Banking StandardsWritten evidence from the Bank of England

Resolution and Ring Fencing

Changes to the statutory regime for resolution

1. The key legislative changes relevant to bank resolution that will arise from the Government’s implementation of the recommendations of the Independent Commission on Banking are:

ring fencing of banks providing core insured-deposit services, as provided for in the draft Banking Reform Bill;

a requirement for extra loss-absorbing capacity, in the form of debt or equity, in both ring-fenced banks and at consolidated level for groups containing a ring-fenced bank, which will come via CRD4 implementation; and

insured depositor preference.

2. Those reforms need to be seen in the wider context of other prospective developments in the resolution regime. Those changes stem from the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes), which was endorsed by G20 Leaders as an international standard in November 2011.1 The Key Attributes set out, amongst other things, the essential elements of a resolution regime’s legal framework and powers, including for the resolution of global systemically important financial institutions (GSIFIs). Broadly speaking, the US has already acquired the necessary powers through Dodd-Frank. In Europe, the Key Attributes are currently scheduled to be incorporated into law via the proposed Recovery and Resolution Directive (RRD).2 Two elements of this wider regime are worth highlighting. First, resolution powers are to be extended to bank holding companies; that is already being effected in the UK via the Financial Services Bill. Second, the RRD powers include a “bail-in” resolution tool, under which, once the equity of a distressed bank was exhausted, the Resolution Authority could write down debt claims in order to cover expected losses and could convert part of the residual debt into equity to recapitalise the distressed firm (or a successor entity). The Government plans that that power will be incorporated into UK law as part of its implementation of the RRD; it sensibly waits until then because the RRD will remove some impediments to resolution arising currently from other EU directives.

Resolution strategies

3. The Financial Services Act 2010 requires banks to submit recovery and resolution plans to the FSA (the PRA in future), which has to consult the Bank’s resolution team and HMT on this. The Key Attributes require resolution plans to be drawn up for G-SIFIs by home and key host authorities working together. Recently the FSB has issued a consultative document that, amongst other things, sets out two broad types of resolution strategy (with a spectrum in-between):3

Single point of entry (SPE) resolution involves the application of resolution tools by the home authority at the top of a G-SIFI group to resolve problems in the group as a whole.

Multiple point of entry (MPE) resolution involves the application of resolution tools by a number of home and host resolution authorities to multiple companies in the group, with the overall plan co-ordinated by the home authority.

4. Which type of resolution strategy is better for a particular group will depend on the structure of the group, the nature of its business, and the size and location of the group’s losses. For an “SPE” resolution to be appropriate, loss-absorbing instruments must have been issued at the top of the group and be available to cover losses in the group’s subsidiaries. This is achieved by imposing losses, for example through a bail-in, on the external creditors of the parent holding company and writing down the value of loans from the parent to its operating subsidiaries in a manner that ensures those subsidiaries remain solvent and viable. For “MPE” to be appropriate, it needs to be feasible to separate the group financially, operationally and legally along national or regional lines, and then for each distressed entity to be resolved on a stand-alone basis. The parts might be resolved using bail-in of external debt or other resolution techniques.

5. In either case, for bail-in to be the chosen resolution tool there needs to be sufficient lossabsorbing capacity in the relevant legal entities. The planned PLAC requirement helps this. But another precondition for the use of a bail-in resolution tool is that it is possible to form a reasonably good estimate of the size of the group’s losses. In those cases where a group was toxic through and through, that would not be possible. Instead, the distressed business would need to be broken up into critical and less critical parts. In those circumstances, ICB-style ring-fencing of the domestic retail deposittaking business comes into its own, as described below. The utility to the resolution strategy of the ring-fence of core services will be especially evident in such cases, where an SPE resolution from the top of the group was not feasible.

6. The rest of this note covers the specific questions raised by the Committee. An annex sets out how, on the current state of resolution thinking, the Bank would be likely to address the two case studies set out in the annex to the Committee’s letter.

Questions 1 & 2: Which critical economic functions would you seek to protect? What resolution tools would you expect to use to achieve this, and how would they be applied?

7. In the case of a ring-fenced bank, the key operations would include deposits and payment services. In the case of the non-ring-fenced bank, it would be likely to include any international payments functions, clearing and settlement functions, and possibly wholesale market and capital markets activities where the firm had a dominant position in key markets. But it is not possible to provide in advance an exhaustive list of critical economic functions that would be protected in any individual resolution. The decision would be driven by what was needed to avoid systemic contagion as a result of (i) discontinuity in the key operations of the failing institution; (ii) spillovers due to the substantial value destruction arising from an uncontrolled wind-down of the whole or large parts of the bank’s balance sheet at firesale prices; and (iii) just how bad things were. On the second, for many G-SIFIs, the stabilisation might need to go further than just preserving payments and transactions/deposits services inside the ring-fence and include trading and derivatives portfolios to the extent needed to avoid a disorderly unwind that could adversely affect the functioning of critical capital markets. On the third, the worse the situation, the more the Resolution Authority may have to focus on preserving the most elemental services (insured deposits and payments).

8. Resolution tools for banks have historically focussed—mainly in the US—on the ability to separate critical functions at the point of resolution, for example through the use of transfer powers, with the shareholders and certain creditors being left in a special insolvency procedure for the rump of the assets so that they bear any losses. These powers ensure immediate continuity of access to deposit services through the transfer of deposits to a private sector purchaser (what the US term a “purchase and assumption”) or to a temporary bridge bank. However, the size and complexity of the books of most global wholesale banks greatly increases the challenge in rapidly separating the critical economic functions in this manner without causing severe systemic disruption. A standard p&a resolution strategy might well, furthermore, entail a destruction of value that would endanger wider stability. This is what led to the development of the concept of bail-in resolution strategies, in order to ensure that unsecured creditors are exposed to loss without having over a resolution weekend to split up a bank into critical and other parts that go into liquidation. Within the wider context of resolution work on G-SIFIs, the authorities of some key countries are developing ways to operationalise such bail-in strategies as described above.

Questions 3/4: Who would suffer losses or be otherwise adversely affected and where would public funds be put at risk?

9. For bail-in or other resolution tools to be effective, they must avoid putting public funds at risk. Under any resolution strategy, losses therefore fall, after equity holders, to debtholders instead, broadly following the creditor hierarchy that would apply in liquidation.

10. It will be open to the regulatory authroities to require a layer of debt that was subordinated to senior unsecured creditors. It could contribute to meeting the planned PLAC requirement. But it would be vital that the minumum requirement did not put a cap on the quantum of liabilities of that class and of other classes that could absorb losses, whether via bail-in or other resolution tools.

11. Senior unsecured creditors exposed to loss could include the Financial Services Compensation Scheme (FSCS), which stands in for insured depositors. The insured deposits themselves are fully protected (up to the specified amount of £85,000). But the FSCS can contribute resources to resolutions, whether using resolution powers in the current Banking Act or to bail-in In all such circumstances, any losses incurred by the FSCS would be recovered via the levy imposed on the banking sector (phased as necessary to limit the contagion risk). The EU’s draft RRD provides for Deposit Guarantee Schemes to contribute to bail-in or other resolution tools in this way.

12. In terms of funding, the FSCS might need to access temporary funding from HMT. If a resolved bank were restored to solvency and viability, it would in principle be eligible to use the Bank’s Discount Window or other liquidity facilities. Neither involves solvency support.

Question 5: What would be the main risks to the success of this resolution plan?

13. For those banking groups and entities operating in multiple jurisdictions, international cooperation will be essential to achieving an orderly resolution of the group as a whole. Although that would not be relevant for a purely domestic ring-fenced bank, it would be relevant to the other parts of the groups in which RFBs will be housed.

14. Without co-ordination, there would be a major risk that individual host authorities take unilateral action which threatens the viability of the group wide resolution plan. This could include seizing assets of the group in their jurisdiction, undermining the resolution strategy for the entire group. The Key Attributes put in place a framework for mitigating this risk through the development of both group resolution plans and cooperation agreements for each G-SIFI. These are being worked on in international crisis management groups (CMGs), consisting of supervisory and resolution authorities in the home and key host jurisdictions in which each G-SIFI has substantial operations.4

15. More generally, these resolution strategies require the filling out of SRR powers that is planned via the EU RRD as well as sufficient information provided in advance through an effective RRP process.

Question 6: What are the main potential obstacles to resolution which you would expect to address through the recovery and resolution planning process between now and 2019?

16. The obstacles to resolution will differ between resolution strategies. It follows that the recovery and resolution planning (RRP) process will need to ensure that obstacles to effective implementation of those strategies are overcome. In SPE strategies, obstacles may arise from location of PLAC; debt instruments governed by foreign law; and inadequate management information systems that do not support rapid valuation of losses. In MPE strategies, obstacles include legal, financial and operational dependencies within a group. Obstacles relevant to both strategies include immediate rights of exercise of termination clauses in contracts held by a bank’s counterparties and the exercise of cross-default clauses. Plans are being prepared internationally to tackle these impediments, which in some cases will be more easily pursued once the RRD has passed into law.5

Question 7: What are the wider reforms (eg implementation of a bail-in tool through European legislation) which would need to be in place to deliver your preferred resolution plan?

17. The necessary wider reforms are: full implementation of the Key Attributes across the G20 jurisdictions; within the EU, implementation of the RRD; and, within the UK, a widening of the scope of the Special Resolution Regime as set out in the Financial Services Bill currently before Parliament and the implementation of the ICB proposals in the Banking Reform Bill.

Annex: Case Studies

Case 1

1. Case 1 (annex to the Committee’s letter) is about a distressed ring-fenced bank (RFB), financed largely by retail and wholesale deposits, whose losses are likely to render it insolvent. It is also stated that the parent does not have free capital to downstream, has not raised capital privately and has little wholesale debt in issue.

2. The scale of the RFB’s deposit book and role in the payment system make it unsuitable for liquidation and rapid FSCS pay-out. In order to avoid any taxpayer solvency support in resolving the failed RFB, the unexpected losses need to be imposed on external creditors of the RFB. One way of doing this would be via a bail-in, extending beyond the liabilities included within the minimum PLAC requirement, to absorb current losses and recapitalise the RFB to withstand further losses. Given that the RFB is funded mainly by retail and corporate deposits, some losses would be borne by the FSCS, recovered in due course from the rest of the banking system, phased as necessary to limit the contagion risks.

3. Another resolution strategy, achieving the same economic effect, would be to transfer the RFB’s remaining sound business and insured deposits to a private sector buyer (if a suitable bidder is immediately available) or temporarily to a bridge bank until a buyer is found, while the toxic assets and loss-bearing liabilities are left behind in the bank administration procedure. Again, the FSCS would probably end up contributing to covering any losses incurred by this transfer.

4. The case study states that the RFB requires official liquidity support but does not meet the solvency and viability criteria for access to the Discount Window Facility. Both of the resolution strategies (bail-in or transfer) would, however, be designed to deliver a resolved entity (whether the RFB itself or a bridge bank if used to house the RFB’s sound business) that was restored to solvency and viability and, as such, might in principle be able to access market funding. Until that happened, temporary liquidity support might need to be provided by the authorities, fully collateralised to limit risks to public funds.

5. Either strategy will require the failing RFB to be separated from the group. The ring-fence should limit the extent to which separating out the RFB destabilises the remainder of the group. But if the other parts of the group, including overseas subsidiaries, failed, they would be subject to resolution in accordance with the group resolution strategy agreed amongst the relevant UK and international authorities.

Case 2

6. Case 2 states that the NRFB has suffered a large unexpected trading loss and may face other problems in its balance sheet, which could take its capital below the minimum threshold. It has substantial wholesale operations, including a large derivatives book, and is the owner of a large RFB. A transfer of part or all of its business is stated not to be in prospect. The scenario does not state that the bank goes into resolution, but that is assumed below.

7. In this case, a bail-in could again be appropriate. If the NRFB has a holding company that has issued external debt, the bail-in could be at group level. In that case, the operation would enable the holding company to recapitalise the NRFB and thereby stabilise the group, keeping its vital operations functioning and avoiding the disorder that would result from it suddenly ceasing to trade. Following this stabilisation period, the firm would be reorganised, culpable senior management replaced and the business restructured/wound down in an orderly manner as necessary. The bail-in could be structured to ensure that all subsidiaries of the NRFB, including the RFB, which the example states is well capitalised and stable, remained fully operational and viable, and as such did not need to enter resolution themselves. This top-down strategy would maximise the chances of the US and Asian host authorities cooperating with the bail-in, given that funds would be downstreamed as necessary to ensure that the subsidiaries in the US and Asia continue to trade.

8. If, despite the proposed requirements for quantum and location of PLAC, there was no holding company with sufficient debt in issue, the resolution would be carried out at the level of the NRFB. Initially loss-absorbing capacity created by intra-group debt would be drawn on. After that was exhausted, resolution of the NFRB might be by way of bail-in of external creditors and other creditors. This bail-in would have the effect that ownership of the NFRB would be transferred to those creditors. Resolution planning would need to cover this possibility.

9. A credible recapitalisation by means of bail-in, including a plan for the necessary restructuring, should enable the firm to access private sector liquidity. Until that happens, temporary liquidity support from the authorities may be needed given that the example states that the bank is facing immediate redemptions and that counterparties are rapidly withdrawing funding and requiring significant additional margin collateral. The RFB may also need temporary liquidity support to address contagion affecting the brand.

10. Other resolution techniques would be unlikely to work for the NRFB and its subsidiaries taken as a whole. If a bail-in strategy proved not to be feasible for whatever reason, then a MPE strategy would be needed for local subsidiaries. The RFB would, in these circumstances, be protected financially and operationally by the ring-fence from the resolution of the rest of the group; the resolution authority would have powers to transfer ownership of it away from the NRFB to a purchaser or bridge bank. Such a backstop strategy would also require advance planning. For that reason, the RRP process and the resolution strategies developed by the resolution authorities, once the RRD package is in place, must accommodate this eventuality.

20 November 2012