Paul L Lee of Debevoise & Plimpton looks at the impact of the reform programme for the international financial markets that was adopted by the G20 leaders in 2008 and the efforts of different jurisdictions to meet this programme.
"The resolution efforts for cross-border branches of banking entities present significant coordination issues and have frequently devolved into ring-fencing or territorial responses."
In the immediate wake of the global financial crisis precipitated by the failure of Lehman Brothers and the bailout of the American International Group in September 2008, the G20 leaders in November 2008 adopted an ambitious reform program for the international financial markets. One of the key measures in the programme was directed at the reform of national resolution and bankruptcy regimes. The underlying objective of the reform was to promote the adoption of national resolution regimes that would allow the orderly resolution of systemically important financial institutions without creating severe disruption in the financial markets and without requiring a government bailout of the institution.
Basel Committee Recommendations
The Basel Committee on Banking Supervision through its Cross-border Bank Resolution Group took the initial lead in establishing recommendations that should guide the reform of national resolution and bankruptcy law in a report issued in March 2010 (the BCBS Report). The first recommendation from the BCBS was that the national authorities should have an appropriate set of legal tools to promote the orderly resolution of financial institutions and specifically to promote the continuity of systemically important financial functions. The kind of tools recommended included the ability to create a “bridge” financial institution to which assets and liabilities of a failing firm could be transferred rapidly without the need for consent of other contract parties or counterparties. The BCBS recommended that jurisdictions have specialised resolution regimes for financial institutions rather than relying on corporate bankruptcy laws. The specialised regimes would allow the supervisory and resolution authorities to respond quickly and flexibly to a wide variety of circumstances confronting a banking sector.
Another recommendation related to the bridge financial company and transfer recommendation was that the national resolution authorities should have the legal authority to delay temporarily the operation of contractual early termination clauses in financial contracts such as derivatives issued by the failing firm or its affiliates. The operation of early termination clauses, allowing the close-out and immediate sale of collateral in the Lehman Brothers bankruptcy proceeding, had caused the loss of significant value to the Lehman estate and risked disruption in the general market. A temporary delay on the exercise of such rights is regarded as essential to the successful implementation of the bridge company construct.
Another important recommendation was that each country should have a mechanism to fund the ongoing operations of a cross-border financial firm during the resolution process. This funding mechanism might take the form of a deposit insurance fund or an alternative financing mechanism, including a public funding mechanism that would be reimbursed by an industry assessment. The BCBS Report did not offer any recommendation about how the costs of funding of a resolution of a cross-border financial institution should be allocated or coordinated among the relevant national authorities. The BCBS Report, however, did note that effective crisis management and resolution of cross-border financial institutions required a clear understanding by the different national authorities of their respective responsibilities for supervision, liquidity provision, crisis management, and resolution of cross-border firms. As a practical counterpoint to this observation, the BCBS Report noted that in the 2008 financial crisis national interests drove the actions of national resolution authorities, leading generally to a ring-fencing or territorial approach to dealing with the failing firms. The need to address ring-fencing actions and territorial instincts in a cross-border banking crisis continues to bedevil efforts at establishing an international approach to resolution.
Financial Stability Board Key Attributes
The Financial Stability Board (the FSB) functions as an umbrella body overseeing and coordinating the work of other international financial standard-setting groups, including the BCBS. Among its functions the FSB develops “international financial standards” that its member jurisdictions have committed by the terms of the FSB charter to implement. The FSB assumed a leading role in promoting reform in national resolution regimes through the issuance in November 2011 of its Key Attributes of Effective Resolution Regimes for Financial Institutions (the Key Attributes). The Key Attributes have been designated as “international financial standards” by the FSB.
The Key Attributes constitute a comprehensive and relatively detailed set of standards for implementation by FSB member jurisdictions to reform their resolution or bankruptcy regimes for systemically important financial institutions. The Key Attributes build on the general principles included in the BCBS Report, but provide significantly more specificity than the BCBS Report. A threshold Key Attribute specifies that each jurisdiction should have a designated administrative authority responsible for exercising resolution powers over financial firms. This Key Attribute derives from the FSB conclusion that corporate bankruptcy law administered by a court is not well suited to deal with the failure of large banks and other financial institutions, including from the perspective of speed. For example, it is now commonplace among supervisors to speak of the need to resolve a large banking institution over the course of a “resolution weekend”.
The FSB also introduced or at least memorialised other new concepts, such as bail-in, in its Key Attributes. Bail-in within resolution entails the power for the administrative resolution authority to write-off the equity and write-down or convert various classes of debt into equity, all as a means of either recapitalising a failed entity or capitalising a new bridge institution. The Key Attributes provide that an exercise of bail-in power should be done in a way that respects the hierarchy of claims and the general principle of equal treatment of creditors in the same class. However, the Key Attributes recognise that a resolution authority may depart from the pari passu treatment of creditors in the same class if necessary to contain the systemic effects of a firm’s failure. This exception would permit, for example, the exclusion of certain uninsured deposits from bail-in. The treatment of uninsured deposits in the recent Cyprus bank resolution process has focused renewed attention on the complexities of the bail-in process.
A related issue involves the desirability of a depositor preference provision in national law. A depositor preference provision creates a priority for deposit claims over other general unsecured claims against a banking entity. The priority might apply only to claims on insured deposits or to claims on uninsured deposits as well. The UK, for example, is currently considering legislation that would create a priority for claims on insured deposits. The European Union, on the other hand, is considering a directive that would provide a priority not only for claims on the insured portion of a deposit, but also for the uninsured portions of deposits held by certain classes of depositors. The scope of any depositor preference provision would indirectly affect the scope of bail-in as well.
Other important Key Attributes relate to the allocation of responsibilities between home and host countries for the planning and ultimate execution, if necessary, of a resolution of a cross-border banking group. Many banking groups have argued that the home country of a banking group should have exclusive control over the planning and execution of a resolution process for a group, while coordinating with host country supervisors. While the Key Attributes indicate that the home jurisdiction should lead the development of a group resolution plan in coordination with the members of a firm’s crisis management group, they also specifically provide that host jurisdictions may also develop their own resolution plans for the banking operations in their jurisdictions, seeking to make them as consistent with the group plan as possible. Likewise, the Key Attributes provide that a resolution regime in a country should extend to local branches of foreign banks (except where the host country is subject to a legal obligation to defer to a foreign resolution authority as is the case under European Union directives). The resolution efforts for cross-border branches of banking entities present significant coordination issues and have frequently devolved into ring-fencing or territorial responses.
National Reform Efforts
The issuance of the Key Attributes by the FSB was intended to promote the reform of individual national resolution regimes along convergent lines. This effort has met with some initial success.
While the FSB’s Key Attributes were still in preparation, the United States was already in the process of adopting a fundamental reform to its laws to deal with the resolution of systemically important financial institutions. Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) enacted in July 2010 created a new Orderly Liquidation Authority, a resolution regime specifically designed for systemically important financial institutions. The Orderly Liquidation Authority is intended to be available as an alternative to a proceeding under the Bankruptcy Code for a financial institution whose resolution under the Bankruptcy Code or other applicable law would have serious adverse effects on financial stability in the United States. The Federal Deposit Insurance Corporation (the FDIC) would administer the proceeding under the Orderly Liquidation Authority, applying rules that generally parallel the longstanding rules for the resolution of insured depository institutions in the United States.
The FDIC has devised a new approach to the resolution of firms under the Orderly Liquidation Authority, the so-called single point of entry. Under this approach, it is envisioned that only the top-tier company of a US financial group would go into a resolution proceeding, avoiding to the greatest extent possible the initiation of bankruptcy or other insolvency proceedings at the level of the operating subsidiaries. This approach minimises the complexities and conflicts that would otherwise arise if multiple resolution proceedings in home and host jurisdictions had to be commenced for the operating subsidiaries. Under this approach, losses incurred at the operating subsidiaries would be “pushed up” to the top-tier company. These losses would be borne by the subordinated and senior debt holders of the top-tier company through the bail-in of their debt claims. The successor bridge company would simultaneously recapitalise the operating subsidiaries by contributing assets to the operating subsidiaries or by forgiving pre-existing debt obligations running from the operating subsidiaries to the top-tier company and the bridge company as its successor.
This approach is premised on a number of significant assumptions. One key assumption is that there will be sufficient loss-absorbing capacity at the top-tier company in the form of equity, subordinated debt, and senior unsecured debt to bear the losses suffered not only at the top-tier company, but also at the operating subsidiaries. The US regulators are currently formulating a proposal that will require the largest US bank holding companies to maintain a specified minimum level of such loss-absorbing capacity.
Another key assumption is that the operating subsidiaries upon their recapitalisation would be able to continue to function largely in the ordinary course. This assumption in turn rests on the sub-assumption that the operating subsidiaries either on their own or with assistance from the successor bridge company would be able to meet their ongoing liquidity needs. Public sector liquidity facilities may have to play a role in meeting this assumption.
The UK was one of the first jurisdictions to reform its bank insolvency regime in response to the financial crisis. The UK Banking Act 2009 created a special resolution regime for banking institutions, including both new pre-insolvency stabilisation options and new specialised insolvency procedures for banks. The UK is also in the process of enacting legislation to implement the recommendations of a 2011 report of an Independent Commission on Banking. The most prominent of these recommendations is that the retail banking operations within a banking group should be ring-fenced in a legally and operationally separate subsidiary.
At the same time that legislation implementing these recommendations is progressing, the Bank of England and the FDIC are engaged in efforts to coordinate planning for the cross-border resolution of major banking groups. In December 2012 the Bank of England and the FDIC issued a joint paper focusing on the application of a “top-down” resolution strategy that would involve a single resolution authority applying its powers to the top of financial group. The joint paper discussed the benefits and challenges of such an approach. Importantly, however, in its section of the joint paper the Bank of England expressly noted that a top-down or single-point-of-entry approach would not necessarily be appropriate for all UK systemically important financial institutions. This reservation was presumably added in recognition of the possible ring-fencing of retail banking entities.
Like the UK, Switzerland has adopted fundamental changes to its bank insolvency regime. Indeed, Switzerland is one of the few jurisdictions to have already implemented in its laws all the Key Attributes. There are national imperatives at play in Switzerland. The situation in Switzerland is virtually unique. As of the end of 2012, the aggregate on – and off – balance sheet assets of its two systemically important banks, UBS and Credit Suisse, were still four times the size of Switzerland’s gross domestic product, notwithstanding a significant reduction in the size of the two banks since 2007. The Swiss Financial Market Supervisory Authority (FINMA) has indicated that the preferred resolution strategy for these two banks would be a single-point-of-entry bail-in. This strategy is particularly well suited to the central funding structure of these two banks at their parent level. A multiple-point-of-entry bail-in strategy would not be viable because the foreign subsidiaries of these banks would not have sufficient or appropriate types of external liabilities for the use of bail-in at the subsidiary level. The FINMA approach comes closest to the current FDIC preferred approach for the resolution of US institutions.
As home to 14 of the 28 entities currently designated by the FSB as global systemically important banks, the European Union will play a critical role in the implementation of the FSB Key Attributes. The European Union is in the midst of a trilogue process involving the European Commission, the Council of the European Union, and the European Parliament to adopt a bank recovery and resolution directive that implements the FSB Key Attributes. The directive would provide for significant convergence in the bank resolution laws among the member states in the European Union. Consideration of the proposed recovery and resolution directive has become entwined with consideration of a banking union proposal for the eurozone member states, a subject of controversy with some member states. The banking union proposal itself rests on a proposed single supervisory mechanism and single resolution mechanism for banks in the eurozone. There are elements of the proposed recovery and resolution directive as well that continue to provoke controversy, such as the extent of bail-in and the adequacy of national resolution funding schemes. The outcome of the deliberative processes on these various proposals will shape the future course not only of resolution, but also of supervision and regulation of banks in the European Union.