A growing number of countries have introduced resolution regimes for their systemically important banks, but making sure they work together globally is a larger challenge.
The complexity and uncertainty of resolving a large, cross-border bank was one of the key reasons why taxpayers in the US and Europe were forced to step in and bail out distressed institutions in 2008. The political drive to cut the risk of taxpayers ever again being called on to rescue a failing bank has been one of the strongest themes of post-crisis regulatory reform.
The heart of the challenge was succinctly summed up by the then Bank of England governor Mervyn King at the height of the crisis, when he commented that global banks “live globally but die nationally”. Home regulators feared rescuing a bank that was plunged into trouble by its overseas operations – such as the lending to private equity and real estate funds across Europe that triggered an Icelandic systemic crisis in 2008. And host regulators fretted that the branch or subsidiary of a global bank operating in their country might just shut its doors one day to protect or recapitalise the parent.
Simply thinking about how to respond to a global bank in distress already represented progress from the alarming lack of planning that confronted regulators in 2008. The G20’s regulatory arm – the Financial Stability Board (FSB) – published recommendations for the 'Key Attributes of Effective Resolution Regimes for Financial Institutions' in November 2011, and their implementation will be policed by the G20 members. Measures such as the Dodd-Frank Act in the US and the EU’s Bank Recovery and Resolution Directive (BRRD) now enshrine in law the requirement to draft recovery and resolution plans – setting out in advance a theoretical framework to avoid (recovery) or manage (resolution) the failure of an at-risk systemically important bank (SIB).
“We have gone from a situation where there was no formal framework to one where the FSB Key Attributes have been applied in many major jurisdictions, and banks are drafting recovery and resolution plans and discussing them with their supervisors. That takes us a long way down the road compared with where we were in 2008, but of course the focus is on areas that remain to be clarified,” says Adam Cull, policy director at the British Bankers’ Association.
A question of trust
The relationship between home and host supervisors is still the core concern around the resolution of a global SIB. This centres mainly on the conduct of the two jurisdictions where global banks tend to have their largest overseas presence: the US and UK.
“Flexibility seems like a good thing until day one of a resolution, when it becomes a source of uncertainty. The key governments need to be able to move with alacrity, and markets need a sense of how the cross-border aspect will play out – under whose law and authority will the resolution take place,” says Rodgin Cohen, senior chairman of law firm Sullivan & Cromwell and a member of the systemic resolution advisory committee to the US Federal Deposit Insurance Corporation (FDIC).
The FSB Key Attributes set out a choice in the approach to resolution that has knock-on effects for how banks are structured and managed. This is between a single point of entry (SPE) approach, where the home resolution authority runs the process worldwide, and a multiple point of entry (MPE) approach, where each host supervisor may step in and resolve the subsidiary in its jurisdiction. Paul Tucker, former deputy governor of the Bank of England, suggested in a speech in Switzerland in July 2014 that the MPE approach would only be suitable “for those groups whose business model allows different business lines to be ring-fenced from each other financially and operationally”. This is not an approach favoured by many global banking groups.
“If every jurisdiction is requiring enough resources to carry out resolution locally without reference to what happens at the top of the group, that is not likely to be an efficient allocation of capital and liquidity across the bank. The best answer is for different national resolution authorities to be able to trust each other,” says Randall Guynn, head of the financial institutions group at US law firm Davis Polk, and a member of the legal advisory panel to the FSB’s resolution steering committee.
The better way
There are also indications that the SPE approach is a better way to contain systemic risk and contagion from a large bank resolution. The Clearing House, the mutual organisation that runs payments systems for US dollar clearing banks and a trade group for those same banks, carried out a simulation exercise in November 2012 that brought together bankers, investors and former regulators to map out how a cross-border resolution scenario might unfold. One of the most notable difficulties raised was the fear among investors that other global SIBs would be affected because of their counterparty exposure to the distressed SIB, for instance through derivative trades (see box).
“The beauty of SPE is that all critical operating companies remain solvent and operational with access to liquidity, and losses are absorbed by holding company shareholders and creditors. The fact that the operating companies remain well capitalised and able to continue performing on their obligations should quell panic about counterparty cross-exposures and prevent runs in the system,” says John Court, senior associate general counsel of The Clearing House.
The holding company structure is standard in the US, but less so in Europe. In a consultation paper on 'Measures to Reduce or Remove Impediments to Resolvability' published in July 2014, the European Banking Authority asked industry participants about the feasibility of switching European banks over to a holding company structure. But Thomas Huertas, a former member of the Basel Committee on Banking Supervision who now works for consultancy Ernst & Young, says this is not a simple exercise. It would involve the existing operating subsidiaries effectively selling their businesses to a newly created holding company, bringing with it a wide range of regulatory and tax implications.
Even if a bank structure is suitable for SPE, the MPE approach has its appeal from the perspective of a host supervisor. The US FDIC favours an SPE approach for US-headquartered banks, but foreign banking organisation (FBO) rules under the Dodd-Frank Act require foreign subsidiaries to form an intermediate holding company with enough capital and liquidity to operate independently of its parent.
“The US authorities have clearly stated that they do not want to depend on a foreign home supervisor correctly carrying out a resolution – they want capital and liquidity to be positioned in the US ex ante, with no risk of it being removed,” says Mr Huertas, who has just published a book on resolution entitled Safe to Fail.
Bargaining chips
Although the EU theoretically has a more unified cross-border resolution framework thanks to BRRD, the directive itself had to incorporate mechanisms for tackling potential home-host disagreements. Jay Modrall, a partner at law firm Norton Rose Fulbright in Brussels, is unsure whether the complex architecture of BRRD can deliver the rapid response needed to resolve a bank and keep its critical operations running smoothly.
“The attraction of SPE is clear in terms of efficiency, but only if there is one regulator with the power to take this route. The EU has had to be more flexible, because of the complex web of regulators. Although BRRD provides for group plans, it also provides that national authorities may require local subsidiaries to draw up their own plans. This was a key sticking point in the negotiations on BRRD and means that the same entities may be covered by more than one plan, subject to review by different authorities,” says Mr Modrall.
The European Commission and European Council (comprised of member-state governments) also have 24 hours to object to any resolution, which would throw the entire process into doubt.
Overcoming the swaps obstacle
The Lehman Brothers collapse in 2008 laid bare one significant challenge of resolving a cross-border broker-dealer operation. This is the treatment of outstanding derivative contracts to which the entity entering resolution was a counterparty. In standard swaps documentation, one counterparty is allowed to net and close out their positions if the other counterparty is in default on any obligations. Resolution would be likely to trigger that right to early termination, but the results would not help the authorities to maintain stability in financial markets.
“Dealers tend to run balanced books, but regulators need to put hard numbers on the size of directional buy-side trades with any given dealer. If that number is significant, and if the directional buy-side can close out during the 24 to 48 hours that it takes to organise a resolution, then that could leave the resolved entity with large directional positions that could complicate an orderly resolution process,” says Eric Litvack, head of regulatory strategy at Societe Generale Corporate & Investment Banking.
For this reason, national resolution regimes tend to stipulate the power to stay termination rights temporarily while an entity is carved out and capitalised to continue the bank’s critical operations. Under the Dodd-Frank Act in the US, this stay lasts for 24 hours. In most European jurisdictions, the delay is 48 hours, and this has now been enshrined at an EU level under the Bank Recovery and Resolution Directive.
However, these rules apply to creditors and transactions within the home jurisdiction of the bank in resolution. Inevitably, handling a global bank will involve trades and clients in numerous different jurisdictions. In November 2013, the regulators responsible for resolution regimes in the US, UK, Switzerland and Germany wrote to the International Swaps and Derivatives Association (ISDA), urging “a change in the underlying contracts for derivative instruments that is consistently adopted” by ISDA members, to create contractual stays on swap termination rights voluntarily as an industry norm.
But this represents a dilution of the existing legal rights available to a broker-dealer’s clients. Institutional investors that have a fiduciary duty to their customers are particularly concerned that they could be held liable for weakening the fund’s protection against the risks created by a bank counterparty default.
“It is naive to think that looking after one side of the swap trade at the potential expense of the other or indeed of a large segment of the market, is necessarily going to promote financial stability or confidence in the swaps market as an asset class,” says Daniel Harris, a consultant at law firm MacFarlanes, which counts several large alternative investment managers among its clients.
The Financial Stability Board hopes to have a framework agreement on swap stays in place by the time the G20 meets in Brisbane in November 2014. Mr Litvack says a more comprehensive deal will probably need at least another year to quantify the different classes of counterparties and exposures in the swaps market.
Small matters
The sense of not wanting to rely on the good offices of a home supervisor may be most acute among smaller host jurisdictions, which are unrepresented at the FSB and are apparently concerned that the US and UK are dominating the discussions on resolution. A subsidiary that represents a tiny part of the balance sheet at a global SIB is sometimes one of the largest banks in a given country – examples might be HSBC in Malta or UniCredit in Bosnia-Herzegovina. In an update on recent developments in cross-border bank resolution in June 2014, the International Monetary Fund (IMF) flagged up this problem as one of the significant remaining hurdles to co-operation on cross-border resolution.
“This will mean that reforms to resolution frameworks will need to be adaptable enough to account for different degrees of complexity of financial systems and also take into account the potential impacts of cross-border resolution strategies on smaller host jurisdictions,” the report noted.
In smaller countries, the cost of recapitalising one of their largest banks can be high relative to the available sovereign financial resources, says Oliver Wünsch, one of the report’s authors and an IMF representative at the FSB’s resolution working committee. But they do have some leverage to encourage a responsible approach to SPE.
“If the foreign-owned subsidiary has been parent funded, then the parent bank has a claim on the subscribed capital and significant parts of the debt of the subsidiary. Those claims could be written down by the host jurisdiction to pass the loss up to the parent,” says Mr Wünsch.
Gone-concern capital
Resolution plans are not legally binding documents, and the prospects for some form of international binding treaty among the G20 countries are thought to be very slim. What is vital is to reassure every supervisor that the risk of a taxpayer bail-out in each jurisdiction can be reduced to a minimum. This is why the FSB has prioritised the development of a global standard for what it calls 'gone-concern loss-absorbing capital' (GLAC). This is essentially a designated layer of unsecured bank debt that can be converted into equity to recapitalise the healthy parts and operations of a failed bank. Mark Carney, Bank of England governor and chair of the FSB, has pledged to push for an initial agreement on GLAC by the end of 2014.
Once this layer of bail-in debt is in place, there is a growing strain of thought among bankers and regulators that SPE and MPE do not have to be mutually exclusive. John Perry, an independent consultant who was previously responsible for recovery and resolution planning at HSBC, says the essential part of the process is identifying and protecting what have become known as “critical economic functions” such as a bank’s IT, payment and settlement systems that need to continue operating even when a bank enters resolution. One effect of this is that ring-fenced operational subsidiaries are seen as the solution to this requirement.
“The requirement for cross-border groups is to ensure that pockets of businesses – some of which will be conducted in separate legal entities – are kept together within a single resolution group. The consequence is that the distinction between SPE and MPE business models is no longer as clear cut as it was once thought,” he says.
GLAC debate
However, decisions over the quantity and distribution of GLAC needed by each SIB are likely to provoke debate. European banks understandably want to ensure that GLAC is compatible with the bail-in provisions of BRRD. Industry insiders assume that a GLAC buffer of one times equity would be the minimum.
“The most important point is to avoid any form of serial bail-in. The initial bail-in has to supply sufficient funds for an extended time period with a good safety margin. But that required level can be difficult to calculate, because it depends on the valuation of the bank’s assets that is likely to be very volatile in the stress scenario that has triggered the resolution,” says Mr Wünsch.
The concept of GLAC remains contentious in countries with a tradition of strong state support for 'national champion' banks, substantial deposit funding of the banking sector, or a relatively high cost of issuing bank debt. And agreeing the principle is just a first step.
“The current challenge facing supervisors and bank boards is to ensure that GLAC is in the right locations in the group so that it could be released from one legal entity to another if needed, and that bail-in can be enforced in different legal regimes. There are those who suggest that we should rely upon legal opinions for assurance, but it might be better to have an inter-governmental agreement sponsored by the FSB that recognises the GLAC legal status in advance to eliminate uncertainty,” says Mr Perry.
There is also a debate about creating the right incentives for home-host co-operation by pre-positioning a certain amount of GLAC at the subsidiary level. This is a delicate balance. The pre-positioned GLAC needs to be large enough to induce home supervisors to take account of host authorities, but not so large that the capital and funding of the group is fragmented into a de facto MPE structure.
In search of liquidity
Even once the bank is recapitalised, it will need access to emergency liquidity until market confidence in the salvaged 'good bank' is restored. A global SIB would need central bank liquidity in several currencies, such as dollars, euros and yen. Central banks are understandably nervous about the moral hazard and credit risk implications of lending to an entity in resolution. A manager responsible for resolution planning at one global SIB believes this is simpler to arrange in an MPE structure. The current standard practice is for local operations to use local central bank refinancing windows.
“If the local authorities have the primary role in resolving the local entity, they will be more comfortable to lend to it as well. With an SPE approach, funds have to be sent downstream from the holding company to the operating companies. That means cross-border flows, which have political implications as we saw in the case of the Lehman insolvency,” says the banker.
However, Mr Huertas of Ernst & Young suggests a form of central bank resolution lending syndicate, organised by the home monetary authority. This would collect and distribute emergency funding across the group for an SPE resolution.
“The home central bank would take a charge over the aggregated unencumbered group assets including the parent company’s share of the capital of its subsidiaries. That charge would cover any shortfall in the available collateral for refinancing operations,” says Mr Huertas.
Of course, central banks cannot sign international treaties. As with so many other aspects of cross-border resolution, the liquidity question needs international agreement at a political level. All eyes will be on the G20 meeting in Brisbane in November 2014.
