Comments on "Report and Recommendations of the Cross-border Bank Resolution Group"
Norges Bank's letter of 30 December 2009 to the Basel Committee on Banking Supervision Secretariat / Bank for International Settlements.
The financial crisis has illustrated the shortcomings of the current cross-border crisis management framework. A strong tendency to favor national solutions, including ring-fencing, and inadequate tool kits for crisis resolution at the domestic level, have led to uncoordinated crisis resolutions and unprecedented levels of public financial support to the banking sector. There is now broad agreement on the need for reform, and the current report is therefore to be welcomed.
The report provides, in our view, a balanced review of the challenges involved in resolving cross-border banking problems. We agree with the observation that a broad international agreement on resolution policies is unlikely in the short term and support the reports effort to explore the “middle ground”. This involves a search for pragmatic bank resolution systems that hold shareholders, managers and, where appropriate, other creditors accountable while protecting depositors and if necessary preserving continued access to critical banking services. This would greatly enhance market discipline and limit moral hazard.
As to the 10 recommendations we have the following specific comments.
Recommendation 1: Effective national resolution powers. National authorities should have appropriate tools to deal with all types of financial institutions in difficulties so that an orderly resolution can be achieved that helps maintain financial stability, minimize systemic risk, protect consumers, limit moral hazard and promote market efficiency. Such frameworks should minimize the impact of a crisis or resolution on the financial system and promote the continuity of systemically important functions. Examples of tools that will improve national resolution frameworks are powers, applied where appropriate, to create bridge financial institutions, transfer assets, liabilities, and business operations to other institutions, and resolve claims.
The report correctly observes that the crisis resolution options for the authorities are severely limited if the existing tool kit has not been adequately updated. If private sector participants know that the tool kit is not suited for time critical interventions; they might expect to be bailed out and gamble for resurrection when facing difficulties. This is why the first recommendation is so important: That all national authorities should have appropriate tools to deal with failing financial institutions.
As noted in the recent communication by the European Commission on Crisis Management Policies in the EU, there should be a certain minimum tool kit for crisis management in all countries, including (at least) the power to split and transfer assets, the power to establish a bridge bank to secure essential banking services, and the power to seize and run a bank (temporary public ownership). We encourage the Basel Committee to develop recommendation no. 1 further and specify more precise guidelines in this area.
There is also a need for greater clarity about the intervention points for early intervention. This is particularly important in cross border banks given the uncertainties regarding the crisis management framework for these banks. We agree with the report that similar intervention thresholds may facilitate coordinated solutions across borders, but observe that current practices differ widely.
It is also important to link the ongoing discussion on the appropriate level and quality of capital to the trigger discussion and the loss absorption capacity of the different capital categories. Currently, many supervisors would intervene if regulatory capital falls below 8 %, while others will not have the legal capacity to intervene before the bank is balance sheet insolvent. This regulatory limbo is detrimental to any coordinated crisis resolution and should be addressed as a matter of priority. A first step could be to clarify national differences; then to look for common approaches to intervention within existing legal mandates. Finally, new legal tools should be explored for those authorities with weak tool kits.
Recommendation 2: Framework for coordinated resolution of financial groups. Each jurisdiction should establish a national framework to coordinate the resolution of the legal entities of financial groups and financial conglomerates within its jurisdiction.
Crisis resolution in Norway is facilitated by having an integrated supervisory agency. In addition, the Domestic Standing Committee between representatives from the central bank, supervisory authority and the Ministry of Finance has the potential for being a vehicle for crisis coordination.
Recommendation 3: Convergence of national resolution measures. National authorities should seek convergence of national resolution tools and measures toward those identified in Recommendations 1 and 2 in order to facilitate the coordinated resolution of financial institutions active in multiple jurisdictions.
There are inherent conflicting interests of the home and host countries in cross border banking crisis. These could be increased by differences in national banking crisis resolution regimes. Even within the EU there are important differences in these regimes. As part of the territorial approach to banking crisis resolution, quite often the resolution regime is changed during a crisis. The experience from the EU is broadly that MoUs on crisis management were of limited use during the crisis. Increased convergence is hence a challenging but important task.
Close coordination of regulatory and supervisory standards between countries sharing a banking group will obviously reduce potential conflicts of interest. If bank operations in each country have been established based on rules and standards agreed between individual supervisors, it will also be politically more acceptable to shoulder a part of the burden in cases where banks run into trouble.
One problem area exposed by the current crisis is the widely divergent parameters used by certain IRB banks for similar credit categories. Comparison of financial strength across firms is thereby distorted, and trigger point information for supervisors weakened. The current impact assessment of Tier 1 capital has further strengthened the impression of widely divergent quality of core capital among large cross-border banks. Increased convergence among national supervisors of key principles for capital estimation should be greatly encouraged, as it is a necessary requirement for consistent intervention polices in different jurisdictions.
Better coordination between national authorities will have to build on a more convergent legal basis for crisis resolution and similar responses to emerging stress. Thus, we strongly support the report’s recommendation to require all countries to have a certain minimum tool kit in place. The report notes that greater cooperation should be possible based on improved understanding of the parameters for action by different authorities. This is particularly the case for large subsidiary based financial groups, where resolution must be based on separate legal entities. Closer cooperation in supervisory colleges and more frequent interactions of key policy makers is needed to provide a more solid ground for crisis resolution among such firms.
Large cross-border banking groups with branch based organizations should normally be resolved under the universal approach, i.e. a resolution that provide for uniform measures and mutual recognition of measures across borders. However, as the Icelandic case showed, if the parent banks have outgrown the local supervisory and deposit insurance systems, there is a legitimate basis for host county intervention to protect national interests. We support greater scrutiny of home country regimes in the future, and a due process allowing host supervisors to raise their concerns. Parent banks must not be allowed to outgrow their home base, i.e. the national capacity to supervise and support overseas commitments.
Large cross-border banking croups with business line organization, but with legal subsidiary structure, pose a special challenge for crisis resolution. Host authorities may have reservations about supporting such “quasi subsidiaries”, and may not even be able to ring fence them since their liquidity, funding and IT functions have been centralized to profit centers in another country. This can easily create a stand-off situation between the home and the host authorities. Two possible solutions should be explored: One would be to “pierce the corporate veil” and base responsibilities on the actual operations of the group, i.e. the parent banks should be asked to confirm their support for subsidiaries and home authorities’ responsibilities should likewise reflect the corporate reality. Alternatively, host authorities should ask the locally incorporated banks to bring their organizations in line with the corporate structure. (1) Clarifying responsibility for cross-border banking croups with business line organization is, in our view, quite important and should be explored further as an important premise for further progress on cross-border crisis resolution.
Recommendation 4: Cross-border effects of national resolution measures. To promote better coordination among national authorities in cross-border resolutions, national authorities should consider the development of procedures to facilitate the mutual recognition of crisis management and resolution proceedings and/or measures.
See recommendation 3.
Recommendation 5: Reduction of complexity and interconnectedness of group structures and operations. Supervisors should work closely with relevant home and host resolution authorities in order to understand how group structures and their individual components would be resolved in a crisis. If national authorities believe that financial institutions’ group structures are too complex to permit orderly and cost-effective resolution, they should consider imposing regulatory incentives on those institutions, through capital or other prudential requirements, designed to encourage simplification of the structures in a manner that facilitates effective resolution.
As a preventive measure, we believe cross-border banks should be required to hold ample capital and liquidity buffers. The large negative real economy effects of a potential disorderly resolution process for a large cross-border bank represent a negative externality that should be appropriately captured in the incentives facing such banks. This is indeed the direction of current regulatory initiatives, which we strongly support. This could take the form of a systemic surcharge to the national deposit insurance fund, or as an extra capital charge, probably under Pillar 2. This surcharge could be lowered if the complexity of the group is reduced, for example following a review of a resolution and recovery plan.
Recommendation 6: Planning in advance for orderly resolution. The contingency plans of all systemically important cross-border financial institutions should address as a contingency a period of severe financial distress or financial instability and provide a plan, proportionate to the size and complexity of the institution, to preserve the firm as a going concern, promote the resiliency of key functions and facilitate the rapid resolution or wind-down should that prove necessary. Such resiliency and wind-down contingency planning should be a regular component of supervisory oversight and take into account cross-border dependencies, implications of legal separateness of entities for resolution and the possible exercise of intervention and resolution powers.
This report is one of several international reports on improving the crisis resolution systems both domestically and globally. We believe that the concept of living wills could be particularly relevant for cross border banks. The Financial Stability Board has recently pointed out that contingency plans for banks actually need two distinct components. A recovery plan for maintaining a going concern and a resolution plan for institutions that needs to be closed. These two should be developed and evaluated separately. Having supervisory authorities and central banks in different countries working closely with the relevant institution on these plans will improve the conditions for fruitful cooperation during the crisis as well as increase the probability of ex ante restructuring of the institution that could pave the way for improved crisis management.
We would in addition support the report’s suggestion to reduce the complexity and interconnectedness of group structures, if these are found to be to complex. In Norway, we have for long favored a holding company approach to financial institutions, and as a result most of our financial groups have fairly transparent organizational structures.
Recommendation 7: Cross-border cooperation and information sharing. Effective crisis management and resolution of cross-border financial institutions require a clear understanding by different national authorities of their respective responsibilities for regulation, supervision, liquidity provision, crisis management and resolution. Key home and host authorities should agree, consistent with national law and policy, on arrangements that ensure the timely production and sharing of the needed information, both for purposes of contingency planning during normal times and for crisis management and resolution during times of stress.
This recommendation also needs to be seen in the context of various proposals for more international cooperation on macro prudential analysis and regulation, cf the European Systemic Risk Board. When such an analysis identifies a need to strengthen regulatory and supervisory standards to combat systemic risks in one or more countries, it is extremely important that the strengthening applies to all systemically important financial institutions operating in the market, whether they are domestic or foreign. Otherwise, the concern for a level playing field and regulatory arbitrage will make it difficult to impose the proper measures. A case in point could be a situation where macro prudential concerns necessitate higher capital requirements on lending in one or more of the Nordic countries. In such a situation both subsidiaries and branches of banks from the other Nordic countries should have the same increased requirements on the relevant lending components. This would modify the home country responsibilities in the EU regulations, but based on an agreement that we believe is within the broader EU principles for cross border financial stability.
Recommendation 8: Strengthening risk mitigation mechanisms. Jurisdictions should promote the use of risk mitigation techniques that reduce systemic risk and enhance the resiliency of critical financial or market functions during a crisis or resolution of financial institutions. These risk mitigation techniques include enforceable netting agreements, collateralisation, and segregation of client positions. Additional risk reduction benefits can be achieved by encouraging greater standardisation of derivatives contracts, migration of standardised contracts onto regulated exchanges and the clearing and settlement of such contracts through regulated central counterparties, and greater transparency in reporting for OTC contracts through trade repositories. Such risk mitigation techniques should not hamper the effective implementation of resolution measures (cf. Recommendation 9).
We support this recommendation.
Recommendation 9: Transfer of contractual relationships. National resolution authorities should have the legal authority to temporarily delay immediate operation of contractual termination clauses in order to complete a transfer of certain financial market contracts to another sound financial institution, a bridge financial institution or other public entity. Where a transfer is not available, authorities should ensure that contractual rights to terminate, net, and apply pledged collateral are preserved. Relevant laws should be amended, where necessary, to allow a short delay in the operation of such termination clauses in order to promote the continuity of market functions. Authorities should also encourage industry groups, such as ISDA, to explore development of standardized contract provisions that support such transfers as a way to reduce the risk of contagion in a crisis.
We support this recommendation.
Recommendation 10: Exit strategies and market discipline. In order to restore market discipline and promote the efficient operation of financial markets, the national authorities should consider, and incorporate into their planning, clear options or principles for the exit from public intervention.
We support this recommendation.
1) This could involve strengthen local IT infrastructure, local representation on the board, local listing, etc.
Arild J. Lund