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.

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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.