05 October 2012

Commission launches consultation on a possible framework for the recovery and resolution of non-bank financial institutions

Executive summary

Financial institutions other than banks offer a range of useful and essential services for various participants active in financial markets. These include clearing and settlement, asset management, insurance, trading of various financial instruments etc. Many of these services constitute vital components for the orderly functioning of the financial system, without which socio-economic welfare would suffer.

Like banks, these institutions need to be suitably regulated in view of the public interest at stake. The EU regulatory framework governing the functioning of financial markets aims to ensure that their business sustains and furthers the smooth and orderly functioning of financial markets in all respects. This framework also minimises the risks which their business can, either individually or collectively, represent for other market participants, investors, policyholders, and financial stability in general.

Like banks, these institutions can nonetheless end up in severe financial or operational difficulties which can result in their failure. Regulation can minimise the likelihood of this occurring but it can never preclude it entirely. The event of failure can, depending on the entity, assume varying proportions. For example, the failure of a clearing house amid overwhelming financial tensions in case its members default on their dues can severely impact financial stability.

This consultation paper focuses on these cases. First, it looks to ascertain how and when the failure of a financial institution other than a bank can threaten financial stability. The main institutions considered in this respect are financial market infrastructures, such as central counterparties and central securities depositories, and systemic insurance companies. Second, it considers what arrangements could be needed to prevent their failure from compromising financial stability.

However, in this context it does not delve into the regulation applicable to the daily operations of these institutions, which is covered in other work streams. The focus here is on the extraordinary measures which could be necessary to contain the fallout from failure, not on the regulation which is necessary to mitigate the risks and negative externalities inherent in their business. In other words, the focus is on what is variously termed crisis management or recovery and resolution, not on prudential or market conduct rules.

The principles agreed at the G20 and the Financial Stability Board (FSB) seek to ensure that no financial institution, whether a bank or another financial actor, should be too big to fail. Currently, faced with an imminent failure of a significant financial institution, existing tools available to public authorities may not always be sufficient to enable an orderly recovery or resolution of the situation. In such cases, authorities may have no choice but to provide public support at taxpayer expense to prop up the ailing institution. The alternative – the threat of mass disruption to the financial system and to the economy – would be even more costly.

Contrary to banks, which while not identical tend to fail in similar ways, the question of when the failure of a nonbank financial institution can threaten financial stability is less evident. With the exception of central counterparties and central securities depositories which operate transactions for vast market segments, it is arguably more difficult to establish in advance which other nonbanks are likely to be systemically relevant at the point of failure than it is in the case of banks. However, like banks, this is very likely to be closely linked to how extensive, interconnected and/or substitutable their business is in ordinary times. Furthermore, a nonbank failure of systemic proportions may plausibly take different forms, materialising either in the shape of a serious solvency problem, an overwhelming technical malfunction, or combination of the two.

Still, the financial crisis has demonstrated that the sources and possible channels of contagion of systemic risk can vary significantly. During an institution's lifetime, it is not always possible to foresee its systemic relevance at the point of demise. This consultation therefore looks broadly at how different nonbank financial institutions can fail and cause systemic problems, and what should be done about it. While this consultation paper focuses on the nonbank institutions the failure of which could most clearly cause financial instability (central counterparties, central securities depositories, systemic insurance companies), it also asks questions whether some other institutions could be systematically relevant in this context and, if so, whether and how recovery and resolution mechanisms could also be applied to them.

Consultation

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