The Special Resolution Regime. Mark Adams & Miles Bake Special Resolution Unit, Bank of England 30 June 2010

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1 The Special Resolution Regime Mark Adams & Miles Bake Special Resolution Unit, Bank of England 3 June 21 1

2 Why a Special Resolution Regime? General insolvency law is inadequate for dealing with failing banks, when speed and flexibility are of the essence to maintain financial stability; Need continuity of key banking functions, especially payments to and from customer accounts and access to overdraft and other credit facilities. The European Commission issued a communication in October proposing that Member States each be required to establish a permanent Special Resolution Regime (SRR) for banks; This follows the G2 commitment to develop resolution tools and frameworks for the effective resolution of financial groups to help mitigate the disruption of financial institution failures and reduce moral hazard, and the introduction of an SRR for UK incorporated deposit-takers in March 29 Need to ensure that EU bank resolution framework and State Aid framework are consistent 2

3 UK SRR Objectives The objectives of the SRR: to protect and enhance the stability of the financial systems (including continuity of service); to protect and enhance public confidence; to protect depositors; to protect public funds; and to avoid interfering with property rights in breach of the European Convention on Human Rights. The balancing of objectives will vary according to the specific circumstances to the distressed institution; and the general environment relating to the wider financial system. The scope of the SRR: covers all UK-incorporated banks and building societies. The triggers to action under the SRR: Bank of England can use stabilisation powers where necessary with regard to the stability of UK financial systems, the maintenance of public confidence in the stability of the banking system, or the protection of depositors. 3

4 Stabilisation Tools When trigger conditions are met, the Bank of England has the ability to use the following SRR stabilisation tools: 1. apply for a Bank Insolvency Procedure (BIP) accompanied by transfer or rapid pay-out of depositors accounts covered by the Financial Services Compensation Scheme (UK deposit guarantee scheme); 2. transfer all or part of the business or shares to a private sector purchaser (PSP); AND/OR transfer all or part of the business to a newly-created public sector Bridge Bank as a temporary measure to preserve value prior to onward disposal e.g. sale to a PSP; TOGETHER WITH applying for a Bank Administration Procedure (BAP) to the remaining part of the business following a transfer. In addition, HM Treasury has powers to take an institution into Temporary Public Ownership (TPO) where there is a serious threat to financial stability in the UK. 4

5 Funding of resolutions The SRR recognises that some up-front State contribution or liquidity facility might be needed in the short term to effect a resolution expediently; but that as far as possible this should be met through realisations from the failed entity and/or contribution from the UK s Financial Services Compensation Scheme (FSCS) (the UK deposit guarantee scheme), and hence the financial industry. The FSCS contribution is based on a calculation of what it would have had to pay out to covered deposits had the failed bank fallen into insolvency (on the basis that the FSCS has not actually had to make these payments due to the SRR Authorities intervening) (and taking into account the cost of funding). The FSCS is a wholly-owned subsidiary of the UK Financial Services Authority (FSA), its directors are appointed by the FSA and although it is operationally independent of the FSA, it is ultimately accountable to the FSA (and thereby Parliament).

6 Scenarios The following slides set out: Some typical scenarios for use of the UK SRR powers by the Bank/HM Treasury; and our thoughts on State Aid issues that might arise in these scenarios These are informed by our experience of the resolution of Dunfermline Building Society (under the SRR) and Bradford & Bingley and Northern Rock (under earlier, temporary legislation) and London Scottish Bank (accelerated payout and administration). 6

7 Scenario 1: BIP + FSCS Payout A failed bank is placed into the BIP to be wound-up following transfer or payout of covered depositors. FSCS deposit guarantee funds could be used either to pay covered depositors directly or support transfer of these depositors to a PSP. FSCS may need to borrow temporarily from HMT to provide quick payout. Other shareholders/creditors bear losses in normal ranking on a liquidation. State Aid issues FSCS funds provide insurance payout as in normal insolvency, as required in DGS Directive and with explicit charge to industry (following DGD Directive reforms, likely to be ex ante) + Worked example assuming 2% loss on assets in insolvency: Creditor Claim Recovery in Recovery in scenario normal insolvency FSCS* Uninsured depositors 2 Other senior debt 2 Subordinated debt Capital + Payment of funds by FSCS to depositors is not an aid but giving a new bank the equivalent cash amount to match a depositor transfer is. * Guaranteed depositors are paid in full by the FSCS. FSCS then "stands in the shoes" of these covered depositors as if they were senior creditors in a liquidation. The difference between the paid to covered depositors and the 41.6 recovered is met out of the FSCS guarantee scheme s funds i.e. industry levy (although short term cash flow may be via a Bank/HMT loan, reimbursed from fund. 7

8 Scenario 2: Narrow transfer + BAP Transfer only covered deposit liabilities (plus some assets where possible) to a PSP (for technical reasons, some non-covered deposit liabilities might also have to be transferred as part of this package).* Rump of failed business put into BAP. State Aid issues PSP will require comfort around State Aid before agreeing to acquisition. Will Commission confirm that it will continue to provide comfort if the covered liabilities are only a small part of the failed bank s balance sheet? FSCS/state would provide capital top-up equal to difference between transferred liabilities and assets, in exchange for claim in BAP. Does the aid analysis change if head office, branch infrastructure, IT etc are all left in Rump (i.e. transfer is bare minimum deposit liabilities plus matching financial assets? * Although in practice the State has always topped-up the gap between the total depositors and the covered depositors transferred to PSP, it does not have to and the worked example does not assume State top-up. Mere use of existing statutory powers would not constitute an aid in itself. 8

9 Scenario 2: Narrow transfer + BAP Worked example assuming 2% loss on assets in insolvency, and half of initial assets are transferred at a haircut of 2% In this case, creditors in BAP are entitled to compensation if transfer of assets reduces their recoveries below what an independent valuer assesses they would have received in insolvency. Compensation costs can be charged to the FSCS. Creditor Claim Recovery in scenario Recovery in normal insolvency FSCS (2.8 from BAP + 4 for transferred assets compensation cost) Uninsured depositors (in BAP) compensation Other senior debt (in BAP) compensation Subordinated debt Capital 9

10 Scenario 3: Wide transfer /TPO Transfer of most or all of a failed bank, e.g. by transfer to a PSP of most assets and liabilities or TPO of a bank/banking group. State Aid issues: PSP will require comfort around State Aid before agreeing to acquisition. Shareholders/Subordinated Creditors only eligible for compensation if the resolution leaves them worse off than they would have been in an insolvency of the whole bank. This is considered adequate burden sharing. Capital injection consequent on TPO/transfer must be capable of being approved immediately and not be constrained by bare minimum capital rules e.g Basel II needs to be sufficient to preserve market confidence. Exit from temporary public ownership: a good bank as a restructuring outcome should not be regarded as a phoenix company prohibited from receiving aid. 1

11 Scenario 3: Wide transfer Worked example assuming 2% loss on assets in insolvency, all senior liabilities and half of assets (at a haircut of 2%) are transferred to PSP HM Treasury provides additional capital of to back transfer, and receives recoveries from BAP of 37. and FSCS payment of 8.4, for net loss of 4.1 Creditor Claim Recovery in scenario Recovery in normal insolvency FSCS (8.4 contribution to HMT costs) Uninsured depositors (in PSP) 2 2 Other senior debt (in PSP) 2 2 Subordinated debt (in BAP) Capital (in BAP) 11

12 Scenario 4: Bridge Bank + BAP Good assets and matching liabilities transferred to new bridge bank, for onward sale to PSP. Rump placed in BAP. State Aid issues If Bank provides liquidity to bridge bank to keep it running, can this be used to fund new lending if this preserves franchise value (recovered to Authorities through resolution fund)? Bridge bank is temporary framework for facilitating a long-term solution; not an outcome in itself, but a mechanism. Own contribution of % by beneficiary may not be possible for highly-leveraged banks. 12

13 General points These issues are not specific to the UK SRR they would also arise in an EU framework as outlined in the Commission s October communication. Needs to be consistent with future evolution of resolution regimes, currently a subject of G2 & EU debate (e.g. bail-ins, resolution regimes for non-banks financial companies). State Aid rules should continue to recognise public interest justification for rescue aid after December 21. Regime needs to be available for all banks at all times to adequately protect public interest. In particular, must continue to apply to the successor of a bank which is resolved, so one time, last time rules are problematic. Acquiring banks will need comfort around state aid issues. Remutualisation. 13