Too important to fail-too important to ignore - Treasury Contents

5 Allowing banks to fail

136.  Many of the reforms discussed so far in this Report will go some way to making the system safer. However, they do not address the central problem, which is that Governments find themselves forced to choose between saving institutions or risking financial stability. That problem in turn results in moral hazard: the knowledge that Government will be forced to intervene to save the financial system, and that intervention is likely to take the form of saving individual firms, reduces the risks that market participants are taking, and so reduces market discipline. No reform is adequate unless it is credible that banks can fail and that Governments can and will force them to fail if necessary.

137.  One of the key failings of the current system is that it is extremely difficult to allow systemic institutions to fail smoothly. There are several reforms to ensure that this can happen already in development. Indeed, the United Kingdom Government has led the way in introducing legal frameworks to deal with bank resolution, and has already used that framework in the case of the Dunfermline Building Society. However, much detail still needs to be put in place before we can be confident that it will be possible to ensure that a large, international bank will fail smoothly.

Living wills

138.  There has been much debate about 'resolution and recovery' plans to deal with banking difficulty. Resolution is a matter for national authorities; recovery, it seems to us, is a matter for the management of individual institutions. In this Report, we are concerned with the resolution, rather than recovery, plans of banks, the so-called 'living wills', which determine how the authorities and a bank would deal with the bank's failure. The problems were exemplified by the death-throes of Lehman Brothers, where the failure of a US company affected many other countries.

139.  Action to ensure that orderly wind down of banks, both within individual countries and of cross-border institutions, will clearly produce significant benefits for regulators, other national authorities, and ultimately for the whole economy by leading to more stable banking systems. The reduction of moral hazard is not the only ex-ante benefit of the introduction of living wills. As Professor Goodhart outlined, the information about the structure of banks that such an exercise would provide would also be useful. He told us:

[ ... ] it will enable people to understand, the regulators and everyone else, including within the banks themselves, to understand much more clearly what the jurisdictional arrangements are, and to try to relate the jurisdictional arrangements to the way that the bank functions.[166]

Professor Portes was also supportive of living wills. In written evidence, he stated that:

The only potentially effective policy instrument here is the excellent "living will" proposal that big banks be required to elaborate detailed, pre-packaged resolution procedures that would apply when regulators judged that the bank had gone beyond the stage where prompt corrective action could save it. These would be agreed ex ante with all the bank's regulators, which would require some degree of ex ante acceptance of burden sharing across regulatory jurisdictions. But this would not be in the form of burden-sharing rules that would apply uniformly, regardless of the particular circumstances of the institution. [167]

140.  Living wills appeared to attract support from market participants as well as regulators. Mr Varley told us that:

[ ... ] a feature of a broader regulatory regime change, should be the introduction of resolution regimes and living wills. I would say we are at the front of that process rather than at the back-end of that process. Barclays is one of the pilot banks for the purposes of the FSA in looking at living wills and resolution. I do believe that as a result of the generation of living wills it will be possible for banks to fail more smoothly".[168]

Mr Sáenz of Santander, also proudly told us that his bank had recently submitted its living will to the Bank of Spain:

We have presented our first draft and we will have to interact with the Bank of Spain a bit more in order to fine tune the elements of these living wills. [169]

Mr Corrigan was also keen to emphasise the benefits of a resolution regime: "it is very hard [ ... ] to see how we can really satisfy ourselves and our critics that we can fix too big to fail without a very well designed and well executed framework of resolution authority."[170] However, he also noted the difficulty of attempting to create such a regime, explaining that "We have never done it in the history of mankind. We have never orchestrated and arranged the orderly wind-down of a large, much less complex, institution."[171]

141.  One of the intrinsic problems with resolving international banks is that bankruptcy laws are not international. Professor Goodhart explained that:

One of the great difficulties in this field is that the really serious problems arise when you get a cross-border failure. Lehman's was a particular example of that, where the failure of Lehman Brothers International Europe (which I always think of as Lehman's London) resulted in a chaotic mess. But the difficulty is that, when you get a failure, you find that your international financial institutions which were international in life become national in death, and all the national laws are very different.[172]

142.  The Governor of the Bank of England pointed out that this was not a new problem:

You will remember BCCI. This Committee spent a lot of time worrying about BCCI and the consequences. One of the real difficulties in resolving BCCI was the incompatibility of the US bankruptcy law and the UK bankruptcy law. Just two countries —not a vast number. Just two different bankruptcy laws. I see no prospect in the immediate future of that changing. They are inherent in the legal frameworks. It is going to be very difficult to handle the failure of institutions that span frontiers. A first step is to have a simple, clear, broad-brush approach to how you would break up an international institution that failed and different parts of the world would take responsibility for different bits of it. That is doable, in my view, and I think we will make progress in our international meetings in that direction.[173]

143.  Mr Varley was aware of the concern over cross-border resolution, but told us that

there are initiatives which I welcome which will engender good cross-broader collaboration on resolution. For example, the Bank of England has recently signed a Memorandum of Understanding with the Federal Deposit Insurance Corporation which is designed to ensure that, were a bank which had businesses in both countries in a situation where it looked as though it was going to fail, there would be collaboration between the central banks and the supervisors.[174]

144.  In a speech in October 2009 Mr Tucker provided the following update on international work in this area:

Speaking as chair of the Financial Stability Board's working group on the resolution of cross-border firms, I can update you on the work already in train. Basically for the top roughly 25 banks and dealers, the authorities will work with them over the next 6-9 months to produce recovery and resolution plans. The effort will build on the existing supervisory colleges, but typically at a more senior level, and involving resolution authorities and central banks as well as line supervisors. After official level exchanges, there will be engagement with those firms, also at a senior level (say group CFO). The desired outputs will cover two things. First, recovery plans for 'de-risking' a group where it can and should be maintained as a going concern. Second, a resolution plan when a firm needs to be wound down and put to rest, but with essential economic functions maintained somehow.[175]

Mr Tucker also provided a note of caution over living wills. He stated that "However good, those de-risking and wind-down plans will sometimes prove flawed".[176]

145.  There is wide support for 'living will' type resolution regimes. If they work, they allow the Government to inflict losses on all creditors of a bank because it will be possible for the bank to fail in an orderly way. This will remove some of the moral hazard, and ensure bank bondholders have to pay more attention to the banks' management and solvency. It should transfer some of the costs from the general body of taxpayers and will place them firmly within the financial sector. This may raise the cost of credit, but it will do so because risk is priced more accurately.

146.  Moreover the creation of living wills will make many financial firms, and their investors, think about how they operate their businesses. That would be an initial, potentially large, benefit, as with the mapping of a bank's structure to a regulator.

147.  We look forward to the FSA's eventual announcement that all UK banks have in place an effective living will.


148.  John Kay has written that if living wills and a proper resolution regime were put in place, it would begin to take on aspects of the structural reforms, 'Narrow banking', that he advocates. He explained that:

If [plans for 'living wills', combined with a proper resolution regime for insolvent financial institutions] were implemented sufficiently fiercely, they probably would. To be effective, they would require radical restructuring and simplification of the corporate structures of financial conglomerates. That outcome would effectively amount to narrow banking—in particular, such a regime would require that the assets, financial and operating, needed to run a retail bank would be separated by a firewall from the rest of a financial conglomerate. If you can do that, you have effectively established a narrow bank.[177]

149.  Mr Sáenz's description of Santander's ability to prepare a living will lent some weight to this proposition:

Why have we been able to submit these living wills to the Bank of Spain in such a short period of time? It is because of the simplicity of our format. It is very simple, it is very easy to unwind and as a consequence it is very easy also to put on paper the kind of actions to take in different scenarios of stress.[178]

Professor Portes also thought:

Many policymakers who have opposed such rules therefore seem keen on the living will. It would have the additional, important benefit of forcing the banks to unwind some of the most complex features of their organisational structures—the many and interlocking subsidiaries and branches whose primary purpose is often tax avoidance and whose secondary effect is to hinder effective control and risk management by the centre.[179]

150.  As a general proposition, we consider it likely that if an institution is too complex to prepare for an orderly resolution, it is too complex to operate without imposing unacceptable risks to the states in which it does business. Regulators should take account of any structural difficulties in the preparation of a living will. Living wills, fully applied, will necessarily lead to the structural reform of the banks.

International resolution authorities?

151.  The Governor told us "It does make sense for countries to find ways of working together to deal with the resolution of those institutions and at international level there is a lot of activity in trying to think that through. I am not optimistic about where it will all go."[180] Some of those we met on our visit to the United States suggested there should be an international resolution authority. In written evidence, Mr Corrigan called for the creation of an Enhanced Resolution Authority. He wrote that "the promise of 'Enhanced Resolution Authority' will only be achieved if it is designed and executed—nationally and internationally—with great precision".[181] Mr Sáenz however felt that it would be "impossible" to achieve a global resolution authority.[182]


152.  If a global authority is impossible, what about a European one? In a recent Communication the European Commission proposed a European crisis management system which would extend to resolution and insolvency of cross border financial entities. We are in full agreement with the Commission's aims:

A European framework for bank resolution must therefore be based on agreed and common objectives which should ensure that losses fall primarily on shareholders and junior and unsecured creditors rather than on governments and taxpayers. This is essential for the avoidance of moral hazard which arises from perceptions that banks that are too big or too interconnected to fail and are likely to be rescued by public financing. The overriding policy objective is to ensure that it should always be possible—politically and economically—to allow banks to fail, whatever their size.[183]

153.  The Communication poses a number of pertinent questions, some detailed, some at a high level of generality, such as:

  • What should be the key objectives and priorities for an EU bank resolution framework?
  • What should be the scope of an EU resolution framework? Should it only focus on deposit-taking banks (as opposed to any other regulated financial institution)?
  • If so, should it apply only to cross-border banking groups or should it also encompass single entities which only operate cross-border through branches?
  • Is integrated resolution through a European Resolution Authority for banking groups desirable and feasible?
  • If this option is not considered feasible, what minimum national resolution measures for a cross-border banking group are necessary.
  • Is a more integrated insolvency framework for banking groups needed? If so, how should it be designed?
  • Should there be a separate and self contained insolvency regime for cross-border banks?

On 19 March 2010 the idea of a European Resolution Authority was backed by the Managing Director of the IMF, Mr Dominique Strauss-Kahn.[184]

154.  We welcome the fact the European Commission is addressing these issues. However, in its response the Tripartite Authority suggested that some proposals were likely to be over ambitious:

Resolution and insolvency regimes should operate at a national level because of the fiscal implications. Also, national authorities are closer to markets and are therefore better placed to act and pay due regard to specific national market characteristics. We see difficulties in the proposals for integrated resolution through a European Resolution Authority and/or the introduction of a single European insolvency regime. These would be major undertakings and would have fiscal implications for Member States[ ... ][185]

Other issues outlined in the detailed response include the many differing insolvency regimes across Europe, which may differ significantly in matters such as the extent to which debtors or creditors are protected.

155.  An international authority able to take the lead in the resolution of cross border financial institutions would make wind-down simpler and smoother. Unfortunately, we simply do not believe that such an authority could be introduced in the near future. Even if nation states were prepared to surrender their interests to such an authority, which we doubt, the difference between bankruptcy laws in different countries would prove a significant barrier. The steps taken to put recovery and resolution arrangements in place in the United Kingdom should continue, even if negotiations to establish an international resolution authority are proceeding at the same time. This reform must be pursued regardless of what is happening elsewhere. The primary duty of the UK Government should be to protect the UK taxpayer and consumer.

166   Q 44 Back

167   Ev 110  Back

168   Q 186 Back

169   Q 438 Back

170   Q 306 Back

171   Q 306 Back

172   Q 7 Back

173   Q 133 Back

174   Q 186 Back

175   Paul Tucker, Deputy Governor, Financial Stability, Bank of England at Barclays Annual Lecture, London, 22 October 2009 Back

176   Paul Tucker, Deputy Governor, Financial Stability, Bank of England at Barclays Annual Lecture, London, 22 October 2009 Back

177   'Narrow banking: FAQs', John Kay Back

178   Q 438 Back

179   Ev 110  Back

180   Q 133 Back

181   Ev 142  Back

182   Q 446 Back

183   Brussels, COM(2009) 561/4, Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, the European Court of Justice and the European Central Bank. An EU Framework for Cross-Border Crisis Management in the Banking Sector, {SEC(2009) 1389} {SEC(2009) 1390} Back

184   Crisis Management Arrangements for a European Banking System "Building a Crisis Management Framework for the Single Market" Keynote speech by Dominique Strauss-Kahn, Managing Director of the IMF at the European Commission conference, Brussels, March 19, 2010 Back

185   See Twelfth Report from the European Scrutiny Committee, Session 2009-10, HC 5-ix, Chapter 2: Financial Services Back

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