Update on Banking Reform Bill

The Financial Services (Banking Reform) Bill 2013 received its second reading in the House of Lords on 24 July 2013 details of which can be found in the Hansard text. The Bill will now proceed to the Committee stage on a date to be announced according to the Parliament website.

The Bill had its first reading in the House of Lords on 10 July 2013 and HM Treasury and the Department for Business, Innovation and Skills (BIS) published a consultation paper seeking comments on draft secondary legislation proposed under the Bill on 17 July 2013.

First Nine G-SIIs Named

Introduction

On 18 July 2013, the Financial Stability Board (FSB) published a press release endorsing the assessment methodology and policy measures published by the International Association of Insurance Supervisors (IAIS) discussed below, and naming the first nine globally systemically important Insurers (G-SIIs).  The list will be published each November, starting in 2014 and initially comprises:

  • Allianz SE;
  • American International Group, Inc.;
  • Assicurazioni Generali S.p.A.;
  • Aviva plc;
  • Axa S.A.;
  • MetLife, Inc.;
  • Ping An Insurance (Group) Company of China, Ltd.;
  • Prudential Financial, Inc.; and
  • Prudential plc.

On the same date the IAIS announced that it had published:

  • a G-SII Initial Assessment Methodology;
  • G-SII specific policy measures, and
  • an overall G-SII framework for macroprudential policy and surveillance.

G-SII Initial Assessment Methodology

The methodology (which has already been criticised as being “opaque and arbitrary” on account of the fact that it contains no quantitative cut-off point for G-SII designation, preventing firms from knowing what actions would help them remain below the G-SII threshold) is designed to assess the systemic importance of insurers, using year-end 2011 data collected from selected insurers in 2012 and employing a three-step process involving:

  • the collection of data;
  • a methodical assessment based on five weighted categories and 20 indicators;
    • non-traditional insurance and non-insurance (NTNI) activities (45% weighting);
    • interconnectedness (40% weighting);
    • substitutability (5% weighting);
    • size (5% weighting); and
    • global activity (5% weighting); and
    • a supervisory judgment and validation process.

G-SII Policy Measures

The IAIS policy framework for G-SIIs is three-pronged, consisting of:

Enhanced Supervision

These measures entail the development of Systemic Risk Management Plans, enhanced liquidity planning and management and the granting of direct powers over holding companies to group-wide supervisors.  There is also a reasonably detailed discussion of:

  • the nature of traditional insurance versus NTNI activities; and
  • effective separation of NTNI business.

Traditional versus NTNI Insurance

Traditional Insurance is broadly characterised by insured events which are accidental in nature, random in occurrence and subject to the law of large numbers.  In contrast, NTNI broadly includes activities that are more financially complex than traditional insurance, where liabilities are significantly correlated with financial market outcomes (such as stock prices, and the economic business cycle) and have financial features such as leverage, liquidity or maturity transformation, imperfect transfer of credit risks, (i.e.“shadow banking”), credit guarantees or minimum financial guarantees.

Effective separation of NTNI

Whether NTNI activities are effectively separated goes to the heart of G-SII resolvability and the amount of Higher Loss Absorption (HLA) to be applied to a G-SII. The following conditions are relevant in this determination:

  • Self-sufficiency: an effectively separated entity will be able to operate without the support of parent or affiliates;
  • Operational independence of management;
  • Regulated status: the effective separation of NTNI activities must not result in a non-regulated financial entity;
  • Arm’s length dealings: any intragroup transactions or commitments with the separated NTNI entities must be executed “at arm’s length”; and
  • Reputation risk: the risk that a parent or affiliate provides financial support to an entity even though there is no legal obligation to do so must be limited.

Effective Resolution

The IAIS’s proposals for the effective resolution of G-SIIs are based on the FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions but takes account of the specificities of insurance.  This entails the establishment of Crisis Management Groups, the development of recovery and resolution plans (RRPs), the conduct of resolvability assessments, and the adoption of institution-specific cross-border cooperation agreements.

Higher Loss Absorption Capacity

G-SIIs will be required to have HLA capacity.  This may only be met by “highest quality capital”, being permanent capital that is fully available to cover losses of the insurer at all times on a going-concern and a wind-up basis.  In applying this requirement a distinction may be made based upon whether a firm’s NTNI activities have been effectively separated from traditional insurance business.  HLA may be targeted at the entities where systemically important actives are located and also take account of whether group supervisors have authority over any non-regulated financial subsidiaries.

Report on Macroprudential Policy and Surveillance in Insurance

In addition to the microprudential supervision measures constituting the G-SII Policy Measures, the IAIS also released a framework for implementing macroprudential policy and surveillance (MPS) in the insurance sector, designed to maintain financial stability. Its focus is on enhancing the supervisory capacity to identify, assess and mitigate macro-financial vulnerabilities that could lead to severe and wide-spread financial risk.  Over time, the MPS framework will be refined through the issuance of guidance on the practical application of IAIS Insurance Core Principles, and the development of a toolkit and data template regarding early warning risk measures.

Implementation Timeframe

Key implementation dates are as detailed below:

Event

Date

Implementation   of enhanced supervision for G-SIIs

Immediate

FSB to designate the initial   cohort of G-SIIs based on the IAIS methodology

July 2013

For   designated G-SIIs, implementation commences of resolution planning and   resolvability assessment requirements

July 2013

IAIS   to prepare a workplan to develop a comprehensive, group-wide supervisory and   regulatory framework for internationally active insurance groups (IAIGs)

October 2013

Finalisation   of IAIG framework

End 2013

Systemic   Risk Management Plan (SRMP) to be completed

July 2014

Crisis   management groups (CMGs) to be established for initial set of G-SIIs

July 2014

G-SII   designation of major reinsurers

July 2014

IAIS   to develop straightforward, backstop capital requirements to apply to all   group activities, including non-insurance subsidiaries

September 2014

CMGs to develop and agree RRPs,   including liquidity risk management plans for initial set of G-SIIs

End 2014

IAIS to develop implementation   details for HLA that will apply to designated G-SIIs starting from 2019

End 2015

Implementation   of SRMPs to be assessed

July 2016

FSB to designate the set of   G-SIIs, based on the IAIS methodology and 2016 data, for which the HLA policy   measure will apply, with implementation beginning in 2019

November 2017

HLA   requirements to apply to those G-SIIs identified in November 2017

January 2019

FSB Issues RRP Guidance

On 16 July 2013, the Financial Stability Board (FSB) published the following three papers intended to assist authorities and systemically important financial institutions (SIFIs) in implementing the recovery and resolution planning (RRP) requirements set out under the FSB’s key attributes of effective resolution regimes for financial institutions:

Guidance on developing effective resolution strategies

This paper describes key considerations and pre-conditions for the development and implementation of effective resolution strategies, dealing with such issues as:

  • the sufficiency and location of loss absorbing capacity (LAC);
  • the position of LAC in the creditor-hierarchy, particularly with respect to insured and uninsured depositors;
  • operational and legal structures most likely to ensure continuity of critical functions;
  • resolution powers necessary to deliver chosen resolution strategies;
  • enforceability, effectiveness and implementation of “bail-in” regimes;
  • treatment of financial contracts in resolution, specifically the use of temporary stays on the exercise of contractual close-out rights;
  • funding arrangements;
  • cross-border cooperation and coordination;
  • coordination in the early intervention phase;
  • approvals or authorisations needed to implement chosen resolution strategies;
  • fall-back options for maintaining essential functions and services in the event that preferred resolution strategies cannot be implemented;
  • information systems and data requirements;
  • post-resolution strategies;
  • single point of entry (SPE) versus multiple point of entry (MPE) resolution strategies; and
  • disclosure of resolution strategies and LAC information.

Guidance on identification of critical functions and critical shared services

This guidance is designed to assist authorities and CMGs in their evaluation of the criticality of functions that firms provide to the real economy and financial markets. It aims to promote a common understanding of which functions and shared services are critical by providing shared definitions and evaluation criteria.

After describing the essential elements of a critical function and a critical shared service, the annex to the guidance provides a non-exhaustive list of functions and shared services which could be critical:

Functions

  • Deposit taking;
  • Lending and Loan Servicing;
  • Payments, Clearing, Custody & Settlement;
  • Wholesale Funding Markets; and
  • Capital Markets and Investments activities.

Shared services

  • Finance-related shared services; and
  • Operational shared services.

Guidance on Recovery Triggers and Stress Scenarios

This guidance focuses on two specific aspects of recovery plans:

  • criteria triggering senior management consideration of recovery actions (“triggers”), specifically:  design and nature, firm’s reactions to breached triggers, and engagement by supervisory and resolution authorities following breached triggers; and
  • the severity of hypothetical stress scenarios and the design of stress scenarios generally.

EU Council Publishes new RRD Proposal

On 16 July 2013, the EU Presidency published a compromise proposal amending the EU Commission’s previous compromise proposal (dated 19 June 2013) relating to the Recovery and Resolution Directive (RRD).

As detailed in Annex 2 to the document, the main changes address issues such as:

  • the scope of the bail-in tool; and
  • resolution financing arrangements.

EU Commission proposes Single Resolution Mechanism

On 10 July 2013, the EU Commission proposed a Single Resolution Mechanism (SRM), a complement to the Single Supervisory Mechanism (SSM) and one of the building blocks of EU Banking Union.  The SRM is designed to ensure that the resolution of a failing bank can be managed efficiently with minimal costs to taxpayers and the real economy.

The proposed SRM would apply the substantive rules of the Recovery and Resolution Directive (RRD). The EU’s Council of Finance Ministers reached agreement on a general approach to the RRD on 27 June and the EU Parliament’s Committee on Economic and Monetary Affairs adopted its report on 20 May. Negotiations between the Council and the European Parliament are due to start soon with the aim of reaching final agreement on the RRD in autumn 2013.  At its recent meeting, the EU Council of Ministers set themselves the target of reaching agreement on the SRM by the end of 2013 so that it can be adopted before the end of the current European Parliament term in 2014. This would enable it to apply from January 2015, together with the RRD.

Under the SRM:

  • the European Central Bank (ECB) would signal when a bank in the euro area or established in a Member State participating in the Banking Union was in severe financial difficulties and needed to be resolved;
  • a Single Resolution Board, consisting of representatives from the ECB, the EU Commission and the relevant national authorities, would prepare the resolution of a bank;
  • a Single Bank Resolution Fund, funded by contributions from the banking sector and replacing national resolution funds, would be set up under the control of the Single Resolution Board;
  • on the basis of the Single Resolution Board’s recommendation, or on its own initiative, the EU Commission would decide whether and when to place a bank into resolution and would set out a framework for the use of resolution tools and the Single Bank Resolution Fund; and
  • under the supervision of the Single Resolution Board, national resolution authorities would be in charge of the execution of a resolution plan.

Updated G-SIB Methodology Highlights Importance of Data

Introduction

On 3 July 2013, the Basel Committee on Banking Supervision (BCBS) published an “Updated assessment methodology and the higher loss absorbency requirement” (the “Updated Methodology”) for identifying globally systemically important banks (“G-SIBs”), accompanied by a reporting template and instructions.

The Methodology

The Updated Methodology replaces the BCBS’ previous “Global systemically important banks: assessment methodology and the additional loss absorbency requirement”, published in November 2011.  It defines a methodology for identifying G-SIBs founded on an indicator-based measurement approach.  Each indicator is group into one of five equally-weighted categories, as detailed below:

Quantitative Indicator-Based Approach

Category (and weighting)

Individual Indicator

Indicator weighting

Cross-jurisdictional activity (20%) Cross-jurisdictional claims

10%

  Cross-jurisdictional liabilities

10%

Size (20%) Total exposures as defined for use in the Basel III leverage ratio

20%

Interconnectedness (20%) Intra-financial system assets

6.67%

  Intra-financial system liabilities

6.67%

  Securities outstanding

6.67%

Substitutability/financial institution infrastructure (20%) Assets under custody

6.67%

  Payments activity

6.67%

  Underwritten transactions in debt and equity markets

6.67%

Complexity (20%) Notional amount of OTC derivatives

6.67%

  Level 3 assets

6.67%

  Trading and available-for-sale securities

6.67%

For each bank being assessed, the score for a particular indicator is calculated by dividing the individual bank amount (expressed in EUR) by the aggregate amount for the indicator summed across all banks in the sample.  This figure is then multiplied by 10,000 to express the indicator score in terms of basis points.  Each category score for a bank is determined by taking a simple average of the indicator scores in that category. The overall score for a bank is then calculated by taking a simple average of its five category scores.

Qualitative Supervisory Judgment

The quantitative indicator-based approach described above can be supplemented with qualitative supervisory judgment.  This is only meant to override the indicator-based approach in exceptional circumstances, is subject to peer review and is based on the following four principles:

  • the bar for judgmental adjustment to indicator-based scores should be high;
  • the process should focus on factors pertaining to the impact of a bank’s failure, not the probability of its failure;
  • views on the quality of the policy/resolution framework within a jurisdiction should not be taken into account; and
  • the judgmental overlay should comprise well documented and verifiable quantitative as well as qualitative information.

Identifying G-SIBs and Higher Loss Absorbency

Banks that have an assessment score that exceeds a pre-determined cutoff level will be classified as G-SIBs.  Supervisory judgment may also be used to add banks with scores below the cutoff to the G-SIB list.  G-SIBs will be initially allocated into four equally sized buckets based on their scores, with varying levels of higher loss absorbency (“HLA”) requirements applied to the different buckets, as detailed below.  It is worth noting that the figures below represent minimum levels, with national regulators being free to impose higher requirements if they so wish.

The G-SIB assessment will be performed annually and may lead to the reallocation of a G-SIB into a different bucket.  The timing of the publication of the cutoff score and bucket thresholds has been brought forward by one year to November 2013 and will be based on end-2012 data supplied by banks.  Whereas previously, the BCBS had intended to delay updating the denominators used to calculate banks’ scores until the completion of the first three-year review of the G-SIB methodology, denominators will now be updated on an annual basis so as to avoid creating a “cliff effect” for banks.  The methodology itself will be reviewed every three years in order to capture developments in the banking sector and advances in the measurement of systemic importance.

The HLA requirement is to be met only with Common Equity Tier 1 capital and will be implemented through an extension of the capital conservation buffer.  It will be phased in in parallel with the capital conservation and countercyclical buffers, starting on 1 January 2016 and becoming fully effective on 1 January 2019.

Bucket

Higher Loss Absorbency Requirement (common equity as a percentage of risk-weighted assets)

 

5

3.5%

4

2.5%

3

2.0%

2

1.5%

1

1.0%

If a G-SIB breaches the HLA requirement, it will be required to remediate and will be subject to limitations on dividend payouts in the meantime.  If a G-SIB is reallocated into a higher bucket, it will be required to meet the additional HLA requirement within 12 months.

Disclosure requirements

Starting with financial year-ends on or around 31 December 2013 and continuing thereafter, all banks with a leverage ratio exposure measure exceeding EUR 200 billion (this will automatically include the world’s 75 largest banks) will be required to ensure that the 12 indicators used in the assessment methodology are made publicly available.  This disclosure should be required no later than four months after the financial year-end, and by the end of the following July at the latest.  The reporting and disclosure requirements necessary to facilitate implementation must be enacted by national regulators by 1 January 2014.

Conclusion

The reporting templates through which bank supply the underlying information on which the G-SIB assessment methodology is based, highlights the increasing importance of data in the lives of banks.  The data required to be provided as part of G-SIB identification process is high level but assumes that banks have equally high levels of underlying data integrity as well as ready access to information pertaining to a wide range of activities, including on- and off- balance sheet items, derivatives, security arrangements and payments.

In an environment where regulatory constraints are restricting the ability of banks to broaden their business offerings, the ability to generate and disseminate accurate data is fast becoming the new frontier by which banks can differentiate themselves in front of both their clients and their regulators.  In order to take advantage of this changing landscape, it is imperative that banks focus on the development of a culture whereby data occupies a position of central importance within the institution.  As the updated G-SIB methodology shows, over time, the consequences of failing to get this right will only become yet more serious.