10 August 2011

ICFR: Being resolute on resolution

Richard Reid of the International Centre for Financial Regulation comments that one of the key elements of the G20's programme for the pursuit of financial stability is the establishment of an effective framework for the rescue or resolution of failing financial institutions.

While much of the regulatory response thus far has focused on improved quantity and quality of capital and liquidity needs as well as more effective and proactive supervision, it is felt by many that in order to address, at least in part, the issues of moral hazard as well as minimising the cost to the taxpayer, a central plank of any regulatory response must include the tools and mechanisms to allow for the winding down of a failing institution with as little as possible risk to the overall provision of financial services and economic and financial stability. Although some countries have made progress on domestic arrangements, reaching workable solutions for cross-border resolutions is fraught with a range of both theoretical and practical issues.

It may also be worth underlining that many of the issues to be addressed to achieve effective cross-border resolution mechanisms will need some time to be agreed upon and organised. Hence, the danger is that a preoccupation with economic fundamentals could consign regulation to the backwaters. In its latest assessment of the EU’s proposals on resolution, for example, the ECB notes that the EU Commission plans, by the end of 2012, to decide whether a reform of bank insolvency regimes is required and by 2014 will make an assessment of “how a more integrated framework for the resolution of cross-border groups might be best achieved (e.g. though the creation of an EU Resolution authority and/or EU resolution fund)” (ECB, July 2011). And this is just within the European context. When broadened to include a global reach, especially for the large systemically important financial institutions (SIFIs), the complexity of reaching effective mechanisms on any near-term timescale is plain to see. But, presumably financial regulators and monetary authorities will be keenly aware of the need to underpin stability in the near-term, especially given the fragility of financial markets.

In addition to contributing to the reduction of the moral hazard question, having in place credible resolution mechanisms can improve the costs of failure and the trade-off between costs and financial stability. For example, an IMF study in 2009 (Figure 1) showed that the existence of a special resolution regime (SRR) was preferable to a disorderly bankruptcy or an injection of public funds under ordinary bankruptcy mechanisms. This is because it imposes on the owners of the failing institution some or all of the losses that would otherwise be carried by the taxpayers. The existence of the SRR also allows the authorities more flexibility (and time?) to explore the trade-off between fiscal costs and systemic risk containment.

The inherent “financial trilemma” (Schoenmaker, 2011) has been highlighted as a key policy issue to be dealt with: this suggests that a stable financial system, an integrated financial system and national financial autonomy are incompatible. In the context of the current sovereign debt crisis, this “financial trilemma” is also another way of arguing that a greater degree of fiscal “Europeanisation” will be required. This has of course always been seen as an inevitable tendency under the creation of the single currency but such fiscal harmonisation can take a very long time – as the history of the US has shown.

The ECB also refers to some of the more theoretical proposals which have been put forward to address a new crisis management framework. These include ex-ante legally binding burden sharing rules, a stringent rules-based framework (similar to the US), or even a full-blown European resolution authority, perhaps in concert with European deposit insurance and resolution funds.

It will be interesting to see if recent events surrounding the sovereign debt crisis in the EU and the role of the ECB and various autonomous fiscal authorities will lead in the autumn to calls for major changes to European economic and financial governance mechanisms. There have already been political rumblings to this effect with calls in Germany for example for a Euro area ‘stability council’.

The FSB’s latest consultation focuses first on four key elements of “good resolution” plus a discussion of two additional points for further consideration (points 5 and 6 below). Subsequent to the consultation, the FSB will revise the proposals and submit to the G20 as part of measures to address moral hazard for the G20 summit in Cannes, 3-4 November.

1. The key attributes of effective resolution regimes (including dealing with SIFI’s and bail-in proposals [known under the EU rules as debt writedowns]);
2. Cross border arrangements (proposed minimum elements of institution specific cooperation agreements);
3. Planning for resolution (the framework for Recovery and Resolution Plans [RRPs] which are mandatory for SIFIs);
4. Removing obstacles to resolvability (especially for complex firms);
5. Creditor hierarchy, depositor preference and protection;
6. Conditions for imposing temporary stays (suspension of contractual early termination rights to support some resolution tools).

As a generalisation, most of the questions posed for consultation concentrate on asking for an assessment as to whether or not the proposals are comprehensive enough to cover all the measures which might be considered, and if the proposals strike the right balance between being specific enough to be effective yet flexible enough to be adaptable to the range of jurisdictions they are likely to apply to. In some cases respondents are asked to comment on the range of liabilities likely to be affected by any bail-in measures and, also more broadly, what respondents consider would be the effect of these proposal on the provision of credit and therefore by extension to the economy. The consultation also asks for views on how statutory duties between home and host authorities could be framed. In addition, the FSB seeks comments about the timeline for having in place resolvability assessments for SIFIs (by December 2012).

Many of these questions will elicit answers from the institutions themselves and from the legal companies which are specialists in dealing with financial institutions. There will inevitably be a range of responses given that the balance sheets of the financial institutions and their mix of business, both domestic and international, will differ markedly. But the momentum for pushing ahead with plans to develop resolution mechanisms is now well advanced and it seems unlikely that the consultation in its final form will differ markedly from the current iteration. However, this is not the same as saying that effective mechanisms will be in place anytime soon. Moreover, in this ‘implementation phase’ for financial regulation, the opportunities for both national discretion in application as well as the difficulty of designing one-size-fits all solutions suggests the framework for resolution regimes will remain quite flexible.

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