A consultation paper recently issued by the Financial Stability Board (FSB) proposes that systemically significant banks will be required to have a Recovery and Resolution Plan (“RRPs”) or so-called ‘living will’.1
A number of jurisdictions already require or are considering requiring these plans, among them the United States2 and the United Kingdom.3 Whilst the Australian regulators are yet to make any public announcements regarding requirements for Australian banks to maintain such plans, it would seem very likely that they will follow overseas developments and introduce corresponding requirements here. Further, although the FSB paper focuses on banks, it contemplates that Recovery and Resolution Plans may ultimately be required for systemically significant firms in other sectors such as insurance companies.
The FSB’s paper, entitled ‘Effective Resolution of Systemically Important Financial Institutions’, contemplates that the following plans should be developed for systemically significant banks:
- a ‘recovery plan’ developed by senior management of a bank, that is intended to serve as a guide to the recovery of a distressed bank; and
- a ‘resolution plan’ developed and implemented by regulators, that is intended to facilitate the orderly resolution of the bank, in the event that the recovery measures are not feasible or have proven ineffective.
The FSB’s proposal for RRPs comprises part of a broader framework being established by global regulators to facilitate the resolution of failing systemically important financial institutions without systemic disruption or exposing taxpayers to the risk of loss.
Importantly, the paper contemplates that regulators should have powers to require that banks adopt measures to reduce the complexity and cost of resolution, where such measures are necessary, and appropriate taking into account their effect on the soundness and stability of the relevant bank’s ongoing business. The types of measures identified in the paper include changes to a bank’s business practices, structure or organisation, such as the separation of functions into legally and operationally independent entities that are shielded from group problems - for example, separating a bank’s trading and deposit-taking institutions.
The key features of the plans set out in the FSB paper are summarised below.
Key features of a recovery plan
The paper states that a recovery plan for a bank should include credible options to cope with a range of scenarios that may either affect the bank only or the market generally, and should be capable of execution within a relatively short time frame.
- Capital recovery, including recapitalisations after extraordinary losses, capital conservation measures such as suspension of dividend, and capital raising measures;
- Liquidity recovery, including identifying measures to secure sufficient funding and diverse sources of funding, and adequate availability of collateral and, where applicable, transfers of liquidity within a group;
- Restructuring of business, including debt-for-equity swaps and possible sales of subsidiaries and spin-offs of business units, and the pre-conditions and risk associated with such transactions. Banks should ensure that key service level agreements (e.g in relation to trade settlement, custody, payments or information technology) can be maintained in both recovery and resolution phases and that service provider’s termination rights are not triggered by recovery or resolution events or the transfer of assets to a bridge-institution or a third party acquirer;
- Organisational & operational set-up, including, for example, ensuring that internal processes, IT systems and access to clearing and settlement facilities, exchanges and trading platforms continues during any recovery phase and resolution phase;
- Communication strategy - including developing a communication strategy with financial markets and other stakeholders so as to limit doubts about their viability, and with regulators to provide necessary data and information.
Key additional features of a resolution plan
- Impact of potential resolution actions, including effect on other business lines/legal entities, financial contracts, markets and market participants and losses to be borne by creditors.
- Resolution funding, including actions to protect depositors and ensure the rapid return of segregated client assets.
- Communication strategies and cross-border co-operation. In particular, regulators should have the capacity to share information, including RRPs, with foreign regulators, where this is necessary to co-ordinate plans and their implementation, subject to adequate confidentiality requirements and protections for sensitive data.
Written submissions on the FSB paper are requested by 2 September 2011, and the final document will be submitted to the G20 leaders summit in Cannes in November 2011. While it is no doubt prudent for an institution to have a clear, sensible structure, accurate records of the services and infrastructure needed to carry on its business and to make some plans to cope with possible disasters, in our view the emphasis and reliance placed on RRPs should be kept in proportion. In particular:
- the exact nature of any crisis, and hence how best to respond to it, will be difficult to predict. Any plan must therefore be evolutionary (hence, the use of the term, a ‘living will’) rather than revolutionary, and capable of adaptation with changes in the circumstances of the institution and the markets in which it operates;
- the plan can be no substitute for the institution’s existing risk management processes, which should be intended to prevent the need for recovery or resolution from arising;
- so far as recovery or resolution requires recapitalisation of the institution, the plan needs to operate in light of a settled prudential framework regulating capital. The status of techniques such as contingent capital and of mooted regimes to “bail-in” classes of creditor to hold equity in the institution must be settled in order for any recovery or resolution plan to be effective; and
- if the plan dominates decisions about business structures, it is likely to impose other costs and risks. The easiest of institutions to resolve (e.g. by sale of its business), might have all its separate businesses in separate legal entities, each with its own stand alone business infrastructure. But this is unlikely to be efficient and may also lead to increased risks (e.g. the loss of reduction in risk through netting which can be achieved across the whole institution’s books).
Early dialogue between the regulators and Australia’s banks about any proposal to require the preparation of recovery and resolution plans, and the criteria to be adopted for identifying systemically significant banks in the Australian context, would facilitate an outcome which will result in enhanced stability in Australia’s financial system rather than future instability.