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FSC 2018 – Summaries Controversy

Under the headline ‘Credibility of the Resolution Regime and Preference of Creditors: First Experiences with Decision Making, Liability and Bail-in’ first the resolution director of the Federal Financial Supervisory Authority introduced with an impulse, and thereafter regulators, academics and industry experts discussed in particular how credibility can be improved and the resolution regime be better implemented.

Financial Stability Conference 2018
31 October 2018
Controversy  –  Impulse
Controversy  –  Discussion

Credibility of the Resolution Regime and Preference of Creditors: First Experiences with Decision Making, Liability and Bail-in

Dr. Thorsten Pötzsch, Chief Executive Director of the Resolution Directorate, Federal Financial Supervisory Authority

Controversy  –  Impulse

Thorsten Pötzsch started his keynote by recalling that the financial crisis peaked almost exactly ten years ago with the collapse of Lehman Brothers, which was followed by calls for a credible alternative to government bail-outs for banks that were generally considered “Too Big To Fail”. The idea was that the risk should be borne by those who enjoy the economic benefit rather than by the taxpayer. The European resolution regime is frequently criticised for its lack of liquidity and that resolutions fail due to this, a non-transparent decision-making process and insufficient credibility of the system as a whole. Nonetheless, since we started out about ten years ago the European resolution regime has been created as a completely new system, he underlined. Even though the project is not yet complete, constantly adjusting certain parameters can help to further raise the regime’s credibility.

In this regard, Thorsten Pötzsch elaborated on four topics of major importance and its premises. Firstly, clarity is key in terms of transparency and predictability in resolutions, but there are limits to it. The need for transparency to boost credibility of resolution decisions stems from the fact that keeping aspects of a resolution arrangement secret does not work. It is important that investors and other stakeholders, in other words the markets, have an understanding of whether or not a bank is resolvable. Public disclosure of the MREL requirements and the actual amount of MREL eligible own funds and liabilities clearly enhances transparency for market participants. However, enhancing transparency is a balancing act, since transparency on specific resolution decisions and the decision-making process should be limited by the requirements of professional secrecy and confidentiality on behalf of banks. A sound transparency policy should not require the disclosure of business secrets, which by themselves put the bank at a competitive disadvantage.

As a second premise Thorsten Pötzsch noted that a forward-looking planning and analysis of liquidity are key factors for successful resolution, which in the end needs to be a reliable and credible alternative to uncontrolled insolvency. Liquidity in resolution needs to be addressed both before and during resolution planning, because preventions is vital. Alertness and prevention considerably reduce risks, he pointed out. But even with the best possible prevention, fast and efficient assistance in a distress situation is needed and fosters market confidence. The Single Resolution Fund has the ability to provide such assistance, and for further improvement it might be extended by the availability of funds through a backstop. Over the last few years, great accomplishments have been made to create a much better system, which is to be continued going forward. Still, more clarity on the Lender of Last Resort issue is needed.

Thirdly, tailored and harmonised national adjustments to insolvency regimes could support the resolution regime. Before resolving an institution it is assessed how creditors would be treated under normal insolvency proceedings. Nevertheless, individual creditors might end up being worse off after resolution, in which case the SRM ensures respective compensation via the Single Resolution Fund. The principle of “No Creditor Worse Off” is crucial for the credibility of resolution. The real issue, though, is that insolvency regimes across the SRM appear to be fragmented implying that the liability basis is national while the compensation scheme is shared. We should strive for harmonised and tailored adjustments to insolvency regimes, where necessary, Thorsten Pötzsch said. Such adjustments would lead to consistent no-creditor-worse-off compensation across the SRM while simultaneously raising credibility of the resolution regime. Moreover, the introduction of the bail-in rules would have the dual effect of not just governing the recommended bail-in process, but also of promoting more market discipline, since they have shaken people’s belief that banks can be too big to fail. However, if a bail-in is to be a credible option, then the existing rules need to by applied and enforced.

At last, Thorsten Pötzsch formulated his fourth premise on the enforceability of a bail-in noting that initial experiences in Denmark and the Banking Union have demonstrated that a bail-in can be applied effectively. With MREL, TLAC, reporting obligations and other provisions regulators and supervisors have created the necessary conditions for a bail-in to be possible. Banks, on their part, must issue sufficient amounts of bail-inable instruments, provide respective data, and it must be possible for these instruments to be bailed in without undue complexity. Finally, banks must make investors and debt holders aware of the risks of these instruments.

These four premises illustrate how the European resolution regime “ten years after“ can be made even more weatherproof and credible. Of course some key areas still need more work to ensure greater precision and effectiveness, but the foundation for this detailed work is the credibility of the resolution regime. In a brief summary Thorsten Pötzsch reiterated the following aspects as necessary to achieve this credibility, such as greater transparency in the decision-making process, more clarity about a “Lender Of Last Resort” to provide a bridge for short-term liquidity shortfalls, harmonised fine-tuning of the national insolvency rules and finally practical rules that allow a bail-in to actually be carried out.

Credibility of the Resolution Regime and Preference of Creditors: First Experiences with Decision Making, Liability and Bail-in

with Giuseppe Boccuzzi, Director General, Italian Interbank Deposit Protection Fund; Samy Harraz, Head of Policy Coordination and International Relations, Single Resolution Board; Dr. Thorsten Pötzsch, Chief Executive Director of the Resolution Directorate, Federal Financial Supervisory Authority; Dr. Sven Schelo, Partner, Linklaters, Prof. Tobias Tröger, Chair of Private Law, Trade and Business Law, Jurisprudence, Goethe University Frankfurt; moderated by Prof. Bart Joosen, Professor of Financial Law, VU University Amsterdam

Controversy  –  Discussion

Bart Joosen introduced the panelists and first collected initial thoughts on the current resolution regime in terms of credible results or how credibility could be improved.

Giuseppe Boccuzzi remarked that the new legal resolution framework is in place but needs to be completed and implemented further. A major issue is that MREL requirements were established only in the aftermath of creating bail-in, which reduces credibility. Liquidity funding constitutes another challenge, as central bank money is also needed before and after resolution. Moreover, having 19 different national insolvency legislations in the face of the new resolution framework at EU level is another pending issue as well as the complexity of the decision making process in resolution with too many actors involved. Finally, the resolution fund needs to be strengthened through a public back stop in order to improve upon the status quo. Subsequently, Samy Harraz acknowledged that great accomplishments were made on the path towards the current resolution framework even in the light of resistance and a seemingly over-complexity. “We should be more optimistic and proud of what we have achieved rather than listening to those calls from clearly interested parties that want to break it all down.” Opposing the allegation of insufficient transparency he noted that public authorities require a certain level of trust to act appropriately in the decision making process that is free of any conflict of interests. Hence, trust and transparency go hand in hand.

Sven Schelo highlighted that resolution is a variance of insolvency law in a failing or likely to fail situation constituting a case by case assessment and demanding tailor-made solutions, which also holds for the resolution regime and tools. “The belief that the resolution regime works like a mechanism is wrong from the outside.” Whether the resolution regime will work hinges on whether there is sufficient bail-inable, ideally subordinated and clearly defined capital as well as a concept post bail-in with a set of business tools. Banks that are largely refinanced by deposits therefore do not have sufficient bail-inable capital, and pose a challenge to resolution. In such, insolvency might present a more practical solution, since most of these banks are either small or medium sized. Still, interlinkages with deposit protection schemes have to be accounted for. Tobias Tröger viewed resolution results as hardly credible and not in line with the social optimum due to a conflict of objectives within the regulatory framework. That is, ex-post efficient outcomes from tailor-made solutions require a high degree of discretion, which in turn impedes market discipline and its pricing mechanism. “For investors to price the associated risk correctly, they need to have an idea of the resolution outcome at the time of investment.” Therefore, the ex-ante incentive effect of the regime depends on the predictability and transparency of the outcomes, Tobias Tröger said. To disentangle these objectives there are capital instruments that are risk bearing as to induce market discipline among investors and others that are loss bearing in resolution. Thorsten Pötzsch in turn stressed the importance of avoiding tax payers‘ money in the resolution process as noted by Samy Harraz. Assenting Giuseppe Boccuzzi, he recognised complexity to be a challenge to resolution, which, however, does not prevent workable results as can be seen in the Banco Popular case. Furthermore concurring with Tobias Tröger he noted that transparency is crucial for market investors to assess bail-in instruments. “Still, we are even more transparent with the resolution regime we have created”, Thorsten Pötzsch said.

Bart Joosen asked whether it made sense to publish MREL requirements for the various institutions and how much credibility was needed to prepare the market for potential resolution consequences and risks from bail-in instruments. Sven Schelo expressed great scepticism towards publishing MREL quotas or even resolution planning given that banks are special institutions that are sensitive towards investor behaviour depending on trust, refinancing abilities and safe deposits. Making resolution scenarios public bears the risk of circumvention and flexibility, and as well liability issues prevail once the authority chooses a resolution scenario other than previously published. Samy Harraz clarified that the current EU regulations do not allow publishing this kind of information while banks are free to publicly state their loss-absorbing capacity. Otherwise he agreed with Sven Schelo that to publish ex-ante resolution strategies in a given crisis would be self-defeating. Thorsten Pötzsch added that indicative resolution plans are not legally binding, but may be changed upon external factors thereby failing to provide reliable information for investors. He remained very hesitant to publish resolution plans acknowledging that the European system is still very young, which is why business models as well as any impediments and critical functions of resolution need to be analysed first. In the midterm, given some years of precedents, further publications could be discussed, but so far this kind of transparency should be treated very carefully.

In contrast to the panel, Tobias Tröger advocated the disclosure of resolution plans. In the midst of a resolution, asset managers may very well understand regulatory deviations from the previously published plan. Nonetheless, investors taking relevant information from it is to whether there is a credible resolvability assessment. Pointing towards the harsh treatment of US institutions on the resolvability assessment of particularly large bank owes to the fact that they have published the resolution strategy to some degree and were then exposed to market criticism. Samy Harraz responded that US comparisons are misleading, since there exists an environment with up to 80 years of resolution precedents, and the legal situation differs drastically. Tobias Tröger agreed that a litigious system prevails in the US, but in contrast it is no solution for the European system to paper over law violations and remain opaque.

On MREL quotas Thorsten Pötzsch noted that they do not harm if publicised and might lead to more clarity as an additional financial figure that is legally binding from 2019 onwards. Tobias Tröger denied that markets might potentially evaluate banks with higher MREL quotas as being weaker, because they are rationally justified and can induce desirable price effects. Investors are unlikely to misinterpret the MREL quota as to derive false default probabilities from it. Samy Harraz intervened to clarify that MREL does not necessarily tell investors where they are going to end up in a bail-in scenario, because moreover there is liability other than MREL that could go ahead. The interesting piece of information for investors is to see how much there is overall and their own relative position in the stack. Still, he doubted that MREL quotas represented a useful indicator for investors also given that loss given default reveals little about the actual default probability. Tobias Tröger persisted that MREL quotas might not deliver precise information, something which investors are well aware of, but they are still valuable and generate at least more certainty.

Resonating with the panel, Giuseppe Boccuzzi summarised that while transparency was important for market discipline, it cannot be the only solution to guarantee credibility and predictability of resolution. “We should avoid over-confidence in the resolution, because it embodies a mere simplification of what can happen in the future.”

Going forward, Bart Joosen touched upon the ECB‘s role as a Lender of Last Resort stepping in and providing liquidity to ensure that banks can operate the day after resolution. Such a strong commitment, however, could be abused and create moral hazard risks. Sven Schelo viewed the liquidity issue more connected to resolution than to central bank lending, since for the latter strict rules on securities are in place. However, the issue of where stable funding comes from in a bank post resolution presents an even greater challenge. If resolution is combined with a set of business tools, such capital ideally comes from the safe haven of a new investor. An otherwise potentially dangerous open bank bail-in situation could jeopardise a lot of trust and be an expensive solution. Giuseppe Boccuzzi criticised that the new resolution framework focusses more on solvency funding and less on liquidity funding, which is also very important pre resolution in the case that banks are unable to meet prudential requirements when preparing for resolution. It is important to ensure additional funding, because in an open bank bail-in the bank is restructured and recapitalised without any additional financial resources while some outflow of funds might occur in the process. This would be a case for Emergency Liquidity Assistance (ELA) instead of a Lender of Last Resort scenario, but still require a major ECB involvement. Moreover, it takes a clearer role of the resolution fund in terms of providing loans and liquidity to banks in resolution and an effective backstop for it.

Samy Harraz reflected on the interplay of liquidity and resolution noting that banks should first rely on internal then private sources and ultimately it needs a credible public source of liquidity. He warned that the Single Resolution Fund, even with a backstop, could not cover liquidity shortfalls of European large banks that could easily go into the three figure billions. Instead, the ECB‘s role and capacity as a Lender of Last Resort to stabilise significant institutions is unchallenged. While public facilities are not to be used in resolution, more clarity in advance on the terms and conditions for access to a Lender of Last Resort function makes it less likely to be applied. Thorsten Pötzsch stressed that a solution is needed for when liquidity coming from either the buyer, the market or the Single Resolution Fund proves to be insufficient, which could either be an increased common backstop or the ECB as Lender of Last Resort. For the latter, moral hazard problems can be counteracted by stating clearly defined conditions of liquidity access and by having no automatism but discretionary decisions such that no bank can naturally rely on this solution.

The first remark from the audience clarified that the Lender of Last Resort function is to solve liquidity but not capital adequacy problems. Moreover, ELA constitutes an expensive measure, because the actual lending in case of a national commercial bank default is done by the national central bank, which also takes associated losses, not the ECB. Moreover, ELA implies heavy recapitalisation programs including large lay-offs, divestitures and intensive consolidation. As for NPLs, to simply wipe them off the balance sheets obviously does not erase payment problems in a real world setting. Tobias Tröger concurred that the objective of the resolution regime is to have a solvent and viable bank post resolution with sufficient trust in the market to provide its essential services instead of liquidity problems. In terms of Lender of Last Resort, moral hazard plays less of a role, since the parties involved have no incentive to rely on this ex-post liquidity provision through the ECB given that resolution was executed in view of precisely avoiding such a situation. Giuseppe Boccuzzi added that by definition banks are solvent after resolution and additional funding should merely support the resolution process, otherwise it would not be credible. As on ELA, Tobias Tröger highlighted that provisions to Greek and other banks show that it is no mechanism to avoid harsh resolution measures.

Furthermore, some concerns were raised about the level of communication between the SSM, the Single Resolution Board and the ECB in a resolution case which is crucial for a smooth resolution operation. Samy Harraz admitted to some teething problems regarding the exchange of data due to legal impediments, but by now the dynamics have changed for the better with close cooperation and a sufficient level of trust.

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