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.

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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.

An Introduction to RRP for FMI

Background

Broadly, the term ‘financial market infrastructure’ (“FMI”) refers to:

  • central counterparties (“CCPs”);
  • payment systems;
  • central securities depositories;
  • securities settlement systems; and
  • trade repositories.

FMIs contribute to maintaining and promoting financial stability.  However, they also concentrate risk and their disorderly failure could have systemically important consequences.  This brings into focus the issues of how to determine the systemic significance of an FMI as well as the design of recovery and resolution (“RRP”) regimes for FMIs that are determined to be systemically important.

Determining Systemic Significance

The key factors in identifying systemic importance in the context of FMIs are generally considered to be:

  • size;
  • inter-connectedness; and
  • substitutability of services.

Sometimes a distinction is also drawn between FMI which take credit risk and those that do not.  On this basis, non-CCP FMIs such as payment systems are generally regarded as being non-systemic in importance on account of the fact that they tend not to have financial exposure to the same degree as, say, a CCP, and because any failure would likely to be of a more operational or technological nature.  In contrast, and particularly in light of the move towards mandatory clearing of OTC derivatives, CCPs are usually regarded as the most important type of FMI, often to the point where their systemic significance is assumed.  Given their importance and the fact that CCP resolution requires an understanding of all of the issues which are of relevance to FMI resolution generally, CCP resolution constitutes the main focus of this article.

RRP for Systemically Important FMI

RRP for FMIs can trace its roots back to the G20 Pittsburgh summit in September 2009 in which it was declared that all “systemically important financial firms should develop internationally-consistent firm-specific contingency and resolution plans…to help mitigate the disruption of financial institution failures and reduce moral hazard”.  This was followed in October 2011 by the FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” (the “Key Attributes”), which not only set out the core elements considered necessary for effective resolution regimes but also provided sector specific guidance on how these elements apply to FMIs.  Subsequently, the high level principles laid down in the Key Attributes were overlaid with more detailed guidance in the CPSS-IOSCO “Principles for Financial Market Infrastructures”, published in April 2012 (the “Principles”) which identified a number of specific recovery measures that FMIs should take.  By the time of the G20 Los Cabos Summit in June 2012, RRP for FMI had become a major focus, with the leaders’ declaration providing guidance on the future timetable for financial sector reform in this area.  Subsequent work has included the CPSS-IOSCO consultative report on RRP for FMI published on 31 July 2012, followed swiftly on 1 August 2012 by HM Treasury’s consultation document entitled “Financial Sector Resolution: Broadening the Regime”.  On 5 Oct 2012 the EU also published a consultation paper on RRP for non-banks and on 17 Oct 2012 HM Treasury published a summary of responses to its August consultation paper.

Viewed in the aggregate it is clear that the overriding concern in designing resolution regimes for FMIs is to maintain continuity of critical FMI functions.  In this context, each of the elements detailed within the Key Attributes continues to be relevant, but the following take on a particular level of importance:

  • bail-in;
  • transfer of critical functions; and
  • suspension of contractual rights.

Bail-in

It is generally accepted that all FMIs should hold minimum levels of liquid resources, above and beyond those held to cover normal participant defaults, in order to ensure an ability to continue to operate as a going concern.  The Principles suggests that this minimum should equate to at least six months of current operating expenses.  Nonetheless, losses could, in theory at least, still exceed available financial resources, meaning that some form of statutory bail-in for the purposes of loss allocation (and also recapitalisation), must also be considered.

Traditional bail-in involves the write-down of existing debt and/or its conversion into equity.  Unfortunately, unlike banks or investment firms, most CCPs typically do not issue debt securities, limiting the utility of traditional bail-in as a resolution tool.  Moreover, whilst loss-allocation mechanisms such as CCP default funds already exist, these arrangements are primarily concerned with loss-allocation rather than recapitalisation.  A number of CCP-specific bail-in proposals have been suggested, particularly focused on the ability to apply a haircut to margin.  Each has certain advantages and disadvantages, and can result in a very different distribution of losses, as detailed below.

Bail-in Option

Advantage

Disadvantages

Haircutting of 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’
  • Does not necessarily follow insolvency   rankings
  • Losses may also fall on the clients of   clearing members
Haircutting 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’
  • Does not necessarily follow insolvency   rankings
  • Losses may also fall on the clients of   clearing members
Enforcing FMI rules to replenish default funds/make   cash calls 
  • Avoids random allocation of losses resulting   from margin haircuts
  • Increased pro-cyclicality as all clearing members are called for fund
Specific clearing member liquidity   calls
  • Avoids random allocation of losses resulting   from margin haircuts
  • Increased pro-cyclicality as all clearing   members are called for funds
Establishment of ex-ante resolution   fund
  • Avoids negative counter-cyclical impact
  • Difficulty in calculating appropriate levels   of contribution
CCP right to terminate contracts   with non-defaulting clearing members for an amount equivalent to that of the   defaulter 
  • An immediate solution
  • Random, and therefore potentially unfair   loss allocation
  • Potential to amplify systemic effect
Issuance of CoCo bonds by CCPs
  • Burden would not fall on clearing members
  • Uncertainty as to market for CCP CoCo bonds

A number of industry participants have opposed proposals to allow resolution authorities to impose excess losses on a CCP’s clearing members.  It was felt that this would cause uncertainty, potentially lead to distorted incentives such as the early termination and exit of members, result in competitive disadvantage and could have capital and liquidity implications.  In light of this opposition, the UK government has recently decided to shelf its plans in this area.  Instead, it intends to establish a requirement that loss allocation rules be made mandatory for the purposes of authorisation as a Recognised Clearing House within the UK.  However, in general, it seems clear that some form of bail-in for CCPs, probably based on the haircutting of margin, will be the norm, as evidenced by the recent EU consultation paper on RRP for non-banks.

Transfer of Critical Functions

There is a general recognition of the difficulty of successfully applying the business transfer tool to an FMI in general and to a CCP is particular, due, inter alia, to:

  • the relative lack of firms which could act as alternative providers of a failed FMI’s critical operations/services;
  • the different nature of an FMI’s assets and liabilities;
  • operational constraints such as IT system incompatibility;
  • competition issues which may flow from ownership structures; and
  • national political agendas, such as those currently driving the fragmentation of central clearing of OTC derivatives.

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, it is arguable that they do not merit being transferred to a separate ‘bad’ asset management vehicle under an asset separation tool.  All of these factors tend to increase the importance of both bail-in and the bridge institution tools as a method of resolving a failed FMI.  This should enable authorities to ensure stability and the continuity of critical services whilst a private sector purchaser is identified, whilst simultaneously avoiding the legal and operational impediments that may arise with an outright transfer to a third party.

Suspension of contractual rights

The ability of resolution authorities to suspend contractual rights is seen as a necessary pre-condition to achieving the transfer, and therefore the continuity, of critical FMI functions.  It is recognised that the suspension of payments by an FMI is likely to perpetuate or even amplify systemic risk and could defeat the overriding objective of ensuring continuity of critical operations and services.  However, a stay on the termination rights of participants, other counterparties and third party service providers is regarded as an important resolution tool with respect to an FMI, particularly a CCP.

By way of safeguards, the principal of “no creditor worse off than in liquidation” continues to apply. However, with respect to FMIs, this concept should be assessed on the basis of creditor claims as they exist following the FMI’s ex ante rules and procedures for addressing uncovered credit and liquidity needs and the replenishment of financial resources.

Conclusion

RRP for FMI is just one of a number of current initiatives focused on entities that could contribute to the build-up or transmission of systemic risk.  These include RRP for insurance companies, domestic systemically important banks (“DSIBs”), investment funds and certain trading venues.  However, RRP for FMI is of particular importance given, firstly, the central role played by FMIs (and particularly CCPs) in providing the plumbing for financial markets and, secondly, the emphasis placed on bail-in as a tool in FMI resolution.  Bail-in is undoubtedly the most powerful of the resolution tools, capable of delivering immediate and significant results.  Unfortunately, the very nature of this power means that, if applied incorrectly, bail-in is just as likely to kill as save.  Ultimately, the success of RRP for FMI will lie in striking a delicate balance between the political imperative of ending taxpayer guarantees on the one hand and the economic imperative of securing the financial system on the other.  Detailed guidance on the resolution of FMI will begin to emerge in the first half of 2013.  At that point, we will have a better understanding of whether the attempts of EMIR and Dodd-Frank to harness the potential of FMIs have merely resulted in the creation of a time bomb which RRP cannot defuse.

EIOPA Responds to EU Commission Consultation on RRP for Non-Banks

Introduction

On 5 December 2012, the European Insurance and Occupational Pensions Authority (EIOPA) published its response to the EU Commission Consultation on a possible recovery and resolution framework for financial institutions other than banks.

RRP for Insurers

EIOPA supports the principle of RRP for insurers, but emphasises that (re)insurers are believed to have a more stable business model, are less interconnected and, in some cases, are more substitutable than banks.  As such, it claims that the financial stability argument for resolving insurers is not as persuasive as for banks.  It recognises that some insurers are rightly regarded as systemically important but warns that this should not be the sole motivating factor for developing RRP for insurance companies.  Rather, the importance of policyholder protection must be recognised alongside the more general goal of ensuring financial stability and further work is required in order to determine the hierarchy of these objectives.

Resolution Authorities

EIOPA believes that a clear delineation between the mandates of supervisory authorities and resolution authorities is required in order to smooth the transition from recovery to resolution and so avoid “inaction bias” and the “cliff effect”.  Supervisory authorities should have discretion to provide “breathing space” to failing firms as this can lead to better outcomes and avoid pro-cyclical actions that might arise as a result of immediate enforcement.  However, excessive forbearance is to be avoided.  As such, a balance must be struck between the need to act early in the interests of maintaining critical functions and preserving financial stability and the need to protect private property rights.  This balance should be based on a graduated approach to trigger conditions referencing factors such as authorisation requirements.  The graduation would reflect the severity of a breach.  For example, a trigger allowing the appointment of a Special Manager or Administrator would be less onerous and further from the point of balance sheet insolvency than a trigger authorising asset separation or forced sales/transfers.

Resolution tools

EIOPA considers that the following resolution tools are applicable to traditional insurance:

  • Run-off;
  • Portfolio transfer;
  • For non-life mutual and mutual-type associations with variable contributions, the ability to call for supplementary member contributions;
  • Recourse to Insurance Guarantee Schemes to secure continuity of insurance policies by transfer to solvent insurers or compensation of beneficiaries/policyholders;
  • Restructuring of liabilities to ensure that losses are fairly distributed among policyholders/creditors;
  • Appointment of an Administrator/Conservator or Special Manager; and
  • Compulsory winding-up.

However, there is a recognition that the effectiveness of these tools in the resolution of a large, complex insurance group with extensive cross border operations (or the failure of several smaller insurers within a single jurisdiction) is as yet untested and may prove to be inadequate.   In addition, EIOPA believes that some resolution tools, such as the imposition of a moratorium on payments, are primarily designed to protect creditors and so may not provide optimal outcomes for policyholders.  As such, it welcomes the initiative to consider expansion and development of the resolution toolkit to address broader objectives.

With specific reference to the Asset Separation tool, EIOPA sees the merits of being able to separate non-insurance related assets/activities in order to affect resolution of an insurance group but questions the practical relevance of such a power given that non-insurance activity conducted by a solo insurance undertaking is likely to be limited.  Moreover, to the extent that insurance liabilities are matched by assets, it is not clear to EIOPA how such a power would be used.

EIOPA would support measures to broaden the availability of the Bridge Institution tool, especially in the context of dealing with multiple failures.  Similarly, it views the ability to appoint an Administrator or Special Manager options as being useful if capable of being triggered at a suitably early stage.

EIOPA considers that the Bail-In tool is relevant to the insurance industry, but suggests that policyholders should not be subject to its terms.  In addition, development of a Bail-In tool for insurance would need to take account of the fact that the insurance sector is primarily equity funded with unrestricted Tier 1 funds accounting for in excess of 80% of own funds.  In these circumstances, Bail-In may be less effective as a tool than is the case for the banking industry.

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.

Derivsource Guide to RRP

Attached is a link to a guide to RRP written by Derivsource and yours truly.  There is also an accompanying podcast on the subject of RRP for financial market infrastructures.  I hope that you enjoy them – and feel free to share the links!

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.