Resolution: Managing the failure of large financial institutions

Regulatory Briefings
Last update: October 2012
Resolution: Managing the failure of large financial institutions
Perspectives from
• Regulators
• Industry
• Academics
Regulators consider
resolution regimes to be one
of the most important
initiatives of recent years,
but appear to have
recognised the limits of
international coordination…
Industry groups have been
supportive, but some have
criticised a perceived lack of
ambition over the
international dimensions,
calling for a legally binding
treaty…
Academics point out that
cross-border resolution has
been a problem for decades,
and that current plans do
not go far enough to
harmonise divergent
domestic legal
environments…
The International Centre for Financial Regulation
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• Resolving failing financial institutions quickly and saving core functions is crucial
in a crisis
• The Financial Stability Board is leading international efforts with its ‘Key
Attributes for Effective Resolution Regimes for Financial Institutions’
• Resolution is entering the implementation phase for banks, although discussions
are ongoing about a possible extension to systemically important non-banks
SUMMARY: Resolving large failing financial institutions has been a struggle for
regulators and insolvency practitioners for decades. New rules requiring large firms
to draw up ‘living wills’ and ‘recovery and resolution plans’ (RRPs) make major
steps towards solving the problem, but significant questions remain over crossborder
coordination. 2012 marked the beginning of the implementation phase,
with pilot schemes ongoing, and the first sets of resolution plans required.
However, the idea also looks increasingly likely to be extended to non-banks, such
as insurers, giving rise to fresh rounds of consultation.
Resolution effectively replaces insolvency proceedings for banks. During the financial
crisis, politicians were caught between the rock of allowing large, complex banks to
enter administration, and the hard place of tax-payer funded bailouts. With the
notable exception of Lehman Brothers Holdings Inc., governments opted for the
latter. However, the political appetite for future bank bail-outs is, to say the least,
very low. Resolution as an alternative to insolvency is therefore an attempt to resolve
this dilemma.
Resolution is best thought about as a set of legal techniques for restructuring failed
institutions and their balance sheets. The aim is both to preserve financial stability,
through the preservation of ‘critical functions’ provided by the failed bank, and to
prevent the widespread value destruction and contagion which insolvency creates for
banks, epitomised by the Lehman bankruptcy.
There are a number of initiatives ongoing examining the possible extension of
resolution regimes to systemically important non-banks, which may include insurers
and central counterparties (CCPs). However, authorities undertaking consultations
have taken pains to make clear that these discussions are at an early stage, with no
presumption that resolution tools are appropriate for non-bank institutions.
Constructing and maintaining resolution plans will entail significant compliance costs
on a continuous basis. Substantial amounts of work will need to be undertaken,
particularly in terms of firms understanding the consequences for their business
models, which may need to be significantly simplified to convince regulators that the
negative consequences of firm failure could be contained without systemic
consequences or loss to the taxpayer. The stability benefits of an effective resolution
regime for banks are generally recognised, but comprehensive global implementation
will be a difficult and drawn-out process as both industry and regulators feel their
way through new territory. It is also important to note that there are substantial
barriers remaining for the creation of a truly cross-border resolution framework, not
least of which is an apparent lack of political will.
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The ICFR Regulatory Briefing on Resolution October 2012
Details in Brief
Resolution is multifaceted. The FSB’s Key Attributes
sets out 12 principles and over 60 sub-principles that
resolution regimes should adhere to, and are intended
to be applicable both to banks and non-banks.
Core among the aims of resolution regimes is to
preserve systemically important functions performed
by financial institutions. To make this possible, a
resolution framework comprises a range of powers,
legal techniques, and forms of cooperation agreements
between firms and their often multiple supervisors.
Although there are outstanding questions about the
precise point at which resolution will be ‘triggered’, a
firm will enter resolution generally when it is close to,
but not at, the point of balance sheet insolvency, and
after its recovery plan has failed to restore it as a going
concern. At this point senior management will be
replaced, and a ‘resolution authority’ will take control
of the institution. Resolution authorities will have the
“It isn’t whether the bank
fails or not. It is how it is
handled subsequent to its
failure that matters. And we
have to find a way.”
C.T. Conover, Former US Comptroller of the
Currency, speaking in the wake of the 1984 failure
of Continental Illinois which gave rise to the term
‘too big to fail’.
power to restructure the balance sheet and the firm itself, to terminate contracts, to sell assets or whole sections of
the firm, and so on. Such authorities may establish a ‘bridge institution’, which can continue to operate the firm in
resolution. They may also establish an asset management firm to take control of ‘bad’ assets.
Resolution authorities may also trigger a ‘bail-in’, whereby senior creditors have their debt claims converted to
equity in order to fund the firm through resolution. Bail-in itself presents significant difficulties, but represents only
one of many powers that resolution authorities will possess. The need for bail-in points to a more general funding
problem associated with resolution, as firms in resolution will need not just equity in order to operate, but significant
amounts of liquidity, which may well have to be provided through official channels.
Firms will be subjected to ‘resolvability assessments’ by their ‘crisis management groups’ (CMGs – groups of
supervisors responsible for dealing with firms in crisis situations). The FSB has advised that banks will be resolvable if
their resolution plans are both “feasible” and “credible”. There is a degree of uncertainty at present as to how such
terms will be interpreted, and it may be that more experience of resolution is needed in order to set precedents.
Until such experience is gained, there will be inevitable concern that regulators adopt an overly cautious approach.
As an example of the potential impact of such a concept, the FSB’s Key Attributes, suggest supervisors or resolution
authorities should have powers to require changes to firms’ business practices or structures in order to improve
resolvability. Such changes could be required without an institution actually being in danger of entering resolution.
Progress has been made in a number of jurisdictions. The Dodd-Frank Act creates the Orderly Liquidation Authority
(OLA) through which the Federal Deposit Insurance Corporation (FDIC) can go beyond its existing resolution powers.
In the EU, the European Commission published its resolution Directive proposals in June 2012, and these are
currently being negotiated with the European Parliament and Council. The Commission has called for the legislation
to be expedited as part of its broader plans on bank union, but the final shape of the legislation remains uncertain.
The UK has been ahead of the curve on resolution, although it has been waiting for the final EU Directive before
proceeding further. However, the UK’s Financial Services Authority (FSA) has committed to publishing final rules by
autumn 2012 at the latest. In Japan, regulators are yet to provide detailed guidance on their expectations for such
plans, and several other jurisdictions, such as Hong Kong, are only in the early stages of work on resolution.
There are a number of consultations being conducted with respect to non-bank resolution. In August, HM Treasury
in the UK consulted on the issue, followed in October by the European Commission. However, both consultations
made clear that it was an open question as to whether resolution would be appropriate for non-banks. The
International Association of Insurance Supervisors (IAIS) recently confirmed that insurers designated as systemically
important would be expected to develop recovery and resolution plans, and has stated that the FSB’s Key Attributes
would form the basis for improving resolvability. However, no insurer has as yet been designated as systemic.

The ICFR Regulatory Briefing on Resolution October 2012
The Regulators
Regulators have consistently identified resolution as a fundamentally important part of the future of financial
regulation, and crucial to overcoming the “too big to fail” problem. The FSB has coordinated international work, with
regular input from a wide range of countries. The FSB has also stated that it sees resolution as providing “incentives
for market-based solutions.” As an example of this, the UK’s FSA has stated that it would leave trigger points for
initiating recovery plans down to firms, rather than mandate them. However, it was made clear that these should be
set at “appropriate levels,” in order to prevent proactive regulatory intervention. A further example of such
incentives can be seen with so-called ‘bail-in’ capital, whereby debt can be converted into equity when a triggerpoint
is breached. Regulators have been keen to stress that statutory bail-in regimes, which could be triggered by
regulators, should not prevent firms from entering into private contractually-based bail-in agreements with higher
trigger points than statutory bail-in would require, thus reducing the need for regulatory intervention.
Regulators have pointed to a crucial difference between the objectives of special resolution regimes and the
objectives of corporate insolvency proceedings. The former have a “public interest” objective, such as the
maintenance of financial stability, while the latter are designed to achieve the best outcomes for creditors.
Regulators have recognised the implications this may have for the creditor hierarchy in insolvency, and the FSB has
accepted that the creditor hierarchy should be preserved in resolution.
The Basel Committee on Banking Supervision noted in July 2011 that the various new Special Resolution Regimes
brought in after the crisis fail to address the difficulties of resolving whole financial groups, with particular
shortcomings in the cross-border context. Even with the FSB’s new principles, however, the problem of resolving
cross-border institutions looks set to remain. The FSB has stated that “there is no immediate prospect of [a] formal
multilateral agreement addressing the set of issues raised in the resolution of financial institutions” and that binding
mechanisms “will not be feasible” until existing proposals are already in place. In this respect, regulators have
recognised the limits of international coordination, and appear to be taking a pragmatic approach to the short-term.
Regulators are currently examining whether and how to extend resolution principles to non-banks.
The Industry
The industry’s views have been laid out in responses to consultation papers and industry-led research. Interestingly,
the FSB has acknowledged a “significant minority” of respondents to its 2011 consultation who pointed to an
apparent lack of ambition in the FSB’s proposals. This group included a range of large, cross-border banks, as well as
various banking associations, such as the British, French and German bankers’ associations. There were concerns
that there will still be a “considerable danger that national self-interest may prevail over global interest in the
resolution of a global SIFI.” It was argued that it is the responsibility of the FSB and G20 to promote a more
ambitious programme, and many called for an internationally binding treaty.
Construction and maintenance of recovery and resolution plans will require extensive work by firms, with
consequences for governance, strategy, and structure. “Resolvability assessments” will require firms to convince
resolution authorities that it is “feasible and credible” for those authorities to perform a resolution without severe
systemic disruption or taxpayer loss. This will be a continuous and demanding process. However, resolution planning
has also brought benefits by forcing an acquaintance with and understanding of complex legal structures. It is clearly
in the interests of firms to have robust recovery plans, as successful recovery planning may stave off resolution.
While the banking industry is in some jurisdictions advancing through the process of writing plans and working with
regulatory authorities, other industry sectors are only beginning their journeys, and not all are supportive. For
instance, many in the insurance industry are keen to point out that several aspects of resolution are designed with
the specificities of the banking sector in mind, and highlight fundamental differences in business models between
banks and insurers as a reason why resolution should not be applied to the insurance sector. However, work is
continuing at both national and international levels, revolving around the issue of systemic importance. There is also
resistance from investment firms to proposals to extend the net broadly over the sector. However, support for an
extension to cover central counterparties has been widespread, given the likely systemic importance of these
institutions as a result of new requirements for over-the-counter derivatives to pass through such institutions.

The ICFR Regulatory Briefing on Resolution October 2012
The Academics
Richard Herring points out that the problems of cross-border resolution have been with us for many decades. To
name but a few cases, Herstatt (1974), BCCI (1991), Barings (1996), LTCM (1998), Fortis (2007-8), Dexia (2008), the
Icelandic system (2008), and of course, Lehman Brothers (2008), to which we can now add MF Global, are all
illustrative of the difficulties of resolving failing institutions with cross-border operations. Unfortunately, despite this
“long, troubling history”, Herring argued as recently as 2011 that “no real progress has been made.”
Schoenmaker and Osterloo investigated the cross-border externalities of firm failure in Europe in 2004, concluding
that the extent of cross-border externalities is closely tied with the extent of cross-border banking business, but that
national authorities tend to focus on national consequences rather than cross-border externalities. Schoenmaker
notes that without a convergence of national interests there are few incentives for internalising these externalities.
It is interesting to note in this regard the rise to prominence of concerns for systemic consequences and stability,
which may prove to be the glue with which to join national interests in a world of cross-border banking. However,
there is often a gap between agreement in principle and committed action in practice.
For Avgouleas, Goodhart and Schoenmaker, the problem of cross-border resolution is that there is a “gross
incompatability” between global cross-border reality and national regulatory/legal attempts to respond. They point
to a continuing divergence in insolvency regimes between jurisdictions, between those that operate a “territorial”
approach, whereby assets held in a particular country are ring-fenced, and those that operate a “universal”
approach, whereby the group is treated as a whole, across borders. Institutions which operate in multiple
jurisdictions may as a result be subject to conflicting regimes, which may create conflict between regulators and
insolvency practitioners. This marks a “glaring weakness” in the system. It is not clear that this weakness has been
addressed by existing proposals, though many academics recognise that significant progress has been made in many
other respects.
Outstanding Issues
Practical implementation of recovery and resolution regimes is now crucial. However, implementation often throws
up difficulties, both expected and unexpected. Progress is likely to be regionally diverse. Both US and UK banks have
achieved much, owing to the proactivity of their respective regulators, who required draft plans in 2010. This
progress is not reflected in the EU or Japan, and particularly in the latter, where guidance is yet to be published.
However, in all cases it appears that recovery plans are being prioritised over resolution plans, for which less work
has been done in all jurisdictions. The level of work required for the resolution aspects plans will vary depending on
banks’ domicile There is a danger that the sheer difficulty of rationalising complex banking structures to such a level
as to satisfy regulators of their resolvability will delay the process. Companies should not underestimate the extent
of the work required, both now and on a continuous basis in the future.
The core problems for cross-border resolution remain the divergence of local legal systems for dealing with
insolvency, and the lack of an international burden-sharing protocol for funding the resolution of failed firms. Given
that regulators believe a binding treaty to be infeasible, the key developments will be the ongoing drafting and
revision of banks’ plans, as well as the requisite data collection. More progress on cross-border elements may come
in time as current plans are assessed and regulators can compare theoretical aspirations against practical outcomes.
But regulators will need to work together closely to overcome mistrust between home and host authorities.
Resolution is of course more complicated for systemically important financial institutions (SIFIs). By definition, the
failure of these institutions will have systemic implications, and it is an open question as to whether resolution tools
which may work for single non-systemic institutions will function as intended in the midst of a systemic crisis.
Finally, the extension of resolution regimes to non-bank institutions such as insurance companies, investment firms
and CCPs will provide more difficulties for regulatory authorities and firms themselves. Discussions about non-bank
resolution are in their relative infancy, and a lot is still to play for in terms of the eventual outcomes.
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