In this blog, Dr. Maryam Malakotipour highlights the economic impact of EU insolvency and banking law reforms introduced since the 2008 Financial Crisis.
The financial context of legal reforms
In response to the 2008 global Financial Crisis, the European
Commission proposed more than 50 legislative and non-legislative
measures aimed at strengthening and
further integrating the EU financial sector and improving risk
sharing across the EU member states. The "Capital Markets
Union" (CMU) Action Plan and the
"Banking Union" are the two major policy initiatives that
the EU has undertaken in this respect.
The CMU Action Plan was launched in 2015, aiming to create a single market for capital across Europe. This initiative seeks to diversify funding sources available to corporates beyond bank finance (i.e. bond market and equity financing) to strengthen the resilience of borrowers to shocks in the banking sector. In line with the CMU initiative, several legislative and non-legislative measures have been introduced.
Initiated in mid-2012, the Banking Union project is a cornerstone of the European Union's efforts to strengthen its economic and monetary union by ensuring the robustness of banks and instilling greater confidence in the European financial system among businesses, investors, and citizens.
The introduction of the CMU Action Plan and Banking Union initiatives have led to reforms in insolvency law and banking regulations, with significant economic consequences. While the legal reforms are intended to facilitate growth and enhance financial stability, they could affect the position of banks and other lenders (particularly bondholders) in a way that has led to unintended consequences both for corporates' access to debt financing and financial stability.
The position of secured creditors under the Preventive Restructuring Directive
A key legislative component of the CMU Action Plan is the 2019 Preventive Restructuring Directive (Restructuring Directive). This is designed to level the playing field for credit access and recovery rates across the EU. The Restructuring Directive primarily aims to provide viable businesses and entrepreneurs facing financial difficulties with access to effective national restructuring frameworks to sustain operations. It introduces a debtor in possession (DIP) restructuring procedure, which allows debtors to retain asset control and manage daily business activities during restructuring. This procedure is supplemented with several tools to aid restructuring, including a stay on enforcement actions by creditors, the right of the DIP to use or sell assets and attract interim financing, clawback protections for DIP financing, and provisions for cross-class cram-down.
The existence of some of these restructuring tools may result in restrictions on rights that secured creditors enjoy outside restructuring proceedings. Against this background, one of the more controversial issues in the context of restructuring procedures revolves around maintaining a balance between, on the one hand, upholding the key features of security interests and on the other hand, facilitating restructuring procedures.
Undermining or even diluting core features of security rights in a restructuring can result in secured creditors' bias against such proceedings. At the same time, extending excessive legal protections to secured creditors can have microeconomic and financial stability implications. Tipping the scales in favour of secured creditors in a restructuring would hamper bond market development, continue dependence on bank financing, and worsen the resilience of borrowers to banking shocks.
Effects of the Capital Requirements Regulation on lending and restructuring
A critical aspect of the Banking Union initiative is the Capital Requirements Regulation. This was introduced in 2013 and aims to enhance the ability of banks to absorb losses resulting from counterparty default.
Under the Capital Requirements Regulation, banks are required to maintain a minimum level of regulatory capital . This is calculated based on the risk-weighted asset (the RWA) system. The requirement is designed to ensure that banks have sufficient loss-absorbing capacity to act as a buffer against potential financial shocks. The Capital Requirements Regulation also adopts a pre-emptive stance towards anticipated future losses. It mandates that banks must reclassify certain loans as non-performing loans (the NPLs) and adhere to stringent measures, including the implementation of the "prudential backstop measure," to safeguard their solvency.
There is a complex interplay between regulatory frameworks and corporate finance. The capital requirement rules under the RWA system can have significant implications for corporates' access to bank financing, as well as broader economic consequences. Another instance of this interaction relates to the effects of NPL regulations on the behaviour and incentives of banks acting as creditors in restructuring proceedings. Regulations related to NPLs potentially could alter the dynamics between debtor corporations and their creditor banks, thereby influencing the strategies adopted during restructuring proceedings.
Final thought
While the CMU and the Banking Union initiatives pursue different
primary goals, in reality, legal reforms under one of these two
initiatives can influence the other. There also can be tension
between them, where advancing one policy goal may be to the
detriment of the other.
Further legislative deliberations with a view to dovetailing the
Preventive Restructuring Directive and the Capital Requirements
Regulation would be welcomed to align the objectives of creating a
vibrant funding climate and increasing financial stability, with
the desired practical outcomes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.