Capital Inquiry: Recovery and Resolution Evidence from the British Bankers Association

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1 Capital Inquiry: Recovery and Resolution Evidence from the British Bankers Association Introduction The BBA is pleased to respond to the Treasury Committee s call for evidence for the first stage of its capital inquiry on recovery and resolution. The BBA is the leading association for UK banking and financial services representing members on the full range of UK and international banking issues. It has over 200 banking members active in the UK, which are headquartered in 50 countries and have operations in 180 countries worldwide. Eighty per cent of global systemically important banks are members of the BBA. As the representative of the world s largest international banking cluster the BBA is the voice of UK banking. 1. What progress have the major UK banking groups made in developing realistic and effective resolution and recovery plans, including ring-fence arrangements? - What are the main steps still to be undertaken and what are the key uncertainties? - Is it possible to establish, in the absence of a bank failure, whether the UK s recovery and resolution regime is sufficiently robust to achieve its objectives? Background The EU s Directive 2014/59/EU (the Bank Recovery and Resolution Directive - BRRD) was implemented in January 2015 and supported by PRA policy statement PS1/15 and other implementing laws and regulations, but the UK has had a Special Resolution Regime from as far back as the beginning of The BRRD requires banks to have a recovery plan in place, refreshed every year, and a resolution plan written by the resolution authority (in the UK, the Bank of England s Resolution Directorate), which also has legal powers to direct firms to address impediments to resolvability, and ensure preparedness for operational continuity of critical services (e.g. deposit taking) in resolution. All UK banks now have recovery plans in place, which are reviewed by Supervisors and resolution plans written by the Resolution Directorate at the Bank of England. It is considered that the key mechanics required for resolution are now in place, but there is still work to the calibration and operationalisation of the strategies that should be undertaken in order to ensure plans are credible. Assessing Effectiveness In respect of recovery planning, there is no need for a bank failure to test whether recovery planning arrangements are effective; given recovery planning occurs before a firm enters into resolution and we understand the Resolution Directorate is currently undertaking this work. Additionally, it is probable that recovery plan actions (e.g. enacting Contingency Funding Plans) have already been taken place at some firms and such actions have resulted in restored capital/liquidity positions. It is more challenging to determine the effectiveness of the UK resolution framework in the absence of a bank failure given that, while institutions in resolution may initially recapitalise

2 2 via bail-in and restructure to a sound business model in the necessary time frame, a bank will ultimately need liquidity from the market. If, due to loss of confidence and trust this liquidity is not forthcoming, a successful restructuring could be undermined requiring the bank to be wound down rather than restructured. This could in turn present challenges to the ongoing and orderly provision of critical economic functions (CEFs). Particularly in a systemic crisis context, which will generally underpin a G-SIB failure, and where risk appetite and availability of liquidity in the market are likely to be relatively low, resolution may result more in a solvent wind down than a restructuring. Therefore, how effective the resolution plans are would only be properly tested if a globally systemically important bank (G-SIB) were to fail. We believe this is now less likely because of the increased capital and liquidity requirements imposed on banks since the Great Financial Crisis (GFC) and the development of effective recovery plans. There is further uncertainty about how different regulators globally will react to the resolution of a G-SIB. While the FSB is working to harmonise resolution regimes across the world and ensure the international recognition of resolution actions (which we fully support), and the UK and EU has a clear regime in place for this, many regimes are still in their infancy and regulatory cooperation needs to improve further in the interest of achieving an effective global resolution. For non-uk based large international banks operating through subsidiaries in the UK, the PRA has also been undertaking work to assess their ability to appropriately wind down businesses in a going concern, but stressed, environment (known as solvent wind down analysis). The UK authorities should be commended for the leadership role they have played in the international policy development work conducted through the Financial Stability Board (FSB) and European institutions to bring about the development of credible and effective regimes for the orderly resolution of failed financial institutions, without resort to public solvency support. Loss Absorbing Capacity Since the GFC, bank capital requirements have increased in order to ensure that there is sufficient loss absorbing capacity to support unexpected losses. The BBA agrees with the Bank of England s view that bank capital is not costless to society and supports the use of other forms of allowable loss absorbing capacity that are now being introduced. Significant progress has been made to ending the too big to fail concern, and this is likely to be further improved by the introduction of a total loss absorbing capacity (TLAC) requirement for G- SIBs and the minimum requirement for own funds and eligible liabilities (MREL) for all EU banks, set on a case by case basis, depending on the risk of disruption to CEFs, such as operating current accounts, taking deposits or providing mortgages that a bank s failure could create. TLAC and MREL can help when banks fail; by ensuring that the tax payer does not pay for a bank s failure. It does this by shifting the burden from public support to private bail-in of the bank s MREL, under the bail-in approach. Equity holders and the providers of certain types of debt liabilities, rather than the tax payer, would be required by the resolution authority to absorb losses and recapitalise the continuing business, so that it would be able to carry on providing CEFs to customers. We believe the Bank of England s approach to calibrating MREL under the bail-in strategy is a more conservative requirement than implied by the TLAC Term Sheet, which would have competitive effects within the UK market and on the ability of UK banks to compete globally. This is because, if the full Pillar 2A requirement was included in the recapitalisation amount, the approach would imply a minimum MREL of ~22% of risk weighted assets (RWA) on average, which would need to be maintained in addition to capital buffers, giving a likely

3 3 overall capital stack of approximately 27% of RWA 1 - excluding time-varying requirements (e.g. countercyclical capital buffer) and any firm-specific or internal management buffers held in addition to the requirements. The historic loss analysis conducted by the FSB shows only one bank (Fortis) saw losses and recapitalisation needs which exceeded 20% of RWAs during the global financial crisis 2. This illustrates the importance of adjusting the Pillar 2A contribution to the recapitalisation amount. TLAC is intended to be applied on the basis of resolution groups. The proposed approach diverges from this by implementing MREL on a group consolidation basis. For banks with more than one resolution group, i.e. with a multiple point of entry (MPE) resolution strategy, overall group requirements should correspond to the aggregation of locally applicable requirements of each resolution group/entity. In the European Commission proposals for revisions to the BRRD published on 23 November, we note that there are some requirements that are over and above those agreed internationally. In particular, the proposed Article 72b relating to what can qualify as an eligible liabilities instrument, the definition is more restrictive than the existing definition of eligible liabilities in Article 45 BRRD. The BBA does not think it is appropriate for all eligible liabilities to be required to contain contractual recognition of bail-in nor should there be limitations on acceleration rights. Consistent with the FSB s TLAC term-sheet, the requirement for eligible liabilities instruments to be subordinated can be satisfied by appropriate contractual or statutory provisions. In the UK, there is already a statutory framework that provides authorities with the right to override contractual terms and allow them to step in and withdraw such rights as deemed necessary. Therefore, we believe that the Bank of England should work with the Commission to amend this aspect of the proposals appropriately, as the BBA intends to do. Banks understand that the credibility of their resolution strategies depends on an assurance that their businesses operate with sufficient resources which can be subject to loss in the event of their failure. This is central to ensuring that the CEFs they provide to customers in the UK and other markets are resilient and can continue to be provided even in the event of the failure of the wider business. Loss absorbing capacity in the form of MREL or TLAC, however, is just one aspect that makes this possible and the significance of the progress made in other areas should not be underestimated. In particular, we note the substantive work underway to ensure that banks transact with their clients and counterparties on resolution friendly terms and that critical shared services within a banking group, such as IT infrastructure, can continue to operate even in the event of the failure of the wider group. Ring-Fencing The larger UK banking groups, i.e. those with eligible deposits in excess of 25bn, are significantly advanced in their plans to introduce ring-fencing by 1 January In keeping with recommendations first made by the Independent Commission on Banking in September 2011, ring-fenced banks will be required to separate out their retail and SME banking activities from investment banking services with the aim of ensuring continuity of service in the event of disruption arising elsewhere in the banking group or in the wider financial system. 1 Calculated using the average requirements for the UK banking system as set out in the Bank of England s Supplement to the December 2015 Financial Stability Report: The framework of capital requirements for UK banks, as follows: 2 x (Pillar 1 (8%) + Pillar 2A (3.2%)), + combined buffer requirement (~4.5%) = ~26.9% 2 FSB, Historical Losses and Recapitalisation Needs: 9 November

4 4 The complexity of the exercise is evidenced by the deliberate steps needed to bring ringfencing about and the fact that it has taken until only a matter of weeks ago for the regulatory regime to be completed, although there occasional consultation papers will continue to be issued by the PRA as implementation becomes more advanced and yet to-be identified technical challenges need resolving. There has, however, been an iterative process during the completion of the statutory and regulatory regime, involving several consultations on the part of both the PRA and the FCA, and draft plans have been shared with the regulatory authorities and this in our view has resulted in a refined ring-fencing regime that meets the regulators objectives whilst being implementable by the banks concerned. These are now being drawn up into Ring-fencing Transfer Scheme reports, including the Skilled Persons report, and once completed will be submitted to the regulatory authorities for approval prior to banks seeking Court approval for the reorganisation that they plan to follow in order to bring ring-fencing into effect. These final preparatory stages are expected to be completed this year enabling impacted banking groups to put their reorganisation plans into effect significantly before the 1 January 2019 deadline. Ring-fencing can be seen as a further means of placing firewalls within the financial system and, for the UK banking groups affected, can be said to give a sharper edge to recovery and resolution planning given the separation of activities into different legal entities. Further Work Notwithstanding the above, we observe that there are a few areas where further progress could be made, such as cross border arrangements, and the Resolution of Financial Market Infrastructures. Chief amongst these is the promotion of legal and commercial certainty in cross-border resolution. The FSB has made some progress on this topic but contractual arrangements can only go so far. Ultimately we believe the major jurisdictions need to increase efforts to move towards formal procedures for the recognition and enforcement of resolution measures. We recognise that this will take time to deliver but believe it must be the long-term objective of the FSB and its members, in particular the Bank of England, to continue focus on this in order to achieve this objective. Furthermore, it is important that the Bank of England, in conjunction with other competent authorities, works to prevent systemic issues from being created by recovery plans the banks have written and ensure that they can be invoked coherently should a number of banks be approaching the Point of Non Viability at the same time, without exacerbating systemic risk. 2. What progress has been made by major foreign economies in developing realistic and effective resolution and recovery plans? - What are the main steps still to be undertaken and what are the key uncertainties? - Are there any differences in the way recovery and resolution regimes are being implemented in other countries that have significant implications for the UK financial system? - What conflicts are likely to arise between UK, European and other major economies as a result of different approaches to recovery and resolution? - Based on experience to date, including in the euro area, are there any elements of the UK s recovery and resolution regime that should be re-examined? - What is the best way to monitor for and ensure consistency between international jurisdictions on recovery and resolution regimes?

5 5 The BBA draws the attention of the Committee to the Financial Stability Board s (FSB) Second Thematic Review on Resolution Regimes 3, published in March 2016, which shows the progress made by key jurisdictions to implement the FSB s Key Attributes of Effective Resolution Regimes for Financial Institutions. This report also shows that the UK is among the jurisdictions that have gone the furthest in this regard. Europe In Europe, the Single Resolution Board (SRB) is empowered in much the same way as the Bank of England to be responsible for resolvability assessments and is able to mandate changes to banks legal entity, financial and operating structures to improve resolvability. EU Intermediate Parent Undertaking The European Commission published on 23 November its proposals for revisions to CRD/CRR and BRRD. These incorporate changes to the Basel framework agreed since Included within these proposals is a new requirement (Article 21b), for non-eu groups to create a single intermediate parent undertaking (IPU) in the EU (with de minimus exemptions). It is important to note that EU authorities already have the ability to require the creation of an IPU, but to the best of our knowledge, have not actually exercised this right. This proposal is similar to the US requirement for an intermediate holding company (IHC), but there are a number of issues with the way the CRR may implement this. Of particular note is that the incompatibility of a single IPU with US regulatory requirements that mandate the separation of banking and broker-dealer activities. Similar concerns may arise, as a result of the rules in the Financial Services (Banking Reform) Act 2013 which require UK banks with material retail operations that will be ring-fenced from wholesale or investment banking activity to set up separate IPUs, depending on a bank s particular business model and legal structure, should they wish to carry out both types of activity in the EU. These IHC/IPU requirements in the EU and the US runs counter to resolvability aims in the cross-border context by adopting a ring-fencing approach that has the potential to undermine home-host cooperation and does not allow for parity of group wide single point of entry (SPE) and multiple point of entry (MPE) resolution strategies that banks adopt. For SPE strategies, an IHC or IPU will add a further layer in the transmission of recapitalisation capacity from the ultimate parent to the hosted subsidiaries. United States As the non-eu jurisdiction with the most interconnectedness with the UK, the BBA has included an overview of the US recovery and resolution regime, but does not consider it to be any further ahead of the UK in implementing international standards. In the US, banks annually submit resolution plans to the Federal Reserve Board (FRB) and the Federal Deposit Insurance Corporation (FDIC). Each plan, commonly known as a living will, must describe the company's strategy for rapid and orderly resolution in the event of material financial distress or failure of the company, and include both public and confidential sections. The public sections of the plans are available on the Federal Reserve website for all submitting firms. The plans are reviewed by the FRB and the FDIC. Following their review, the FRB and the FDIC may jointly determine that a plan is not credible or would not facilitate an orderly resolution of the company under the U.S. Bankruptcy Code ( joint determination ). If there is 3

6 6 a joint determination, the agencies must notify the firm of the deficiencies in the plan jointly identified by the agencies. If both agencies agree that a firm has not adequately remediated the deficiencies, the agencies, acting jointly, may impose more stringent prudential requirements on the firm until it remediates them. The US authorities then publish their determination of the adequacy of the plans for their systemically important domestic banks. In 2014, the Board approved a final rule to require a foreign banking organisation with a significant US presence (in excess of $50bn non-branch assets) to establish an intermediate holding company (IHC) over its US subsidiaries by 1 July 2016 (with a transition period for residual interests to July 2017), in order to facilitate consistent supervision and regulation of the US operations of the foreign bank. It has been widely publicised that the current US administration plans to make some possible changes to the Dodd Frank Act. We urge the Bank of England to work with the US authorities to ensure that any changes made to this Act, particularly Title I and II relating to improvements to the inadequate insolvency procedures for financial institutions as borne out by the impact of the failure of Lehman Brother, do not have a negative impact on the work that has been done since the financial crisis to make the global financial system safer and reduce the likelihood of future taxpayer-funded bailouts. Article 55 Requirements under Article 55 of the BRRD are intended to facilitate the cross-border recognition of resolution action, specifically bail-in. However, the rules apply to a very broad scope of liabilities, including liabilities arising out of contractual arrangements which are clearly unsuited to write-down or conversion via bail-in, and which are unlikely to contribute to a recapitalisation of a bank under resolution. The BBA considers that the cost of implementing aspects of Article 55 are more than the benefit they accrue to increasing bailinable liabilities and can be disruptive to the banking business. However, the BBA recognises that some steps have been taken to address these issues in the Commission s 23 rd November proposals. Internal TLAC The FSB has recently issued a consultation on its Guiding Principles on the Internal Total Loss-absorbing Capacity of G-SIBs ( Internal TLAC ) 4 in which there are principles relating to the determination of the size of internal TLAC by the home and host authorities. The Bank of England should work with the FSB to ensure that these principles are amended so that host authorities are not able to cause external TLAC to increase by requiring higher levels of internal TLAC at sub-group levels. 3. What impact might Brexit have on the likely effectiveness of the UK s recovery and resolution regime? - What actions should the Bank of England and the UK Government take regarding recovery and resolution policy in response to the Brexit vote? - How will Brexit affect the management of cross-border resolution for banks that have operations in both the UK and EU, as well as other places? Once the UK is no longer an EU state, the recognition of UK resolution actions in the EU by the Bank of England may be more cumbersome. The Bank of England and the Government 4

7 7 should work to ensure the continued UK benefit from the EU cooperation framework in the BRRD. Other immediate impacts are not expected to be material, however as the EU continues to develop recovery and resolution rules, there is a risk that the UK regime may not be deemed equivalent - mitigated by virtue of the UK having been a front-runner in this area. However, should the UK diverge from the rest of the EU then this is likely to have a material impact on any potential cross-border resolution. Intermediate Parent Undertaking As mentioned above, the implementation of the requirement for non-eu banks to set up a single IPU will mean that post-brexit this rule could, for some banks, conflict with UK ringfencing requirements. This will create a further layer of complexity for some UK banks operating in the EU and may reduce multinational cooperation, which would detrimentally impact the effectiveness of plans for banks with an SPE strategy in a resolution. Systemic Risks Introduced Brexit may introduce further systemic risk as the global financial landscape adapts to this fundamental change. This is likely to impede the progress being made in this area as bank business models and strategies will have to account for the loss of passporting arrangements and other, potentially unforeseen, consequences of exiting the EU. Restructuring of banking businesses in response to a change in the United Kingdom s relationship with the European Union could also lead firms to seek to operate more complex business models to serve EEA-based clients. 4. What assumptions has the FPC made as to the efficacy and feasibility of resolution plans? What are the risks to effective implementation, and how is the probability of non-implementation, non-effectiveness or contagion effects factored in? - Is the FPC's judgment of the appropriate reduction in capital requirements resulting from effective resolution plans a reasonable one? - Has the FPC made the correct judgement of the balance between the weights placed on equity capital and bail-in securities? - What evidence is there, if any, that the development of recovery and resolution regimes have already reduced moral hazard and the 'too big to fail' subsidy? The BBA believes that the changes made since the financial crisis have significantly reduced moral hazard, but there is still an implied too big to fail subsidy as shown through the correlation between credit default swap (CDS) spreads and possible measures of systemic importance. Studies have shown that banks perceived as too big to fail have CDS spreads 44 to 80 basis points lower than other banks, depending on the asset-size threshold and controls used. Additionally, an Office of Financial Research study suggests market participants pay more attention to asset size than to a more complex measure, such as designation as a globally systemically important bank (G-SIB) that includes additional factors, such as substitutability and interconnectedness. However, there is evidence that a number of ratings agencies have withdrawn assumptions of implied government support for some systemic banks, which indicates that there has been a reduction of moral hazard as there is no longer an expectation that public funds will be used to prevent them from failing. Central Counterparties We welcome the work being done to attempt to mitigate this risk, largely through the incentives for banks to use Central Counterparties (CCP). However, with this the largest

8 8 CCPs are becoming increasingly systemic and interconnected themselves, such that their critical services could not stop suddenly without risk of wider contagion and, therefore, it is necessary that a suitable resolution regime for CCPs is established to reduce the potential risks from one of these systemically important CCPs failing. It is helpful that the FSB is currently consulting on resolution planning for CCPs 5. The cost to the financial system for a CCP failing has the potential to create considerable issues for many market participants. This is particularly true if the CCP is the sole or dominant clearer for a particular asset market. The failure of this CCP would act as a channel for contagion. We encourage the FPC to continue its work on mitigating the systemic risks inherent in the CCPs being single points of failure and echo the comment made by the Systemic Risk Council that the work to put in place effective resolution regimes and plans for clearinghouses is incomplete but, given their mandated role at the center of capital markets, is absolutely vital How serious is the risk that falls in the prices of particular bail-inable securities will cause contagious uncertainty about the solvency of banks in general? If there are contagion risks, how could these be reduced? - Does the market for bail-inable securities need any minimum degree of continuous liquidity? If so, how could it be assured? As investors become more familiar with the loss-absorbing mechanisms of bail-inable securities it is not believed that a fall in the prices of these securities is any more likely than a fall in equity prices to cause contagion risks in the banking sector. It is considered that risks inherent in these instruments are well understood, which should prevent contagion or cliffeffect risks on pricing 6. Would it be desirable to have more transparency about the resolution and recovery plans of the major UK banks, and about the PRA s and Bank of England s assessment of them? - Would there be merit in greater transparency concerning international technical discussions on recovery and resolution? The BBA considers that due to the potentially commercially sensitive nature of information that would need to be redacted included in resolution plans that there would be little benefit in public transparency, as the key information for the market and creditors is already available in annual reports. There is, however, merit in transparency for the competent authorities within the crisis management groups, as it is understood is already the case. Greater transparency on international technical discussions is always helpful to be able to provide feedback on proposals; however as recovery and resolution planning is already well advanced this is unlikely to make a material difference at this stage, but there may be merit in exploring disclosure of non-sensitive information in the form of a short summary, as occurs in the US for example, but only if it serves a clear purpose. Responsible executive Nic Edge +44 (0) Nicholas.edge@bba.org.uk