Legal challenges to netting in bank restructuring:

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1 Legal challenges to netting in bank restructuring: Resolution tools and policy choices Geoff Davies The views expressed in this presentation are those of the presenter and are not necessarily of the Bank of England. 1 Why are special legal tools required for bank resolution? What are they and what drives their selection? What are the implications of these tools for netting arrangements? 2 1

2 Bank resolution in the UK: the problem with deposit-takers Reliance on a combination of general insolvency law and deposit insurance to handle bank failure can suffer from a number of deficiencies: vulnerable to losses of confidence, which may quickly lead to runs; not well suited to ensuring continuity of key banking functions,; means that prompt payout to insured depositors of failed bank may not be possible 3 The dilemma pre-srr Allow the bank to be placed into insolvency depriving depositors of access to money and banking services, and risking wider instability through contagion and loss of depositor confidence; or Use public funds to keep open or bail out all bank creditors simply to secure position of depositors, contributing to moral hazard. 4 2

3 The conventional tools for bank restructuring Resolution regimes developed to address this dilemma tend towards the following general features: An ability to split the balance sheet of a bank by statutory transfer. Power to intervene in pre-insolvency and ahead of a run on the bank An ability to warehouse part of the business in a bridge bank pending eventual sell-off to private sector. 5 The UK s response: The Banking Act special resolution regime Applicable to UK incorporated banks and building societies Trigger based on a regulatory assessment by FSA Use of a pre-insolvency tool by Bank of England only if necessary to protect financial stability, confidence in the banking sector or depositors (or, if TPO, by HMT only if serious risk to financial stability) Actions of the resolution authority guided by balancing these public interest objectives together with protection of public funds and compliance with ECHR (the SRR Objectives ). A Code of Practice offering a more detailed guide as to use of the tools Compensation mechanisms for creditors including a no creditor worse off safeguard Further safeguards for certain protected arrangements An ability to call on the deposit insurance scheme to contribute to the costs of resolution. 6 3

4 SRR Tools Transfer (by operation of law) of part or all of failed bank s shares or business to a private sector purchaser. Transfer of part or all to a Bank of England bridge bank. Temporary Public Ownership (TPO) of failed bank. Bank Insolvency Procedure (BIP): normal insolvency but with priority to facilitate fast payout or transfer of insured depositors. Bank Administration Procedure (BAP) in case of a partial transfer. 7 Practical issues in selection of tools The selection and effectiveness of resolution tools will also be driven by: Whether or not a prospective buyer exists or is likely to be found The amount of contingency planning The quality of information about a bank s business, assets and liabilities The challenges of cross-border resolution: 8 4

5 Implications for netting arrangements The implications for netting will clearly depend upon the choice of tool. Whole bank solutions (TPO, insolvency) will have relatively few implications for netting. But where TPO is not necessary and insolvency cannot meet the SRR objectives, a resolution is likely to involve a partial transfer of property 9 Partial transfers Partial transfers of some but not all of the assets and liabilities of a bank to a transferee could disrupt netting in two ways: It can lead to the separation of rights and obligations that are subject to a netting agreement ( cherry-picking ) It can override a counterparties ability to exercise rights to close-out under the netting arrangement 10 5

6 Splitting up netting arrangements An unconstrained ability to cherry-pick contracts within netting arrangements would: remove a counterparty s ability to gauge its exposure to a bank in resolution. potentially impact on capital treatment if a lack of legal enforceability caused regulators to require exposures to be calculated on a gross basis. 11 UK statutory safeguards for netting Secondary legislation (Banking Act 2009 (Restrictions of Partial Property Transfers) Order 2009) to prevent the resolution authority from separating rights and obligations contained within a netting or set-off arrangement. A transfer in breach of the netting safeguard has no effect on the set-off or netting But the statutory protection is subject to certain key exceptions. 12 6

7 Exceptions to the netting safeguard The following rights and liabilities are excluded: Deposits held in accounts mainly used or marketed to FSCS eligible claimants; Loans made to FSCS eligible claimants Contracts entered into not in the course of carrying on an activity under BCD Annex 1 or relating to relevant financial instruments Rights/liabilities relating to damages or indemnity claims Subordinated debt Rights/liabilities relating to transferable securities 13 Relevant financial instruments Financial instrument Instrument within Section C, Annex 1 MiFID Any option, future, swap, forward, cfd or other derivatives contract not within above, or any combination of these Deposit Loan Corporate debentures, loan stock, bonds etc Contract for sale, purchase or delivery of Transferable securities Currency of the UK or other country or monetary union Palladium, platinum, gold, silver, other precious metal Other commodity 14 7

8 Consequences of the netting safeguard on resolution Can significantly add to contingency planning and to the shape of a partial transfer Transfer may end up being on a counterparty-bycounterparty basis rather than on an asset class basis Issues may still arise in respect of foreign contracts that are not transferred by the statutory powers Where a netting arrangement will end up in a resolution depends on the particular facts in this regard, the statutory safeguards can make it harder to treat all counterparties the same. 15 Overriding close-out rights Problems if contracts covered by netting arrangements are closed out immediately upon transfer. For example: They may hedge or service an integral part of the transferred business They may have been transferred to avoid a contagion risk in the market that could be triggered by mass closeout A mass close-out of amounts owed by the transferee could risk destabilising it. 16 8

9 Treatment of close out under the Banking Act The Banking Act confers a general ability on the resolution authority to override contractual termination rights that arise by virtue of the transfer. But it was decided to restrict this power in relation to netting and set-off arrangements An uncomfortable policy choice but the risks of closeout are mitigated by an ability to transfer these liabilities back to the insolvency The proposed EU framework may not offer this protection. 17 To conclude In the absence of another whole bank tool that can achieve policy objectives (bail-in?), resolution will generally operate through splitting a balance sheet. Importance of protecting netting is well understood and hard-wired into the regime in the UK (and the proposed regime in the EU) but exceptions to this protection are necessary to ensure that resolution remains feasible. 18 9