The Bank of England and the Federal Deposit Insurance Corporation (FDIC) issued on 10 December a joint paper on the resolution of global systemically important financial institutions (G-SIFIs).
The most important aspect of this paper is confirmation that the Bank of England intends to follow where possible a top-down “single point of entry” approach to the resolution of G-SIFIs. The FDIC has long favoured such an approach.
The Bank of England believes that the proposals in the paper are consistent with the EU’s draft Recovery and Resolution Directive, even though the Directive is based more on a “multiple points of entry” approach.
Implications for firms
The main implication of a "single point of entry" approach to resolution is that G-SIFIs would have to put into place:
- A group structure based on a parent holding company;
- The ring-fencing of (domestic and overseas) subsidiaries that undertake critical economic activities, so that the continuity of these activities can be more easily maintained in a resolution;
- Sufficient debt issuance at holding company level to enable the group to be recapitalised in a resolution through the conversion of this debt into equity;
- Using this holding company debt to make loans to subsidiaries, so that subsidiaries can be supported in a resolution through writing off these loans.
However, it is less clear what would happen where:
- A G-SIFI is funded mostly through retail deposits. At least for UK G-SIFIs the answer is to follow the EU’s draft Recovery and Resolution Directive (RRD) and to treat the Deposit Guarantee Scheme as a creditor that can be bailed-in, with the costs of this falling on other firms who have to fund the Scheme.
- A UK G-SIFI chooses to issue debt lower down the group. The joint paper envisages an alternative approach here, at least for UK groups, under which debt is issued by the top operating companies within a group. This seems to be a half way house between the “single” and “multiple” points of entry approaches.
- An overseas G-SIFI has substantial operations in the US. The latest pronouncements from the Federal Reserve suggest that these operations would have to held through a US holding company. It is not clear whether the US authorities would then seek to resolve the US operations on a stand-alone basis (by applying the “single point of entry” approach within the US), or would stand back and allow the overseas parent to be resolved without the US authorities taking action.
- Overseas subsidiaries need to be resolved because they are both loss-making and are undertaking critical economic functions. It may not be possible or efficient to resolve them through an injection of capital from the parent holding company.
- Overseas resolution authorities choose to exercise their own national resolution powers to intervene in the overseas subsidiaries – or even branches – of US and UK G-SIFIs. This would be consistent with the "multiple points of entry" approach that underpins the EU RRD, and with the growing trend towards "localisation" under which overseas host authorities seek to protect their national positions through the ring-fencing of the operations of foreign firms in their countries.
In the detail…
The “single point of entry” approach to resolution has long been favoured by the FDIC, and the joint paper contains no new insights on how this approach would be operated by the FDIC. Further detail around the FDIC approach can be found in our publication, Bail-in liabilities: Replacing public subsidy with private insurance.
Similarly, the Bank of England has stated in the past that it was inclined to favour a similar approach, but this is the first time that it has set out in any detail how this might be applied to UK G-SIFIs.
As described in the joint paper, the essence of the “single point of entry” approach to resolution is that:
- A group is structured under a (largely non-operational) holding company;
- This holding company issues sufficient debt to enable any losses and any required recapitalisation to be met through converting this debt into equity in a resolution. Both the draft RRD and the UK Government’s plans for implementing the ICB recommendations include requirements that banks have sufficient capital and debt in issue to make them resolvable using bail-in or other resolution tools;
- Although initially a group taken into resolution would be “owned” by the FDIC (in the US) or under a trustee arrangement (in the UK), the intention is that the group would be returned to private ownership, with the creditors whose debt is converted into equity becoming the new owners of the group;
- The continuity of critical economic activities is preserved because – in most cases – the subsidiaries of the holding company should be able to continue in operation, either because they have remained solvent and viable, or because they can be recapitalised through the writing down of intra-group loans made from the holding company to its subsidiaries. A subsidiary would need to be resolved independently only where it had suffered large losses and where it undertook critical economic activities.
The joint paper includes further details on how this general approach would operate in the UK context, including the transposition of the EU RRD into UK legislation (which is of particular importance in providing the powers under which the UK authorities would be able to bail-in debt issued by a holding company). These details include:
Role of a trustee
The equity and debt of a holding company would be held initially in a resolution by a trustee. The trustee would hold these securities during a valuation period in which the extent of the losses expected to be incurred by the firm would be established and, in turn, the recapitalisation requirement determined. During this period, listing of the company’s equity securities (and potentially debt securities) would be suspended. Once the recapitalisation requirement has been determined, an announcement of the final terms of the bail-in would be made to the previous security holders.
On completion of the exchange the trustee would transfer the equity (and potentially some of the existing debt securities written down accordingly) back to the original creditors of the firm. Those creditors unable to hold equity securities (for example, for reasons of investment mandate restrictions) would be able to request that the trustee sell the equity securities on their behalf. The trust would then be dissolved and the equity securities of the firm would resume trading.
During resolution, a valuation process will need to be undertaken to assess the losses on assets that the group firm has incurred and the capital needed under stress assumptions to restore confidence in the group. This will determine the extent to which creditor claims should be written down and converted. The valuation process will also determine what financial instruments if any - for example, common equity in the new group or warrants - the different classes of original creditors of the firm should receive.
The authorities in both the UK and the US are considering how much of the valuation process can be prepared in advance of resolution; whether new financial statements would be required; and whether the firm's external auditors would need to be replaced for the valuation process to provide sufficient comfort to the market that the continuing operations were fully (re)capitalised and solvent.
Equal treatment of creditors
Consideration will need to be given to ensuring that debt issued at the top of a group (or in the top operating companies) that is subject to foreign law can be written down or converted alongside liabilities subject to the law of the home jurisdiction. This may require the inclusion of contractual recognition of foreign resolution proceedings within debt contracts.
Enabling losses to be imposed on debt held in top operating companies would require careful planning given that senior unsecured bonds typically rank alongside other unsecured liabilities that are unlikely to be bailed-in. Detailed consideration of this part of the resolution strategy for individual banking groups will need to take account of the precise provisions of the RRD as eventually passed into law.
Official liquidity support
It is recognised that a group in resolution may require official liquidity support. This would only be provided on a fully collateralised basis with appropriate haircuts applied to the collateral to reduce further the risk of loss. In the unlikely event that losses were associated with the provision of temporary public sector support, such losses would be recovered from the financial sector.
Where a group is funded primarily through insured retail deposits held in the operating subsidiaries, Deposit Guarantee Schemes may be required to contribute to the recapitalisation. The proposed RRD permits such an approach by allowing Deposit Guarantee Scheme funds to be used to support the use of resolution tools, including bail-in.
The joint paper recognises the importance of cross-border cooperation, and the importance of Crisis Management Groups. However, the tone of this section of the paper implies a top-down application of the “single point of entry” approach. There is little appreciation that overseas authorities may feel excluded from resolution planning and that this may further reinforce the growing trend towards “localisation” through the ring-fencing of foreign groups’ operations in overseas countries.