ECB Publishes Opinion on RRD

Introduction

On 5 December 2012, the European Central Bank (ECB) published its opinion on the EU’s draft directive establishing a framework for recovery and resolution of credit institutions and investment firms (the “Recovery and Resolution Directive” or “RRD”).

In general, the ECB fully supports the RRD, welcomes the fact that it is in line with the FSB’s “Key Attributes” document and believes that it should be adopted rapidly.  It also encourages the EU to take further steps to implement an independent European resolution mechanism, which it views as one of the three banking union pillars.  Beyond clarifying its general position, the ECB also made a number of more specific observations, a summary of which are provided below.

Definition of resolution

The ECB notes that “resolution” under the RRD involves, inter alia, restoring the viability of all or part of a failing institution.  However, it is of the opinion that, if there is no public interest element to a proposed resolution action, the institution in question should not be resolved as a going concern and instead should be liquidated under normal national insolvency law.  As such, the ECB is of the view that the RRD should be amended to clarify that the aim of resolution is not to preserve a failing institution, but to ensure the continuity of its essential functions.

Resolution conditions and the need for extraordinary financial public support

In the interests of “prompt and efficient resolution action”, the ECB believes that the relevant competent authority should have responsibility for determining whether an institution is failing or likely to fail (and thus has triggered the conditions for resolution).  Moreover, this determination should be based solely on an assessment of the situation of the institution in question.  It should not be based on an institution’s particular need for State aid, although the circumstances surrounding any grant of State aid would be relevant in assessing the institution’s general situation.

Involvement of central banks in recovery and resolution

In recognition of the role of central banks in promoting macro-prudential and financial stability, the ECB recommends that, where a central bank is not itself the resolution authority, the relevant competent authority and resolution authority engage in an “adequate exchange of information” with the central bank.

With respect to the use of the bridge institution and asset separation tools, the ECB believes that the RRD should clarify the fact that, where a central bank acts as a resolution authority, it will not assume any financing obligations with respect to either the bridge institution or the asset management vehicle created pursuant to the asset separation tool.

Involvement of national designated authorities in assessment of recovery plans

The ECB recommends that, when assessing recovery plans, competent authorities consult with competent national designated authorities (to the extent that they are separate entities).

Intra group financial support

The ECB considers that further investigation may be required into whether additional provisions are necessary in order to ensure the legal certainty and enforceability of voluntary intra-group financial support arrangements.

The bail-in tool and write down powers

The ECB believes that bail-in should be used predominantly for the resolution of institutions that have reached a point of non-viability.  Any use of the tool to restore a failing institution to the position of a going concern should only be considered in “exceptional and justified” circumstances.

The ECB also notes that the RRD requires the European Banking Authority (EBA) to report to the EU Commission on the implementation of the requirement for institutions to maintain an aggregate amount of own funds and eligible liabilities expressed as a percentage of total liabilities.  The ECB believes that further investigation, together with an impact assessment, should be conducted as to whether the minimum requirement should be expressed as a percentage of total liabilities or as a percentage of risk weighted assets – it being thought that the latter may represent a better measure of the riskiness of the assets of the institution in question.

The ECB further recommends that the EBA conduct an assessment of whether it would be beneficial to introduce a prohibition or limitation on the banking sector’s ability to hold instruments which are eligible for bail-in.  It also suggests amending Article 38(2) of the RRD to make clear that all liabilities to members of the European System of Central Banks (ESCB) are explicitly excluded from the application of the bail in tool, on the basis that EXCB members are public bodies whose basic tasks require them to have exposures to institutions.

Financing of resolution

The ECB is concerned that the proposal to set up a European system of resolution financing arrangements will not solve all cross-border resolution issues.  In particular, the current proposal for 27 national arrangements which can borrow from, and lend to, each other suffers from a lack on clarity with respect to details such as the rights and obligations of lenders and borrowers.

Deposit guarantee schemes (DGS)

The ECB supports the proposal that any available resources of a DGS should be available to finance resolution, but warns that this should not be allowed to compromise the core DGS function i.e. the protection of insured deposits.

In contrast to the proposed RRD, which requires Member States to ensure that DGS rank pari passu with unsecured non-preferred claims under national insolvency law, the ECB recommends that Member States should be allowed to establish preferential ranking of claims that the DGS has acquired by subrogation (i.e. after having paid out the amount corresponding to covered deposits).  This, it believes, would help ensure that sufficient funding is always available to the DGS.

Disclosure of marketing materials

The RRD currently allows for a delay in publication of any public disclosure regard the sale of any part of an institution under resolution.  The ECB recommends extending this power to facilitate a delay in the publication of any price sensitive information relating to publicly traded financial instruments of the institution under resolution.

Further harmonisation of recovery and resolution rules

The ECB supports the development of a recovery and resolution framework for systemically important non-bank financial institutions e.g. insurance companies and market infrastructures.

 

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!

European Banking Federation responds to Liikanen

Introduction

On 14 November 2012, the European Banking Federation (EBF) published its response to the final report of the Liikanen Group on proposed structural reforms to the EU banking sector.  Broadly, the Liikanen Group had recommended the mandatory separation, with respect to all banks exceeding a certain threshold, of trading business from more ‘traditional’ banking activities.  The resulting entities would be required to fund themselves separately and meet other prudential regulatory requirements on a stand-alone basis.  The main issues addressed by the EBF are summarised below.

Mandatory Separation

The EBF believes that the case for mandatory separation has not been made in light of the Liikanen Group’s conclusions that:

  • no particular business model was more or less vulnerable in the crisis;
  • the benefits of the universal banking model should be retained;
  • the EU Single Market should remain intact; and
  • the regulatory reform agenda represents a “substantive and robust” response to addressing the deficiencies which become apparent during the financial crisis.

The EBF believes that mandatory separation:

  • does not adequately address the riskiness of assets;
  • does not solve the issue of systemic risk;
  • has distortive effects upon bank functions;
  • will impact negatively on banks’ ability to lend;
  • will reduce diversification benefits of the universal banking model;
  • will reduce the competitiveness of the European financial sector by creating a two-tier system where banks with risky trading positions below the threshold obtain an unfair advantage;
  • will lead to a further fragmentation of the Single Market due to the fact that the reforms proposed by the Liikanen Group represent an add-on to national structural reform proposals such as Vickers and Volcker as well as future proposals being discussed in other Member States, including France, Holland and Belgium; and
  • would result in higher costs for bank customers.

The EBF believes that there is a real risk that an independent trading entity would not be viable and would be downgraded by credit rating agencies, forcing up funding costs.  This, together with the likely increase in administrative costs arising from the proposed requirements for separate reporting and  independent boards and governance, could lead to non-EU banks replacing European banks as providers of ‘trading’ services as well as the concentration of risk in the few market participants large enough to bear the increased cost.

Instead of the proposed mandatory separation, the EBF supports a solution that targets high-risk and speculative trading activities, using proprietary trading activities with no link to clients’ needs as an example.  To this end, it recommends the enhanced use of Recovery and Resolution Plans (RRPs) as a way to address any impediments to resolvability.  However, it maintains that structural separation of certain activities conditional on the RRP should be viewed as a last resort.

Bail-In

The EBF is yet to be convinced that a designated bail-in category, as recommended by the Liikanen Group, is preferable to the proposals in the draft EU Recovery and Resolution Directive (RRD) requiring a broad range of bail-in-able debt instruments.  The EBF also believes that further consideration needs to be given to the exclusion of short-dated instruments, although it acknowledges that a broad range of views exist even within the EBF, from suggestions to remove the short-dated exclusion altogether, to proposals that the one month period be increased to six months on the basis that this is more consistent with other supervisory requirements such as the Net Stable Funding Ratio under Basel III.  The EBF believes strongly that derivative positions should not be included within the scope of bail-in.

Capital Requirements

The EBF believes that the introduction of floors for risk weightings “constitutes a significant threat to risk modelling and to the principle of calibrating capital requirements according to actual risks”.  It also believes that proposals to establish extra non-risk based capital buffers for the trading book as well as LTV caps for real estate related lending (both of which would take effect on top of existing risk-based requirements) should be deferred pending the finalisation of the new Capital Requirements Directive.  Specifically, the EBF states that exposures to funds falling within the scope of the Alternative Investment Fund Managers Directive should not be perceived as risky or speculative activities for which extra measures needs to be undertaken.

 

IAIS consults on policy measures for global systemically important insurers

Introduction

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

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

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

Enhanced Supervision

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

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

Enhanced Liquidity Planning and Management

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

Systemic Risk Reduction Plan

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

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

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

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

 Effective resolution

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

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

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

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

Higher loss absorption (HLA) capacity

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

Implementation time frame

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

Key Implementation Dates and Timeframes

Action Required

 

April 2013

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

From 2013

Implementation of enhanced supervision and effective resolution   commences

End 2013

IAIS   to elaborate proposed HLA capacity measures

Within 12 months of designation

Crisis   Management Groups (CMGs) to be established

Within 18 months of designation

Other   resolution measures to be completed

Within 18 months of designation

Systemic   Risk Reduction Plan (SRRP) to be completed

Within 36 months of designation

Implementation of SRRP to be assessed

November 2014 to 2016

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

November 2017

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

January 2019

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

 

EU Parliament Sets its Sights on RRD Early Intervention Powers

The RRD needs to focus less on the issue of individual failing banks and more on ways to resolve a general banking crisis, according to an EU Parliament press release published on 6 November 2012.

In addition, the next priority should be to clearly define the point at which resolution is triggered and control of an institution passes from its management to resolution authorities.  According to the EU Parliament, there must be no “grey zones” as to who is running a bank.

Beyond this, the question of resolution financing must be also addressed.  Clear rules, which allow the use of public funds only once shareholders have been wiped out, should be established.  These arrangements should be supported by the creation of a resolution fund, financed by way of ex ante industry contributions.

Deadline for G-SIB Resolution Plans Pushed Back

On 5 November 2012, the Financial Stability Board (FSB) published a letter dated 31 October 2012 addressed to the G20 regarding progress made with respect to financial regulatory reforms.

The FSB reported ‘solid but uneven’ progress” in the four priority areas identified by the G20, being:

  • building resilient financial institutions (i.e. Basel III);
  • ending “too big to fail” (i.e. RRP);
  • strengthening the oversight and regulation of shadow banking activities; and
  • completion of OTC derivatives and related reforms.

On the subject on ending “too big to fail”, the FSB noted that a peer review of national actions taken to legislate its “Key Attributes of Effective Resolution Regimes” document will now be published in the first half of 2013.  More importantly, however, on the subject of resolution planning for Globally Systemically Important Financial Institutions (G-SIFIs), the FSB confirmed that the deadline for completion of operational resolution plans for Globally Systemically Important Banks (G-SIBs) has been extended by six months until mid-2013.  Consequently, the FSB’s peer-based resolvability assessment process will now be delayed until the second half of 2013.

Changes to the G-SIFI List

In November 2011, the Financial Stability Board (FSB) published its initial list of Global Systemically Important Banks (G-SIBs).  On 1 November 2012, the list was updated, with BBVA and Standard Chartered being added to the list and Commerzbank, Dexia and Lloyds all being removed.

The significance of being classified as a G-SIB lies in the fact that, under Basel III, any bank identified as a G-SIB in November 2014 will be required to maintain additional loss absorbency.  This requirement will be phased in between January 2016 and January 2019 and ranges between 1% and 2.5% of risk weighted assets depending on the significance of the individual firm.  G-SIBs are also required to meet higher supervisory standards for risk management functions, data aggregation capabilities, risk governance and internal controls.  Any firm newly designated as a G-SIB is required to implement certain resolution planning requirements within specified deadlines.  Furthermore, even where a financial institution is no longer designated as a G-SIB it will continue to be subject to the requirement to prepare an RRP to the extent that it is assessed by its national regulator to be systemically significant or critical in the event of failure.

For the first time, the current list of G-SIBs has been allocated into provisional buckets corresponding to the required level of additional loss absorbency, as set out in more detail in Annex 1 below.  The timetable for implementation of resolution planning requirements for newly designated G-SIFIs is detailed in Annex 2 below.

Annex 1

  

Bucket

G-SIB in alphabetical order within each   bucket

5

(3.5%)

(Empty)

 4

(2.5%)

Citigroup

Deutsche Bank

HSBC

JP Morgan Chase

3

(2.0%)

Barclays

BNP Paribas

 2

(1.5%)

Bank of America

Bank of New York Mellon

Credit Suisse

Goldman Sachs

Mitsubishi UFJ FG

Morgan Stanley

Royal Bank of Scotland

UBS

1

(1.0%)

Bank of China

BBVA

Group BPCE

Group Credit Agricole

ING Bank

Mizuho FG

Nordea

Santander

Societe Generale

Standard Chartered

State Street

Sumitomo Mitsui FG

Unicredit Group

Wells Fargo

Annex 2

G-SIFI Requirement Deadline for completion following date of G-SIFI designation
Establishment of Crisis Management Group (CMG)

6 months

 

Development of recovery plan

12 months

 

Development of resolution strategy and review within CMG

12 months

 

Agreement of institution specific cross-border cooperation agreement

18 months

 

Development of operational resolution plan

18 months

 

Conduct of resolvability assessment by CMG and resolvability assessment process

24 months

 

 

SSM Proposals Being Watered Down?

Introduction

On 8 October 2012, the EU Parliament’s Committee on Economic and Monetary Affairs (ECON) published a draft report proposing amendments to the European Commission’s draft regulation establishing a single supervisory mechanism (SSM).

The most significant amendment proposed by the EU Parliament would restrict the number of banks coming under direct ECB supervision.  Whilst subject to safeguards (and admittedly still in draft form) these proposals nonetheless have the potential to undermine the effectiveness of the SSM as a mechanism for ensuring a coordinated cross-border response to bank resolution within the EU.  As such, it will be important to monitor the way in which these proposals develop.  More detail on the contents of the draft report is provided below.

Scope of the SSM Regulation

As drafted by the EU Commission, the ECB would have been given supervisory responsibility for “all banks of participating Member States”.  In contrast, the EU Parliament amendment proposes that the ECB’s powers be limited to exercising “specific and clearly defined supervisory tasks” in relation to:

  • systemically important European banks (measured by reference to size of exposures, systemic risk for the relevant domestic economy and scale of cross-border activity); and
  • banks which have received or requested public financial assistance.

Under the EU Parliament’s proposed amendments, national competent authorities would continue to supervise all banks falling outside the scope of direct ECB supervision.  However, the ECB would establish a supervisory framework under which national supervision would take place and would be responsible for monitoring national authorities’ compliance with this framework.  The framework would be supported by a requirement on national authorities to report to the ECB on a quarterly basis, and provide notification “without delay” where:

  • serious concerns exist about the safety and/or soundness of a credit institution falling outside the scope of direct ECB supervision;
  • the stability of the financial system is or is likely to be endangered by a credit institution falling outside direct ECB supervision; or
  • a credit institution for which they are competent ceases to fall outside the scope of direct ECB supervision.

The ECB would commence supervision from 1 July 2013 but may, by way of notification, exercise its powers before this date in relation to any credit institution which has received or requested public financial assistance.  In addition, the ECB would also retain the right to exercise supervisory power of any Member State credit institution if:

  • national authorities failed to perform their obligations under the SSM regulation;
  • there was evidence that a credit institution posed, was likely to pose, or would exacerbate  a threat to the single market or financial stability; or
  • a credit institution falls under the scope of direct ECB supervision.

 

IMF Speech on Global Financial Sector Reform

On 26 October 2012, the IMF published a speech given in Toronto by its Managing Director, Christine Lagarde, on global financial sector reform.

Ms Lagarde noted that progress had been made on implementing financial sector reform, specifically referring to Basel III and improved standards for the resolution of banks.  In particular, she welcomed the EU’s moves to adopt a legal framework for a single supervisory mechanism by the end of 2012 as well as provisions regarding national resolution and deposit guarantee frameworks.  However, she noted that a globally coordinated discussion and response was still required in a number of areas, including:

  • current efforts to resolve the issue of “too important to fail” through structural reform as proposed by Volcker, Vickers and Liikanen; and
  • international agreement on methodologies to assess compliance of recovery and resolution planning for large cross-border institutions.

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.