Weighing the Balance: The Cost of (and of not) Implementing a Living Will

Michael Beaton, managing partner at Derivatives Risk Solutions explains that although the cost of of implementing a Living Will is significant, the cost of not implementing a recovery and resolution plan may outweigh any minor cost savings from doing the minimum.

The Cost of Implementing a Recovery and Resolution Plan

By any measure, the costs of properly implementing a recovery and resolution plan (RRP) are significant.  Using the FSA’s own cost-benefit analysis conducted as part of Consultation Paper CP11/16, the costs to firms of preparing and maintaining a Recovery and Resolution Plan (excluding the costs associated with CASS Resolution Packs) over the next five years are:

These figures seem to be supported by anecdotal evidence.  Bob Diamond, former CEO of Barclays testified before the Treasury Select Committee on 8 June 2011 that Barclays had, at that point, spent over GBP 30 million on the production of its recovery and resolution plan.  More recently, a survey conducted by Ernst & Young concluded that UK firms estimated spending USD 20 million on average on the production of a recovery and resolution plan – a figure which did not include any additional costs incurred in overcoming barriers to resolution, such as changes to legal structure, funding arrangements or operational processes.  Moreover, the same survey suggested that the process requires a material investment in terms of headcount, involving on average 10 full time members of staff dedicated to the project and a further 40-50 employees involved to a lesser degree in the collation of the information required to underpin a plan.

In these circumstances , it is perhaps not surprising that some firms view the process of recovery and resolution planning as little more than a necessary evil.  This seems to be particularly the case with respect to resolution planning in which a firm is effectively asked to contemplate its own demise and accordingly draft its own funeral plan – a state of mind which can be seen as synonymous with managing for failure rather than success.

The Cost of Not Implementing a Recovery and Resolution Plan

However, it may be that firms are underestimating the benefits of implementing a robust recovery and resolution planning regime, and the risks of not doing so.  These benefits and risks are both direct and indirect and are discussed in more detail below.

Risk Weighted Asset Benefits

Once enacted, Basle III will require systemically important banks to have equity of at least 10% of risk-weighted assets (RWAs) plus credibly loss-absorbing debt.  However, some jurisdictions have gone further in “gold-plating” (or applying a “Swiss finish”) to regulatory capital requirements on their local banks.

The UK appears to be one such jurisdiction.  In September 2011, the Independent Commission on Banking (ICB) issued its final report, the conclusions of which were accepted in full by the UK government in December of that year.  The ICB has recommended that the retail and other activities of large UK banking groups should both have primary loss-absorbing capacity (i.e. regulatory capital and bail-in bonds) of at least 17%-20% of RWAs.

Within the 17%-20% range detailed above the ICB recommends applying regulatory discretion about the amount and type of loss-absorbing capacity.  In particular, the ICB has suggested that 3% extra equity capital might be required of a UK banking group that was judged “insufficiently resolvable to remove all risk to the public finances”.  In contrast, no additional equity capital might be needed for a bank with “strongly credible recovery and resolution plans”.

It would be simplistic to assume that the ICB’s recommendations would be applied in a binary fashion by the FSA, or its successor, the Prudential Regulation Authority (i.e. a 3% RWA penalty or no penalty at all with nothing in between).  Nonetheless, it is instructive to attempt to place an actual value on this 3% figure.  The table below is based on the 2010 financial statements of a number of major UK banks and building societies, and quantifies the daily amount of interest (assuming a rate of 50 basis points) that would be payable if an amount equal to 3% of RWA, being freed up as a result of having a robust recovery and resolution plan, were simply placed on overnight deposit.

1 Where financial statements are reported in USD, the USD/GBP exchange rate as at 8 March 2012 has been used for comparison purposes

2 Assuming an overnight interest rate of 0.5%

The potential dangers of false economy become clear – the opportunity cost of not implementing a robust recovery and resolution planning regime may quickly outweigh the marginal cost savings derived by doing just enough, but not more, to comply with RRP regulations.

Business Benefits

 The process of creating and maintaining a recovery and resolution plan entails a large-scale data extraction exercise the purpose of which is to understand group-wide exposures, interdependencies and other areas of weakness.  As a result of acquiring and assimilating this information areas where there is room for improvement quickly become apparent.  More specifically, some of the benefits of implementing a robust recovery and resolution planning regime include:

•    Gaining a better operational understanding of the overall business;

•    Facilitating the streamlining of group structures;

•    Optimisation of group funding and liquidity; and

•    Understanding intra-group dependencies.

Regulatory Risks

The FSA has a range of options it can apply in the event of non-compliance with the regulations regarding recovery and resolution plans.  However, the two which seem most likely to be used in this context are:

•    the appointment of a “skilled person” pursuant to section 166 of the Financial Services and Markets Act 2000 to gather the required data or perform the required acts – the risk then becomes one that the recovery and resolution process is removed from the control of the firm; or

•    the ultimate sanction under section 45 of the Financial Services and Markets Act 2000 pursuant to which the FSA has the power to vary, or even cancel, a firm’s permission to carry on a regulated activity.

Reputational Risk

In light of the continuing round of ‘banker bashing’ amongst politicians and the press, firms would be well advised to grasp the recovery and resolution planning regime as an opportunity to present themselves as responsible corporate citizens.  In particular, given the recent scandal over client money held with MF Global, a concerted effort to comply, and be seen to comply, with the requirements of the CASS Resolution Pack rules would appear to be sensible.

Recovery and Resolution Planning Optimisation

CP 11/16 is a fantastic tool which lays out a detailed roadmap of the FSA’s requirements in relation to recovery and resolution planning.  From an analysis of CP 11/16 it quickly becomes clear that the majority of the data points, particularly those in modules 3, 4 and 5, are quantitative in nature and naturally lend themselves to some form of automated data capture and presentation process.  Implementing an automated regime will undoubtedly require a greater amount of initial effort than a manual solution.  However, the marginal difference is unlikely to be a large as one might imagine as the major hurdles of identifying the location and owners of specific points of data, extracting information from large portfolios of documentation, and ensuring robust and efficient procedures for plan maintenance must be overcome irrespective of whether a manual or a technology-based solution is to be implemented.  The benefit of a semi-automation solution is, of course, felt in future years due to the reduced administrative burden associated with ad-hoc and annual plan updates.

It is also equally clear from CP11/16 that a major part of the process of creating and maintaining a recovery and resolution plan can be distilled down to a process of medium-to-low-level data extraction from a wide variety of documentation, including leases, software licences, other intellectual property agreements, joint ventures, outsourcing contracts, and exchange membership documentation.  Of particular importance is the information which must be extracted from portfolios of derivative and securities financing documentation.  Many firms will not have the expertise or capacity to perform this exercise from existing headcount.  Depending on the scale of their ongoing planning activity, other firms may not be able to justify an investment in additional headcount.  Fortunately, the process is well suited to a cost-effective outsourced solution and firms should give serious consideration to this as a long-term solution to the question of plan maintenance.

Conclusion

Recovery and resolution planning is the product of a political agenda which has its roots in the financial crisis of 2007-2008.  The quasi-public nature of the service provided by banks to the real economy, coupled with the overriding desire within government to ensure that public funds never again bail out a financial institution, means that RRP is here to stay.  By design, it is a task that is both large in scale and intellectually challenging in scope.  Moreover, it is at least arguable that, in order to be compliant with existing regulations, a plan must be in a constant state of updating – a possibility which implies a huge administrative burden on firms.

Ironically, the less a firm invests in its recovery and resolution planning process, the more concerned the FSA will be about that firm and the greater the degree of supervision to which that firm will become subject.  In turn, this is likely to result in more frequent regulator requests for plan updates with the ultimate result that the overall cost of plan maintenance will increase.  As such – even where motivated primarily by a desire to save cost – firms would be well advised to focus from the outset on the material benefits to be derived from the implementation of a strategic, robust and long-term solution to the question of recovery and resolution planning.

SCHEDULE 1

RRP COST ESTIMATE CALCULATIONS

High Impact Firms

Initial Costs

Annual On-Going Costs

Cost of Refreshing a Recovery and Resolution Plan

Total 5-Year Average Cost

Medium High Impact Firms

Initial Costs

Annual On-Going Costs

Cost of Refreshing a Recovery and Resolution Plan

Total 5-Year Average Cost

Medium Low and Low Impact Firms

Initial Costs

Annual On-Going Costs

Cost of Refreshing a Recovery and Resolution Plan

Total 5-Year Average Cost