EU Publishes Responses to Liikanen Consultation

Introduction

On 21 December 2012, the European Commission published a summary of the replies received to its October 2012 consultation on the recommendations of the high-level expert group on reforming the structure of the EU banking sector (the “Liikanen Group”).  It also published links to individual responses.

In total, the Commission services received 89 responses and broke its summary down by reference to the five main recommendations of the Liikanen Group, as set out below.

Mandatory Separation of Proprietary Trading Activities and Other Significant Trading Activities

In general, banks believe that a compelling case for mandatory separation has not been made and contend that the current reform agenda is sufficient to tackle identified problems in the banking sector.  Structural separation was criticised on the following grounds:

  • Costs are high: the proposals are regarded as being inconsistent with universal banking and the associated costs will ultimately be borne by users of banking services;
  • Claimed benefits may not materialise: bank structure is not regarded as a main driver of the financial crisis and structural change may actually create incentives for regulatory arbitrage;
  • EU banking competitiveness will be harmed: Non-EU banks may not be subject to similar rules and only the largest trading houses will remain viable, leading to increased market concentration;
  • Lack of consistency with other structural reform initiatives: such as those proposed in the USA and the UK; and
  • Lack of clarity and detail: what is to constitute ‘significant’ trading activity that would mandate separation; which activities are to be separated; and what will be nature of the resultant relationship between a separated trading entity, a deposit bank and their holding company?

Even public authorities, including central banks and national finance ministries do not universally hold the view that the Liikanen reforms are necessary, although other types of financial institution, as well as consumer groups and think-tanks, were generally in favour of the proposals.

Additional Separation of Activities Conditional on Recovery and Resolution Plans (RRPs)

Respondents were generally in support of strengthened RRPs, with banks arguing that an effective RRP obviated the need for mandatory separation.  However, some respondents argued that conditional separation based on RRPs would be arbitrary and that supervisors lack the capacity to adequately evaluate RRPs.  Accordingly, mandatory separation would not only simplify banks but make the RRP framework more effective and credible.

Amendments to the Use of Bail-In Instruments as a Resolution Tool

There were respondents both for and against a more targeted bail-in approach involving clearly designated bail-in instruments (as opposed to bail-in of almost all unsecured liabilities).  However, the majority of respondents did not support the proposal that bail-in instruments should not be held by other banks, on the basis that this would limit the investor base, raise bank funding costs and be ineffective at limiting interconnectedness in the financial system.

Review of Capital Requirements on Trading Assets and Real Estate Related Loans

Most respondents opposed the proposal to revise capital charges for the trading book, by setting an extra capital buffer or introducing a minimum floor to risk-based requirements, believing that these risks are being addressed via CRDIII and CRR/CRDIV.

Strengthening the Governance and Control of Banks

Respondents pointed out that significant progress has been made in banks’ corporate governance practices in recent years, and that further improvements are in the pipeline. There was general support for enhanced shareholders’ say on pay.  Whilst the need for diversity of skills and experience of Board members was recognised, there was less support for introducing the proposed “fit & proper” tests.  The general support for strong risk management contrasted against the lack of support for the proposed parallel risk reporting by Risk and Control Management to the Chief Executive Officer and the Risk and Audit Committee.  There was also a lack of support (among banks) for the proposal to set a maximum ratio between variable and fixed pay or for the proposal to fix remuneration to dividends.  Views were split on the use of bail-in bonds as part of remuneration.

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.

The Phantom of Banking Union

This is a link to an excellent opinion piece in the FT on the recent announcement regarding EU banking union.

The first steps towards banking union announced last week were widely lauded as representing a significant in-principle agreement.  The truth is that this principle was agreed two years ago.  Unfortunately, what happened last week was a failure of the political process to deliver the results logically required by the economic reality in Europe.

FSB Press Release on RRP Consultation

On 18 December 2012, the Financial Stability Board (FSB) published a press release regarding responses received to its 2 November 2012 consultation on Recovery and Resolution Planning, together with links to the responses of the following institutions:

  • Association of British Insurers
  • Barclays
  • BNP Paribas
  • British Bankers’ Association
  • Credit Suisse
  • Deutsche Bank
  • Federation Bancaire Francaise
  • FirstRand Bank
  • Global Financial Markets Association
  • Institute of International Finance
  • International Banking Federation
  • Investment Management Association
  • Polish Financial Supervision Authority
  • Santander
  • UBS

 

EBA Provides Opinion on Liikanen

Introduction

On 14 December 2012, the European Banking Authority (“EBA”) published its opinion on the recommendations of the High-level Expert Liikanen Group on reforming the structure of the EU banking sector.

The final report of the Liikanen Group was published on 2 October 2012 and made the following recommendations:

  •  mandatory separation of proprietary trading and other high-risk trading activities to the extent exceeding a threshold;
  • possible additional separation of activities conditional on an institution’s resolvability;
  • possible amendments to the use of bail-in as a resolution tool;
  • review of the capital requirements on trading assets and real estate loans; and
  • strengthening banks’ governance and controls.

General Comments

In general, the EBA considers that the Liikanen proposals strike an appropriate balance between protecting the core features of the universal banking model and strengthening the resilience of the financial sector.  However, it believes that an impact assessment is required in order to properly be able to evaluate the potential benefits and cost of the proposals.

Aware that several Member States are considering structural change to national banking industries, the EBA emphasises the need to ensure consistency across the EU so as to protect the operation of the Single Market.  To this end, it states that clear criteria must be established in relation to such issues as:

  • the situations where separation is mandatory;
  • parameters that apply to exceptions such as the provision of “hedging services to non-banking clients”; and
  • the provision of financial support between deposit banks and trading entities pursuant to the proposed bank recovery and resolution directive (the “RRD”).

Banks’ compliance with the proposals should also be subject to periodic review and macro-prudential monitoring to avoid structural arbitrage.  In addition, any structural changes must be consistent with existing legislation, such as the RRD and the large exposures regulation, but should not be viewed as a substitute for adequate supervision.

Bail-in

The EBA considers that there is a need to further develop the bail-in framework in the RRD in order to improve its legal and operational certainty and so avoid possible destabilising effects.  The EBA repeats its preference for a two-tier bail-in regime.  Under such a regime, bail-in would initially be applied to a targeted category of debt instruments.  This targeted approach would, it is hoped, avoid the risk that a wide ex ante bail-in regime turns out to be of limited value once resolution actually occurs.  Only if the targeted approach proved insufficient, would remaining creditors be bailed-in within a proper administrative resolution procedure.

In addition, banks would be required to issue and hold a minimum percentage of their liabilities as “bail-inable” debt.  It is anticipated that this would create a market in bail-in debt, encourage the standardisation of contracts and incentivise rating agencies to focus on the rating of bail-in instruments.  However, the EBA supports the proposal that such debt should be held outside of the banking system, suggesting that penal risk-weightings could be introduced in order to discourage acquisition of such securities by the banking sector.  It also welcomes the suggestion to use bail-in instruments in remuneration schemes for top management and as part of bonus schemes.

RRD to be agreed by June 2013

On 14 December 2012, the European Council published its conclusions regarding the steps necessary to complete economic and monetary union (EMU).  These include:

  • the need for the rapid adoption and implementation of the single supervisory mechanism (SSM);
  • the agreement on the terms of the Recovery and Resolution Directive (RRD) and the Deposit Guarantee Schemes Directive by June 2013; and
  • the rapid follow-up to the proposals of the Liikanen Group.

Insurers Less Systemically Important Than Banks Says Geneva Association

Introduction

On 11 December 2012, the Geneva Association, a think-tank for the insurance industry, published a cross-industry analysis comparing the 28 Global Systemically Important Banks (G-SIBs) to 28 of the world’s largest insurers on indicators of systemic risk.

The analysis studied 17 indicators that are regarded as being comparable between insurers and banks to provide an analysis of the size of each activity. The conclusions drawn were that:

Insurers are significantly smaller than banks

  • The average bank’s assets are 3.9 times larger than the average insurer;
  • The largest insurer would rank only 22nd in the list of G-SIBSs by size.

Insurers write considerably less CDS than banks

  • The average bank writes 158 times the value of gross notional Credit Default Swaps (CDS) than the average insurer;
  • The lowest ranked banks on average have 12.5 times the CDS sold by the average insurer.

Insurers utilise substantially less short-term funding than banks

  • Short-term funding as a percentage of total banks assets is 6.5 times higher than short-term funding as a percentage of insurer assets.

Insurers are less interconnected to other financial services providers than banks

  • Banks carry 219 times more gross derivative exposure than the insurer average;
  • The lowest ranked banks carrying 66 times more gross derivative exposure than the average insurer;
  • At the measurement date, banks owed on average 68 times more than insurers in gross negative derivatives;
  • Banks are owed 70 times more from derivatives counterparties through derivatives exposure than insurers.

 

FDIC and BoE Publish Strategy Paper on Resolution Plans

Introduction

On 10 December 2012, the Federal Deposit Insurance Corporation (FDIC) and the Bank of England (BOE) published a joint strategy paper on the resolution of globally active, systemically important, financial institutions (G-SIFIs).

Broadly speaking, there are two main approaches to the resolution of G-SIFIs:

  • “Single point of entry” (or “top down”) resolution pursuant to which a single national resolution authority applies resolution powers to the parent company of a failing financial group; or
  • “Multiple point of entry” resolution whereby resolution powers are applied to different parts of a failing financial group by two or more resolution authorities in coordination.

The paper focuses on “top-down” resolution with respect to both UK and US cross-border financial services groups.  The key advantage of “top-down” resolution is seen as being the ability for viable subsidiaries, both domestic and foreign, to continue to operate.  Not only should this limit contagion but it will hopefully mitigate cross-border complications arising as a result of the institution of separate territorial and entity-focused insolvency proceedings.  However, it is expressly recognised that there are certain circumstances where “multiple point of entry” resolution will be necessary, for example where losses are so great that they could not be absorbed by a group level bail-in or make the job of valuing the capital needs of the institution in resolution too difficult.

US approach to single point of entry resolution

The sequence of events with respect to a US single point of entry resolution is as follows:

Appointment of Receiver

The FDIC is appointed receiver of the parent holding company of the failing financial group.

Asset Transfer

The FDIC transfers assets (primarily equity and investments in subsidiaries) from the receivership estate to a bridge financial holding company.  In contrast, shareholder claims and claims of subordinated and unsecured debt holders remain in the receivership.  As such, the assets of the bridge holding company will far exceed its liabilities.

Valuation

A valuation process is undertaken so as to estimate the extent of losses in the receivership and allow their apportionment to shareholders and unsecured creditors in accordance with insolvency rankings.

Bail-In

Bail-in occurs to ensure that the bridge holding company has a strong capital base.  So as to provide a cushion against future losses, remaining debt claims are converted in part into equity claims in the new operation and/or into convertible subordinated debt.  Any remaining debt claims are transferred to the new operation in the form of new unsecured debt.

Liquidity Concerns are Addressed

To the extent that liquidity concerns have not been addressed by the transfer of equity and investments in operating subsidiaries to the bridge holding company, the FDIC can provide assurances of performance and/or limited scope guarantees.  As a last resort, the FDIC may also access the Orderly Liquidation Fund (OLF), a fund within the U.S. Treasury set up under the Dodd-Frank Act.  However, the Dodd-Frank Act prohibits the loss of any taxpayer money in the orderly liquidation process.  Therefore, any OLF funds used must either be repaid from recoveries on the assets of the failed financial company or from assessments made against the largest, most complex financial companies.

Firm is restructured

In this stage, the focus will be on making the failed firm less systemically important and more resolvable.  Senior management are likely to be removed at this point.

Ownership Transfer

The final stage of the process is to transfer ownership and control of the surviving operation to private hands.

UK approach to single point of entry resolution

The sequence of events with respect to a UK single point of entry resolution is as follows:

Equity/Debt Transfer

Initially, existing equity and debt securities will be transferred to an appointed trustee.

Listing Suspension

Subsequently, the listing of the company’s equity securities (and potentially debt securities) would be suspended.

Valuation

A valuation process would then be undertaken in order to understand the extent of the losses expected to be incurred by the firm and, in turn, the recapitalisation requirement.

Bail-In

Following valuation, an announcement of the terms of any write-down and/or conversion pursuant to the exercise of bail-in powers would be made to the previous security holders.  In writing down losses, the existing creditor hierarchy would be respected.   Inter-company loans would be written down in a manner that ensures that the subsidiaries remain viable.  Deposit Guarantee Schemes would also be bailed-in at this point.  At the end of the process, the firm would be recapitalised and would likely be owned by its original creditors.

Liquidity Concerns are Addressed

So as to mitigate liquidity issues and facilitate market access, illiquid assets could be transferred to an asset management company to be worked out over a longer period.  In the event that market funding was simply not available, temporary funding could be provided by authorities on a fully collateralized, haircut, basis.  However, any losses associated with the provision of such temporary public sector support would be recovered from the financial sector as a whole.

Firm is Restructured

On completion of the bail-in process, the firm would be restructured to address the causes of its failure.

Re-Transfer

Subsequently, the trustee would transfer the equity (and potentially some debt) back to the original creditors of the firm.  Any creditors which are unable to hold equity securities (e.g. due to mandate restrictions) would be able to request that the trustee sell the equity on their behalf.

Resumption of Trading

The final stage of the process would involve the dissolution of the trust and the resumption of trading in the equity and/or debt securities of the restructured firm.

Similarities Between the Regimes

Both approaches emphasise the importance of ensuring the continuity of critical services of the failing group, whether in the home jurisdiction or abroad.  Shareholders under both regimes can expect to be wiped out and unsecured debt holders can expect their claims to be written down (to reflect any losses that shareholders cannot cover) and/or partly converted into equity (in order to recapitalise the entity in question).  Existing insolvency hierarchies will be respected, but in both cases, a valuation process will be required.  The precise mechanics of any such valuation are unlikely to be the same across both the UK and the US, but consideration is being given in both jurisdictions as to the extent to which the valuation process can be prepared in advance.  Not only would the valuation process assess the losses that a firm had incurred and what financial instruments (if any) the different classes of creditors of the firm should receive, but it would also assess the future capital needs of the business necessary to restore “confidence” in the firm.  It seems likely that this will be a level significantly higher than that required simply to restore viability.  In both cases, resolution will be accompanied by an restructuring of the business.  This may involve breaking an institution into smaller, less systemically important entities, liquidating or closing certain operations and a replacement of management.

The future

The high level strategies detailed by the FDIC and BOE will be translated into detailed resolution plans for each firm during the first half of 2013. It is anticipated that firm-specific resolvability assessments will be developed by the end of 2013 on the basis of the resolution plans.

EMU Roadmap Sheds Light on Future Resolution Initiatives

Introduction

On 6 December 2012, the EU Council published a report entitled “Towards a Genuine Economic and Monetary Union”, building on an interim report on the same topic published in October 2012.  It proposes a timeframe and a 3-stage approach to the completion of Economic and Monetary Union (EMU), describing the RRP-specific requirements which form part of this initiative, as detailed below.

Stage Timescale Description 
Stage 1 End 2012 – beginning 2013

Ensuring fiscal sustainability and breaking the link between banks and sovereigns.

From an RRP perspective, this would involve:

  •   The   establishment of a Single Supervisory Mechanism (SSM) for the banking sector;
  •   Agreement   on the harmonisation of national resolution and deposit guarantee frameworks;
  •   Ensuring   appropriate resolution funding from the financial industry; and
  •   Establishing   the operational framework for direct bank recapitalisation through the   European Stability Mechanism (ESM).
Stage 2 Beginning 2013 – end 2014

Completing the integrated financial   framework and promoting sound structural policies at national level.

RRP specific measures would include the establishment of:

  •   A   single resolution authority (SRA); and
  •   A   financial backstop, in the form of an ESM credit line to the SRA.
Stage 3 Post 2014

Establishing a mechanism to create the   fiscal capacity necessary to enable EMU members to better absorb future country-specific   economic and financial shocks.

Single Supervisory Mechanism

The Council regards it as imperative that preparatory measures with respect to the SSM commence at the beginning of 2013, so that the SSM can be fully operational from 1 January 2014 at the latest.  This will involve granting strong supervisory powers to the ECB.

Single Resolution Mechanism (SRM)

Measures to establish the SSM are to be complemented by an SRM, build around an SRA and established at the same time as the ECB assumes its supervisory responsibilities with respect to the SSM.  Whilst the SSM would provide a “timely and unbiased assessment of the need for resolution”, the SRA would ensure timely and robust resolution measures are actually implemented in appropriate cases.  In other words, the SRM would complement the SSM by making certain that failing banks are restructured or closed down swiftly.  The establishment of an SRM is regarded as an indispensable element in the completion of EMU as it would:

  • Promote a timely and impartial EU-level decision-making process: it is hope that this would mitigate many of the current obstacles to resolution, such as national interest and cross-border cooperation frictions;
  • reduce resolution costs;
  • break the link between banks and sovereigns; and
  • Increase market discipline by ensuring that the private sector and not the taxpayer bears the cost of bank resolution

The SRM would be financed via a European Resolution Fund.  In turn, the fund would be financed via ex-ante risk-based levies on all banks directly participating in the SSM.  As mentioned previously, the fund would be buttressed by an backstop in the form of an ESM credit line to the SRA.  However, any support provided via the ESM would be recouped in the medium term by way of ex-post levies on the financial sector.

Deposit Guarantee Schemes (DGS)

References to an EU-wide deposit guarantee scheme seem to have been dropped in favour of a proposal to ensure that sufficiently robust national deposit insurance systems are set up in each Member State.  This, it is hoped, will limit the contagion effect associated with deposit flight between institutions and across countries, and ensuring an appropriate degree of depositor protection in the EU.

Financial Shock absorption function (FSAF)

This stage 3 measure would likely take the form of a contract-based insurance system set up at an EU level. Whilst RRP-specific, the establishment of an FSAF is seen as contributing to macroeconomic stability and therefore providing important support to the effectiveness of bank resolution measures in stages 1 and 2.  However, the Council is keen to emphasise that the FSAF would not be an instrument for crisis management per se, as this is a role to be performed by the ESM.  Rather, the purpose of FSAF would be to improve the overall economic resilience of EMU and eurozone countries.  In other words, it would contribute to crisis prevention and make future ESM interventions less likely.