DB Experience Highlights RRP Challenge

Risk Magazine has published an article in which Deutsche Bank highlights the issues it has experienced in complying with global recovery and resolution plan (RRP) requirements.

This is an all too common story.  The lack of guidance from regulators, absence of globally coordinated regulatory requirements and the move towards subsidiarisation combine to pose a significant challenge to firms which are subject to RRP rules.  From experience, the only real solution lies in the creation of a robust yet flexible data architecture, capable of serving up only that view of information which is necessary for the particular audience and with the capacity to adapt to meet future regulatory developments.

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.

HM Treasury Publishes Draft Annex to SRR Code of Practice

Introduction

On 8 October 2013, HM Treasury published a draft annex on the new bail-in option to the Special Resolution Regime (SRR). The bail-in tool is being introduced through amendments to the Banking Act 2009 by the Banking Reform Bill 2013 for the purpose of offering a new stabilisation option to the Bank of England as lead resolution authority. It will be available to failing banks and investment firms, with necessary modifications to building societies via secondary legislation and under specified conditions to banking group companies.

The draft annex to the Code of Practice supports the legal framework for the SRR and provides guidance as to when and how the bail-in tool may be deployed by authorities in practice.

A summary of the key points include:

General and Specific Conditions for Use of SRR Tools (Section 7)

The conditions for use of the bail-in option are identical to those for the stabilisation options set out in the existing Code :

  • the regulator must determine that the institution is failing or likely to fail;
  • it is not reasonably likely that action will be taken by or in respect of the bank to avoid its failure; and
  • the Bank of England is satisfied that exercising the bail-in power is necessary having regard to the public interest.

When choosing between the original resolution tools, the Bank of England will consider the relative merits of the stabilisation options and the bank insolvency procedure given the circumstances in addition to general considerations . The Bank of England may also choose resolution by way of bail-in for situations where the use of another stabilisation power would threaten financial stability or confidence in the banking systems.

Use of the Bail-in Powers (Section 8)

The bail-in option gives the Bank of England the power to cancel or modify the terms of any contract in a resolution scenario for the purposes of reducing or deferring a liability of the bank (“special bail-in provision”). A conversion power also exists that allows for liabilities to be converted into different forms. Certain liabilities are excluded from the scope of the power to make special bail-in provision including:

  • deposits covered by the Financial Services Compensation Scheme (FSCS) or an equivalent overseas scheme;
  • liabilities to the extent they are secured;
  • client assets, including client money;
  • liabilities with an original maturity of less than seven days which are owed to a credit institution or investment firm (save in relation to credit institutions or investment firms which are banking group companies in relation to the bank);
  • liabilities arising from participation in a designated settlement system and owed to such systems, or to operators or participants in such systems;
  • liabilities owed to central counterparties recognised by the European Securities and Markets Authority (ESMA) in accordance with Article 25 of Regulation (EU) 648/2012;
  • liabilities to employees or former employees in relation to accrued salary or other remuneration (with the exception of variable remuneration);
  • liabilities owed to employees or former employees in relation to rights under a pension scheme (with the exception of discretionary benefits); and
  • liabilities to a creditor arising from the provision of goods or services (other than financial services) that are critical to the daily functioning of the bank’s operations (with the exception of creditors that are companies which are banking group companies in relation to the bank).

Prior to taking resolution action or converting liabilities, resolution authorities are expected to carry out a valuation of the assets and liabilities of the institution as is reasonably practicable.

The UK has chosen to exercise the discretion granted to it under the Recovery and Resolution Directive and has included derivatives in the list of liabilities which can be bailed-in. Specific power to make special bail-in provision to derivatives and similar financial transactions can be found in Sections 8.14 – 8.17 of the Annex. The Bank of England will, where appropriate, exercise its power to close-out contracts before they are bailed in with any applicable close-out netting being taken into account. If a liability is owed, it will be excluded from bail-in so far as it is secured and compensation arrangements will follow the “no creditor worse off” principle. This ensures that no person is worse off as a result of the application of the bail-in option than they would have been had the bank gone into insolvency.

Banking Reform Bill Bulks Up

H.M. Treasury yesterday published 86 proposed amendments to the Banking Reform Bill. The bill is due to enter its committee stage in the House of Lords on the 8th October 2013. The proposed amendments were widely-flagged and broadly mirror the 11th March 2013 recommendations of the Parliamentary Commission on Banking Standards.  Highlights are as follows:

  • Payments: the introduction of a wholly new and distinct payment systems regulator, the intention being to stimulate competition by facilitating access to payment systems for new market participants, as well as decreasing the costs of account portability. A special administration regime to deal with cases where a key element in a payment fails or is likely to.
  • Misconduct: an extension of the FSMA approved persons regime. If passed, the amendments will allow the regulators to: make the approval subject to conditions or time-limits, extend time limits for sanctions against individuals, impose “banking standards rules” on all employees , and to hold senior managers responsible for regulatory breaches in areas which they control. PCBS chairman Andrew Tyrie, (perhaps confusing Ford Open Prison with Guantanamo), had previously advocated putting “guilty bankers in bright orange jump suits”; as widely expected, the proposals introduce criminal sanctions for reckless misconduct in the management of a bank.
  • Electrified ring-fence:  proposed new powers to formalise and streamline the “electrification” power introduced at the Commons report stage. The electricity in the ring-fence is the regulator’s power to compel separation of a banking group which breaches the boundary between retail and investment banking. The effect of the new powers is to make the ring-fence into a “variable-voltage” device. Under the proposal, the regulator will:
  1. issue a preliminary notice, the affected party will have a minimum of  14 days to reply and 3 months to make necessary changes to its behaviour/structure
  2.  failing this and with the consent of the Treasury, a warning notice will then be issued, itself triggering a minimum of 14 days for representations by the affected party
  3. a decision notice is then issued, which may be appealed before a Tribunal
  4.   a final notice is issued which set s a dead line by which a bank must separate its activities

The whole process will take approximately 14 months and the various notices will be issued in accordance with general FSMA principles.

Bail-in:  the introduction of a bail-tool as initially mandated by the European BRRD and recommended by the domestic ICB and PCBS. The Banking Act of 2009 will be amended to include a “stabilisation option” (bail-in), covering banks and investment firms and to be applied by the bank of England as lead resolution authority.  The conditions for its use are identical to those of the Special Resolution Regime:

  1. the regulator must determine that the bank is failing or is likely to fail
  2. it is not likely that any other action can avoid the failure
  3. The BoE determines that application of the bail-in power is in the public interest

The bail-in option includes the right to modify existing contracts for the purpose of mitigating the liabilities of a bank under resolution. There are a number of liabilities which will be excluded from the provision: client money, FSCS protected deposits, employee pension schemes, payment system liabilities, debts to a creditor who is critical to the bank’s daily functioning etc.

In short- the electric ring-fence is reconnected to the mains and bail-in is set to become a reality. These and other less fundamental proposed amendments represent a significant extension of regulatory powers. It remains to be seen if they will be rigorously and consistently applied to their full extent.

RRD Pushed Back Yet Again

On 20 September 2013, the EU Parliament updated its procedure file on the Recovery and Resolution Directive (RRD).  It seems that the RRD proposal will now be considered at the Parliament’s plenary session scheduled for 3 to 6 February 2014, rather than the session scheduled for 18 to 21 November 2013, as was previously the case.

Bob Diamond shines a light on TBTF

Bob Diamond, ex–chief of Barclays writes about the TBTF problem in today’s FT, bemoaning the lack of progress in dealing with this elephant in the financial reform room. He fully supports the consensus opinion that the problem requires: a global resolution system, a level playing field with respect to capital and leverage, and international consistency and coordination. Of greater interest is the FT’s front page article about the article. It quotes Sheila Bair, Chairman of the FDIC, who makes the salient point that TBTF is as much a problem of perception as tangible reality. As long as financial institutions and their counterparties believe that they benefit from an implicit (supra?) sovereign guarantee, the problem will persist. The article quotes Jim Millstein, who led the effort to initially disentangle the AIG can of worms. Despite all the reforms of the past five years, he believes that it would take “10 to 15 years” to identify and unwind the myriad interconnections between large financial institutions.  As a legion of commentators has pointed out since 2008, the problem is not “Too Big to Fail”, it’s more akin to “Too Interconnected to Let Fail”.

FSB Publishes Assessment Methodology for the Key Attributes of Effective Resolution Regimes

On 28 August 2013, the Financial Stability Board (FSB) published a press release announcing the launch of a proposed Assessment Methodology for the Key Attributes of Effective Resolution Regimes for Financial Institutions.  The Key Attributes of Effective Resolution Regimes for Financial Institutions (‘the Key Attributes’) were endorsed by G20 Leaders at the Cannes Summit in November 2011 as the international standard for resolution regimes. The Key Attributes sets out the core elements that the FSB considers to be necessary for an effective resolution regime.

The FSB developed the draft methodology to facilitate the objective and consistent assessment of a jurisdiction’s compliance with the Key Attributes and to assist jurisdictions in the implementation of legislative reforms.  The methodology proposes a set of assessment criteria for each Key Attribute and includes examples and explanatory notes to guide their interpretation.  The FSB welcomes comments on the draft methodology by 31 October 2013.

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

FMI Recovery Continues to Take Centre Stage

On 12 August 2013, the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) published a consultative report on the Recovery of financial market infrastructures (FMI) and a cover note detailing the specific issues on which comment is sought.  The consultation period ends on 11 October 2013.

The report provides guidance to FMIs and authorities on the development of robust recovery plans. It was produced in response to requests for additional guidance following the publication in July 2012 of the CPSS-IOSCO report on Recovery and resolution of financial market infrastructures and supplements the Principles for financial market infrastructures, published in April 2012.  It should also be read in conjunction with the recent Financial Stability Board consultation regarding the Application of the Key Attributes of Effective Resolution Regimes to Non-Bank Financial Institutions (see this blog post for more detail).

The report includes an interesting high-level discussion on the design and use of recovery tools, touching on issues such as:

  • transparency versus flexibility;
  • loss allocation waterfalls;
  • mutualisation of loss versus targeting of losses;
  • the balance between pre-funded and non-prefunded resources;
  • incentivising stakeholders to:
    • manage risk vis-à-vis FMIs;
    • assist in default management processes; and
    • maintain/increase the use of an FMI rather than settle bilaterally.

Recovery tools are separated into five categories:

  • tools to allocate uncovered losses caused by member default;
  • tools to address uncovered liquidity shortfalls;
  • tools to replenish financial resources;
  • tools to allocate losses not related to participant default;
  • tools for central counterparties (CCPs) to re-establish a matched book; and
  • tools to address structural weaknesses (not addressed further in the report).

Tools to allocate uncovered losses caused by member default include:

  • cash calls on participants;
  • position based loss allocation tools;
  • variation margin haircutting; and
  • initial margin haircutting.

There is an interesting discussion as to how cash calls should be calculated – whether fixed or as a proportion of default fund contributions, volumes or positions – and the pros and cons of capped versus uncapped calls.  The potential downsides of this tool are highlighted, particularly the pro-cyclical effects they can have as well as the credit risk inherent within the application of this tool.  Position based loss allocation tools include borrowing funds owed to participants (loans, repos etc.), variation margin haircuts, reduced payouts and contractual tear-ups.  On the plus side, they are generally regarded as being a comprehensive solution to the problem of shortfalls which can be executed immediately and involve no performance risk vis-à-vis the FMI participants.  On the down side, it was noted that they can have a negative effect on participants’ confidence in the FMI.  Variation margin haircutting in particular may not allocate losses to those best able to cope with them.  Initial margin haircutting is also regarded as an effective tool and one which may facilitate access to a much larger pool of assets than variation margin haircutting.  Unfortunately, it is also one which exposes a CCP to risk during the period where initial margin is being replenished, may well have pro-cyclical effects and would likely result in a capital charge for participants (due to the initial margin not being held in a bankruptcy remote manner).

Tools to address uncovered liquidity shortfalls mainly involve obtaining liquidity – either from third-party institutions or from non-defaulting participants.  In the case of the latter, there is a discussion as to whether participants which are owed money by the FMI should be accessed first as they would not be required to pay-in money to the FMI, thus reducing performance risk associated with the use of this tool.

In the main, the discussion regarding tools to replenish financial resources focuses on cash calls on participants (see above for more detail).

Tools to allocate losses not related to participant default range from simple loss allocation, to capital raising, insurance and indemnities.  The risks inherent with respect to insurance (the time taken to process a claim, the uncertainties of a pay-out and the capped nature of most pay-outs) are noted.

Discussion with respect to the tools for CCPs to re-establish a matched book focus, in the first instance, on incentivising participants to accept unmatched contracts.  This can be achieved by making the default fund contributions associated with these trades the last to be used in a default scenario.  Whilst this is regarded as a transparent tool which mitigates the risk of a failed auction, it is accepted that it does not represent a comprehensive solution.  As such, consideration is given to the forced allocation of contracts.  Whilst this is a comprehensive solution which involves no performance risk, it is noted that it may result in contracts being allocated to participants which are unable to manage them.  The option of contract termination is also discussed.  Whilst another comprehensive and effective solution, the use of this tool exposes participants to replacement cost risk, is disruptive to the market where contracts are terminated, may actually trigger the spread of contagion and could create disincentives for firms to participate (as their hedged positions could effectively be turned into directional ones at the option of the CCP).  As such, it is questionable whether the use of this tool actually contributes to achieving the objective of continuity of key services.  The conclusion is that the use of contract termination (at least full, as opposed to partial, termination) should be avoided to the extent practicable.  Indeed, the report suggests that the use or imminent use of such a tool may itself be regarded as a trigger for resolution.

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.