TWN Info Service on Finance and Development
on cross-border bank resolution
The final report and recommendations of the Cross-Border Bank Resolution Group of the Basel Committee contain a set of ten recommendations.
These recommendations are intended to strengthen national resolution powers and their cross-border implementation. They also provide guidance for firm-specific contingency planning, as banks, as well as key home and host authorities, should develop practical and credible plans to promote resiliency in periods of severe financial distress and to facilitate a rapid resolution should that be necessary.
The recommendations also aim to reduce contagion by advocating the use of risk mitigation mechanisms such as netting arrangements, collateralisation practices and the use of regulated central counter-parties. Strengthening the use of these and other measures would help limit the market impact of a bank failure, said BCBS.
Mr Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank, noted that "the resolution of a cross-border bank is a complex and multi-dimensional process and the financial crisis exposed gaps in intervention techniques and tools needed for an orderly resolution. Based on the lessons of the crisis and our analysis of national resolution frameworks, I believe that implementation of the Committee's recommendations will help make meaningful progress toward addressing systemic risk and the too-big-to-fail problem."
[Meanwhile, Lord Turner, Chairman of the UK Financial Services Authority, who also sits on the BCBS and is now viewed as an intellectual leader in the global financial reform debate, has called for new powers for regulators to control lending practices in targeted financial sectors and products to enable them to prick dangerous asset bubbles before they build up and bring down financial institutions. His latest remarks are being seen as breaking new ground and arguing in favour of asking for bank capital requirements based on perceived economic or social benefits of different categories of lending.]
According to the BCBS report, which was first issued for consultation in September 2009, the Cross-Border Bank Resolution Group (CBRG) of the Basel Committee developed the recommendations as a product of its stocktaking of legal and policy frameworks for cross-border crises resolutions and its follow-up work to identify the lessons learned from the financial crisis which began in August 2007.
The report stresses that the global financial crisis which began in August 2007 illustrates the importance of effective cross-border crisis management. The scope, scale and complexity of international financial transactions expanded at an unprecedented pace in the years preceding the crisis, while the tools and techniques for handling cross-border bank crisis resolution have not evolved at the same pace.
Some of the events during the crisis revealed gaps in intervention techniques and the absence in many countries of an appropriate set of resolution tools. Actions taken to resolve cross-border institutions during the crisis tended to be ad hoc, severely limited by time constraints, and to involve a significant amount of public support.
A viable and commonly understood process for resolving cross-border financial institutions and financial groups may help support market discipline by encouraging counter-parties to focus more closely on the financial risks of the institution or group. Discipline is enhanced if market participants clearly perceive that authorities are willing and able to effect a managed resolution of a financial institution, the report adds.
According to the report, an important consideration in recommending national resolution frameworks for cross-border financial firms is to reduce reliance on (implicit or explicit) public support to institutions deemed "too big to fail." The assumption, and reality, that some institutions are too big or too interconnected to fail has introduced additional risk and a greater likelihood of cross-border contagion into global finance.
One of the necessary measures to control the likelihood that institutions will require public support or forms of collective private support because they are too big to fail is within the mandate of the CBRG - an effective crisis management and resolution process. It is important to recognise that, as vital as prudential measures may be in controlling the likelihood of relying on public support, such measures cannot limit the potential for increased moral hazard without instituting, among other things, a viable resolution process for cross-border financial institutions.
The current crisis has illustrated the importance placed by national authorities on avoiding the disruption and potential contagion effects that could result from a disorderly failure of a cross-border or other large financial institution.
Noting that some ad hoc responses to date have been necessitated in part by the absence of viable resolution tools that would avoid those disruptions and potential effects, the report says: "An effective resolution regime would allow the authorities to act quickly to maintain financial stability, preserve continuity in critical functions and protect depositors. At the same time, an effective regime would maintain market discipline by holding to account, where appropriate, senior managers and directors and imposing losses on shareholders and, where appropriate, other creditors."
The report notes that existing legal and regulatory arrangements are not generally designed to resolve problems in a financial group operating through multiple, separate legal entities. This is true of both cross-border and domestic financial groups. "There is no international solvency framework for financial firms and a limited prospect of one being created in the near future."
The report says that challenges in resolving a cross-border bank crisis arise for many reasons, one of which is that crisis resolution frameworks are largely designed to deal with domestic failures and to minimise the losses incurred by domestic stakeholders. As such, the frameworks are not well suited to dealing with serious cross-border problems.
The report adds that many earlier discussions of these issues have been framed in terms of either a so-called universal resolution approach that recognises the wholeness of a legal entity across borders and leads to its resolution by a single jurisdiction - or a territorial or ring fencing approach - in which each jurisdiction resolves the individual parts of the cross-border financial institution located within its national borders. Neither characterisation corresponds to actual practice, though recent responses, like prior ones, are closer to the territorial approach than the universal one.
However, even in jurisdictions that adhere to a universal insolvency procedure for banks and their branches, such as in the European Union, each national authority is likely to attach most weight to the pursuit of its own national interests in the management of a crisis.
The report underscores that the absence of a multinational framework for sharing the fiscal burdens for such crises or insolvencies is, along with the fact that legal systems and the fiscal responsibility are national, a basic reason for the predominance of the territorial approach in resolving banking crises and insolvencies.
National authorities tend to seek to ensure that their constituents, whether taxpayers or member institutions underwriting a deposit insurance or other fund, bear only those financial burdens that are necessary to mitigate the risks to their constituents. In a cross-border crisis or resolution, this assessment of the comparative burdens is complicated by the different perceptions of the impact of failure of a cross-border institution and the willingness or ability of different authorities to bear a share of the burden.
According to the report, one option for reform would be to reach broad, and enforceable, agreement on the sharing of financial burdens by stakeholders in different jurisdictions for crisis management and resolution of cross-border financial institutions and groups. This would be an essential element, along with other important changes in national legal frameworks, for the creation of a comprehensive framework for the resolution of cross-border financial groups.
However, the development of mechanisms for the sharing of financial burdens for the resolution of future cross-border financial institutions would give rise to considerable challenges, and broad international agreement on such mechanisms appears unlikely in the short term, it adds.
An alternative and opposite approach would be to move toward a ring fencing approach to supervision and a territorial approach to resolution in which all transactions and institutions are separately structured for capital, liquidity, assets, and operations within each national jurisdiction.
This could provide a more predictable result if financial institutions restructured their operations along national lines. However, it could also be directly counterproductive. Ring fencing measures taken by authorities in one country could increase stress on the banking group's legal entities in other jurisdictions or for the banking group as a whole. As a result, in some cases, ring fencing may increase the probability of further defaults and complicate crisis management.
The report suggests that a middle ground that reflects lessons from recent experience, but also looks to preserve a greater share of the value from cross-border provision of financial services by global financial institutions for global financial well-being, may be more realistic at the present time.
This middle approach recognises the strong likelihood of ring fencing in a crisis, and helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders. It also recommends certain changes to national laws to create a more complementary legal framework for resolution that helps to facilitate the maintenance of global financial stability and the preservation of continuity for key financial functions across borders.
In addition to the legal and policy initiatives that are necessary in many countries, there are a number of practical issues that must be considered, says the report. These include the challenges created by complex corporate structures, information technology systems that may not provide timely or complete information, and the identification and retention of critical staff.
"Efforts to further develop cross-border cooperation on crisis management and resolution, for example, to explore mechanisms for burden sharing, either on a regional basis, or in relation to specific banking groups, should be encouraged."
In illustrating the shortcomings of the current cross-border crisis management frameworks, the Cross-Border Bank Resolution Group conducted case studies of Fortis (a Belgian/Dutch financial conglomerate), Dexia (a result of a merger between a Belgian and French bank), Kaupthing (an Icelandic bank) and Lehman Brothers.
The lessons learned from these case studies formed a basis for the group's recommendations highlighted in the report.
In respect of the Lehman Brothers experience, a group that consisted of 2,985 legal entities that operated in some 50 countries, the report cited the following factors that it said are particularly relevant to effective crisis resolution:
-- If an acquirer for the entire firm can be found in an appropriate timescale, trading counter-parties and other parties providing short-term funding will expect some sort of guarantee in the interim for them to continue to do business with the firm until the transaction closes - this can be challenging to achieve in a tight time-frame;
-- As the amounts of liquidity needed are likely to be sizable, governmental resources may be required;
-- For international firms and groups of this degree of complexity, a prepared, orderly resolution plan would be of great assistance to the authorities;
-- Monitoring by regulators and the interplay of insolvency regimes are important;
-- Group structures create interdependencies within the organisation that responsible regulators need to understand and monitor for both going concern and gone concern purposes;
-- In the event of the failure of a cross-border financial institution, once the relevant component entities enter into insolvency proceedings, the insolvency regimes applicable to the major entities are likely to be separate proceedings, serving different policies, with different priorities and objectives; and
-- These differences continue to make coordination and cooperation among insolvency officials difficult as such coordination and cooperation may conflict with the duties of the officials to an entity's creditors. To do their job effectively, insolvency officials may need access to information and records that are part of an insolvency proceeding in another jurisdiction.
The ten recommendations outlined in the report are as follows:
Recommendation 1: Effective national resolution powers - National authorities should have appropriate tools to deal with all types of financial institutions in difficulties so that an orderly resolution can be achieved that helps maintain financial stability, minimise systemic risk, protect consumers, limit moral hazard and promote market efficiency. Such frameworks should minimise the impact of a crisis or resolution on the financial system and promote the continuity of systemically important functions. Examples of tools that will improve national resolution frameworks are powers, applied where appropriate, to create bridge financial institutions, transfer assets, liabilities, and business operations to other institutions, and resolve claims.
Recommendation 2: Frameworks for a coordinated resolution of financial groups - Each jurisdiction should establish a national framework to coordinate the resolution of the legal entities of financial groups and financial conglomerates within its jurisdiction.
Recommendation 3: Convergence of national resolution measures - National authorities should seek convergence of national resolution tools and measures toward those identified in Recommendations 1 and 2 in order to facilitate the coordinated resolution of financial institutions active in multiple jurisdictions.
Recommendation 4: Cross-border effects of national resolution measures - To promote better coordination among national authorities in cross-border resolutions, national authorities should consider the development of procedures to facilitate the mutual recognition of crisis management and resolution proceedings and/or measures.
Recommendation 5: Reduction of complexity and interconnectedness of group structures and operations - Supervisors should work closely with relevant home and host resolution authorities in order to understand how group structures and their individual components would be resolved in a crisis. If national authorities believe that financial institutions' group structures are too complex to permit orderly and cost-effective resolution, they should consider imposing regulatory incentives on those institutions, through capital or other prudential requirements, designed to encourage simplification of the structures in a manner that facilitates effective resolution.
Recommendation 6: Planning in advance for orderly resolution - The contingency plans of all systemically important cross-border financial institutions and groups should address as a contingency a period of severe financial distress or financial instability and provide a plan, proportionate to the size and complexity of the institution's and/or group's structure and business, to preserve the firm as a going concern, promote the resiliency of key functions and facilitate the rapid resolution or wind-down should that prove necessary.
Such resiliency and wind-down contingency planning should be a regular component of supervisory oversight and take into account cross-border dependencies, implications of legal separateness of entities for resolution and the possible exercise of intervention and resolution powers.
Recommendation 7: Cross-border cooperation and information sharing - Effective crisis management and resolution of cross-border financial institutions require a clear understanding by different national authorities of their respective responsibilities for regulation, supervision, liquidity provision, crisis management and resolution. Key home and host authorities should agree, consistent with national law and policy, on arrangements that ensure the timely production and sharing of the needed information, both for purposes of contingency planning during normal times and for crisis management and resolution during times of stress.
Recommendation 8: Strengthening risk mitigation mechanisms - Jurisdictions should promote the use of risk mitigation techniques that reduce systemic risk and enhance the resiliency of critical financial or market functions during a crisis or resolution of financial institutions. These risk mitigation techniques include enforceable netting agreements, collateralisation, and segregation of client positions. Additional risk reduction benefits can be achieved by encouraging greater standardisation of derivatives contracts, migration of standardised contracts onto regulated exchanges and the clearing and settlement of such contracts through regulated central counter-parties, and greater transparency in reporting for OTC (over-the-counter) contracts through trade repositories. Such risk mitigation techniques should not hamper the effective implementation of resolution measures (cf. Recommendation 9).
Recommendation 9: Transfer of contractual relationships - National resolution authorities should have the legal authority to temporarily delay immediate operation of contractual early termination clauses in order to complete a transfer of certain financial market contracts to another sound financial institution, a bridge financial institution or other public entity. Where a transfer is not available, authorities should ensure that contractual rights to terminate, net, and apply pledged collateral are preserved. Relevant laws should be amended, where necessary, to allow a short delay in the operation of such termination clauses in order to promote the continuity of market functions.
Recommendation 10: Exit strategies and market discipline - In order to restore market discipline and promote the efficient operation of financial markets, the national authorities should consider, and incorporate into their planning, clear options or principles for the exit from public intervention. +