The Road to Non-Bank Resolution

On 6 May 2013, the EU Commission published a roadmap regarding a framework for crisis management and resolution for financial institutions other than banks (i.e. central counterparties, central securities depositories, insurance and reinsurance firms, payment systems, investment funds and certain trading venues).  The roadmap follows the consultation paper published on 5 October 2012, a summary of which is available here.

Rather than adopt a broad framework approach in terms of applicable nonbank institutions and general tools for authorities to intervene, the Commission believes that more specific provisions and tools in relation to each sectors is more appropriate due to the different types of risk to which each sector is exposed and the differing consequences their failure would have.  The Commission makes clear that any regulation will be proportionate in nature and “only entities which are big, interconnected or central enough in the financial system to cause widespread disruption should they fail” are to be subject to the regulation.

As noted in this update, the EU Commission currently expects a legislative proposal in this area to be adopted in November 2013.

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.

FSB to Complete G-SIFI RRP Reforms Before Concentrating on Non-Banks

The Financial Stability Board (FSB) has published a press release regarding the meeting which took place in Zurich on 28 January 2013 to discuss vulnerabilities affecting the global financial system and progress to strengthen global financial regulation.

On the subject of resolving failing financial institutions, the FSB confirmed that, in April, it will publish its final peer review of resolution regimes.  Thereafter, the FSB’s work on resolution in 2013 will focus on three main objectives:

  • addressing remaining obstacles to the implementation of resolution strategies for G-SIFIs;
  • launching an effective resolvability assessment process for G-SIFIs; and
  • developing guidance for the resolution of non-bank financial institutions.

EU to Adopt Liikanen Proposals and Non-Bank RRP in 2013

On 21 January 2013, the European Commission published a timetable for certain legislative proposals that it expects to adopt between 1 January 2013 and 31 December 2013, including the following:

Q3 2013:

  • Directive/Regulation on the reform of the structure of EU banks (i.e. the Liikanen reforms)

Q4 2013:

  • Framework for crisis management and resolution for financial institutions other than banks
  • Regulation on a single resolution authority and a single resolution fund within a Single Resolution Mechanism.

ISDA Responds to EU Commission Consultation on RRP for Non-banks

On 23 December 2012, ISDA published a letter sent in response to the EU Commission’s Consultation on a possible recovery and resolution framework for financial institutions other than banks.

ISDA’s response focuses mainly on RRP for Central Clearing Counterparties (CCPs).  It believes that a common resolution framework should apply to all FMIs (and not just to those which exceed specific thresholds in terms of size, level of interconnectedness etc.).  To the extent that an FMI is also a credit institution, ISDA believes that this framework should apply above and beyond the RRP requirements applicable to banks.

ISDA agrees that the general objective for the resolution of FMIs should be continuity of critical services and that any RRP framework should emphasis the issues of recovery and continuity over that of resolution.  More specifically, ISDA emphasises that any RRP initiative should be consistent with seven key principles as set out below.

1. CCP loss allocation procedures must be certain, transparent and avoid unlimited liability for Clearing Members

ISDA asserts that limited liability for clearing members will promote financial stability as it will reduce incentives to “rush for the exits” during a period of stress.  Loss allocation procedures which are not consistent with this principle, such as forced tear-ups and uncapped default fund liability should be avoided.  In addition, ISDA believes that it is unrealistic to think that indirect participants and clients of clearing members can be shielded from losses, although it believes that the specifics of this aspect are best dealt with as a matter of direct agreement between counterparties and to relevant conduct-of-business regulations.

2. CCP loss allocation rules should be respected and applied prior to implementation of resolution

ISDA believes that resolution should only be triggered after an FMI’s agreed and documented recovery arrangements have been given the opportunity to succeed an only after consultation (however brief) with market participants.

3. Any framework must be consistent with CPSS-IOSCO FMI RRP principles

ISDA believes that the ultimate success of any RRP initiative is dependent on the creation of a globally consistent standard.

4. The relationship between recovery and resolution of CCPs must be clear, predictable and transparent

Resolution should only occur when it is where it is ‘necessary’ (rather than merely ‘desirable’) to address a serious threat to financial stability.  This arises when an FMI has reached the point where there are no realistic prospects of recovery over an appropriate timeframe, when all other intervention measures have been exhausted, where additional losses arise from a source for which there are no CCP rules, and when winding up the institution under normal insolvency proceedings would risk causing financial instability.

In the interests of predictability, there should be no ability for authorities to intervene before an FMI meets the conditions for resolution.  Rather pre-resolution actions of a supervisor should be limited to providing guidance and ensuring the effective implementation of the FMI’s own procedures.

5 Robust procedures for the transfer of membership agreements and positions must exist

Procedures regarding the porting of positions to a solvent FMI must be established before the event and tested periodically.  In addition, any transfer must be done in a way that does not interfere with members’ existing rights to net exposures against a CCP.  More specifically, ISDA believes that the power to impose a temporary stay on the exercise of early termination rights is not necessary in the context of a failing FMI.  Moreover, it regards the ability to enforce a moratorium on payments beyond a “very limited grace period” as a potentially “dangerous” tool, which should only be available on an exceptional basis when a CCP has non-cash collateral which it is unable to convert into cash as quickly as necessary.  However, as a last resort only, ISDA regards it as “entirely appropriate” for CCPs to include within their recovery provisions the possibility of terminating a particular product set if this is necessary in order to restart a particular market or avoid the effects of contagion.

6 Co-operation and co-ordination between authorities is essential

ISDA agrees that strong cross-border cooperation and coordination, both before and during resolution, are essential to the successful resolution of a failed FMI, with the failing FMI’s national resolution authority taking the lead coordinating role.  Fundamentally, however, it believes that the CPSS, IOSCO and FSB should move beyond existing international RRP standards and adopt a substantive international convention on the resolution of cross-border financial institutions, such as was recommended by the International Institute of Finance in its June 2012 paper entitled “Making Resolution Robust – Completing the Legal and Institutional Frameworks for Effective Cross-border Resolution of Financial Institutions”.

7 Safeguards: Netting and collateral arrangements must be protected throughout resolution

ISDA believes that intervention powers cannot be unfettered or apply retrospectively.  Rather, they should contain restrictions on the transfer of part only of a CCP’s business in a way that interferes with members’ netting rights.  In addition, it is essential that the hierarchy of claims in insolvency be respected and that creditors should not be worse off than in insolvency.

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.

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.