Recent events show that the desire to put in place a global recovery and resolution regime to prevent the kind of government intervention that was required during the financial crisis is very much a work in progress. For banks it requires a tremendous amount of work and unprecedented transparency about their operations. For national regulators, it means forging agreements that bring together disparate insolvency regimes.

The need for the Belgian, French and Dutch governments to rescue troubled Benelux bank Dexia from imminent collapse in October 2011 showed that policy-makers and regulators had failed to achieve one the major aims to emerge from the financial crisis: that the bankruptcy of a financial institution can be resolved without the need of government support.

While policy-makers and regulators across much of the globe are determined to prevent a recurrence of the 2008 financial crisis – and the scale of intervention that was required to prevent the collapse of the financial system – putting in place mechanisms able to resolve complex cross-border bankruptcies has been easier said than done.

Following long debate and consultation, the first steps towards change are under way. Banks have been told to produce ‘recovery and resolution plans’ by the end of 2012, a deadline that may seem reassuringly distant but that is, in fact, frighteningly close.

Recovery positions

The difference between recovery and resolution is simple, at least in theory. A bank is deemed to be in a state of recovery when it is struggling to survive but it has not yet collapsed completely. It can recover, provided certain steps are taken. At this stage, existing management would still be in place but regulators would expect them to be taking specific actions to deal with the loss of capital or liquidity.

These actions can take a number of forms. A bank could reduce the size of its balance sheet by withdrawing from capital-intensive business; it could turn to emergency back-up lines with other banks or even central banks, if feasible; it could sell businesses, if feasible; it could conserve capital by stopping the payment of shareholder dividends and employee bonuses and it could issue new capital, most probably by triggering the conversion of contingent capital from debt to equity.

Banks are being asked to calculate now how they might deal with a recovery situation, drawing up a menu of options and addressing each option in turn. But fundamental questions remain.

“There are several challenges facing regulators and banks. First and foremost, at what point is a bank deemed to be in recovery? Who decides? What will the trigger be? Banks may well be in denial but if regulators become involved too quickly, they may precipitate the very outcome they were trying to avoid,” says John Liver, head of global regulatory reform, Europe, the Middle East, India and Africa, at Ernst & Young.

Broken resolutions

The outcome everyone is seeking to avoid is the point of resolution, when a bank is no longer independently viable and the regulators take over. 

At this point, it becomes a public policy issue around who should bear the losses and who should be protected. In 2008, everyone apart from shareholders was bailed out; now the feeling is that a wider range of creditors should share the losses, including bondholders.

In terms of protection, no one disputes that individual deposit-holders should be paid out but there are further questions around small and medium-sized enterprises, for example, as well as mortgage customers and savers. And payment systems need addressing too. If a large clearing bank collapses, systems should be in place to ensure smaller players do not lose out.

On the wholesale side, the situation is even more complicated. If a bank has lots of outstanding derivatives positions, for example, the challenge is to find a way to wind them down in an orderly fashion without triggering a loss of confidence. This means knowing what a bank’s outstanding positions are and in what jurisdiction they are booked: no small task when trades are multi-faceted and go across borders and legal entities.

Resolution planning is at an early stage but banks have been asked to amass certain key pieces of information, such as the range of products they sell, where they sell them and to whom; what their exposures are and where they are located; which IT systems they use; where these sit within the organisation and the link between a bank’s headquarters and its international offshoots.

Information drive

The purpose behind such questions is speedy resolution. Specifically, regulators are concerned about how to avoid the ‘Lehman’s weekend’ when the bank failed on a Friday and turmoil ensued from the following Monday. Should such a weekend ever recur, policy-makers are determined to be better equipped, and recovery and resolution planning is supposed to allow better decision-making to be made in very little time.

But the provision of information is not a passive exercise. If a bank provides information that shows its current structure would prevent policy-makers from achieving swift resolution, they will request a change of structure now.

Banks need to make sure the information they give recognises the wider agenda. In other words, the authorities do not just want a mass of information, they want to know what impediments may exist that would prevent a bank being rescued in a short space of time. This is what a living will is all about.

In many respects, this is entirely understandable. Governments now know the taxpayer is the banking industry’s ultimate sugar daddy, there to bail the sector out if need be. But, just as banks are unwilling to lend capital without knowing the borrower’s creditworthiness, so governments are reluctant to extend even the possibility of credit without knowing as much as possible about their potential debtors.

Inconsistent application?

Nonetheless, many banks are concerned about the implications of the recovery and resolution debate. They are worried about regulators interfering prematurely in their businesses, so hastening the move from recovery to resolution. And they are particularly worried about regulators moving at different speeds and with different priorities in the UK, Europe and the US.

“In the UK, the Independent Commission on Banking [ICB] has recommended that large banks ring-fence their retail banking operations but they have until 2019 to do it. Michel Barnier, the EU commissioner for internal markets, has said he is interested in what the ICB is doing but we believe there is almost no chance of Europe following the UK’s lead. And in the US, the political will seems to be blowing against the separation of investment and retail banks. In fact, Republicans are openly talking about repealing Dodd Frank, which was supposed to be the big financial reform act in the US,” says one banker.

Do you believe that international  regulatory coordination is becoming stronger?

Some bankers are concerned that different attitudes towards recovery and resolution are already affecting business activity on a regional basis. “European regulators seem much more intrusive and European banks are in contraction mode. US banks are not,” says one.

Barney Reynolds, partner at Shearman Sterling, admits this is an unsettling time for banks. While there is no supranational authority in charge of regulation, he does not necessarily agree with banks' concerns that some jurisdictions will be harder to do business in than others.

“Of course, there could be differences between the US and Europe and little glitches are opening up but there is broad agreement about recovery and resolution at a high conceptual level. The key issue is local application but overall, I believe harmonisation is less of an issue than many people think,” he says.

Ernst & Young’s Mr Liver, however, believes that this could be a real problem. "Insolvency regimes and developing resolution regimes, while working to achieve the same objectives, do diverge by country. This presents major challenges to both the authorities and the banks as they consider the impacts on individual parts of the group and their creditors, as it falls into resolution."

Questions remain

The conundrum is far from straightforward. Regulators claim to be keen to work with one another, share information and promote global co-operation. But, their primary role is to protect the local taxpayer. This dichotomy becomes clear when the rescue involves a bankrupt entity with overseas branches or subsidiaries. And divergent insolvency regimes only highlight the tensions.

With this in mind, regulators are keen to ensure that banks operating in their jurisdiction are adequately capitalised at a local level. Currently, many banks operate a centrally capitalised branch system. Now they are being encouraged to set up locally financed subsidiaries rather than branches outside their own jurisdiction. But this, too, has wide-ranging implications, such as 'trapping' liquidity in a country that may not need it.

Moreover, it is not an efficient use of capital. “If banks have lots of subsidiaries, this could create pockets of excess capital and this is fundamentally inefficient. At the moment, therefore, it seems as if the new regulations will reduce capital flexibility and potentially liquidity too,” says Jon Peace, banking analyst at Nomura.

Overall, banks and their advisors are pushing hard for a global approach to regulation, particularly around recovery and resolution planning. In the meantime, banks will be required to submit their initial thinking on this issue and the more thought they put into it at this stage, the more fruitful discussions with the regulators are likely to be. Predicting the pitfalls around their own possible downfall is fraught with challenges for the banking community. But these need to be addressed sooner rather than later.

Mr Liver says many banks are under-estimating the extent of work involved. “These are big complex projects that require a lot of thinking. Uncomfortable questions need to be asked and difficult issues need to be addressed. Fundamentally, banks are being asked to assess their business through a different lens. Ranging from the complexity of their organisation to merger and acquisition activity to outsourcing, there are consequences for every big business decision.“

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