Triggering recovery and resolution plans
Governments can no longer afford to bailout banks. The unexpected but essential policy of propping-up banks has proved expensive, for some countries, such as Iceland and Ireland, near ruinous public attitudes towards any ongoing or future government intervention is hostile, and there is clear consensus that taxpayers should no longer have to pay out if a bank gets into trouble. On the other hand, creditors who should be relied upon to impose a certain discipline on borrowers, failed to do so in the run up to the financial crisis but came out of it largely unscathed. But they are unlikely to do so in the future.
Paul Tucker, Deputy Governor of the Bank of England who leads the Financial Stability Board’s recovery and resolution work programme, believes that banks have “nowhere to hide” in the post crisis era and that they must take the steps necessary to enable them to survive stress in the future without relying on government support. Politicians’ favoured approach to codifying this process is “living wills” or recovery and resolution plans (RRPs). In its recovery plan the bank will establish a series of predefined recovery options to use in the face of a range of negative financial shocks. In contrast, its resolution plan will determine how resolution authorities will be able to wind-down the bank in an orderly manner, minimising both the impact on financial stability and the need for government support.
In a speech given at the Institute for Law and Finance Conference, Frankfurt on 3 May 2012, Tucker expressed the belief that RRPs should reduce the direct hit to public finances following a bank’s failure or distress, while also containing system-wide contagion. Moreover, they should contribute to better managed firms, with stronger market discipline, risk management practices and less stability-threatening imprudence.
In the past few months commentators have focused considerable attention on one particular resolution tool: the bail-in bond, which pushes losses automatically onto unsecured creditors at certain trigger points. Banks are concerned that such provisions will make it harder to raise debt in bond markets at a time when they need extra capital to comply with new regulations and replenish their damaged balance sheets as they amortise impairments and write-down certain sovereign exposures. Tucker believes that the intense focus on bail-in by financial institutions is “mistaken”. All resolution tools, whichever ones are chosen, place losses on to debt holders and creditors “because that is the only place they can go”. The Bail-in only differs from other tools in that it applies losses up front based upon a valuation rather than at the end when assets are liquidated. As such, it “prospectively avoids an unnecessary destruction of value”, according to Tucker.
According to Tucker, banks need two plans, one for recovery and one for resolution. The recovery plan would come into play when the bank begins to struggle in meeting prudential norms. The resolution plan would be triggered when the bank no longer meets the criteria for being authorised and has ‘no reasonable prospect’ of meeting the regulatory criteria again.
Clearly, both situations create uncertainty. In different countries and at different points in time, resolution authorities will interpret this statement differently: these decisions are inherently subjective. Clearly, they will need to be based on reliable, and comprehensive, information on the bank’s financial position and prospects. The current regulatory overhaul should go a fair way to provide, in time, much of the information needed but the available information may still not be complete. Efforts to recover or resolve a bank could be seriously hampered, or even prevented, if information on its condition were to leak to the markets and customers. Who pulls the trigger is another issue. In the recovery phase, management is in the driving seat with much closer scrutiny from supervisors. However, according to Tucker, the resolution authority, or authorities, would make the decision to activate a resolution plan. This could take control, and responsibility, away from management at a crucial time. In practice, the decision to pull the trigger
will need to be collaborative, but the resolution authority will have the final say.
The FSB, and others, deserve credit for making progress in tackling the tricky issue of how to allow banks to fail without damaging the financial system and without recourse to taxpayer funds. The European Commission is expected to come out with proposals for a European regime in the next few weeks. However, a wide array of questions remain to be answered and this is one area where one size simply cannot fit all. Each situation will need to be tackled on a case-by-case basis, albeit using a common toolkit. More important, each actor needs to understand their role in this exercise, be ready to take action when necessary, and take responsible actions at the appropriate time. This is not a theoretical issue. With the continued stress in the financial markets, a number of banks continue to be at risk of failure. Without a regime in place, the chances are the taxpayer will, at least in the short term, continue to carry the can.
Deal close on Capital Requirements Directive IV
European financial ministers (the ECOFIN Council) made “huge progress” in finalising their position on the Capital Requirements Directive (CRD) IV (the EU’s framework for implementing Basel III) on 2 May, according to the Danish Presidency. Although full and final agreement eluded ministers during the meeting which endured through to the early hours of 3 May, ministers made clear progress on a number of fundamental issues, leaving only some technical details to be resolved. This paves the way for a final agreement on a text on which to begin negotiations with the European Parliament (EP) at the next ECOFIN meeting on 15 May 2012. The EP Economic and Monetary Affairs (ECON) Committee has deferred its own vote until 14 May to enable further debate which appears warranted, given the 2,195 amendments to the text introduced in the EP. In spite of these delays, the commitment of both the Council and the ECON committee to finalise the regime - in line with the Basel III deadlines - holds firm.
Regardless of the outcome of the debates in ECOFIN and the ECON vote, a couple critical issues are likely to engender ongoing discussion as the negotiations enter the next stage.
Michel Barnier, Internal Market and Services Commissioner, emphasised in his opening comments on 2 May that the EU is committed to a “faithful, complete and prompt” adoption of the Basel III regime. However he also reiterated that certain European specificities would need to be addressed, given that the regime would be applied to all of the EU’s 8,300 or some banks, arguing that this did not go against the Basel regime overall. Some ministers are worried about the nature of some of these specificities. For example, George Osborne, the UK Chancellor, is concerned about the requirements for bancassurers, seeing the possibility for banks to include holdings in insurance companies (in the same group) in own funds as watering down the regime overall.
The other key issue relates to the flexibility to be awarded to individual countries to increase capital requirements in face of emerging national or cross-border systemic risks. Ministers generally understood the need for countries whose banking industry constitutes a large proportion or multiple of GDP to have such a facility – a concept supported by the Basel Committee, the International Monetary Fund, the FSB and the European Systemic Risk Board in recent months. However, questions remain about the level of additional capital that can be applied by national regulators without consultation with the European Banking Authority or other national regulators, because a crucial issue is the potential knock-on effect cross-border, and the relative power of home and host country regulators in determining additional capital requirements.
Further clarity on these issues will be forthcoming soon but the debate will continue. The Danish Presidency is committed to achieving political agreement on the CRD IV package before the end of its term on 30 June 2012, so we should have a much clearer picture of the way forward in a matter of weeks.
Fundamental changes to trading capital rules
Trading desks at major European banks could be required to hold more capital against the risk of market losses, according to proposals issued by the Basel Committee on 3 May 2012. These proposals will supplement the Basel III regime, and address issues not fully dealt with in Basel 2.5.
The Basel Committee wants banks to hold more and better capital against their trading book and to make it harder for them to switch capital between their balance sheets and trading books. While not going as far as the Volcker rule ―which bans proprietary trading ― the provisions will restrict trading and reduce profitability. European banks may have been hoping to gain some competitive advantage over their U.S. peers who must implement the Volcker rule; however, any anticipated gains are likely to be eroded if these proposals are implemented.
The consultation sets out a revised market risk framework and proposes a number of specific measures to improve trading book capital requirements. These proposals reflect the Committee's increased focus on achieving a regulatory framework that can be implemented consistently by supervisors and which achieves comparable levels of capital across jurisdictions.
Key elements of the proposals include:
- A more objective boundary between the trading book and the banking book that materially reduces the scope and incentives for regulatory arbitrage - feedback is sought on two alternative approaches
- Moving from value-at-risk to expected shortfall, as a measure that better captures “tail risk”
- Calibrating the revised framework in both the standardised and internal models-based approaches to a period of significant financial stress, consistent with the stressed value-at-risk approach adopted in Basel 2.5
- Comprehensively incorporating the risk of market illiquidity, again consistent with the direction taken in Basel 2.5
- Measures to reduce model risk in the internal models-based approach, including a more granular process for approving models and constraints on diversification
- A revised standardised approach that is intended to be more risk-sensitive and act as a credible fallback to internal models.
The Basel Committee envisages a long phase-in period to implement these rules, reflecting the degree of change to business models which will be required. Firms have until Friday 7 September 2012 to gather their thoughts and make their voice heard to the Committee on this important issue.