Imagine
the following situation: You are poor. Luckily, a few years ago, you
married the daughter of a wealthy hedge fund manager. Your
father-in-law has passed away just a few months after your marriage,
so there is – -besides your wife – just your mother-in-law left,
sitting on a huge fortune. She has already celebrated her 90th
birthday and is, in addition, sick. A trustee has been put in place.
Her passing away is just a question of time…
In the
above story, your mother-in-law is a systemically important financial
institution, her trustee is the regulator, and you are the general
public.
What
should you do? The European Commission, in its draft proposal dated
June 6, 2012, proposes a six step approach:
- Clarify your goals! (Purpose)
- Evaluate whether there is any need to act now! (Scope of application)
- Make sure that your mother-in-law makes the right decisions! (Measures by financial institutions)
- Verify that the trustee is on your side and makes the right decisions! (Measures by member states’ authorities)
- Make alliances with other members of your family! (Relation with third countries)
- Check your own bank account and make sure that you have enough money to pay for your operations! (European system of financing arrangements)
A. Purpose
– Which?
Which?
- Strengthen banks’ vital role for the economy and people’s trust on which banks’ business depends.
- Reduce systemic risk in the banking industry and enhance financial stability by providing resolution tools other than traditional insolvency proceedings.
- Manage bank failures in an orderly way to limit the risk of contagion.
- Safeguard financial stability and limit taxpayer exposure to loss from solvency support.
- Harmonize procedures for resolving credit institutions at EU level.
B. Scope
of application – Who?, What?, When?
Who?
The directive applies to any financial institution. The definition is
large – it namely includes credit institutions and investment
firms, whether in subsidiary, independent, or holding form.
What?
As its title indicates, the directive applies to recovery and
resolution scenarios. Resolution refers to a restructuring of the
institution. A recovery is somewhat broader. It refers to a situation
in which a financial institution succeeds to redress its financial
situation after a significant deterioration.
When?
The directive will apply from January 1, 2015 on.
C. Measures
financial institutions take
I. Recovery
planning– Who?, What, When?
Who?
What? The institution must draw up a plan to ensure recovery. In
case of a group of companies, the directive requires recovery plans
at subsidiary and group level. But what precisely is a recovery plan?
It is a document that analyzes the firm’s strategy, how its
financial situation and strategy could be affected by stress
situations, and how the firm could fix this situation, without public
financial support. A detailed list of contents is included in Annex /
Section A of the directive. Recovery planning cannot rely on
extraordinary financial support.
When?
The plan must be in place when the directive becomes applicable, i.e.
on January 1, 2015. If its organization or business or financial
situation changes materially, it must update the plan. An annual
update must be made in any case.
II. Intra-group
financial support – What?, When?
What?
Intra-group financial support refers to financial support agreements
that will become mandatory within a group of financial institutions.
The support shall be remunerated and the calculation of consideration
fixed in advance.
When?
Article 19.1 of the directive provides for detailed support
conditions. Namely, support shall only be given for the group as a
whole, it must be reasonably likely to be successful, and it should
not endanger the financial stability of the entity granting the
support.
D. Measures
member state authorities take
I. Resolution
planning – What, When?
What?
Resolution plans are drawn up by public authorities and deal with
the question of how to unwind failing financial institutions, without
public financial support and without significant adverse consequences
for the financial system. Article 9.4 of the directive specifies the
content (separation of critical functions and core business lines,
timeframe of resolution, valuation of critical functions and core
business lines, financing, critical interdependencies, communication
plan, etc.). A resolution plan is mandatory at parent and subsidiary
level; if different authorities are competent at parent and
subsidiary level, they shall coordinate their decision within the
resolution college. Resolution planning cannot rely on extraordinary
financial support.
When?
After first establishment upon entry into force of the directive,
resolution plans must adjust to material changes in the legal and
organizational structure of the institution and are updated, at
least, annually.
II. Early
intervention – What?
What?
Prior to resolution measures, member state authorities have access to
early intervention measures such as requiring the application of
recovery tools and preparing specific management decisions (replace
the management team, restructure negotiations, contact potential
purchasers of the financial institution, appoint a temporary special
manager, etc.).
III. Write
down of capital instruments – When?, What?
When?
A write down of capital instruments is a pre-requisite for the
application of any resolution tool. It can intervene if a financial
institution meets the conditions for its resolution.
What?
A write-down means to reduce the principal value of a capital
instrument to zero, usually without any compensation for its holder.
IV. Exercise
resolution tools
1. Objectives
– Which?, Who?
Which?
Objectives all turn around financial stability: ensuring the
continuity of critical functions, preventing contagion, and
maintaining market discipline.
Who?
Resolution planning intends to protect the general public –
taxpayers, depositors, investors, and clients.
2. Principles
– Which?
Which?
- Ranking: Shareholders shall bear losses before creditors.
- Treatment of creditors: Within the same class, creditors shall be treated equal. They cannot incur greater losses than under normal insolvency proceedings.
- Participation of senior management: Senior management of a failing institution shall be replaced and bear losses, through civil and criminal responsibility.
3. Conditions
– Which?
Which?
- The institution is failing or likely to fail (i.e. breach of capital requirements, assets less than liabilities, inability of the institution to pay its obligations as they fall due, or institution’s request of extraordinary financial support)
- There is no reasonable prospect for any alternative private sector or supervisory action that would prevent the failure in a reasonable time frame.
- The resolution is necessary in the public interest.
4. Valuation
– What?, Who?, How?
What?
Assets and liabilities of the financial institution
Who?
Valuation is usually carried out by an independent expert. In case of
urgency, resolution authorities themselves may evaluate.
How?
Valuation is normally based on fair market value. If, however, the
market is not working properly, valuation shall reflect the long-term
economic value of assets and liabilities. Extraordinary public
support is not taken into consideration. Finally, the valuation shall
indicate the ranking of creditors.
V. Resolution
tools – Which?
Which?
Resolution tools can be either normal insolvency proceedings or any
of the following specific resolution tools:
- Sale of business
- Bridge institution
- Asset separation
- Bail-in
Resolution
tools may be applied separately or in conjunction with each-other.
1. Sale
of business – What?, How?
What?
- Shares or other instruments of ownership
- Specified assets, rights, or liabilities
- Combination of assets, rights, and liabilities
How?
The transfer must be made on commercial terms. Except for the
purchaser, no shareholder or third party consent is required. Guiding
principles for the selling process are transparency,
non-discrimination, prevention of conflicts of interest, avoidance of
unfair advantages on a potential purchaser, rapidity, and sale price
maximization.
2. Bridge
institution – What?, When?, How?
What?
Specific or all assets, rights, or liabilities or an institution
under resolution can be transferred to and re-transferred from a
bridge institution as well as transferred from a bridge institution
to a third party. A bridge institution is a special purpose vehicle
(partially) owned by one or more public authorities. Its purpose is
to hold the financial securities until selling them to a private
investor becomes appropriate.
When?
A transfer is possible if the financial institution is under
resolution.
How?
A transfer requires no shareholder or third-party consent or specific
procedure. A re-transfer is only possible if provided for prior to
the initial transfer.
3. Asset
separation – What?, How?
What?
Assets, rights, or liabilities of an institution under resolution can
be transferred to a publicly owned asset management vehicle to
maximize the value of such assets or wind down the business. Asset
separation is only possible if normal insolvency proceedings could
have an adverse effect on the financial market.
How?
A transfer requires no shareholder or third-party consent or specific
procedure. A re-transfer must be provided for prior to the initial
transfer.
4. Bail-in
– Why?, When?, What?, How?
Why?
A bail-in of a financial institution’s liabilities can pursue a
dual purpose – to recapitalize the institution to reach sufficient
equity levels or to reduce the debt level of the institution.
When?
It must be realistic for a bail-in to restore the financial soundness
and long-term viability of the institution.
What?
All liabilities can be bailed in except guaranteed deposits, secured
liabilities, assets held for third parties, liabilities with an
original maturity of less than one month, privileged liabilities
towards employees, liabilities towards commercial or trade creditors
that are essential for the creditor’s operations, and liabilities
towards tax and social security authorities.
How?
A bail-in must be accompanied by a business reorganization plan.
VI. Resolution
powers – Which?
Which?
- Require information from any person to decide upon and prepare a resolution action
- Take control of an institution under resolution
- Transfer shares, debt instruments, and specified rights, assets or liabilities of an institution under resolution
- Write down or convert instruments (other than equity instruments) into equity instruments of the institution under resolution
- Reduce the principal amount of liabilities of an institution under resolution
- Cancel shares and debt instruments of the institution under resolution
- Require the institution under resolution to issue new equity instruments
- Amend or alter the maturity of debt instruments of the institution under resolution
- Remove or replace senior management of the institution under resolution
- Ancillary powers such as modifying contractual terms of the institution under resolution, restrict enforcement of security right against the institution under resolution, and temporarily suspend termination rights towards an institution under resolution
VII. Group
resolution – What?
What?
In case a financial institution has subsidiaries in several member
countries, the resolution of the group as a whole or any of its
subsidiaries shall be coordinated within a resolution college. Main
features of the cooperation are exchange of information, resolution
strategies, and communication plans. The group level resolution
authority coordinates the activities.
VIII. Relations
with third countries – What?
What?
To coordinate resolution issues with countries outside the EU, the
directive intends for the European authorities to
- negotiate international agreements;
- sign cooperation agreements with non-EU resolution authorities;
- recognize or refuse third country resolution proceedings.
IX. European
system of financing arrangements – What?, Why?
What?
The European system of financing arrangement sets up national
financing arrangements, provides for borrowing among them, and
combines them in case of a group resolution. Its target financing
level, ten years after entry into force of the directive, is 1 % of
total deposits with credit institutions.
Why?
The system is put in place to guarantee or purchase assets or
liabilities of an institution under resolution, to grant loans to it,
or to contribute to a bridge institution.
As a
reminder, the above has not been formally agreed upon by the European
legislator. Even though the big picture is not likely to change,
details are still under discussion.
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