SSM Proposals Being Watered Down?

Introduction

On 8 October 2012, the EU Parliament’s Committee on Economic and Monetary Affairs (ECON) published a draft report proposing amendments to the European Commission’s draft regulation establishing a single supervisory mechanism (SSM).

The most significant amendment proposed by the EU Parliament would restrict the number of banks coming under direct ECB supervision.  Whilst subject to safeguards (and admittedly still in draft form) these proposals nonetheless have the potential to undermine the effectiveness of the SSM as a mechanism for ensuring a coordinated cross-border response to bank resolution within the EU.  As such, it will be important to monitor the way in which these proposals develop.  More detail on the contents of the draft report is provided below.

Scope of the SSM Regulation

As drafted by the EU Commission, the ECB would have been given supervisory responsibility for “all banks of participating Member States”.  In contrast, the EU Parliament amendment proposes that the ECB’s powers be limited to exercising “specific and clearly defined supervisory tasks” in relation to:

  • systemically important European banks (measured by reference to size of exposures, systemic risk for the relevant domestic economy and scale of cross-border activity); and
  • banks which have received or requested public financial assistance.

Under the EU Parliament’s proposed amendments, national competent authorities would continue to supervise all banks falling outside the scope of direct ECB supervision.  However, the ECB would establish a supervisory framework under which national supervision would take place and would be responsible for monitoring national authorities’ compliance with this framework.  The framework would be supported by a requirement on national authorities to report to the ECB on a quarterly basis, and provide notification “without delay” where:

  • serious concerns exist about the safety and/or soundness of a credit institution falling outside the scope of direct ECB supervision;
  • the stability of the financial system is or is likely to be endangered by a credit institution falling outside direct ECB supervision; or
  • a credit institution for which they are competent ceases to fall outside the scope of direct ECB supervision.

The ECB would commence supervision from 1 July 2013 but may, by way of notification, exercise its powers before this date in relation to any credit institution which has received or requested public financial assistance.  In addition, the ECB would also retain the right to exercise supervisory power of any Member State credit institution if:

  • national authorities failed to perform their obligations under the SSM regulation;
  • there was evidence that a credit institution posed, was likely to pose, or would exacerbate  a threat to the single market or financial stability; or
  • a credit institution falls under the scope of direct ECB supervision.

 

IMF Speech on Global Financial Sector Reform

On 26 October 2012, the IMF published a speech given in Toronto by its Managing Director, Christine Lagarde, on global financial sector reform.

Ms Lagarde noted that progress had been made on implementing financial sector reform, specifically referring to Basel III and improved standards for the resolution of banks.  In particular, she welcomed the EU’s moves to adopt a legal framework for a single supervisory mechanism by the end of 2012 as well as provisions regarding national resolution and deposit guarantee frameworks.  However, she noted that a globally coordinated discussion and response was still required in a number of areas, including:

  • current efforts to resolve the issue of “too important to fail” through structural reform as proposed by Volcker, Vickers and Liikanen; and
  • international agreement on methodologies to assess compliance of recovery and resolution planning for large cross-border institutions.

HM Treasury Publishes Summary of Responses to Consultation on Non-bank resolution

Introduction

On 17 October 2012, HM Treasury published a summary of responses received to its August 2012 consultation paper, entitled “Financial Section Resolution: Broadening the Regime” (the “Consultation Paper”).  Broadly, the Consultation Paper had proposed the widening of resolution regimes to systemically important non-banks, specifically:

  • Investment firms and parent undertakings;
  • Central counterparties (CCPs);
  • Non-CCP financial market infrastructures (non-CCP FMIs); and
  • Insurers.

For a full summary of the Consultation Paper, please see our previous blogpost “HM Treasury Consultation:  RRP for Financial Market Infrastructures” dated 8 August 2012.

Summary of Responses

HM Treasury received 45 responses to the Consultation Paper prior to the 24 September 2012 deadline.  Broadly, respondents were supportive of the original position of the Government, which reconfirmed its intention to develop the UK regime in advance of European legislation.  The main changes to be implemented in light of the Consultation Paper are set out below.

Investment firms and parent undertakings

The Government proposes:

  • to narrow the definition of investment firms which are subject to the resolution regime proposals so as to promote consistency with the Recovery and Resolution Directive by excluding small investment firms that are not subject to an initial capital requirement of €730,000; and
  • an extension of stabilisation powers to group companies in order to facilitate resolution, but subject to certain conditions, such as limiting such powers to financial groups (rather than financial elements of any group that contains a bank, as was proposed in the Consultation Paper).

Central Counterparties

The Government proposes to include an additional objective for intervention in a failing CCP, which seeks to maintain the continuity of critical services.  It notes the mixed response from the industry regarding the intervention power generally but continues to regard this as justified given the systemic consequences which closure of a CCP’s critical functions could have, particularly where there are no obvious substitutes for the CCP.  However, the Government also accepts that recognised clearing houses that do not provide central counterparty clearing services should be excluded from the regime altogether, meaning that they are likely to be covered by proposals relating to non-CCP FMIs.

The Government also noted the strong industry opposition to its proposal to allow resolution authorities to impose on the clearing members of a CCP any losses which were above and beyond those dealt with by the CCP’s existing loss allocation provisions.  It was felt that this proposal would cause uncertainty, could potentially lead to distorted incentives such as the early termination and exit of members, might put UK CCPs at a competitive disadvantage and could have capital and liquidity implications for clearing members.  In light of this, the Government has decided not to pursue the proposal, but remains of the view that taxpayers should not be expected to meet the cost of restoring a failed CCP.  As such, it proposes to make loss allocation rules mandatory for the purposes of authorisation as a Recognised Clearing House within the UK and will re-consult on this new proposal in due course.

Non-CCP FMIs and Insurers

The government accepts that the case for a full resolution regime for Non-CCP FMIs or insurers is less clear cut.  Most Non-CCP FMIs have no financial exposure, similar to those faced by CCPs, and any failure is more likely to be operational or technological in nature.  In addition, there seems to be a general recognition that traditional insurance activities – whether general or life insurance business – do not generate or amplify systemic risk.  In contrast, non-traditional insurance and non-insurance activities (such as derivative trading) are regarded as sources of systemic risk.

It seems that the Government accepts that a strengthening of the existing regimes appears to be the most appropriate option and will engage in further dialogue to determine how best this can be achieved.

Next Steps

The changes to proposals regarding investment firms and their parent undertakings, deposit taking institutions and CCPs will be effected by changes to the Financial Services Bill that is currently before Parliament.  For non-CCP FMIs and insurers, the government will take further time to consider the arguments presents by respondents to the Consultation Document and decide the best way to proceed.

European Parliament Publishes Draft Report on RRD

Introduction

On 16 October 2012, the European Parliament’s Committee on Economic and Monetary Affairs (ECON) published a draft report (the “draft report”) on the EU Commission’s proposal for a Directive establishing a recovery and resolution framework for credit institutions and investment firms (the “RRD”).  The overriding concern of the authors of the draft report relates to the level of interference with property rights permitted by the current draft of the RRD and the need to provide certainty to investors.  There is a perceived need to draw a more definite distinction between the pre-resolution period, where management remains in control of the firm, and the post-resolution phase, where control passes over to the relevant authority.  As a consequence, the draft report suggests far-reaching amendments to the RRD in areas such as:

  • resolution authority powers during the recovery phase;
  • preventative powers;
  • early intervention powers;
  • triggers to resolution; and
  • resolution tools: proposing both new resolution tools and amendments to existing resolution tools, particularly bail-in.

A more detailed summary of the main proposals is provided below.

Role of resolution authorities

In order to safeguard legal certainty and avoid conflicts of interest, the draft report proposes that national supervisory authorities should not also be able to act as resolution authorities.

Recovery Phase

Replacement of management

Currently, the draft RRD authorises competent authorities to replace the management of a firm during the recovery phase.  The draft report suggests replacing this power with a right to request  the replacement of the management body, on the basis that, during recovery (as opposed to resolution) shareholders should retain full control of a company.

Assessment of recovery plans

Article 6 of the draft RRD empowers a resolution authority to take the following actions in the event that it considers deficiencies to exist in a firm’s recovery planning: 

  • the reduction of the risk profile of the institution;
  • recapitalisation measures;
  • changes to the firm strategy;
  • changes to the funding strategy;
  • changes to the governance structure of the institution.

The draft report proposes to remove all of these powers on the basis that they constitute too great an imposition on the way in which a firm is run during a recovery stage.

Group recovery planning

Article 7 of the draft RRD currently states that recovery plans must cover each entity in a group.  The draft report suggests amending this provision so that the requirement applies only to relevant entities.

Preventative Powers

Article 14 of the draft RRD requires resolution authorities to notify firms about “potential substantive impediments to resolvability”.  Once notified, a firm must formulate proposals to remove these impediments within four months, failing which the authority can suggest a number of alternative measures.  The authors of the draft report believe that the current list of powers goes far beyond what is necessary and represent a “far reaching interference with property rights in banks”.  Of the current list of powers detailed within the RRD, the draft report suggests deleting those highlighted in red below:

  • requiring the institution to draw up service agreements to cover the provision of critical economic functions or services;
  • requiring the institution to limit its maximum individual and aggregate exposures;
  • imposing specific or regular information requirements relevant to resolution;
  • requiring the institution to divest specific assets;
  • requiring the institution to limit or cease specific existing or proposed activities;
  • restricting or preventing the development or sale of new business lines or products;
  • requiring changes to legal or operational structures;
  • requiring a parent undertaking to set up a parent financial holding company in a Member State or a Union parent financial holding company;
  • requiring a parent or holding company to issue subordinated debt/loans;
  • where an institution is the subsidiary of a mixed-activity holding company, requiring that the mixed-activity holding company set up a separate financial holding company to control the institution.

Early Intervention

Early intervention measures

Article 23 of the draft RRD allows for early intervention by a resolution authority if a firm does not meet, or is likely to breach, the terms of the Capital Requirements Directive (“CRD”).  The draft report suggests amending this so that early intervention is triggered where a firm’s capital is reduced below an amount equal to 1.25% above the level required by CRD IV.  In addition, the draft report proposes the removal of the early intervention power in Article 23(1)(g) of the RRD which allows authorities to contact potential purchasers in order to prepare for the resolution of the institution on the basis that this could damage attempts by management to restore the viability of the institution in question.

Special Management

The draft report proposes moving Article 24 (Special Management) of the RRD in its entirety from the recovery phase to the resolution phase.  The authors of the draft report believe that, during recovery, the owners should have full control over the institution and that this control should only pass to authorities once resolution has commenced.

Resolution Phase

Preparation of resolution plans

The report proposes that national competent authorities should be able to waive the requirement to prepare a resolution plan if a firm is judged to be not systemically important.

Conditions for resolution

Article 27 of the RRD triggers resolution in circumstances where a firm “is failing or likely to fail”.  The authors of the draft report believe that the term “fail” is vague.  Given the impact which application of the resolution tools can have on property rights, it is felt appropriate that resolution should only be used where a firm is very close to insolvency.  However, the authors of the draft report remain keen to avoid liquidity related triggers to resolution due to the possible systemic effects of triggering resolution on this basis.  Accordingly, the draft report proposes to:

  • include an additional condition for resolution such that the firm is also no longer viable pursuant to CRD IV; and
  • remove the trigger that the “institution will be, in the near future, unable to pay its obligations as they fall due”.

Resolution Tools

The draft report proposes the inclusion of a new resolution tool, the “government financial stabilisation tool”.  This takes the form of a new Article 50 (replacing the current Article 50 which addresses contractual recognition of bail-in).  Broadly, there are three elements to the government financial stability tool:

  • Guarantee tool – which facilitates government guarantees of assets or liabilities of institutions in resolution;
  • Equity support tool – which facilitates government recapitalisation of an institution in resolution; and
  • Temporary public ownership.

The authors of the draft report view this very much as a last resort and state clearly that taxpayers must be the beneficiaries of any surplus that may result.

Bail-In

Use of the Bail-In Tool

The draft report suggests amending Article 37 of the RRD to clarify that bail-in must not be used until a firm is beyond the point of non-viability and then only to meet the objectives of resolution as specified by Article 26.  Furthermore, a new Article 37(a) is proposed.  This would require Member States to conduct an assessment of the potential impact on the stability of the EU financial system before the bail-in tool is applied.

Scope of the Bail-In Tool

The draft report proposes amending Article 38 of the RRD to:

  • remove the exclusion relating to guaranteed deposits;
  • specifically refer to covered bonds in the context of the exclusion relating to secured liabilities; and
  • Extend the short-term exclusion from liabilities with an original maturity of less than one month to include liabilities with an original maturity of less than 6 months (so as to minimise the risk of bank runs).

Replacement of management

Recital 46 of the draft RRD states that, following application of the bail-in tool, management should always be replaced and the firm should be restructured.  The draft report proposes removing the reference to ‘replacement of management’.

Minimum amount of bail-in

The draft RRD requires firms to hold a minimum amount of bail-in debt, calculated by reference to the total liabilities of the institution.  The draft report of the Parliament proposes changing this to refer to the “risk exposure amount” (i.e. risk weighted assets) under CRD IV which is to be added to a firm’s minimum capital requirements.  The report claims that the reference to “total liabilities” introduces a totally new capital requirement on firms.  Moreover, in practice, this would operate as a leverage ratio which would not distinguish between low-risk banks and high-risk banks. 

Assessment of amount of Bail-In

Article 41 of the draftRRD requires resolution authorities to calculate the amount of bail-in that would be necessary not only to restore the Common Equity Tier 1 capital ratio of the institution to regulatory minimums but also to “sustain sufficient market confidence in the institution and enable it to continue to comply with the conditions for authorisation”.

The authors of the report point to the uncertainty that application of the bail-in tool can cause to investors in a firm and the increased funding costs firms may experience as a result.  The draft report highlights the need to strike a balance between providing certainty to investors on one hand and the need for creating capital for a bank under resolution on the other.  It suggests removing reference to ‘amounts necessary to sustain market confidence’ on the basis that this is, by definition, an arbitrary assessment, which may be artificially high during times of market stress.

Hierarchy of Claims

In order to provide certainty to investors regarding the hierarchy of claims, the draft report proposes to clarify Article 43 of the RRD.  Specifically, in order to avoid the unfair consequences associated with the upside potential of an equity position as opposed to the write down of a debt position, it is proposed that resolution authorities shall not write down the principal of one class of liabilities, while a class of liabilities that is subordinated to that class is converted into equities.

Contractual recognition of bail-in

In light of the fact that the RRD will apply to all capital and debt instruments regardless of any contractual provision, the draft report proposes the deletion of Article 50, which deals with contractual recognition of bail-in, believing it to be both irrelevant and potentially confusing.

Resolution Financing Arrangements

Ex-ante contributions

The draft report proposes that resolution should be funded ex-ante, rather than ex-post on the grounds that:

  • large ex-post contributions might exacerbate systemic risk during a financial crisis; and
  • properly managed banks would, in effect, be liable for the losses of failed banks.

The draft report also proposes using contributions to pay down public debt, rather than creating a formal fund with necessitates an investment strategy.  The financing arrangements would effectively form the premia of an insurance scheme provided by Member States.  The authors believe that a structure along these lines would render the target funding level of 1% of aggregate deposits within 10 years of the entry into force of the directive, as detailed within Article 93, irrelevant.

Borrowing between financing arrangements

Broadly, under Article 97, the RRD gives financing arrangements of one member state the right to borrow (and the obligation to lend) to other member state financing arrangements.  The draft report proposes amending this so that financing arrangements have the opportunity to borrow and the authorisation (but no obligation) to lend.

Deposit Guarantee Schemes

The draft report proposes amending Article 99 of the RRD to make clear that DGS may not be used for resolution purposes (other than through a potential bail-in of the DGS) so as to “safeguard the credibility of the deposit guarantee scheme”.

Single Supervisory Mechanism to Commence on 1 January 2013

The BBC reports that EU leaders have agreed to phase in a single supervisory mechanism, under the auspices of the ECB, for eurozone banks during the course of 2013.  However, according to the report, it is not clear whether the ECB will have direct responsibility for all 6,000 eurozone banks – specifically, whether German Landesbanks will continue to be subject to national supervision on a day-to-day basis.

This FT article sees the timetable for implementation as a victory for the group of nations, led be France, which had been pushing for a speedy first step towards banking union.  However, it notes that there is still no agreement as to when the European Stability Mechanism will be empowered to recapitalise troubled banks directly, thus relieving sovereigns of the burden of debt.  The German government insists that this can only happen once the new bank supervisor is established and running effectively.  The ECB itself estimates that this would take between 6 and 12 months.

Banking Reform Under Fire

The effectiveness of both the proposed Vickers and Liikanen ringfenced were questioned yesterday during evidence given by Paul Volcker to the UK Parliamentary Commission on Banking Standards.

According to this FT article, Mr Volcker described the Vickers ringfence as “difficult to sustain” and full of holes “likely to get bigger over time”.   The article also suggests that the future direction of the legislation designed to enact Vickers may diverge from a wholescale adoption of its proposals.

Elsewhere, the FT also reports that legal advice provided to the EU Council has concluded that plans to create a single eurozone banking supervisor may be illegal unless treaty change is enacted so as to broaden the scope of governance rules at the ECB.  Moreover, non-eurozone countries that wish to opt into the new regime would not legally be entitled to vote, making it less likely that those countries would wish to join and so undermining the effectiveness of the initiative from the outset

Basel Committee publishes framework for D-SIBs

Introduction

On 11 October 2012, the Bank for International Settlements (BIS) published a framework for identifying and dealing with domestic systemically important banks (D-SIBs).

The purpose of the framework is to reduce the probability of D-SIB failure compared to non-systemic institutions.  In furtherance of this goal, 12 principles have been identified.  These establish a minimum set of requirements in relation to treatment of D-SIBs, whilst recognising the need for a degree of national discretion.  They can be applied both to consolidated groups and to branches within a host jurisdiction.  Broadly, the principles fall into two categories which define:

  • the assessment methodology for D-SIBs; and
  • higher loss absorbency (HLA) requirements for D-SIBs.

Assessment Methodology

Assessment methodologies should be public and clearly articulated with a focus is on the impact D-SIB failure would have on both the domestic financial system and the domestic economy.  In determining systemic importance, home authorities should consider banks from a (globally) consolidated perspective and host authorities should assess foreign subsidiaries in their jurisdictions on a consolidated basis which includes any downstream subsidiaries, some of which may be in other jurisdictions.  Annual assessments of the systemic importance of domestic banks should be conducted by reference to the following bank-specific factors:

  • size;
  • interconnectedness;
  • substitutability/financial institution infrastructure; and
  • complexity.

National authorities can also consider other factors that would inform the above list, such as the size of a bank relative to domestic GDP.

Higher Loss Absorbency

From January 2016, any institution identified as a D-SIB will be subject to an HLA requirement, which must be met fully by Common Equity Tier 1 through an extension of the Basel III capital conservation buffer.   Banks that are both D-SIBs and Global SIBs should be subject to the higher HLA requirement, but double counting should be avoided.  Specific HLA requirements should be commensurate with the D-SIB’s degree of systemic importance and could be affected by:

  • the resolution regimes (including recovery and resolution plans) in and between jurisdictions; and
  • available resolution strategies and any specific resolution plan in place for the firm.

 

CPSS/IOSCO Consultative Report on RRP for FMI

I have been asked whether we have a summary of the CPSS/IOSCO consultation on RRP for FMI that was published in July of this year.  We do, and it is provided below.

All the best

Michael.

Introduction

On 31 July 2012, the Committee on Payment and Settlement Systems (CPSS) and the Board of the International Organization of Securities Commissions (IOSCO) published a consultative report on the recovery and resolution of financial market infrastructures (FMIs), i.e. systemically important:

  • payment systems;
  • central securities depositories (CSDs);
  • securities settlement systems (SSSs);
  • central counterparties (CCPs); and
  • trade repositories (TRs).

FMIs play an essential role in the operation of the global financial system.   The commitment of the G20 at the Pittsburgh Conference in September 2009 that all standardised over-the-counter (OTC) derivatives should be cleared through CCPs will increase yet further the importance of FMIs, as well as the systemic risk associated with their failure, particularly that of CCPs.   As such, the creation of an effective resolution regime for FMIs represents an important link in ensuring the continuity of services which are critical to the financial system.

The purpose of the report is to outline the features of effective recovery and resolution regimes for FMIs in accordance with the “Key Attributes of Effective Resolution Regimes for Financial Institutions” (the “Key Attributes”) published by the Financial Stability Board (FSB) on 4 November 2011.  The report also develops further the thinking of the CPSS and IOSCO as first detailed in the “Principles for financial market infrastructures” (the “Principles”) published in April 2012.

Broadly speaking, the report concludes that:

  • it is vital that robust arrangements exist for the recovery and resolution of FMIs;
  • the Principlesset out a framework for the recovery and resolution of FMIs;
  • regulators will need to ensure that such a framework is put in place; and
  • the Key Attributesprovide a framework for a statutory FMI resolution regime.

The deadline for responses to the report closed on 28 September 2012.  However, FMI resolution remains an aspect of the regulatory reform agenda.  A more detailed summary of the report’s conclusions is provided below.

Relationship with the Key Attributes and the Principles

The report identified six areas for avoiding and mitigating systemic risk through strong recovery and resolution capabilities:

Preventive measures and recovery planning

The stability of FMIs relies on them:

  • maintaining a sufficient amount of liquid financial resources;
  • developing a sound process for replenishing financial resources as necessary; and
  • designing effective strategies, rules and procedures to address losses.

Oversight and enforcement of preventive measures and recovery plans

FMIs should be required to create and maintain RRP which are consistent with the Principles.

Activation and enforcement of recovery plans

Relevant authorities should have the power to require implementation of recovery measures, impose fines and require management changes, as appropriate.

Beyond recovery

Resolution authorities must have the power to ensure the continuation of an FMI’s critical services in a resolution scenario and to allocate losses across participants or other creditors of the FMI.

Resolution planning

FMIs should be required to provide authorities with specifically identified data and information needed for the purposes of resolution planning.

Cooperation and coordination with other authorities

Ex ante and “in the moment” cooperation procedures must be agreed between relevant home and host authorities.

Recovery and resolution approaches for different types of FMI

A key distinction exists between FMIs that take credit risk, such as CCPs, and those that do not, such as TRs.

FMIs that do not take credit risk

Recovery

All FMIs, including those that do not assume credit risk, have the potential to fail.  As such, they should be required to maintain minimum levels of capital and produce recovery plans which, inter alia, are capable of ensuring that critical functions continue to operate and additional resources can be raised from participants or shareholders.

Resolution

Given that there are often few (if any) substitutes for, or alternative service providers to, a particular FMI, this may limit the utility of the sale of business tool within resolution and increase reliance on a transfer to a bridge institution on an interim basis.  An alternative may be some form of statutory management, the primary purpose of which would be the continuation of the FMI’s critical functions until they could be transferred or wound down in an orderly manner.

FMIs that take on credit risk

Recovery

FMIs that assume credit risk include CCPs, SSSs that extend credit, and payment or settlement systems that operate on a deferred net settlement basis and in which the system operator provides guarantees to participants due to receive funds or other assets.  This type of FMI typically employs a “waterfall” mechanism which allocates losses in the following order:

  • margin;
  • collateral;
  • defaulting party’s default fund contributions;
  • FMI contribution (often capped);
  • non-defaulting parties’ default fund contributions.

The Principlesrequire a CCP, and any other FMI that faces credit risk, to establish rules and procedures that address how credit losses in excess of the above would be allocated.  The suggestion is that this would be achieved by haircutting the margin of the CCP’s clearing members.

As they do not take directional positions, CCPs must also maintain a matched book at all times.  Following a member default, this is normally achieved via an auction process which seeks to replace the defaulter’s positions.  However, in a stressed scenario, the auction may receive no bids, or those bids that are received may be at prices which would not allow the CCP to remain solvent.  In these circumstances, an alternative solution would be for the CCP’s rules to permit for the termination and settlement of any unmatched contracts that could not be sold in auction.  All other contracts would remain in force but would potentially be subject to haircutting of margin if in-the-money so as to balance the books of the CCP.

Selective termination would undoubtedly alter the risk exposure of affected participants to the CCP, but is considered preferable to the alternative of insolvency, with the effect that this would have on all contracts cleared by the CCP as well as the wider systemic problems this might cause.

Resolution

A resolution framework for FMIs is still required due to the possibility that losses could still exceed the limits of the contractual loss mutualisation rules.  Of the tools available to a resolution authority, statutory loss allocation is likely to remain key in ensuring the continuation of critical services.  It is assumed that this would be implemented through haircutting of margin and by enforcing outstanding obligations to replenish default funds or respond to cash calls.

This raises questions as to the consequences of each loss allocation strategy, and whether the liability of participants should be limited.  In practice, enforcing obligations to replenish default funds or meet cash calls may prove difficult during times of market stress.  In this respect, haircutting of margin may represent a more speedy solution.  However, both potential solutions may act as a source of contagion if clearing members have the right to pass on losses to indirect members.  Statutory loss-allocation could also be extended to include any issued debt or borrowings of a FMI or any intragroup balances.  However, in reality, it is unusual for FMI to have such debt, at least in significant amounts.

Wherever possible, loss-allocation within resolution should follow the normal insolvency ranking, meaning that equity should suffer losses before debt.  However, a degree of flexibility may be necessary in order to contain the spread of risk where, for example, the owner of the FMI operates not only the service under resolution, but also other critical FMI services.

A stay on early termination rights may be a useful tool in mitigating stress on the FMI associated with a possible mass close-out of positions and maintaining a “matched book”.  It may also be of benefit in circumstances where the FMI is reliant upon services provided by an external third party for continuity of critical services, such as IT services.

Interpretation of the Key Attributeswhen applied to FMIs

Resolution authority (Key Attribute 2)

An effective resolution regime requires a designated resolution authority to implement it.  The statutory objective regarding the protection of depositors (Key Attribute 2.3 (ii)) is not applicable with respect to resolution of FMIs.

Tools for FMI resolution (Key Attribute 3)

Resolution authorities should have available the broad range of resolution tools specified within the Key Attributes, although there are a few exceptions that require an FMI-specific interpretation, as detailed below.

Entry into resolution (Key Attribute 3.1)

The triggers for FMI resolution are likely to be similar to those for other types of financial institution.

Payment Moratorium (Key Attribute 3.2 (xi))

The enforcement of a payment moratorium with respect to an FMI is likely to risk continuing or even amplifying systemic disruption, defeating the objective of continuity of critical services.  As such, it is likely to be of little relevance.

Appointment of an administrator to restore FMI viability or effect an orderly wind-down (Key Attribute 3.2 (ii) and (xii))

Placement of an FMI into some form of statutory administration is likely to be suitable only for those types of FMI whose critical operations can be continued during a general moratorium on payments to creditors. Therefore, this may not offer a credible resolution strategy for many FMIs.

Transfer of critical functions to a solvent third party (Key Attribute 3.3)

For some FMIs there may be few (if any) alternative providers of its critical services to which operations can be sold.  Even if an alternative provider does exist, there may be a number of practical issues that would prevent a prompt transfer, including:

  • different participants and participation requirements;
  • IT system compatibility;
  • differing access criteria; and
  • legal barriers (such as antitrust or competition laws).

Bridge institution (Key Attribute 3.4)

This tool may represent an attractive option, as a speedy transfer to a bridge institution can help facilitate the maintenance of critical services whilst avoiding (at least temporarily) the legal and operational impediments that may arise with an outright transfer to a third party.

Bail-in within resolution (Key Attributes 3.5 and 3.6)

Unlike banks or investment firms, FMIs rarely issue subordinated debt instruments.  However, some FMIs, such as CCPs, do have access to financial resources in the form of initial margin, variation margin and default fund contributions which could be made subject to a haircut in a resolution situation, with creditors being given equity in the FMI in return.  The haircut would respect the creditor hierarchy and would apply to collateral and margin only where it was held in a way that meant that it would bear losses if the FMI became insolvent.

Setoff, netting, collateralisation, segregation of client assets (Key Attribute 4)

Effective resolution of an FMI requires that the legal framework governing setoff, netting and collateralisation agreements, and segregation of client assets should be clear, transparent, understandable and enforceable.

Stays on early termination rights (Key Attributes 4.3 and 4.4)

In order to ensure that the commencement of resolution cannot be used as an event of default to trigger termination and closeout netting, an FMI should have the ability to stay the termination rights of its participants or service providers.  Due to the risks associated with running an unmatched book, this is particularly important where the FMI is a CCP.

Safeguards (Key Attribute 5)

The principle of “no creditor worse off than in insolvency” should apply to FMIs.  However, the starting point for calculating whether, ultimately, a creditor is ‘worse off’ should be claims as they exist following the FMI’s ex ante rules and procedures for loss allocation.

Funding of FMIs in resolution (Key Attribute 6)

The provision of temporary funding should be highly exceptional, and limited to those cases where:

  • it is necessary to foster financial stability;
  • will facilitate orderly resolution; and
  • private sources of funding have been exhausted or cannot achieve an orderly resolution.

Resolvability assessments (Key Attribute 10)

Resolvability assessment must take account of an FMIs’ specific role in the financial system, including the impact on its participants and linked FMIs (such as CCPs which are subject to interoperability arrangement), in particular, their ability to retain continuous access to the FMI’s critical operations and services during resolution.

Recovery and resolution planning (Key Attribute 11)

An FMI should develop comprehensive recovery plans that identify and analyse scenarios which are specific to its role in the financial system and which may threaten its ability to continue as a going concern.

Access to information and information-sharing (Key Attribute 12)

There should be no impediments to the appropriate exchange of resolution information. However, being market neutral, the concept of sensitive trading data does not apply to FMIs in the same way as to other financial institutions.  Nonetheless, position information specific to individual members should be subject to confidentiality arrangements.

Cooperation and coordination among relevant authorities (Key Attributes 7, 8 and 9)

The resolution of FMIs should also be supported by transparent and expedited processes to give effect to foreign resolution measures.

EU Commission publishes consultation paper on RRP for non-banks

Introduction

On 5 October 2012, the European Commission published a consultation paper on a possible recovery and resolution framework for financial institutions other than banks.  The aim of the consultation is to ensure that all nonbank financial institutions the failure of which could threaten financial stability are capable of being resolved in an orderly manner and with minimal cost to taxpayers.  Responses are requested by 28 December 2012.  A more detailed summary of the consultation paper is provided below.

Defining ‘Systemic Risk’

The consultation paper concludes that, with the exception of central counterparties (CCPs) and central securities depositories (CSDs), it is difficult to establish in advance which nonbanks are likely to be sources of systemic risk.  As such, it is necessary to have a framework that applies to all firms, both those identified as systemic ex ante and after an event of failure.  As to the question of when a specific institution might be considered as being a source of systemic risk, the following are identified as key factors:

  • size;
  • inter-connectedness; and
  • substitutability of services.

Financial Market Infrastructures (FMIs)

Central Counterparties

The Commission notes that there is a high risk of contagion associated with CCPs as:

  • they are strongly inter-connected with other FMIs and other financial institutions;
  • they often operate on an almost quasi-monopolistic basis; and
  • clearing members of a CCP are often also clearing members of other CCPs, with the effect that losses suffered by a clearing member on the failure of a CCP could indirectly impact other CCPs (if these losses triggered a default vis-a-vis the other CCPs).

The consultation paper makes reference to measures employed by CCPs which act as safeguards with respect to the risks they face:

Risk

Safeguard 

Credit risk and liquidity risk
  •   Initial margin
  •   Variation margin
  •   Default fund contributions
  •   Own capital
Operational risk
  • Contingency arrangements such as   those required by Article 34 of EMIR
Market risk
  • Investment restrictions such as   those required by Article 47 of EMIR
  • Haircuts

 Central Securities Depositories

The principal risks to which CSDs are exposed are operational and legal in nature, with legal risks being particularly relevant given the cross-border nature of some CSD activities.  However, the services provided by CSDs are characterised by their high levels of interconnection and their low degree of substitutability.  Therefore, if managed in a disorderly fashion, the failure of a CSD could have considerable effects on the financial system.

Recovery and resolution of CCPs and CSDs

The most critical element of CCP/CSD resolution is to ensure the continuation of systemically important functions and services.  This is achieved through a combination of recovery and resolution plans.  Authorities should also be able to intervene in the business of a firm prior to the triggering of a resolution condition, if it is in breach of its regulatory requirements.  However, resolution of an FMI must be conducted in a manner which preserves the principle of ‘no creditor worse off than in insolvency’.  In addition, the normal hierarchy of claims in insolvency and pari passu treatment of creditors of the same class should be respected.

Resolution triggers for CCPs and CSDs are the same as for banks and should be set at the point when a firm is no longer viable or likely to be no longer viable, and has no reasonable prospect of becoming so.  A further condition for resolution is that its failure and the disruption of its services must have systemic implications.  The balance between the need for flexibility in triggering resolution on the one hand and the need for clarity as to the level of the trigger on the other hand are both recognised.

In the context of FMI resolution, authorities should have the power to:

  • remove and replace a firm’s senior management;
  • appoint an administrator;
  • operate, restructure and/or wind-down a firm;
  • transfer or sell specified assets or liabilities;
  • establish a temporary bridge institution;
  • separate non-performing assets into a distinct vehicle;
  • recapitalise an entity by amending or converting specified parts of its balance sheet;
  • override rights of shareholders;
  • impose a temporary stay on the exercise of early termination rights;
  • impose a moratorium on payment-flows; and
  • effect an orderly closure/wind-down.

With respect to the resolution tools at the disposal of authorities, the difficulties of applying the Sale of Business tool is recognised, due to:

  • the relative lack of firms in the industry;
  • the different nature of an FMI’s assets and liabilities;
  • operational constraints such as IT system incompatibility; and
  • the competition issues which may flow from ownership structures.

In addition, as the core assets of an FMI (its technical facilities and processes, infrastructure and know-how) do not tend to cause losses in the way a bank’s assets might, they do not merit being transferred to a separate ‘bad’ asset management vehicle under the Asset Separation Tool.  In turn, these facts increase the importance of the Bridge Institution Tool as a method of resolving a failed FMI due to the fact that this will enable authorities to ensure the continuity of critical services whilst a private sector purchaser is identified.

Of most interest is the discussion of the use of the Bail-In Tool with respect to FMIs.  FMIs typically do not issue debt which can be made subject to a haircut or converted into equity for the purposes of loss allocation or recapitalisation.  It is noted that loss-allocation mechanisms, for example CCP default funds, already exist for some FMIs. However, these arrangements are primarily concerned with loss-allocation rather than recapitalisation.  With respect to the resolution of a CCP, the following options were identified:

Bail-In Option

Advantages

Disadvantages 

Applying haircuts to initial margin
  • Funds are available for immediate use
  • Initial margin levels may need   to increase across the board
  • Possibility that this departs from the principle of ‘no creditor worse off than in insolvency’
Applying   haircuts to payments of variation margin
  • Funds are available for immediate use
  • Does not have pro-cyclical effects for out-of-the-money payors
  •  Has pro-cyclical effects for in-the-money payees
  • Possibility that this departs from the principle of ‘no creditor worse off than in insolvency’
Specific   liquidity calls on clearing members
  • Avoids random allocation of losses resulting from margin haircuts

 

  • Increased pro-cyclicality due to the fact that all clearing members are called for funds
Establishment   of ex-ante resolution funds
  • Avoids negative countercyclical   impact
  • Difficulty in calculating appropriate levels of contribution
Issuance of CoCo bonds by CCPs
  • Burden would not fall on clearing members
  • Uncertainty as to market for CoCo bonds

The Commission also noted that the industry has considered providing CCPs with a right to terminate contracts with non-defaulting clearing members for an amount equivalent to the contracts held on behalf of the defaulter so as to return the CCP to a balanced net position.

Insurance and Reinsurance Firms

Defining Systemic Importance

The consultation paper notes that most insurance business is unlikely to be systemically important due to its competitive nature and relatively low barriers to entry.  Traditional insurance is considered to be the least risky to the financial system.  In contrast, non-traditional insurance, such as bond insurance, implies a higher degree of risk as a result of its non-standard characteristics that makes it more interconnected with the rest of the financial system.  Non-insurance activities, such as entering into derivatives (particularly as sellers of credit protection) carry the greatest risk.  Although derivatives transactions are generally undertaken through different legal entities, they tend to be connected through a common parent, which sometimes acts as guarantor, meaning that an insurance entity in this position can be both a source or recipient of financial contagion for other entities in its group.

Applying these generalisation to specific areas of the insurance industry, the Commission concludes that short-term funded insurers (which issue commercial paper and reinvest the funds in assets offering a higher return or enter into repos in relation to securities comprised within their investment portfolios) could be systemically risky, but only if the practice is indulged in to an excessive extent and with inadequate liquidity and collateral management.  Similarly, any contagion from the failure of a reinsurer would be limited to its direct customers due to the “comparatively limited” nature of its connections.  However, other types of insurance are considered to have a greater potential to be systemically important due to their high inter-connection with the real economy and the fact that they do not constitute readily substitutable services.  Examples include:

  • compulsory insurance such as motor insurance, employers’ liability insurance, professional indemnity insurance and warranty insurance; and
  • trade credit insurance, by which a business receives protection against losses incurred by late payment or failure to pay by its buyers.

Recovery and resolution of insurance companies

In the case of systemic insurers, it is critical to ensure the continuity of policyholder protection, in relation to which recovery and resolution plans will play an important role.  Triggers to resolution and resolution powers also remain the same as for CCPs/CSDs.  However, with respect to resolution tools, the Commission notes that existing legislation is primarily designed to protect policyholders and is not designed to contain the wider effects associated with the failure of a systemic insurer.  Traditional resolution tools include:

  • run-off;
  • portfolio transfer;
  • insurance guarantee scheme;
  • bridge institution;
  • restructuring of liabilities; and
  • compulsory winding-up.

These tools are generally considered to be effective in conserving the value of an insurer’s assets and protecting policyholders from unnecessary losses.  However, in order to avoid the disruption to financial markets and the real economy associated with the failure of a systemically important insurer it is necessary to have a variety of alternative ways to carry out resolution, such as the ability to separate the systemically important non-traditional activities of the insurer from the traditional activities.

Again, “bail-in” in the context of insurance companies is of most interest.  This would entail the recapitalisation of an insurer by writing down debt and converting claims to equity, either in a bridge institution or in the original firm.  In doing so, it would be possible to ensure the continuation of critical services and provide sufficient time to facilitate the orderly reorganisation or wind-down of the failed insurer.  The consultation paper notes that bail-in could potentially apply to all liabilities of the institution with the exception of:

  • secured liabilities;
  • insurance policies;
  • client assets; and
  • other liabilities such as salaries, taxes or payments due to commercial partners.

Payment Systems And Other Nonbank Financial Institutions/Entities

Two types of entity are identified:

  • Payment Systems (such as TARGET2 or CHAPS), and
  • Payment Institutions (PIs) and Electronic Money Institutions (EMIs).

The Commission concludes that neither merits further consideration in the context of the consultation due to:

  • the vital nature of payment systems, and their specific relationship with and oversight by central banks; and
  • the fact the neither the failure of a PI nor an EMI is likely to represent a significant risk from a systemic point of view.

Other nonbank financial institutions

The consultation paper identifies other financial institutions, including investment funds and certain trading venues, which have not previously been discussed  and which could contribute to the build-up or transmission of systemic risk.  The Commission believes that the resolution of such entities is likely to be very similar to those for banks, investment firms, insurance companies and other entities captured by the consultation.

Living Wills to be a Condition of Authorisation?

This FT article reports on a speech given yesterday in Edinburgh by Andrew Bailey, director of banks and building societies at the FSA.  According to the report, any new entrant to the banking or insurance sectors will be required to produce a credible Living Will as a pre-condition to authorisation.

Concerns have been raised that this will further stifle competition, particularly in the banking sector.  However, the principle of requiring new entrants to consider issues relating to their ultimate resolvability from day one and factor any conclusions into initial business structures, seems an eminently sensible one.