Recovery and resolution planning (RRP) is part of wider, international efforts to promote the stability of the financial markets through the use of consistent contingency and resolution plans required under new legislation. Financial institutions must understand the details of RRP legislation and plan for RRP implementation in 2012. Michael Beaton, managing partner at Derivatives Risk Solutions offers an introduction into RRP in the UK.
BACKGROUND
Introduction
The roots of recovery and resolution planning (RRP) can be traced back to the financial crisis of 2007-2008, and the collapse or near collapse of the following household names:
• Sept 2007: Northern Rock;
• Mar 2008: Bear Stearns;
• July 2008: Bradford & Bingley;
• Sept 2008: AIG;
• September 2008: Lehman Brothers;
• Oct 2008: Royal Bank of Scotland;
• Oct 2008: Halifax Bank of Scotland.
These events prompted the G20 to declare at Pittsburgh in September 2009 that all “systemically important financial firms should develop internationally-consistent firm-specific contingency and resolution plans…to help mitigate the disruption of financial institution failures and reduce moral hazard”.
The Current Context of Recovery and Resolution Planning
Recovery and resolution planning forms part of a wide, international effort to promote stability within financial markets. This is a multi-faceted initiative, incorporating measures regarding capital, liquidity and stress testing for financial institutions, promotion of central counterparty clearing, market reform and regulation of the funds industry. Regulatory developments specifically focused on recovery and resolution planning include:
• the Financial Stability Board’s (FSB) consultation on Effective Resolution of Systemically Important Financial Institutions;
• the EU Commission proposals on crisis management;
• the FSA Rules on Recovery and Resolution Plans as detailed in CP 11/16; and
• the Independent Commission on Banking (ICB), chaired by Sir John Vickers, which issued its final report in September 2011.
RECOVERY AND RESOLUTION PLANNING IN THE UK
Recovery and Resolution planning in the UK has its legislative roots within the Financial Services and Markets Act 2000 (particularly sections 139B and 139C), the Banking Act 2009, the subordinated legislation enacted thereunder, and the guidance issued by the FSA within CP11/16.
Application
The RRP provisions of CP 11/16 apply to the following institutions:
• UK incorporated deposit-takers covered by the Financial Services Act 2010
This includes foreign branches of UK institutions, but excludes UK branches of foreign institutions. However, with respect to the UK branches of foreign institutions, the FSA would expect that the relevant sections of RRPs will be made available by home regulators and regard evidence of acceptable RRPs being in place as an important condition for firms to be able to establish and maintain branches in the UK.
• Credit unions and some insurers who have permission to accept deposits
• Investment firms that could present “significant risks” either to the stability of the financial system or to one or more entities within their group which are regulated by the Prudential Regulation Authority.
At a minimum, this will include all full scope BIPRU 730k investment firms with assets exceeding at least GBP 15 billion.
The requirements of RRP may also be extended to other types of financial services firms in the future (after consultation), with specific mention being made of insurance companies.
The proposals relating to CASS Resolution Packs apply to all firms subject to CASS 6 or 7 by virtue of their holding of client money or custody assets.
Timetable
Firms will have to submit initial RRPs to the FSA in June 2012. It is envisaged that the initial submission process will assist in identifying barriers to resolution. These barriers are to be removed over the course of the 12 to 18 months that follow the initial submission. By the end of 2013/beginning of 2014 it is envisaged that this process will be complete and firms will be firmly bedded down into the process of submitting annual RRPs to the FSA.
The policy relating to CASS Resolution Packs will come into force six months after the publication of the relevant policy statement. The policy statement is currently expected in Q1 2012, meaning that compliance with the CASS Resolution Pack requirements will come into force in Q3 2012. However, given recent criticism of the drafting of the CASS rules by the Supreme Court, it is possible that the publication of the policy statement may be delayed.
RECOVERY PLANS
Introduction
Recovery Plans are developed and maintained by individual firms. The role of the authorities within a recovery planning context is not to draft the plan itself, but rather to review the adequacy of the plan. Within a recovery plan, firms are required to identify a menu of options which can be implemented in order to assist the firm to return to a “stable and sustainable condition” should it come under severe stress.
Recovery Plan Triggers and Early Warning Signals
Recovery Plan Triggers
Given their wide scope, recovery plans must include unambiguous and forward-looking ‘triggers’ of both a quantitative and qualitative nature which, when breached, will create a strong presumption that the plan will be activated. Each recovery plan should be reviewed at least annually and approved by the board of directors of the firm in question.
Early Warning Signals
In addition to the triggers described above, recovery plans should also include early warning signals. These early warning signals would not, of themselves, trigger the plan, but would “act as a starting point within the firm to allow action to be taken to avoid further stress”. Examples of early warning signals would include:
• the invocation of the firm’s contingency funding plan;
• negative market sentiment or perception towards the firm, possibly measured by liquid market-based indicators (e.g. widening of a firm’s CDS spread relative to peers, unexpected fall in share price relative to peers etc);
• an expectation of a drop in a firm’s credit rating; and
• utilisation of a firm’s Capital Planning Buffer.
Recovery Plan Options
The options detailed within a recovery plan must contemplate a number of different stress scenarios, whether they are the result of:
• problems which are idiosyncratic to the firm in question;
• market-wide problems; or
• a combination of the above.
The options under consideration will typically go far beyond the firm’s current regulatory stress testing scenarios, such as those addressing capital shortfalls and liquidity pressures. Any options which are identified should be complemented by appropriate governance processes designed to ensure timely implementation of the appropriate recovery options irrespective of the type of stress scenario. These processes must be integrated within the firm’s existing risk management framework.
Criteria for assessing recovery options
The FSA places great emphasis on a firm’s recovery options being “credible”. In reality this means that the recovery options need to be material in impact and capable of being executed with relative ease and in a timely manner. Specifically, the options proposed under a recovery plan should meet the following criteria:
• the benefits should be capable of being realised within an acceptable timeframe – preferably no longer than six months;
• the benefits should be material, individually and in the aggregate – in the FSA’s words, they must be capable of ‘moving the dial’;
• in combination with the firm’s existing crisis management tools, they should collectively be sufficiently diverse; and
• they should be credible to key stakeholders such as depositors, debt holders, counterparties, shareholders and the authorities.
Typical Recovery Options
It is likely, that the Recovery Plan will feature options that the firm would not consider in less severe circumstances such as:
• disposals of businesses or entities;
• withdrawal from certain markets;
• raising equity capital which has not been planned for in the firm’s business plan;
• complete elimination of dividends and variable remuneration;
• debt exchanges and other liability management actions; and
• sale of the whole firm to a third party.
RESOLUTION PLANS
Introduction
In contrast to recovery planning, in which the firm is responsible for producing the plan, resolution planning requires firms to submit detailed information about their business and operational structure to authorities. From this information the authorities will produce the resolution plan, the general aim of which is to provide a strategy and detailed roadmap to ensure that the firm in question is “resolvable”. The FSB regards a firm as being “resolvable” if it is “feasible and credible for the resolution authorities to resolve it without taxpayer exposure to loss from solvency support, while protecting vital economic functions”. Resolution packs must also be reviewed at least annually and the board of the firm in question is responsible for ensuring that there are processes in place to produce timely and accurate data.
Specific Aims of the Resolution Plan
The information and analysis in the Resolution Pack provided to the authorities as part of CP11/16 will help the authorities to prepare a resolution plan with the following aims:
• to ensure that resolution can be carried out without public financial support;
• to seek to minimise the impact on financial stability;
• to seek to minimise the effect on depositors and consumers;
• to allow decisions and actions to be taken and executed in a short space of time (for example, over a ‘resolution weekend’);
• to identify those economic functions for which continuity is critical to the economy or financial system;
• to identify those economic functions which would need to be wound up in an orderly fashion;
• to identify and consider ways of removing barriers to effective resolution;
• to allow a resolution that separates the identified critical economic functions from non-critical activities which could be allowed to fail; and
• to enhance international cooperation and crisis management planning between international regulators for globally significant financial institutions.
Resolution Tools
In order to resolve a failing institution, authorities will have a number of ‘tools’ at their disposal which may be applied singly or in conjunction. These tools will include:
The Sale of Business Tool
This tool enables a resolution authority to transfer assets of, or instruments of ownership relating to, a failing institution to a purchaser. The consent of the shareholders of the institution under resolution or of any third party will not be required. However, there will be provisions designed to protect creditors against ‘cherry picking’.
The Bridge Institution Tool
A bridge institution is an institution controlled by one or more public authorities, but operated on a commercial basis, the main purpose of which is to ensure that essential financial services continue to be provided to the clients of an insolvent institution. A resolution authority can transfer assets belonging to an institution which is subject to resolution without obtaining the consent of the shareholders or any third party, and without complying with any procedural requirements under company or securities law that would otherwise apply. Again, however, safeguards apply to protect creditors against partial transfers of assets or other property.
The Asset Separation Tool
The asset separation tool must only be applied in conjunction with another resolution tool. The tool enables authorities to transfer under-performing or impaired assets to a separate vehicle, or ‘bad bank’ with a view to maximising their value through eventual sale or otherwise ensuring that the business is wound down in an orderly manner. As with the other tools, no consents are required in order to effect the transfer. However, safeguards are in place to protect creditors against partial transfers.
The Debt Write-Down Tool
The debt write-down tool is designed to minimise the cost to the public purse of resolving a failing institution by:
• writing down debt in order to recapitalise a failing institution; or
• converting debt to equity in order to reduce the amount of claims that are transferred to a bridge institution.
Subject to certain limited exceptions, the debt write-down tool can be applied to all unsecured liabilities of a failing institution but must respect the pari passu treatment of creditors and applicable statutory creditor insolvency rankings.
CONCLUSION
The impetus behind the political agenda underpinning international recovery and resolution planning shows no sign of abating. The quasi-public nature of the service provided by banks, coupled with the overriding desire within government to ensure that public funds never again bail out a financial institution, means that RRP is to be regarded as a permanent fixture. A high-level summary cannot assist in helping firms understand the true scale of the administrative burden implied by RRP. By design, recovery and resolution planning is a task that is both large in scale and intellectually challenging in scope. 2012 is the year when firms will be required to get to grips with the detailed provisions of RRP legislation and the practical difficulties of RRP implementation. For those firms which do not commit to a sufficient degree of forward planning in this area, 2012 promises to be a difficult year.
