Financial Crisis and Resolution Rules: What is the Cost of a Safer EU Banking System? Prof. G. A. Vento Regent s University London

Transcription

1 Financial Crisis and Resolution Rules: What is the Cost of a Safer EU Banking System? Prof. G. A. Vento Regent s University London UCEMA University, Buenos Aires, 09 th May 2016

2 Content The Financial Crisis The Response to Financial Crisis Basel III European Banking Union Directive BRRD and Bail-in Cost 1

3 The Financial Crisis 2

4 The Financial Crisis The financial crisis, that began to unfold in the summer of 2007 in the United States and let to the worst economic downturn after the Great Depression, with huge direct and indirect costs to public finances, brought to the fore great weaknesses in the system of financial surveillance worldwide. Macroeconomic imbalances were major underlying factors of the crisis, together with the a-critical celebration of the invisible hand and of markets efficiency, rationality and self-corrective prosperities. The turmoil in the most advanced financial markets that started in the summer of 2007 was the culmination of an exceptional boom in credit growth and leverage in the financial system. 4

5 The Financial Crisis The exceptional boom in credit growth was fed by: A long period of benign economic and financial conditions, including historically low real interest rates and abundant liquidity, which increased the amount of risk and leverage that borrowers, investors and intermediaries were willing to take on; By a wave of financial innovation, which expanded the system s capacity to generate credit assets and leverage but outpaced its capacity to manage the associated risks. Banks and other financial institutions gave substantial impetus to this process by establishing off-balance sheet funding and investment vehicles, which in many cases invested in highly rated structured credit products, in turn often largely backed by mortgage-backed securities (MBSs). 5

6 The Financial Crisis The demand for high-yielding assets and low default rates also encouraged a loosening of credit standards, most glaringly in the US subprime mortgage market, but more broadly in standards and terms of loans to households and businesses Moreover, some of the standard risk management tools used by financial firms are not suited to estimating the scale of potential losses in the adverse tail of risk distributions for structured credit products. The absence of a history of returns and correlations, and the complexity in many of these products, created high uncertainty around value-at-risk and scenario-based estimates. Market participants severely underestimated default risks, concentration risks, market risks and liquidity risks, particularly for super-senior tranches of structured products. 6

7 The Financial Crisis Weaknesses in rating models and methodologies represent another underlying of the 2007 financial crisis. In particular, they were caused by: Insufficient transparency about the assumptions, criteria and methodologies used in rating structured products; Insufficient information provision about the meaning and risk characteristics of structured finance ratings; Insufficient attention to conflicts of interest in the rating process. 7

8 The Financial Crisis The weaknesses in the regulatory framework and other policies: Public authorities recognised some of the underlying vulnerabilities in the financial sector but failed to take effective countervailing action, partly because they may have overestimated the strength and resilience of the financial system. Limitations in regulatory arrangements, such as those related to the pre- Basel II framework, contributed to the growth of unregulated exposures, excessive risk-taking and weak liquidity risk management. The Basel I approach did not address the issue of risk emanating from securitized instruments. In fact, it prompted regulatory arbitrage, by encouraging off balance sheet operations. Basel II offered only partial correction and, in any event, it did not apply to investment banks in the US. Regulatory requirements created feedback loops, which enormously amplified the inherent pro-cyclicality of the system 8

9 The Response to the Financial Crisis 9

10 The Response to the Financial Crisis The Basel II framework needed fundamental review. It underestimated some important risks and over-estimated bank s ability to handle them. The perceived wisdom that distribution of risks through securitization (the originate-to-transfer, OtD banking model) took risk away from the banks turned out, on a global basis, also to be incorrect. The pre-crisis Basel methodology was too much based on recent past economic data and good liquidity conditions. A critical reflection was also needed with regard to the reliance of Basel II on external ratings. During the crisis it became evident that the regulatory and supervisory nets should extend, in a proportional manner, to all intermediaries, market, operations, instruments and derivatives, that may have a systemic impact, even if they have no immediate links with the retail investors. 10

11 The Response to the Financial Crisis Both the EU and the US have improved the regulatory environment. The approach has two main common objectives: first, decreasing the likelihood of a similar financial crisis reoccurring; Second, ensuring that the costs of any failure of financial institutions are not borne by taxpayers, but by the failing bank and the financial sector more generally. The enacted Dodd-Frank Act (July 2010) represents the most important change to financial regulation in the US since the Great Depression: it impacts all federal supervisory agencies and affects all major aspects of the financial services industry. 11

12 Response to the Financial Crisis To design a new financial architecture in Europe consistent with global developments and international trends, the de Larosière Report examined the causes of the crisis and underlined the importance of sustainable economic policies and of macro-prudential oversight, also on economic policies, for financial stability. Four principal lines of actions were outlined as the basis for financial reform: The creation of a European Systemic Risk Board, largely coordinated by the European Central Bank, that would be responsible for the identification and monitoring of macro-supervisory risk and would have the duty of issuing specific recommendations for corrective actions also to policy makers. 12

13 Response to the Financial Crisis The creation of a European-level financial micro-supervisory framework based on three Authorities, to oversee banks, insurances, and securities and markets, respectively. These Authorities would replace the Lamfalussy Agencies and would have formal decision making capabilities and binding powers. Regulatory repair notably with respect to the shortcomings and failures of the faulty triad and of securitised products and derivative markets. A procedure to deal with crisis management and resolution, covering both situations and institutions posing systemic risks, and capable of containing moral hazard and sheltering taxpayers from the costs of banking failures. 13

14 Basel III 14

15 Basel III After the financial crisis the Basel Committee has integrated Basel II. Basel III introduced: Strengthening the global capital framework ; Capital conservation buffer ; Countercyclical buffer. Leverage ratio; Global liquidity standard; Risk Coverage. 15

16 Strengthening the global capital framework Total regulatory capital will consist of the sum of the following elements: Tier 1 Capital (going-concern capital) Common Equity Tier 1 Additional Tier 1 Tier 2 Capital (gone-concern capital) All elements above are net of the associated regulatory adjustments and are subject to the following restrictions: Common Equity Tier 1 must be at least 4.5% of risk-weighted assets at all times. Tier 1 Capital must be at least 6.0% of risk-weighted assets at all times. Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 8.0% of risk- weighted assets at all times. 16

17 Capital Conservation Buffer Outside of periods of stress, banks should hold buffers of capital above the regulatory minimum. When buffers have been drawn down, one way banks should look to rebuild them is through reducing discretionary distributions of earnings. This could include reducing dividend payments, share-backs and staff bonus payments. Banks may also choose to raise new capital from the private sector as an alternative to conserving internally generated capital. A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement. 17

18 Capital Conservation Buffer 18

19 Countercyclical buffer Losses incurred in the banking sector can be extremely large when a downturn is preceded by a period of excess credit growth. These losses can destabilise the banking sector and spark a vicious circle, whereby problems in the financial system can contribute to a downturn in the real economy that then feeds back on to the banking sector. The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. 19

20 Countercyclical buffer The countercyclical buffer regime consists of the following elements: National authorities will monitor credit growth and other indicators that may signal a build up of system-wide risk and make assessments of whether credit growth is excessive and is leading to the build up of system-wide risk. Based on this assessment they will put in place a countercyclical buffer requirement when circumstances warrant. This requirement will be released when system-wide risk crystallises or dissipates; Internationally active banks will look at the geographic location of their private sector credit exposures and calculate their bank specific countercyclical capital; The countercyclical buffer requirement to which a bank is subject will extend the size of the capital conservation buffer. Banks will be subject to restrictions on distributions if they do not meet the requirement. 20

21 Leverage Ratio One of the underlying features of the crisis was the build-up of excessive onand off-balance sheet leverage in the banking system.. During the most severe part of the crisis, the banking sector was forced by the market to reduce its leverage in a manner that amplified downward pressure on asset prices, further exacerbating the positive feedback loop between losses, declines in bank capital, and contraction in credit availability. The leverage ratio is intended to achieve the following objectives: constrain the build-up of leverage in the banking sector, helping avoid destabilising deleveraging processes which can damage the broader financial system and the economy; and reinforce the risk based requirements with a simple, non-risk based backstop measure. The Committee will test a minimum Tier 1 leverage ratio of 3% during the parallel run period from 1 January 2013 to 1 January

22 Global liquidity standard During the early liquidity phase of the financial crisis that began in 2007, many banks despite adequate capital levels still experienced difficulties because they did not manage their liquidity in a prudent manner. The crisis again drove home the importance of liquidity to the proper functioning of financial markets and the banking sector. Prior to the crisis, asset markets were buoyant and funding was readily available at low cost. The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in some cases, individual institutions. 22

23 Global liquidity Standard The Committee has developed two standards that have separate but complementary objectives for supervisors to use in liquidity risk supervision: Liquidity Coverage Ratio; Net Stable Funding Ratio. 23

24 Liquidity Coverage Ratio This standard aims to ensure that a bank maintains an adequate level of unencumbered, high-quality liquid assets that can be converted into cash to meet its liquidity needs for a 30 calendar day time horizon under a significantly severe liquidity stress scenario specified by supervisors. At a minimum, the stock of liquid assets should enable the bank to survive until Day 30 of the stress scenario, by which time it is assumed that appropriate corrective actions can be taken by management and/or supervisors, and/or the bank can be resolved in an orderly way. 24

25 Net Stable Funding Ratio This metric establishes a minimum acceptable amount of stable funding based on the liquidity characteristics of an institution s assets and activities over a one year horizon. In particular, the NSFR standard is structured to ensure that long term assets are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles. The NSFR aims to limit over-reliance on short-term wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across all on- and offbalance sheet items. 25

26 The European Banking Union 25

27 European Banking Union 27

28 Single Supervisory Mechanism Directly supervised banks The ECB directly supervises the 129 significant banks of the participating countries. These banks hold almost 82% of banking assets in the euro area. The decision on whether a bank is deemed significant is based on a number of criteria. Indirectly supervised banks Banks that are not considered significant are known as less significant institutions. They continue to be supervised by their national supervisors, in close cooperation with the ECB. At any time the ECB can decide to directly supervise any one of these banks to ensure that high supervisory standards are applied consistently. 28

29 Single Resolution Mechanism The Single Resolution Mechanism (SRM) is set to centralise key competences and resources to deal with failures of banking firms. As the crisis in Cyprus in 2013 demonstrated, bank resolution conducted at national level has a crucial impact on the domestic real economy, exacerbates the negative loop between sovereigns and banks, does not prevent contagion. The Single Resolution Mechanism (SRM) applies to banks covered by the SSM. In the cases when banks fail despite stronger supervision, the mechanism will allow bank resolution to be managed effectively through a Single Resolution Board and a Single Resolution Fund, financed by the banking sector. 29

30 Single Resolution Board The Single Resolution Board is the central decision-making body of the Single Resolution Mechanism. Its mission is to ensure that credit institutions and other entities under its remit, which face serious difficulties, are resolved effectively with minimal costs to taxpayers and the real economy. The Board will also be responsible for managing the Single Resolution Fund which is established by the Single Resolution Mechanism. The Single Resolution Board is a self-financed agency of the European Union. 30

31 European Deposit Insurance Scheme The European Deposit Insurance Scheme (EDIS) would apply to deposits below euros of all banks in the euro area. When a bank is placed into insolvency or in resolution and it is necessary to pay out deposits or to finance their transfer to another bank, the national deposit guarantee schemes and EDIS will intervene. At the final stage of the EDIS set up, the protection of those deposits will be fully financed by EDIS, supported by a close cooperation between EDIS and national DGS. Given that national DGS may remain vulnerable to large local shocks, the purpose of EDIS is to ensure equal protection of deposits through the Banking Union regardless of the Member State where the deposit is located. 31

32 The Single Rulebook Both the supervisory and resolution mechanisms are underpinned by a set of common rules for banks in all 28 Member States, known as the Single rulebook. These rules are designed to prevent bank crises from happening in the first place, for example by increasing the amount of capital that banks are required to have (Capital Requirements Directive/Regulation) and when they do happen, providing a common framework to manage the process of winding the banks down (Directive on Bank Recovery and Resolution). The rules will also help protect consumers if banks should get into difficulty. For instance, deposits of up to 100,000 are guaranteed throughout the EU, which should help to prevent panic withdrawals if a bank is in trouble. Whereas the current Deposit Guarantee Schemes (DGS) are national in nature, the Commission will review the functioning of the DGS Directive by 2019 and see whether, in the context of the banking union, a single, pan- European, DGS should be set up. 32

33 The Single Rulebook The Single Rulebook includes: Capital Requirement Regulation (CRR); Directive CRD IV; Bank Recovery and Resolution Directive; Reg. on Single Resolution Mechanism; Directive European Deposit Insurance Scheme. 33

34 The BRRD Directive and the Bail-In tool 34

35 The BRRD Directive The Bank Recovery and Resolution Directive (BRRD, May 2014) provides a framework to cope with align banks. Powers and tools are created to deal in an effective way with prevention, early intervention and, ultimately, resolution. Banks will have to draw up recovery plants, while authorities are requested to prepare resolution plans. The BRRD includes a range of instruments of three phases: Preparatory and preventive (e.g. recovery plans); Early intervention (e.g. Special managers); Resolution: 35

36 Recovery Plan An institution will be required to draw up a detailed recovery plan setting out the actions to be taken to restore long-term viability in the event of a material deterioration in its financial circumstances. The plan must take into account how the institution will react in a range of scenarios, including system-wide events as well as stress to both the legal entity and to its wider group. Institutions must not assume that there will be any access to public financial support as part of their planning. Supervisors will review and approve recovery plans. A copy of the plan will be provided to the relevant resolution authority which may make its own recommendations in respect of the plan to the competent authority. 36

37 Resolution Plans Using the recovery plan as a basis, the resolution authority, in consultation with the competent authority, will prepare a resolution plan for an institution (at an entity or group level, as applicable) setting out options for resolving the institution in a range of scenarios, including systemic instability. The resolution plan will include details of the application of the resolution tools and ways to ensure critical functions continue to be provided by the institution 37

38 Resolution Tools When a resolution is triggered, the resolution authorities have four resolution tools: the sale of business tool; the bridge institution tool; the asset separation tool; the bail-in tool, plus additional resolution powers. 38

39 The Sale Business Tool The resolution authorities will be given the power to transfer shares (or other instruments of ownership) or all or specified assets, rights or liabilities of an institution to a purchaser without obtaining the consent of the institution s shareholders or any third party and without complying with any procedural requirements of company or securities law that would otherwise apply. The transfer must be made on commercial terms and a resolution authority must take reasonable steps to obtain such terms, having regard to the preresolution valuation of the institution. The proceeds must be for the benefit of the institution's shareholders where the sale is effected by transferring shares (or similar) and for the benefit of the institution where effected by transferring some or all of the assets or liabilities. 39

40 The Bridge Institution Tool The resolution authorities will be given power to transfer shares (or other instruments of ownership) or all or specified assets, rights or liabilities of an institution to a bridge institution temporarily without obtaining the consent of the institution s shareholders or any third party and without complying with any procedural requirements of company or securities law that would otherwise apply. A bridge institution is a legal entity that is wholly or partially owned by one or more public authorities (which may include the resolution authority or the resolution financing arrangement) and which is controlled by the resolution authority, created to receive or hold some or all of the shares or the assets, rights and liabilities with a view to continuing some or all of the functions, services or activities of an institution under resolution. The bridge institution will require appropriate authorisation although this requirement may be waived for a short period of time by the competent authority at the request of the resolution authority 40

41 The Asset Separation Tool The resolution authority has the power to transfer assets, rights and liabilities of an institution under resolution to a specially created asset management vehicle that is wholly or partially owned by one or more public authorities (which may include the resolution authority or the resolution financing arrangement) and which is wholly controlled by the resolution authority. The resolution authority will appoint or approve the members of the vehicle s management body to manage the assets transferred with a view to maximising their value through sale or otherwise ensuring an orderly wind down of the business. There is no time limit for this process. 41

42 The Asset Separation Tool Assets may only be transferred if the particular market for those assets is of such a nature that liquidation of the assets under normal insolvency proceedings could have an adverse effect on the financial market, if such a transfer is necessary to ensure the proper functioning of the institution under resolution or if such a transfer is necessary to maximise liquidation proceeds. The asset managers appointed have no duty or responsibility to the shareholders or creditors of the institution under resolution when exercising their functions, save when there is gross negligence or serious misconduct. 42

43 The Bail-in Tool The resolution authority is given the power to: write down or convert relevant capital instruments into shares (or other instruments of ownership) of the institution; reduce the principal of, or outstanding amount due in respect of, eligible liabilities (down to zero); convert eligible liabilities (see below) into ordinary shares (or other instruments of ownership) of the institution, a relevant parent institution or an associated bridge institution; cancel debt instruments or write down the nominal amount of shares to zero; require the issue of new shares or other capital instruments. Once the conditions for resolution are met, the bail-in of relevant capital instruments must be exercised before any resolution action is taken. Relevant capital instruments are those recognised for the own funds requirements of an institution (on either an individual or consolidated basis). 43

44 The Bail-in Tool The debt write-down may only be applied to meet the resolution objectives, in accordance with the resolution principles and to recapitalise an institution (or financial holding company) to the extent sufficient to restore compliance with the conditions for authorisation (including capital requirements), to carry on its authorised business and to sustain sufficient market confidence in the institution (or entity); or to convert to equity or reduce the principal amount of claims or debt instruments that are transferred to abridge institution with a view to capitalising the bridge institution or under the sale of business or asset separation tool. A write-down takes effect immediately and is binding on the institution, affected creditors and shareholders 44

45 The Bail-in Tool Certain liabilities are excluded from the scope of the bail-in tool: liabilities with an original maturity of seven days owed to institutions (other than group institutions) or owed to systems or operators of systems designated according to the Settlement Finality Directive, participants of such systems or arising from the participation in such a system; secured liabilities including covered bonds and similarly secured liabilities; insured deposits; liabilities arising from the holding of client monies or client assets or arising by virtue of a fiduciary relationship, provided the beneficiary is protected under applicable insolvency or civil law; employee salary and benefit or other fixed (but not variable) remuneration; liabilities owed to tax or social security authorities; and liablities to deposit guarantee schemes (DGS) arising from contributions due under the DGS Directive. 45

46 Cost 46

47 What are the costs of bail-in rules? Higher cost of funding for banks Higher rates on loans More difficult to raise funds through bonds More difficult to raise funds for smaller and less capitalised banks Unfair payoffs on banks deposits Impact on international competition among banks The high volatility in banks stock prices in the last week is also due to these rules 47

48 Some unanswered questions Which are the perspectives of the European banking industry in a context of negative rates and bail-in rules? How the deleverage of banks is affecting European SMEs? Is the effect the same in all EU countries? 48

49 Thank you for your attention! Prof. Gianfranco Vento Questions? 49