SPE and MPE – which are you?

Introduction

On 14 October, the Bank of England published a speech given by Paul Tucker, Deputy Governor Financial Stability, at the Institute of International Finance 2013 Annual Membership meeting on 12 October 2013 on the subject of ‘too big to fail’.

Mr Tucker made five general points:

  1. The US authorities could resolve most US SIFIs right now on a ‘top-down’ basis pursuant to the powers granted under Title II of the Dodd Frank Act;
  2. Single Point of Entry (SPE) versus Multiple Point of Entry (MPE) may be the most important innovation in banking policy in decades;
  3. There is no such thing as a “bail-in bond”.  Bail in is a resolution tool.  All creditors can face having to absorb losses.  What matters is the creditor hierarchy;
  4. Some impediments to smooth cross-border resolution need to be removed; and
  5. The resolution agenda is not just about banks and dealers.  It is about central counterparties too, for example.

Reorganisation

Mr Tucker noted that Europe is not far behind the US in its enactment of resolution powers.  However, of more interest to the industry will be his belief that most banking groups will have to undergo some kind of reorganisation, irrespective of the camp into which they fall.  SPE groups will need to establish holding companies from which loss-absorbing bonds can be issued.  In addition, key subsidiaries will need to issue debt to their holding companies that can be written down in times of distress.  MPE groups will need to do more to organise themselves into well-defined regional and functional subgroups.  In addition common services, such as IT will need to be provided by stand-alone entities that can survive the break-up of an MPE group.  Capital requirements for regional subsidiaries forming part of an MPE group may also be higher due to the absence of a parent/holding company that can act as a source of strength through a resolution process.

Bail-in

On the subject to bail-in, creditors of SPE groups will be interested to read Mr Tucker’s comments about how, within the context of a top-down resolution, bonds issued by a holding company will absorb losses before debt issued by an operating subsidiary.  In effect, the holding company’s creditors are structurally subordinated to the operating company’s creditors.

Impediments to Resolution

On the subject to impediments to cross-border resolution, Mr Tucker noted that, in order to provide clarity on its previous ‘in principle’ commitment, the Bank of England needs to set down detailed conditions under which it would step aside and allow US authorities to resolve the UK subsidiaries of a US banking group.  In turn, other resolution authorities, and particularly the US, need to make the same ‘in principle’ commitment as the Bank of England.

Extension of the Resolution Regime

Finally, on the subject of the resolution agenda, Mr Tucker confirmed that CCPs are the most important example of where resolution regimes need to apply.  However, he did not rule out resolution regimes being extended to cover shadow banking, funds and SPVs.

Paul Tucker Speech on Resolution

On 20 May 2013, Paul Tucker, Deputy Governor of Financial Stability at the Bank of England gave a speech entitled “Resolution and future of finance” at the INSOL International World Congress in the Hague.

Within the wider context of discussing solutions to the problem of “too big to fail”, the speech gives a useful summary of the ways in which both “single point of entry” and “multiple point of entry” resolution would operate in practice.  It also touches upon the interaction between resolution regimes and bank structural reform, noting the way in which bank ring-fencing, as will be implemented in the UK via the Financial Services (Banking Reform) Bill, represents a back-up strategy to resolution, under which essential payment services and insured deposits would be provided by a “super-resolvable” ring-fenced and separately capitalised bank.  This, it is believed, should make it easier for the UK authorities to “retreat to maintaining at least the most basic payments services” if a preferred strategy of top-down resolution of a whole group could not be executed.

CCP Loss-Allocation Rules Under the Microscope

This is a link to an article in risk magazine regarding CCP recovery planning, and specifically loss allocation rules.

The article highlights differing views within the market regarding the extent to which loss-allocation rules within a recovery (but not necessarily a resolution) scenario should be flexible or prescriptive in nature.  The article points to a paper published by the Bank of England in April 2013, which states that loss-allocation rules should provide a full and comprehensive description of the way in which losses would be allocated and be capable of being implemented quickly.

CCP loss-allocation rules play an important part in the recovery of financial market infrastructures, such as CCPs.  However, as the CPSS/IOSCO paper on Recovery and resolution of financial market infrastructures makes clear, they are not one and the same thing.  General recovery planning options must remain flexible in nature so as to allow firms to respond appropriately to financial stress scenarios the exact nature of which are impossible to determine before the event.  Nonetheless, account must be taken of clearing members, given their systemic importance and the need for them to be able to effectively manage their own risks.  As such, it must surely be the case that CCP loss allocation rules applied as part of the recovery process must provide a clear, detailed and transparent description of the way in which clearing members which would be liable for shortfalls at the CCP.

CCP Loss Allocation Rules

This is a link to an interesting paper published by the Bank of England relating to CCP loss allocation rules (first spotted over on The OTC Space).  The paper explains the reasons why CCPs must maintain a matched book at all times and the process typically followed on the occurrence of a clearing member default.  It also provides a useful discussion of the pros and cons associated with various loss-allocation options (particularly around cash calls from clearing members, margin haircutting and contract tear-up) as well as a helpful summary of existing loss-allocation rules of various CCPs, presented in tabular form.

Although it doesn’t provide any answers, the paper does proffer a set of principles, designed to guide CCPs in designing loss-allocation rules.  It notes that the Bank of England will have regard to these principles in assessing the suitability of CCPs’ loss-allocation rules.  In summary, the principles state that:

  • loss-allocation rules should provide a full and comprehensive description of the way in which losses would be allocated – they should be clear, transparent and capable of being implemented quickly;
  • tear-up of contracts should be a last resort to prevent the disorderly failure of the CCP;
  • where tear-up is used, it should as far as possible be isolated to the affected clearing services so as to limit the risk of contagion;
  • loss-allocation rules should positively incentivise participation by clearing members (for example in auctions) and avoid incentives to resign membership (which may prove to be destabilising);
  • loss-allocation rules should not disincentivise effective risk management by CCPs, for example by imposing losses solely on participants and not shareholders; and
  • loss-allocation rules should not compromise the CCP’s risk management of open positions, for example by ensuring the replacement of initial margin which has been made subject to a haircut.

HM Treasury to Extend Special Administration and Resolution Regimes

On 25 April 2013, HM Treasury published a consultation paper on the introduction of a Special Administration Regime (SAR) for inter-bank payment systems (such as Bacs, CHAPS, Continuous Linked Settlement, CREST, LCH Clearnet Ltd, Faster Payments Service and ICE Clear Europe), operators of securities settlement systems (CREST being the only example in the UK) and key service providers to these firms (e.g. IT and telecommunications providers).  Responses are requested by Wednesday 19 June 2013.

The SAR would be a variant of a normal corporate administration and would be modelled on the special administration framework used in the utilities industries and the investment bank SAR.  However, it would be modified to allow the Bank of England to exercise control of the SAR process, to enable a special administrator to transfer all or part of the business to an aquirer on an expedited basis, and to facilitate the enforcement of restrictions on early termination of third party contracts.  Under the SAR, the special administrator would have the overarching objective of maintaining the continuity of critical payment and settlement services in the interest of UK financial stability. “Non-CCP FMI”, such as exchanges and trade repositories, and entities already covered by resolution powers for central counterparties (such as LCH and ICE) would be excluded from the regime.

On 25 April 2013, HM Treasury also published a statement confirming the fact that, before the end of the summer, it will consult on the extension of the special resolution regime (SRR) established under the Banking Act 2009 to group companies, investment firms and UK clearing houses.

FSA Updates RRP Guidance

The FSA has published an update to its Recovery and Resolution Planning (RRP) guidance dated 20 February 2013.

It expects to publish formal RRP rules “soon” after the FSA hands responsibility over to the Prudential Regulation Authority on 1 April 2013.  An updated RRP information pack for firms can be expected soon thereafter with subsequent updates aimed at aligning UK domestic requirements with Financial Stability Board guidance and the EU Recovery and Resolution Directive also expected.

In light of the experience of RRP submissions to date and international policy development, the FSA update also details the following two policy changes:

  • firms will be required to update recovery plans annually as part of their normal risk management procedures and submit it to supervisors for review when requested; and
  • firms will not have to update their resolution information pack (RRP Modules 3-6) on an annual basis as a matter of process. Instead, they should respond to requests for resolution planning information from their supervisors.

“2013 is the year when we re-set our banking system…”

…said George Osborne in a speech to staff at JP Morgan in Bournemouth yesterday.  According to the Chancellor, the reset button comprises four main elements:

  • The transfer of responsibility for banking supervision from the FSA back to the Bank of England, which will have the “power to call time before the party gets out of control”;
  • The ringfencing of retail banking from investment banking;
  • Changing the culture and ethics of the banking industry; and
  • Giving customers more choice in their receipt of banking services.

Ringfencing

On the subject of ringfencing of retail banking, Mr Osborne confirmed that the Banking Reform Bill was published yesterday.  The bill is based on the recommendations of the Vickers Report and will require the creation of a ringfence around the retail arms of banks, enabling essential operations to continue in the event that the whole bank fails.  If a bank flouts the rules, the Bank of England and the Treasury will have the power to break it up altogether.  Mr Osborne expects the bill to be passed into law this time next year.  In addition, the Chancellor announced that:

  • A high street bank will be required to have different bosses from its investment bank;
  • A high street bank will manage its own risks, but not the risks of its investment bank; and
  • Investment banks will not be allowed to use retail savings in order to fund “risky investments”.

Increased Choice

On the subject of increased choice, the Chancellor announced that the Government would bring forward detailed proposals to open up payment systems, ensuring that new players in the market can access these systems in a “fair and transparent way”.  The implication is that responsibility for supervision of payment systems will be taken away from the Payments Council, a bank-led body.

Osborne Promises to Electrify the Ringfence

The FT reports that George Osborne will today make clear that any bank which attempts to circumvent the ringfencing rules, proposed as part of the Vickers Report and published today in the form of the Banking Reform Bill, faces the prospect of separation in full by the Bank of England.

FDIC and BoE Publish Strategy Paper on Resolution Plans

Introduction

On 10 December 2012, the Federal Deposit Insurance Corporation (FDIC) and the Bank of England (BOE) published a joint strategy paper on the resolution of globally active, systemically important, financial institutions (G-SIFIs).

Broadly speaking, there are two main approaches to the resolution of G-SIFIs:

  • “Single point of entry” (or “top down”) resolution pursuant to which a single national resolution authority applies resolution powers to the parent company of a failing financial group; or
  • “Multiple point of entry” resolution whereby resolution powers are applied to different parts of a failing financial group by two or more resolution authorities in coordination.

The paper focuses on “top-down” resolution with respect to both UK and US cross-border financial services groups.  The key advantage of “top-down” resolution is seen as being the ability for viable subsidiaries, both domestic and foreign, to continue to operate.  Not only should this limit contagion but it will hopefully mitigate cross-border complications arising as a result of the institution of separate territorial and entity-focused insolvency proceedings.  However, it is expressly recognised that there are certain circumstances where “multiple point of entry” resolution will be necessary, for example where losses are so great that they could not be absorbed by a group level bail-in or make the job of valuing the capital needs of the institution in resolution too difficult.

US approach to single point of entry resolution

The sequence of events with respect to a US single point of entry resolution is as follows:

Appointment of Receiver

The FDIC is appointed receiver of the parent holding company of the failing financial group.

Asset Transfer

The FDIC transfers assets (primarily equity and investments in subsidiaries) from the receivership estate to a bridge financial holding company.  In contrast, shareholder claims and claims of subordinated and unsecured debt holders remain in the receivership.  As such, the assets of the bridge holding company will far exceed its liabilities.

Valuation

A valuation process is undertaken so as to estimate the extent of losses in the receivership and allow their apportionment to shareholders and unsecured creditors in accordance with insolvency rankings.

Bail-In

Bail-in occurs to ensure that the bridge holding company has a strong capital base.  So as to provide a cushion against future losses, remaining debt claims are converted in part into equity claims in the new operation and/or into convertible subordinated debt.  Any remaining debt claims are transferred to the new operation in the form of new unsecured debt.

Liquidity Concerns are Addressed

To the extent that liquidity concerns have not been addressed by the transfer of equity and investments in operating subsidiaries to the bridge holding company, the FDIC can provide assurances of performance and/or limited scope guarantees.  As a last resort, the FDIC may also access the Orderly Liquidation Fund (OLF), a fund within the U.S. Treasury set up under the Dodd-Frank Act.  However, the Dodd-Frank Act prohibits the loss of any taxpayer money in the orderly liquidation process.  Therefore, any OLF funds used must either be repaid from recoveries on the assets of the failed financial company or from assessments made against the largest, most complex financial companies.

Firm is restructured

In this stage, the focus will be on making the failed firm less systemically important and more resolvable.  Senior management are likely to be removed at this point.

Ownership Transfer

The final stage of the process is to transfer ownership and control of the surviving operation to private hands.

UK approach to single point of entry resolution

The sequence of events with respect to a UK single point of entry resolution is as follows:

Equity/Debt Transfer

Initially, existing equity and debt securities will be transferred to an appointed trustee.

Listing Suspension

Subsequently, the listing of the company’s equity securities (and potentially debt securities) would be suspended.

Valuation

A valuation process would then be undertaken in order to understand the extent of the losses expected to be incurred by the firm and, in turn, the recapitalisation requirement.

Bail-In

Following valuation, an announcement of the terms of any write-down and/or conversion pursuant to the exercise of bail-in powers would be made to the previous security holders.  In writing down losses, the existing creditor hierarchy would be respected.   Inter-company loans would be written down in a manner that ensures that the subsidiaries remain viable.  Deposit Guarantee Schemes would also be bailed-in at this point.  At the end of the process, the firm would be recapitalised and would likely be owned by its original creditors.

Liquidity Concerns are Addressed

So as to mitigate liquidity issues and facilitate market access, illiquid assets could be transferred to an asset management company to be worked out over a longer period.  In the event that market funding was simply not available, temporary funding could be provided by authorities on a fully collateralized, haircut, basis.  However, any losses associated with the provision of such temporary public sector support would be recovered from the financial sector as a whole.

Firm is Restructured

On completion of the bail-in process, the firm would be restructured to address the causes of its failure.

Re-Transfer

Subsequently, the trustee would transfer the equity (and potentially some debt) back to the original creditors of the firm.  Any creditors which are unable to hold equity securities (e.g. due to mandate restrictions) would be able to request that the trustee sell the equity on their behalf.

Resumption of Trading

The final stage of the process would involve the dissolution of the trust and the resumption of trading in the equity and/or debt securities of the restructured firm.

Similarities Between the Regimes

Both approaches emphasise the importance of ensuring the continuity of critical services of the failing group, whether in the home jurisdiction or abroad.  Shareholders under both regimes can expect to be wiped out and unsecured debt holders can expect their claims to be written down (to reflect any losses that shareholders cannot cover) and/or partly converted into equity (in order to recapitalise the entity in question).  Existing insolvency hierarchies will be respected, but in both cases, a valuation process will be required.  The precise mechanics of any such valuation are unlikely to be the same across both the UK and the US, but consideration is being given in both jurisdictions as to the extent to which the valuation process can be prepared in advance.  Not only would the valuation process assess the losses that a firm had incurred and what financial instruments (if any) the different classes of creditors of the firm should receive, but it would also assess the future capital needs of the business necessary to restore “confidence” in the firm.  It seems likely that this will be a level significantly higher than that required simply to restore viability.  In both cases, resolution will be accompanied by an restructuring of the business.  This may involve breaking an institution into smaller, less systemically important entities, liquidating or closing certain operations and a replacement of management.

The future

The high level strategies detailed by the FDIC and BOE will be translated into detailed resolution plans for each firm during the first half of 2013. It is anticipated that firm-specific resolvability assessments will be developed by the end of 2013 on the basis of the resolution plans.

Bank of England Provides its Take on Bail-In

Introduction

The Bank of England (BoE) has published a speech given by Andrew Gracie, Director of the BoE’s Special Resolution Unit, to the British Bankers’ Association on 17 September 2012 entitled “A practical process for implementing a bail-in resolution power”, a summary of which is provided below.

By way of introduction, Mr Gracie noted that bail-in was only one among a suite of resolution tools, but that it may be of particular use in resolving G-SIFI’s whose operations are too large, complex or interconnected to resolve without threatening critical functions (although he also recognised that there may be cases where the failure of a firm is so comprehensive as to mean that it would need to be wound down instead of being bailed-in).  Nonetheless, Mr Gracie warned that, whilst it can be valuable in restoring a firm’s solvency and so allowing critical functions to continue during a reorganisation, bail-in alone cannot restore a firm’s viability.

Principles behind the exercise of the bail-in tool

Any exercise of the bail-in tool would have to:

  • respect creditor hierarchies;
  • protect secured claims and netting arrangements;
  • be proportionate (in order to minimise the risk of compensation claims);
  • be clear and transparent to creditors; and
  • satisfy clearly defined public interest objectives (e.g. the maintenance of financial stability and the protection of depositors).

The trigger for bail-in

Bail-in would only be used if a firm had reached the point of non-viability i.e. where a supervisory authority identifies that the institution is:

  • failing or likely to fail, and
  • no other solution, absent the use of resolution tools, would restore the institution to viability within a reasonable timeframe.

Bail-in in practice

Assuming that the pre-resolution efforts of a firm to restore its own viability had failed, Mr Gracie identified four stages in the application of the bail-in tool.

1. Stabilisation

Stabilisation of a firm would include some or all of the following steps:

  • suspension of the listing and trading of the firm’s shares and debt;
  • Communication with all stakeholders, confirming:
    • that the firm had reached the point of non-viability and had met the conditions for resolution;
    • the broad resolution strategy for the firm;
    • the range of liabilities that would be completely written down without conversion;
    • the range of liabilities that would be subject to potential write-down and/or fully or partially converted into equity;
    • that the firm would be restructured;
    • that all of the firm’s core functions would continue without disruption;
    • that any insured depositors would be fully protected; and
    • the proposed timing for the announcement of the final terms for the bail-in (including the final extent of creditor write-downs, and rates of conversion to equity).

2. Valuation and exchange

Immediately following the stabilisation phase, a valuation exercise would need to be carried out in order to determine the extent of losses incurred or likely to be incurred by the firm.  In turn, this would be used to calculate the appropriate terms of the bail-in.  Subsequently, the creditors identified in the stabilisation announcement would be subject to write-downs in an aggregate amount sufficient to cover all of the firm’s losses.  Next, the authorities would determine the amount of capital that would be necessary to help restore the firm to viability. This amount would likely exceed minimum prudential capital requirements in order to ensure market confidence in the firm.  The actual recapitalisation would be effected by the conversion of eligible liabilities into equity.

In passing, Mr Gracie confirmed the BoE’s objection to the principle enshrined within the RRP Directive requiring, at all times, the pari passu treatment of creditors within the same class.  Rather, the BoE believes that it is important for resolution authorities to retain some discretion in deciding which liabilities to bail-in, to take account of any potential adverse impact on the stability of the financial system.

3. Relaunch

Once the valuation had been completed, and creditors written-down as appropriate, equity would need to be transferred to affected creditors as a quid pro quo for the recapitalisation. This could be effected by the issuance of new shares or by the transfer of existing de-listed shares from shareholders who had been fully written down.  At this point, trading of the firm’s equity and debt in the primary market could resume.  In the event that it was subsequently found that any bailed-in creditor or shareholder had suffered a loss greater than that which would have occurred on the insolvency of the firm, an ex-post adjustment mechanism would be applied to the capital structure of the firm in favour of the affected party by way of compensation.

4. Restructuring

Any relaunch would be accompanied by a “concrete and effective” restructuring strategy.  In the simplest cases this strategy may take a matter of months to implement, but may take much longer in relation to more complex failures.  Any strategy would be designed to prevent disruption to critical economic functions while also addressing the causes of the firm’s failure.  In all instances, culpable management would be replaced.