Impossible is nothing? – How the FDIC and Bank of England want to resolve G-SIFIs
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LIECHTENSTEIN: 18 March 2013 - With banks and sovereigns still suffering from after pains of the financial crisis, regulatory clean up is continuing in many parts of the world. On both sides of the Atlantic, the resolvability of major financial institutions has represented a focal point of regulators’ and policy-makers’ attention. Needless to say that countries’ lack of adequate legal frameworks to deal with the failure of large and complex banks, if any, has proved detrimental to crisis management efforts and exposed taxpayers to a lot more financial risk than necessary. Meanwhile, some States have reacted to this experience by implementing comprehensive legislative frameworks for bank resolution. In the U.S., the Dodd-Frank Act entered into force in 2010, appointing the Federal Deposit Insurance Corporation (FDIC) as receiver of systemically important financial institutions in severe financial troubles under a new orderly liquidation authority. Similarly, the U.K. Banking Act of 2009 empowers the Bank of England (BoE) to transfer all or parts of a failing bank to a private-sector acquirer or bridge institution. If all else fails, the U.K. Treasury may also take a failing bank into temporary public ownership. Further reforms are expected in the U.K. as a consequence of the European Commission’s proposal for a Recovery and Resolution Directive, discussed elsewhere, and the recommendations by the U.K. Independent Commission on Banking.
While these national legislative frameworks have gone a long way towards improving the resolvability of large and systemically important banks, they naturally only apply within the bounds of one country’s jurisdiction. A workable strategy that would interconnect the different national frameworks and allow authorities to resolve banking operations in a cross-border context is still missing. Given that almost all systemically important financial institutions will have potentially extensive operations outside their home country, the development of such a strategy constitutes a necessary precondition for the resolvability of any such institution. The FDIC and the BoE – the two principal resolution authorities in the world’s leading financial markets – have taken up work to jointly assess the challenges from each country’s approach to resolution when implemented on an international scale. In a joint paper, published in late-2012, the authorities address the resolution of globally active, systemically important financial institutions (“G-SIFIs”) operational in both the U.K. and U.S.
At this point, the joint paper is largely confined to a compilation of similarities and differences between the U.S. and U.K. resolution frameworks. That does not mean, however, that no substantial progress was made in the process of preparing the paper. In fact, identifying potential legal and factual obstacles represents the first and perhaps most important step in developing a common strategy as to the resolvability of financial institutions with substantial operations in both jurisdictions. On the one hand, the strategy envisaged by the FDIC and BoE – essentially a “top-down” approach, whereby resolution action targets a banking group’s parent holding – can build on common ground in terms of general resolution principles. Both legislative frameworks promote the continuity of all critical functions and services; a decisive restructuring of institutions during or after resolution; the eventual transition of ongoing operations to private ownership; and loss-absorption by shareholders and creditors, partially via debt-to-equity conversion. On the other hand, the different ways in which banking groups are structured on either side of the Atlantic may require different approaches towards their resolution. Unlike in the U.S., where the assets of bank holding companies are typically largely confined to the equity stakes in the subsidiaries, U.K. parent undertakings frequently constitute operating entities themselves.
The paper cherishes great expectations in the possibility of writing down or converting into equity the liabilities of failing banks at group level. Indeed, for the most integrated and international banking groups, splitting off or transferring certain operations to other entities may prove too complex a task to accomplish in the course of a weekend and thus jeopardise financial stability. Moreover, keeping the structure of a banking group intact facilitates its cross-border resolution, as subsidiaries – including those established abroad – remain operating and their balance sheets largely unaffected by resolution action taken at the top of the group. A whole-group resolution will require that the host-country authorities recognise the bail-in initiated by the group’s home country, including a potential stay imposed on contractual and statutory termination rights. It will avoid, however, the need to coordinate separate, entity-specific resolution proceedings at the subsidiary level. Yet, a group-level resolution through bail-in raises the problem of the availability of sufficient bail-inable debt. Especially for U.K. banking groups, the liabilities may not include enough debt issuance at the level of the parent bank for authorities to pursue this strategy successfully.
Nevertheless, both jurisdictions primarily aim at implementing a single-point-of-entry strategy to the resolution of G-SIFIs. In the U.S., the FDIC, under its receivership mandate, would transfer the equity in subsidiaries held by a parent holding company to a bridge financial holding company, while equity as well as subordinated and unsecured debt holders would remain in the receivership. A comprehensive valuation process would determine the losses in the receivership estate and distribute these losses to the shareholders and creditors left behind. The remaining creditor claims would be converted into equity claims or convertible subordinated debt in order to capitalise the new operations prior to their transition to private ownership. To ensure coverage of liquidity needs that cannot be satisfied by market sources, the FDIC may – as a last resort – access the Orderly Liquidation Fund (OLF) backed by the U.S. Treasury.
The U.K.’s planned strategy is based on a similar mechanism, albeit without necessarily transferring parts of the failed bank to a bridge institution. Instead, the BoE would apply its bail-in powers to the bank’s existing capital structure and cancel or write down equity and debt securities. During a valuation period, a designated trustee would establish the failing bank’s recapitalisation needs and thus the extent and terms of the bail-in. Following the execution of the write down, the trustee would transfer ownership of the now recapitalised bank to the remaining layer of original creditors. While the U.K.’s planned strategy acknowledges that temporary public-sector funding may be needed, the paper does not specify the source of such liquidity provision. Like the OLF in the U.S., the U.K. authorities would have the power to recover any net losses associated with public-sector support from the financial industry. In addition to targeting the parent undertaking, the U.K.’s strategy encompasses the option of intervening at the level of one or several subsidiaries. This may prove particularly useful where losses concentrate in one or a few subsidiaries within a not very integrated group structure.
The FDIC-BoE joint paper lays the groundwork for developing a commonly accepted cross-border resolution strategy that takes into account the particularities of the U.S. and U.K. legal frameworks and the structure of the banking sector in both jurisdictions. Whether that strategy is worth being pursued further largely depends on whether the European Union manages to introduce a practicable bail-in approach in due course. At this point, the joint paper can only be an early attempt to explore common ground in a still unsettled regulatory environment – a task that is by far more complex and challenging than it sounds. It will take years of further negotiations and collaboration at various levels of policy-making until authorities may come up with a workable blueprint for putting group resolution into practice across different jurisdictions. But this is the goal – eventually.
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