INTRODUCTION
Disruptions from the collapse of some systemically important financial institutions (SIFIs) during the crisis have prompted policymakers to consider various options to tackle systemic risk in the financial system and restore public and market confidence. Various proposals have been deliberated, with the common objective of reducing the probability of bank failures and the associated social cost of a bailout. One of the much debated options concerns using “recovery and resolution plans” (RRPs), also termed “living wills,” as part of a resolution framework, along with other measures to ensure that all financial institutions can be resolved safely, quickly, and without destabilizing the financial system and exposing the taxpayer to the risk of loss.
RRPs or living wills are planning documents that create a road map to facilitate either the recovery of an institution in case of severe stress or its orderly wind-down in the event of failure. Essentially, they are contingency plans that encompass both recovery and resolution. Work is evolving at the international level, endorsed by the G-20, to identify how a consistent framework for the design and assessment of RRPs can be put into place. This chapter reflects current thinking but is clearly subject to change as progress is made.
THE OBJECTIVES, SCOPE, AND MODALITIES OF APPLICATION
The rationale behind requiring SIFIs to develop RRPs is to reduce the probability and impact of the failure of such institutions and thus to raise the likelihood of outcomes that do not require recourse to taxpayer support (i.e., to bailout). At a more granular and practical level, the rationale for such living wills is to ensure that a firm has identified and is capable of implementing strategies for recovery should there be a firm-specific or system-wide stress, as well as to ensure that the authorities fully understand the structure and operation of the institution and its systemic significance and could put in place a viable resolution mechanism without recourse to public funds.
The aim of a living will, therefore, is to require an institution’s management to make contingency plans in normal times for how the various stresses could be mitigated, as well as to understand how its key economic functions are distributed across the firm. The ultimate goal is for the bank or the resolution authority to know which parts of an institution could be separated or sold without damaging the continuation of its key functions.
In the context of the ongoing work at the Financial Stability Board (FSB), living wills have become part of the international framework for reducing moral hazard associated with SIFIs. In its November 2010 Seoul summit, the G-20 leaders endorsed the FSB’s framework for addressing SIFIs, including a requirement that international RRPs be mandatory for global systemically important financial institutions (G-SIFIs) and that institution-specific crisis cooperation agreements be negotiated within cross-border crisis management groups. The G-SIFIs will be subject to a sustained process of mandatory recovery and resolution planning to assess their resolvability under applicable resolution regimes. Where resolvability is not assured, authorities should have the powers, exercisable under clear criteria, to require the institution to change its legal and operational structures to ensure its resolvability. Current consultations by the European Commission (EC) on recovery and resolution similarly suggest that all banks may be required to supply such documents, with further discussions planned to determine whether investment banks will fall within the same scope.
Recovery Plans
The recovery component of the RRPs requires that an institution and its group develop contingency plans. Such plans include arrangements or measures that will enable the institution to take early action to restore or ensure its viability, and can be likened to a financial contingency form of business continuity planning in the event of an extreme disruption (e.g., damage to physical infrastructure because of fire, floods, or earthquakes). Specifically, the RRP is intended to focus on the means to maintain capital adequacy and liquidity even under extreme stress scenarios. The stress scenarios considered will be for the firm or group to identify, but they should be expected to include both firm-specific (idiosyncratic) and system-wide distress.
In identifying recovery or survival options, the firm or group will be expected to provide information on a set of key issues: sources of funding, whether additional capital or liquidity is needed, and other options to reduce the scale or riskiness of its activities. Options could include capital conservation measures, such as restrictions on the distribution of dividends, issuance of fresh capital, and supply of liquidity from backup lines or collateralized borrowing. For reducing exposure, options include the sale of business units or subsidiaries, the closing or scaling down of business lines, and the wholesale rescue of the institution by another entity. The plan that is produced needs to be specific, including the identification of trigger factors that would cause the institution to put the plan into effect. Last, the plan needs to be scrutinized and assessed as viable by the relevant supervisory authorities.
Resolution Plans
The resolution planning required as part of living wills is predicated on the understanding that the institution might not survive extreme stress and that its wind-down and liquidation should be as orderly as possible to avoid threat to financial stability or publicly funded support. A resolution plan should thus identify how an orderly resolution or wind-down by the authorities could be achieved should the recovery and contingency strategies identified in the recovery plan fail or prove to be inadequate in practice. A key focus of resolution planning is to preserve core functions and to avoid contagion risk. As with recovery planning, it will have to assess the likelihood of success of different resolution and wind-down options in a range of possible market environments. The resolution planning will also need to provide clarity with respect to the point of intervention by the authorities.
An important aspect of resolution planning is the opportunity it creates for the authorities to assess whether their own powers of intervention, resolution, and wind-down would be sufficient to respond to a firm-specific or system-wide stress. Legislative reform may be a first-round consequence of detailed work on RRPs. Additionally, the authorities might need to require changes to the financial, structural, and operational arrangements in the firm or the banking group in order to improve contingency options or remove obstacles to orderly resolution or liquidation.
Data Needs
The data needed for the RRPs will need to be shared to a considerable extent. The data set will also need to be maintained and be ready to be supplied to authorities at short notice in a crisis situation. Information needs will be broad and include structural, legal, organizational, operational, and financial elements. These would include, for example, detailed financial information (including on segregated client assets); data on the structure and key business lines; identification of core functions; use of payment, settlement, and clearing infrastructure; and identification of intragroup connections, dependencies, and relevant contacts. Information for resolution would include plans to facilitate rapid and orderly wind-down; information on client assets to facilitate rapid delivery; obstacles to asset transfers; and legal constraints. Absence of such information would undermine a robust analysis of potential contingencies and the authorities’ ability to assess or act on the options for resolution and wind-down.
Preparation and Responsibility
Broad international consensus suggests that recovery plans will be seen as the responsibility of the firm or group and resolution plans the responsibility of the relevant authorities. However, for the authorities to draw up a resolution plan or to assess either a resolution or a recovery plan, the contribution from the firm or group is an essential component. For a meaningful RRP to be created, it is essential for senior management of the firm or group to take ownership of the project. Both the firm and the authorities will have responsibility to ensure that RRPs are not treated as occasional crisis warning exercises but are maintained as current, active, up-to-date documents, evolving with the firm so that they are capable of being successfully executed should trigger signals emerge.
Similarly, recovery plans developed by the firm should be vetted by the supervisory authority. Once RRPs are drawn up, they will need to be assessed by the authorities. It is probable that there will be internationally agreed guidance and this will assist in cross-border consistency and in the global management of complex cross-border groups. FSB plans to have formulated criteria to assess the resolvability of SIFIs and the essential element of RRPs by the end of 2011, possibly including the continuity of essential functions, contagion control, and loss absorbency and resolution cost.
POTENTIAL BENEFITS
There are a range of potential benefits associated with the requirement for firms or banking groups to draw up RRPs. At the macro level, it affords scope for national jurisdictions to carry out a stock-taking of potential systemic risks and to consider the challenges or risks to financial stability posed by financial institutions. In the light of this information, the authorities can assess whether intervention, resolution, and wind-down powers are sufficient to address problems that may arise or whether amendments to such powers are needed. Alternatively, the authorities may consider that their powers are adequate but that changes to the structure or operation of a firm or group will enhance future prospects for stability. On the international scale, RRPs could serve as a focus for dialogue between jurisdictions to identify the extent to which cross-border cooperation and, in the event of crisis, resolution may be enhanced or delivered.
Although regulatory requirements to alter group structure or operational arrangements are likely to be undesirable, there are also potential benefits at the level of the firms. The RRP process acts as a forceful reminder to focus on the strengths and resilience of the group structure and may prompt the group management to modify the structure in light of identified structural weaknesses, even without regulatory intervention. By encouraging a more simplified and streamlined corporate and financial structure of the banking group, such plans can facilitate resolution of the group. The RRP would also help the firms focus on contingency planning (for capital, liquidity, and systems) and on the quality and timeliness of information communicated to their own management as well as to the authorities.
CHALLENGES
Although RRPs should have the capacity to contribute to higher standards of contingency planning and systemic resilience, there may be significant challenges to implementation. First, a meaningful RRP will depend critically on a considerable body of detailed, reliable, high-quality data that is fully maintained and can be supplied at extremely short notice. Such information needs are non-negligible, and meeting them will be an expensive investment for industry and quite possibly the authorities alike.
Similarly, since it is possible that financial groups may choose to restructure or be required to do so by the authorities as a result of the analysis of the RRPs, there may be further significant costs for the industry. Modification of corporate structures is a costly undertaking, and since most groups are presently optimized for taxation purposes it may also be assumed that revised structures may put the profitability of the institutions under additional pressure. Moreover, in transforming the groups into simpler, more streamlined corporate structures, the plans may affect the diversification benefits of groups with different business lines (also see Chapter 11). Should the expected effect of such changes be significant, strong resistance from the industry, including political lobbying, is possible.
RRPs may be challenging to put into action, although they will permit a considerable degree of preplanning and preparation by institutions and authorities and ought to create greater clarity with respect to the range of viable options should a crisis emerge. However reasonable the assumptions underlying the range of scenarios on which the RRP was based (both idiosyncratic and system-wide) may be, crises rarely follow the same pattern twice, and the institution and authorities are likely to have to react quickly to events that were not foreseen in the RRP. Nor should it be assumed that there will be straightforward choices with respect to the eventual intervention or resolution of an institution or its group. The authorities will need a framework to assess and distinguish between the merits of the resolution options available at the time.
Further complexities may arise when an institution is part of a cross-border group. At the planning stage, it will be important to involve all other relevant authorities. Should stress emerge, coordinated decision making will be necessary to ensure the best outcome. In order to ensure effective coordination, cooperation, and communication, whether precrisis or during a crisis, it may be necessary to make further amendments to domestic legislation (e.g., to improve gateways for the exchange of information or to permit resolution regimes to work together seamlessly). Such changes may be complex or simple, but in either case are the necessary basis for agreements for coordination and effective decision making and actions during a crisis.
Finally, resolution plans are highly sensitive to the institutions in question. Early experience suggests that institutions are reluctant to populate plans with the level of detail required by the authorities, partly due to the concern that if plans are disclosed, “break-up plans” could make them commercially vulnerable, and competitors could benefit from detailed information on the bank’s or group’s structure, exposures, and interdependencies.
INTERACTIONS WITH OTHER MEASURES TO RESPOND TO RISKS POSED BY SIFIS
RRPs will interact with other “structural” proposals, such as restrictions on the scope of a group’s activities or business lines or mandatory changes to group structure (e.g., the requirement for cross-border banking groups to establish legally and financially independent subsidiaries, rather than branches; see Chapters 10 and 11, respectively, for these proposals). Having assessed a financial group’s RRP, authorities may impose structural remedies on the group, either with a view to enhancing its resolvability through a more streamlined, simpler group structure, or with a desire to govern its risk profile and thus reduce the probability of failure by limiting or prohibiting certain activities. Structuring groups as a constellation of independent subsidiaries may be seen to ease implementation of RRPs. Although the recommendations to provide authorities with the power to insist upon such changes to financial groups have been endorsed by the G-20, whether there will be an appetite for global agreement on how and to what extent such powers should be exercised remains to be seen.
It is therefore clear that much attention will focus on whether authorities will choose to intervene in group structures, since this is an obvious potential first-round consequence arising from their assessment of the feasibility of recovery and resolution options. At the very least, the requirement to draw up RRPs is likely to focus the attention of both senior management (the corporate board) and the authorities on the strengths and risks of the corporate group structure. The anticipated benefit is that the relevant authorities will be fully informed of the group structure and the senior management of the financial group will be able to demonstrate how its interests could be managed, protected, or resolved in a crisis situation (e.g., which parts may be systemically important, which parts might be possible to liquidate, and where the interdependencies within the group exist).
It is therefore possible that as a result of the RRP process, complex groups may voluntarily opt to simplify their corporate arrangements. For example, they might create structures based on subsidiarization, with a higher degree of self-sufficiency in capital and liquidity for the individual legal entities and with reduced reliance on intragroup support (operational and financial). Alternatively, the authorities may choose to encourage or require changes should they believe the group structures are too complex to permit orderly, cost-effective resolution.
Naturally, the benefits and costs of simplifying a complex, integrated group structure will need to be weighed carefully, irrespective of whether this process takes place as a consequence of an assessment of an RRP or due to a broader, potentially international policy initiative. The costs of subsidiarization (and also ring-fencing) can be high,2 and subsidiarization will not necessarily lead to the segregation of assets by legal entity if the group in practice operates on an integrated basis. Even where a subsidiary is set up in its own legal right, the pooling of assets in the event of insolvency may be allowed by bankruptcy courts, especially in the United States under “substantive consolidation.”3 Furthermore, in the event of crisis or stress, it may be argued that there can be risks in breaking up a group structure if the reputational franchise of the wider group is seen to be undermined, even though this may be a lesser concern than the disorderly collapse of an entire complex group.
STATE OF PLAY
RRPs have been one of the options discussed for enhancing systemic stability from the onset of the crisis. Some jurisdictions have already moved in that direction:
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For example, the United Kingdom has moved quickly and has already amended domestic legislation to require institutions to prepare such documents. The initial experience was that institutions were not supplying the extent of information that the authorities had expected, and guidance was issued in mid-2010 to the industry so that it could revise its submissions; six major U.K. banks are using these documents in a pilot study.
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A number of systemically important U.S. banking groups are also putting together living wills in coordination with the U.S. regulatory authorities.
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Similarly, the European Commission has been consulting on potential amendments to EU legislation that would make RRPs mandatory for all EU member states.
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Meanwhile, with the endorsement of the G-20, the FSB (through its Working Group on Cross-Border Crisis Management) has been working on developing criteria, templates, and standards for the construction of RRPs (scheduled to be finalized by end-2011), building on work by the BCBS Working Group on Cross-Border Bank Resolution.
POLICY IMPLICATIONS
Overall, notwithstanding the possible implementation challenges they may face, RRPs are an important step forward and can make a valuable contribution to effective resolution frameworks for SIFIs. Such plans can promote better preparedness by individual firms for contingencies and by authorities for effective resolution. They provide essential information on a firm’s assets and liabilities, commitments, exposure, and legal and operational structure. They should be useful in informing authorities about the type of reforms needed to strengthen their supervisory and resolution powers and tools and in identifying actions to address institutions that are too complex to resolve.
The process of iterating RRPs is likely to act as a stimulus in several fields of policy related to crisis management and resolution. Within individual jurisdictions, it will be necessary to focus on the adequacy of domestic legal arrangements, such as intervention and resolution powers for authorities and the ability of relevant domestic authorities to communicate and coordinate. The relevant authorities in this regard include supervisory authorities, resolution authorities, central banks (where functions are not combined), finance ministries, and authorities responsible for market infrastructure such as payment, clearing, and settlement systems.
On a cross-border basis, the RRP process will further highlight the need for effective cross-border arrangements for cooperation, information sharing, and decision making, not least since all relevant authorities for a financial group should be involved in the development and assessment of an RRP. College arrangements for supervisory and crisis management purposes have received much attention following the crisis, but work is likely to continue to ensure that colleges are working optimally with substantive flow of information and clarity of decision-making structures in times of stress to increase the probability that cross-border groups can be resolved in a coordinated and orderly manner.
International coordination can also be expected on specific policy issues. These include, for example, ensuring that authorities have a consistent and adequate set of powers for intervention. Potentially, there may now be just enough momentum to ensure the consistency of application of such powers, such as the development of a consensus on the use of structural measures (e.g., mandatory changes to group structures and restrictions of business activities).
The most significant area of policy development that might benefit from work being undertaken on RRPs is that concerning cross-border resolution regimes. Progress will not be easy, because there are many components that will need to be addressed, not merely ensuring legal compatibility between different domestic regimes (which is challenging enough in its own right), but, critically, coming to agreement on burden sharing. The G-20 has already endorsed the objective of making progress on cross-border resolution, and work on RRPs is likely to bring into focus the magnitude of the potential costs for failing to make headway.
The author is grateful to Julian Chow and Michael Moore for valuable input.
See Cerutti and others (2010) and Fiechter and others (2011) or Chapter 11 in this volume.
In the United States, federal common law gives rise to “substantive consolidation,” which allows a bankruptcy court to treat a group of affiliated companies as if they are one, thus merging their assets and liabilities for purposes of the bankruptcy proceedings. Courts may even merge assets of non-bankruptcy affiliates with those of bankruptcy affiliates if they find that substantive consolidation is required. U.K. courts, by contrast, have been less keen to do so, except on suggestions of outright fraud, etc.