Without a destination in mind, any road may seem like a good option. But for banks reviewing their business models and operating structures, a lack of clarity on major regulatory reforms could lead them down the wrong road. This is especially the case with recovery and resolution planning (RRP), which could drive structural change across the industry. Andrew Davidson, Principal Advisor at KPMG, considers this further.
Recovery and Resolution Strategies - setting the direction for travel
The attention of the G20 is switching from addressing bank failure and interdependency to ensuring that systemically important institutions are capable of failing both without systemic disruption and without putting public finances at risk.
While the final framework and rules will be designed with the large global banks in mind, all deposit takers must take action.
The first step is to create a recovery strategy that provides senior management with a clear set of options to protect their position in a crisis, including the practicality of quickly exiting core businesses, selling subsidiaries and/or conserving capital and liquidity.
A parallel resolution strategy outlines the options for regulators to manage the demise of the bank in a 'controlled' manner. Identifying and removing potential financial and operational barriers to separating out legal entities as well as unplugging critical economic functions, should allow deposits and good assets to be transferred or sold whilst bad assets are put into receivership or run-off.
Anticipating the inherent conflict between commercial operating structures and resolution structures, a capital surcharge is proposed to reflect the size, interconnectedness and resolvability of a bank. As is a framework enabling unsecured debt to be written-off or converted into loss absorbing equity (the 'forced bail-in' principle).
This may help to re-introduce market discipline and allow the cost of failure to be shared while the bank is still a 'going concern', but possibly at the expense of higher funding costs for the industry and end customer.
While RRP planning is likely to provide a better understanding of operating structures and their associated risks (not to mention improve overall corporate governance), it should also drive changes in market practice, rules governing the infrastructure connecting banks, and the legal or economic conditions under which resolution is managed. Banks' strategic decisions will need to factor these in.
For RRPs to meaningfully contribute toward reducing the chance of potential bank failure or government support whilst boosting market confidence, a number of key challenges remain:
Providing legal certainty for stakeholders
All stakeholders need to understand their position in relation to a resolution, its process and options (e.g. early equity injection, deposit transfer/bridge bank and liquidation/depositor pay-off or stripping out specific functions).
This decreases the probability of irrational behaviour which would jeopardise the resolution plan. Furthermore, it could introduce uncertainty into mature markets, while the danger of forced bail-ins may increase funding costs or create a further shift toward the encumbrance of bank assets.
Providing confidence that the recovery strategy is grounded in reality
Many potential recovery options may become unviable when an extreme stress triggers the recovery plan, and competition rules may restrict viable banks from purchasing assets. Indeed, it is possible that some recovery plans may boil down to an ability to raise fresh capital/liquidity before the buffers and contingent facilities have been exhausted, or investor appetite dissipates.
Providing confidence that the resolution strategy is grounded in reality
Although it may be possible to address legal, financial and operational dependencies to 'unplug' critical economic functions, certain bank products and services are intrinsically linked even in resolution (e.g. current accounts remain linked to deposit and lending products, and all three require the use of payment services).
Moreover, some customers may require multiple products and services to remain within a single banking group post-resolution (e.g. where a single property acts as collateral against lending and risk management products). Therefore, decisions need to be made on which products and services are critical to the real economy, and thus need to be preserved through resolution.
Clarity is also important on whether these products and services will need to be ring-fenced within bank legal entity structures, or even within industry-wide utilities. This will influence the urgency with which regulators need to tackle the inherent risks within banks' operating structures highlighted during resolution planning.
Given the time it takes for banks to adapt to changing conditions, some transformation may be required before they arrive at their final and desired regulatory destination. Effective recovery and resolution planning should stop banks from heading too far down the wrong road!