New rules governing UK banks and investment firms in financial difficulty come into force

The EU's Recovery and Resolution Directive must be implemented by each member state to take effect before 1 January 2016, although member states can choose to apply the new rules sooner. The UK's Prudential Regulation Authority (PRA), which regulates most banks, and Financial Conduct Authority (FCA), which regulates certain investment firms, have chosen to apply the majority of the new rules from 19 January 2015.

The PRA said that the new regime would ensure "preparedness" in the event that a struggling firm had to be rescued, referred to as 'recovery' under the new regime; or wound up, which is referred to as 'resolution'.

Confirmation of the PRA's and the FCA's regulatory approaches follows publication by the UK Treasury of two statutory instruments giving effect to the new rules in the UK at the start of this year. The Bank Recovery and Resolution Order made the necessary legal changes to the Bank of England's existing 'special resolution regime' to bring it into line with the directive. In addition, a Banks and Building Societies (Depositor Preference and Priorities) Order reclassifies any part of a bank deposit that goes beyond that guaranteed by the Financial Services Compensation Scheme (FSCS) as a secondary preferential debt in the event of a firm's insolvency.

The new rules will apply to banks, building societies and large investment firms whose failure could have consequences for the wider economy, as well as to their holding companies. The new rules will require firms to produce 'recovery plans', identifying options available to strengthen their financial position in times of difficulty; and 'resolution packs' containing information for regulators to use when stepping in to wind up a firm. The rules form part of the EU's response to the 2008 financial crisis, during which national governments were forced to intervene and provide public funds to recapitalise some struggling lenders, as well as updating the UK's existing resolution regime.

Under the new regime, regulators in every EU member state will have access to the same tools and powers to be used in the event that a firm gets into difficulties. These include the ability to sell all or part of the failing bank to another bank; the ability to create a 'bridge bank' so that a bank's good assets and essential functions can be separated from the rest in order to be sold on; and a 'bail in' tool allowing debt held by shareholders and bondholders to be called in to recapitalise the bank.

Both EU law and the Basel III regulatory reform programme will require large banks to issue debt that could be 'bailed in' if necessary equivalent to 8% of their assets once the new legal regime is fully in force. If this is triggered, shareholders' rights will be wiped out or diluted and creditors will have their claims reduced or converted to shares. Any shareholders or creditors affected should not be left worse off than if the firm had been placed into insolvency.

So that regulators would be able to bail-in creditors in the event of the failure of a cross-border firm, a contractual clause recognising bail-in powers will be inserted into liabilities governed by the law of another member state. The PRA intends to apply contractual recognition to debt instruments from 19 February 2015; and to all other relevant liabilities from 1 January 2016, according to the final rules.