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FSC 2019 – Summary Panel III

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Under the headline ‘Making Resolution Work: How to deal with Legal Loopholes, Institutional Implementation Challenges and Impediments to Practice’ first the board member of the Single Resolution Board Sebastiano Laviola introduced with an impulse, and thereafter regulators, policy and industry experts discussed in particular how the resolution regime can be put on a credible and reliable practicable track.

Financial Stability Conference 2019
28 October 2019
Panel III  –  Impulse
Panel III –  Discussion
Summariy

Making Resolution Work: How to deal with Legal Loopholes, Institutional Implementation Challenges and Impediments to Practice

Sebastiano Laviola, Board Member, Director of Strategy and
Policy Coordination, Single Resolution Board

Panel III  –  Impulse

Sebastiano Laviola started his impulse speech on how to make resolution work anticipating that there is no silver bullet for it. While the Single Resolution Board (SRB) has done a substantial amount of work in terms of resolution, this enterprise is in line with a ‘marathon, not a sprint’ analogy. Banks have to progressively get up to speed and to the level of being resolvable utilizing suggestions by the SRB authorities, which in turn have to continuously push towards this goal.

So far, the SRB has built several policy guidances and orientation papers to account for different aspects of resolution, and to then progressively develop resolution plans. As has been declared, in 2020 the SRB will be in the steady-state with the entirety of banks covered with decisions concerning the approval of resolution plans and MREL decisions at the consolidated and internal level. Subsequent measures include firstly, effectively implementing the rules via the Banking Package as devised by the political masters. Secondly, communicating the tools, time frame and direction of travel to banks, and thirdly, assessing what is working and what still needs fine-tuning. In this regard, the SRB profits from an open and constructive dialogue with stakeholders characterized by transparency to jointly achieve the goal of resolution.

In 2020 the SRB will be in the steady-state with the entirety of banks covered with decisions concerning the approval of the resolution plans and MREL decisions.

Elaborating on the panel‘s first topic of legal loopholes, Sebastiano Laviola emphasized the need to harmonize national insolvency laws as otherwise an EU administrative bank liquidation or regulation framework will have to be implemented. This lack of harmonization in the EU liquidation regime is an obstacle to completing the Banking Union (BU). For instance, a no-resolution decision by the SRB would require national authorities to apply their insolvency procedures, which widely differ between the 19 different countries. Therefore, the analysis of the insolvency counterfactual is a challenge, especially given the ‚no-creditor-worse-off‘ criterion, and may result in diverging outcomes depending on the home country of the institution. As a second consequence, the definition of failing or likely to fail (FOLTF) is a forward-looking concept and if its definition is not common among national insolvency frameworks, there is a risk of declaring a bank FOLTF, when this is not the case according to a judicial procedure in that country.

A step forward in the new BRRD is that national resolution authorities and the SRB commit to undertake everything possible to have an orderly resolution or liquidation. Beyond that, it proposes an EU bank administrative procedure, possibly following the FDIC model, which is equipped with a range of tools and under a purchase and assumption procedure can provide for the exit of the bank‘s liquidated part and the selling to a competitive procedure, thereby respecting the least cost criterion. For the issue of funding, the deposit guarantee schemes (DGSs) might be used while providing for issues of arbitrage and state aid. If this was to become a centralized tool, it could pave the way for a European deposit insurance scheme (EDIS).

A step forward in the new BRRD is that NRAs and the SRB commit to undertake everything possible to have an orderly resolution or liquidation.

On the panel‘s second topic of institutional implementation challenges, Sebastiano Laviola noted that even with a functioning resolution measure, following the resolution weekend a bank might be well-capitalized, but still faces a liquidity issue as the market needs time to regain confidence in that bank. The SRB needs to bridge this time-confidence gap and ensure financial continuity. While the common backstop will cover all uses of the Single Resolution Fund (SRF) to provide liquidity, it is not enough to address the liquidity needs of mid-sized to large banks. Therefore, discussions to find a solution for liquidity in resolution are ongoing at the European level. On the other hand, banks have to do their part as well, and private resources need to be mobilized first before public tools are being used. Banks have to be able to measure and identify all the sources of funding and liquidity that are needed in resolution, particularly concerning the mobilization of collateral including cross-border.

While the common backstop will cover all uses of the SRF to provide liquidity, it is not enough to address the liquidity needs of mid-sized to large banks in resolution.

The issue of financial continuity led Sebastiano Laviola to the panel‘s final topic of impediments to practice stating that among other resolvability elements, loss-absorbing and recapitalization capacity are especially crucial to a successful implementation of a resolution strategy. While the SRB already specifies consolidated and internal levels of MREL, new regulation provides a significant change in terms of quality and quantity, calibration of the entire amount, subordination and precisely defined internal MREL. The SRB works hard to release the final paper on SRMR2/BRRD2 MREL policy by the first quarter of 2020, which will form the basis for the MREL setting under the new framework. As of January 2021, the legislation will come into force, provided that the BRRD2 has been implemented at the national level.

Building up MREL can be challenging for medium-sized banks that have no history in issuing unsecured debt. Therefore, the SRB pursued a gradual approach to MREL with transition periods for each bank.

Building up MREL can be particularly challenging for medium-sized banks that have no history in issuing unsecured debt in the wholesale markets. Therefore, the SRB consistently pursued a gradual approach to MREL with transition periods adapted to each bank‘s funding ability. Despite difficulties, data for the first half of 2019 indicate a substantial gross amount of MREL-compliant liabilities. Under the current favorable conditions and buoyant financial markets, banks should exploit the maximum level possible to continue on the path towards resolvability, which would otherwise be much harder once the cycle turns. Sebastiano Laviola concluded that ensuring resolution is a process that takes time, and eleven years after the beginning of the crisis, significant work remains for the SRB to be done.

Making Resolution Work: How to deal with Legal Loopholes, Institutional Implementation Challenges and Impediments to Practice

with Cristina Dias, Parliamentary Research Administrator, European Parliament; Sebastiano Laviola, Board Member, Director of Strategy and Policy Coordination, Single Resolution Board; Sven Schelo, Partner, Linklaters LLP; Reto Schiltknecht, Head of International Affairs and Policy Issues, Recovery and Resolution Division, FINMA; Carola Schuler, Managing Director, Financial Institutions Group, Moody’s; moderated by Luís Silva Morais, Professor of Law, University of Lisbon

Panel III  –  Discussion

Luís Silva Morais welcomed the various expertise on the panel to critically assess the obstacles to resolution and to discuss how to ensure an orderly market exit for banks opening with a round of observations.

Cristina Dias highlighted transparency and disclosure as key elements to ensure the credibility of resolution frameworks and acknowledged the decisive steps of the Single Resolution Board (SRB) at the institutional level to ensure an adequate resolution regime, while doing important educational work of explaining resolution to market participants.

Transparency and disclosure are key elements to ensure the credibility of resolution frameworks.

Still, the main issue remains on whether capital markets have enough information to assess the resolvability of an institution. In this respect, resolution plans are crucial for investors, but still not publicly available in the EU in contrast to the US and UK. However, increasing transparency is also a balancing act between forgone investments due to insufficient resolution information and the risks from disclosing information that investors do not understand. Therefore, transparency has to be linked to financial education, and market participants have to understand exactly what the information is about, also in terms of risks, to avoid bank runs and disruptions of the financial system. Nonetheless, with greater transparency, resolution authorities need to be able to make decisions that differ from their originally provided guidance given the circumstances of the case.

With greater transparency, resolution authorities need to be able to make decisions that differ from their provided guidance given the circumstances of the case.

Every system of transparency and disclosure on resolution needs to be coupled with a number of safeguards. Insights from stress tests before and during crisis demonstrated that to disclose non-confidential parts of resolution plans it requires a clear time framework for disclosure, a simultaneous publication of information on all banks, and coordinated communication between the various authorities involved.

Sven Schelo focused on the large number of mid-sized banks across Europe, which are refinanced by deposits, have limited access to capital markets and ergo little opportunity to build up MREL capital for bail-in. They are less likely to be in the public interest of resolution and therefore subject to insolvency at the national level. However, for a bank with 30 to 40 billion Euro on its balance sheets, no national deposit scheme would be refunded to such an amount to ensure all deposits of up to 100.000 Euro. In this context, national banks would have to refill the deposit protection scheme via ex-post contributions. Consequently, the deposit base of mid-sized banks constitutes a challenge that has to be solved to avoid a state aid situation. One solution to facilitate ordinary insolvency proceedings is to find some form of pre-financing for this deposit protection scheme, possibly through EDIS or the European Stability Mechanism. Alternatively, liquidation that is fully funded by the assets on the banks‘ balance sheets presents another option to avoid insolvency, as the capital ratios of mid-sized banks are typically sufficient to cover all liabilities, though not enough for shareholders. Sebastiano Laviola added that while a full harmonization of insolvency frameworks would take too much time, an administrative tool is needed now, especially for cases where there is no resolution decision for a mid-sized bank, which is also a cross-border level playing field issue.

One solution to facilitate ordinary insolvency proceedings is to find some form of pre-financing for this deposit protection, possibly through EDIS or the ESM.

On Luís Morais‘s question of how to overcome difficulties related to MREL requirements, Sven Schelo remarked that MREL has evolved to an almost obligatory capital requirement that is more difficult for mid-sized banks to meet. The problem with MREL in the form of material ready for bail-in ready at resolution in the form of subordinated liabilities is that banks would have to take up those liabilities at the bond market, to which they have no access. Alternatively, MREL waivers in the case that no resolution strategy can be applied lead back to insolvency, either in the form of an open bank bail-in or a sale/transfer of business to an investor. For this, however, senior liabilities have to be written off, which possibly destroys confidence and makes it more difficult for a bank to operate. On these grounds, a workable solution for smaller banks to comply with MREL is difficult.

In this regard, Carola Schuler made the observation that recently capital markets appear to appreciate small to mid-sized banks that start to communicate their MREL gap and a plan on how to close it. They start by issuing Tier 2 and Additional Tier 1 (AT1) capital getting ready to eventually issue senior non-preferred bonds. Favorable conditions for absorption are given by a highly liquid market where there is a search for yield in a low interest rate environment. On a more cautious note, she emphasized that banks, either small or large, need a high creditworthiness in order to convince investors to buy their resolution capital instruments. So, given today‘s interest rates, size alone is no longer the only barrier.

Favorable conditions for absorption of senior non-preferred bonds are given by a highly liquid market where there are a search for yield and low interest rates.

Subsequently, Reto Schiltknecht provided a Swiss perspective on handling the two domestic GSIBs, UBS and Credit Suisse, which have an estimated two-thirds of their balance sheets abroad primarily in the UK and the US. On the first aspect of funding in resolution, he stressed that free flows of funds in capital and liquidity are essential to overcome a crisis scenario. Therefore, Swiss authorities estimated a respective liquidity need by defining a stress test scenario with a gradual outflow of liquidity coverage ratio (LCR) over 90 days. As a result, a relatively large deficit of liquidity was observed at the parent bank level, while at the same time there was a substantial liquidity surplus in the UK and the US. To improve upon these results, solutions include increasing the LCR, discussing workable management actions to create additional liquidity, forcing banks to build up more sophisticated models for their liquidity needs, and introducing a public backstop. Reto Schiltknecht then explained that, at the end of the day, resolvability is a test of whether the machine with all its different components works; that is to say, it is the proof of the pudding. Substantial work and unsolved challenges remain in the area of the after restructuring and after bail-in phase given the structure of wholesale banks with large trading books outside as well as inside Switzerland. In this regard, the UK, as well as shared experiences with the US, serves as an orientation as far as insurance and testing are concerned.

Substantial work and unsolved challenges remain in the area of the after restructuring and after bail-in phase given the structure of wholesale banks.

From a creditor‘s perspective, Carola Schuler considered the lack of disclosed resolution plans to be one of the largest barriers to the credibility and effectiveness of resolution. Investors and capital markets need reliability, credibility and a clear understanding of what would happen in resolution, she underlined. To hold back resolution plans from the public domain limits the understanding of respective processes, loss-absorption requirements and the distribution of loss-absorption material among group entities. If investors cannot understand the real resolution risk, they are likely to not invest or to demand an additional risk premium. Authorities can always change their mind as unexpected barriers to the execution of a resolution plan might arise, which the market would not mind. But some planning certainty is necessary, she said.

Investors and markets need reliability, credibility and a clear understanding of what would happen in resolution. If they cannot understand the real risk, they are likey to not invest or demand a premium.

Regarding liquidity in resolution as another obstacle, Carola Schuler explained that the recapitalizationo of a bank is not enough to restore market confidence. Therefore, it needs the public sector, access to the central bank and liquidity to get banks back into the market. Moreover, markets need to have the confidence that authorities have access to these tools ahead of time. Lastly, she considered inconsistencies in insolvency legislation and creditor hierarchies across Europe as the most contentious issue. Modifications in form of the BRRD 2 still entail too many deviations constituting a real barrier to resolution, particularly for cross-border groups. In addition, Sebastiano Laviola highlighted the negative repercussion for the ‚no-creditor-worse-off‘ criterion, as some countries have a different hierarchy between resolution and insolvency.

With respect to Cristina Dias and Carola Schuler, Sven Schelo expressed concern about publishing bank-specific resolution plans, as it might have unforeseeable consequences and destroy trust, which is essential for banks and difficult to restore. Investors might need to accept that there is no silver bullet for resolution, and in reality resolution can never be fully predictable, he pointed out. While acknowledging the balancing act between as much transparency as possible and respecting the roles and responsibilities of different actors, Carola Schuler replied that nonetheless the market is desperate for more information, and the lack of it leads to volumes and pricing of bail-in liabilities not coming along and hence deviating prices, which is neither in the interest of banks nor financial stability. Reto Schiltknecht distinguished between two fundamentally different levels of transparency regarding what authorities should publish about the state of a bank‘s resolvability in contrast to measures they would take in resolution. From a Swiss perspective, he indicated that an upcoming resolution report will cover taken measures, potential loopholes, assessment of banks‘ progress on resolvability and partial information on resolution plans in the limited scope of the Swiss emergency plan.

Investors might need to accept that there is no silver bullet for resolution, and in reality resolution can never be fully predictable.

Luís Morais summarized the panel‘s topics of transparency, communication policy, the particular issue of mid-sized banks between resolution and insolvency as well as the issues of liquidity in insolvency proceedings and resolution.

On the first remark from the audience on the measure of early intervention for mid-sized banks instead of either resolution or liquidation, Sven Schelo responded that such precautionary recapitalization measures might be a way out of this dilemma but also present a loophole as it is some kind of bail-out. Prior to the BBRD, precautionary recapitalization might have worked in cases of some Southern European banks, but this is likely to be different in the future. Sebastiano Laviola added that overall the BRRD framework was designed for idiosyncratic cases, while authorities are working on an analytical framework for issues of contagion and indirect effects on the real economy. Regarding another comment on the Emergency Liquidity Assistance (ELA) for mid-sized banks, Sebastiano Laviola ensured that while there is no discrimination towards mid-sized banks to be subject to ELA, they still have to face the condition of adequate collateral. Sven Schelo noted that this issue constituted a political balancing act, as ELA might sometimes appear to delay the inevitable. Reto Schiltknecht added that before ELA comes into play, there are other possibilities for the central bank to inject liquidity, and he raised the question of the quality of collateral.

The BRRD framework was designed for idiosyncratic cases, while authorities are working on an analytical framework for issues of contagion and indirect effects.

The final question referred to whether a US-like reversal of the burden of proof should be introduced when calling for greater transparency in Europe, as more transparent jurisdictions typically have a resolution system with a higher level of legal certainty. Though possibly convenient for regulators, Cristina Dias considered a reversal of proof would put excessive pressure on investors, which is unwarranted. While transparency and certainty are important, public authorities need to be able to stand for scrutiny and explain their decisions without benefitting from more favorable legal conditions.

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