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This report sets out a global financial services industry perspective on a number of priority issues in cross‐border resolution. The global industry strongly supports the development of an international framework for the resolution of cross‐border financial firms. This is key to ensuring durable financial stability consistent with sustainable growth of the global economy. Achieving this will require both the will to address this challenge as well as solutions to a number of difficult technical questions. This report is designed to contribute to both of these aspects. It articulates an industry consensus on a number of key challenges and puts forward proposals for approaching them. The report builds on the Institute’s earlier submissions to the Financial Stability Board on the subject: A Global Approach to Resolving Failing Financial Firms: An Industry Perspective (May 2010) and Preserving Value in Failing Financial Firms (September 2010). On preserving critical functions, the report advocates a sharply focused approach to the identification of critical functions, noting that the preservation of such functions in the event of a failure is not a cost‐free exercise. This should be dealt with as part of resolution planning. Firms have a responsibility to provide the information and explanations that need to be available to supervisors to achieve this. While the industry does not believe there is a case for routine demands from supervisors for structural changes such as modularization of businesses or required subsidiarization, it is incumbent on firms to ensure that properly identified critical functions can be maintained and transferred in the event of a firm’s failure. The report supports the use of bail‐in techniques to reduce loss of value in failing firms and avoid systemic trauma. The primary focus of bail‐in should be subordinated debt, which could be expected, in a majority of cases, to be sufficient to achieve the objectives. The bailing‐in of unsecured senior debt should occur only in the special circumstances, that this is necessary as a last‐resort alternative to winding‐down or liquidation, with certain requirements imposed on authorities if they wish to use these supplementary senior debt bail‐in powers. Credit liabilities arising from trading activities should be excluded from the scope of bail‐in, and the introduction of bail‐in should be on a prospective basis only. An effective framework for the resolution of cross‐border firms requires both convergence of national regimes and enhanced cooperation and coordination among resolution authorities, based on legally effective crisis management agreements. Such agreements have the capacity to allow for approaches to resolution that are consistent 1
with the structural and organizational approaches adopted by firms, and which avoid increased ring‐fencing of countries and fragmentation of the international marketplace. There are significant benefits to the global and local economies deriving from the diverse range of approaches and structures that global firms deploy. Cross‐border resolution arrangements need to preserve these. To be effective such crisis management agreements need to be embedded in national resolution frameworks incorporating a number of provisions designed to underpin and support the international market in financial services. The global industry is strongly committed to the development of an effective international framework for the resolution of cross‐border financial firms. We consider that, building on the work to date by the FSB and its members as well as by industry representatives, this goal is now potentially within our grasp. The IIF is pleased to present this report as an industry contribution to the work in this area. The industry stands ready to participate in further work and dialogue in order to leverage the insights and solutions of all parties toward the achievement of this strongly shared objective.
Josef Ackermann Chairman of the Management Board and the Group Executive Committee, Deutsche Bank AG Peter Sands Group Chief Executive, Standard Chartered, PLC
Urs Rohner Chairman of the Board of Directors Credit Suisse Group AG Charles H. Dallara Managing Director Institute of International Finance
Preface IIF Board of Directors IIF Special Committee on Effective Regulation IIF Working Group on Cross‐Border Resolution Executive Summary Introduction 1 4 7 12 16 21 23 30 42 53 55 57 60
Section 1 ‐ Effective resolution planning—ensuring the continuance of critical functions Section 2 ‐ Avoiding systemic trauma—making bail‐in techniques operational Section 3 ‐ Resolving cross‐border financial firms—addressing key issues
Annex 1: Key components of an effective resolution framework as set out in IIF Report, A Global Approach to Failing Financial Firms: An Industry Perspective Annex 2: Critical functions—some putative examples to be considered Annex 3: Summary of IIF Paper, Preserving Value in Failing Firms Annex 4: Legal issues in group support and resolution
IIF Board of Directors
Chairman Josef Ackermann* Chairman of the Management Board and the Group Executive Committee Deutsche Bank AG Chairman Chairman Chairman Francisco González* Roberto E. Setubal* Rick Waugh* Chairman and Chief President and Chief President and Chief Executive Officer Executive Officer, Itaú Executive Officer BBVA Unibanco Banco S/A Scotiabank and Vice Chairman of the Board of Itaú Unibanco Holding S/A Treasurer Marcus Wallenberg* Chairman of the Board SEB Mr. Michael Smith Ms. Suzan Sabanci Dincer Chief Executive Officer Chairman and Executive Board Member Australia and New Zealand Banking Akbank T.A.S. Group Limited Mr. Yannis S. Costopoulos* Mr. Walter Bayly Chairman of the Board of Directors Chief Executive Officer Alpha Bank A.E. Banco de Crédito del Perú (BCP) Mr. Peter Wallison Mr. Baudouin Prot* Senior Fellow Chief Executive Officer Financial Policy Studies BNP Paribas American Enterprise Institute Mr. Hassan El Sayed Abdalla Mr. Robert P. Kelly* Vice Chairman and Managing Director Chairman and Chief Executive Officer Arab African International Bank BNY Mellon
Mr. Vikram Pandit Chief Executive Officer Citigroup, Inc. Mr. Martin Blessing Chairman of the Board of Managing Directors Commerzbank AG Mr. Urs Rohner Chairman of the Board of Directors Credit Suisse Group AG Mr. Andreas Treichl Chairman of the Management Board and Chief Executive Officer Erste Group Bank AG Mr. Gary D. Cohn President and Chief Operating Officer Goldman, Sachs & Co. Mr. Douglas Flint Group Chairman HSBC Holdings plc Mr. K. Vaman Kamath Chairman of the Board ICICI Bank Ltd. Mr. Jiang Jianqing Chairman of the Board of Directors and President Industrial and Commercial Bank of China Mr. Jan Hommen Chairman of the Executive Board ING Group Mr. Charles H. Dallara (ex officio)* Managing Director Institute of International Finance 5
Mr. Corrado Passera Managing Director and Chief Executive Officer Intesa Sanpaolo S.p.A. Mr. Jes Staley Chief Executive Officer Investment Bank J.P. Morgan Chase & Co. Mr. Yoon‐dae Euh Chairman KB Financial Group Inc. Mr. Yasuhiro Sato President and Chief Executive Officer Mizuho Corporate Bank, Ltd. Mr. James Gorman President and Chief Executive Officer Morgan Stanley Mr. Ibrahim S. Dabdoub Group Chief Executive Officer National Bank of Kuwait Mr. Frédéric Oudéa Chairman and Chief Executive Officer Société Générale Mr. Peter Sands Group Chief Executive Standard Chartered, PLC Mr. Walter B. Kielholz Chairman of the Board of Directors Swiss Reinsurance Company Ltd. Mr. Nobuo Kuroyanagi* Chairman The Bank of Tokyo‐Mitsubishi UFJ, Ltd.
Mr. Oswald Gruebel Group Chief Executive Officer UBS AG
Mr. Martin Senn Chief Executive Officer Zurich Financial Services
*Member of the Administrative and Nominations Committee
IIF Special Committee on Effective Regulation
Chairman Mr. Peter Sands Group Chief Executive Standard Chartered, PLC Mr. David Hodnett Mr. Gerd Häusler Group Financial Director Chief Executive Officer ABSA Group Limited Bayern LB Mr. Bob Penn Ms. Maria Abascal Rojo Partner Chief Economist—Regulation and Public Allen & Overy LLP Policy BBVA Research BBVA Ms. Alejandra Kindelán Oteyza Head of Research and Public Policy The Honourable Kevin Lynch Communications, Group Marketing and Vice‐Chair Research Division BMO Financial Group Banco Santander Mr. Rob Everett Mr. Baudouin Prot European Chief Operating Officer Chief Executive Officer Bank of America Merrill Lynch BNP Paribas Group Mr. Robert Pitfield Mr. Christian Lajoie Group Head, Chief Risk Officer Head of Group Prudential Affairs / Co‐ Bank of Nova Scotia head of Group Prudential and Public Affairs Mr. Richard Quinn BNP Paribas Group Director, Regulatory Affairs Group Compliance Mr. Mark Musi Barclays EVP, Chief Compliance and Ethics Officer Mr. Mark Harding BNY Mellon Group General Counsel Barclays PLC
Mr. Brian Rogan Vice Chairman and Chief Risk Officer BNY Mellon Ms. Jill Considine Chairman Butterfield Fulcrum Group Mr. Michael Helfer General Counsel and Corporate Secretary Citigroup Inc. Mr. Simon Gleeson Partner Clifford Chance LLP Dr. Stefan Schmittmann Chief Risk Officer and Member of the Board of Managing Directors Commerzbank AG Mr. Jörg Erlebach Divisional Board Member Group Risk Controlling & Capital Management Commerzbank AG Dr. Rodney Maddock Executive General Manager Group Strategy Development Commonwealth Bank of Australia Mr. Hubbert de Vauplane Direction Juridique et Conformité Groupe Crédit Agricole Mr. Olivier Motte Head of Public Affairs Member of the Management Committee, CA‐CIB Credit Agricole CIB 8
Mr. Jérôme Brunel Head of Public Affairs, Member of the Executive Committee Crédit Agricole SA. Mr. Urs Rohner Chairman of the Board of Directors Credit Suisse Group AG Dr. René Buholzer Managing Director, Global Head Public Policy Credit Suisse Mr. Robert Wagner Chief Analyst Group Finance, Regulation Danske Bank Dr. Hugo Banziger Chief Risk Officer & Member of the Management Board Deutsche Bank AG Mr. Bjørn Erik Næss Group Executive Vice President Group Finance and Risk Management DnB NOR ASA Mr. Roar Hoff Executive Vice President, Head of Group Risk Analysis DnB NOR ASA Mr. Wolfgang Kirsch Chief Executive Officer DZ BANK AG Dr. Florian Strassberger General Manager Head of New York Branch DZ Bank
Dr. Manfred Wimmer Chief Financial Officer, Chief Performance Officer, and Member of the Management Board Erste Group Bank AG Mr. Barry Stander Head of Banks Act Compliance Regulatory Risk Management FirstRand Mr. Faryar Shirzad Managing Director, Global Head Office of Government Affairs Goldman Sachs Mr. Gregory Wilson President Gregory P. Wilson Consulting Ms. Lara de Mesa Head of Public Policy Research Department Grupo Santander Mr. Nasser Al‐Shaali Chief Executive Officer Gulf Craft Mr. James Chew Deputy Head, Strategy and Planning GMO International HSBC Mr. Koos Timmermans Member of the Executive Board and CRO ING Group Mr. Carlo Messina Chief Financial Officer Intesa Sanpaolo Spa 9
Mr. Roberto Setubal President and CEO of Itau Unibanco S/A and Vice Chairman of the Board of Itau Unibanco Holding S/A Itaú Unibanco S/A Dr. Jacob Frenkel Chairman JPMorgan Chase International Dr. Mark Lawrence Managing Director Mark Lawrence Group Mr. Philip Härle Director McKinsey and Co. Mr. Masao Hasegawa Managing Director, CRO, and CCO Mitsubishi UFJ Financial Group, Inc Mr. Daisaku Abe Managing Executive Officer, Chief Strategy Officer, Chief Information Officer, General Manager of Group Strategic Planning Mizuho Financial Group, Inc. Mr. David Russo Chief Financial Officer Institutional Morgan Stanley Ms. Clare Woodman Chief Operations Officer EMEA Morgan Stanley Mr. Ibrahim Dabdoub Group Chief Executive Officer National Bank of Kuwait, S.A.K.
Mr. Parkson Cheong General Manager and Group Chief Risk Officer Group Risk Management National Bank of Kuwait, S.A.K. Mr. David Benson Vice Chairman, Nomura Holding Nomura International plc Mr. Samuel Hinton‐Smith Director, Public Affairs Corporate Communications Nomura Mr. Ari Kaperi Executive Vice President, Chief Risk Officer Group Risk Management Nordea Bank AB Mr. John Drzik President and Chief Executive Officer Oliver Wyman Mr. William Demchak Vice Chairman PNC Financial Services Group Mr. John W. Campbell Partner Advisory Financial Services PricewaterhouseCoopers LLP Mr. Eugene A. Ludwig Founder and Chief Executive Officer Promontory Financial Group, LLC Mr. Fernando Barnuevo Sebastian de Erice Managing Director RHJI Swiss Management 10
Mr. Morten Friis Chief Risk Officer Royal Bank of Canada Mr. Russell Gibson Director, Regulatory Affairs, Group Regulatory Affairs & Compliance Royal Bank of Scotland Group Mr. Nils‐Fredrik Nyblaeus Senior Advisor to the Chief Executive Officer SEB Group Mr. Pierre Mina Head of Group Regulation Coordination Société Générale Mr. Rodgin Cohen Senior Chairman Sullivan & Cromwell LLP Mr. Nobuaki Kurumatani Managing Director Sumitomo Mitsui Banking Corporation Mrs. Kerstin af Jochnick Managing Director Swedish Bankers Association Mr. Philippe Brahin Director Risk Management Swiss Reinsurance Company Ltd Mr. Donald F. Donahue Chairman and Chief Executive Officer The Depository Trust & Clearing Corporation
Mr. Takashi Oyama Counsellor on Global Strategy to President and the Board of Directors The Norinchukin Bank Dr. Steve Hottiger Managing Director & Head Group Governmental Affairs UBS AG Mr. Sergio Lugaresi Senior Vice President Head of Regulatory Affairs Institutional and Regulatory Strategic Advisory UniCredit Group
Mr. Richard Yorke EVP & Group Head International Group Wells Fargo & Company Mr. Kevin Nixon Head of Regulatory Reform Westpac Dr. Peter Buomberger Group Head of Government and Industry Affairs Zurich Financial Services Dr. Madelyn Antoncic
IIF Working Group on Cross‐Border Resolution
Chairman Mr. Urs Rohner Chairman of the Board of Directors Credit Suisse Group AG Mr. John Whittaker Mr. Diederick van Mierlo Group Operational Risk Director Managing Director Corporate & Markets Barclays Bank PLC Risk Central Risk Management Ms. Maria Abascal Rojo ABN‐AMRO Chief Economist—Regulation and Public Policy Mr. Bob Penn BBVA Research Partner BBVA Allen & Overy LLP Mr. Christian Lajoie Ms. Suzanne Chomiczewski Head of Group Prudential Affairs / Co‐ Director head of Group Prudential and Public Corporate Treasury/GRRP Affairs Bank of America BNP Paribas Mr. Mark Lunn Mr. Bradley Gans Senior Vice President Chief Legal Officer Bank of America Europe, Middle East & Africa Mr. Michael D'Souza Citi Managing Director Bank of America Merrill Lynch Ms. Tina Locatelli Managing Director & General Counsel‐ Mr. Richard Quinn Independent Risk Director, Regulatory Affairs Citigroup Inc. Group Compliance Barclays Mr. Seth Grosshandler Partner Cleary Gottlieb Steen & Hamilton LLP
Mr. Simon Gleeson Partner Clifford Chance Mr. Jérôme Brunel Head of Public Affairs, Member of the Executive Committee Crédit Agricole SA. Mr. Volker Bätz Director Treasury Credit Suisse Mr. D. Wilson Ervin Senior Advisor to the CEO Credit Suisse Mr. Andrew Procter Global Head of Government & Regulatory Affairs Government & Regulatory Affairs Deutsche Bank AG Mr. Karl‐Heinz von Oppenkowski Director, Credit Restructuring Credit Department DZ Bank Ms. Gerda Holzinger‐Burgstaller Head of Chairman’s Support Chairman’s Office Erste Group Bank AG Dr. Oliver Schütz Head of EU Legislative and Regulatory Affairs Erste Group Bank AG Mr. Stephen Davies Managing Director Finance Goldman Sachs International 13
Ms. Lara de Mesa Head of Public Policy Research Department Grupo Santander Ms. Sheryl Slater Head of Asset and Liability Management Asia Pacific Finance Hong Kong and Shanghai Banking Corporation Limited Mr. James Chew Deputy Head, Strategy and Planning GMO International HSBC Mr. Alain C. Stangroome Head of Group Capital Planning Group Financial Planning and Tax HSBC Holdings plc Mr. Henk Huisman Deputy Director Public & Government Affairs ING Group Ms. Ellen Bish Legal Counsel—Regulatory Affairs Corporate Legal Department ING Group Mr. Luigi Ruggerone Head of Country Risk Risk Management Department Intesa Sanpaolo S.p.A. Ms. Karen Linney Managing Director and EMEA Investment Bank General Counsel JP Morgan Chase & Co. Mr. Michael Offen MD, Corporate Finance JP Morgan Chase & Co.
Ms. Sandra Boss Director McKinsey & Company Mr. Akihiro Kitano Senior Manager Basel 2 Implementation Office Mitsubishi UFJ Financial Group, Inc. Mr. Hideyuki Toriumi Senior Manager Basel 2 Implementation Office Mitsubishi UFJ Financial Group, Inc. Mr. Tetsuo Iimori Executive Officer and General Manager of Corporate Planning Mizuho Financial Group, Inc. Mr. Guy Clayton Managing Director Legal and Compliance Morgan Stanley Mr. Parkson Cheong General Manager and Group Chief Risk Officer Credit & Risk Management Group National Bank of Kuwait S.A.K. Mr. John Bovenzi Partner Oliver Wyman Ms. Sheryl Kennedy Chief Executive Officer Promontory Financial Group, Canada ULC Mr. Ralph Ricks Head, Group Regulatory Developments Group Regulatory Affairs Royal Bank of Scotland 14
Mr. Sean McGuckin Senior Vice President and Head, Risk Policy & Capital Markets Scotiabank Dr. Byung‐Chul Lim Managing Director Shinhan FSB Research Institute Shinhan Financial Group Mr. Denis Devers Head of Financial Management DEVL/FIN Société Generale Ms. Frédérique Marchal Capital Planning and Regulations Finance Department Société Générale Mr. Gareth Berney Head, Capital Optimisation Group Treasury Standard Chartered Bank Mr. Tetsuro Yoshino Joint General Manager Corporate Planning Sumitomo Mitsui Banking Corporation Mr. Philippe Brahin Director Risk Management Swiss Reinsurance Company Ltd. Mr. Thomas Pohl Executive Director, Head Executive & International Affairs Group Governmental Affairs UBS AG
Mr. Sergio Lugaresi Senior Vice President and Head of Regulatory Affairs Institutional and Regulatory Strategic Advisory UniCredit Group
Mr. Kevin Nixon Head of Regulatory Reform Westpac Mr. Edmund Bosworth Head of Risk Reward Group Finance Westpac Banking Corporation
1. This submission builds upon the Institute’s previous submissions to the FSB: A Global Approach to Resolving Failing Financial Firms: An Industry Perspective (May 2010) and Preserving Value in Failing Financial Firms (September 2010). Effective resolution is essential in achieving long‐term resilience and financial stability. It plays a key role in addressing moral hazard and issues associated with systemically important firms. This paper addresses three key components of an effective framework for cross‐ border resolution: (a) resolution planning for the maintenance of critical functions, (b) bail‐in mechanisms and (c) addressing key cross‐border issues.
Resolution planning for critical functions
4. High‐quality recovery and resolution planning is an essential component of effective resolution. Such planning should take place on a group‐wide basis. There should be a single resolution plan for the group as a whole, though this should address the situation in the different parts of the group and should be developed on the basis of strong coordination between the authorities in the different jurisdictions in the context of a well‐functioning firm‐specific crisis management group. Maintaining critical functions is not a cost‐free exercise. In addition to administrative costs—to the extent that good assets are transferred to support critical liabilities—there may be fewer such assets available to cover losses in the failing firm. It is important therefore to adopt a tight definition of critical functions. Resolution planning is the primary responsibility of the authorities. Firms have a responsibility to provide the information necessary to allow the authorities to plan effectively. Planning for the continuance of critical functions should not involve requests to firms as a matter of course to change their organizational structures. In particular, forced modularization or subsidiarization should not become the preferred choice of authorities. It is important that a group’s structure and organization reflect its business model and strategy. A requirement to move away from such an approach will give rise to significant inefficiencies and economic costs. Firms have the responsibility to provide the information and explanation necessary to enable: a) An assessment of the degree of the function’s criticality to the economy; 16
b) Clear understanding of the function in question, including its key features and the scale of provision by the firm; c) Identification of how that function is provided by the firm; d) Separation and transfer of the function in a crisis; and e) Understanding of how the function is financed, and will continue to be financed in a transfer situation. 9. In the context of cross‐border groups, authorities must cooperate and coordinate on the basis of effective firm‐specific agreements to carry out resolution planning that avoids the imposition of particular organizational structures and the fragmentation of international markets.
10. It is important to avoid that the failure of a financial firm gives rise to losses of such a scale that systemic trauma occurs. It is important that the failure of such a firm does not, through its interconnectedness with the broader system, give rise to a systemic event that undermines financial stability. In contrast with the situation involving a non‐financial firm, the simple fact of the declaration of a firm’s insolvency and liquidation can cause loss of business value sufficient to cause systemic damage. In the case of Lehman, the loss to creditors post‐declaration of insolvency is expected to be a number of times greater than the loss of asset value incurred prior to the declaration of insolvency. Bail‐in can forestall precipitous loss of value and systemic shock by recapitalizing the firm and allowing it to be restructured. A set of principles is put forward as a suggested basis for the development of bail‐ in regimes in different jurisdictions. While good progress has been made in developing proposals to make the bail‐in concept more operational, there remain difficult questions to be resolved and challenges to be overcome. Accordingly, in a number of areas the need for further work has been identified. The views of investors will also be important in arriving at final proposals for a bail‐in mechanism. In putting forward now the suggested approach in Section 2, it is envisaged that this approach can form the basis for a well‐grounded engagement with the investor community. The objective of a bail‐in is to preserve systemic stability. Accordingly, all financial institutions should potentially be able to be the subject of a bail‐in determination. 17
12. 13. 14.
In practice, only those the failure of which would be systemic in the circumstances as determined by the authorities should actually be subject to bail‐in. 17. The order of priority between classes of shareholders and classes of creditors should be maintained in all cases. Within a class, certain creditors may be bailed‐in while others are not. However, no creditor should be left worse off as the result of a bail‐in than s/he would have been in the liquidation of the firm. It is proposed that the primary scope of a bail‐in mechanism should be limited to subordinated debt. In many cases this is likely to be sufficient to recapitalize the firm so as to achieve the objectives set out. Such an approach can help address some of the potential disadvantages of bail‐in, including enhanced uncertainty, increased pricing of debt, and possible funding arbitrage. Moreover, such an approach helps lock in tightly adherence to the strict order of priorities in an insolvency. However, it is acknowledged that it is not possible to calibrate precisely ex ante the scale of the potential need for fresh capital in a crisis situation. Therefore it is envisaged that as a last resort, and subject to clear requirements and criteria, it may be necessary to bail‐in a proportion of the senior debt of the firm as an alternative to the winding‐down of the firm. The Industry believes that obligations arising from the trading activities of the firm should be excluded ex ante from the scope of this exceptional power of bail‐in. Whether the scope of this bail‐in should be more precisely determined ex ante— for example, by the exclusion of liabilities with a maturity of less than 365 days, or of uninsured deposits—is a key issue requiring further consideration. In all cases, the order of priority between different classes of shareholder and debtholder must be maintained. While this principle is immutable, further work is needed to identify the best technical options to achieve this. Bail‐in allows the firm to be restructured, weak management to be replaced, and the recapitalized firm to access sources of liquidity as being now firmly capitalized. In the case of cross‐border firms, the preferred approach is for the Financial Stability Board (FSB) to reach agreement on the requirement for each country to adopt a bail‐in mechanism. This would avoid divergent approaches. To the extent that this is not achieved contractual solutions will be required.
Key aspects in resolving cross‐border firms
24. National resolution regimes must form consistent and convergent components of an international framework for the resolution of cross‐border firms.
Firms adopt a variety of structural and organizational approaches to the operation of their cross‐border businesses. Such approaches are determined primarily by the nature of the business of the firm and the business model adopted. As such, material disbenefits would follow from any attempt to require firms to adopt particular structures or organizational approaches. For certain types of business and under certain business models, the ability of groups to run their business so as to optimize the “group interest” can result in enhanced outcomes for all parties and the economy. However, there is a potential mismatch between such a group‐interest concept and the legal entity–based nature of resolution regimes. Moreover, in such cases the requirement for authorities primarily to pursue outcomes defined in national jurisdiction terms can also, depending upon the nature of the business, produce negative sum outcomes. The work being carried out by the FSB on firm‐specific crisis management agreements is important and has the potential to achieve significant progress in this regard. To be successful, however, these agreements should establish legally effective resolution modalities that reflect the organizational structure and business model of the group. This in turn requires that national resolution frameworks are adapted to give effect to such agreements. Among the components of such frameworks should be: International mandates for authorities; A requirement of non‐discrimination against creditors of the group on the basis of their location or nationality; A objective to optimize outcomes for creditors of the group as a whole; A requirement for joint planning in the context of crisis management and resolution colleges, and clear cooperation and coordination agreements led by the home authority; A requirement for authorities to share all relevant information on the basis of strict confidentiality; and Principles for the effective and fair interoperation of funding arrangements in respect of the additional costs of resolution.
Resolution and resolution planning in respect of a host branch needs to take into account local requirements, regulations, and depositor protection arrangements. It should generally be led by the home authority in close cooperation with the host authority (though there may be exceptional cases in which the particular
configuration makes it more appropriate for the resolution to be led by the host authority). 30. In the development of firm‐specific resolution agreements between authorities, one of the issues to address will be achieving fair outcomes among creditors across the group. The development of mechanisms that can achieve this—in particular by addressing the distribution of resources in the group during a resolution—remains a difficult and challenging subject. Intensified work and close dialogue between the official and private sectors is needed to try and develop optimal solutions.
31. This paper has been prepared by the Institute’s Cross‐Border Resolution Working Group (CBRWG), chaired by Urs Rohner, Chairman of the Board of Directors, Credit Suisse Group AG, as a continuation of the Industry’s contribution to the efforts aimed at establishing an effective international framework for the resolution of cross‐border financial firms. The work has been carried out under the auspices of the Special Committee on Effective Regulation, chaired by Peter Sands, Group Chief Executive, Standard Chartered PLC.
Building on previous work
32. In May 2010, the Institute published a report developed by the CBRWG, A Global Approach to Failing Financial Firms: An Industry Perspective 1 , which outlined the key elements of a framework that would make it possible for any firm, irrespective of its size or interconnectedness, to exit the market without causing systemic disruption and without any expectation that taxpayers’ money will be used. Such a framework is key to achieving a durably resilient financial system. A summary of the key components of an effective resolution framework as contained in the May 2010 report are set out in Annex 1. After the May 2010 report, the Institute submitted to the FSB the paper, Preserving Value in Failing Firms 2 in September 2010, focused on the power for authorities to convert some of the debt of the firm to capital to bring about its recapitalization (“creditor bail‐in” or “bail‐in”). The paper was largely exploratory and did not seek to reach final conclusions on several key issues; however, it expressed considerable merit in examining bail‐in arrangements further.
Importance of resolvability
34. The Institute believes that effective resolution is essential to achieving long‐term resilience and financial stability. Such effective resolution plays a key role in addressing moral hazard and issues associated with systemically important firms. As the Institute has said previously, we strongly believe that addressing systemic risk requires an approach based on four mutually reinforcing components: (a) Enhanced regulation, (b) Improved industry practices, (c) Strengthened supervision, and
(d) Effectively functioning markets. 36. Not only is the balanced integration of these four components necessary to achieve long‐term stability, failure to achieve such balance is likely to have significant adverse consequences. There is currently a real risk of disproportionate reliance on the regulatory component at the expense of the other three, and there is significant potential for adverse consequences flowing from this. An effective framework for the resolution of all financial firms, including large, complex financial institutions, is a key component in achieving effectively functioning markets and finding a balanced integration of the four components outlined. Putting in place effectively functioning resolution regimes is therefore a key priority.
Structure of the paper
38. This paper continues the Industry’s work in this area. In particular, three broad priority areas have been identified for further work. These are reflected in the three sections of this paper: Section 1 considers the need to ensure the continuance of critical functions in the event of the failure of a large, complex financial firm. Section 2 continues the Institute’s work on “bail‐in.” It seeks to outline an effective and economically viable mechanism whereby the systemic shock potentially arising from the failure of financial firm is significantly reduced. The section develops a draft set of principles that might be envisaged for the creation of a bail‐in regime. Section 3 develops an analysis of the key obstacles to achieving the effective resolution of cross‐border, as opposed to purely domestic, financial firms and proposes solutions to these obstacles.
Section 1 ‐ Effective resolution planning—ensuring the continuance of critical functions
42. For financial institutions to be able to exit the market in an orderly manner, it is necessary that their doing so does not cause a failure in essential service provision within the financial system such that the wider economy suffers a major disruption. This section seeks to advance the analysis aimed at achieving that objective. The issue is closely tied to, indeed forms an integral part, of the broader issue of resolution planning. Ensuring the continuance of critical functions is a key aspect of such planning. Accordingly the analysis in this section seeks to enhance the quality and effectiveness of such planning.
The meaning of “critical function”
44. It is important to be clear about what is meant by a “critical function.” This is necessary for two reasons. First, different objectives may be achieved by different tools. Being precise about the particular objective in view—for example, maintaining critical functions, as opposed to, say, avoiding contagion, preserving value, or minimizing costs to the deposit protection scheme—can contribute significantly to the design of an effective resolution framework.
Not a cost‐free question 45. Second, the preservation of critical functions may not be a cost‐free exercise. To take a simple stylized example: the transfer of the liabilities that constitute the essence of the critical function to a bridge bank will require the transfer of “good” assets of at least the same value to support those liabilities. This means—and indeed it depends for its effectiveness on the fact—that the transferred liabilities are protected from losses. On the other hand, those liabilities left behind in the rump institution are exposed to greater losses than they would otherwise be, due to the removal of their access to the transferred, good assets. Because of the principle that no creditor should be worse off than s/he would be in a liquidation, and assuming that the value in the failing firm taken as a whole is less than its liabilities, this would result in a shortfall that needs to be somehow made good. More realistically, it is likely that the decision will be made to transfer a full business line incorporating the critical function. This will encompass both the liabilities and the assets that constitute that business. Of course, if the assets are impaired the purchaser will wish to see further assets provided to ensure that what s/he is receiving is at least a parity of asset value and liabilities. In this case, it may be likely that the franchise value of the business line will also contribute
materially to the value transferred so that the “value gap” created in the rump firm (to be borne by the residual creditors) might be significantly reduced. Systemic relevance necessary, but not sufficient 47. In the paper, Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations (October 2009), the FSB, the International Monetary Fund (IMF), and the Basel Committee on Banking Supervision (BCBS) provided a broad definition of a systemic event: The disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy. 48. The following key elements contribute to the systemic relevance of the disruption: a. b. non‐substitutability: the disrupted services cannot be substituted within a reasonable time and at acceptable costs; negative externalities: the failure of one institution and the discontinuance of its critical functions cause friction and spill over to other market participants; and real economy impact: the disruption—both directly and through its negative externalities—causes a significant spill‐over into the real economy.
To an important extent, these three criteria are relevant for the determination of what is a “critical function” for current purposes. It is clear that it is a necessary condition for a particular function to meet the requirements of systemic relevance in order to be considered a “critical function.”
Clarity as to mode of “systemicness” 50. However, some further specification may be required to arrive at a practical definition of critical functions for this purpose. For example, the fact that a firm is connected to a large number of counterparties because it operates a very large derivatives business might mean that the firm is systemic due to the counterparty contagion risk to which it gives rise. However, it does not mean that its derivatives business is a critical function. There are a number of means by which the “systemic relevance” of a firm will be addressed—these include, for example, ensuring that creditors are aware that they will be fixed with loss and should therefore manage their risk more effectively ex ante; ensuring that a continuum of effective powers are available to authorities; enhancing the resilience of market infrastructure; and putting in place
possible measures such as bail‐in techniques and contingent capital instruments to reduce risks of contagion. 52. The concept of “critical function” is designed to address just one aspect of systemic relevance: that is where there is an essential function or service performed by the institution and the only way that it can reasonably be dealt with is to carve it out and transfer it in the event of the failure of a firm. One important aspect of this question therefore is that a particular function should not be deemed critical just because it will give rise to some disruption if it fails. Rather, it should be determined to be critical only if it is more or less essential that the service not be disrupted, or at least that the degree of disruption likely to result is very great. A further relevant consideration is the extent to which users of the service might reasonably be expected to take appropriate measures ex ante to insulate themselves from the disruptive effects of the firm’s failure. For example, large corporates can be expected to ensure that they are not exclusively dependent upon one financial firm for their ongoing liquidity and should not be incentivized not to do so by the treatment of such liquidity provision as a critical function. Accordingly, a service should be considered critical when the following criteria are met: a. the function represents a critical part of the financial system infrastructure; b. users of the service could not reasonably be expected to have put alternative, fall‐back options in place ex ante; c. the service cannot be substituted in a timely manner; and d. the service is essential to the financial system and the economy and its failure would cause severe trauma. Considering critical functions 56. In general terms it is not possible to say in the abstract whether a particular function is critical or not without a specific assessment of the wider context in which it is provided. For not only is the nature of the function key to this determination, so too is the scale upon which the service is provided by the failing bank, and the prevailing financial sector and economic circumstances. The market share of the activity enjoyed by the firm in question will be a key question in determining whether or not a function should be deemed critical. Criticality of function is therefore a matter which falls to be determined on a firm‐ by‐firm basis. Nonetheless, it is useful to consider, by way of example, a number 25
of putative critical functions to examine how the determination of whether they may, in fact, be critical functions might be approached. In Annex 2 we consider the potential criticality of a number of functions. 58. Care is required in considering these examples as a number of fine, if important, distinctions are made. For example, it is said that deposit‐taking is unlikely to be a critical function. However this means only that the provision of deposit taking services per se by a particular firm is unlikely to be critical. This does not mean that insured depositors will not require to receive repayment of their funds in a timely manner; nor that the payment service aspect of such accounts may not be critical. It simply means that, being precise in our thinking, the approach to a failing firm’s deposit taking activities should be determined not by critical function considerations per se, but rather by the need to avoid a loss of confidence amongst consumers and outcomes considered unfair. Accordingly the key means of addressing the issue of insured depositors will be (a) by having in place an appropriate deposit protection scheme; and (b) by making sure that arrangements are in place to provide protected depositors with timely access to their insured funds. It is also important to take the time horizon into consideration. The continuance of certain services may be necessary only over a short timeframe to allow other providers to step in and fill the gap. The different circumstances prevailing in the context of an idiosyncratic failure as compared with an episode of wider systemic trauma should also be taken into consideration. Sale to a third party in the context of the latter may be more challenging with greater resulting need for the use of bridge‐bank arrangements.
61. As we said in our May 2010 report, resolution planning is primarily the responsibility of authorities. This is distinct from recovery planning, the primary responsibility for which falls on the firm. In the event of the need for a resolution, it will be the authorities who will be in control of the process, with the firm playing an assistive role. The key purpose of resolution planning is to ensure that both firms and authorities are well positioned to handle the situation if and when a firm fails.
No matter‐of‐course requests for restructuring… 62. Firms have a responsibility to provide all of the information necessary to allow authorities to carry out resolution planning. It is legitimate and appropriate for authorities to wish to be satisfied that is practicable and feasible for critical functions provided by the firm to be isolated and transferred with all due speed in the event of the imminent failure of the firm.
We do not believe that it is appropriate or necessary for this to be sought to be achieved by matter‐of‐course requests by authorities for firms to restructure themselves so as to isolate particular functions in dedicated legal entities or to require a modularization of the firm along entity and function lines. It is important that a group’s structure and organization reflect its business model and strategy. A requirement to move away from such an approach will give rise to significant inefficiencies and economic costs. Our May 2010 report considers this question at some length. 3 It sets out the Industry’s concern “that if regulatory demands for changes to organizational structure become a normal aspect of recovery and resolution planning, that will lead to a proliferation of requirements for change that could result in a significant mismatch between a firm’s organizational structure and its overall business model. This is a real risk that could cause significant harm over the long run.” There is also considerable concern that such interventions in how firms structure themselves will lead to increased national ring‐fencing. Though firms should be able to demonstrate how a critical function could otherwise be extricated and transferred, a firm’s organizational and legal structures should reflect and be determined by its business model. There are many reasons why more complex approaches may be necessary. Indeed, such services often make most sense and add the most value for clients when embedded in the broader business of the firm. What is essential is that it is made clear by a firm how the separation and transfer of critical functions can be achieved in a speedy manner. Firms’ fulfillment of this requirement will obviate any need for over‐prescriptiveness by authorities as to the manner in which this should be done.
…or separation 68. As to the desirability of requiring firms to completely separate their retail and wholesale banking activities, as discussed above, we do not agree that all forms of retail activity are necessarily to be deemed critical functions within the strict meaning of that term as we have defined it here. Moreover, for the reasons set out in the preceding paragraphs, while it is the responsibility of firms to explain and demonstrate how critical functions can be maintained in the event of the failure of the firm, this does not mean that such functions are required to be separated ex ante and subjected to modularization.
Firms’ responsibilities 69. There is, therefore, an important obligation on firms to provide clear information and explanations to the authorities as to how any critical function activities can be isolated and transferred in the event of failure. There is a need for a clear and concrete description of how this can be done. The Industry is of the view that the explanation and information to be provided by firms for critical functions should cover the following: a) b) A clear description of the function in question, including its key features and the scale of provision by the firm. Identification of how that function is provided by the firm. This should include: c) Key aspects of the contractual basis upon which the service provided rests; Whether the service forms part of an integrated suite of services provided to clients, or is a more stand‐alone service; How to identify which clients use the service; Where and how the assets and liabilities arising from the provision of the service are booked; How the service is supported in terms of infrastructure and IT; and How the service is supported in terms of funding.
Separating and transferring the function in an event of failure: What contractual / legal issues arise? Is it needed to transfer a large part of relevant clients’ business with the firm, or just specific accounts? If specific accounts, are these limited to the critical activity or are they broader? What does it mean in practice to transfer this business: Who will be the new legal parties? By whom/how will the IT be provided? What is the transfer mechanism? What interdependencies need to be addressed?
Financing the function/financing the transfer: Assuming that the main moving parts of the service to be transferred are liabilities to clients, what assets will be transferred to support those 28
liabilities? How will these assets be identified? How will they be transferred?
Maintaining critical functions on a cross‐border basis
71. It is essential that resolution frameworks are effective not just in the domestic but also the international context. Indeed, given the international nature of many of the firms falling within the current moral hazard discussion, it is in many ways even more important that such regimes are effective in a cross‐ border context. The issue of achieving effective resolution of specifically cross‐border firms is considered in full detail in Section 3. We note here, however, the importance of being able to handle the maintenance of critical functions on a cross‐border basis. Crucial to this will be coordination among authorities in different jurisdictions. Determining which functions are critical—be that locally or internationally— and how they should be dealt with in the event of the failure of a firm requires close cooperation and coordination among authorities. This should be an important component of the work to establish firm‐specific resolution agreements among authorities currently underway in the FSB and a key aspect for consideration in the firm‐specific crisis management groups.
Section 2 ‐ Avoiding systemic trauma—making bail‐in techniques operational
74. On the issue of bail‐in, the Institute made a submission to the FSB in September 2010: “Preserving value in failing firms. 4 Since that time, the Institute—through its Working Group on Cross‐border Resolution (CBRWG)—has continued to work on the topic, in particular to address a number of the difficult issues that arise in making bail‐in techniques operational. The FSB’s report, Reducing the moral hazard posed by systemically important financial institutions, of October 20, 2010, to the G20 leaders noted that bail‐in could potentially form part of the higher loss absorbency required of systemically important firms. The European Commission is also considering the question of bail‐in measures as part of its recent consultative document, Technical details of a possible EU framework for bank recovery and resolution, 5 published on January 6, 2011. In the text below we set out a set of principles for operationalizing bail‐in techniques. It should be noted, however, that this remains a challenging area and in a number of places further work will be required to arrive at final conclusions.
IIF’s Preserving Value paper
77. In our earlier Preserving Value paper, we expressed the preliminary view that there was considerable merit to examining the introduction of a bail‐in regime. We said that the technique offered a promising means of forestalling the disorderly liquidation of systemically important firms, with the attendant instability that might result from such an event. However, the paper also recognized and cautioned on the need to address a number of open issues and a range of technical matters that needed further analysis in order to have a clearer understanding of how such a regime could operate. Key aspects of the analysis contained in the Preserving Value paper are set out in Annex 3.
Scope of liabilities subject to bail‐in 78. A key issue in the Preserving Value paper, and one that we return to below, is the scope of liabilities that should be subject to a bail‐in power, and the extent to which this should be decided ex ante or ex post. Supporting a limited scope/ex ante approach were the degree of clarity and certainty that this would bring to the situation. This approach was considered to have benefits in terms of making it clear to certain categories of credit
http://www.iif.com/download.php?id=ryVjoux4FSs= January 6, 2011
counterparties, including trading counterparties, short‐term creditors and liquidity providers, and uninsured depositors, that they would not be subject to bail‐in measures, thus minimizing the likelihood of flight. By determining in advance which categories of credit counterparty might be subject to bail‐in it was possible to increase the consensual nature of the mechanism. Beyond this it was also the view of a number of Members that by limiting clearly the scope of bail‐in it would be possible to limit any potential increase in bank funding costs. 80. A number of disadvantages associated with an ex ante limited scope approach also were identified. This approach has the potential to contribute to moral hazard in the system, as those liabilities explicitly exempted from the bail‐in mechanism may be perceived as receiving considerable additional protection against losses. That significant distortions would be introduced under an ex ante approach also was identified as an important risk, with funding techniques being arbitraged to avoid potential bail‐in exposures. On the cost of bank funding some argued that a broad or “comprehensive” approach, by replicating a “pre‐packaged bankruptcy” by way of a residual power vested in authorities, would minimize any possible increase in funding. In the text that follows we seek to resolve the tension between these different approaches. In particular, it is envisaged that the primary scope of bail‐in powers will be limited to subordinated debt. In proposing this approach we are influenced by some research indicating that in many cases adequate recapitalization of firms in difficulty might be achieved on the basis of the conversion of subordinated debt only. However, it is acknowledged that it is not possible to calibrate precisely ex ante the scale of the potential need for fresh capital in a crisis situation. Therefore it is envisaged that as a last resort, and subject to clear requirements and criteria, it may be necessary to bail‐in a proportion of the unsecured senior debt of a firm as an alternative to the winding‐down of the firm.
82. Building upon the initial work in Preserving Value, the objective in this subsequent contribution is to make more operational the concept and in doing so to address a number of the key challenges identified in that earlier analysis. In particular, we now seek to articulate a more concrete elaboration of the concept and provide a more detailed specification of the key building blocks. To this end, this Section puts forward a draft set of principles that might be envisaged to underpin the development of a bail‐in regime in different jurisdictions. By putting forward this set of principles, supported by appropriate commentary and discussion, it is hoped to both provide a clear path to the solution of outstanding difficulties and promote an agreement on the subject among key participants across the different jurisdictions.
84. The general view among Industry participants is that it would not be appropriate to retrospectively subject existing debt to a new power of bail‐in. Moreover, it is considered desirable that there should be—to the extent possible—a graduated, rather than abrupt, adjustment of Loss Given Default (LGD) estimates in respect to such debt. Accordingly, it is proposed that bail‐in techniques should be prospective only.
Bail‐ins and bridge banks: the Dodd‐Frank approach
85. The discussion in the following text focuses on the desirability of a mechanism that allows a firm to be recapitalized by converting a certain proportion of debt into equity so as to prevent a precipitous loss of value and a resulting systemic shock. It is argued by some that these outcomes could also be achieved by the use of a bridge‐bank mechanism deployed in a particular way at the point of insolvency. This question is of importance as the approach enacted in the United States under Dodd‐Frank—while it requires the winding‐up of failing firms—also envisages the use of bridge‐bank mechanisms to optimize outcomes. It may indeed be possible that bail‐in outcomes could, depending upon the legal context of a particular jurisdiction, be achieved by such alternative means. Whether this is the case requires further study. In this regard see, for example, the article, “The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd‐Frank Act.” 6
The key elements of a bail‐in regime
87. Set out below is a set of suggested principles that might form the basis for bail‐in regimes to be adopted in different jurisdictions. The principles are accompanied by explanatory text.
GENERAL OBJECTIVES AND GOVERNING PRINCIPLES 1.1 The general objectives of bail‐in arrangements are as follows: To create the conditions whereby every financial firm may be restructured through an orderly “failure” in the event that it is no longer able to meet its obligations or becomes otherwise not viable; To avoid the financial instability that may result from the disorderly liquidation of a systemically important firm;
FDIC, April 2011
To reduce moral hazard and expectations that risks and losses will be borne by taxpayers. Losses should be borne by shareholders, providers of other forms of capital, and creditors; and To forestall precipitous and major loss of value in the firm, which could give rise to traumatic effects on the financial system and the broader economy. 1.2 These objectives should be pursued in accordance with the following conditions: Property rights must be respected. This includes, in particular, full respect for security and collateral rights. These should not be abrogated. Creditors should not be worse off than they would be in a normal bankruptcy. Bail‐in should be seen as part of the continuum of measures and tools necessary to protect the financial system, and especially to ensure that all firms can be resolved safely in the event of their failure or imminent failure. Bail‐in measures should be deployed only after such other measures and tools have been exhausted. Triggers should be clearly defined, avoiding undue uncertainty. There should be consistency across jurisdictions. When relevant, effective cross‐border coordination should be ensured and fragmented national responses prevented. To the extent that additional costs are incurred in resolving a firm in a manner that avoids systemic damage, such costs should not be imposed on creditors (or a particular group of creditors). COMMENTS ON GENERAL OBJECTIVES AND GOVERNING PRINCIPLES 88. 89. This set of principles sets out the central objectives of a bail‐in regime and the key conditions for such a regime. The key objectives of facilitating restructuring or allowing an orderly failure while preserving financial stability are broad enough to cover in general terms a number of concerns often highlighted by the official sector, for example, protecting retail depositors and protecting systemically important functions. Allowing every financial firm to undergo an orderly “failure” in the event that it is no longer able to meet its obligations or becomes otherwise not viable must be a key feature of any resolution regime. Bail‐in is a tool that contributes to achieving this objective; it should be seen as a form of restructuring for a firm that has failed.
The objective of any resolution tools should not be the survival of a failing firm per se, but rather allowing firms to fail in an orderly way without any cost to taxpayers; however, a byproduct of a bail‐in mechanism is that firms, in some form, survive legally at least ad interim, and if the effort is fully successfully, in the longer term. In this respect the outcomes can be seen as rather similar to the potential outcome of a Chapter 11 bankruptcy in the United States.
SCOPE 2.1 Unless otherwise determined in accordance with these provisions, a financial firm that fails should exit the market in accordance with the normal rules for the resolution of such firms. 2.2 All financial institutions may be potentially subject to bail‐in. 2.3 A financial institution should only be subject to bail‐in measures to the extent determined by the designated authorities: (a) that to allow the firm to be subject to normal resolution rules would carry a significant risk of causing significant financial instability; (b) that such risk would derive from a precipitous loss of value affecting the assets of the firm due to a declaration of insolvency and/or affecting the wider financial system due to the interconnectedness of the firm with the wider market; and (c) that there is a reasonable prospect of such loss of value being averted or significantly reduced if the measures in this set of principles are deployed. COMMENTS ON SCOPE 92. The effect of these “Scope” principles is to give bail‐in measures a broad potential scope in terms of the firms to which they may potentially apply and to clarify that, when a number of conditions are met, any financial institution may be subject to a bail‐in. This is consistent with IIF’s view that systemic risk cannot be linked to any particular category of firms. Moreover, any possible perception that a regime directed only at some firms may lead to a non‐level playing field (and, specifically, might give large firms some advantage) needs to be rejected. The question of the systemic importance of a firm needs to be made on a case‐by‐case basis against the backdrop of the prevailing circumstances. It is important that the purpose for which bail‐in powers can be exercised be clearly and tightly drawn. Such powers significantly enhance the administrative power of the State to intervene in private contracts. If the conditions for use are 34
drawn too broadly, there is material risk that it could be exercised too early (see the “Bail‐In Triggers” principles below) or too broadly, giving rise to undue interference with private contracts. In short, unless the power is defined tightly there is a risk of a disproportionate increase in financial firm funding costs as creditors’ confidence and certainty is undermined by the potential for significant State administrative intervention. 95. The benefit of bail‐in techniques as compared with the application of general resolution provisions is that a bail‐in can forestall a precipitate loss of value such as that seen in the Lehman’s case. 7 It is such loss of value that, either directly or indirectly through the interconnectedness of the firm, can give rise to systemic instability. Accordingly, only where it is determined that there is a significant risk of such loss of value should bail‐in measures be deployed.
BAIL‐IN TRIGGERS 3.1 The decision to trigger the bail‐in power should be exercised by the designated authority(ies) in consultation with relevant authorities who are not the designated authority(ies), including, as appropriate, the resolution authority, the supervisory authorities, the central bank, and the finance ministry. 3.2 The trigger for a bail‐in should be the same trigger that applies for a determination that a financial firm’s activities require to be resolved or wound down. COMMENTS ON TRIGGERS 96. We do not take a view at this stage as to which authority(ies) should be the designated authority for bail‐in purposes. (More broadly, we have not taken a view as to which authority should have the power to determine that a firm should be resolved.) Different modalities are possible. However, in deciding which authority should have this power, it will need to be ensured that risk of authorities’ forbearance is avoided. Moreover, the decision should be exercised in consultation with relevant authorities who are not the designated authorities, including, as appropriate, the resolution authority, the supervisory authorities, the central bank, and the finance ministry.
In our report, Preserving Value in Failing Financial Firms (September 2010), pp. 8–9, we estimate that a loss of asset value in the estimated range of $25 billion became, post‐declaration of insolvency, a loss to creditors of possibly $150 billion. It its article, “The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd‐Frank Act,” (April 2011), the FDIC assumes for the purposes of illustration that the losses on assets prior to the declaration of insolvency would have been $40 billion, representing a loss rate of 60 percent to 80 percent on $50 to $70 billion of assets identified by potential acquirers as being impaired or of questionable value, representing a loss of value significantly less than currently expected under the bankruptcy.
It is desirable that bail‐in measures are triggered as close as possible to the time that the firm would otherwise become insolvent and go into bankruptcy. To avoid undue uncertainty or the potential “bringing forward” of insolvency, the relevant trigger must be tightly drawn, and the judgment of the authority tightly constrained. For this reason the trigger for a bail‐in should be the same as for a determination that a financial firm requires to be resolved or wound down.
THE BAIL‐IN POWER 4.1. The “bail‐in” powers referred to here are: Power to dilute shareholders or write‐off shares of the firm, and
Power to alter the terms and conditions of subordinated debt of the firm, including the conversion of such debt claims into equity. 4.2. In the exercise of such powers no category of equity holder or creditor having priority over another in the event of bankruptcy / insolvency, should be treated other than in line with that priority. 4.3. Senior management The resolution authorities should have power to replace any or all members of the senior management and/or board. Over the period following the exercise of the bail‐in measures, steps should be taken to investigate the reasons for the failure of the firm and to identify those members of the board and senior management considered to be directly responsible for the decisions and/or actions leading to the failure. Such individuals should be replaced. COMMENTS ON BAIL‐IN POWERS 98. As discussed in the introduction to this Section, the question of the scope of liabilities falling within the bail‐in power is a difficult one upon which the industry has had much discussion. A crucial issue is whether any unsecured debt might, at least in principle, be considered bail‐inable (with a number of selected exclusions determined ex post on a case‐by‐case basis by the resolution authority), or whether a bail‐in mechanism should be built on an ex ante determination as to which liabilities should (potentially) be subject to bail‐in.
100. The approach suggested above is to limit the primary scope of application to subordinated debt. On the basis of analysis carried out by some Member firms, it is believed that in many cases the availability of such debt is likely to provide
sufficient resources for effectively re‐capitalizing a firm. As indicated in principle 5 below, however, it may be that in the particular circumstances of the case the bail‐in of subordinated debt will be insufficient for the purpose. In this case authorities should have the power to bail‐in the necessary proportion of senior debt. 101. Principle 4.2 aims to ensure that the order of priorities in bankruptcy be respected. Once again, different modalities are possible—for example, an approach whereby all equity is fully written down and extinguished before debt is converted or, if this is not optimal, whereby remaining original equity remains subordinated to converted debt. Alternatively, another way to achieve this may be to seek to ensure that the economic values of the different instruments (including their relative values), which reflect their ranking in the looming resolution, are maintained. While being very clear that it is essential that the order of priorities must not be subverted, the Industry has not yet reached a firm view as to whether this should be achieved by means that are primarily legal in nature or primarily economic. 102. Concerning principle 4.3, which deals with senior management, the Industry believes that it is important that those considered directly responsible for the failure of the firm be held accountable. ADDITIONAL POWER TO BAIL‐IN SENIOR DEBT 5.1 In particular circumstances, it may be the case that the bail‐in of all subordinated debt will be insufficient to recapitalize the firm sufficiently to achieve the objectives set out above. In this case where there is no other appropriate alternative to achieve the objectives set out above, the designated authorities should have the power to bail‐in a wider category of creditors as described below. 5.2 The supplementary nature of such power should be recognized in the requirement for the authorities to take a separate decision, clearly documented and reasoned, and the subject of a report to be made publicly available as to the basis upon which their decision was reached. The report should inter alia set out how the decision of the authorities complies with the key principles of reasonableness, proportionality, and final necessity. 5.3 The liabilities subject to this power of further bail‐in should be the unsecured senior obligations of the firm except obligations of counterparties arising from the trading activities of the failing firm. [Whether the scope of principle 5.3 should be extended will be the subject of further consideration—see comments below.] 5.4 The designated authorities should decide, in compliance with the principles set out above, and taking into account guidance to be published by the authorities,
whether to limit the types of senior obligations to be subject to the power of further bail‐in and, if so, to which type of obligations. 5.5 In exercising this power, all of the principles governing the bail‐in of subordinated debt shall apply. COMMENTS ON ADDITIONAL POWER TO BAIL‐IN SENIOR DEBT 103. The approach described here is to make the bail‐in of any non‐subordinated debt a last resort when a conversion of subordinated debt is determined to be insufficient to achieve the purposes sought. 104. The industry has reached the view that trading obligations should not be subject to such final‐stage bail‐in, as to do so would defeat one purpose of the mechanism—to preserve the franchise business of the firm. By including such obligations in the potential scope of a bail‐in, trading counterparties’ confidence would be unlikely to be maintained, with a resulting significant loss of business value. 105. The industry has not yet reached a final view as to whether other forms of senior obligation should be excluded ex ante or left to be determined on a case‐by‐case basis and in accordance with administrative guidance to be published by the authorities. The Industry will be working on this issue further in the coming period. SAFEGUARDS FOR CREDITORS AND JUDICIAL REVIEW 6.1. Judicial review: Unless the board of directors (or similar governing body) of the company has acquiesced or consented to the activation of the bail‐in power, it should have the possibility to file a petition for immediate judicial review. Such review should be limited to the legality and legitimacy of the decision and ensure that the bail‐in mechanism is not activated arbitrarily, and any judicial hearing should be strictly private. 6.2. Safeguards for creditors: No creditor of the covered firm that has seen the amount that it is owed written down or the terms and conditions of the instrument it holds amended should be worse off than it would have been under normal bankruptcy/insolvency procedures. The determination as to whether a creditor is worse off shall be made XX year(s) after the exercise of the bail in powers. 6.3. Authorities should not be held liable for negligence in the making of a determination to exercise their bail‐in powers. 38
COMMENTS ON SAFEGUARDS AND JUDICIAL REVIEW 106. It will be necessary to achieve an effective balance between the need to ensure adequate judicial safeguards and review and the need to ensure that a bail‐in mechanism can be deployed swiftly and without creating undue uncertainties in the market. CROSS‐BORDER ASPECTS 7.1. These principles should apply to the liabilities of the firm regardless of the jurisdiction in which they are held and of the national law governing them. 7.2. Foreign creditors should have the right of direct access to the resolution authorities and to judicial authorities to obtain the safeguards described in principle 6. 7.3. To the extent that the jurisdiction where the liability holder is situated does not provide for a recognition of the proceedings launched under these principles, there should be incorporated in the terms of all the relevant liabilities of the firm a contractual provision rendering it subject to bail‐in measures as set out in these principles. COMMENTS ON CROSS‐BORDER ASPECTS 107. These principles seek to outline a response to the coordination problems that arise when deploying a bail‐in mechanism in a cross‐border context. The main route to ensuring effective cross‐border coordination implies agreement among FSB members committing: to undertake those legal changes needed to achieve convergent and internationally consistent resolution tools, and to recognize a foreign proceeding and ensure the necessary cross‐border cooperation and communication among relevant resolution authorities.
108. A supporting alternative approach is set out in principle 7.3. This represents the hybrid approach outlined in the Preserving Value paper: a bank should, in its country of incorporation, be subject to a statutory regime whose effect would be to recognize the bail‐in in national law; the bank would then be required to ensure that for any creditor eligible for a bail‐in whose claims were governed by any other law, the agreement with that creditor would include a clause recognizing the statutory power.
GROUP ISSUES 8. Where: the liabilities subject to the exercise of the bail‐in powers set out in these principles represent liabilities of an entity that is a subsidiary of another entity; the retention of the parent‐subsidiary legal relationship is determined by the resolution authorities to be necessary to achieve the objectives of these principles; and it is necessary to do so to preserve such parent‐subsidiary legal relationship the equity interest received by those creditors of the firm by virtue of the exercise of the powers set out in these provisions shall be swapped for equity of the parent of equivalent value. COMMENTS ON GROUP ISSUES 109. Most large banks are members of groups, and it is frequently the case that in a bank group there is an unregulated bank holding company above the bank. In the case below:
Bank Holding Company
Other Group Entities
if the bail‐in were to be conducted at the bank level, the effect could be to break the group structure since, with the creditors becoming the shareholders, the bank would cease to be a subsidiary of the holding company. The approach proposed in principle 8 requires equity received in the failing bank to be swapped for equity in the parent entity/holding company when that is necessary to achieve the bail‐in objectives. This issue should be identified and addressed as part of the resolution planning in respect of the group. NON‐EFFECT OF DEFAULT OR OTHER “TRIGGER” CLAUSES 9. The exercise of bail‐in powers as described in these provisions shall not be considered a default for legal purposes. Any clause in any contract that seeks to
identify the exercise of bail‐in powers as an event similar to default for the purposes of triggering legal consequences shall be invalid. COMMENT ON “NON‐EFFECT” PRINCIPLES 110. Common practice in many derivatives, repo, bond agreements, etc., is that forced resolution measures by regulators are also deemed to be an event of default, which would allow the counterparts to terminate outstanding agreements. To achieve the bail‐in objective of avoiding the collapse of the firm and a resulting major loss of value and trauma to the system, measures are needed to establish that the exercise of a bail‐in power would not be considered an event of default among counterparties of the firm in question. ISDA master agreements will be particularly important in this regard. It is less clear that the same would need to be achieved in respect of credit derivative contracts referencing the firm. This latter aspect requires further consideration.
Section 3 ‐ Resolving cross‐border financial firms—addressing key issues
111. This section seeks to develop an analysis of the key obstacles to achieving the effective resolution of systemically important cross‐border, as opposed to domestic, financial firms and proposing solutions to such obstacles. In the period since the crisis, the conceptual and practical landscape has changed quite significantly. This means that the challenge now in achieving an effective framework of cross‐border resolution is somewhat different than it was twelve months ago. There has been important progress. It is important to take stock of the developments that have occurred in order to assess progress toward the ultimate objective and to more accurately specify the challenges that remain. 112. It is useful to remind ourselves what we mean by “effective cross‐border resolution.” What we mean is that a large financial services group operating in a number of jurisdictions—either by means of subsidiaries or branches—is capable of exiting the market in an orderly manner and without a perception of unfairness in how the losses incurred by the group are allocated among stakeholders. To preserve the benefits of progress toward an integrated international financial system, it is important that this process be achieved without requiring ring‐fencing or the forcing of significant structural/organizational change on financial groups that have developed their organizational structure to optimally reflect their business model and the nature of their activities. Less risk to taxpayers… 113. One of the major concerns of authorities is that, in the event of the failure of a cross‐border group, the taxpayers in their jurisdiction will incur losses and, further, that these losses will be unfair as between jurisdictions. This is a central concern that lies behind moves toward ring‐fencing and national self‐sufficiency approaches. 114. Significant progress has been achieved, or can be achieved, toward significantly reducing the extent to which taxpayers are exposed to losses in the event of failure. The work that is in train to ensure that shareholders and creditors bear their losses in the event of a failure should go a long way toward achieving this. 115. The acceptance by the financial services industry of its responsibility to fund the costs of effective resolution mechanisms will also make a material contribution toward protecting taxpayers from losses.
…but more to other stakeholders 116. It is not, however, simply disproportionate losses to taxpayers that are of concern to national authorities. They are also concerned about disproportionate or unfair losses accruing to stakeholders in their jurisdictions more generally. For example, in the Lehman case, there were no losses accruing to host country taxpayers. Nonetheless, concern as to suboptimal outcomes for creditors of host country subsidiaries was a major factor in the reaction on the part of host country authorities. 117. Given that an important objective of effective resolution is to place shareholders and creditors more at risk of loss than was the case in the past, this aspect of the situation has become more challenging than heretofore. 118. The protection of taxpayers is likely to be a significantly greater imperative politically than the protection of creditors (at least uninsured creditors), who are better positioned to look after themselves. Accordingly, the overall picture may be one of a potential material easing of the extent to which authorities feel at political risk if they do not manage to ring‐fence. However, the pressures to ring‐ fence are likely to remain considerable as things currently stand.
Typologies and approaches
119. In general, cross‐border financial institutions can adopt a range of approaches to achieving a physical presence in a host country. While they can do so either by establishing a branch or by establishing a subsidiary, it is important to think of cross‐border groups not in binary terms but rather as organizing themselves along a spectrum of modalities as indicated by their particular business model. 120. At one end of the spectrum are groups that organize themselves on the basis of largely stand‐alone subsidiaries interacting with each other on straightforward commercial terms (though within the strong nexus of their intra‐group relationships). At the other end, there can be the use of overseas branches that, both practically and legally, operate more or less as the presence of the home entity in the host jurisdiction. And between these extremes, there are a range of hybrid approaches: many groups utilize both branches and subsidiaries, many make use of subsidiaries in the context of an “integrated” group approach, 8 and others make use of branches that operate to a certain extent and in certain respects as stand‐alone entities.
We would note that within the context of more integrated groups also, transactions between group entities are carried out on market‐based commercial terms. See further the question of “group interest” approaches discussed below.
121. In our May 2010 report, A Global Approach to Resolving Failing Financial Firms, we argued that success in the area of cross‐border resolution required the establishment of an international cross‐border framework. 122. This did not require the establishment of an international insolvency law. Rather, we called on the G20/FSB to set up a high‐level task force with a view to establishing a roadmap toward the creation of such an international framework for the resolution of cross‐border firms. This would involve international agreement combined with national jurisdiction measures. 123. Among the key components would be: (a) convergence of national regimes to incorporate agreed‐upon key features of effective resolution frameworks. The FSB report of October 20, 2010, appears to indicate the potential for good progress in this regard; (b) enhanced coordination among resolution authorities, including a lead authority approach, possibly based on the modified universalism approach suggested by some; and (c) exploring methods for achieving equitable cross‐border outcomes. 124. In the following sections we consider in detail what is needed to take these proposals successfully forward.
Resolving cross‐border groups: respecting structural arrangements determined by business models
125. As the Institute has discussed in a number of places, 9 it is important that financial groups continue to be able to choose the mode of organization and degree of integration of the management of their group that most conforms to the nature of their business model and the needs of their business. A forced requirement that all firms, regardless of their business model, adopt a modular approach to their organization based on the stand‐alone self‐sufficiency of each legal entity or each national sub‐group would dampen economic performance. 126. As we said above, if regulatory demands for changes to organizational structure become a normal aspect of recovery and resolution planning, this is likely to result in a significant mismatch between a firm’s organizational structure and its overall
See, for example, Restoring Confidence, Creating Resilience: An Industry Perspective on the Future of International Financial Regulation and the Search for Stability (July 2009); Systemic Risk and Systemically Important Firms: An Integrated Approach (May 2010); and A Global Approach to Resolving Failing Financial Firms: An Industry Perspective (May 2010).
business model. There is also considerable concern that such interventions in how firms structure themselves will lead to increased ring‐fencing of countries and fragmentation of the international marketplace. 127. Depending upon the nature of the business being carried on, amongst the benefits that can be derived from group strength and strategy can be the following: The ability to deploy capital and liquidity efficiently for the group as a whole; The ability to support customers in cross‐border trade and investment to the benefit of the economy in general; The ability to develop and implement high‐quality, strong governance and risk management strategies at the group level for the advantage of all entities; The development of a strong and reliable brand that yields benefits both for the group and its stakeholders and for consumers and the economy in general; and The strength and resilience that can derive from the ability to provide support from one part of the group to another in times of difficulty or stress.
Note: As well as political obstacles, there are also a number of legal issues to be considered in relation to the provision of group support for entities that get into difficulty. These are considered in Annex 4. Avoiding negative‐sum outcomes 128. Under current arrangements authorities in different jurisdictions are in an invidious position. Legislation requires the adoption of a legal entity–based approach in the resolution and/or insolvency phase. Such an approach means that as the point of failure approaches, it becomes increasingly critical as to where the assets of the group are located. 129. Equally, the authority and legal mandate of authorities to a significant extent relates to the pursuit of certain outcomes within their jurisdiction and to the promotion of the interests of stakeholders—depositors, taxpayers, the economy— within that jurisdiction. This means that to the extent that there are informational and first‐mover advantages arising to some authorities as compared with others, there is a material risk of outcomes that are, when looked at from the perspective of the group as a whole and across all of the jurisdictions in which it operates, suboptimal and potentially unfair. 130. Accordingly, it is important to address the difficulties that arise from approaches to resolution that are uncoordinated among national authorities and based
exclusively on the pursuit of objectives defined in terms of jurisdictional interests, which in relevant cases can produce suboptimal outcomes. Leveraging “group interest” 131. The concept of group interest is an important one in this area. Different approaches have different advantages depending upon the nature of the business and the business model adopted. A subsidiary model can, for example, encourage the standalone strength of the different parts of the group, limit intra‐group contagion, and simplify the insolvency procedures in some cases. A more integrated model can, on the other hand, and depending again on the nature of the business, allow for a more efficient deployment of capital and equity, integrated risk management, etc. Depending upon the business of the group, strategy and decisions taken to optimize the group interest or outcomes for the group as a whole can materially enhance the outcomes for all entities comprising the group and their stakeholders in certain cases. In other words, and again depending upon the nature of the group’s business and in certain cases, the adoption of a group perspective in the running of the business across the constellation of legal entities can result in better outcomes for stakeholders and for the economy. 132. The difficulty arises when, as such a group enters a period of crisis, with the potential need for resolution looming increasingly large, the legal‐entity prism becomes dominant. 10 At this point, with the emphasis increasingly shifting to the location of assets and the claims of the creditors of the different legal entities, the group interest perspective begins to become anomalous. 133. The issue therefore can be seen to be the tension between the group interest perspective that can, depending upon a firm’s business, add significant value in the running of the business of the group, and the legal‐entity perspective that, under current arrangements, dominates during the resolution phase. Success in this area will come from progress in reducing the tension between these two different perspectives dominating different phases of the life cycle of a group. 134. We note again, as identified throughout, that there are a multiplicity of approaches adopted regarding the structure and organization of cross‐border financial groups depending upon the nature of the business and the business model adopted. Each of these has its particular advantages in regard to the business in question. What is essential is that these benefits are not diminished by requiring a group to adopt an approach that is not determined by and aligned with its business model.
Including, in many cases, an increased legal obligation to creditors.
Making progress on resolving cross‐border groups
135. This is therefore a highly complex area. Progress depends upon the implementation of a range of measures and techniques designed on the one hand to ensure that the degree of cooperation and coordination among authorities is materially enhanced and on the other that the legal framework facilitates the adoption of approaches to resolution that reflect more closely than is currently the case the approach adopted by the group to the running of its business. 136. An important area of focus for the FSB at present is the issue of institution‐specific cooperation agreements between relevant home and host authorities. The information available to date on this work is limited; however, it is clear that among the aspects to be addressed by such agreements are the roles and responsibilities in planning and managing resolutions, arranging for cooperation in the assessment of recovery and resolution plans, and setting out the legal basis for and modalities of information sharing. It is stated that “authorities should explore avenues to formalize these agreements and over time make them more binding.” 11 137. In view of the complexity of this topic and the importance of taking into account the specific circumstances of individual groups, the Institute believes there is considerable merit in an approach based on firm‐specific agreements. However, we also note that to be effective in this area, firm‐specific agreements need to be effective on the legal and not simply the operational level. Accordingly, resolution frameworks in the different jurisdictions will need to include those provisions necessary to make such agreements legally effective. 138. Among the steps that will be required to make firm‐specific resolution agreements between authorities effective are the following: International mandate: It should be part of the legal mandate of each resolution authority to coordinate effectively with the authorities of other jurisdictions in the crisis management and resolution of cross‐border groups. Non‐discrimination: It should be required of each authority that it adopts an approach that avoids discrimination against creditors of the group on the basis of their location or nationality. Optimize outcomes for creditors as a whole: Each authority should have, as part of its legal mandate, a requirement to act to optimize outcomes for the creditors of the group as a whole.
FSB, Reducing the moral hazard posed by systemically important financial institutions, October 20, 2010, p 5.
Joint planning/crisis management and resolution colleges: The authorities responsible for the resolution of a cross‐border group should be required to plan jointly in the context of dedicated colleges for the crisis management and resolution of the group under the leadership of the home resolution authority. Cooperation and coordination agreement: Based on their joint planning, the authorities should be required to enter into a cooperation and coordination agreement in respect of the crisis management and resolution of the group. While requiring to be flexible and adaptive to changing circumstances, this plan should nonetheless be in its key components legally effective, including, in particular, in crisis situations. Information sharing: The relevant authorities should share all relevant information with each other on the basis of strict confidentiality arrangements. This shall apply in both the going concern and crisis situations. Detailed consideration shall be given to the information to be shared in both contexts. Joint plan implementation: Authorities should have an obligation, in the event of a crisis or resolution, to act in accordance with the key principles and components of the cooperation and coordination agreement. Early warning: Each authority should have an obligation to alert other authorities without delay in the event of information suggesting that the group is at material risk of approaching a crisis situation. Burden sharing: It is the view of the Institute that there should be no general expectation that losses will be borne by taxpayers. Accordingly, we do not think that it would be desirable to enshrine burden‐sharing principles as between governments in such cooperation and coordination agreements. To do so could send the wrong signals and increase moral hazard. Nonetheless, we note that there will be an increased role for resolution funds (in the majority Industry view, ex post funds 12 ) to meet any additional costs that arise in the resolution of financial firms and that are not appropriately absorbed by shareholders or creditors. We believe that it will be desirable and important to develop principles for the sharing of any such costs among the different national resolution funds that might be called upon in such a situation.
See IIF, A Global Approach to Resolving Failing Financial Firms: An Industry Perspective, May 2010, Section 6.
Resolving host branches
139. The fact that branches are legally part of the home entity can help to achieve progress toward a resolution approach that is in accordance with the degree of integration of the group. 140. The FSB report, Reducing the moral hazard posed by systemically important financial institutions, which was presented to and endorsed by the G20 leaders at their summit meeting in Seoul on November 11‐12 2010 appears to go in this direction. It says that resolution authorities should be required to cooperate with each other and that national rules that pose obstacles to fair cross‐border resolution, such as depositor priority rules that give preference to domestic depositors over those of foreign branches or certain automatic trigger rules, should be eliminated where appropriate. 141. We support this direction of travel. Progress should be made, based on the FSB report, to remove national legal obstacles so that the resolution of such a firm can be based on an approach founded on close cooperation and coordination between the home and host authority led by the home authority. 13 142. In our response to the Basel Committee Working Group’s consultation of September 2009, we expressed support for approaches such as the Swiss, whereby, subject to the protection of secured and privileged creditors, to the need for reciprocity, and to a requirement for the equal treatment of domestic and foreign creditors, the resolution of a firm and its overseas branches is led by the home state administrator. 143. Ensuring the appropriate protection of local depositors is likely to remain a key concern of host authorities. The challenges arising from this aspect can, however, be overcome on the basis of well‐coordinated, legally effective, firm‐specific crisis‐ management and resolution agreements entered into between the respective authorities. Clear agreements should be established, founded in the resolution legislation in both jurisdictions, enshrining principles of reciprocity, non‐ discrimination, and equal treatment of creditors, and incorporating recognition of the imperatives of deposit protection arrangements. 144. Set out below are the features that it should incorporated in such firm‐specific agreements. (We would note that many, though not all, of these principles might apply equally in the context of the resolution of host subsidiaries.)
It is noted that there may be exceptional cases in which, due to the particular configuration of a group, it would make sense for the process to be coordinated by a host authority. This is something that should be addressed in firm‐specific resolution agreements between the relevant home and host authorities.
(a) recognition that the home resolution regime will be applied (except in exceptional circumstances where it may be appropriate to agree that a host regime should be applied); (b) appropriate protection of depositors; (c) equal treatment of creditors regardless of location or governing law of their contract; (d) in calculating liabilities, security, etc the governing law of the contract in question to be applied; (e) elimination of asset maintenance requirements in respect to branches; (f) elimination of measures designed to ensure that unencumbered assets are ear‐ marked for certain categories of creditors; (g) a requirement for close cooperation among resolution authorities in the different jurisdictions to ensure simultaneity of action, effectiveness of measures, etc.; and (h) no obstacle to the transfer of assets, collateral, etc between jurisdictions in furtherance of the resolution;
Achieving consistency between going concern approaches and resolution requirements
145. Under a “group interest” approach it is conceivable that the distribution of assets and liabilities across the entities in the group will be otherwise than they would have been on a strictly legal entity‐based approach. As discussed above, depending upon the nature of the business and associated business model, in the context of a going‐concern organization, not only is this not problematic, it is likely to be significantly to the benefit of the stakeholders of the group taken as a whole and to the wider economy. However, as the failure of the group begins to emerge as a possibility and a crisis begins to crystallize, the mismatch between distributions under the group interest as against the legal entity approach becomes more significant. 146. We think that the work of the FSB on firm‐specific crisis management and resolution agreements has the potential to help address this problem. We would note, however, that this is one of the most difficult issues to be addressed, thinking remains at a very early stage, and firms continue to have different views as to the best way forward. The proposal under this heading is therefore for intensified work and close dialogue between the official sector and the Industry to seek to identify optimal solutions.
147. To take an example of areas to be explored: if a group organizes itself so that resources are distributed among entities in line with a group interest approach, and those entities are subject to integrated business and risk management, then it might be considered desirable, in order to forestall national restrictions being imposed on such an approach, for there to be entered into legally binding agreements that permit the integrated nature of the group’s approach to be reflected in an integrated approach to the resolution of the group, including ensuring that creditors of the group have access to their fair share of the group’s assets. 148. Such an approach would need to be voluntary for the firm in question. To the extent that it wished to include certain entities within such an arrangement, the firm would be free to do so, and to the extent that it wished to exclude entities or, indeed, the whole of the group, it would be equally free to do so. There must be no question of a firm’s business model and organizational approach being undermined by the imposition of group‐support or similar requirements. 149. Such an approach would also need to be embedded in the legal provisions establishing national resolution regimes so that the firm‐specific resolution agreements are reliable and enforceable at a time of difficulty. 150. Properly carried out and with appropriate ambition to arrive at legally binding arrangements, the approach to the development of institution‐specific agreements might have the potential to make a significant contribution to the achievement of an effective international framework of cross‐border resolution.
The U.S. approach: a note on Dodd‐Frank
151. Title II of the Dodd‐Frank Wall Street Reform and Consumer Protection Act is entitled “Orderly Liquidation Authority” and establishes a regime for the resolution of systemically important firms. 152. Many of the principles and techniques embodied in this Title are in line with the proposals the Institute put forth in its May 2010 report. 153. As we have discussed under Section 2 above, the Title takes a “winding up” approach. However, it also allows for the establishment of a bridge bank and other techniques deemed useful to optimizing outcomes. Whether a bridge bank mechanism can be used to achieve bail‐in outcomes is, as we have seen, an open question. 154. However, Title II remains problematic in the limited attention that it pays to cross‐ border issues. It remains an approach grounded in a legal‐entity philosophy of resolution and winding up. The resolution framework created can apply to bank holding companies, non‐bank financial holding companies supervised by the
Federal Reserve Board (FRB), companies predominantly engaged in financial activities, and any subsidiary of any of the foregoing predominantly engaged in financial activities. However there is no remit over foreign subsidiaries and no additional rights to consolidate parents and subsidiaries. 155. What this means is that the Title II approach is strictly national jurisdictional in nature. Subsidiaries of foreign groups that fall within the terms of the Title fall to be resolved independent of and separate from how the rest of the group might be dealt with. Similarly, foreign entities of U.S. groups do not fall to be resolved within the context of the group as a whole. 156. In its recent article, “The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd‐Frank Act,” 14 the FDIC indicates that in the event that Lehman Brothers had fallen to be resolved under Title II of Dodd‐Frank, the FDIC would at an early stage have begun contacting key foreign financial authorities “on a discrete basis to discuss what legal or financial issues might arise out of an FDIC receivership.” The article also gives the example of effective cooperation with the China Banking Regulatory Commission and the Hong Kong Monetary Authority concerning the acquisition by East‐West Bank of United Commercial Bank, San Francisco, with a wholly‐owned subsidiary in China and a branch in Hong Kong. Nonetheless it remains the case that such cooperation and coordination is, under Dodd‐Frank, dependent upon the goodwill of the different parties and perceived common interest in the circumstances. 157. The FDIC is, however, required to coordinate with any appropriate foreign financial authorities regarding the orderly liquidation of a U.S.‐covered financial company that has any assets and operations outside the United States. 158. In addition, the Governmental Accountability Office is required to study and report to the relevant House and Senate committees regarding international coordination relating to the orderly liquidation of financial companies. 159. Much, accordingly, remains to be done to render the Dodd‐Frank approach appropriate for application in the context of cross‐border financial groups.
Annex 1 Key components of an effective resolution framework as set out in IIF Report: A Global Approach to Failing Financial Firms: An Industry Perspective 15
The following elements represent the cornerstones of the approach set out in the above mentioned report: The overall objective is to advance the extent to which it is possible for every financial firm to exit the market in an orderly manner. There must be no expectation that losses will be borne by the taxpayers—though a distinction needs to be drawn between solvency and liquidity support, and between normal expectations and what might be necessary in a situation of systemic crisis in which short‐term support can yield significant dividends. This means that: a) It must be possible to extricate any part of the firm that is an essential part of the general financial infrastructure and maintain its operations by transferring it to a third party or a bridge bank. There must not result a widespread “contagion” effect whereby losses to stakeholders in the firm result in knock‐on losses (or the fear of knock‐on losses) to other participants in the financial system to such an extent that the system suffers material trauma and is put at risk of ceasing to function effectively.
Losses should be borne by shareholders, providers of other forms of capital, and creditors in line with their place in the bankruptcy/insolvency hierarchy laws. Property rights must be respected. This includes, in particular, full respect for security and collateral rights; these should not be abrogated. To the extent that additional costs are incurred in resolving a firm in a manner that avoids systemic damage, such costs should not be imposed on creditors (or a particular group of creditors); rather, they should be borne by the financial industry generally (in line with the principles of resolution funding set out in the May 2010 report). This report indicated that there was a clear majority within the industry in favor of ex post mechanisms for meeting such additional costs of failure rather than the creation of an ex ante fund.
Authorities should have a full range of powers necessary to achieve the above.
Annex 2 Critical functions: some putative examples to be considered
Payment and settlement systems: Depending upon the scale of its involvement, the activities of a failing firm in respect of payment or settlement systems can be potentially critical and thus need to be preserved. A failure to do so could, depending upon the scale of the firm’s activities, lead to significant disruption both as a result of the failed settlement of items currently making their way through the system and as a result of the disruption to real economy activity that can arise from customers being shut out of payment or settlement systems for a material period of time. Deposit taking: The Institute considers that in general, deposit taking should not be considered a critical function per se. Unless there are very specific prevailing circumstances, we think that it is unlikely to be the case that a competitor could not quickly step in to provide a replacement service. It is important to be clear, however, that this does not mean that insured depositors will not require to receive repayment of their funds in a timely manner, nor that the most effective way of achieving this may not be to transfer the deposit accounts to a bridge bank or third party, nor that the payment service aspect of such accounts may not be critical (see above). What it does mean is that maintenance of deposit‐taking services by a particular bank is not, per se and under normal circumstances, a critical function the cost of preserving of which needs to be met. Clearly, robust and reliable deposit protection schemes are essential to the maintenance of financial stability. However, it should be recognized that the systemic feature that is being addressed is the avoidance of financial shock and loss of confidence rather than the continuance of a critical function. Credit availability: In general, it is considered that the provision of credit by any particular firm is unlikely to be a function critical to the financial system or to the economy. There can generally be expected to be competitors ready and able to step in to fill the gap left by any individual failing firm. A possible exception to this is in respect to the availability of credit facilities to small businesses. Such facilities may be important to customers for cash management purposes and may therefore, where the scale of the provision of such facilities by the financial firm in question constitutes a material factor in the smooth functioning of the economy, represent a critical function. Derivatives activities: A firm’s engagement in derivatives activities can be very significant; however, such activities should not be considered a critical function. They do of course have the potential to cause significant losses to counterparties and, through contagion or fear of similar outcomes elsewhere, to participants in the wider economy. Such activities should not, however, be considered critical functions. These are activities that can be quickly taken up by other participants, and the exit of the firm in question 55
does not undermine the continuance of the functions per se. The issue of major loss and contagion is, of course, a very significant one. It is considered in extensive detail in the Section 2 of this paper. The key point here, however, is that such activities do not represent a critical function to be preserved on the basis that the cost of doing so should be met from some source external to the firm. In all of the cases discussed above in which there is a potential for a critical function to be present, it is important that the individual circumstances be closely examined. There are potentially significant costs associated with the preservation of particular business activities of failing firms. These are costs that will not, given the principle that no creditor should be worse off than they would have been in a liquidation, have a natural “home.” They will, accordingly, need to be externalized outside the firm and so should be kept to an absolute minimum. The question therefore is not whether discontinuance would be disruptive or regrettable, but whether it would cause major disruption to the real economy.
Annex 3 Summary of IIF Paper, Preserving Value in Failing Firms
In September 2010, 16 the CBRWG made a submission to the FSB on the issue of bail‐ins: Preserving Value in Failing Firms. Set out here is a summary of the key points of the analysis contained in that document. Part of a continuum The paper noted the importance of recognizing a bail‐in measure as one in a continuum of measures and powers, running from those deployed by supervisors in the business‐ as‐usual phase, through those used during crisis management and emerging risks of insolvency to, at the other end of the spectrum, resolution and wind‐down mechanisms, including, potentially, bail‐in. Need for clarity The distinction between contingent convertible capital instruments (CoCos) and bail‐in measures was considered, with the central difference being thought to lie in the contractual nature of CoCos combined with the strictly defined nature of their triggers as compared with the more statutory nature of a bail‐in regime and the role given to authorities in invoking bail‐in powers. Avoiding precipitous loss of value It was noted that the central effect that could be achieved by bail‐in measures was likely to be the avoidance of the precipitous loss of value in the failing firm giving rise to a systemic event. Such loss can occur when a financial firm enters bankruptcy or liquidation. It is this sharp and significant evaporation of value—arising from a combination of impact on franchise, customer, and workforce value; the unwinding of financial contracts, including a move to mid‐market from bid/ask pricing; and fire‐sale effects— that is at the heart of the systemic trauma associated with contagion and fear of further failures and that is a key reason why the failure of a large, complex financial institution can be so problematic. The interconnectedness of such firms and the wider financial services market can give rise to a systemic shock that needs to be forestalled. The bail‐in of credit counterparties, combined with restructuring and a change of senior management, allows the firm to be recapitalized, returned to solvency, and put back into a position whereby liquidity is once more available to it. While losses will occur, these will be absorbed by equity holders, providers of other forms of capital, and, to a
September 9, 2010
limited extent, by senior credit counterparties. And, indeed, to the extent that the recapitalization is successful, some of even these losses may be reversed. To be used for securing systemic stability It was the view of the Preserving Value paper that, while bail‐in would be likely to operate to the benefit of the creditors of the failing firm, the grounds for the exercise of the bail‐in power should be limited to that of securing systemic stability through the preservation of value and avoidance of traumatic losses. Respecting priorities between classes The order of priority between equity, other forms of capital, subordinated debt, and senior debt needed to be preserved. To the extent that the bail‐in mechanism might eventually turn out to be unsuccessful, it was identified as a key principle that no creditors should emerge worse off than they would have done in a normal liquidation. Determination ex ante or ex post An important question considered in the Preserving Value paper was the extent to which those liabilities to be made subject to the bail‐in decision should be decided ex ante or ex post. It was also noted that the question of the extent to which bail‐in should rest on a contractual versus a statutory basis would be determined by the answer to this prior question. A number of advantages and disadvantages of both the ex ante and the ex post approaches were identified. Supporting a limited scope/ex ante approach were the degree of clarity and certainty that this would bring to the situation. This approach was considered to have benefits in terms of making it clear to certain categories of credit counterparties – such as trading counterparties, short‐term creditors and liquidity providers, and uninsured depositors ‐ that they would not be subject to bail‐in measures, thus minimizing the likelihood of flight. By determining in advance which categories of credit counterparties might be subject to bail‐in, it would be possible to increase the consensual nature of the mechanism. Beyond this it was also the view of a number of Members that by limiting clearly the scope of bail‐in, it is possible to limit any potential increase in bank funding costs. Counter to this, it was identified that there were also a number of disadvantages associated with an ex ante limited‐scope approach. This approach had the potential to contribute materially to moral hazard in the system as those liabilities explicitly exempted from the bail‐in mechanism would be perceived as receiving considerable additional protection. There was also identified to be considerable risk that under an ex ante approach significant distortions would be introduced, with funding techniques being arbitraged to avoid potential bail‐in exposures. On the cost‐of‐bank‐funding issue, some argued that a broad or “comprehensive” approach, by replicating a “pre‐packaged
bankruptcy” by way of a residual power, would minimize any possible increase in funding. Triggers Preserving Value noted the importance of effective trigger design. While bail‐ins required a determination by the authorities, the judgment of the authorities should be appropriately constrained so as to maximize predictability. It would also be crucial to minimize the extent to which the development of a bail‐in mechanism could have the effect of bringing‐forward the point of failure of financial firms. Termination and close‐out rights The paper noted that for bail‐in measures to be effective it would be important to incorporate in the legislation establishing bail‐in mechanisms, provisions which would have the effect of suspending automatic default, cross‐default, and close‐out clauses. Group issues To deal with the common situation whereby a failing financial firm is part of a wider group, it was identified in the Preserving Value paper that it would be necessary to introduce measures capable of addressing the complexities arising in such a context. It would be important that a group‐level approach be adopted, including notably in the context of recovery and resolution planning. Concerning the mechanics of a bail‐in in such a context, it was envisaged that there would be a potential need for provisions enabling the swap of equity in the bailed‐in entity for that in the group parent. Cross‐border aspects Because they have the potential to significantly reduce the losses arising from failure of a cross‐border group, bail‐in mechanisms were seen as having considerable potential to alleviate the difficulties that have arisen previously in dealing with the failure of cross‐ border financial firms. It also, however, gives rise to complexities of implementation of the technique itself. The paper identified that this was effectively a coordination problem that should be addressed by the FSB achieving agreement among its members that they would introduce bail‐in mechanisms in their own jurisdictions. Failing this, it might be necessary to supplement the statutory approach with contractual techniques in particular jurisdictions.
Annex 4 Legal issues in group support and resolution
Obstacles to group support Where a group is entering resolution, there are a number of issues that arise out of the nature of the group that may cause difficulty for the effective resolution of the situation. Limitations on the ability of group members to transfer assets inter se. The basis of a group structure is that each group member is a separate entity subject to the relevant company law regime. Company law regimes generally restrict or prohibit directors from dealing with company assets in a way that is not of some benefit to the company concerned. Thus, for example, directors of a solvent subsidiary of a troubled parent bank might be prohibited from transferring assets to the parent in order to ensure its liquidity, and will almost invariably be prohibited from subscribing for new capital in the parent. These issues can vary depending upon the configuration of the group concerned: (1) Transfers from a parent to a subsidiary are generally straightforward, in that the parent will generally subscribe new capital into the subsidiary. However, even loans from a parent to a subsidiary can, in extreme cases, be prohibited when the loan is almost certain not to be repaid. (2) Transfers from subsidiaries to parents are considerably more restricted, and they cannot be used to create new capital at the level of the parent. In addition, any transfer of assets from a subsidiary to a parent is likely to be characterized as a dividend, and company law frequently restricts or prohibits the payment of dividends in certain circumstances. (3) Direct transfers between subsidiaries are in general subject to many of the restrictions imposed on transfers from subsidiaries to parents. It is important to note that these issues constitute a separate set of legal issues from those involved in designing a resolution regime. Where a bank parent in country A has a solvent non‐bank subsidiary in country B, it is likely to be the case that the solvent subsidiary in country B will not be (or possibly cannot be) placed in a bank resolution regime. Thus the legal measures necessary to deal with the issues above must be approached through the company law regime in country B.
Resolution of groups One of the most difficult issues in the construction of resolution regimes arises out of the resolution of cross‐border groups containing multiple banks. If bank A in country A is the parent of bank B in country B, the making of a resolution order in respect of B will not, without some sort of mutual recognition regime, result in the making of a resolution order in respect of A. Furthermore, if B is in financial difficulty but A (considered as a freestanding entity) is solvent, there may be difficulties for supervisors and resolution authorities in country A in placing a solvent institution into resolution to assist in the resolution of country B. However, if this is not done then the resolution of bank B may be seriously hindered. When both bank A and bank B are in financial trouble and are placed in resolution, there are still considerable difficulties to overcome. Most important, any transfer of assets between the two will advantage the one at the cost of disadvantaging the other. If the objective of the resolution authorities is to work together for the benefit of creditors as a whole, it may be necessary for one resolution authority to make a transfer whose effect is to reduce the claims of the creditors of the institution in respect of which he is appointed, and this is clearly politically unpopular.
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