As part of the IMF/EU bailout, Ireland will need to put draft legislation before the Dail to facilitate the creation of a legal framework for dealing with financial institutions on the verge of collapse. This legal framework is known as a Special Resolution Regime (SRR).
These are extraordinary times. The Irish banking sector needs reform and the gurus at the International Monetary Fund (IMF) have seen it all before. They know that the key to creating a successful and robust banking environment is sensible regulation, appropriate restructuring and provision for a special resolution regime for the orderly winding-up of financial institutions that threaten to bring down the fabric of society. This article will focus on the last of those steps - special resolution regimes (SRRs) for failing credit institutions.
Under the 'Programme of Financial Support' agreed with the International Monetary Fund (IMF) and the EU, Ireland is obliged to bring draft legislation before the Dáil by the end of February to make SRRs a reality in Ireland. It is key to the IMF's requirements.
Put simply, SRRs enable a more orderly resolution of failing banks. Banks are not like other non-financial institutions; they are not suited to the normal insolvent winding-up and bankruptcy procedures set out in legislation applicable to normal trading companies.
Key to ensuring an effective SRR is the enactment of proper legislation. This legislation must specifically contemplate how the banks shareholders, creditors and depositors are dealt with if a bank fails.
Ideally, an SRR will be comprised of a number of elements:
- The minimisation of financial and economic costs
- (including the protection of the supply of credit to the economy)
- Ensuring a minimum level of protection to depositors
- No bail out for shareholders, and
- Being capable of implementation in a transparent and timely fashion.
The legislation should also deal with how authorities can intervene in order to save a bank which, while on the verge of collapse, is still capable of being recovered should an appropriate purchaser emerge. This may involve splitting the bank into a good bank and a bad bank. It may also contain provisions for the creation of a 'bridge bank', where no purchaser emerges during the resolution process. The legislation may also contain a level of immunity for the authorities, protecting them against prosecution by any party that feels compromised by the process. This is usually provided for on public policy grounds.
The experience in the UK
Britain did not have SRR legislation in place at the time of the Northern Rock crisis in late 2007. The UK's Banking Act in February 2009 was the response to the risk of large financial institutions failing. The legislation created an SRR built on the tripartite authority of the Bank of England, HM Treasury and the Financial Services Authority (FSA). The SRR gives these authorities the power to:
- Transfer all or part of a failing bank to a private sector purchaser;
- Transfer all or part of a failing bank to a bridge bank - a subsidiary of
- the Bank of England - pending a future sale;
- Place a bank into temporary public ownership (HM Treasury's decision);
- Apply to put a bank into the bank insolvency procedure, which is designed to allow for rapid payments to depositors insured under the Financial Services Compensation Scheme, and
- Apply for the use of the bank administration procedure to deal witha part of a bank that is not transferred and is instead put into administration.
Not long after its introduction, the SRR was called into action. On 28 March 2009, the FSA issued a statement that Dunfermline Building Society (DBS) was likely to fail to meet the FSA's threshold conditions for authorisation.
Over the weekend that followed, the various powers available under the legislation were used to transfer much of the assets and liabilities of DBS to Nationwide Building Society. Any assets and liabilities remaining were transferred to a bridge bank and this was then placed into special administration - a process to administer the run-off and potential sale of the remaining assets. On 30 March 2009, the Bank of England issued a press release confirming that it was business as usual for the customers of DBS.
The US Position
The Federal Deposit Insurance Corporation (FDIC) is an independent federal agency created in 1933 to create public confidence and stability in the US banking system. The FDIC oversees the bank resolution process in the United States and has a number of resolution procedures at its disposal. One hundred and fifty one banks failed in the United States in 2010. The FDIC has been very busy.
Most typically, the agency that issued the banking license can close an institution and appoint the FDIC as its receiver. The most common reason for deciding to close an institution is classification "critically undercapitalised" - having assets insufficient to meet obligations. In 2008, America saw its largest-ever bank failure. Washington Mutual Inc held assets worth $327.9 billion at the end of 2007, but reckless lending meant that when the credit crunch hit the following year Washington Mutual got caught in a classic "run on the bank" situation. The FDIC was quick to intervene and offered the ailing giant to a number of institutions before JP Morgan Chase purchased the entire organisation for $1.9 billion. The US taxpayer did not have to foot one cent of the resolution process.
The Irish Position
In its report entitled Ireland 2010: Article IV Consultation published in July 2010, the IMF noted that Ireland should "take early action to introduce a special resolution mechanism … to meet contingencies and strengthen the stability framework". The Irish government is now under an obligation to reform the banking sector following the recent memorandum of understanding entered into with the European Central Bank (ECB) and the IMF. Under the terms of the memorandum, the Irish government must present draft legislation before the Dáil by the end of February 2011 to facilitate the introduction of an SRR.
With the effective nationalisation of the largest Irish banking institutions, an SRR might well be regarded as locking the gate after the Celtic Tiger has bolted. Had the process been in place at the outset of the banking crisis in 2008, it is very possible that an institution such as Anglo Irish Bank could have been resolved far more efficiently and without the enormous expense which ultimately landed at the door of the Irish taxpayer.
While it may seem toothless now, an SRR is one pillar of effective banking regulation that modern, developed economies must have in place. The ECB and the IMF have recognised this. Patrick Honohan recently made a speech to the Institute of Chartered Accountants in Ireland in which he stated that the Irish banks were for sale. While there may not be too many willing buyers currently in the market, we must plan now for a scenario where privately-owned banks of systemic importance require an effective resolution process.
It will be interesting to see how the proposed SRR legislation will deal with the transfer of the property and shares of large financial institutions. The section in the memorandum of understanding dealing with the SRR also notes that the Irish legislature will need to ensure the legislation is "consistent with similar initiatives going on at EU level". This would appear to be a reference to recent developments in the EU regarding the resolution of crises where cross-border financial institutions are at risk of failing. In any event, the next few months will be full of interesting developments in this area.