The recent global financial crisis created havoc in the financial markets and dramatically affected the lives of millions of people across the globe. Quite naturally, it also triggered a reconsideration of the proper role of regulation and the best way to deal with so-called global systemically important banks (G-SIBs) or systemically important financial institutions (SIFIs).1 “Too-big-to-fail” became a rallying cry for greater restrictions on SIFIs in order to prevent a recurrence of the crisis—as well as the title of a book by Andrew Ross Sorkin—and the focus of a string of books analyzing the causes and responses to the crisis (Lewis 2010; Sorkin 2009). The crisis equally pointed out the inadequacies of legal frameworks and of the existing plans on how to deal with SIFIs under stress, and particularly those unable to continue operating. This chapter focuses on this latter issue and examines how the process of reform has changed legal frameworks and planning for regulators and SIFIs alike. What began as a process to address the evident inadequacies of insolvency laws has now evolved into a process that affects how SIFIs operate every day and their fundamental structure, operations, and funding.
Initially, it is useful to consider how the process of reform has developed. In the interest of simplicity, we can consider the process of reform as having proceeded through several overlapping phases.2
During the crisis, regulators and the industry took a series of ad hoc steps designed to gain some measure of control over the rapidly declining spiral of real estate—related assets and loss of liquidity in the market (Scott 2016). This first phase of adaptive applications of preexisting laws—supplemented by a few hasty improvisations—fundamentally affected the future framework of reform either by framing what should not recur or what must be available. The crisis responses saw a great expansion of the government’s role in the markets and quite creative applications of then-existing laws under the necessity of addressing a potentially existential threat to financial stability.
The second phase of the process of reform began while regulators, SIFIs, and markets were still struggling to stem the crisis. This phase included far-reaching changes to the statutes and regulations governing all financial institutions, financial markets, and the resolution of insolvent financial institutions, with a natural focus on SIFIs. This phase continues today, though the speed of statutory and regulatory changes has varied both by subject matter and jurisdiction.
The third phase of reform—in which we are immersed today—is the implementation of those broad and deep changes to statutes and regulations. While one could subdivide these phases into many subphases, I believe that examining the interaction between three major groupings of events provides a valuable conceptual tool for understanding how they interact and how the process has affected financial companies and markets.
Another more recent phase in the responses to the crisis also bears note, particularly following the 2016 US presidential election. That pattern, which continues in many countries affected by the crisis, is a profound change in the policy dialogue and political debate. While a thorough description is far beyond the scope of this article, the significance of the changes to the policy and political dynamic since 2008 cannot be overstated. The 2016 election, like Brexit, was a direct product of the discontent that arose from the competing storylines following the financial crisis because it dovetails with a theme of populist anger at the governing and financial “class,” which has swirled around movements as diverse as the US “Tea Party” movement and the “Occupy” movement. For our present purposes, this discontent has made sober policy discussions almost impossible in the United States because they are consistently overwhelmed by cries of Wall Street “bail-out” or corruption. With the election, the United States potentially could see a rolling back of many reforms designed to improve resiliency and resolution for SIFIs—ironically yielding a regulatory framework much like that existing on the cusp of the crisis.
This chapter focuses on the first three of these phases.
The Process of Reform
While there are many interpretations (and stories) about the origins of the crisis and the efforts of central banks, regulators, and financial institutions to stem the crisis, those events did lead to profound consequences for virtually every institution associated with financial regulation, clearly including the SIFIs themselves. To consider the question posed in my title requires a recognition—for good as well as bad—of the role of the logic of events: the steps to halt the crisis created an interpretative framework through which future reforms were judged.
The crisis responses drove many portions of the reform agenda, but other parts of that agenda involved longstanding recommendations to improve resiliency of financial institutions and markets that had been debated for many years. The postcrisis reforms of the derivative markets, including requirements for central clearing for much greater proportions of financial market contracts, fall into this category. Others, such as increased capital and liquidity requirements, are probably a mixture of the logic of the crisis responses along with a more traditional emphasis on increasing the quantity and quality of capital as a buffer against future stress.
Nonetheless, substantial portions of the postcrisis reform agenda unmistakably bear the marks of the lessons drawn by policymakers from the crisis. In the United States, those lessons included a need for improved consumer protection, reform of the mortgage markets3 (this no doubt wins the award for the most ignored reform agenda), and addressing the problems of too-big-to-fail. One of the key steps, although not the only element in reform, was to mandate improved resiliency and to develop the tools and strategies to make resolution a realistic tool in a future crisis. It is clear that the initial focus on developing new statutory frameworks for the insolvency of SIFIs, resolution planning by SIFIs, and new resolution strategies to use those new frameworks bear the hallmarks of the lessons drawn from the necessarily ad hoc responses to the crisis in 2008–09.
At the time of the financial crisis, virtually no country had an adequate insolvency process to address failing financial conglomerates. The judicial bankruptcy framework then available to resolve large, complex nonbank financial entities and financial holding companies was not designed to protect the stability of the financial system or even efficiently address the failure of large financial companies. In contrast, the United States had a clearly defined and proven statutory framework to resolve an insured bank, principally by using an administrative process that relied upon prompt action by its deposit insurer, the Federal Deposit Insurance Corporation (FDIC). This process emphasized immediate authority to take over the bank’s business and operate it if need be, transfer assets and liabilities either to another privately owned bank or to a FDIC-created bridge bank, limit termination of key contracts, and address the potential for instability from the termination of derivative contracts—all without requiring prior approval by a court. Under this process, the imperative for quick action to maintain value and continue key operations takes precedence over ex ante court approval. Judicial authority remains available to adjudicate claims and award damages, but it is limited to ex post decision-making and is severely constrained from intervening in the ongoing FDIC receivership processes. This dichotomy between a judicial process for nonbank corporate debtors and an administrative receivership process for insured banks was, before the financial crisis, almost unique to the United States. In virtually all other countries, banks and nonbanks were resolved through the court-based normal insolvency procedures, which focused on liquidation rather than reorganization. Not surprisingly, when faced with bank failures, most countries preferred a bailout to a liquidation with its normally significant negative impact on depositors.
The financial crisis highlighted the imperative for reform while providing the incentive to pass significant legislation in many countries to provide for more flexible and stronger authorities to resolve failing financial firms. The impulse to legislate grew out of the ineffectiveness of the procedures outlined here, and the recognition that inadequate resolution authorities led inexorably to a simple, politically problematic, and economically troublesome bail-out.
International Responses
In the wake of the crisis, in 2009 the G20 leaders called on the Financial Stability Board (FSB) to develop “internationally-consistent firm-specific contingency and resolution plans” and a framework for recommended legal changes. In response, the FSB in March 2017 developed the “Key Attributes of Effective Resolution Regimes for Financial Institutions.”4
The Key Attributes seek to address the too-big-to-fail problem by setting out a common set of principles and resolution tools that should be in place to resolve SIFIs in an orderly manner and without exposing taxpayers to the risk of loss, all while protecting vital financial functions. The importance of the Key Attributes lies both in establishing an internationally recognized set of resolution tools and principles and, perhaps most important, in its endorsement by the G20 and the extensive efforts made to codify the Key Attributes into national or, in the case of the European Union (EU), into a multilateral legal framework.
The US Response
In the wake of the financial crisis, the United States created a special insolvency regime for failing SIFIs under the Orderly Liquidation Authority (OLA) provisions of Title II of the Dodd-Frank “Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”). OLA is designed exclusively to address the failure of SIFIs in cases where such an insolvency would have serious adverse effects on the financial stability of the United States.5 It is important to note that OLA supplements—rather than replaces—existing insolvency regimes. Unless a decision is made to place a SIFI into OLA resolution, the normal insolvency laws—such as the Bankruptcy Code—continue to apply.6 The resolution of a SIFI under OLA requires a determination by the secretary of the Treasury, in consultation with the president and based on the recommendations of the Federal Reserve and the FDIC (or other designated regulators in the cases of broker dealers or insurance companies), that the resolution of the SIFI under otherwise applicable insolvency law would have systemic consequences. Of course, FDIC-insured banks remain subject exclusively to resolution under the Federal Deposit Insurance Act.
The FDIC’s powers under OLA draw heavily from those long-used by the FDIC as receiver for failed insured banks and thrifts. Under OLA, the FDIC as receiver for a SIFI has the power to transfer assets and liabilities of the company either to a third-party acquirer or to one or more specially chartered bridge financial companies. OLA can be helpfully viewed as combining four key powers in the resolution of systemically important companies that follow the guidance provided in the Basel Committee on Banking Supervision’s Cross Border Resolution Group (CBRG) report as well as in the FSB’s Key Attributes.7 Those four powers are:
The ability to conduct advance resolution planning for SIFIs through a variety of mechanisms similar to those used for problem banks (these mechanisms will be enhanced by the supervisory authority and the resolution plans, or “living wills,” required under section 165(d) of Title I of the Dodd-Frank Act);
An immediate source of liquidity for an orderly liquidation, which allows continuation of essential functions and maintains asset values;
The ability to continue key, systemically important operations, including through the formation of one or more bridge financial companies; and
The ability to temporarily stay (for one business day) and then transfer all qualified financial contracts8 with a given counterparty to another entity (such as a bridge financial company) and avoid their immediate termination and liquidation to preserve value and promote stability.9
The overall goal of OLA is to resolve a SIFI by facilitating continuity for that institution’s systemically important operations as a means to stabilize the financial system, while imposing all of the costs for the resolution on the institution’s shareholders and creditors.
The EU and the UK Response
The EU Response
At the time of the financial crisis there was no harmonization of the insolvency regimes for resolving banks or other financial institutions in the EU, and the crisis underscored a lack of adequate tools both at the EU level and in the member-states to deal effectively with unsound or failing banks.10 The Bank Recovery and Resolution Directive (BRRD) is designed to fill this gap by laying out a harmonized toolbox of resolution powers that will be available to national authorities in each member-state.11
The BRRD provides national authorities with four resolution tools: the sale of business tool, the bridge institution tool, the bail-in tool, and the asset separation tool. In common with other directives, the BRRD sets out a “floor” and member-states are free to introduce or maintain stricter or additional rules in their resolution schemes as long as they are not inconsistent with the BRRD. The implementation process will inevitably introduce some variations in how certain principles and rules laid out in the BRRD will be addressed by national law.
The United Kingdom’s Response
The United Kingdom’s initial response to the financial crisis was focused on putting in place emergency measures, in response to the failure of a number of financial institutions. The Banking Act 2009 in February 2009 introduced a Special Resolution Regime that allows failing or collapsed banks to be transferred into public ownership or into the hands of other market participants under exigent circumstances. The Financial Services Act 2012 then restructured the United Kingdom’s financial services’ regulatory framework by giving the Bank of England (BoE) responsibility for macroprudential oversight for the financial system, supervisory authority for systemically important financial services companies, and authority for implementation of the Special Resolution Regime.
The United Kingdom adopted a further reform through the Banking Reform Act 2013 to provide for a bail-in tool. This tool gives the BoE the power to impose losses on shareholders and creditors of certain banks and other SIFIs before initiation of insolvency proceedings in order to prevent them from becoming insolvent. The aim is to ensure that critical banking services continue to be provided while imposing recapitalization costs on shareholders and creditors rather than meeting this cost out of UK Government funds.
Perhaps most significantly, the United Kingdom has developed a resolution strategy to resolve its largest financial institutions, which is built around bail-in. Starting with a paper released by the BoE on October 23, 2014, entitled “The BoE’s Approach to Resolution” (BoE Resolution Paper), and subsequent publications and speeches, the BoE has described how it plans to use its authority under UK law to initiate a bail-in of a failing company without initiating a formal insolvency proceeding for a systemically important financial company in the future.12 Of course, many of these developments preceded the June 2016 referendum in favor of the United Kingdom exiting from the EU, the Brexit vote. While the timing and precise parameters for any Brexit remain to be resolved, it is highly likely that the basic resolution framework, although implementing the BRRD, will remain in place after any exit. The BoE was a prime engineer of the development of bail-in strategies for the resolution of SIFIs and adopted many of its legal reforms prior to BRRD. While the United Kingdom may modify some components of its law that would have been required by BRRD, it is unlikely that wholesale changes will be made.
Resolution Strategies and the Role of Bail-In
With the adoption of new statutory frameworks to support the resolution of SIFIs, the authorities now have a basic set of tools that provide significant flexibility to design resolution strategies. The challenge was, and remains, to develop resolution strategies that fulfill the statutory mandates to achieve the orderly resolution of large, complex financial institutions with business operations in multiple countries without relying on a bail-out from taxpayers and without exposing the financial system to undue systemic risks.
While the role of public funding for resolutions remains a hotly debated issue, the statutory frameworks were designed to impose the losses principally, if not wholly, on shareholders and debt holders of the SIFIs. For example, the Orderly Liquidation Authority, under the Dodd-Frank Act, includes express provisions prohibiting the imposition of losses on taxpayers and requiring repayment of any public funds used in the resolution from the assets of the failed SIFI and, if a shortfall remains, from assessments on the industry.
Applying the new resolution tools to achieve an orderly resolution that mitigates any systemic risks poses significant challenges. Two issues are paramount. One is the continuity of systemically important operations or, failing that, an orderly wind-down of those operations in a manner that avoids creating risks of illiquidity or insolvency for other financial institutions. Achieving an orderly resolution becomes even more complex when the institution’s systemically important operations occur in multiple jurisdictions. The second issue is liquidity. SIFIs fail because they cannot fund their operations. An orderly resolution requires liquidity resources of sufficient size to reassure the markets that the failed SIFI’s systemically important operations can continue or can be gradually wound down without transmitting shocks that could render other market participants insolvent or illiquid in turn.
These issues can be addressed through three basic approaches. The first is the traditional bail-out approach in which the government injects sufficient liquidity and capital into the SIFI in order to prevent its insolvency. The merits and problems with this approach in 2008 have been well-demonstrated (see Scott 2016, 265–72). The second is to use the new resolution tools put in place after the crisis to achieve an orderly wind-down of each insolvent company within a SIFI. This so-called multiple point of entry (MPOE) approach leverages past experience of separate proceedings for insolvent parts of a company and, in the case of cross-border operations, seizure of subsidiaries by host regulators. Under the MPOE strategy, the parent and its subsidiaries would be wound down or recapitalized separately. Some SIFIs, such as Santander, are organized around relatively independently capitalized and funded subsidiaries in host jurisdictions. For these SIFIs, the MPOE approach is consistent with their normal operational and corporate structure and follows past experience of separate resolutions. The third approach seeks to resolve only the top-level holding company, whereas the operating subsidiaries remain out of insolvency proceedings and are recapitalized, if necessary, through resources provided by the parent holding company. This approach is called the single point of entry (SPOE) strategy.
Although the SPOE strategy may not be suitable for some financial companies, it has dominated the international debate since 2011 about the best resolution strategies to apply to complex, global financial companies. Quite obviously, the SPOE strategy works best where the holding company does not perform any material business operations and serves principally as an issuer of equity and debt to investors. Whereas the SPOE strategy was developed to implement OLA under the Dodd-Frank Act, it has come to be viewed as the most promising approach for the resolution of SIFIs from other jurisdictions as well.
Summary of the SPOE Strategy
Under the SPOE strategy, the operating subsidiaries, in which the systemically important financial businesses are conducted, would remain open and operating and would not be placed into insolvency proceedings. Under OLA, the SPOE strategy would be implemented immediately after appointment of the FDIC as receiver by the transfer of all of the SIFI’s assets, including ownership of its subsidiaries, to a newly chartered bridge financial company (Bridge). Following the transfer, the Bridge would become the new top-tier holding company of all of the operating subsidiaries of the failed SIFI.
The SPOE strategy has a number of key advantages, including:
Greatly reducing the likelihood of systemically destabilizing disruptions to subsidiary operations;
Imposing losses on the equity holders and creditors of the holding company, who are structurally subordinated to the creditors of operating subsidiaries;
Mitigating potential cross-border coordination issues by keeping foreign subsidiaries open and operating; and
Preserving the going-concern value of the SIFI, which should minimize losses for creditors and lessen the impact of the failure on the broader economy.
The SPOE strategy builds on several interrelated factors. First, US financial holding companies are not operating companies and instead provide funding for their subsidiaries by issuing equity and debt. As a result, the receivership of the holding company likely would not affect continuity in the systemically important financial operations that could spread instability, including the settlement of payment transactions. Second, the potential systemic consequences of a failure of a SIFI derive principally from the operations of the holding company’s subsidiaries. If those subsidiaries continue to operate unimpaired, the systemic effects on financial stability are likely to be mitigated. Third, because the parent holding company serves principally as a source of capital and liquidity, if it can continue to fulfill those functions in resolution, it can provide liquidity and sources for the recapitalization of its subsidiaries, and it can continue to facilitate their continued operations.
Funding for the Bridge operations would be available from private sector sources or through the Orderly Liquidation Fund.13 The FDIC has stated a strong preference for private sector funding when available.
A central component of the SPOE strategy is the exit strategy designed around an eventual swap of creditor claims for equity in a new company that will emerge from the Bridge. This achieves a bail-in of creditor claims after the SIFI is placed into insolvency proceedings. The FDIC has indicated that it anticipates that the bail-in of the Bridge would occur in approximately six to nine months through the exchange of creditor claims for equity or debt of the restructured Bridge (or one or more successors to the Bridge) in satisfaction of the claims of creditors left behind in the receivership.14 In its 2013 paper, the FDIC noted that this time-frame is driven by the time needed to complete a reliable valuation, achieve systemic stabilization, and comply with Securities and Exchange Commission standards for the issuance and trading of the new equity and debt. Ownership and control of the newly capitalized Bridge would thereby be transferred to its former holding company creditors. This result would be similar in effect to a restructuring under Chapter 11 of the Bankruptcy Code. Similarly, the SPOE Notice states that the FDIC plans to use the “fresh start” accounting model commonly used for companies emerging from bankruptcy.
One particularly notable recent step forward is the international industry and regulator agreement on a new protocol for stays in termination of derivatives contracts. The stay protocol involved complex negotiations between major global banks, the International Swaps and Derivatives Association, and regulators. The protocol will allow imposition of a stay on cross-default and early termination rights within standard International Swaps and Derivatives Association derivatives contracts with the eighteen largest global financial firms in the event one of them is subject to resolution action in its jurisdiction. The stay is intended to give resolution authorities time to facilitate an orderly resolution of a troubled bank. Under the stay protocol, counterparties will opt into certain overseas resolution regimes by modifying the default provisions of their derivatives contracts. This is particularly important because the existing statutory stays may only apply to domestic counterparties trading under domestic law agreements. As a result, the ability to stay contracts involving cross-border parties could be challenged. The inclusion of modified default provisions along with the statutory stays is significant. First, the protocol will help prevent the unwinding of a financial group if a global SIFI’s holding company is closed by barring the termination of contracts with its subsidiaries under the commonly used “cross-default” provisions. Second, once regulations are adopted in the United States, the extension to the US Bankruptcy Code will help prevent direct defaults and the termination of contracts otherwise permitted under the current code. This will significantly improve the effectiveness of the code in resolving financial companies.
Summary of the UK Approach to SPOE
The BoE’s Approach to SPOE
In its Resolution Paper, the BoE provided insight into its approach to using the SPOE strategy. While the Resolution Paper does not discuss SPOE by name, it is clear from the BoE’s prior public pronouncements, as well as through its citation of its 2012 joint paper with the FDIC, that its preference is to use SPOE to resolve most UK global SIFIs.15
The BoE Resolution Paper builds on the new authority provided in the BRRD while providing additional details. First, the BoE Resolution Paper describes bail-in as a preferred resolution strategy for global SIFIs compared to use of its transfer powers, which include the power to transfer operations of the failing SIFI to a Bridge. The reason lies in the BoE’s concern that it will be exceedingly difficult to separate the critical economic functions of the SIFI from those that are less critical in making the transfer.16 In contrast, the FDIC plainly considers that a transfer to a Bridge will involve nearly all (other than equity, litigation, and matters under investigation) of the operations of the failed SIFI, while noting that one advantage of applying the SPOE at the holding company level is that there are few, if any, critical operations actually conducted by the holding company.
Second, the bail-in strategy is perceived as having the advantage of better facilitating continuity in critical operations. To the extent it is effective at recapitalizing the SIFI and achieving renewed market confidence, this could prove an advantage. However, absent market disruption from the insolvency “event” itself, if the transfer to the Bridge involves all key operations of the SIFI or if the “point of entry” is at a holding company level where there are few, if any, operating facilities, the United Kingdom’s preinsolvency bail-in strategy may not produce a significant difference.
Third, the bail-in strategy is viewed as presenting an advantage because it can potentially operate before insolvency as well as after initiation of resolution actions.17 However, as is clear from the discussion in the BoE Resolution Paper, the decision to impose any official action will likely be only at the moment just before insolvency—if beforehand at all—given the issues that must be addressed regarding safeguards for equity holders under the European Convention of Human Rights.18 If bail-in occurs at that time, the need for central bank or governmental liquidity will be clear, because the SIFI most likely will be on the doorstep of failure due to its inability to obtain sufficient market liquidity.
Fourth, the BoE Resolution Paper discusses a further issue that continues to create challenges in implementing a bail-in approach before resolution, as well as after resolution under some proposals. This issue revolves around the reliability of valuations of the assets of the failing SIFI in order to determine the extent of necessary write-downs for creditor claims and the resulting terms of the bail-in.19 If the bail-in occurs before resolution, this issue becomes more difficult as obtaining accurate valuations in the midst of a near-failure scenario will prove complex, at best. The BoE and the FDIC have noted that this may be addressed by issuing new equity based on an estimated valuation while providing “warrants” or “certificates of entitlement” to creditors so that a true-up of the value of their claims can be completed when more complete market valuations are available.
In its paper, the BoE said that it would address the uncertainty of the valuations through creation of a draft resolution instrument that would give legal effect to the bail-in, including the write-down and/or conversion of outstanding regulatory capital instruments. As part of this preparation, the BoE would identify those liabilities that may be within scope for the bail-in on the basis of an initial valuation exercise (for example, shares, subordinated debt, and unsecured senior creditors). Over the resolution weekend, the BoE would identify the liabilities to be bailed-in, and the Financial Conduct Authority likely would suspend trading in those instruments. Certificates of entitlement would be issued by the firm to investors in bailed-in liabilities. The certificates would represent a potential right to compensation and provide a mechanism for former creditors to be provided with shares or other instruments in due course. During the period immediately after the resolution weekend, the BoE would seek to refine the valuations so that it could determine the final terms of the bail-in. Then the BoE would announce the final terms of the bail-in, including how the certificates of entitlement will be exchanged for shares in the firm.
Because one of the goals of the UK process is to return the firm to “normal” trading activity almost immediately after the bail-in weekend, the legal title to the shares may be transferred to a third-party commercial bank appointed by the BoE to act as a depositary. There, the shares could be held in trust until a final valuation and distribution to claimants.
The BoE and the FDIC clearly agree that the exit strategy would likely involve a bail-in of creditors of the failed SIFI to recapitalize the SIFI (or more properly in a Bridge scenario, to capitalize this newly chartered entity for the first time). This inherently demands that the SIFI hold sufficient loss-absorbing capacity to provide sufficient bail-inable creditor claims to provide a strong base of capital for future operations that, at the least, fully complies with Basel capital standards and, perhaps more important, meets market expectations for sufficient capital.20
Total Loss-Absorbing Capacity and Bail-in
As can be seen from this brief summary of the principal US and UK strategies, the existence of sufficient equity and long-term debt in the SIFI at the time of failure is critical. These strategies are all based on recapitalizing the SIFI by converting or bailing in capital instruments, including longer-term debt instruments, to create a new capital base that is sufficient to meet both regulatory and market capital requirements. This requires that existing equity absorb all of the losses that led to the failure, and that the SIFI have enough additional, eligible capital and/ or debt instruments outstanding so that when these instruments are converted into equity, the SIFI will meet its capital requirements. Because the goal is to maintain ongoing operations, it is imperative that other creditors, such as liquidity providers and ongoing operational vendors, not be impaired.
If the SIFI can be recapitalized in this manner, it will also be critical to address losses and capital deficits in any subordinate operating companies. For US holding companies, the operations likely to lead to losses that could impair the survival of the financial group will almost always arise in an operating subsidiary. This is also true for many non-US financial groups. As a result, if the financial group is to continue its systemically important business operations, there must be a way of recapitalizing the impaired operating subsidiary to meet its own market and regulatory capital requirements. If the holding company is to retain control over the impaired operating subsidiary and continue to receive the future value in that subsidiary, the holding company’s equity and creditors must absorb those losses and quickly recapitalize the subsidiary and return it to normal operations. This means that not only is the SIFI holding company’s loss-absorbing equity and debt important, but so is the loss-absorbing equity and debt between the holding company and a systemically important subsidiary. This dynamic, of course, can raise a dilemma: is the subsidiary worth salvaging, or should it be liquidated to preserve the value of other holding company subsidiaries (Gordon and Ringe 2015)?
Among the most significant developments toward ultimately ending too-big-to-fail has been the extensive progress in establishing international standards and beginning the practical implementation to require cushions of debt and equity to permit the recapitalization, rather than the unwinding, of a troubled SIFI. As discussed previously, the availability of sufficient bail-inable debt can allow a SIFI to reestablish a sound capital foundation and serve as a source of strength to its operating subsidiaries by providing resources to recapitalize subsidiaries that may have incurred losses that impair their compliance with regulatory requirements and/or lead to their inability to maintain market-based funding. Obviously, the quantum of bail-inable debt at the parent company level, along with cancellable obligations from the subsidiaries to the parent, must be sufficient to absorb the losses of the parent and subsidiaries.
To achieve these objectives, the FSB—as well as the regulators in the United States, the EU, and the United Kingdom—has concluded that all SIFIs must maintain levels of equity capital and debt as total loss-absorbing capacity (TLAC). The EU has framed its requirements in terms of a “minimum requirement for own funds and eligible liabilities” (MREL), but has only recently addressed how banks within the EU should comply with the differing requirements for MREL and TLAC, as discussed subsequently.
In November 2015, the FSB released its final “Principles on Loss-absorbing and Recapitalization Capacity of G-SIBs in Resolution” and related TLAC Term Sheet (collectively, the “FSB TLAC Principles”).21 The FSB TLAC Principles are designed to achieve broadly common requirements to ensure that global SIFIs maintain sufficient debt and equity cushions to permit their recapitalization in resolution. The FSB TLAC Principles set minimum standards both for the quality of the debt or equity as well as its quantity. These principles address the availability of sufficient loss-absorbing debt and equity, both at the top-tier parent (external TLAC) as well as at material subgroups (internal TLAC). Internal TLAC is an important piece of the puzzle for implementation of resources for resolutions, because it allows for prepositioned resources to be available to recapitalize the operating subsidiaries of a SIFI and prevent a cascade of failures within the SIFI’s financial group. As recently observed by the FSB, many of the home jurisdictions of global SIFIs have either developed, proposed, or adopted national standards.22
On December 15, 2016, the Federal Reserve Board issued its final rule to define US requirements for TLAC (“Federal Reserve Rule”).23 The rule, among other things, imposes TLAC and long-term debt requirements on global SIFIs and on the US intermediate holding companies of non-US global SIFIs.
The Federal Reserve Rule clarifies the required resources targeted to achieve both loss absorption and recapitalization. The rule includes the following key elements:
Minimum external TLAC requirements for the bank holding companies of US global SIFIs, which include a minimum level of long-term debt and related TLAC buffers;
Minimum internal TLAC and long-term debt requirements for the US intermediate holding companies of non-US global SIFIs, which differentiate between SPOE and MPOE groups. In response to comments, the Federal Reserve Rule will allow MPOE intermediate holding companies to issue TLAC and long-term debt to external parties; and
“Clean holding company” requirements that impose stringent limitations on the ability of covered bank holding companies and intermediate holding companies to incur common types of non—TLAC-related liabilities.
While the rule is largely consistent with the proposal, it has been modified to address some of the comments—principally to provide for grandfathering of debt issued before December 31, 2016, and to permit intermediate holding companies of MPOE firms to issue TLAC and eligible external long-term debt to third parties. While the Federal Reserve Rule did reduce somewhat the overall long-term debt requirements applicable to intermediate holding companies, it does require higher levels of TLAC for those of MPOEs than for those of SPOEs.
The policy behind the Federal Reserve Rule is clear: to facilitate the recapitalization of the troubled bank holding company or foreign-owned intermediate holding company. The key features focus on ensuring that long-term debt will be available in stress for conversion into new equity for the bank holding company or intermediate holding company. This is achieved by narrowly defining what qualifies as long-term debt by strictly limiting the amount of non-long-term debt that the holding company can issue (so that it is a “clean” nonoperating entity), and by requiring a calibration of the amount of TLAC that must be issued so that the holding company can be fully recapitalized after it has exhausted its prior equity base. In addition, the Federal Reserve Rule places the Federal Reserve squarely in control of the triggers for conversion of the long-term debt into new equity. In effect, the Federal Reserve Rule doubles the required equity and debt requirements for US global SIFIs and for those portions of non-US global SIFIs operating in the United States. These standards are designed to ensure that both US SIFIs and foreign SIFIs operating in the United States retain sufficient resources to permit recapitalization and resolution without relying on US public capital resources.
While the Federal Reserve Rule, like the original proposed rule published for public comment, is broadly consistent with the framework of the FSB’s TLAC Standards, the Federal Reserve Rule is much more restrictive than, and deviates from, the FSB TLAC Standards in several meaningful ways. First, while calibration of the risk-weighted assets component of the Federal Reserve’s proposed minimum TLAC requirement is aligned with the FSB TLAC Standards, the additional constraints on eligible liabilities, along with other elements, make the Federal Reserve Rule more stringent. Among the key elements making the Federal Reserve Rule more stringent are the formal long-term debt requirement, TLAC buffer, and clean holding company limitations. There are no comparable requirements in the FSB TLAC Standards. Second, the standards for eligible debt under the Federal Reserve Rule are much more stringent than the FSB TLAC Standards and current Tier 2 standards. Tier 2 capital instruments would be eligible for inclusion in TLAC under the FSB TLAC Standards, but not in the Federal Reserve Rule. By contrast, and as only one example, much of the existing long-term debt issued by bank and intermediate holding companies includes acceleration clauses that are barred for eligible debt under the Federal Reserve Rule. Third, the Federal Reserve Rule’s treatment of intermediate holding companies of foreign SIFIs deviates significantly from the FSB TLAC Standards applied to entities in host jurisdictions in a number of ways. It imposes more onerous requirements for internal TLAC, significantly increases the required proportion of long-term debt required, and severely limits the financing and operational flexibility allowed for intermediate holding companies.
The TLAC Standards are only one component in a multilayered structure of capital, bail-inable debt, enhanced liquidity, and improvements in internal corporate structures, services, and operations for large financial companies that has created greatly enhanced resiliency and resolvability. For this reason, any assessment of where we are today in ending too-big-to-fail has to consider these overlapping improvements. Among the principal components of this structure are:
Legal entity restructuring to facilitate an SPOE strategy, often referred to as “legal entity rationalization”;
Strengthened capital requirements;
Stringent liquidity standards to require the availability of large reservoirs of high-quality liquid assets that can support liquidity under stress;
Internal operational reforms to rationalize and strengthen services, risk management, and management information systems, and to create so-called playbooks defining the quantitative and qualitative triggers leading to escalating responses to stress by management and regulators;
International protocols and requirements limiting cross-defaults in derivative contracts to prevent cascading defaults under stress;
Supporting contractual structures to facilitate the transfer of capital and liquidity resources to operating subsidiaries;
The “Volcker Rule” in the United States and “ring fencing” in the United Kingdom to limit the perceived impact that certain trading activities might have on banks; and
Of course, the TLAC and MREL standards discussed previously.
While this litany illustrates some of the key reforms, many other regulatory initiatives have been pursued in an effort to improve resiliency and resolvability, such as greater margin requirements and mandatory central clearing for many derivative transactions. Financial institutions themselves have responded with enormously expensive steps to implement these reforms. As a product of internal reviews, and the combination of regulatory pressure and a reassessment of the value of certain businesses subject to increased regulatory requirements, many global SIFIs have reassessed whether some business lines should be continued. In short, the steps taken since the financial crisis have created potentially more resilient and fundamentally different global financial institutions.
However, the question of whether these reforms and the resulting transformations will be successful in fending off the next crisis can only be answered then. To state a cliché, if history is any guide, past performance cannot predict future results. Nonetheless, while some argue that the obvious future unknowables confirm their skepticism about the value of the reforms, this posture itself ignores experience and delves into the realm of the pseudo-sophisticate who doubts everything so as to be possibly proven right about something. History and experience both prove that greater resilience and redundancy around the key components of risk—here asset quality (and its effect on capital solidity), liquidity, and operational continuity—provide a cushion that prevents sudden collapse and gives time to respond with countermeasures. Better and more rigorous planning provide the basis for well-developed countermeasures to be deployed during the additional time bought by this cushion to respond to differing sources of the risk. Does this planning provide a guarantee? No, that would be a fantasy akin to the unsinkable Titanic. However, it does focus improvements on those areas that experience proves are the linchpins of potential SIFI destabilization.
The multilayered structure created by the reform process does create its own risks. These include measurable risks from the great expense of these reforms and from some features that, if not flexibly applied, can create sclerotic corporate and transactional structures that could impair the deployment of capital and liquidity during a crisis. For example, as noted by the comment letters of the trade associations, many of the requirements ultimately implemented in the Federal Reserve Rule, which exceed those mandated by the FSB, tend toward requiring more narrowly defined eligible instruments, more limited potential investors (including requiring intermediate holding companies to issue all of their internal TLAC to their foreign parents), fewer funding options, and significant constraints on the ability to redeploy resources where it might be needed in a crisis. These issues could lead to SIFIs with large, theoretical resources of TLAC but also with more limited capabilities to survive liquidity stress or use the TLAC where it is needed.
These risks are illustrated in the internal TLAC requirement imposed by the FDIC and Federal Reserve on the largest US global SIFIs through the resolution planning process.24 The April 2016 Guidance for future resolution plans emphasized that future capital analyses must focus on “appropriate positioning of additional loss-absorbing capacity within the firm (internal TLAC).”25 The FDIC and Federal Reserve noted that such internal TLAC could be achieved by prepositioning recapitalization resources at the subsidiary or at the parent, but that firms should not rely exclusively on either option. The guidance also created a direct link between the internal TLAC, triggers based on specific quantitative and qualitative criteria, and specific binding contractual mechanisms to push the TLAC down to operating subsidiaries. It also required firms to quantitatively analyze their required capital and liquidity resources under stress conditions to ensure that these contractual mechanisms operated to recapitalize and reliquify the operating subsidiaries. As a result, the granular and specific capital and liquidity requirements are tied closely to the requisite structured governance framework, but give less discretion to SIFI management. While this approach provides a contractual framework that gives greater assurance that TLAC resources could be down-streamed from parent to subsidiary, the highly structured nature of the arrangements runs the risk of limiting the resources that can be deployed by management to where they are most needed in a crisis.
As a result of the April 2016 Guidance, US global SIFIs have developed detailed analyses for their capital and liquidity requirements under stress and in resolution.26 In effect, the resolution-planning guidance has become a parallel set of requirements for long-term debt, capital, and liquidity buffers. As described in the April 2016 Guidance, contributable resources from the parent will require structured capital contribution agreements, also referred to as a contractually binding mechanism, in order to meet the governance standards that require specific triggers linked to escalating stress that permit the recapitalization of subsidiaries before the parent’s failure. The guidance also required detailed legal analyses of potential challenges to these structures from creditors of the parent bank holding company. As a result, the US global SIFIs have undertaken corporate realignments to create intermediate holding companies, detailed legal analyses of possible creditor challenges, implemented capital contribution agreements, and ongoing analytical efforts to meet the resolution-planning requirements. As a result, while TLAC is a regulatory requirement, the resolution-planning regime has put in place new standards that carry the regulatory requirements to additional levels of granularity. This illustrates the close relationships between the different components of reform.
While foreign global SIFIs active in the United States have not received precisely the same US resolution planning guidance as the US global SIFIs, these foreign companies also have taken major steps to improve resiliency and resolvability. As described previously, the Federal Reserve Rule imposes internal TLAC requirements on the intermediate holding companies of foreign global SIFIs. The rule mandates that this internal debt include a contractual provision permitting its conversion into common equity outside insolvency proceedings—which the Federal Reserve can trigger if it determines that the intermediate holding company is in default, or in danger of default, or certain other circumstances apply.27 This creates a key dynamic in the relationship between the foreign global SIFI’s home country supervisor and the Federal Reserve. In effect, for any foreign global SIFI with major operations in the United States, the Federal Reserve controls the timing and decision to initiate resolution in the United States as well as in the home country. The former is clear on the face of the regulation, but the latter is a byproduct of the impact that the Federal Reserve triggering a US resolution would have on the stability and market access of the home country, or other global, operations of the foreign SIFI. Once the Federal Reserve pulls the US trigger, it is hard to imagine that the home country supervisor could manage the ensuing market chaos without intervening in the home country as well. This symbiotic relationship may lead to greater stability by necessitating close cooperation by the home country authorities with the Federal Reserve, but it also may lead to destabilization if the Federal Reserve ever felt compelled to act due to an idiosyncratic event in the United States that did not have similar dire effects in other jurisdictions. The answer may simply be that the home country authorities will always have to ensure that the foreign global SIFI’s operations in the United States are well-supported to avoid this risk. At a minimum, this choice places the onus on the home country supervisor to ensure that the global SIFI’s US operations remain stable and supported, while limiting that supervisor’s ability to control activities in the United States.
On the other hand, the internal TLAC and other reforms also provide resources to allow foreign global SIFIs active in the United States to recapitalize their US operations by conversion of the internal TLAC into new equity. This should mean that both US branches and US intermediate holding companies will not need to enter into bankruptcy because the conversion of the bail-inable debt at the parent and at the intermediate holding company will restore those entities to a sound capital condition. Because this will predominantly or exclusively involve the conversion of debt owned by the parent foreign SIFI, the process also transfers the preconversion losses to the foreign parent. In a future crisis, the now-required regulatory liquidity resources will provide an internal buffer to help weather stress and avoid the potential death-spiral that can result from an overreliance during a crisis on market-based liquidity resources. However, it will also be essential for central banks to maintain their traditional role as lenders of last resort to ensure that the market understands that ample liquidity is available both internally and through the central bank (or perhaps in the future through a market-based facility) to address any possible liquidity stress. This is the clear, practical meaning of the concept that having more than adequate resources available usually means fewer resources actually must be used.
Once the intermediate holding company is recapitalized, the issue remains of providing capital and liquidity to the US operating subsidiaries. US resolution planning guidance to the foreign global SIFIs, issued in 2017, similarly includes requirements for detailed analyses of capital and liquidity requirements along with transactional and other structures to allow for the down-streaming of capital and liquidity from the Intermediate Holding Company to the operating subsidiaries. Foreign global SIFIs are developing transaction structures similar to those being implemented by the US global SIFIs, such as capital contribution agreements and contractual frameworks to assure that financial resources can be downstreamed to operating subsidiaries. In comparison to the US global SIFI bank holding companies, the risk of successful creditor challenges to the downstreaming of resources from the intermediate holding company to the operating subsidiaries is substantially reduced, given that the foreign intermediate holding companies are wholly owned by foreign parents. The parent’s ultimate value is based on its ability to continue the operations of its subsidiaries, and the use of contractually binding mechanisms between the now recapitalized intermediate holding company and its subordinate operating subsidiaries significantly ameliorates any potential risk that could arise from direct transfers between a insolvent bank holding company and its direct subsidiaries.
In summary, great progress has been made in creating much more resilient and resolvable global SIFIs, and major contributors to that progress have been the new strategic insights on strategies and discoveries of and responses to address previously unappreciated vulnerabilities. There are risks created by this process as well. While there is no question that larger buffers of equity, debt, and liquidity are important components of more resilient financial companies, the US drive to tie specific actions to binding playbooks that are built around presumed or automatic responses through recapitalization or other deployment of those resources may provide a false sense of predictability and reliability. Though appearing to create reliability, this approach could lead to a much more mechanical structure that sacrifices needed flexibility to deploy resources at key pressure points in a timely manner. Experience also shows that some supervisory or company responses can lead to overcompensating market reactions during periods of stress. If the regulators mandate a too prescribed set of responses with prepositioned resources, thus leaving few resources for a more flexible deployment, we may create a series of predefined, mandated trigger events that cause the market to overreact in fear of the next preplanned response. This could increase, rather than reduce, company and market stress and instability, while impairing or undercutting a response that may be more effective. In another realm, we only have to look at the series of predictable, but self-interested, responses to mobilization by different contesting powers in August 1914 to see the catastrophe that can occur from inflexibility interacting with anxiety under stress.28
Recent European initiatives continue to pursue the implementation of the BRRD by creating greater clarity in the relationship between MREL and TLAC, as well as defining more clearly the liabilities to be written down in a future bail-in. The original Article 45 of the BRRD requires an institution to maintain at all times a minimum amount of its own funds and eligible liabilities (that is, liabilities that may be written down or converted under the bail-in tool). The MREL is to be calculated as the amount of own funds and eligible liabilities (including subordinated debt and senior unsecured debt with a remaining maturity of at least 12 months that are subject to the bail-in power) expressed as a percentage of the total liabilities and own funds of the institution. Resolution authorities, after consultation with the supervising authorities, are tasked with determining the minimum requirement for each institution based on a number of criteria taking into account the size, the business model, the funding model, and the risk profile as well as the potential effect of the institution’s failure on the financial markets. Article 55, in turn, helped implement the requirements by requiring inclusion of a contractual term providing that the party to the instrument recognized that it may be subject to write-down and conversion by a resolution authority.
On November 23, 2016, the European Commission published legislative proposals to amend the BRRD in several ways. Two particularly important proposals would (1) modify the creditor hierarchy in insolvency in order to better implement a bail-in strategy for resolution, and (2) adopt widespread revisions to the EU prudential regulatory framework for banks and investment banks (the
BRRD Proposals).29
First, the BRRD proposals introduce a new rank in insolvency (“senior non-preferred”) for long-term debt instruments, which will rank senior to regulatory capital and subordinated debt, but junior to other unsecured liabilities. These debt instruments would therefore be bailed-in before other unsecured liabilities (such as operational liabilities, derivatives, and deposits), which is designed to improve the resolvability of EU institutions and facilitate compliance with the FSB’s TLAC standard. This proposal builds upon legislation recently enacted in certain EU member-states, including France, Germany, and Italy, and closely aligns with the French “Sapin 2” law enacted on December 9, 2016. In effect, it will allow the EU global SIFIs to issue debt that complies both with their MREL requirements as well as their TLAC requirements.
Second, among the proposed revisions to the EU prudential regulatory framework, the BRRD proposals would require certain non-EU financial institutions to establish an EU intermediate holding company where they have two or more banks or investment firms in the EU. This is certainly controversial among non-EU banks and other financial firms. This late addition to the proposal prompted commentary highlighting its apparent “retaliatory” nature as a response to regulations issued by the Federal Reserve requiring all non-US banking organizations with US nonbranch assets of $50 billion or more to establish a US intermediate holding company to hold all of their US subsidiaries (banking and nonbanking). These US regulations were strongly opposed by non-US banking organizations and criticized by numerous government officials, including representatives of the European Commission, who expressed concern that the US Intermediate Holding Company requirement “could spark a protectionist reaction from other jurisdictions.”30 A US intermediate holding company is subject to US capital and liquidity, stress testing, and other prudential requirements as if it were a US bank holding company. If adopted as proposed, the EU intermediate holding company requirement would impose similar requirements and create certain conflicts with home country regulations, including the US requirement that broker dealer subsidiaries be under a separate ownership branch from US banking subsidiaries. The EU intermediate holding companies also would be subject to the BRRD resolution process as well as the EU internal TLAC and discretionary MREL requirements.
These EU developments point out the complex interplay of still-developing regulatory and supervisory standards and how they can differentially affect domestic and foreign banking operations. As noted, the US intermediate holding company requirements were very controversial in Europe, and the EU proposal is likewise controversial outside the EU. These developments do not give great comfort about the likely consistency of regulation and supervision for global SIFIs or for the likely cooperation between regulators in a future crisis. All of the reforms since the financial crisis must be premised on improved cooperation in order to avoid an isolated financial problem from once again becoming a global crisis. The political and policy winds do not seem to be blowing favorably.
Further Implementation Steps
The development of new insolvency laws, creative resolution strategies to address some of the key conceptual problems in SIFI resolutions, and the first phases of putting in place sufficient bail-inable resources to allow a timely and effective bail-in strategy (whether SPOE or MPOE) are promising steps toward ending too-big-to-fail.
These steps build on a foundation of real measurable progress in building more resilient SIFIs. First, the SIFIs today hold much greater required capital and liquidity resources under regulatory capital and liquidity standards than did similar institutions at the time of the crisis. These capital levels are augmented in the United States by annual stress-testing requirements for the eight US global SIFIs, which effectively establish an additional required level of capital protection. The requirement that global SIFIs hold larger resources of high-quality liquid assets provides substantial liquidity resources to allow them to weather significant stress. Further requirements have been proposed by the Federal Reserve, but whether those will be implemented is more uncertain given the priorities of the current US administration.31 In addition, SIFIs are required to prepare recovery plans to provide well-developed strategies for recovering required capital and liquidity levels in periods of stress. These are joined with additional requirements under the rubric of enhanced prudential standards.32 Second, SIFIs have undertaken real corporate reorganizations and restructuring of their funding and operational infrastructures to make them more resolvable. These changes have greatly reduced the reliance on short-term funding; they also have provided a much more granular understanding of shared services, financial interconnections both between SIFIs and within the companies, and the effectiveness of funding strategies during periods of stress. Finally, we should not forget that implementation of the TLAC requirements remains to be completed. When those resources are in place, we will have cushions that should be sufficient to allow for the recapitalization of SIFIs even after their regulatory capital buffers are exhausted. While these steps are not complete, the way forward to final TLAC implementation is now relatively set. But all of these steps are only the foundational elements for a viable and actionable resolution plan for SIFIs.
Much additional work is required on the granular issues that will determine whether any future resolution can be successful. This work must be accompanied by a much more extensive interaction with market participants to engender a greater understanding of the strengths and weaknesses of the resolution strategies by the regulators, SIFIs, and market participants as well. Only a rigorous process of testing, challenges to assumptions and analyses, and corrective steps can give real confidence that the resolution strategies can be implemented. If there is insufficient confidence by the markets, policymakers, or politicians that the resolution strategies can actually be implemented successfully, there will be no resolution, and we will return to the default measure of a full governmental bail-out or, even worse, we will do nothing and allow a small crisis to cascade into a major catastrophe for the financial system and the economy.
It is wise always to be skeptical because how the reformed system will respond to the stress of a new crisis is virtually impossible to know. More information, more probing, and more testing of assumptions, plans, and internal strategies is essential. A transparent appraisal of the challenges and possible solutions is the only response.33 Unfortunately, and perhaps even more importantly, how will future regulators, politicians, bankers, and market participants respond in some future crisis? International cooperation is essential to successfully respond to any future crisis, because the best-designed resolution frameworks, strategies, and capital and liquidity resources can be undone if improperly used or not used at all. The headwinds today of nascent protectionism and resurgent nationalism give cause for pause and concern. We have made great progress, but if the most valuable components of that progress are unwound, we may be laying the groundwork for a future dislocation with unpredictable consequences.
Where Are we After All?
There is no question that we have made great progress in implementing reforms designed to end too-big-to-fail in the years since the financial crisis. The ultimate question—have we ended too-big-to-fail?—may be impossible to answer until the strengthened SIFIs, legal frameworks, and resolution strategies are tested in a crisis.
As noted by a number of commentators, the individual impact of many regulatory reforms is very difficult to measure, and their cumulative impact is even more difficult to assess. One clear result of the regulatory reforms has been that the implementation costs have been enormous by any measure. Tens of billions of dollars are spent each year on meeting the new standards under the Dodd-Frank Act and other new regulatory requirements.34 The costs and rewards of new cushions of capital and liquidity alone are hard to assess. Those costs have led some European regulators to challenge the need to further strengthen requirements and have led the new US president to decry the impact of regulations on the availability of credit and to support legislative and regulatory steps to modify or undo many of the regulatory reforms since 2008.35 Today, we appear to have entered a part of the implementation phase of the postcrisis regulatory reform where real questions are being raised about the value of further reform measures and about whether the Western economies can afford further steps to create a more resilient financial system. The consensus in favor of reform seems to have been overtaken by fatigue.
Where are we, after all?
References
Gordon, Jeffrey N., and Wolf-Georg Ringe. 2015. “Bank Resolution in The European Banking Union: A Transatlantic Perspective on What It Would Take.” Columbia Law Review 115 (1297): 1352–53.
Lewis, Michael. 2010. The Big Short: Inside the Doomsday Machine. New York: Norton.
Scott, Hal S. 2016. Connectedness and Contagion: Protecting the Financial System from Panics. Cambridge, MA: MIT Press, 75-78.
Sorkin, Andrew Ross. 2009. Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves. New York: Viking.
Tuchman, Barbara W. 1963. The Guns of August. New York: MacMillan.
The author is a Partner with Cleary Gottlieb Steen & Hamilton and former General Counsel and Deputy to the Chairman for Policy at the US Federal Deposit Insurance Corporation. The views expressed in this chapter are solely those of the author and do not necessarily represent the policies or views of Cleary Gottlieb or any of its partners.
As in most areas of human endeavor, jargon and acronyms continue to separate those “in the know” from those less focused on the topic. While unfortunate, acronyms do have the merit of promoting brevity in references. So I will use those that have achieved some level of common usage in policy, regulatory, and legal discussions. For ease of deciphering these acronyms, rather than use the common term “G-SIB,” I will refer to “global SIFIs” except where G-SIB is used in the title of an article or regulatory publication.
Please note that by using the term “reform” I do not mean to imply that all of the changes during the “reform process” have been unmitigated positive achievements. In many areas, it is likely that quite a substantial number of the changes have improved resiliency and resolvability. However, even in some of these areas of reform, the difficulty of fully understanding the interaction of one “reform” within the broader market environment makes any judgment difficult. Unquestionably, and unfortunately, the political environment has made mid-course corrections—which are common for any major legislative reform—much more difficult to achieve.
While there have been reforms of mortgage origination and, to a lesser degree, securitization standards, there have been no material reforms in the secondary mortgage market framework. Today, the US secondary mortgage market remains dominated by the federal government, following the 2008 collapse of the private mortgage securitization market and the federal conservatorships of Freddie Mac and Fannie Mae. The political deadlock and the uncertainties about the impact of any reform in the federal role in this market has prevented further steps.
FSB, March 10, 2017, Letter by Chairman Mark Carney “To G20 Finance Ministers and Central Bank Governors,” http://www.fsb.org/wp-content/uploads/FSB-Chairs-letter-to-G20-FMCBG -March-2017.pdf.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Title II—Orderly Liquidation Authority, codified at 12 U.S.C. §§5381–5397.
OLA § 210(a)(11), 12 U.S.C. §5390(A)(11) makes eligible for resolution any company that is incorporated or organized in the United States; a bank holding company; a nonbank financial company supervised by the Federal Reserve; predominantly engaged (defined as 85 percent or more of its consolidated revenues) in financial activities, as defined by the Federal Reserve; a subsidiary of a company in the foregoing categories that also is predominantly engaged in financial activities; and not a Farm Credit System institution a governmental entity, or a Federal Home Loan Bank or housing-related government sponsored enterprise.
Basel Committee on Banking Supervision, Report and Recommendations of the Cross-border Bank Resolution Group, March 2010, The author co-chaired the Cross Border Resolution Group with Eva Hupkes.
Generally, qualified financial contracts are financial instruments such as securities contracts, commodities contracts, forwards contracts, swaps, repurchase agreements, and any similar agreements. See section 210(c)(8)(D)(i) of the Dodd-Frank Act, 12 U.S.C. § 5390(c)(8)(D)(i).
See generally section 165 of Title I of the Dodd-Frank Act, 12 U.S.C. § 5365 and “The Orderly Resolution of Covered Financial Companies—Special Powers under Title II—Oversight and Advanced Planning,” infra.
A directive dealing with reorganization and winding up of credit institutions having branches in several member-states was adopted in 2001 (Directive 2001/24/EC), but its purpose was essentially to determine applicable laws and to provide for some coordination between member-states.
As a practical matter, national authorities will be replaced by the Single Resolution Board under the Single Resolution Mechanism in certain cases.
See Andrew Gracie, “Ending Too Big to Fail: Getting the Job Done,” Speech at Deloitte, London (May 26, 2016), at 3–4, http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech912.pdf. Also, BoE, “The BoE’s Approach to Resolution,” October 2014, www.bankofengland .co.uk/financialstability/Documents/resolution/apr231014.pdf, which will be updated periodically. Another important recent paper released in the United Kingdom is the Prudential Regulation Authority’s paper, “Ensuring Operational Continuity in Resolution - DP1/14” published on October 6, 2014, at https://www.bankofengland.co.uk/prudential-regulation/publication/2014/ensuring-operational-continuity-in-resolution. This paper discusses, and seeks comment, on operational arrangements that may be necessary to facilitate operational continuity.
12 U.S.C. §5390(h)(2)(G)(iv).
FDIC, December 2013, “The Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy,” https://www.fdic.gov/news/board/2013/2013-12-10_notice_dis-b_fr.pdf.
BoE Resolution Paper, 12, footnote 2, in reference to holding company bail-in strategies. The 2012 BoE-FDIC paper at https://www.fdic.gov/about/srac/2012/gsifi.pdf.
See BoE Resolution Paper, 18.
See BoE Resolution Paper, 9–10.
See BoE Resolution Paper, 8.
See BoE Resolution Paper, 18–19.
It is appropriate to note that there are many discussions around the issue of what liabilities should be eligible for bail-in. This is one of the reasons that regulators have sought to require a likely sufficient level of long-term debt so that shorter-term liabilities—more often used for liquidity rather than loss absorbance—are not bailed in.
Financial Stability Board, November 9, 2015, http://www.fsb.org/wp-content/uploads/TLAC-Principles-and-Term-Sheet-for-publication-final.pdf.
Financial Stability Board, 2016, “Resilience through Resolvability—Moving from Policy Design to Implementation,” 15–16, http://www.fsb.org/2016/08/resilience-through-resolvability-moving-from-policy-design-to-implementation/.
The Federal Reserve Rule is codified at 12 C.F.R. 252. The proposed rule is at: https://www.gpo.gov/fdsys/pkg/FR-2015-11-30/pdf/2015-29740.pdf. See also Cleary Gottlieb Alert Memorandum, “Final TLAC Rule: Effect on US GSIB Debt” (December 15, 2016); and Cleary Gottlieb Alert Memorandum, “Final TLAC Rule: Federal Reserve Responses to FBO Comments” (December 15, 2016).
See FDIC and Federal Reserve, “Guidance for 2017 §165(d) Annual Resolution Plan Submissions by Domestic Covered Companies That Submitted Resolution Plans in July 2015,” April 13, 2016 (referenced below as “April 2016 Guidance”), https://www.fdic.gov/news/news/press/2016/pr16031b.pdf; Cleary Gottlieb, “Judgment on 2015 Domestic First Wave Resolution Plans: Five Deemed ‘Not Credible,’ and Along with Mixed Progress Comes a More Prescriptive Process” (April 29, 2016).
April 2016 Guidance, 4.
The April 2016 Guidance coined additional acronyms for these analyses: Resolution Capital Execution Need (CEN), Resolution Capital Adequacy and Positioning (RCAP), Resolution Liquidity Execution Need (RLEN), and Resolution Liquidity Adequacy and Positioning (RLAP). RCEN and RLEN are analyses designed to evaluate the capital and liquidity resources, respectively, required in resolution. RCAP and RLAP are analyses to support identification of the capital and liquidity needs of entities and position those resources where needed.
See 12 C.F.R. 252.163. The other circumstances include the intervention by the home authorities to initiate resolution of the foreign SIFI or recommendation by the Federal Reserve to place the intermediate holding company into receivership under the OLA.
See Barbara W. Tuchman, The Guns of August (MacMillan 1963).
European Commission, November 23, 2016, “Proposal for a Directive of the European Parliament and of the Council amending Directive 2013/36/EU as Regards Exempted Entities, Financial Holding Companies, Mixed Financial Holding Companies, Remuneration, Supervisory Measures and Powers and Capital Conservation Measures,” http://ec.europa.eu/transparency/regdoc/rep/1/2016/EN/COM-2016-854-F1-EN-MAIN.PDF; and European Commission, November 23, 2016. “Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 806/2014 Regards Loss-Absorbing and Recapitalization Capacity for Credit Institutions and Investment Firms,” http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52016PC0851&qid=1513190659261&from=EN.
Letter from Michel Barnier, European Commissioner for Internal Market and Services, to Federal Reserve Chairman Ben Bernanke, dated April 18, 2013. http://www.federalreserve.gov/SECRS/2013/April/20130422/R-1438/R-1438_041913_111076_515131431183_1.pdf.
The imposition of effective capital measures in normal times through analyses based on stress tests from more troubled times calls to mind my friend Charles Goodhart’s famous, and true, aphorism: “When a measure becomes a target, it ceases to be a good measure.” See Cleary Gottlieb, October 5, 2016, “Significant Increase in Capital Requirements for US GSIBs Relief from Qualitative Stress Test Objections for Smaller Banking Organizations.”
80 Fed. Reg. at 74927; Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking Organizations (Regulation YY), 12 C.F.R. § 252.
Darrell Duffie, June 2016, “Financial Regulatory Reform After the Crisis: An Assessment,” ECB Forum on Central Banking, https://www.darrellduffie.com/uploads/policy/ DuffieSintraJune2016.pdf. Also, Stijn Claessens and Laura Kodres, 2014, “The Regulatory Responses to the Global Financial Crisis: Some Uncomfortable Questions.” IMF Working Paper 14/46, International Monetary Fund, Washington, DC, https://www.imf.org/external/pubs/ft/wp/2014/wp1446.pdf.
Duffie at 8, fn. 6 (citing Kristen Glind and Emily Glazer, Wall Street Journal, May 30, 2016, based on estimates provided by Federated Financial Analytics, Inc., http://www.wsj.com/articles/nuns-with-guns-the-strange-day-to-day-struggles-between-bankers-and-regulators-1464627601?mod=e2tw).
White House, February 24, 2017, “Presidential Executive Order on Enforcing the Regulatory Reform Agenda,” https://www.whitehouse.gov/the-press-office/2017/02/24/presidential-executive-order-enforcing-regulatory-reform-agenda; European Commission, September 29, 2016, Speech by European Commission Vice President Valdis Dombrovskis, “Embracing Disruption,” before the European Banking Federation Conference, https://ec.europa.eu/commission/commissioners/2014-2019/dombrovskis/announcements/speech-vp-dombrovskis-european-banking-federation-conference-embracing-disruption_en; see also Catherine Contiguglia, September 29, 2016, “Regulatory Fragmentation Drives Basel RWA Impasse,” Risk.net, https://www.risk.net/regulation/basel-committee/2472331/regulatory-fragmentation-drives-basel-rwa-impasse.