Including updates on recovery and resolution plans proposals, assessment of global systemic important insurers and regulating securitisation markets


EC issues recovery and resolution proposals and outlines a European banking union

On 6 June 2012 the European Commission (EC) published its long-awaited draft Directive on a recovery and resolution framework for financial institutions. The proposal is one of the last of some 30 proposals issued by the EC to strengthen and stabilise the European financial system as a reaction to the crisis. The issue of how to resolve financial institutions in an orderly manner has been at the core of the global financial reform agenda since 2008 but one of the last on the EC’s list. As a result, the European Parliament (EP) has introduced some preliminary measures in the latest amendments to the Capital Requirements Directive (CRD IV/CRR) currently being negotiated. According to Sharon Bowles, Chair of the EP’s Economic and Monetary Affairs Committee (ECON), the EU cannot wait another two years for this latest proposal to come into force before taking action. The UK and US regulators have already outlined what they expect to see in recovery and resolution plans of large institutions and the banks affected are well into the planning phase.

With this new regime, the EC hopes, above all, to provide sufficient powers and flexibility to the various authorities involved to quickly intervene with any distressed financial institution to return to health within a short timeframe but also to avoid wider contagion in the financial system. However, the proposals have much more of a ‘micro’ flavour, than a ‘macro’ one.

The proposed regime will apply to credit and investment firms subject to the CRD. Resolution powers will also apply to holding companies where one or more of its subsidiaries are credit or investment firms and where applying resolution measures on the parent entity is necessary for the resolution of the subsidiary or the group as a whole.

In the EC’s proposals, we see many of the ideas tabled in earlier consultation papers. The proposed Directive structures the process into three phases: preparation and prevention, early intervention and resolution.

Supervisory authorities come to the fore in terms of the recovery and early intervention phases. Specific resolution authorities will need to be identified at the national level which would take over at the resolution phase. Both supervisory and resolution authorities are involved in the preparatory phase. If multiple authorities are involved in the resolution phase, then each Member State needs to determine how they should work together. Where resolution activities are combined with other roles within a public administrative body (e.g. central bank, treasury department), these activities will have to be functionally independent. For cross-border groups, supervisory and resolution colleges are foreseen to facilitate collaboration on a pan-European basis. Early work in the UK and the US on resolution plans has already revealed difficulties in relation to developing resolution plans: resolution authorities do not have the same experience of cross-border coordination and collaboration as national supervisors. The EC stipulates that resolution authorities will work closely with supervisory authorities, and that the European Banking Authority (EBA) will play a mediation role if difficulties surface. Given the nature of some resolution authorities at the national level, this mediation task may prove challenging.

The preparation and resolution phases bring no surprises. In the preparation phase, firms will be required to prepare ‘living wills’ or recovery plans, on a solo and group basis, to determine the actions that they would take given certain crisis scenarios. Resolution authorities, working with the firm and its supervisors, will develop solo and group plans, detailing amongst other things how critical functions would be safeguarded in the case of failure. Importantly, during the preparation phase, the firm and its supervisors would also ascertain whether, what and when group support mechanisms could be used.

Under the resolution phase, the EC sets out considerations for when resolution would be triggered, and for associated valuation procedures and processes. It also presents a varied resolution toolkit, including sale of part or all of the business, bridge institutions, asset separation and bail-in which would be at the disposal of the resolution authorities, either separately or in combination, once a firm is on the verge of failure.

Something new comes in the EC’s proposal for the supervisory toolkit envisaged in the ‘early intervention’ phase - the stage at which a firm is beginning to struggle but, with the right action, could still recover from its troubles. Here the toolkit includes activation of the recovery plan, a request to management to draw up an action plan with a timetable and/or to call a shareholder meeting to gain support for actions to be taken (which may be specified by the supervisor), and to restructure debt. More significantly, the proposals also propose that the supervisor itself could convene a shareholders’ meeting, or appoint a special ‘manager’ on a temporary basis. Clearly, the use of various tools within this particular toolkit could have considerably different consequences for a beleaguered firm.

The proposal now goes to the Council and the EP to begin their separate deliberations. Given the timing of the publication, legislators are unlikely to make much progress before September this year, after the summer recess.

As negotiations on the Directive progress, we will need to keep an eye on how the EC elaborates the related concept of a ‘banking union’, also recently announced, because this may address ‘macro’ dimensions not fully covered in the current proposal. The EC plans to initiate a process to “map out the main steps towards full economic and monetary union (including), among other things, moving towards a banking union including an integrated financial supervision and a single deposit guarantee scheme.” Political agreement on the concept is needed before the EC can propose specific measures (and senior officials in Germany and the UK have already voiced concerns). However, EC President Barroso believes that change could be effected as early as next year, without the need of Treaty changes, if such political agreement comes quickly. It is not clear yet what are the implications of this announcement for the ongoing negotiation on revisions to the Deposit Guarantee Schemes Directive which the EC tabled some two years ago. Clearly, though, these initiatives will have a significant cumulative effect on the banking industry.


Regulating securitisation markets: the challenges

On 7 June 2012 the International Organisation of Securities Commissions (IOSCO) published a consultation report: “Global developments in securitisation regulation”. This report responds to a request from the Financial Stability Board (FSB) to undertake a stock-take of current national and regional initiatives in relation to risk retention, enhanced transparency and the standardisation of securitization products, in the context of its ongoing work on shadow banking. The report builds on previous work by IOSCO, the US Securities Exchange Commission (SEC) and the EC. It underlines how important the recovery of the securitisation markets to the global financial system and to economic recovery is, but also emphasises the balance that must be struck in regulating the industry to ward off future crises.

IOSCO based its analysis on the following principles:
  • Securitisation markets cannot be seen as purely domestic and differences in regulation between territories might lead to decreased activity, dampening the potential benefits of securitisation. As a result, IOSCO believes “consistency or integration of regulatory approach between jurisdictions is desirable”.
  • Securitisation markets are heterogeneous. These differences will drive to an extent differences in regulation, so the first objective of consistency has to be understood in the context of these differences between markets.
IOSCO notes that cross-border securitisation is currently very limited or non-existent outside of the US and the EU, although the report considers practices in other jurisdictions. The report looks at risk retention and disclosure requirements, the securitisation process and issues relating to credit rating agencies. Its consultation, however, focuses on two issues:
  • Risk retention: IOSCO found that the US and the EU applied risk retention rules differently. Risk retention requirements in the EU focus on investors, whereas US requirements focus on sponsors. Significantly, the US regime allows for exemptions to the risk retention rules subject to the assets backing the securitisation being of a certain quality, such as commercial loans, commercial real estate loans, automobile loans, residential loans and those securities backed by government-insured or guaranteed assets. The EU regime, on the other hand, requires banks to ensure that originators retain 5% minimum risk before they invest, unless the exposures are to, or guaranteed by, central governments and central banks, multilateral development banks, regional and local governments or institutions with a risk weighting of 50% or less. IOSCO believes that the exemptions in the US potentially go much further than those in the EU and that such disparities would be detrimental to the issuance of cross border instruments and increase costs. IOSCO proposes monitoring the impact of these differences and, if industry feedback and experience support it, developing regulation to address them.
  • Disclosure: Well-developed disclosure regimes exist in most jurisdictions in relation to public offerings and in some in relation to private placements. Some differences noted reflect national market conditions and practices but IOSCO sees no need to address these issues. However, IOSCO believes that disclosure of stress testing information would help stimulate risk mitigation while decreasing reliance on credit rating agencies. IOSCO plans to ascertain investors’ appetite for such information. Moreover, IOSCO believes that standardisation of disclosure templates across jurisdictions would be effective in helping investors understand the risk profile of products. IOSCO will consider developing principles to support and encourage the ongoing development of industry best practice templates.
The consultation is open for comments until 6 August 2012. The report provides a good insight into current regulation of securitisation markets across jurisdictions. The outcome of the consultation, through the FSB, is likely to bring forth recommendations for adjustments to existing regimes, so all firms actively involved in these markets would be well advised to give this consultation some attention.


Are insurers systemically risky?

The collapse of Lehman Brothers in 2008 showed that the failure of a relatively small financial institution can seriously threaten the financial system internationally. ‘Too big to fail’ was a well-discussed concept prior to this event, but the Lehman collapse led to the concepts of ‘too-interconnected-to-fail’ and ‘too-complex-to-supervise’ to get significant air-time. The FSB is driving an initiative to identify global systemically important financial institutions (G-SIFIs) and to develop recommendations for their regulation and supervision globally. So far, the analysis had concentrated on the assessment of banks (G-SIBs) but, given the experience with AIG, insurance and reinsurance companies are also in the cross-hairs. Consequently, the International Association of Insurance Supervisors (IAIS) has been tasked with an analysis in relation to potential global systemically important insurers (G-SIIs).

On 31 May 2012, the IAIS issued a consultation paper outlining a proposed assessment methodology for G-SIIs. Supervisors, insurers and other interested parties are encouraged to submit comments on the proposed methodology by 31 July 2012.

The IAIS proposes an assessment methodology similar to the Basel Committee's approach for identifying G-SIBs, but significantly adjusted to reflect the particular characteristics of the insurance business. The IAIS's assessment methodology involves three steps:
  • data collection
  • methodical assessment and supervisory judgement
  • validation.
The IAIS methodology proposes the assessment of indicators in five categories: size, global activity, interconnectedness, non-traditional and non-insurance activities and substitutability. It concludes that the two most important categories for assessing the systemic importance of insurers are the non-traditional insurance, non-insurance activities category (weight of 40% to 50%) and interconnectedness category (weight of 30% to 40%): hence these receive higher weights in the assessment. To illustrate how this weighting is intended to work, the IAIS Chair explains: "The potential for systemic risk within the insurance sector needs to be considered where insurers deviate from the traditional insurance business model and more particularly where they enter into non-traditional insurance or non insurance activities."

Non-traditional activities would include non-policyholder liabilities, derivatives trading, short-term funding, financial guarantees and variable annuities and intra-group commitments to non-insurance entities of the group. Some insurance groups have already voiced concerns about variable annuities being considered under this “high risk” category.

According to the IAIS, this indicator-based methodology will only provide a list of G-SII candidates, and will be paired with the application of a segment specific approach. This second approach considers the relative systemic risks associated with specific segments of the business portfolio of insurers and applies increasingly higher weights to the segments associated with activities that pose greater systemic risk. This step permits, for example, large insurers to be filtered out when size is the only category under which they score. In addition, the IAIS plans to carry out further analysis and apply supervisory judgement in determining the final list of G-SIIs.

The IAIS is also considering the policy measures that should apply to G-SIIs and plans to consult on these in the second half of 2012. It plans to designate and publicise the list of G-SIIs (if any are identified) in the first half of 2013. The IAIS expects that current proposals will give insurers incentives to change their risk profile and business models in ways that reduce their systemic importance over time and will act as a deterrent for insurers to move into areas of business that could make them systemically important. Finally, the IAIS acknowledged that recovery and resolution plans will be part of the G-SII measures and would be in place by mid-2014 (18 months later than recovery and resolution plans for systemically important banks) any additional measures for G-SIIs would not be implemented before mid-2017.


Spanish Government obtains help to recapitalise the banking sector

On 9 June 2012 the Eurogroup agreed to the Spanish Government’s request for aid in recapitalising the Spanish banks that have run into difficulties. The loan facility is estimated at €100bn and it will be provided on condition of certain reforms in the financial sector. This rescue greatly differs from the Irish and Greek bailouts as the European Financial Stability Facility (EFSF) is using specific powers to recapitalise banks. In turn, this means that the conditions attached to the loan are likely to be less punitive than those previously applied to Ireland and Greece.

The injection of capital into the entities that need assistance will be arranged through the Fund for Orderly Bank Restructuring (FROB) in the form of a loan at an interest rate below market rate. The financial assistance granted will be attached to strict policy conditions that are set out in a Memorandum of Understanding between the country and the EC. It is expected that the reforms to the financial sector required for the loan to go ahead will include restructuring of financial institutions, possible sale of significant parts of the businesses of financial institutions, additional conditions related to financial supervision, corporate governance and development of national laws on restructuring and resolution practices, as well as compliance with European state aid rules.


G20 priorities: what’s next on the financial markets reform agenda?

On 18/19 June 2012, Mexico, which holds the 2012 G20 Presidency, will chair a key summit in Los Cabos. In addition to focusing on growth and unemployment, food security and promoting sustainable development to combat climate change, the Mexican Presidency’s priorities include strengthening the financial system and the international financial architecture.

In anticipation of the summit, EC President Barroso and European Council President Van Rompuy sent a joint letter to EU heads of State outlining the key issues to be discussed at next week G20 meeting. The letter stresses that financial regulatory reform must remain at the core of the G20 agenda and that the EU is well on track with its implementation of financial reforms. The EU will press for consistent implementation in relation to the Basel III framework on bank capital, reforms of OTC derivatives markets, compensation practices, policy measures for G –SIFIs, resolution frameworks and shadow banking.

On the 8 June, the FSB released a much anticipated paper on the development of a Global Legal Entity Identifier (LEI) which will be tabled at the summit. The paper sets out the plans to establish a governance framework for a global LEI, an operational model, the scope of LEI reference data, access and confidentiality and funding model. The paper also considers implementation and phasing over the coming months, with a view to having LEIs in place by March 2013. The FSB sees the LEI as “a valuable ‘building block’ to contribute to and facilitate many financial stability objectives, including: improved risk management in firms; better assessment of micro and macroprudential risks; facilitation of orderly resolution; containing market abuse and curbing financial fraud; and enabling higher quality and accuracy of financial data overall”.

We will be reporting on the outcomes of the G20 meeting at next week’s weekly news.