Including updates on letting banks fail, G-SIIs and risk appetite

 

Breaking the taboo: letting banks fail

The policy of propping up banks has proved expensive, in some cases near ruinous for smaller countries. Debt-laden governments cannot now afford to bail out banks, if they ever could. Public attitudes towards further government intervention are hostile. Market sentiment in banks has been knocked following the crisis, pushing stock prices down, with the obvious consequence that yields required by creditors to hold bank debt have gone up.

Paul Tucker, Deputy Governor of the Bank of England, who leads the Financial Stability Board’s  (FSB) recovery and resolution work programme, believes that banks have "nowhere to hide" in the post-crisis era and must navigate stress situations in the future with no recourse to a government safety-net. Breaking the taboo of letting banks fail will require effective resolution strategies and the analysis of conditions relating to firms’ legal, operational and financial structures and their effect on resolvability.

On 16 July 2013, the FSB published three papers setting out its latest thinking on recovery and resolution planning. All three papers are intended to assist authorities and systemically important financial institutions (SIFIs) in implementing the recovery and resolution planning requirements set out under the FSB's key attributes of effective resolution regimes for financial institutions. In time, the concepts elaborated in these papers are likely to be applied to most other banks.

Developing effective resolution strategies: The FSB believes that there are a number of key considerations and pre-conditions for the development and implementation of effective resolution strategies. First and foremost, effective bail-in must be facilitated through the sufficiency and location of loss absorbing capacity (LAC). LAC needs to be available in sufficient amounts and in the right location to facilitate a recapitalisation or orderly wind down of the firm (or of part of the firm) and avoid the need for a bail-out with public funds. The position of LAC in the creditor hierarchy under the laws applicable to the group entities where the LAC is located is also important in deciding on appropriate resolution strategies.

According to the FSB, a firm needs to be structured, legally and operationally, in a way that supports effective resolution on the one hand, while ensuring the continuation of critical functions on the other. This sounds good in theory but the FSB doesn’t provide any definitive insights into how to go about this. The Lehman Brothers debacle demonstrates the operational challenges in winding up a large investment firm, never mind a bank.

As always, the FSB hammers home the need to establish a resolution authority with sufficient teeth to deliver a far-ranging resolution strategy, such as the use of a bridge institution, asset purchase and assumption or “bail-in” powers. In doing so, governments need to develop a legal framework around the procedures whereby a firm can be placed into receivership in such a way so that some or all if its operations can be transferred to a newly established bridge institution or establishing how the “bail-in” of debt instruments will be affected.

The FSB’s guidance also touches briefly on the following:

  • enforceability, effectiveness and implementation of “bail-in” regimes
  • treatment of financial contracts in resolution, specifically the use of temporary stays on the exercise of contractual close-out rights
  • funding arrangements
  • cross-border cooperation and coordination
  • coordination in the early intervention phase
  • approvals or authorisations needed to implement chosen resolution strategies
  • fall-back options for maintaining essential functions and services in the event that preferred resolution strategies cannot be implemented
  • information systems and data requirements
  • post-resolution strategies
  • single point of entry (SPE) versus multiple point of entry (MPE) resolution strategies
  • disclosure of resolution strategies and LAC information.

Identifying of critical functions and critical shared services: In an annex to the guidance, the FSB provides a non-exhaustive list of functions and shared services which could be critical, namely:

  • deposit-taking
  • lending and loan servicing
  • payments, clearing, custody and settlement
  • wholesale funding markets
  • capital markets and investments activities
  • finance-related shared services
  • operational shared services.

No surprises there. But the FSB’s work is important here in terms of promoting a common understanding of which functions and shared services are critical by providing shared definitions and evaluation criteria.

Guidance on Recovery Triggers and Stress Scenarios: This paper focuses on two specific aspects of recovery plans:

  • criteria triggering senior management consideration of recovery triggers, specifically  design and nature, a firm’s reactions to breached triggers, and engagement by supervisory and resolution authorities following breached triggers
  • the severity of hypothetical stress scenarios and the design of stress scenarios generally.

In practice, the decision to pull the trigger will be collaborative, with the resolution authority having the final say. While the FSB has done good work in outlining some of the quantitative triggers that need to be considered, the decision will likely be political, rather than financial or economic.

Some groping in the dark is inevitable as recovery and resolution plans are totally untested. Banks and authorities have a short window to successfully implement such plans to avoid contagion in the financial system.  Markets, investors and depositors (in the case of banks) can't be kept in the dark for long.  Authorities now understand that this is not a theoretical exercise: banks will fail, and recovery or resolution plans will be used. We may have to wait until the trigger gets pulled for real to see just who ends up having to hold the gun.

 

Hello G-SIIs

We have learned lot of new acronyms and terms since the crisis, G-SIBs, ESAs, feedback-loop, macro-prudential. Another term has officially joined the already bloated lexicon of the financial industry: globally systemically important insurers (G-SIIs). On 18 July 2013 the FSB and the International Association of Insurance Supervisors (IAIS) published a list of nine G-SIIs. It follows more than a year's deliberation on whether insurers should be deemed systemically important and if so, what policy measures are appropriate. The nine G-SIIs are Germany-based Allianz; AIG, MetLife and Prudential Financial in the US; French group Axa; Ping An Insurance of China; the UK's Aviva and Prudential; and Italy's Assicurazioni Generali. The list does not include reinsurers. The FSB will make a call on the classification of these firms in July 2014.  The list is not fixed; insurers can migrate in and out of G-SII status over time, so they will have incentives to adjust their risk profile and reduce their systemic importance where applicable.

The designation triggers a range of requirements on these insurers including enhanced supervision, capital buffers and the removal of barriers to orderly resolution. It might also result in regulators taking a fresh look at their supervisory approach, leading to a bolder use of existing regulatory tools; tailored regulation; and greater collaboration between cross border supervisors. One aspect which insurers and regulators will need to consider is the supervisory interaction with boards. This interaction may need to become more frequent and involve more senior staff from the supervisor. Boards will need to be prepared for this level of dialogue. Regulators must also consider ways in which to formally assess the risk culture of G-SIIs and insurers will need to reflect on what they can do to demonstrate a strong risk culture throughout the firm.

Along with the nine G-SIIs, the IAIS published its final assessment methodology for identifying G-SIIs (which the FSB endorsed). Similar to the Basel Committee’s approach to identifying systemically important banks, the IAIS approach attempts to measure global systemic importance by focusing more on the impact that an insurer’s distress or failure could cause, rather than the probability of such a failure. The assessment methodology is based on three steps: the collection of data, an indicator-based assessment of the data, and a process of supervisory judgment and validation based on an 18-point system. The 18-point system is divided into five categories covering size, global activity, interconnectedness, substitutability, and non-traditional and non-insurance activities. Over and above their size and global reach (5-10% weighting for each), the range and scope of firms’ non-traditional insurance activities (40-50% weighting) and the level of interconnectedness (30-40% weighting) are important when determining G-SIIs’ status.

The overall weighting structure is markedly different to banks, where size is a much more important factor. The IAIS is of the opinion that size in traditionally regulated insurance is actually a favourable characteristic since “in an insurance context size is a prerequisite for effective pooling and diversification of risks".

However, insurers and their industry associations are still not happy with the IAIS’s approach, suggesting that prosaically applying the Basel Committee’s methodology to insurance firms is not appropriate. The traditional banking model (i.e. deposit gathering, credit intermediation and investment services) is very different from the traditional insurance model (i.e. pooling insurance risk, liability-driven investments, and stable cash outflows over a long horizon). Fundamentally insurers do a better job of matching assets with liabilities, are less exposed than banks to the systemic risk of maturity transformation, and carry substantially lower positions in derivatives. 

In addition to the assessment methodology, the IAIS also released a framework for implementing macroprudential policy and surveillance (MPS) in the insurance sector. Its focus is on enhancing the supervisory capacity to identify, assess and mitigate macro-financial vulnerabilities that could lead to severe and wide-spread financial risk. Over time, the MPS framework will be refined through the issuance of guidance on the practical application of IAIS Insurance Core Principles, and the development of a toolkit and data template regarding early warning risk measures.

 

Risky business

The FSB released draft Principles for an Effective Risk Appetite Framework on 19 July 2013, as it continues to evangelise on the need for a harmonised approach to the supervision of global banks. The Principles are mainly geared towards SIFIs, and establish minimum expectations for the key elements contained in an effective risk appetite framework.  Those elements include an actionable risk appetite statement, quantitative risk limits, and clearly defined roles and responsibilities of the board of directors, senior management and business lines.

The Principles also aim to establish a common classification for terms used in the risk appetite framework which will help facilitate a common understanding between supervisors and firms and narrow any gaps between supervisory expectations and firms’ practices.

Interestingly, the FSB indicates that all banks should have their own risk appetite statement. The statement should be linked to the firm’s short- and long-term strategic, capital and financial plans, as well as its compensation programmes. It should assess the firm’s material risks under both normal and stressed market and macroeconomic conditions, and set clear boundaries and expectations by establishing quantitative limits and qualitative statements for risks that are difficult to measure.

While this proposal might appear be motherhood and apple pie, an effective risk appetite framework is the foundation of good risk management, and good risk management is a top-down process. Getting the right risk appetite statement in place at the top might be the key to unlocking better decision making throughout the firm.