This article was originally published on 13 March 2011 in The Sunday Business Post.

The new banking legislation published last week is arguably a case of locking the stable door after the horse has bolted, but a special resolution regime is an important part of any modern economy’s financial regulation.

The Central Bank and Credit Institutions (Resolution) Bill 2011 is one of the requirements of the EU-IMF programme of financial support for Ireland.

Indeed, the IMF has been urging Ireland for some time to introduce the measures in the bill, commonly known as special resolution powers or a special resolution regime (SRR).

An SRR is intended to allow a more orderly resolution of failing banks and other financial institutions, including building societies and credit unions.

The normal winding up procedures available to companies are inadequate when it comes to banks. Without an SRR, the only alternative is nationalisation.

In the US, where 151 banks have failed in the last year alone, the equivalent legislation has been much utilised. Britain hurriedly enacted measures in 2009 - too late for Northern Rock but in time for the Dunfermline Building Society, which is widely considered a successful example of an SRR exercise.

Similar regimes are also being created at EU level.

As such, the introduction of this legislation in Ireland is to be welcomed. It is intended to come into effect when the interim measures in the Credit Institutions (Stabilisation) Act 2010 lapse at the end of 2012. If enacted, it will give the Central Bank powers to deal with financial institutions which are failing or likely to fail.

The main powers are listed below

  • To establish ‘bridge-banks’ to hold the assets and liabilities of failing institutions temporarily pending transfer to a third party (ie, an external buyer once one has been found).
  • To make a transfer order to a third-party in respect of a failing institution (subject to prior notice to the institution concerned and approval of the order by the High Court). If there is an imminent threat to the financial stability of the institution or of the financial system in the state, there is no obligation to notify the institution in advance.
  • The Minister for Finance also has powers to make financial incentives (loans, guarantees etc.) available to any proposed acquirer of a financial institution.
  • To make a special management order, whereby the Central Bank would take over the effective management of the institution. Again, subject to an imminent threat to financial stability, any such order would be on prior notice to the financial institution concerned and subject to the approval of the High Court.
  • Powers in relation to the winding-up of a financial institution, such that nobody can appoint a liquidator without the Central Bank’s approval.
  • To direct a financial institution to prepare and implement a recovery plan, together with powers to prepare a resolution plan for that institution. When action has to be taken in respect of a failing financial institution, experience has shown that there is always a large amount of uncertainty over how bad the problems really are. However, it is vital that the authorities take decisive action, as otherwise there is a real risk that a run on deposits will ensue. In reality, any measures by the Central Bank will need to be taken with the full knowledge and cooperation of the institution. Speed and confidentiality will be critical to ensure the confidence of depositors is maintained. There will be enough uncertainty and lack of confidence in the institution, and the resolution process must not add to that.

Experience in Britain has shown that most resolutions happen over a weekend.

Normal insolvency procedures are inadequate when it comes to banks because the procedures can only be implemented when the entity is already insolvent.

In the case of a bank, depositors will long since have lost confidence and fled. Also, banks need to ensure continuity of functions, such as access to deposits and credit, and the performance of derivative contracts. Because of their inter-connectedness, a bank failure will invariably spill over to other institutions, so it cannot be treated in isolation. The appointment of an examiner or liquidator is not conducive to the continued functioning of a financial institution. A depositor will not wait around while an accountant prepares his report for an examiner.

Given recent experience, the state should be doing everything possible to ensure that financial institutions do not rely on the availability of public money.

With that in mind, the draft legislation provides for the establishment of a credit institutions resolutions fund ‘‘to provide a source of funding for the resolution of financial instability’’. The source of the funding is envisaged to be contributions from financial institutions and the Minister for Finance.

Should an institution not contribute to the fund, it cannot carry on business and is guilty of an offence. Given the crippled state of most of the institutions in this state, it remains to be seen whether meaningful contributions to this fund are a realistic prospect or whether the taxpayer will have to pick up the tab.

In whatever guise the SRR is adopted by the incoming government, the key to a successful regime will be information and advance planning. The draft legislation contains important powers in this area in relation to recovery and resolution plans.

Cooperation between the institutions and the Central Bank will be vital to ensuring the operation of a successful resolution regime into the future.