Too Physical to Fail? Regulators Turn Attention to Commodities Houses

This is a link to an article in Risk Magazine discussing the systemic risk posed by commodity houses such as Cargill, Noble Group, Glencore Xstrata, Trafigura and Vitol.

The FSB has commissioned a study into the potential systemic risk posed by commodity trading houses, citing their involvement in  ‘shadow banking’ activities, such as lending and securitisation, as a cause for concern.  In addition, by the end of 2013, it is also due to publish guidelines for identifying non-bank, non-insurance Global Systemically Important Financial Institutions.

Whilst ‘prepayment transactions’, in which commodities houses pay cash upfront for a commodity to be delivered over time, do act as a source of financing it is generally thought that these deals are designed to provide access to additional commodity flows and do not represent lending for the sake of lending.  In addition, whilst some commodities houses, such as Trafigura, have a programme for the securitisation of trade finance receivables, the scale of these activities is currently very limited compared to those of banks.  Furthermore, in contrast to bank securitisations, it seems that commodity house securitisations tend not to involve a potentially dangerous maturity mismatch, whereby long term assets are financed by short-term money.

The article also makes reference to the joint report issued on 9 July 2013 by the Centre for European Policy Studies and the European Capital Markets Institute (ECMI), which concluded that larger commodity trading houses had grown to the point where their sheer size and importance in physical markets meant that they would have to be bailed out if they went bankrupt in order to avoid widespread disruption to commodity markets.  However, the structure of commodities markets, in which producers can go directly to consumers, would suggest that the failure of a commodity trading house would not have such a significant impact on supply security.  Furthermore, this view is supported by history, with the bankruptcy of Enron and Andre & Cie in 2001, Amaranth Advisors in 2006 and Petroplus in 2012 suggesting that disruption to markets may be limited.

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

RRP for Non-Banks – Is Your Data Up to Scratch?

On 12 August 2013, the Financial Stability Board published a consultation document regarding the “Application of the Key Attributes of Effective Resolution Regimes to Non-Bank Financial Institutions”, inviting comments by 15 October 2013.

The consultation document proposes draft guidance on how the Key Attributes should be implemented with respect to systemically important non-bank financial institutions.  It deals with three main areas:

  • The resolution of financial market infrastructure (FMI) and systemically important FMI participants;
  • Resolution of insurers; and
  • Client asset protection in resolution.

The proposed rules are, to a large extent, little more than the formalisation of existing thought and best practice regarding the resolution of non-bank financial institutions.  However, this does not detract from the value of the document.  Indeed, it highlights the practical challenge that institutions which are subject to the rules will face in providing the data necessary to facilitate the implementation of resolution measures by regulators.

Both FMIs and insurers will be required to maintain information systems and controls that can promptly produce, both in normal times and during resolution, all data needed for the purposes of timely resolution planning and resolution.  In the case of FMIs, this will include:

  • Information on direct and indirect stakeholders, such as owners, settlement agents, liquidity providers, linked FMIs and custodians;
  • Exposures to each FMI participant (both gross and net);
  • Information on the current status of obligations of FMI participants (e.g. whether they have fulfilled their obligations to make default fund contributions);
  • FMI participant collateral information, such as:
    • location;
    • holding arrangements; and
    • rehypothecation rights; and
    • netting arrangements.

Insurers will also be required to generate data regarding:

  • sources of funding;
  • asset quality and concentration levels; and
  • derivatives portfolios.

In addition, any entity holding client money, must have the ability to generate a wide variety of data that would facilitate its speedy return in a resolution scenario.  That data must be in a format understandable by an external party such as a resolution authority or an administrator and includes information on:

  • the amount, nature and ownership status of client assets held by the firm (directly or indirectly);
  • the identity of clients;
  • the location of client assets;
  • the identity of all relevant depositories;
  • the terms and conditions on which client assets are held;
  • the applicable type of segregation (e.g. “omnibus” or “individual”);
  • the effects of the segregation on client ownership rights;
  • applicable client asset protections (particularly where client assets are held in a foreign jurisdictions);
  • any waiver, modification or opting out by a client of the client asset protection regime;
  • the ownership rights of clients and any potential limitations to those rights;
  • the existence and exercise of rehypothecation rights; and
  • outstanding loans of client securities arranged by the firm as agent, including details of:
    • counterparties;
    • contract terms; and
    • collateral received.

If the experience of banks is anything to go by, the capture, analysis, delivery and updating of this type of data is a significant undertaking.  The FSB is clearly laying out its intentions and the direction of travel on this issue.  As such, non-bank financial institutions would do well to start analysing their capabilities in these areas, with a view to upgrading their data architectures where necessary.

Legislation Update

On 3 June 2013, the EU Commission published an updated summary detailing the timetable for certain legislative proposals and non-legislative acts that it expects to adopt between 28 May 2013 and 31 December 2013.  Of most note are the following:

 

Initiative

Current Adoption Date

Previous Adoption Date (per April/May summary)

Regulation on a single resolution authority and a single resolution fund within a Single Resolution Mechanism

July 2013

No reference

Directive/Regulation on the reform of the structure of EU banks (the Liikanen Reforms)

October 2013

Q3 2013

Framework for crisis management and resolution for financial institutions other than banks

November 2013

No reference

 

G-SII List Delayed

Risk Magazine is reporting that the initial list of global systemically important insurers (G-SIIs), originally due to be published in April 2013 by the Financial Stability Board (FSB) and the International Association of Insurance Supervisors (IAIS), has now been delayed until the end of Q2 2013.

Elsewhere, the FT is reporting that the IAIS is set to publish proposals on Wednesday which will mean the G-SIIs will not be subject to capital surcharges on their entire balance sheets, but only on that part of the balance sheet which constitutes non-traditional non-insurance business.  Moreover, insurers that take steps to segregate these businesses in separately capitalised entities will be subject to lower charges than those that allow co-mingling with other business lines to take place.

Defining Systemic Importance for Insurers

On 12 February 2013, Julian Adams, FSA Director of Insurance, gave a speech at the Economist Insurance Summit in London on the lessons for insurance supervisors from the financial crisis.

Mr Adams explained that the overall objective of the FSA is to create an environment in which no insurer is too big, too complex or too interconnected to fail, and where participants are able to exit the market in an orderly fashion which ensures continuity of access to critical services.

He noted that the UK currently does not have a resolution regime for insurers, instead relying on ‘run-off’, Schemes of Arrangement and formal insolvency.  However, each of these options carries attendant risks meaning that it is necessary to at least consider whether a resolution regime for insurers in necessary.  Any such regime would be consistent with the Financial Stability Board’s ‘Key Attributes’ document and would also take a lead from the International Association of Insurance Supervisors, which is due to publish its initial list of Globally Systemic Important Insurers in the summer of 2013.  The key challenge is to recognise the specificities of insurance compared to other financial sectors – particularly the factors that make an insurer ‘systemically important’.  On this topic, Mr Adams highlighted three issues:

Use of Leverage – such as:

  • engaging in stock lending in order to invest proceeds in higher yielding (and therefore higher risk) paper; or
  • facilitating borrowing by non-insurance group members on the strength of an insurance business;

Asset Transformation – such as the sale of long-term investment products by life insurance companies; or

Assumption of Credit Risk – such as:

  • the securitisation of corporate paper; or
  • the funding of annuity liabilities through exposure to subordinated corporate debt.

If the answer to any one of these questions, alone or in combination, is positive then the FSA would “consider carefully” whether the firm in question was systemically significant.

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.

ISDA Responds to EU Commission Consultation on RRP for Non-banks

On 23 December 2012, ISDA published a letter sent in response to the EU Commission’s Consultation on a possible recovery and resolution framework for financial institutions other than banks.

ISDA’s response focuses mainly on RRP for Central Clearing Counterparties (CCPs).  It believes that a common resolution framework should apply to all FMIs (and not just to those which exceed specific thresholds in terms of size, level of interconnectedness etc.).  To the extent that an FMI is also a credit institution, ISDA believes that this framework should apply above and beyond the RRP requirements applicable to banks.

ISDA agrees that the general objective for the resolution of FMIs should be continuity of critical services and that any RRP framework should emphasis the issues of recovery and continuity over that of resolution.  More specifically, ISDA emphasises that any RRP initiative should be consistent with seven key principles as set out below.

1. CCP loss allocation procedures must be certain, transparent and avoid unlimited liability for Clearing Members

ISDA asserts that limited liability for clearing members will promote financial stability as it will reduce incentives to “rush for the exits” during a period of stress.  Loss allocation procedures which are not consistent with this principle, such as forced tear-ups and uncapped default fund liability should be avoided.  In addition, ISDA believes that it is unrealistic to think that indirect participants and clients of clearing members can be shielded from losses, although it believes that the specifics of this aspect are best dealt with as a matter of direct agreement between counterparties and to relevant conduct-of-business regulations.

2. CCP loss allocation rules should be respected and applied prior to implementation of resolution

ISDA believes that resolution should only be triggered after an FMI’s agreed and documented recovery arrangements have been given the opportunity to succeed an only after consultation (however brief) with market participants.

3. Any framework must be consistent with CPSS-IOSCO FMI RRP principles

ISDA believes that the ultimate success of any RRP initiative is dependent on the creation of a globally consistent standard.

4. The relationship between recovery and resolution of CCPs must be clear, predictable and transparent

Resolution should only occur when it is where it is ‘necessary’ (rather than merely ‘desirable’) to address a serious threat to financial stability.  This arises when an FMI has reached the point where there are no realistic prospects of recovery over an appropriate timeframe, when all other intervention measures have been exhausted, where additional losses arise from a source for which there are no CCP rules, and when winding up the institution under normal insolvency proceedings would risk causing financial instability.

In the interests of predictability, there should be no ability for authorities to intervene before an FMI meets the conditions for resolution.  Rather pre-resolution actions of a supervisor should be limited to providing guidance and ensuring the effective implementation of the FMI’s own procedures.

5 Robust procedures for the transfer of membership agreements and positions must exist

Procedures regarding the porting of positions to a solvent FMI must be established before the event and tested periodically.  In addition, any transfer must be done in a way that does not interfere with members’ existing rights to net exposures against a CCP.  More specifically, ISDA believes that the power to impose a temporary stay on the exercise of early termination rights is not necessary in the context of a failing FMI.  Moreover, it regards the ability to enforce a moratorium on payments beyond a “very limited grace period” as a potentially “dangerous” tool, which should only be available on an exceptional basis when a CCP has non-cash collateral which it is unable to convert into cash as quickly as necessary.  However, as a last resort only, ISDA regards it as “entirely appropriate” for CCPs to include within their recovery provisions the possibility of terminating a particular product set if this is necessary in order to restart a particular market or avoid the effects of contagion.

6 Co-operation and co-ordination between authorities is essential

ISDA agrees that strong cross-border cooperation and coordination, both before and during resolution, are essential to the successful resolution of a failed FMI, with the failing FMI’s national resolution authority taking the lead coordinating role.  Fundamentally, however, it believes that the CPSS, IOSCO and FSB should move beyond existing international RRP standards and adopt a substantive international convention on the resolution of cross-border financial institutions, such as was recommended by the International Institute of Finance in its June 2012 paper entitled “Making Resolution Robust – Completing the Legal and Institutional Frameworks for Effective Cross-border Resolution of Financial Institutions”.

7 Safeguards: Netting and collateral arrangements must be protected throughout resolution

ISDA believes that intervention powers cannot be unfettered or apply retrospectively.  Rather, they should contain restrictions on the transfer of part only of a CCP’s business in a way that interferes with members’ netting rights.  In addition, it is essential that the hierarchy of claims in insolvency be respected and that creditors should not be worse off than in insolvency.

IAIS consults on policy measures for global systemically important insurers

Introduction

On 17 October 2012, the International Association of Insurance Supervisors (IAIS) published a consultation document relating to proposed policy measures for global systemically important insurers (G-SIIs) i.e. insurers whose distress or disorderly failure would cause significant disruption to the global financial system.

The consultation remains open until 16 December 2012 and details policy measures designed to reduce the probability and impact of G-SII failure as well as to incentivise G-SIIs to become less systemically important and non G-SIIs not to become G-SIIs.  The policy measures are broken down into three main categories:

  • Enhanced supervision;
  • Effective resolution; and
  • Higher loss absorption (“HLA”) capacity.

Enhanced Supervision

Non-traditional and non-insurance (NTNI) activities of G-SIIs, such as derivates trading, are regarded as particular sources of systemic risk.  Within most G-SIIs, NTNI activities are carried out within separate group companies.  As such, it is necessary for supervisors of G-SIIs to have group-wide supervision powers.  Within this context, enhanced supervision will take the form of:

  • Enhanced liquidity planning and management; and
  • Systemic Risk Reduction Plans.

Enhanced Liquidity Planning and Management

G-SIIs will be required to have adequate arrangements in place to manage group liquidity risk, primarily in relation to NTNI activities and channels of interconnectedness.

Systemic Risk Reduction Plan

In addition to maintaining recovery and resolution plans (RRPs), G-SIIs will be required to develop Systemic Risk Reduction Plans (SRRP).  The purpose of an SRRP is to shield traditional insurance business from NTNI business (and vice versa), reduce the systemic importance of the G-SII and improve resolvability.  Where appropriate, an SRRP should include ex-ante measures to ensure the effective separation of systemically important NTNI activities from traditional insurance business into standalone, regulated entities.  GSIIs must ensure that any entities created as a result of this process do not benefit from subsidies in the form of capital and/or funding and are:

  • Structurally self-sufficient: meaning that the entity could be liquidated without impacting the remaining group and that intra-group transactions such as guarantees  and cross-default clauses are either prohibited or at a minimum adequately monitored and restricted; and
  • Financially self-sufficient: meaning that the entities in question are adequately capitalised.

 In addition, the following specific policy measures should be considered:

  • Direct prohibition or limitation of systemically important activities;
  • Requirements for prior approval of transactions that fund or support systemically important activities;
  • Requirements for spreading or dispersing risks relating to systemically important activities; and
  • Limiting or restricting diversification benefits between traditional insurance business and other businesses.

 Effective resolution

The FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” (Key Attributes) details the specific resolution requirements for all G-SIFIs and forms the basis for improving G-SII resolvability.  These requirements include:

  • The establishment of Crisis Management Groups (CMGs);
  • The elaboration of recovery and resolution plans (RRPs);
  • The conduct of resolvability assessments; and
  • The adoption of institution-specific cross-border cooperation agreements.

However, measures to resolve G-SIIs must also account of the specificities of insurance including:

  • Measures needed to separate NTNI activities from traditional insurance activities;
  • The possible use of portfolio transfers and run off arrangements as part of the resolution of entities conducting traditional insurance activities; and
  • The existence of policyholder protection and guarantee schemes (or similar arrangements).

Higher loss absorption (HLA) capacity

The IAIS proposes a cascading approach to increasing HLA capacity.  Initially, higher HLA requirements would be targeted on specific G-SII group entities depending on the extent to which it had demonstrated effective separation between traditional insurance and NTNI activities, with additional capital being required in relation to activities that have the potential to generate or aggravate systemic risk (e.g. NTNI businesses).  Subsequently, an assessment of the adequacy of group HLA levels would also be performed.  This would take into account the level of HLA in individual group companies and any entity separation that exists, but only where that HLA was not created by multiple-gearing through down streaming capital within the G-SII.  However, the IAIS acknowledges that there is an on-going internal discussion as to whether this subsequent step is required if targeted HLA and other measures (such as restrictions and prohibitions) are effective in reducing systemic importance to an acceptable level.  In all cases, higher HLA capacity could only be met by “the highest quality capital”, being permanent capital that is fully available to cover losses of the insurer at all times on a going-concern basis.

Implementation time frame

A detailed timeline for the implementation of G-SII policy measures is detailed below:

Key Implementation Dates and Timeframes

Action Required

 

April 2013

First G-SIIs designated (with annual designations thereafter   expected each November)

From 2013

Implementation of enhanced supervision and effective resolution   commences

End 2013

IAIS   to elaborate proposed HLA capacity measures

Within 12 months of designation

Crisis   Management Groups (CMGs) to be established

Within 18 months of designation

Other   resolution measures to be completed

Within 18 months of designation

Systemic   Risk Reduction Plan (SRRP) to be completed

Within 36 months of designation

Implementation of SRRP to be assessed

November 2014 to 2016

G-SIIs   designated annually (with HLA not applicable until 2019)

November 2017

G-SIIs   designated based on 2016 data (with HLA applicable from 2019)

January 2019

HLA   capacity requirements apply based on assessment of implementation of the   structural measures

 

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.