Battle Lines Drawn Over CCP Resolvability

Introduction

In the context of the continuing industry and regulator discussion regarding CCP resolvability, last week ISDA published a position paper entitled “CCP Loss Allocation at the End of the Waterfall”.  The paper addresses two scenarios:

  • “Default Losses” – i.e. losses that remain unallocated once the ‘default waterfall’ is exhausted following a clearing member (“CM”) default; and
  • “Non-default Losses” – i.e. losses that do not relate to a CM default but exceed the CCP’s financial resources above the minimum regulatory capital requirements.

Default Losses

ISDA recognises the importance of central clearing for standard OTC derivatives, the difficulty of achieving optimal CCP recovery and resolution and the fact that no loss allocation system can avoid allocating losses to CMs.  It takes the view that residual CCP losses should be borne not by the taxpayer, nor solely by surviving CMs who as guarantors have no control over losses.  Rather, ISDA believes that all CMs with mark-to-market gains since the onset of the CCP default should share the burden of CCP losses.  Accordingly, ISDA is an advocate of Variation Margin Gains Haircutting (“VMGH”) being applied at the end of the default waterfall.

Under a VMGH methodology, the CCP would impose a haircut on cumulative variation margin gains which have accumulated since the day of the CM default.  In doing so, ISDA believes that:

  • losses fall to those best able to control their loss allocation by flattening or changing their trade positions;
  • CMs with gains at risk are incentivised to assist in the default management process; and
  • in the event that the CCP runs out of resources, VMGH mimics the economics of insolvency.

ISDA believes that a VMGH methodology should not have an adverse impact on the ability of a CM to net exposures or gain the appropriate regulatory capital treatment for client positions held at the CCP[1].  In contrast to contractual tear-up provisions or forced allocation mechanisms, VMGH allows a CM to assume that its portfolio of cleared transactions outstanding as of any given date will be the same as of the point of a CCP’s insolvency (because there is no mechanism by which they can be extinguished prior to any netting process).  As such, because it has certainty with respect to its legal rights in the CCP’s insolvency, the CM should be able to conclude that netting sets remain enforceable.  In addition, to the extent that VMGH provides incremental resources to the CCP, ISDA believes that it effectively protects initial margin held at a CCP and therefore strengthens segregation.

In theory, VMGH should always be sufficient to cover a defaulting CM’s mark-to-market losses in the same period.  However, if in practice this was not the case (e.g. because the CCP was not able to determine a price for the defaulting CM’s portfolio) and in the absence of other CMs voluntarily assuming positions of the defaulting CM, ISDA advocates a full tear-up of all of the CCP’s contracts in the product line that has exhausted its waterfall resources and has reached 100% haircut of VM gains.  ISDA contends that there should be no forced allocation of contracts, invoicing back, partial non-voluntary tear-ups, or any other CCP actions that threaten netting.  Furthermore, prior to the point of non-viability, ISDA believes that resolution authorities should not be entitled to interfere with the CCP’s loss allocation provisions (as detailed within its rules) unless not doing so would severely increase systemic risk.

Non-default Losses

An example of Non-default Loss (“NDL”) would be operational failure.  ISDA views NDL in a different light to Default Losses believing there to be no justification for reallocating NDL amongst CMs and other CCP participants.  Accordingly, it does not believe that VMGH (or similar end-of-the-waterfall options) are appropriate for allocation of NDL.  Rather, it considers that NDL should be borne first by the holders of the CCP’s equity and debt.

Conclusion

The ISDA paper is a useful contribution to the ongoing discussion around CCP resolvability.  It suggests a sensible CCP default waterfall,[2] but is probably most noteworthy for its opposition to initial margin (“IM”) haircutting as a resolution tool.  In ISDA’s view, IM haircutting would distort segregation and “bankruptcy remoteness”.  In doing so it would have significant adverse regulatory capital implications and would create disincentives for general participation in the default management process.  In this sense, it adopts the opposite position to that detailed by the Committee on Payment and Settlement Systems (“CPSS”) and the International Organization of Securities Commission (“IOSCO”) in their recent consultative report on the Recovery of financial market infrastructures (see this blog post for more detail).  CPSS/IOSCO see IM haircutting as an effective tool which may facilitate access to a much larger pool of assets than VMGH.

There is general agreement on the principle that the taxpayer should never again have to pick up the tab following the failure of a systemically important firm.  On this basis alone, one suspects that IM haircutting will ultimately be included in the suite of resolution tools, if only to act as additional buffer between derivatives losses and the public purse.  In fairness, it’s difficult to see how a general tear-up of contracts is consistent with one of the underlying goals of CCP resolution – to ensure the continuity of critical services.  Ultimately, however, we will have to wait to see whether the contagion which may result from ISDA’s tear-ups outweighs the regulatory impact associated with CPSS/IOSCO’s IM haircutting.


[1] Pursuant to Article 306(1)(c) of the Capital Requirements Regulation, a CM will likely have to be able to pass on the impact of a CCP default to its clients in order to attract the appropriate regulatory capital treatment

[2] See page 8

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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.

EU Commission Publishes Summary of Responses to Non-Bank RRP Consultation

Introduction

On 8 March 2013, the EU Commission published a summary of the responses (67 in total) it received to its October 2012 consultation on a possible recovery and resolution framework for financial institutions other than banks.  There is also a set of links to individual responses.

The summary addresses views expressed on the three categories of financial Institutions considered in the consultation, being:

  • financial market infrastructures (“FMI”) i.e. central counterparties (“CCP”) and central securities depositories (“CSD”);
  • insurance companies; and
  • other non-bank entities and institutions e.g. payment systems.

Financial Market Infrastructures

There was general agreement on the need for recovery and resolution plans (“RRP”) for FMIs, due to their systemic importance.  Although resolution measures for all FMIs should focus on ensuring the continuity of essential services, the RRP regimes for CCPs and CSDs should be tailored, reflecting the general view that CCPs are more systemically important than CSDs.  Both the RRP regimes for CCPs and CSDs should be different from the current proposals regarding RRP for banks, although powers to transfer operations of a failing FMI to a purchaser or bridge entity would still be required.  There was little common ground on the application of loss allocation to FMI beyond the need for predictability, clarity, preciseness, transparency and parity.

Insurance and Reinsurance Firms

There was a wide-spread recognition that insurance companies are less systemically important that banks and that Solvency II will enhance supervisors’ powers of intervention.  Nonetheless, except amongst insurers, there was general support for further investigation into the scope for resolution tools which could protect policyholders as well as financial stability in the event of an insurer’s failure. However, even outside of the insurance industry, there was no conclusive support as to the need for a detailed RRP framework.  The insurance industry objected to insurance-specific RRP proposals, arguing at a high-level that there is no evidence that RRP is needed and specifically that:

  • as yet, no sources of systemic risk in insurance have been identified;
  • consistency with international developments must be ensured before the EU legislates;
  • the current framework is sufficient, particularly in light of Solvency II; and
  • bank RRP is not suited to the insurance industry.

Other non-bank financial institutions

The majority of respondents expressed the view that payment systems currently do not require further consideration from an RRP perspective due to the fact that they are subject to central bank oversight.

AIMA Questions Systemic Importance of Funds

Introduction

On 11 January 2013, the Alternative Investment Management Association (“AIMA”) published its response to the EU Commission’s Consultation on a Possible Recovery and Resolution Framework for Financial Institutions Other than Banks (the “Consultation”).

Identifying Systemic Importance

AIMA supports the introduction of a robust and effective framework for dealing with the recovery and resolution of systemically important non-bank financial institutions, but believes that neither hedge fund managers nor asset managers are systemically important given their nature, size, activities and structures, as well as the regulatory environment in which they operate.  In contrast, it agrees that central counterparties (“CCPs”) are, in general, systemically important and that national insolvency laws are not adequate to address CCP failures.

Resolution Objectives

AIMA proposes that an alternative resolution objective be adopted in place of the main objective currently within the Consultation i.e. maintenance of critical functions. This alternative objective would stress the need to ensure the rapid and efficient liquidation of all open positions of all CCP members and the timely return of client monies.

Resolution Tools

AIMA is concerned that the tools designed for the resolution of banks or large investment firms are not suitable for CCP resolution.  It also advocates that certain aspects of the Recovery and Resolution Directive (“RRD”) be revisited, proposing that:

  • all CCP clearing members be subject to the RRD;
  • the main objectives of resolution under the RRD are amended to include the continuity of CCP services; and
  • haircuts not be applied to open derivative positions or to margin held by CCPs or clearing members.

AIMA regards the sale of business and asset separation tools as potentially unsuitable for CCPs primarily due to the lack of substitutability between CCPs and the practical difficulties in effecting a transfer of a failed CCPs services to a private sector purchaser.  With respect to the bridge institution tool, AIMA expresses concerns that the sheer operational complexity of CCP activities reduces the likelihood of a successful application of the tool.

AIMA also regards traditional bail-in as being unsuitable to a CCP resolution.  It believes that loss allocation mechanisms for CCPs must avoid the bail-in of open derivative positions held by CCPs and clearing members.  It also regards the haircutting of margin as undesirable, particularly the haircutting of variation margin for ‘in the money’ participants which it views as entirely arbitrary.  It considers that specific liquidity calls on clearing members implies unlimited liability (which may result in higher capital and liquidity charges on clearing members), may exacerbate pro-cyclicality and will potentially promote contagion.  Instead, AIMA stresses the importance of robust pre-failure capitalisation measures and the use of ex-ante resolution funds in order to avoid the need to apply such loss allocation/recapitalisation tools.

Conclusion

AIMA is right to question the application of this legislation to asset managers and hedge fund managers, although its argument that the use of ‘gates’ and ‘side pickets’ are factors which reduce systemic importance is a little difficult to follow at times.  In general, it is not easy to see how funds can legitimately be regarded as systemically important.  However, ‘gates’ and ‘side pockets’ are generally regarded as mechanisms allowing the manager of a fund to manage its liquidity risks, rather than reducing systemic relevance per se.  Indeed, the use of ‘gates’ and ‘side pockets’ can actually amplify systemic risk – particularly in the case of institutional investors unable to redeem investments from affected funds.

With respect to some of the other AIMA proposals, CCP membership itself is not a definitive indicator of systemic importance.  Moreover, whilst AIMA makes a number of valid observations on the subject of loss allocation, there needs to be a recognition that, if ex-ante arrangements fail, losses must be allocated somewhere.  The haircutting of margin, particularly variation margin, is indeed unpalatable.  However, in the absence of an ultimate backstop provided by the taxpayer, we are yet to see a better solution.

EBA Responds to EU Commission’s Consultation on RRP for Non-Banks

On 21 December 2012, the European Banking Authority (EBA) published its response to the EU Commission’s “Consultation on a Possible Recovery and Resolution Framework for Financial Institutions Other Than Banks”.

In general, the EBA believes it important that RRP regimes should be harmonised so as to avoid regulatory arbitrage across borders and between industries such as banking and insurance.  Clear guidance should also be provided on the circumstances and extent to which FMIs which also hold banking licences will be subject to bank or non-bank resolution proposals.  Ultimately, it may be necessary to extend the non-bank RRP proposals to include ‘shadow banking’ entities such as money market funds and hedge funds.

The EBA agrees that the objectives of a resolution regime for FMIs should be aligned with those of banks, namely the continuation of critical functions and the maintenance of financial stability.  Cross-border co-ordination in the form of supervisory Resolution Colleges should also be encouraged.

With respect to resolution tools, the EBA supports the proposal concerning the transfer of critical functions of a failing FMI to a surviving FMI.  In order to facilitate such a transfer, the EBA suggests that ex-ante operational arrangements between FMIs should be established and specifically endorses the actions referred to in the FSB “Key Attributes” paper, namely:

  • A centralised repository for all FMI membership agreements;
  • Standardised documentation for payment services;
  • Draft transition services agreement; and
  • A ‘purchasers’ pack’ including key information on payment operations and credit exposures, and lists of key staff.

With respect to loss-allocation tools, specifically the haircutting of margin held on behalf of clearing members of a failing FMI, the EBA believes that more consideration should be given to the specific circumstances of the clearing member and their ability to actually absorb losses so as to avoid the possibility of financial contagion.  Moreover, any loss-allocation mechanism which goes beyond normal pre-funded loss mutualisation measures (i.e. the guarantee fund) should be closely coordinated with authorities responsible for the supervision and oversight of the clearing members.

On the subject of group resolution of FMIs, the EBA is of the opinion that any recovery and resolution framework should aim to maintain the ‘healthy’ parts of the FMI in question.  In order to protect these ‘healthy’ parts, it may be necessary to wind up or even ‘tear up clearing’ of specific instruments.  In addition, it may be prudent to allow for one part of an FMI group to provide temporary financial support to an FMI in difficulty, provided that this does not risk contagion or involve lending to an insolvent entity.

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.

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.