-PIERRE CASEY & KAREL LANNOO, THE MIFID
REVOLUTION (2009). For what specifically concerns MiFID and subordinated debt, see Gotz et al.,
supra note 26.
54
   According to the procedure depicted in the D.L. n. 59/2016 – “Urgent measures for liquidating
banks investors”.

                                                 267
                                                                      University of Bologna Law Review
                                                                                          [Vol.2:2 2017]
                                                                          https://doi.org/10.6092/issn.2531-6133/7664




ongoing negotiation with BPER for the last good banks still managed by the
Bank of Italy.55

         It is important to notice how the acquirers of the good banks are going
to pay just a symbolic price for the acquisition. The main issues on which the
parties have been contracting about are the management of non performing
loans (hereinafter N.P.L.) and the level of additional Common Tier Equity 1
(hereainafter CET1) to be raised in order to be able to sustain those
acquisitions.

         This conclusion could cause some problems to the S.M.Es. network and
their funding costs; moreover, the lack of trust resulting from this story will
not be easy to fix. Nonetheless, even if counterfactual assessments are always
difficult to make and prove, the intuition is that the situation could have been
far worst without this resolution intervention since the atomistic liquidation of
the resolved banks would have threatened the continuity of the territorial
S.M.Es. themselves.




     3.2 THE MARKET FOR SUBORDINATED DEBT IN THE ITALIAN BANKING SYSTEM

To link the narrative of the resolution intervention of § 3.1 and the empirical
analysis of § 4 is crucial to understand the scope and the functioning of the
Italian market for banks subordinated bonds. Some figures about the market
itself can give a quite accurate idea of what we are dealing with.

         The 31st October 2015, the issued subordinated bond amounted to €67,2
billion of which €8.5 billion, i.e.: about 13% of the entire amount of issued
bonds, were held by the issuing banks themselves. Thus, there were €58,7
billion of bonds floating in the market, of which over the 50% allocated to
individual investors and households (thirty-one billion).56

         Again, some figures might facilitate the understanding of what €67
billion mean in the Italian banking system: the total assets of the seventh

55
   Insofar, there are no ufficial documents nor discosure of contractual terms, but only an official
press release from the Bank of Italy, (2015)
https://www.bancaditalia.it/media/comunicati/documenti/2017-01/cs_good_bank.pdf.
56
    See BANK OF ITALY, Informazione sui detentori di obbligazioni subordinate [Information about
subordinated bond holder]. Unfortunately there are no data available on the share who are also client of the
issuing bank.

                                                   268
                                                                         University of Bologna Law Review
                                                                                             [Vol.2:2 2017]
                                                                            https://doi.org/10.6092/issn.2531-6133/7664




Italian banking group (Banco Popolare dell’Emilia Romagna) amount to €61
billion and the total regulatory capital of the first Italian banking group
(Unicredit) amounts to €55 billion.

          Moreover, investing in banks’ subordinated bonds seems to be very
popular when looking at household investment preferences. In fact, in 2015 the
volume of Italian household financial investments is €3,848 billion of which
727 are bank deposits, and only 60 billion are listed stocks,57 while 30 are in
banks subordinated debt (i.e.: almost 1% of total investments).

          A possible explanation of those figures could be that Italian households
are highly risk-adverse and under the previous regime, where the State
indirectly subsidized banks bonds through the implicit guarantee of bail-outs,
this type of investment attracted them since the risk profile was close to zero
and the interest rate was about 1.5 % higher than that of senior bonds.58

          After the new regulatory stream, some variations were predictable;
nevertheless, the events of November 2015 triggered what seems to be an
enormous revolution. Indeed, those resolution interventions made clear to
everybody, and in particular to small and medium banks under the direct
supervision of Bank of Italy, that the new European rules – despite all the
effectiveness and efficiency concerns – would have been to be actually applied.

          First of all, it is necessary to distinguish between the biggest banks in
the system and all the others. In fact, for Intesa San Paolo and Unicredit, which
are the only two Italian S.I.F.Is., the market for subordinated bonds is going to
disappear because of the lack of supply. Intesa has not issued retail
subordinated bond in the last four years, while Unicredit launched a huge
buyback campaign for floating subordinated debt from the beginning of 2016.59

          Those are the only two Italian commercial banks that can afford to shut
down that market, thanks to multiple funding sources and greater stability. For

57
   Accord, Banca d’Italia, Gli investimenti delle famiglie italiane: solo l’1,5% è destinato alle azioni quotate
[Investments of Italians families: just 1,5% addressed to the Stock Exchange], IL SOLE 24 ORE, March 27,
2015, at 3.
58
   A partial empiric confirmation of this substitability effect can be found in Regression Table 1
(Appendix), where “Bond Spead” depict a sort of beauty contest between Subordinted Debt issued
by banks and 10y Italian Governamental Bond.
59
   Unicredit offered to buy back up to 1.8 billion of subordinated bonds. According to the last
information available the share of adhesion was over 60%. Compare
http://www.ft.com/cms/s/0/f5d8fb6a-c04b-11e5-9fdb-87b8d15baec2.html.

                                                     269
                                                                  University of Bologna Law Review
                                                                                      [Vol.2:2 2017]
                                                                     https://doi.org/10.6092/issn.2531-6133/7664




all the other banks the stream of financial reforms affects the demand side and
the pricing mechanism.




Table 2 – Banks Subordinated Debt Market in Italy. Bank of Italy, 2015b

On one hand, the demand side of the market for subordinated debt, even if it is
an ongoing process and no specific data are now available, a simple and
straightforward prediction can be stated: the increased risk profile will cause a
shift from households and non-professional investors to professional and
institutional investors.

         On the other hand, a more accurate description – even though not
systematic – of the price for subordinated bonds is feasible since that type of
data is more steadily available. Before 22nd November 2015 the average gross
yield of a basket composed by eighty-nine subordinated bond was 4.68%. At
the beginning of January 2016, the average gross yield of the same bundle of
bonds skyrocketed to 6.18%. Moreover, sixteen out of eighty-nine bonds
yielded more than 10%, of which seven even more than 20%.60 The most
expensive bonds were issued by banks perceived as particularly vulnerable by
the market (e.g.: Monte Dei Paschi di Siena and Banca Popolare di Vicenza),
which is consistent with the lack of implicit State guarantee.

         Those data appear quite astonishing, but they are – at least in part – to
the shock provoked by the resolution intervention of the last November. Thus,
to precisely evaluate the actual spread between the yields before and after the


60
  Data from SkipperInformatica. With Nicola Borzi, Bond subordinati nella bufera: i rendimenti si
impennano [Bond subordinated in the storm/blizzard: the profits nose up], IL SOLE 24 ORE, January 20,
2016Il Sole 24 Ore, (Jan. 20, 2016).

                                                270
                                                                   University of Bologna Law Review
                                                                                       [Vol.2:2 2017]
                                                                      https://doi.org/10.6092/issn.2531-6133/7664




bail-in regulation, more time is going to be necessary, even though the
tendency is clear and indicates a remarkable increase in subordinated bond
prices in the long run either.




         4. EMPIRICAL ASSESSMENT OF THE DETERMINANTS OF SUBORDINATED DEBT

In the previous Section, the resolution intervention and its first spillover
effects were discussed both from the banks, investors and regulatory
standpoint; the next step consists in empirically investigating whether the
decision of issuing subordinated bonds has some structural determinants.
Therefore, the question that this paragraph aims to answer is whether there
are reliable determinants that lead a bank to issue subordinated bonds.

         This is quite an uncommon step for a legal paper,61 nonetheless what
follows is going to make clear, at least I hope, how an empirical investigation
of legal issues can be useful to – in this very case – evaluate the possibility of
implementing more tailored resolution interventions on subordinated bonds in
the future.

         As far as I am aware, there are no specific studies dedicated to the
determinants of subordinated bonds in the banking industry, neither for
general corporate subordinated bonds. Nonetheless, the corporate finance
literature62 about determinants of capital and debt structure for non-financial
firms is impressively extensive and represents the unavoidable starting point
of this analysis.63 In fact, that literature stems from the departure of Modigliani
and Miller irrelevance proposition, as analyzed under Section § 2.1.


61
   Even though “Empirical legal studies” is for sure an expanding and successful field of research.
For a sound introduction on this research methodology see ROBERTO M. LAWLESS, JENNIFER K.
ROBBENNOLT & THOMAS ULEN, EMPIRICAL METHODS IN LAW (2010).
62
   That stream of literature dealing with funding and capital structure decisions of both financial
and non-financial corporations. For a survey and introduction, even though not updated, see e.g.,
Raghuram G. Rajan & Luigi Zingales, What do we know about capital structure? Some evidence from
international data, 50 THE J. FIN. 1421 (1995).
63
   In addition, the empirical corporate finance literature generated over time a certain degree of
consensus about some standard variables related to the capital structure of non-financial firms.
See e.g., Sheridan Titman & Roberto Wessels, The Determinants of Capital Structure Choice. 43 THE J.
FIN. 1 (1988).; Milton Harris &Artur Raviv, The Theory of Capital Structure, 46 THE J. FIN. 297 (1991);
Id.; and Murray Z. Frank Vidhan K. Goyal, Capital structure decisions: which factors are reliably
important?, 38 FIN. MGMT. 1 (2009).

                                                 271
                                                               University of Bologna Law Review
                                                                                   [Vol.2:2 2017]
                                                                  https://doi.org/10.6092/issn.2531-6133/7664




This represents quite an uncommon approach, since the standard one for
banking capital structure is based on capital requirement regulations as the
only significant departure from Modigliani and Miller proposition,64 paying no
attention to capital and debt structure of financial firms. Anyhow, stemming
from corporate finance literature, there are recent studies focused on banks’
capital structure that deviate from the classical approach. Heider and Gropp 65
focused on bank’s leverage, showing a high grade of similarity between their
empirical evidence and other studies carried out on non-financial firms. Thus,
they concluded that capital requirements are not a first order determinant for a
bank’s capital structure. For what more closely concerns debt structure,
Santos66 showed a cost advantage for larger banks in raising debt which is only
partially due to the “too big to fail” policy.

         Speaking specifically about subordinated debt, the most useful and
enlightening study has been carried out by Zanghini,67 both for the contents
and methodology. He analysed the bank bonds spread, focusing on the role of
implicit and explicit public guarantees through the analysis of “Asset swap
spread” of different bonds. Moreover, Pop 68 empirically proved the intuitive
idea according to which subordinated creditors are more sensitive than seniors
to the risk profile of the issuing institution.

         Applying all this theoretical and empirical insights to the present case
study, the rest of § 4 tries to establish reliable determinants for Italian
subordinated debt issuances in the banking industry.



     4.1 SAMPLE AND VARIABLES

The analyzed sample consists of twenty-five Italian parent banks that have
available balance sheet data on subordinated debt in BankScope Bureau Van


64
   See FREDERIC MISHKIN & ADDISON WESLEY, THE ECONOMICS OF MONEY, BANKING AND FINANCIAL MARKETS
(6th ed., 2000).
65
   GROPP, Reint; HEIDER, Florian. The determinants of bank capital structure. ECB Working Paper
Series n. 1096/2009.
66
   SANTOS, João AC. Evidence from the Bond Market on Banks ''Too-Big-To-Fail'' Subsidy. Economic
Policy Review, Forthcoming, 2014.
67
   ZAGHINI, Andrea. Bank bonds: size, systemic relevance and the sovereign. Working Paper n- 966.
Bank of Italy.
68
   POP, Adrian. Market discipline in international banking regulation: keeping the playing field
level. Journal of Financial Stability, 2006, 2.3: 286-310.

                                              272
                                                     University of Bologna Law Review
                                                                         [Vol.2:2 2017]
                                                       https://doi.org/10.6092/issn.2531-6133/7664




Dijk DataBase. In building the panel database, the considered time series goes
from 2006 to 2015.

        Starting from balance sheet data of those banks, the analysis focuses on
the listed subordinated bonds issued both in Eurobond and Italian Market,
according to the information available in Pillar 3 documents about issued
bonds of each bank of the sample. The specific financial data for each of those
bonds has been analyzed through Thomson Reuters DataBase.

        The final database is made up of 102 bonds issued by thirteen banks.
The small number of analyzed banks is due to the fact that most of the small
Italian banks issued only retail and non-listed subordinated bonds whose data
are not available. Nevertheless, the sample turns out to be quite representative
for big and medium Italian banks. Furthermore, some of the results, after a
case by case analysis based on economic theory and common sense, can be
generalized even for small banks.

        Because of the different dates of issue of the analyzed bond, the sample
results are unbalanced throughout the time series. Moreover, data on
secondary market yields of the bonds were not or only partially available along
the time series (427 yield observation out of 626 total ones).

(See Table in the next page)




                                       273
                                                                University of Bologna Law Review
                                                                                    [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




Table 3 – Summary Statistics

Finally, the data on duration are biased by the fact that some of the
subordinated bonds are perpetual, thus in the summary statistics of Table 3 are
shown only the bonds with a defined time duration.69

        From a methodological point of view, in analyzing the data, the linear
regression70 method is employed. That basically means to check whether the
(increasing or decreasing) trend of the dependent variable is somehow
correlated with the trend of one or some independent variables, thus
establishing correlation linkages. In § 4.3 those correlation linkages are to be
discussed in order to draw some policy conclusions. In discussing them a
cornerstone is the level of statistical significance of those linkages, meaning
the level of certainty that the actual level of correlation is different from zero.
As a rule of thumb, a 95% confidence is considered a good threshold to draw
reliable inferences.



69
  For a deeper description of the variables used in the study see the Appendix.
70
  All the regressions are run with the Random Effect estimation method, to catch both the cross-
sectional and time variances. Random Effect has been preferred over Fixed Effect after running the
Hausmann-test. Robust Error estimation has been used as well to avoid heteroskedasticity
problems.

                                              274
                                                             University of Bologna Law Review
                                                                                 [Vol.2:2 2017]
                                                               https://doi.org/10.6092/issn.2531-6133/7664




     4.2 HOW TO UNDERSTAND DECISIONS ON SUBORDINATED DEBT ISSUANCE?

Using the data set defined above, this study aims to understand what are the
drivers of decisions about subordinated debt both from the bank and the
investor point of view. In order to do that, the data described in the previous
sub-paragraph are used to approximate different aspects concerning the
decision of both the issuer and the investor.

         For the sake of simplicity, what follows is a mere qualitative description
of this process, which explains the variable approximating those decisions
(dependent variable) and the variables analyzed to explain such decisions
(independent variables). Then, in the footnotes and in the Appendix, the
economic and econometric underlying rationale of the models used in the
analysis are discussed in more detailed. Throughout the study, the bank’s
decision of issuing subordinated debt has been disentangled and analyzed
under two related but still different perspectives: the decision concerning the
overall financial structure of the firm and the decision specifically concerning
the structure of regulatory capital.

         Firstly, to understand the determinants of these decisions, the data
analyzed are related to financial data of the bank (e.g.: balance sheet structure;
N.P.L. patio etc.); financial data of the specific bond (e.g.: yield) and some
approximation of the bank-specific role of the regulator.71 Secondly, the
variation on subordinated debt issuances over the last decade is taken into
consideration. This is important to understand if economic or legal shocks (i.e.:
financial crisis and reform implementation) played a decisive role in the
subordinated debt market. Practically, the same variables are to be explained;
but now only the evolution over time is computed in order to explain the
variations. Finally, the issue at stake is further disentangled taking into
account the investors’ decisions, which are approximated through the yield on
the secondary market and the spread between those yields and the yield of
ten-year Italian governmental bonds. This proxy makes sense since the
average duration of the analyzed bonds is over nine years, thus investing in
banks subordinated debt can be considered a close substitute of investing in


71
  For more detailed on the variables used see Appendix, Variable List Table, where a detailed
description of the variables is provided.

                                            275
                                                     University of Bologna Law Review
                                                                         [Vol.2:2 2017]
                                                       https://doi.org/10.6092/issn.2531-6133/7664




Italian Treasury bond, and so it represents the perfect benchmark for the
present study.




   4.3 ARE THERE RELIABLE DETERMINANTS?

Regression Tables 1, 2 and 3 in the Appendix summarize the empirical findings
of the models depicted in the previous paragraph.

       The first interesting insight concerns the sharply different outcome in
the decisions about financial and regulatory capital structure, indicating that
each bank has to face two distinct orders of decisions, following separate
aspects.

       For what concerns financial structure decisions the ‘Capital ratio’ and
‘Tier1 ratio’ parameters sign and magnitude are consistent with common
sense: the higher the capital ratio, the higher the subordinated debt ratio; the
higher the Tier1 ratio, the lower the subordinated debt structure.

       The highly statistical significance of the negative parameter of the
dummy “E.C.B. supervision” shows that the less systemic a bank is, the higher
the share of subordinated debt. In fact, the S.S.M. entered into force only in
2015. Thus, that variable only indicates the relevance of the requirements to be
subjected to direct E.C.B. supervision, which are – indeed – about the systemic
importance of the banking institution within European and domestic banking
system.

       The significant negative parameter of N.P.L. ratio is of particular
importance since it is becoming the major issue for the problematic Italian
(and even European) banking system. The relatively high-risk profile of the
subordinated bonds can explain this evidence: for a bank with a high N.P.L.
ratio funding itself by subordinated debt represents a too expensive option.

       On the other hand, in deciding the structure of regulatory capital, the
banks are remarkably influenced by the spread between the yield of
subordinated bonds and the ten-year Italian governmental bond: the higher
the spread, the larger the share of subordinated capital. This can be explained




                                          276
                                                                 University of Bologna Law Review
                                                                                     [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




by the particular attractiveness of investing in bank’s subordinated bonds, for
the reasons discussed in § 3.2.

        Another       important       result,    confirming        the      E.C.B.        supervision
requirement as a proxy for systemic relevance, is the negative highly statistical
significance of the size indicating that for smaller banks the subordinated debt
funding option is more convenient compared to bigger banks.

        What is constant throughout all the regressions in Regression Table 1 -
Appendix      is   the   remarkably       high     (99.9%      level),    though           conflicting,
significance of two different profitability ratios, namely the “Return on
Average Assets – R.O.A.A.” and the “Return on Average Equity – R.O.A.E.”. In
particular, a higher R.O.A.A. is positively correlated with a higher ratio of
subordinated debt, while R.O.A.E. is negatively correlated with subordinated
debt ratio. Hence, the profitability of the bank is an important argument for
issuing subordinated debt: only the above-average performing banks can
afford to release a high level of subordinated debt, but still if a bank is highly
capitalized (which leads to a high ROAE) the level of subordinated debt
decrease. Thus, between equity and subordinated debt, a certain degree of
substitutability seems to exist, on top of the regulatory capital threshold.

        Finally, another variable which is constantly highly statistically
significant and with positive parameter throughout the regressions (always at
99.9% level) is the ratio between loans and assets. Hence, issuing subordinated
bonds is a common way to fund, at least in part, marginal loans over the
average level of the sample. That represents a crucial contingency since the
credit crunch has been considered one of the primary determinates of the
Italian (and more generally European) economic stagnation after the global
financial crisis; consequently, this finding turns out to be particularly dense of
policy implications.72

        Some of those findings are of particular interests, and their policy
implication will be analyzed later on in this chapter. However, to make this




72
  The equations which comprehend all the variable categories prove to fits particularly well to the
data, explaining the 50% and 75% of variations, respectively for financial structure and regulatory
capital structure decisions.

                                                277
                                                       University of Bologna Law Review
                                                                           [Vol.2:2 2017]
                                                          https://doi.org/10.6092/issn.2531-6133/7664




analysis as accurate as possible, some further insights can be added thanks to
the second and third models introduced in the previous paragraph.

            The fact that the high-level subordinated debt issuers have both higher
loan-to-asset-ratio and lower N.P.L.-ratio is striking. In fact, for an
institution with lower borrowing opportunities is expected to exert a more
careful evaluation of the marginal loans, therefore resulting in a lower N.P.L.-
ration. A possible explanation is that subordinated debt holders actually
monitor better what is going on in the bank, resulting in better choices about
marginal borrowers. This is somehow in line with the study carried out by
Sironi in 2003;73 nevertheless, it is in contrast with the actual identity of debt
holder underlined in § 3, mostly non-professional retail investors. A plausible
alternative explanation is that the correlation between N.P.L. and level of
subordinated debt entails a better risk taking by the management of the bank
which is determined by unobservables (i.e.: variables that are not included in
the statistical analysis). This latter explanation, even though it falls out of the
model hereby proposed, seems to be more plausible.

            For what concerns the variations over time (Regression Table 2 in
Appendix), the regressions show pretty different pictures for the decisions
about financial and regulatory capital structure. The latter has an irregular and
not always significant path in the first years of the time series, while the
coefficient of 2013 and 2014 are highly statistically significant, positive and big
in magnitude. Those years were crucial for the implementation of new
European Banking framework, with the entrance into force of C.R.D. IV/C.R.R.,
the proposals of the new Banking Union and the document about Burden
Sharing in banking crisis. This evidence confirms the arguments of Chapter § 3
about the role of subordinated debt as a cushion to protect senior creditors.

            On the other hand, in the decision about financial structure, the most
notable outcome of the time dummy model is the highly statistically
significant increase in subordinated debt share during the hardest years of the
global financial crisis (2008-2010).




73
     Sironi, supra note 19.

                                          278
                                                      University of Bologna Law Review
                                                                          [Vol.2:2 2017]
                                                        https://doi.org/10.6092/issn.2531-6133/7664




Finally, the regressions shown in Table 7 give a perspective on the investor’s
point of view when deciding whether to invest in banks subordinated bonds or
in something else.

       Consistently with common sense and basic economic theory, the higher
the class of regulatory capital (i.e.: the greater the loss absorbency capacity of
the financial instrument), the higher the yield of the bond. What is less
intuitive is that the bond rating variable has the expected negative coefficient
though is not statistically significant. The same can be said for the N.P.L. ratio,
meaning that investors relied on other types of information or, simpler, on the
implicit guarantee of the domestic sovereign. Thus, those regressions perfectly
depict the past but have a (hopefully) small capacity to predict what is going to
happen in the future, since the old paradigm generates some biases in the
regressions.

       Nevertheless, there are two elements that are likely to hold even in the
future: firstly, the profitability and size of the banks will remain an argument
in investor’s decisions. Secondly, there is a highly significant but slight cost
advantage for bigger issues, which are usually adopted by larger banks,
consistently with the findings by Santos (2014). On the other hand, there is a
highly significant and substantial negative correlation between yield and bank
profitability (measured through R.O.A.A.) which still have a straightforward
explanation.

       Another intuitive finding, useful to confirm the consistency of the
model, is shown in the time series, where the yield of subordinated bonds
increased significantly in 2008, when the global financial crisis broke out and,
only for the bond spread, in 2011 when the public debt crisis began.




   4.4 POLICY CONSEQUENCES

The findings of the present empirical analysis lead to one main policy
conclusion, namely: agreeing with I.M.F. in supporting subordinated debt as a




                                       279
                                                                  University of Bologna Law Review
                                                                                      [Vol.2:2 2017]
                                                                     https://doi.org/10.6092/issn.2531-6133/7664




powerful tool to increase the soundness and resolvability of banking
institutions.74

         In fact, summarizing the evidence shown by the models, the banks that
are more likely to issue a high share of subordinated debt (i.e.: finding it a
convenient funding decision) are the medium-small banks, which are not
systemically relevant and whose level of performance is above average. Given
those arguments, creating an institutional framework which is “subordinated-
debt-friendly” seems to foster efficiency. Moreover, it is also consistent with
the goal of generating a level playing field among European banks as well,
reducing the cost-advantage in complying with more requesting regulatory
framework joined by bigger banks.75

         On the other hand, there is no evidence that the act of issuing
subordinated bonds itself leads to moral hazard or adverse selection. In fact,
issuing subordinated debt can lead to an inefficient outcome if: the supervisory
activity is suboptimal, the implicit guarantee of the sovereign on bank solvency
still exists, and the enforcement of the subordination clause through resolution
tools is uncertain. Assuming an optimal suspensory activity,76 the implicit
guarantee that characterized the last decades should not exist anymore in the
new institutional framework;77 what remains a problem is the level of certainty
in enforcement mechanism. This issue will be specifically tackled in Chapter §
5.

         Beyond the arguments already discussed, previous empirical findings
allow to add two other important aspects supporting the use of subordinated
bonds in banks financing. First of all, issuing subordinated debt signals the
market that the bank has the appropriate level of soundness to go to the
market and sell those bonds at a reasonable price. Second of all, and more
important, the higher the level of issued subordinated bonds the higher the
level of loans granted. Such a contingency should be highly relevant for the


74
   Davies, supra note 13, at 512.
75
   As proved by SANTOS, supra note 66.
76
   That is quite an unrealistic assumption, even though the S.S.M. reform improved the quality of
supervision toward Eurozone Banks. See FERRARINI, Guido A. Single Supervision and the Governance
of Banking Markets. ECGI-Law Working Paper, 2015, 294.
77
   Still, this assumption is not completely true since B.R.R.D. leaves a certain room for bail-outs
intervention: Council Directive 2014/59, art 100, 2014 O.J. (L 173). Nonetheless, for the sake of this
analysis this represents a workable assumption.

                                                280
                                                                University of Bologna Law Review
                                                                                    [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




European policy makers since there is a broad consensus in considering the
credit crunch as one of the crucial determinants of the prolonged economic
stagnation of Eurozone.78

        Chapter 3 showed that current institutions (both formal and informal
institutions and their enforcement mechanisms) might lead to a lack of
incentives to issue subordinated bonds. Then, this Chapter strengthens the
arguments in favor of desirability for a dynamic market for subordinated
bonds. Hence, the last step of this paper will be devoted to proposing an
institutional framework with an enhanced degree of certainty in the
enforcement (i.e.: resolution) phase.




        5. CONVERTIBLE SUBORDINATED BOND: A SOLUTION THROUGH CONTRACTS?

Given the uncertainty and unpredictability underlined in the previous sections,
the question arising is whether the current institutional framework furnishes
efficient incentives to all the relevant agents to foster the resilience of the
bank. Borrowing from Douglas North:79 is the institutional matrix providing a
pay-off matrix which leads the actors to act efficiently?

        To answer this question, the outcome of the empirical study carried out
in Section § 4 has to be combined with some other insights about bail-in in
general. First of all, under Article 37 § 10 sub. a, any sort of bail-out operations
become lawful if and only if at least the of 8% of the bank’s liabilities were
written down. Some scholars80 predicted the tendency to prefer a “private bail-
out solution” right after the 8% threshold has been reached. “Private bail-out”
solutions indicate all the available mechanisms providing external funds to the
distressed bank without a direct State intervention or a market operation.81




78
   Juan R. Cuarado-Roura, Ron Martin & Andrés Rodrìguez-Pose, The economic crisis in Europe: urban
and regional consequences, 9 CAMBRIDGE J. REGIONS, ECON. AND SOC’Y 3 (2016).
79
    Duglas C. North, Institutions and the performance of economies over time, in HANDBOOK OF NEW
INSTITUTIONAL ECONOMICS 21-30 (2008).
80
   Goodhart & Avgouleas, supra note 7, at 20; MCANDREWS, supra note 46.
81
   Council Directive 2014/59, supra note 77, art. 100 and ff.

                                               281
                                                                 University of Bologna Law Review
                                                                                     [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




In the second place, the fact that during the 2007-08 crisis the losses of the
distressed banks were in average, around 8%.82 Thus the expected outcome in a
2007 crisis scenario with the new regulatory framework can be depicted as
follows: the new regulation determines the need to bail-in the 8% of
distressed banks liabilities; therefore, subordinated debt will act, in practice, as
a cushion to protect senior creditors.

        Piecing all these aspects together, subordinated bondholders suffer a
high uncertainty about their investment, and they cannot correctly ex-ante
assess this risk. In fact, the investors do not only face the risk of bank
insolvency, but also the risk to be bailed-in by the resolution authority,
according to the non-strictly quantitative trigger events of Article 32. Thus, the
predictable outcome is to overestimate the risk, asking for an abnormally high
yield and subsequently reducing the scope of subordinated bond market, as the
Italian case depicted in Section § 3 suggests.

        To make the investment in subordinated bonds feasible for both banks
and investors, this Section proposes a contractual solution setting a trigger
event to convert or write-down the creditors’ claim, tailored upon the model
offered by “Contingent Convertible” bonds. In fact, subordinated bonds seem
to be pretty attractive for both investors and several banks; moreover, they
turn to be important even from the resolution authority’s standpoint,83 to
protect senior creditor from bail-in and, hence, safeguarding some degree of
trust within the banking system.

        While the issue of certainty in subordinated bond investments is still
without an answer, two recent proposals for amending B.R.R.D. could somehow
change the role of subordinated debt as a cushion of senior creditors. In fact,
the European Commission issued two proposals of Directive amending the
B.R.R.D. in order to implement T.L.A.C. requirements.84 What is of interests for

82
   Conlon & Cotter, supra note 24; See also Paolo Santella et al., Il Nuovo Regime Europeo Di
Risoluzione Delle Crisi Bancarie: Un’Analisi Comparata Dell’Applicazione Del Bail-In [A Comparative
Analysis of the Bail-In Regime in Europe], 9 BANCARIA 46-62 (2015).
83
   Davies, supra note 13, at 512.
84
   Commission Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL
Amending Directive 2014/59/EU on Loss-Absorbing and Recapitalisation Capacity of Credit
Institutions and Investment Firms and Amending Directive 98/26/EC, Directive 2002/47/EC,
Directive 2012/30/EU, Directive 2011/35/EU, Directive 2005/56/EC, Directive 2004/25/EC and
Directive 2007/36/EC, COM (2016) 852 final (Nov. 23, 2016); and Commission Proposal for a
DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on Amending Directive

                                               282
                                                               University of Bologna Law Review
                                                                                   [Vol.2:2 2017]
                                                                  https://doi.org/10.6092/issn.2531-6133/7664




the present paper is the proposal to establish an intermediate class of bail-
inable liabilities which lies in between subordinated and senior debt, as of
hierarchy of creditors’ claim. The “new class” of creditors could be written
down only during a formal resolution intervention and not with a plain on-
going write-down. The purpose of the proposal is helping banking institutions
to match the T.L.A.C. requirement at a reasonable price, protecting senior
creditor creditors even further.

        On the one hand, those proposed amendments are consistent with –
and even confirm –the main idea carried out in this paper, i.e.: de jure condito,
subordinated liabilities act as a cushion for protecting senior creditors. On the
other hand, as noticed above, the main problem that has been identified in the
paper (i.e.: uncertainty) is not solved, but just shifted and pooled between two
different classes. Thus, the prospective implementation of those proposals will
not falsify the arguments of this study, which should just be accordingly re-
shaped.

        For those reasons, the analysis that follows is carried out de jure
condito, i.e.: without taking into consideration the possible changes if the
latter proposal will be implemented

        The following sub-section provides an introduction to the idea of
contractual bail-in in the literature and the current institutional framework;
eventually, that same framework will be compared with the conditions under
which a contractual arrangement is a value-creating institution in the classic
law and economics sense.85



   5.1 CONTRACTUAL CLAUSE FOR WRITING DOWN AND CONVERSION: A PROBLEM SOLVING TOOL

Literature about contractual clauses to convert debt into equity, and thus
enhance capital stability and bank resilience, is extensive and precede the
global financial crisis,86 even if the concrete applications are few and



2014/59/EU of the European Parliament and of the Council as Regards the Ranking of Unsecured
Debt Instruments in Insolvency Hierarchy, COM (2016) 853 final (Nov. 23, 2016).
85
   See ROBERT COOTER & THOMAS ULEN, LAW AND ECONOMICS 283 (6th ed., 2011).
86
    See Mark J. Flannery, No Pain, No Gain? Effecting Market Discipline via ‘‘Reverse Convertible
Debentures’’, in CAPITAL ADEQUACY BEYOND BASEL: BANKING, SECURITIES, AND INSURANCE 171 (2005).

                                              283
                                                                      University of Bologna Law Review
                                                                                          [Vol.2:2 2017]
                                                                          https://doi.org/10.6092/issn.2531-6133/7664




ambiguous in their results.87 This mechanism is usually labeled as “Contingent
Capital Instruments” or “CoCo Bonds”. A major distinction is drawn between
high-trigger and low-trigger instruments, where the event that triggers the
conversion for the former is to reach the minimum capital requirement, while
for the latter the trigger point is set to a higher level of capital ratio.

         Coffee88 approaches contingent capital as a tool to avoid the necessity to
bail-out banks and, at the same time, to preserve the financial stability of the
banking system, which – in his view – would be threatened by a pure bail-in
scenario. Thus, the mandatory contingent capital regime is seen as a substitute
and not as a complement of the bail-in mechanism.

         Even though this approach is far from the position of the present paper,
some aspects underlined by Coffee are of utmost interest. High-trigger
contingent capital instruments allow banks to create adequate “potential”
capital buffers, increase the level of certainty of investments and have a tax
advantage over the “raise more equity” option.

         In contrast with the latter approach, Tucker incisively noticed: “Today,
Cocos with decently high triggers are likely to be prohibitively expensive . . . .
Eventually, I can conceive that Cocos with highish triggers might be issued as a
means for the market to maintain control of its own destiny in the shadow of
resolution”.89

         This scenario acquired a new and broader meaning with the entrance
into force of the post-crisis resolution frameworks. The issuance of Cocos must
happen “in the shadow of resolution”, which means that the contingent capital
instruments are – by definition – a complement and not a substitute of bail-in
mechanism, so the Coffee’s model is entirely overturned, at least in the
Eurozone.

         The B.R.R.D. provides two foremost normative references to the role of
contractual clauses in the bail-in process. Article 55 deals with the typical case
where the bonds are issued under a non-E.U. applicable law (e.g.: bonds issued

87
   See Carolin E. Schmidt, Ted F. Azarmi, The Impact Of CoCo Bonds On Bank Value And Perceived
Default Risk: Insights And Evidence From Their Pioneering Use In Europe, 31 J. APPLIED BUS. RES. 2297
(2015).
88
   COFFEE, John. Bail-ins versus bail-outs: using contingent capital to mitigate systemic risk. Columbia Law
and Economics Working Paper, 2010, 380.
89
   Tucker, supra note 23, at 8.

                                                   284
                                                            University of Bologna Law Review
                                                                                [Vol.2:2 2017]
                                                               https://doi.org/10.6092/issn.2531-6133/7664




under the New York State law are quite common), asking for a contractual
recognition of the power of conversion and write-down. This aspect is crucial
to make bail-in effective since one of the biggest problems in previous
resolution attempts were exactly the cross-border issues.90

         Even more interesting for this paper is Article 45 (13) and (14) about
M.R.E.L.91: this can be reached issuing debt instruments with contractual clause
for conversion and write-down, following two conditions:

         -The Resolution Authority is free to write down or convert the
contractual instrument in case of resolution;

         -The contractual clause is applied to a subordinated debt instrument.

So, the B.R.R.D. only keeps the possibility of contractual bail-in open, on the
contrary of the Swiss Regulator which impose a mandatory 3% R.W.A. of high-
trigger Cocos92.

         Davies93 noticed how such a clause would reverse the hierarchy in
bearing losses, meaning that subordinated creditors bear losses before
shareholders. This contingency seems to contrast with all the three principals
of creditor treatment stated by Article 34 B.R.R.D., confirming again that it
provides only disposable rights which generate ex post legal remedies (i.e.:
liability and not property rules).




     5.2 INCENTIVE STRUCTURE OF RELEVANT ACTORS

Given all the background information of § 5.1, the last question has still to be
answered: “Is the institutional framework depicted in the previous paragraph
giving adequate incentives to all the relevant actors?”. In order to properly
answer, the relevant variables discussed in this section are four: the incentives
of the management, the role of resolution authority, the desirability of ex-ante



90
   Gleeson, supra note 9, at 274.
91
   See European Banking Authority, Interim report on MREL, EBA-Op-2016-12, at 76 (Jul. 19,
2016).
92
   Stefan Avdjiev, Anastasia V. Kartasheva & Bilyana Bogdanova, CoCos: a primer, BANK INT’L
SETTLEMENT QUARTERLY REV., Sept. 2013, at 43. See AVDJIEV, Stefan; KARTASHEVA, Anastasia V.;
BOGDANOVA, Bilyana. CoCos: a primer. Available at SSRN 2326334, 2013.
93
   Davies, supra note 13, at 511.

                                            285
                                                      University of Bologna Law Review
                                                                          [Vol.2:2 2017]
                                                        https://doi.org/10.6092/issn.2531-6133/7664




rights (i.e.: governance power) to bondholders; the trigger event and
conversion formula.

          1) Management: the fundamental aspect to be analyzed is whether the
issuance of subordinated debt with contractual bail-in clause incentivizes the
incumbent management to assume opportunistic behaviors or excessive risk
taking.

For what concerns opportunistic behavior, the underlying assumption is that –
in a non-strategic environment – the decision to issue subordinated debt is a
function of the resolution authority conduct. Even though this assumption
does not fully hold in the real world, for this analysis it represents a workable
proxy.

          Article 28 B.R.R.D. provides the possibility to remove the incumbent
management “where there is a significant deterioration in the financial
situation”, while Article 34 § 1 (c) set as a general principle of each resolution
intervention the dismissal of the incumbent board. In case of contractual
conversion/write-down, the application of Article 34 is highly unlikely, so that
the contractual write-down instruments act as a costly insurance paid by the
bank to avoid a proper resolution intervention, hence their dismissal. To avoid
such a risk, the threat set by Article 28 has to be credible, since the contractual
conversion/write-down, even if it is not a proper resolution intervention, is
still a “resolution-sensitive” occurrence.

          For what concerns excessive risk taking, the arguments stated above
can be replicated. Moreover, as the empirical evidenced in § 4 showed, the
issuance of subordinated bonds is correlated both with higher loan-to-asset-
ratio and lower N.L.P.-ratio. In a hypothetical scenario where the certainty
about the subordinated bonds is enhanced, there is no reason to suspect that
those evidence would be reversed.

          In a nutshell, the formal institutional framework theoretically allows
giving suitable incentive to the management if and only if the enforcement
mechanism works efficiently.

          2) Resolution Authority: the role of the Resolution Authority is perhaps
the most important one. From this perspective the formal institutions seem to


                                        286
                                                                University of Bologna Law Review
                                                                                    [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




be severely lacking, since the only direct provision on contractual clauses is
Article 45 (13) and (14), where is stated the abstract possibility to issue those
instruments to reach the M.R.E.L.. The bank and the investor enter into a
contract and, at the same time, a third party (the Resolution Authority) might
affect a great deal the situation that the contract aims to discipline. In this
situation, there is no or very little room for a cooperative solution (i.e.:
conclude the deal) since the payoff matrix is highly unpredictable.

        A possible settlement for this problem is to make the Resolution
Authority enter somehow into the agreement. The easiest and cheapest way to
do so would be to submit the issuance contract to the resolution authority and
ask for its formal inclusion in the resolution plan,94 stating that the terms of
the contract are consistent with a sound resolution planning and, thus, will be
respected by the Authority in case of future interventions. This solution would
also help to ex-ante mitigate the risk of strategic issuance of the management
since the Resolution Authority shall control the consistency of the issuance
with the safe and soundness of the banking institution in an on-going concern.

        3) Investors: as noted above, because of the contractual bail-in clause,
the investors give up some of the rights provided by the Article 34 of the
Directive. Thus, granting some ex-ante “property” protection could seem
reasonable.95 A pragmatic approach suggests avoiding the creation of well-
design but too complicated and ineffective mechanisms to let subordinated
creditors protect ex-ante their entitlement. In fact, the effectiveness of the
shareholder’s empowerment rights is ambiguous, and the possibility to
enhance the corporate governance in the case of subordinated bondholders is
limited. Therefore, the transaction costs generated by introducing those rights
are particularly likely to outweigh some, uncertain and unpredictable,
benefits.96


94
   For what concerns the crucial role of resolution planning, which was not possible to properly
describe throughout this paper, see Binder, 2015.
95
   For example including in the contract some powers modeled on the rights granted to
shareholders to empower their position vis-à-vis the board. On shareholder’s empowerment, see
Van Der Elst, 2014:30-33 and Denes et al., 2016.
96
   Those arguments hold for what specifically concerns the case for contingent convertible holder.
A completely different scenario can be depicted in general for the need of corporate governance
rights to bail-inalble creditors after B.R.R.D. On those issue see extensively Mülbert, P. O., &
Citlau, R. D. (2011). The uncertain role of banks’ corporate governance in systemic risk
regulation. ECGI–Law Working Paper, (179) Chiu, I. H. (2014). Corporate governance: the missing

                                              287
                                                                University of Bologna Law Review
                                                                                    [Vol.2:2 2017]
                                                                   https://doi.org/10.6092/issn.2531-6133/7664




Even though giving specific substantive rights turn out to be ineffective and
too expensive, this does not mean that there is absolutely no room for some
recognition of the “contractual bail-in bondholder” status, at least from a
procedural perspective. In fact, this type of investors should be recognized as
an independent class, expressively allowing them to act collectively. This
represents a value-creating device since it gives more contractual power to the
investors, which will be incentivized to enter into the contract because of
decreasing transaction costs, at least in two contingencies:

        i) before and regardless any resolution intervention, in case of
renegotiation of the contract (savings in bargaining costs);

        ii) after a resolution in suing the bank to obtain a compensation
(savings in enforcement costs).

From this point of view, the European institutional framework seems to be
completely lacking. In fact, a uniform procedural rule for civil justice are far to
be reached within the European Union nor specific rules concerning these
issues are provided by the Directive. Thus, the concrete configuration of the
investors’ rights and claims is devolved to national laws, undermining the
“level playing field” among E.U. countries, which is one of the primary goals of
the B.R.R.D..97

        4) Trigger Event and Conversion Formula: represents the most
awkward clause of the contract for convertible subordinated bonds. Indeed,
most of the Contingent Capital literature focuses on this instance developing
elaborated theoretical models.98 In this paper is not possible to add any
contribution to such a complex and technical dispute. Anyhow. what is of
interest here is whether the current institutional framework allows and
incentivize to adopt the efficient solution.

        The answer seems to be positive since neither the Directive nor the
Guideline on the trigger event 99 or conversion rate100 forbids to agree on a


paradigm in the mandatory bail-in regime for creditors of banks and financial
institutions. Journal of Business Law, (8).
97
   See Council Directive 2014/59, recital 57, 108, 2014 O.J. (173).
98
   For a survey, see Glasserman, P., and Nouri, B. (2012). Contingent capital with a capital-ratio
trigger. Management Science, 58(10), 1816-1833.
99
    European Banking Authority, Final Report, Draft Regulatory Technical Standards on the
contractual recognition of write-down and conversion powers under Article 55(3) of Directive

                                              288
                                                         University of Bologna Law Review
                                                                             [Vol.2:2 2017]
                                                            https://doi.org/10.6092/issn.2531-6133/7664




tailored solution, with the external limit of respecting the bail-in principle
stated in Article 34, leaving to the market any further consideration.
Nonetheless, to incentivize the investors to enter into those contracts and to
give the market appropriate signals, the conversion formula should favor the
creditors and burden shareholders.101 The potential (plausible) negative
externalities of some specific kind of trigger event shall be addressed by the
regulator in its “intervention”, as proposed above, under n. 3.

       The signaling effect is of particular importance both for creditors and
the market in general. In fact, a conversion of debt into equity means a dilution
in shareholders’ cash flows, and likely in management’s ones as well. Thus, a
bank willing to issue those bonds with a decently high trigger and with a
creditor-favorable conversion formula signal to the market and the perspective
bondholders its soundness.




       6. CONCLUSION

Throughout this study has been demonstrated – theoretically and empirically
– that, following F.S.B. position, the existence of an active and functioning
market for subordinated bonds enhance the soundness and the resolvability of
banking institutions, especially of the medium-small ones. In fact, the cost
advantage in raising funds of systemically important banks is reduced, and
thus level playing field within European banking market is enhanced.

       The new regulatory framework for capital requirements and resolution
of distressed institutions lead to tremendous changes in the market for
subordinated bonds, both in their demand, supply and pricing mechanism. As a
consequence, both banks and investors have to internalize all the costs and
risks linked with subordinated bond; which is – at least theoretically –
particularly desirable to incentivize more efficient decisions on funding
decision, to avoid moral hazard and strategic behavior by both banks and


2014/59/EU, EBA/RTS/2015/06, (Jul. 3, 2015).
100
     European Banking Authority, Consultation Paper, Draft Guidelines Concerning the
Interrrelationship Between the BRRD sequence of writedown and conversion and CRR/CRD IV,
EBA/CP/2014/29, (Oct. 1, 2014).
101
    COFFEE, supra note 88, at 35.

                                          289
                                                      University of Bologna Law Review
                                                                          [Vol.2:2 2017]
                                                        https://doi.org/10.6092/issn.2531-6133/7664




investors and, consequently, to enhance market discipline capacity of the
secondary market.

       Nevertheless, due to the concrete bank’s financial structure and bail-in
regulation, the subordinated debt in resolution, and especially if the Authority
resorts to the bail-in tool, assumes the peculiar role of a cushion that allows
protecting senior creditors from conversions or dilution in their claims. This
leads to a high level of uncertainty in the enforcement of the subordination
clause, which endangers the functioning of a market for subordinated bond.

       On the other hand, the empirical analysis carried out sub § 4 clearly
showed the desirability of a well-functioning market for subordinated bonds,
especially for its positive correlation with the lower level of N.P.Ls. and the
higher level of loans over assets, i.e.: weakening the credit crunch.

       In a nutshell, the current institutional framework appears not to be able
to give the appropriate incentives to both investors and banks to issue the right
amount of subordinated bonds. Therefore, this paper concludes that a plain
mandatory conversion and write down of subordinated debt does not achieve
an efficient outcome because of the spillover effects that these rules have on
subordinated debt market on a dynamic perspective. To fix those spillover
effects and maintain all the positive innovation led by bail-in regulation, this
paper proposes the adoption of a “contractual bail-in” regime, tailored on the
contingent capital model.

       Finally, the paper shows the condition under which the “contractual
bail-in” solution turns out to be appealing to banks and investors and, at the
same time, desirable from the regulator’s standpoint, i.e.: the contractual
solution enhance the soundness and resolvability of the regulated institutions.
Even though all the actors are involved in the analysis, the role of the
supervisory and resolution authorities in abstaining to infringe and protecting
the property rights allocated by the contract is the first, necessary, condition to
reach an efficient outcome and to balance as well as possible all the interests
involved.




                                       290
                                                       University of Bologna Law Review
                                                                           [Vol.2:2 2017]
                                                           https://doi.org/10.6092/issn.2531-6133/7664




        7. APPENDIX

Variables list

        Rating        From Thomson Reuters. It measures the rating (if
                      available) for each bond. We relied on three different
                      rating agency: Moody's, Fitch and S&P, according to the
                      availability of complete data for the time series. The
                      ratings   are   encoded     to   make        them         comparable,
                      according to the conversion table published in BIS. See
                      http://www.bis.org/bcbs/qis/qisrating.htm. The higher
                      the code assigned, the higher the rating.

        Coupon          From    Thompson        Reuters.     This       variable         can       be
                        continue or vary over time depending whether the
                        bond provides for fixed, variable or floating coupon.

     Bond Spread        Own calculation. Underlying variables from Thomson
                        Reuters. The spread between the secondary market
                        yield of each bond and the secondary market yield of
                        10-year Italian governmental bond. The 10-yaer bond
                        is taken as a benchmark since the duration mean of
                        the subordinated bonds is over nine years, so the 10-
                        year bond represents a significant benchmark.

        Volume          From Thomson Reuters. The amount in mil € of the
                        issue calculated in the issue date and invariant over
                        time.

   Class of Capital     From Thomson Reuters and Pillar 3 documents.
                        Categorical variables which describe the class of
                        regulatory capital to which the bond belongs. The
                        available possibilities are Additional Tier 1; Tier 2; Low
                        Tier 2 for Basel II agreements, now under the
                        Grandfathering clause during the transitory period;
                        not belonging to regulatory capital.




                                      291
                                                      University of Bologna Law Review
                                                                          [Vol.2:2 2017]
                                                        https://doi.org/10.6092/issn.2531-6133/7664




E.C.B. supervision   From     SSM    website.    Dummy           variable         describing
                     whether the bank is under the direct supervision of
                     the E.C.B. (in this case the value 1 is assigned). It
                     measures whether the threshold provided by SSM
                     regulation are significant but still say nothing about
                     the impact of E.C.B. supervision since it started only
                     two years ago.

  Capital Ratio      From BankScope. The ratio between total regulatory
                     capital and total liabilities.

   Tier 1 ratio      From BankScope. Ratio Between Tier 1 Capital and
                     total liabilities

  n° companies       From BankScope. Number of financial and non-
                     financial company controlled by the parent bank. It is
                     used as a proxy of the complexity of the banking
                     group.

Return on Average    From BankScope. Measure the profitability of the
     Assets          bank. It is defined as the ratio between income and the
                     average amount of assets.

Return on Average    From BankScope. Measure the profitability of the
     Equity          bank. It is defined as the ratio between income and the
                     average amount of common shares.

Total assets (log)   From BankScope. Total asset accounted on the balance
                     sheet.

   N.P.L. ratio      Own      calculation.      Underlying            variables            from
                     BankScope. The ratio between substandard loans and
                     total net loans. In building the variables we used
                     "substandard loans" for the sake of pragmatism, since
                     it was the only component of N.P.L. for which data
                     where available throughout all the sample. Anyhow,
                     substandard loans and the other component of N.P.L.
                     are highly correlated; thus this variable is completely



                                    292
                                                         University of Bologna Law Review
                                                                             [Vol.2:2 2017]
                                                           https://doi.org/10.6092/issn.2531-6133/7664




                       reliable.

Loans over assets      From BankScope. Describe the relative amount of
                       loans granted by each bank.

  Sub. debt over       From BankScope. Describe the ratio between the
regulatory capital     amount       of    issued   subordinated           debt       and       total
                       regulatory capital. We use this variable as dependent
                       to investigate the determinants of decision about
                       capital      structure      for    what        concerns             issuing
                       subordinated debt.

Sub. debt over total   Own         calculation.     underlying           variables            from
     liabilities       BankScope. Describe the ratio between the amount of
                       issued subordinated debt and total liabilities on
                       balance sheet We use this variale as dependent to
                       investigate the determiants of decision about financial
                       structure for what concerns issuing subordinated debt.




                                         293
                                                  University of Bologna Law Review
                                                                      [Vol.2:2 2017]
                                                     https://doi.org/10.6092/issn.2531-6133/7664




Regression Table 1




Regression table on financial structure and regulatory capital structure
decision and subordinated debt. Regressions are run with the random effect
estimation method and robust error to avoid heteroskedasticity; t-statistic in
parenthesis. *, ** and *** denote statistical significance at the 5%, 1% and
0,1% levels, respectively

       The same independent variables are used to explain two different
dependent variables which aim to describe the two distinct aspects above-

                                     294
                                                                University of Bologna Law Review
                                                                                    [Vol.2:2 2017]
                                                                  https://doi.org/10.6092/issn.2531-6133/7664




mentioned,      respectively:     ‘subordinated       debt    over    total       liabilities’         and
‘subordinated debt over regulatory capital’ according to the models in
equations (1) and (2):



(1) SubDebt/TotLiabilities = a0 + a1 Σ VBanki,t + a2 Σ VBondi,t + a3 Σ VRegulation i,t+ εi,t ;




(2) SubDebt/RegCapital = a0 + a1 Σ VBanki,t + a2 Σ VBondi,t + a3 Σ VRegulation i,t+ εi,t ;



where VBank are the variables characterizing the issuing bank (number of
companies belonging to the group; Return on Average Assets; Return on
Average Equity; Total Assets; Non-Performing Loans ratio; Loans over assets
ratio); VBond are the variables characterizing the individual bond issued
(Coupon; Volume; Rating; Bond Spread), and VRegulation are variables related to
regulatory constraints on banking activity (dummy for class of capital; direct
E.C.B. supervision; regulatory capital ratio; Tier 1 capital ratio).

        The regressions are run both separately for each category of variable
and, eventually, with all the variables together.




                                              295
                                                    University of Bologna Law Review
                                                                        [Vol.2:2 2017]
                                                      https://doi.org/10.6092/issn.2531-6133/7664




Regression Table 2




Regression table on financial structure and regulatory capital structure
decision over time. Regressions are run with the fixed effect estimation
method and robust error to avoid heteroskedasticity; t-statistic in parenthesis.
*, ** and *** denote statistical significance at the 5%, 1% and 0,1% levels,
respectively.



                                     296
                                                          University of Bologna Law Review
                                                                              [Vol.2:2 2017]
                                                              https://doi.org/10.6092/issn.2531-6133/7664




This issue is addressed as shown in equations (3) and (4), utilizes a time
dummy variable to observe whether there has been some significant variation
as a result of the introduction of new regulations or economic shocks.




       (3) SubDebt/TotLiabilities = a0 + a1 Σ Dtime+ εi,t ;

       (4) SubDebt/RegCapital = a0 + a1 Σ Dtime+ εi,t ;




                                         297
                           University of Bologna Law Review
                                               [Vol.2:2 2017]
                             https://doi.org/10.6092/issn.2531-6133/7664




Regression Table 3




                     298
                                                                University of Bologna Law Review
                                                                                    [Vol.2:2 2017]
                                                                  https://doi.org/10.6092/issn.2531-6133/7664




Regression table on investors’ decisions on buying banks subordinated bonds.
Regressions are run with the fixed effect estimation method and robust error
to avoid heteroskedasticity; t-statistic in parenthesis. *, ** and *** denote
statistical significance at the 5%, 1% and 0,1% levels, respectively.

        The investors decision are analyzed through equations (5) and (6):

(5) Yield= a0 + a1 Σ VBanki,t + a2 Σ VBondi,t + a3 Ratingi,t+ a4 Σ Dtime + εi,t ;

(6) BondSpread= a0 + a1 Σ VBanki,t + a2 Σ VBondi,t + a3 Σ VRegulation i,t+ a4 Σ Dtime+ εi,t ;

where, where VBank are the variables characterizing the issuing bank (Return on
Average Assets; Return on Average Equity; Total Assets); VBond are the variables
characterizing the individual bond issued (Volume; Rating) and D time is a
dummy variable for the time series.




                                              299
