Liikanen Report on EU Banking Reform to be published on 2 October 2012

On 28 September 2012, the EU Commission published a press release confirming that the final report of the Liikanen Committee is due to published on 2 October 2012.

The Liikanen Committee is an expert group, formed by the EU Commission in February 2012 and chaired by Erkki Liikanen (former Governor of the Bank of Finland), to investigate the case for structural reform of the EU banking sector in order to strengthen financial stability and improve efficiency and consumer protection.

According to this FT article, it seems that the Liikanen Committee will draw on the proposals of the Vickers Report in the UK and the Volcker Rule in the US and recommend that certain trading activities of banks are ringfenced.  However, it is thought that the committee will not go as far as recommending actual levels of capital that must be applied to ringfenced operations.  Questions also remain as to the maximum permissible volume of trading activities that may take place before a ringfence must be created.

Bank of England Provides its Take on Bail-In

Introduction

The Bank of England (BoE) has published a speech given by Andrew Gracie, Director of the BoE’s Special Resolution Unit, to the British Bankers’ Association on 17 September 2012 entitled “A practical process for implementing a bail-in resolution power”, a summary of which is provided below.

By way of introduction, Mr Gracie noted that bail-in was only one among a suite of resolution tools, but that it may be of particular use in resolving G-SIFI’s whose operations are too large, complex or interconnected to resolve without threatening critical functions (although he also recognised that there may be cases where the failure of a firm is so comprehensive as to mean that it would need to be wound down instead of being bailed-in).  Nonetheless, Mr Gracie warned that, whilst it can be valuable in restoring a firm’s solvency and so allowing critical functions to continue during a reorganisation, bail-in alone cannot restore a firm’s viability.

Principles behind the exercise of the bail-in tool

Any exercise of the bail-in tool would have to:

  • respect creditor hierarchies;
  • protect secured claims and netting arrangements;
  • be proportionate (in order to minimise the risk of compensation claims);
  • be clear and transparent to creditors; and
  • satisfy clearly defined public interest objectives (e.g. the maintenance of financial stability and the protection of depositors).

The trigger for bail-in

Bail-in would only be used if a firm had reached the point of non-viability i.e. where a supervisory authority identifies that the institution is:

  • failing or likely to fail, and
  • no other solution, absent the use of resolution tools, would restore the institution to viability within a reasonable timeframe.

Bail-in in practice

Assuming that the pre-resolution efforts of a firm to restore its own viability had failed, Mr Gracie identified four stages in the application of the bail-in tool.

1. Stabilisation

Stabilisation of a firm would include some or all of the following steps:

  • suspension of the listing and trading of the firm’s shares and debt;
  • Communication with all stakeholders, confirming:
    • that the firm had reached the point of non-viability and had met the conditions for resolution;
    • the broad resolution strategy for the firm;
    • the range of liabilities that would be completely written down without conversion;
    • the range of liabilities that would be subject to potential write-down and/or fully or partially converted into equity;
    • that the firm would be restructured;
    • that all of the firm’s core functions would continue without disruption;
    • that any insured depositors would be fully protected; and
    • the proposed timing for the announcement of the final terms for the bail-in (including the final extent of creditor write-downs, and rates of conversion to equity).

2. Valuation and exchange

Immediately following the stabilisation phase, a valuation exercise would need to be carried out in order to determine the extent of losses incurred or likely to be incurred by the firm.  In turn, this would be used to calculate the appropriate terms of the bail-in.  Subsequently, the creditors identified in the stabilisation announcement would be subject to write-downs in an aggregate amount sufficient to cover all of the firm’s losses.  Next, the authorities would determine the amount of capital that would be necessary to help restore the firm to viability. This amount would likely exceed minimum prudential capital requirements in order to ensure market confidence in the firm.  The actual recapitalisation would be effected by the conversion of eligible liabilities into equity.

In passing, Mr Gracie confirmed the BoE’s objection to the principle enshrined within the RRP Directive requiring, at all times, the pari passu treatment of creditors within the same class.  Rather, the BoE believes that it is important for resolution authorities to retain some discretion in deciding which liabilities to bail-in, to take account of any potential adverse impact on the stability of the financial system.

3. Relaunch

Once the valuation had been completed, and creditors written-down as appropriate, equity would need to be transferred to affected creditors as a quid pro quo for the recapitalisation. This could be effected by the issuance of new shares or by the transfer of existing de-listed shares from shareholders who had been fully written down.  At this point, trading of the firm’s equity and debt in the primary market could resume.  In the event that it was subsequently found that any bailed-in creditor or shareholder had suffered a loss greater than that which would have occurred on the insolvency of the firm, an ex-post adjustment mechanism would be applied to the capital structure of the firm in favour of the affected party by way of compensation.

4. Restructuring

Any relaunch would be accompanied by a “concrete and effective” restructuring strategy.  In the simplest cases this strategy may take a matter of months to implement, but may take much longer in relation to more complex failures.  Any strategy would be designed to prevent disruption to critical economic functions while also addressing the causes of the firm’s failure.  In all instances, culpable management would be replaced.

 

EU Banks to face Vickers Style Ringfence?

This is a link to an article in today’s Financial Times (subscription required) regarding the progress of an on-going review into the structure of EU banking.

The Liikanen Review was established in November 2011 by Michel Barnier, the EU single market commissioner.  It ‘s remit was to examine the need for structural reform of the banking sector within the EU and it is due to report in October 2012.  Early indications are that it may recommend that any bank which exceeds a specified threshold of trading assets, calculated as a proportion of total assets, should be obliged to establish a separately capitalised subsidiary to house those assets, along this lines recommended by the Vickers Report in the UK.  It is thought that this percentage could be as low as 5%.

However, the members of the committee conducting the review do not appear to be unanimous in their support of this recommendation and it is thought that a compromise proposal may yet emerge.  Under this compromise, a bank may be required to create a ringfenced entity only if it came close to failure.  The trigger for ringfencing would be documented within the bank’s Living Will.  Quite how this compromise would work in practice is difficult to see.

European Banking Federation Publishes Study on Reform of EU Banking Sector

Introduction

On 24 July 2012, the European Banking Federation (“EBF”) published a “Study on the issue of possible reforms to the structure of the EU Banking Sector”.  The report is related to the ongoing work of the High Level Expert Group established by the EU Commission to examine the same issue.

The report distinguishes regulatory reform (such as CRD IV, RRP, EMIR and MiFID) from structural reform – a reference to the Vickers report in the UK and the Volcker rule in the US.

Regulatory Reform

In general, the EBF is supportive of regulatory initiatives.  However, on the subject of RRP, it cautions that “a reasonable balance must be struck between effective, robust supervision and supervisory approaches which are overly intrusive into the normal, day-to-day running of a healthy business”.  The EBF also approves of the concept of “bail-in”, favouring a wide definition of bail-in-able debt so as to reduce the possibility of arbitrage and the need for a statutory minimum quantity of bail-in-able debt to be issued by firms.  However, the EBF believes that the “timing and the implementation of any bail-in mechanism…must…avoid imposing an excessive funding cost that could impair the provision of credit to the real economy and result in an excessive deleveraging”.

Structural Reform

The EBF believes that the objectives of the G20 and the EU are to:

  • increase the stability of the European financial sector by reducing risk;
  • ensure orderly resolution of financial institutions without taxpayer support; and
  • maintain the integrity of the Internal Market and to ensure the ability of banks to serve the real economy.

It claims that all of these objectives can be achieved by the finalisation and implementation of the regulatory reform agenda without the necessity of structural reform.  Citing the ECB’s report on EU Banking Structures, the EBF claims that “there is no convincing evidence that structural reform has a direct influence on systemic risk and would make restructuring or resolution easier in the event of a crisis.”  Quite the opposite, it expresses the view that “the disadvantages deriving from a potential adoption of UK- or US- style structural reforms for the EU would be much larger than the eventual benefits that they would generate” due to the possibility that it will lead to fragmentation of financial markets in the EU and create incentives to circumvent the rules.  As such, it concludes that any structural change should be delayed until the regulatory reform agenda has been completed so that its impact can be properly assessed.

Conclusion

The views of the EBF regarding the definition of bail-in-able debt are interesting.  They accord with opinions expressed by the buyside, such as AIMA,  and are undoubtedly correct.  The more narrow the definition, the greater the risk that the protection afforded by bail-in debt will be rendered toothless at the structuring desks of investment banks around the globe.

The reluctance of the EBF to embrace structural change is understandable.  Whilst the political benefits are clear and opinion both amongst regulators and the industry seems to be swinging behind these initiatives (see, for example, here), the economic case for reforms such as those proposed by Vickers has yet to be made definitively.  Unfortunately for the banks, however, neither the UK nor the US governments seem to have a reverse gear where Vickers and Volcker are concerned.

If you have an hour to spare I would recommend that you read this study for no other reason than it provides an excellent review of the history and developments across the entire regulatory landscape within the EU.

FSA Publishes Feedback Statement FS12/1 on Recovery and Resolution Plans

Introduction

On 10 May 2012, the FSA published Feedback Statement FS12/1 on Recovery and Resolution Plans.  The main purpose of FS12/1 is to provide an update to the market on the current state of the RRP process.

Proposed Date of Final RRP Rules

A Policy Statement with final RRP rules will be published by the FSA no later than autumn 2012.  The final rules are expected to be based on the contents of FS12/1, so firms should pay particular attention to the “RRP Information Pack” which supplements FS12/1 and sets out detailed informational requirements on RRP.  Publication has been delayed so as to allow the final rules to be aligned with other regulatory initiatives, including the:

  • EU Recovery and Resolution Directive;
  • EU Commission Technical Discussion Paper on ‘bail-in’;
  • FSB’s final rules on the Key Attributes of Effective Resolution Regimes; and
  • legislation that will follow the ICB white paper and consultation paper to be published during the summer of 2012.

In the meantime, the FSA will also consult as to whether the final RRP rules should apply to a wider set of firms – specifically UK branches of non-EEA firms.

Proposed changes to RRP Rules

The FSA makes reference to a number of changes between the requirements of the “RRP Information Pack” which supplements FS12/1 and the “RRP Guidance Pack for Firms” which constituted part of CP11/16, including: 

  • the merger of recovery plans and Contingency Funding Plans so as to reduce unnecessary duplication;
  • the provision of additional information by firms to the FSA on issued debt so as to assist in the development of ‘bail-in’ strategies;
  • revisions to the ‘Interbank Exposures’ and ‘Derivatives and Securities Financing’ templates which form part of the data collection requirements of the RRP rules;
  • additional information concerning the triggers for resolution and the actions that are required when resolution triggers are met; and
  • the identification of new economic functions for the purposes of RRP Modules 4 and 5.

Deadline for Submission of RRPs

The deadlines for submission of RRPs are as follows:

Type of Firm

Informational Requirement

Deadline

UK headquartered G-SIFIs that have been part of the FSA’s pilot exercise

Module 1-6

30 June 2012

Non-UK headquartered G-SIFIs

Module 1-4

30 June 2012

Non-UK headquartered G-SIFIs

Module 5-6

End of 2012

Small and medium sized firms

No uniform requirement

Supervisors will discuss deadlines with individual firms

Firms which have not yet been contacted with respect to their particular RRP submission deadline date should expect to hear from the FSA during the second half of 2012.  The FSA will normally aim to give three months’ notice of the requirement to submit an RRP.

If There Was Only One Reason Why Firms Should Want to Commit to Robust RRPs, This Must Surely Be It…

By any measure, the costs of properly implementing a recovery and resolution plan (“RRP”) are significant.  Using the FSA’s own cost-benefit analysis conducted as part of Consultation Paper CP11/16, the costs to firms of preparing and maintaining a Recovery and Resolution Plan (excluding the costs associated with CASS Resolution Packs) over the next five years are:

  • High Impact Firms:  GBP 56,490,833
  • Medium High Impact Firms: 8,522,417
  • Medium Low and Low Impact Firms: 3,299,333

In light of this cost, it’s hardly surprising that some firms intend to do the minimum necessary to comply.  But are firms missing a trick in adopting this attitude?  There are many benefits to implementing a robust recovery and resolution planning regime, but the one most often overlooked relates to risk-weighted assets.

Once enacted, Basle III will require systemically important banks to have equity of at least 10% of risk-weighted assets (RWAs) plus credibly loss-absorbing debt.  However, some jurisdictions have gone further in “gold-plating” (or applying a “Swiss finish”) to regulatory capital requirements on their local banks.

The UK appears to be one such jurisdiction.  In September 2011, the Independent Commission on Banking (“ICB”) issued its final report, the conclusions of which were accepted in full by the UK government in December of that year.  The ICB has recommended that the retail and other activities of large UK banking groups should both have primary loss-absorbing capacity (i.e. regulatory capital and bail-in bonds) of at least 17%-20% of RWAs.

Within the 17%-20% range detailed above the ICB recommends applying regulatory discretion about the amount and type of loss-absorbing capacity.  In particular, the ICB has suggested that 3% extra equity capital might be required of a UK banking group that was judged “insufficiently resolvable to remove all risk to the public finances”.  In contrast, no additional equity capital might be needed for a bank with “strongly credible recovery and resolution plans”.

It would be simplistic to assume that the ICB’s recommendations would be applied in a binary fashion by the FSA, or its successor, the Prudential Regulation Authority (i.e. a 3% RWA penalty or no penalty at all with nothing in between).  Nonetheless, it is instructive to attempt to place an actual value on this 3% figure.  The table below is based on the 2010 financial statements of a number of major UK banks and building societies, and quantifies the annual amount of interest (assuming a rate of 50 basis points) that would be payable if an amount equal to 3% of RWA, being freed up as a result of having a robust recovery and resolution plan, were simply placed on overnight deposit.

 

Bank

Risk-Weighted Assets (GBP Million)1

3% of Risk Weighted Assets (GBP Million)

Overnight Interest (GBP Million)2

Barclays PLC

398,000

11,940

59.7

Clydesdale Bank plc

28,700

861

4.31

HSBC Bank plc

201,700

6,050

30.26

Lloyds Banking Group

406,400

12,190

60.96

Nationwide Building Society

50,100

1,500

7.52

Northern Rock Plc (now Virgin Money)

3,620

110

0.54

Principality Building Society

2,760

80

0.41

Royal Bank of Scotland plc

409,700

12,290

61.46

Santander UK plc

73,560

2,210

11.03

Standard Chartered Bank plc

155,150

4,650

23.27

Yorkshire Building Society

11,200

340

1.68

 

1 Where financial statements are reported in USD, the USD/GBP exchange rate as at 8 March 2012 has been used for comparison purposes

 2 Assuming an overnight interest rate of 0.5%

The potential dangers of false economy become clear – the opportunity cost of not implementing a robust recovery and resolution planning regime may quickly outweigh the marginal cost savings derived by doing just enough, but not more, to pass muster with the FSA.