Appendix I. Suggested Improvements to the Proposals for Legislative Amendments
1. This appendix sets out suggestions for improvements to the proposed amendments to the BoBA and BA. They are not expressed in legal drafting terms; rather, they focus on the policy substance of the issues in question. As recommended in the body of this report, it is recommended that the BoB engage appropriately qualified legal advisers to review the draft proposed amendments to the Acts and develop appropriate revisions, having regard to the points raised in this report.
Issues in relation to the Bank of Botswana Act
Section 4. Objectives of the Bank
2. In subsection 2, the current draft wording is: “Subject to that [the primary objective of price stability], to contribute to the stability of the financial system, and to foster and maintain a stable and competitive market-based financial system.” It is suggested that consideration be giving to the following matters:
Whether the objective of financial stability should rank equally with (rather than being subordinated to) the price stability objective, given the fundamental importance of financial system stability and the complementarity with price stability.
To strengthen the focus on financial stability by replacing “contributing to the stability of the financial system” to “promoting the stability of the financial system.”
Section 5. Functions of the Bank
3. It is suggested that this section be further amended to explicitly designate the BoB as the resolution authority by stating that one of its functions is to facilitate the resolution of banks. In addition, it would be desirable to include reference to the BoB’s function to undertake corrective actions to seek to restore a bank to financial soundness.
4. The BoBA would also appropriately be amended to include a requirement for the governor/Board to ensure that the bank supervision and resolution functions are established in a manner that avoids conflicts of interest between the two functions, and that there is robust accountability for the management of both functions.
Financial Stability Committee
5. In order to oversee coordination of all functions relating to financial stability (including licensing, bank regulation and supervision, resolution, ELA, and financial stability surveillance and policy), it is recommended that the BoBA be amended to establish a Financial Stability Committee (FSCOM). The provisions could be modeled broadly on those in draft sections 25 and 26 in relation to the MPC, with appropriate changes to set out the functions of the FSCOM. Membership of the FSCOM would appropriately be determined by the governor, and could include external members.
Financial stability report
6. In order to provide focus to the financial stability functions of the BoB and to enhance its transparency and accountability, it is suggested that a new provision be included in the BoBA to require the BoB to publish a report, at least every six months, that sets out its analysis of the stability of the financial system, summarizes relevant policy developments relating to financial stability, and provides a range of metrics with which the effectiveness of financial stability policies and actions can be assessed.
Section 12. Establishment, powers, and functions of the Board
7. It is recommended that this section be amended to include reference to the Board’s functions in relation to the proposed FSCOM in a manner that is broadly consistent with the Board’s functions as they relate to the Monetary Policy Committee (but modified to reflect the functions of the FSCOM).
8. It would be desirable to amend draft section 12 to make it clear what the Board’s powers are (vis-à-vis the governor’s powers) in relation to all financial stability functions (and especially functions related to dealing with bank distress and failure). It is essential that there be absolute clarity and certainty as to who is empowered to exercise the BoB’s powers in relation to bank corrective actions and resolution; i.e., the Board, the governor, or the proposed FSCOM). It is also important to ensure that the Board is able to formally delegate powers in these areas, within appropriate safeguards, to the governor, and for the governor to sub-delegate those powers to enable the BoB to act swiftly in exercising its bank corrective action and resolution responsibilities.
Section 18. Powers and functions of the governor
9. It is recommended that this draft section be further amended to include reference to the proposed FSCOM, with clarity as to whether the committee would be a decision-making body in relation to all financial stability matters or a body charged with advising the governor, such that the decision-making authority is vested in the governor.
Section 43. Supervisory functions
10. It is suggested that this section be amended to include reference to the BoB’s functions in relation to bank corrective actions and resolution. In that regard, the title of the section could be changed to ‘Supervisory, remedial and resolution functions.’
Section 46. Operations with account holders
11. It is suggested that the provision in sub-section 2(a) that limits the dealing in certain collateral to those maturing within 184 days from the date of acquisition be considered as to whether or not it is necessary and whether longer dated collateral could be acceptable alongside additional risk control measures such as pricing and haircuts.
Section 47. Lender of last resort
12. It is suggested that some of the more explicit criteria included in section 47 could be removed and, instead, included as best practice principles in an accompanying ELA guideline or ELA policy document that could be approved by the BoB’s Board or the governor. It is recommended that this section be amended to remove (i) the ex ante restriction on provision of ELA to licensed banks, only so that consideration can be given to providing ELA to other financial entities of systemic importance; (ii) the restriction on the provision of liquidity support to no more than 184 days in all cases, as it may unduly restrict the BoB to providing liquidity support in certain justified circumstances; and (iii) the stipulation that the minister has issued to the bank a guarantee securing the repayment of the loan. Each of these are important principles to be followed, but it should be considered whether explicitly stating it in the BoBA may unduly restrict the BoB in providing ELA in a range of circumstances.
Section 53. Cooperation with the government and other authorities
13. In subsection 2 of this section, it is suggested that reference be made to the financial stability functions of the BoB, such that the governor must hold meetings at least biannually with the minister of financial stability matters. On this basis, the subsection could be reworded as follows: “The governor shall hold regular meetings, and at least on a biannual basis, with the minister to consider monetary, financial stability and fiscal policies, and other matters of common interest.”
Section 71. Legal protection
14. Given that the BoB, in its capacity as resolution authority, may need to take actions of a potentially high-risk nature, it is suggested that consideration be given to including a provision in this section that exempts the BoB from liability arising from the exercise of its powers relating to bank corrective action and resolution, provided that the powers are not exercised in bad faith (i.e., fraudulently).
Issues in relation to the Banking Act
Power to take actions in relation a banking group
15. The powers provided for in the proposed draft BA are generally expressed as being exercisable in relation only to banks; e.g., as with corrective action and resolution powers. It is suggested that the draft BA be amended to enable the BoB to exercise its powers for corrective action and resolution in relation to banks and banking groups (where banking groups include bank holding companies and bank subsidiaries).
Section 24. Liquidity management in banks
16. Sub-section (3) requires banks to prepare and submit monthly liquidity reports to the BoB. While other provisions may allow the BoB to request further data, it is suggested that, to avoid potential ambiguity or conflict in the Banking Act, that wording along the lines of ‘or at higher frequency as may be directed by the central bank from time to time,” be inserted after the word ‘monthly.’
17. Sub-section (6) requires that a bank shall not pledge or encumber any portion of its liquid assets without prior authorization of the central bank. The motivation behind this clause should be better understood or defined more clearly. For example, is this intended to only apply to the 10 percent liquid assets ratio that the banks are required to hold for regulatory purposes? If it applies to all liquid assets, even where banks hold in excess of their regulatory requirement, then the reason for requiring BoB authorization should be clarified as it will otherwise provide a hindrance to banks being able to easily mobilize liquid assets as collateral on the interbank market, for example.
Section 49. Corrective measures, administrative penalties and other enforcement actions
18. It is suggested that this section be amended so that the powers included in it can be exercised in relation to banks and banking groups.
19. In subsection 1, there would be merit in expanding the grounds on which the powers in the section can be exercised, so that they enable the BoB to act before a bank or banking group has breached the Act or prudential requirements, and before the ‘unsafe or unsound’ trigger has been breached. This recognizes that corrective actions are best undertaken at an early stage before a bank’s condition becomes unsafe or unsound. On this basis, the triggers could be expanded to enable corrective action powers to be taken where the BoB has concerns that a bank or banking group may conduct business in a manner which could, if left unchecked, lead to an unsafe or unsound situation arising.
20. In addition to the powers set out in the proposed section, it is suggested that the following powers be included:
The power for the BoB to remove and replace a director or senior officer of a bank and any member of the banking group where the BoB is of the view that this is necessary to implement timely and effective corrective action. (We note that the draft changes to the BA make provision for this power to be exercised only in relation to a bank; it should be extended to all entities in the regulated banking group).
A general power for the BoB to issue directions to a bank or any member of the banking group to take actions or cease to take actions specified by the BoB where the BoB is of the view that such directions will assist in achieving timely and effective corrective action.
Requirement to establish a contingency plan
21. It is suggested that a new provision be included in the draft BA to require the BoB to establish and maintain a contingency plan that sets out its policies and practices for undertaking corrective actions, including guidance on the triggers for particular actions and guidance on the nature of potential actions. In this context, we suggest that the BoB have regard for guidance provided by the BCBS in the Core Principles and Guidelines for Identifying and Dealing with Weak Banks when developing its contingency plan and internal guidance, building on the BoB’s existing use of international guidelines.
Section 51. Commencement of official administration
22. It is suggested that, in addition to the triggers set out in the draft section 51, a further trigger be included which enables the BoB to appoint an administrator if it believes that a bank or any member of a banking group is non-viable, and that the bank or member of the banking group cannot restore itself to viability within the timeframe regarded as necessary by the BoB.
23. As noted earlier, we suggest that the BoBA be amended to empower the BoB to appoint an administrator to any member of a banking group.
24. We suggest that a new section be drafted to require the BoB to establish and publish guidance on how it interprets ‘non-viability’ for the purpose of this being a trigger for appointing an administrator and undertaking resolution actions.
Section 52. Objectives and tasks under official administration
25. The provisions in this draft section are generally satisfactory as regards the objectives of resolution. However, greater clarity of objectives would be achieved if there was closer alignment to the Key Attributes, particularly as regards the following objectives and principles set out in the Key Attributes:
ensuring continuity of systemically important financial services;
protecting depositors in accordance with deposit insurance arrangements;
allocating losses to shareholders and unsecured and uninsured creditors in a manner that respects the hierarchy of claims;
avoiding reliance on public solvency support;
avoiding unnecessary destruction of value;
providing for speed, transparency, and predictability through legal and procedural clarity and advanced planning for orderly resolution;
promoting effective domestic and cross-border coordination; and
facilitating market-based solutions where practicable.
Section 53. Appointment of an administrator
26. It is suggested that consideration be given to the following possible amendments to this section:
Enabling the BoB to appoint an administrator for a longer period than stated in the draft; e.g., for an initial term of up to one year, and the capacity to extend the term for a further year in recognition that there may be situations where administration needs to continue for a substantial period.
Enabling the BoB to replace an administrator.
Empowering the BoB to issue binding directions to an administrator on any matters relating to the powers exercisable by the administrator, and obliging the administrator to comply with those directions.
Section 55. Inventory of assets and liabilities and plan of action
27. It is suggested that section 55 be substantially deleted in its current form. As drafted, it requires the administrator to submit to the BoB a restructuring plan or proposal for the bank’s liquidation within 60 days, and gives the BoB a further 10 days to approve or modify the plan or order the bank to be placed into liquidation. This is unnecessarily restrictive, particularly as regards the process and timing. In most situations where an administrator has been appointed to a bank, there will be a need to determine the resolution actions within, at most, a few days of appointing the administrator, given the need to avoid disruption to the financial system and to minimize adverse market reactions. A long period of uncertainty over the bank’s status and its operations would arise from the proposed timeframe allowed for in the draft section.
28. If this section is retained, it should be drafted so that the administrator delivers any reports required by the BoB within the timeframe specified by the BoB and empowers the administrator to make recommendations for resolution or liquidation to the BoB. The timeframe referred to the section should be removed. The section should empower the BoB to issue directions to the administrator to implement specified resolution actions any time from the commencement of the administration.
Section 56. Resolution measures
29. This section should be amended to enable any of the resolution actions listed in the section, and those in section 54, to be implemented at the direction of the BoB at any time following the commencement of administration, regardless of whether the administrator has made recommendations to the BoB. In a bank resolution, time is of the essence; resolution actions generally need to be implemented very quickly and with certainty and clarity. Therefore, the BoB should be empowered to determine the resolution actions without waiting for reports or recommendations from the administrator.
30. The bail-in provision in section 54 is narrow in scope, given that it applies only to a bank’s bonds and notes. It is suggested that the bail-in power be exercisable in relation to any unsecured liability (other than deposits covered by deposit insurance) of the bank in administration, either through conversion to equity or some other form of eligible capital instrument (of a loss-absorbing nature), or through write-down.
31. Section 56(6) makes provision for the administrator to establish a bridge bank with the approval of the BoB, and to be owned by the BoB. It is suggested that this provision be amended to align with more conventional practice with respect to bridge banks, such that:
The bridge bank is established by the BoB (and not by the administrator).
The bridge bank may continue in existence beyond the proposed two-year period where the BoB considers this to be necessary in order to transition the bridge bank to new, permanent ownership or merger or liquidation.
The bridge bank is not owned by the BoB (as is proposed in the draft law), but rather is owned either by shareholders and/or bailed-in creditors of the bank in resolution, or by the government or a resolution fund if the government or a resolution fund has provided equity funding. This recognizes the principle that central banks should not provide equity funding/solvency support to banks, or be owners of banks. If funding from the existing shareholders and creditors of the bank in resolution is insufficient to capitalize the bridge bank, then the government or a resolution fund should provide the equity needed to capitalize the bridge bank.
The initial Board of the bridge bank should be appointed by the BoB, pending the establishment of a standard governance arrangement under the control of the shareholders of the bank.
Section 57. Moratoria during official administration
32. This section provides for an open-ended moratorium upon the appointment of an administrator. As drafted, it creates an inference that the administrator could suspend financial obligations of the bank (including deposit repayment, payments under committed credit facilities and payments under derivatives contracts) for an unlimited period. The only exception to that is for retail deposits, where the option to suspend payment is capped at 10 days.
33. We suggest that the moratorium provision be amended to more closely align with the moratoria guidance in the Key Attributes, with a view to placing a relatively short maximum limit on the period during which payment obligations on certain categories of liability can be suspended. For example, in the case of derivatives obligations, current international thinking is for a moratorium that prohibits counterparties from exercising rights under events of default clauses for a period of just two to three days. This recognizes that open-ended moratoria create major risks of disruption to financial markets and could lead to counterparties withdrawing from markets where open-ended moratoria provisions exist.
Section 58. Creditor safeguards
34. We suggest that the section be amended so that creditor safeguards apply to all resolution actions. As drafted, it appears to be limited to transfers of assets and liabilities. It should apply to any resolution actions, including the bail-in of liabilities (either through conversion to equity or write-down), transfers of assets and liabilities, and restructuring of capital.
35. The section would also benefit from further clarity on the process for determining compensation. For example, it needs to be made clear whether the independent valuer is appointed by the BoB or by a court on application by the BoB. The latter might be a better option, given that it would be more transparent and enable stakeholders to challenge the proposed appointment of the valuer through the court system, leaving it to the court to ultimately determine who the valuer is (subject to a requirement that valuer meet defined requirements in relation to qualifications, experience and independence). It is especially important that the valuer be completely independent of the BoB.
36. Other aspects of compensation processes that require clarification include:
the need for the valuer to report their findings to the court in a manner that is transparent to all stakeholders;
the need to specific a maximum period within which the valuer must report to the court;
the need for the valuation report to comprehensively set out the valuation methodology and assumptions (which should be open to challenge through the court process);
the rights of stakeholders to challenge the valuation findings and compensation recommendations through the court process; and
the court’s ability to require the report and recommendations to be reviewed by a third party.
37. The section should make it clear that, once the court has ruled on the valuation and compensation, the decisions are final (subject to whether an appeals process is allowed). It also needs to make it clear that the court is not empowered to reverse or amend any resolution action; its sole function is to ensure that the valuation process is fair and soundly based, and to rule on compensation recommendations.
38. The section should specify the source of funding for compensation. In this regard, compensation would appropriately be funded from the bank’s assets in resolution, with any shortfall being funded via either a resolution fund or by the government (with the capacity for the government to recover from the banking industry through levies on banks).
39. We suggest that the creditor safeguards provisions be modeled closely on the Key Attributes and international best practice, such as the EU Bank Recovery and Resolution Directive (BRRD).
40. The above points are also pertinent to section 59 – Shareholder safeguards.
Section 75. Cross-border cooperation
41. It is suggested that the section be amended to:
ensure that any actions taken by the administrator to implement in Botswana the resolution proposed by the home resolution authority (where the bank in Botswana is a subsidiary of a foreign bank) are under the strict control and oversight of the BoB;
require the BoB to be satisfied that the implementation in Botswana of resolution actions proposed by the home authorities is consistent with maintaining the financial stability of Botswana, and with all other resolution objectives in the BA before directing the administrator or allowing the administrator to give legal recognition to or facilitate implementation of the home authority resolution proposals in Botswana;
empower the BoB to enter into crisis resolution MOUs with foreign supervisory and resolution authorities, and other agencies relevant to cross-border resolution; and
empower the BoB to participate in (rather than necessarily establish) supervisory colleges and/or crisis management groups for the purpose of facilitating bank-specific resolution planning, resolvability assessments, resolution pre-positioning, and implementation of resolution.
Section 76. Funding of bank resolution
42. We suggest that this section be fundamentally reviewed, with close regard to the resolution funding guidance in the Key Attributes, and other FSB publications and international practice (such as in the EU BRRD). In this regard, it will be appropriate to assess whether Botswana should establish a resolution fund for the purpose of facilitating bank resolution (beyond deposit insurance), where this would be funded via levies on banks. Given the small size of the banking system and the need to establish deposit insurance (and associated levies on banks), our inclination is to suggest that consideration of a resolution fund might best be deferred until the resolution laws have been established, resolution policies are in place, and deposit insurance has been established and a target fund achieved. Once that has been done, it would be desirable to consider whether a sound case exists to establish a resolution fund and, if so, what its purposes would be, its governance arrangements, preconditions for drawing on the fund, calibration of the size of the fund, levy arrangements, and many other factors.
43. In the meantime, however, there will still need to be a mechanism for funding bank resolution in situations where there is inadequate scope to fund a bank resolution from the shareholders and creditors of the bank. To that end, we suggest that a resolution funding mechanism be incorporated into the BA under which the government would, as a last resort only, be the source of resolution funding, subject to the following requirements:
Clearly defined objectives for which government funding may be provided; e.g., to maintain the stability of the financial system and the continuity of critical banking functions;
Preconditions on which the minister must be satisfied before agreeing to the provision of funding—such as shareholders and subordinated creditors of the bank in resolution have absorbed losses to the full extent of their claims, other creditors have been bailed in to the extent practicable and consistent with financial stability objectives, and all market-based sources of funding have been exhausted;
Ministerial power to impose terms and conditions on which any funding will be provided, with a view to ensuring that the risks to the government are appropriately managed and compensated, including in respect of fees, charges, interest rates, dividends, monitoring arrangements, restrictions on the bank’s activities, control over the appointment of directors and senior officers, etc.; and
Ministerial power to levy the banking industry to recover any funding outlays (in net present value terms) that are not able to be recovered from the assets of the bank in resolution.
Provision for bank recovery plans
44. A new section should be drafted to empower the BoB to require banks to develop and maintain plans to facilitate their recovery from adverse events and to restore themselves to financial soundness. The section should empower the BoB to:
specify the requirements in relation to recovery plans, including matters to be covered and responsibility for sign-off of the plans (e.g., at Board level);
require recovery plans to be subject to regular testing in a manner specified by the BoB;
require recovery plans to be subject to review or audit by an independent party approved by the BoB where the BoB considers this to be beneficial;
require banks to make specified changes to their recovery plans; and
require banks to undertake specified pre-positioning actions to enable recovery plans to be readily implemented if triggers for recovery are reached.
45. A new section should be drafted to require the BoB to undertake resolvability assessments of banks; to require banks to provide the BoB with specified information for the purpose of undertaking such assessments; and to require such information be audited or reviewed by an independent party approved by the BoB where the BoB considers this to be desirable.
46. A new section should be drafted to require the BoB to prepare resolution plans for each bank considered by the BoB to be systemically important, and to enable the BoB to prepare resolution plans for other banks. The section should empower the BoB to:
require banks to provide specified information to enable resolution plans to be prepared;
require such information to be audited or reviewed by an independent party approved by the BoB where the BoB considers this to be desirable; and
require banks to make specified changes to their operating arrangements and structure to facilitate resolution in accordance with resolution plans.
Appendix II. Guidance on the Development of a Resolution Toolkit
1. This appendix provides indicative guidance on the development of a resolution toolkit to facilitate the resolution of banks. Its purpose is to assist the BoB in the development of a resolution toolkit in coordination with the MFDP and NBFIRA.
2. The purpose of a resolution toolkit is to provide guidance for the resolution authority (the BoB in the case of Botswana) on the activation of resolution, selection of the resolution strategy, implementation of the resolution, and communication. A resolution toolkit also provides guidance on the coordination of resolution actions between domestic agencies and, in the case of foreign-owned banks or domestic banks with foreign operations, cross-border coordination. It needs to be supplemented by bank-specific resolution plans that set out the details of how particular resolution options could be implemented for individual banks.
3. The key elements of a bank resolution toolkit are set out below, including:
crisis diagnostics—solvency assessment and systemic impact assessment;
resolution strategies, criteria to assist in selecting which strategy might be appropriate in particular circumstances and implementation steps; and
cross-border crisis resolution.
Solvency and financial soundness assessment
4. In a period of emerging stress, any bank considered to be potentially vulnerable should be assessed by the supervisory authority to assess the bank’s:
solvency (i.e., surplus of assets over liabilities);
common equity tier 1 capital position;
total tier 1 capital position;
total capital position;
exposure to shareholders and other related parties;
level of NPLs;
level of specific provisions in relation to NPLs; and
expected loss on NPLs.
5. The analysis would appropriately include an estimation of a range of capital values for the bank, from best case to worst case, with assets estimated at expected recoverable values net of realization expenses. Valuations of assets should be undertaken on a ‘going concern’ basis, unless there is an expectation that the bank will be closed; in which case, valuations would be on a ‘gone concern’ basis.
6. The analysis would also include an assessment of the bank’s liquidity position and a stress-tested assessment of how vulnerable the bank is to wholesale and retail liquidity withdrawals. Liquidity assessment would include analysis of, among other matters:
the amount and quality of liquid assets;
access to parent or other shareholder liquidity (where applicable);
access to committed standby facilities with other banks;
amount and nature of assets capable of being used for collateral to obtain liquidity from the BoB or other sources;
maturity profile of liabilities, both using contractual and behavioral maturities, under assumed stress conditions;
schedule of projected payment and settlement obligations for a defined period (e.g., next one, two weeks, month, etc.); and
stress testing of liquidity by estimating the bank’s capacity to meet payment and settlement obligations, including deposit withdrawals, under a range of plausible stress scenarios.
7. Where a bank has subsidiaries that perform essential functions for the bank, there should also be a solvency and liquidity assessment of the relevant subsidiaries.
8. It would be desirable for the supervisory authority to develop the capacity to undertake solvency assessments, capital adequacy assessments and liquidity assessments under acute time pressure (e.g., within 24 hours), and undertake periodic testing of that capacity.
Systemic impact assessment
9. The resolution toolkit should include guidance on undertaking an assessment by the BoB, in liaison with the MFDP and NBFIRA, of the systemic impact of the bank in distress. This would be based on the BoB’s framework for determining systemically important banks, but the assessment would need to take into account the particular circumstances of the bank and financial system at the time of the distress event. In that regard, it is important to remember that the potential systemic impact of a bank varies over time, and on the fragility of the financial system. In a period of financial system stability, small- to medium-sized banks might be assessed as having a low systemic impact, whereas in periods of financial system instability, the failure of the same banks might have a significant impact on the financial system, given the potential for contagion and confidence effects. Accordingly, it is essential that the systemic impact assessment is made at the time of distress and that it factors in the then prevailing circumstances affecting financial system stability.
10. Systemic impact assessments would appropriately draw on the criteria applied in the D-SIB framework developed by the BCBS. The analysis would therefore take into account:
the market shares of each bank in each of the key lending sectors;
the market shares of each bank in the deposit market (differentiating between retail and wholesale deposits);
the share of payments services, differentiated by payment system and payments product;
the share of lending to economic and social infrastructure providers;
inter-connectedness (including intra-group and between banks);
potential for the bank to cause contagion (drawing on the contagion analysis referred to earlier);
substitutability of systemically important financial functions (including considerations related to the concentrated nature of the banking sector); and
complexity (including any complexities arising from group structures and the location of essential banking functions in subsidiaries, and cross-border activity).
11. The systemic impact assessment should be undertaken not just for the bank on a solo entity basis, but also on a banking group basis (i.e., taking into account the systemic impact of the failure of subsidiaries of the bank), where banks have significant business in subsidiaries.
12. As part of the systemic impact assessment, contagion risk should be assessed. The analysis would appropriately include an assessment of:
contagion via inter-bank exposures;
contagion arising from related party exposures, such as credit exposures to parent banks and other substantial shareholders;
credit rating downgrade risks associated with parent bank stress;
reputation impacts associated with parent bank or other major shareholder distress;
contagion risks associated with functional dependencies between banks with common shareholdings;
contagion via banks having common credit exposures (e.g., syndicated lending, where the failure of one bank to meet commitments under a syndicated loan could impact the other banks in the syndicate);
the contagion impact of bank defaults on interest rate and foreign currency derivatives (i.e., requiring other banks to replace interest rate and currency contracts they had with the failed bank, and the potential difficulty in doing so under stressed conditions, possibly leaving them with unhedged exposures); and
confidence-linked contagion risks and the potential for a generalized depositor run on banks.
13. The systemic impact assessment undertaken by the BoB, in liaison with the MFDP and NBFIRA, will significantly influence the type of resolution strategy to be adopted. In the case of a small bank with little or no systemic impact, and where recovery is not possible, then closure and prompt pay-out of insured depositors or deposit account transfer to another bank via a purchase and assumption transaction would be the likely resolution option. In the case of a systemically important bank, a form of ‘open resolution,’ where the bank’s core banking functions are kept open, would be the likely resolution option.
Resolution strategies and implementation of resolution
14. The resolution toolkit should identify the main resolution strategies and options to deal with banks which cannot restore themselves to financial soundness, and the criteria for determining which option would be appropriate in the circumstances. The plan should also identify the procedures required to implement particular resolution options. The stylized resolution options can then be refined into bank-specific resolution plans for each bank, by category of bank (e.g., domestically owned systemically important banks, foreign-owned systemically important banks, medium-sized banks, and small banks).
15. An important part of the resolution toolkit is establishing guidance on systemically important functions—i.e., those functions that need to be continued, either in the recapitalized bank, a bridge bank, or other acquiring bank, in order to minimize adverse impacts on the financial system and economy. The toolkit would set out the generic functions that would normally be regarded as critical functions required for systemic stability. It would also include guidance on what quantitative thresholds might appropriately be applied by the BoB in determining, as part of bank-specific resolution plans, whether particular banks have sufficient critical functionality so as to warrant a form of resolution that maintains the continuity of these functions (i.e., an ‘open resolution,’ in essence).
16. Systemically important functions would generally include, as a minimum:
transaction-capable deposit facilities;
committed credit facilities;
payment system interface and payments execution functions;
inter-bank settlement functions;
settlement functions performed for other financial institutions on an agency basis;
currency and interest rate derivatives functions; and
IT support, risk management, and other back-office arrangements required for systemically important functions.
17. Resolution options which could be considered in developing the resolution toolkit (and on which resolution plans would be based) are likely to include the following:
Option 1. Closure of a bank and pay-out of insured deposits followed by liquidation of the bank. This would involve the appointment of an administrator to the bank and withdrawal of the bank from all payment channels. Eligible deposit balances would be calculated on the basis of end-of-day positions. The deposit insurance agency (once established) would confirm the amount to be paid to each depositor, capped at the level of the deposit insurance cover per depositor. Payments would then be made to depositors, presumably via a bank that is appointed as the paying agent, funded by the deposit insurance fund. Payments should be made as soon as practicable following the bank’s closure and, desirably, within seven days.
Option 1 might be appropriate where:
a. The bank is insolvent (i.e., negative equity) or close to insolvent, or otherwise very substantially below minimum capital requirements.
b. The bank cannot recover; i.e., there is no prospect of shareholder support or external financial private sector support in the required timeframe.
c. No other bank is prepared to acquire equity in the failing bank or to assume all deposit liabilities or even just insured deposit liabilities and acquire assets from the failing bank.
d. Closure of the bank would not have a significant adverse impact on the stability of the financial system or economy.
e. Closure and pay-out is a lower cost option than the alternative closed resolution options.
Option 2. Closure of a bank and transfer of insured deposit accounts to a receiving bank (either an existing bank or a bridge bank). This would involve the appointment of an administrator to the bank and withdrawal of the bank from all payment channels. Eligible deposit balances would be calculated on the basis of end-of-day positions. The deposit insurance agency (once established) would confirm the amount to which each depositor is entitled, capped at the level of the deposit insurance cover per depositor. The deposit accounts (together with associated IT systems) would be transferred to an acquiring bank that is willing to assume the deposit liabilities or to a bridge bank established for the purpose. The acquiring bank/bridge bank would administer the failed bank’s IT systems required to operate the deposit accounts. The deposit accounts would operate as usual, with no change of account numbers once transferred to the receiving bank. The receiving bank would purchase assets from the failed bank at market value, if it wished to do so. The net cost to the acquiring bank of assuming the insured deposit liabilities would be funded by the deposit insurance agency. The failed bank would then be wound up through the insolvency law arrangements and the deposit insurance agency would have a subrogated claim of the insured depositors on the assets of the bank in liquidation.
Option 2 might be appropriate where:
b. The bank cannot recover; i.e., there is no prospect of shareholder support or external financial private sector support in the required timeframe.
c. No other bank is prepared to acquire equity in the failing bank or to assume all deposit liabilities and acquire assets from the failing bank.
d. One or more banks are willing to assume the insured deposits, funded either fully by the deposit insurance agency or funded through a combination of deposit insurance funding and assets transferred to the acquiring bank. If there is sufficient time available, the deposit insurance agency would seek competitive bids from banks which the BoB regards as being in a sufficiently sound financial condition to acquire the insured deposits of the failed bank.
e. Closure of the bank would not have a significant adverse impact on the stability of the financial system or economy.
f. Closure and transfer of insured deposits are assessed as being a lower cost option than the alternative closed resolution options.
Option 3. Transfer of some or all of the failed bank’s assets, liabilities, and business functions to another existing bank or a bridge bank. This would involve the appointment of an administrator to the bank and withdrawal of the bank from the payment systems. An assessment would be of the systemically important and otherwise viable business that is to be transferred to either an existing bank willing to acquire this business and associated functionality, or to a bridge bank established for the purpose. The business to be transferred (most likely including all critical functions and performing assets) would be valued and transferred at the assessed market value.
If the assets (including estimated franchise value) to be transferred equal, at least, the liabilities to be assumed by the acquiring bank, then no resolution funding would be required. A surplus of assets relative to liabilities transferred would entail payment of the net amount to the account of the bankruptcy estate of the failed bank. A deficiency in assets relative to liabilities transferred would require funding from either the bail-in of liabilities, the deposit insurance agency or the government (as a last resort only). The deposit insurance agency’s funding would be capped at the amount it would have paid (net of recoveries) under a least-cost deposit insurance pay-out or insured deposit account transfer.
The failed bank would be closed and its residual business would be wound up under insolvency law. Ex post compensation would be paid to shareholders and creditors, respectively, to the extent they were rendered worse off than under a conventional winding up had the bank been retained whole and wound up, applying the statutory ranking of claims in winding up.
NPLs could either be retained in the failed bank or transferred to an asset management company established by the BoB for the purpose, or to an existing private sector entity in the business of acquiring and working out impaired assets.
Option 3 might be appropriate where:
a. The bank is still solvent (i.e., has positive equity), at least with respect to deposit liabilities and possibly other senior unsecured debt.
b. The bank cannot recover—i.e., there is no prospect of shareholder support in the required timeframe.
c. The closure of the bank would have a significant adverse impact on the stability of the financial system.
d. At least one suitably capitalized bank is able and willing to acquire the systemically important business of the bank or a bridge bank could be established to acquire the relevant business. (The latter would be an option where no existing bank is willing or able to acquire the systemic business of the failed bank or where market concentration factors would make it undesirable for the business to be transferred to an existing bank).
Option 4. Sale of the bank to another bank. This would involve placing the bank into administration and selling a majority shareholding position to an acquiring bank. This could be done by cancelling existing shares (assuming the powers were in place to do this), with compensation to shareholders for the assessed value of the shares and issuing new shares to the acquiring bank. Alternatively, it could be achieved by issuing new shares to an acquiring bank and diluting existing shares to their assessed market value, resulting in the acquiring bank assuming a controlling shareholding. In either case, the distressed bank would be recapitalized to the appropriate target level (i.e., sufficient to comfortably exceed the regulatory requirements and to maintain an acceptable credit rating and maintain depositor and investor confidence).
Option 4 might be appropriate where:
a. The bank is still solvent (i.e., has positive equity), at least with respect to deposit liabilities and, possibly, other senior unsecured debt.
b. The bank cannot recover; i.e., there is no prospect of shareholder support in the required timeframe.
c. The bank’s closure would have a significantly adverse impact on the stability of the financial system.
d. At least one suitably capitalized bank is able and willing to acquire either 100 percent or a majority shareholding in the bank that is sufficient to recapitalize the bank to the required target level.
e. The acquisition of the failed bank by the acquiring bank would not lead to excessive market concentration or systemic risk.
Option 5. Recapitalization of the bank through bail-in. This would involve appointing an administrator to the bank, assessing the worst-case capital position of the bank (taking into account the need for any capital support to essential subsidiaries), and determining the amount of capital required to meet a target capital ratio that is sufficient to comply with capital requirements and maintain market confidence and credit ratings. Bail-in could be implemented via a number of routes, including by write-down of the liabilities or conversion of liabilities to an equity instrument that ranks equal to diluted equity of existing shareholders or converted to preference shares that rank above existing equity. Liabilities would be bailed in in the inverse order of their ranking in a winding-up; i.e., the lowest ranking liabilities (such as subordinated debt) would be bailed in first, followed by senior unsecured bonds, followed by uninsured deposits, etc. Insured deposits would either be exempted from bail-in or the deposit insurance agency would bear the bail-in cost if it were applied to insured deposits. Some other liabilities might also be exempted from bail-in, potentially including liabilities payable to suppliers of essential services and liabilities in relation to derivatives required to maintain balance sheet hedges.
Bail-in can be achieved through different mechanisms, as discussed later in this note.
Option 5 might be appropriate where:
a. The bank cannot recover; i.e., there is no prospect of shareholder support in the required timeframe.
b. The bank has sufficient subordinated debt and senior unsecured debt (excluding insured deposits) to be a source for recapitalization, either through conversion to equity or other eligible capital instrument or write-down, after first writing down existing equity.
c. The closure of the bank would have a significant adverse impact on the stability of the financial system.
d. Bail-in would not trigger contagion or other systemic disruption on a significant scale. Bail-in is more likely to be a viable solution for an idiosyncratic bank failure, where the other banks in the financial system are in a prudentially sound condition and market confidence in the banking system as a whole is reasonably strong. Bail-in is less likely to be an attractive option in the case of multiple bank distress and where the bail-in of one bank could trigger a contagious run on other banks.
Option 6. Recapitalization of the bank through bail-out via public funds. This is a last-resort option and would only be used where the other options are considered to be impracticable, and that some form of government-funded bail-out is required for the purpose of meeting resolution objectives. It should be applied with robust safeguards, as discussed below.
This would involve appointing an administrator to the bank, assessing the worst-case capital position of the bank (taking into account the need for any capital support to essential subsidiaries), and determining the amount of capital required to meet a target capital ratio that is sufficient to comply with capital requirements and for maintaining market confidence and credit ratings. Recapitalization would be implemented by the issuance of shares to the government (either directly or via a government-owned entity) sufficient to achieve the target capital ratio. This would be a last-resort option where all other options (including bail-in) have been assessed and found to be non-viable or systemically destabilizing. Government-funded recapitalization should occur only after existing shareholders have been fully bailed in, such that their shares are either cancelled (if of no value or of very little value) or diluted to the assessed market value. Subordinated debt should also be bailed in.
The government’s shareholding could either take the form of ordinary shares with full voting rights or preference shares with full or limited voting rights (where existing shareholders and bailed-in creditors hold a substantial proportion of total equity). In either case, the government should ensure that it prices the shares it holds, and any other support it provides (e.g., guarantees or indemnities), at appropriate commercial pricing to ensure that taxpayers are compensated for the risks involved. It should also ensure that it has sufficient control of the bank to manage all risks arising from its equity stake and other forms of support it provides.
Option 6 might be appropriate where:
a. The bank cannot recover; i.e., there is no prospect of shareholder support in the required timeframe;
b. The bank does not have sufficient subordinated debt and senior unsecured debt (excluding insured deposits) to be a source for full recapitalization, either through conversion to equity or other eligible capital instrument or write-down, after first writing down existing equity;
c. The bank’s closure would have a significantly adverse impact on the stability of the financial system;
d. Bail-in would likely trigger contagion or other systemic disruption on a significant scale; and
e. The government ensures that existing shareholders and subordinated creditors are required to absorb all losses to the extent of their holdings before any government-funded support is provided.
The principle of “no creditor or shareholder left worse off than under whole-of-bank liquidation” should be applied, such that shareholders and creditors are compensated to the extent that the resolution option chosen left them worse off than had the bank been retained whole and liquidated under conventional insolvency law.
In the case of recapitalization of an existing bank or transfer of business to a bridge bank, the following issues would need to be considered:
Nature of directions to the bank. For example, if there is a likely need to recapitalize the bank or to transfer some or all of the bank’s business and functionality to another entity, the BoB may need to issue directions to the bank to undertake the required pre-positioning; e.g., preparation of specific documentation for capital issuance, IT changes to facilitate the transfer of some parts of the undertaking to another entity, etc. There may also need to be directions to remove directors and management to the extent they are thought to be obstacles to resolution and not required for the resolution process.
New directors and management. If the BoB believes new directors and management are needed before the appointment of an administrator or as an alternative to administration, they should pre-identify candidates for the appointments, potentially including senior staff from the NBS or from suitable foreign banks. For example, the replacement of directors and senior management might be required ahead of the appointment of an administrator in situations where the BoB wants to pre-position the bank for an expected resolution—e.g., to restructure the bank, curtail new lending, etc., and where they do not have confidence in some of the existing directors or management team to undertake pre-positioning for resolution.
Administration. It is suggested that the BoB document the process required to appoint an administrator if that becomes necessary, and maintain a list of possible appointees for administrator (e.g., senior staff from the BoB or another government agency, or possibly a seconded senior executive from a bank or parent bank with a sound understanding of the Botswana banking system). The administrator might need to be supported by advisers to bring market credibility and assist in the management of technical aspects of the resolution process. The toolkit should desirably include a list of potential firms and individuals for this purpose, and updated regularly. It should also include draft terms of reference and documentation for appointment.
Directions to an administrator. The BoB would also need to identify the directions to give to an administrator; i.e., as to the particular business functions to keep open (e.g., deposit-taking, payments functions, meeting commitments on derivatives, meeting commitments under committed credit facilities, etc.) and which ones to be suspended. Directions would also extend to what actions should be taken to keep subsidiaries functioning where this is necessary for the bank’s functioning. The toolkit should also identify the particular pre-positioning directions to an administrator applicable to each type of resolution.
Public and other stakeholder communications. The toolkit should include guidance on public and other stakeholder communications for each type of resolution. For example, if, in an open resolution, most or all of the bank’s business is to be maintained, the BoB needs to be ready to publicly announce at the time an administrator is appointed the intended scope of the bank’s business under administration, and which obligations will be continued and which will be suspended. Clarity and certainty is crucial for counterparties, depositors, and other stakeholders. The communications strategy should include an identification of the information to be conveyed by each agency to each category of stakeholder, the timing of each communication in the resolution process, and the channels used for communications. Key stakeholders will include:
a. depositors of the bank being resolved;
b. depositors in other banks;
c. other creditors of the bank being resolved;
d. borrowers of the bank being resolved, especially those with overdraft and other committed credit facilities;
e. the management of other banks;
f. the financial institutions which meet their payment obligations through the bank being resolved;
g. foreign regulators (e.g., of the foreign banks operating in the country);
h. the financial news media and general news media;
i. social media; and
j. the general public.
Determination of the capital requirement for the recapitalized bank or bridge bank. the BoB would need to determine an appropriate capital ratio and, therefore, capital injection, required to restore the distressed bank to financial soundness or to capitalize a bridge bank. The capital ratio would need, at the least, to be around the same level as for other banks in the peer group and sufficient to obtain a credit rating similar to the rating that applied before the bank became distressed. In order to restore market confidence and enable the bank to resume normal funding, the target capital ratio is likely to be higher than it was pre-distress, based on a target credit rating (e.g., at least investment grade and likely higher for any major bank). The capital ratio will also be influenced by whether the government is providing an interim guarantee of the bank’s liabilities and, if so, the terms of the guarantee. If there is a guarantee, the required capital ratio would be lower than in the absence of a guarantee. However, given the desire to avoid open-ended commitments by the government, such as those arising under a guarantee, it would generally be better to set the capital ratio at a level where the bank can operate without a guarantee.
Capital support by the government. If the distressed bank is to be recapitalized by the government, or a bridge bank is to be capitalized by the government, it is essential that this is done as a last resort (i.e., failing any other sources of capital) and on commercial terms. It is also essential that the existing shareholders are either removed from the recapitalized bank (e.g., by using a bridge bank and leaving shareholders in the failed bank) or diluted in accordance with the assessed value of shareholders’ funds immediately pre-resolution. If the government does need to provide capital support, the MFDP will need to develop guidance on the following matters:
a. whether capital provided by the government is in the form of preference shares (which would rank ahead of ordinary shares and therefore reduce the risk of the government) or ordinary shares ranking equally with existing ordinary shares;
b. the pricing of the shares paid for by the government, based on a conservative valuation of the bank immediately pre-resolution;
c. the voting rights on preference shares if that form of capital is used;
d. the other forms of control which the government may wish to exercise (either via voting rights on shares or through another means, such as a deed poll entered into by the bank), such as:
the right to appoint directors in proportion to the share of the capital the government holds;
veto rights over the appointment of directors by other shareholders (if they are minority shareholders);
the right to appoint (or veto the appointment of) the CEO, CFO, and CRO;
the right to approve (or veto) key transactions, such as lending to related parties, large exposures, disposal of business, acquisition of new business, etc.;
the right to determine the risk appetite and nature of business strategy adopted by the bank; and
the nature of the exit arrangements, such as eventual sale of the government’s shares to another party (subject to the approval of the RA).
Government underwriting of a rights issue to capitalize a bank. If the capital injection takes the form of a rights issue to existing shareholders, this should be priced on the basis of the estimated value of the bank (on a conservative basis) pre-resolution. Such a rights issue would probably need to be underwritten by the government in order to provide certainty of the capital being raised; i.e., any rights not taken up by the existing shareholders would be taken up by the government via its underwriting obligations. On this basis, the MFDP should develop guidance on the indicative terms for a government-provided underwriting of a rights issue. This should be priced commercially and enable the government to acquire additional shares if necessary to ensure that it has appropriate control of the bank to protect the government’s risks. See above for the types of control the government might wish to have. The contingency plan should include indicative documentation and terms sheets for a government underwriting agreement.
Establishment of a bridge bank. If a bridge bank is to be used, the contingency plan should identify the steps required for the BoB to establish the legal entity. It is suggested that the contingency plan include pre-prepared documentation for the establishment of a bridge bank, including a company constitution, governance structure, management structure, etc. It will also be necessary to maintain updated lists of potential directors and senior management for a bridge bank. The toolkit should also include guidance on the steps required for fast-tracking bank licensing and other consent processes, as appropriate.
Government guarantee of a bridge bank. It may be necessary for the government to provide a guarantee of a resolved bank’s liabilities for a period until the bank has been stabilized. This should be avoided unless absolutely necessary. If this is considered necessary, the guarantee should be on commercial terms where practicable, such that the government charges a fee for the provision of the guarantee. The guarantee documentation may also need to include covenants which confer specific powers on the government to control the bank while the guarantee is in place, such as the need for specific business transactions to be approved by the government, the need for director and management appointments and removals to be approved by the government, etc. The contingency plan should include preparation of an indicative terms sheet for a government guarantee, together with draft documentation. These are matters for which the MFDP needs to take responsibility.
Business transfer to a bridge bank. Consideration needs to be given to what assets and liabilities are transferred to the bridge bank; i.e., only systemically important business or the entire business, and whether impaired assets are retained in the failed bank, transferred to the new bank, or (if substantial) transferred to an asset management vehicle established for the purpose. Consideration is also needed to identify the risks of counterparty defaults as a result of business transfers occurring and how these can be avoided where possible; e.g., assurances or guarantees that the contracts in question will continue to be met by the new bank. At a minimum, one would expect the plan to provide for all systemically important business and performing assets to be transferred to the bridge bank, including deposit liabilities, payments functionality, committed credit facilities, risk hedges, relevant IT infrastructure to maintain all transferred functions and performing assets.
Bail-in. In order to minimize the need for government funding and risks to the taxpayer, consideration should be given to the possibility of achieving some form of bail-in of existing bank debt; e.g., subordinated debt and possibly senior unsecured bonds. Bail-in could potentially be achieved by any of the following mechanisms:
a. Requiring banks, as part of recovery planning requirements, to have a tranche of debt capable of being contractually converted to eligible capital instruments or written down upon defined triggers (such as the capital ratio falling below a trigger level).
b. Using statutory powers in the BA to bail-in any unsecured debt instrument by converting it to an eligible capital instrument or write it down. The bail-in would apply to debt in a manner consistent with the ranking of claims in a winding up; i.e., lower-ranked debt in a winding up would be bailed-in before higher-ranked debt.
c. Implementing a bail-in using business transfer powers, whereby a tranche of debt is retained in the failed bank, such that the reduced level of debt transferred to a bridge bank provides the funding for capital in a bridge bank. A similar option would be to assess whether tranches of debt could be transferred out of the failed bank to a special entity established for the purpose if the decision were made to recapitalize the failed bank rather than establish a bridge bank. The creditors of the debt retained in the failed bank or transferred to the special entity, as the case may be, would be compensated ex post to the extent that they are left worse off than if the bank had been liquidated in its entirety (on the basis of the ranking of claims in winding up).
Communications and coordination
18. Communications and coordination are essential in a crisis. For each resolution strategy, the toolkit needs to identify what communications need to be made to each category of stakeholder (including depositors, the wider public, banks, other financial institutions, foreign counterparties, foreign regulators, rating agencies, news media, and social media). The toolkit should identify the key information to be conveyed to each category of stakeholder and which agency has responsibility for each element of this. It should also include the development of checklists for the issues to be considered by each agency in preparing media statements and other forms of communication.
Cross-border coordination and cooperation
19. The toolkit needs to include guidance on cross-border coordination and cooperation.
20. Matters that should be covered in this area include the following:
A clear delineation of resolution responsibilities between the parent authorities (the prudential supervisor/resolution authority) and the Ministries of Finance in the home and host countries. These should be documented in either a multilateral MoU (for all agencies) or bilateral MoUs.
Identification of information exchange arrangements between the respective agencies, based on the above-mentioned MoU(s).
Coordination of the development and enforcement of recovery plans, resolvability assessments and resolution plans, such that the recovery plans and resolution plans for the subsidiary banks in the host country are informed by, and not materially inconsistent with, the parent bank recovery and resolution plans.
Processes for coordinating the solvency/capital assessment and liquidity assessment for the parent banking group and subsidiaries in the host country.
Process for coordinating the identification and assessment of resolution options. This is especially important for recapitalization options for the subsidiary, drawing on the two generic models for group-based recapitalization: Single Point of Entry (SPE) and Multiple Points of Entry (MPE). Under an SPE model, the recapitalization of the subsidiary in a host country would be performed by the parent bank, either via bail-in of liabilities in the parent bank, bail-in of liabilities in the subsidiary (in exchange for shares in the parent bank) or external injection of capital into the parent bank, with the capital being cascaded to the subsidiary in the host country. Under an MPE model, the recapitalization of the subsidiary in the host country would be performed at the level of the subsidiary, either by bail-in of liabilities of the subsidiary or injection of capital into the subsidiary by the government or another party approved by the BoB. Under an SPE approach, the parent bank remains the shareholder of the subsidiary. However, under the MPE approach, the subsidiary might cease to be a member of the parent banking group, reflecting its new shareholding arrangements. In that event, it would be necessary to ensure that contractual arrangements are entered into between the subsidiary and parent bank for all essential functional support provided by the parent bank to be continued (on commercial terms) until alternative arrangements can be made.
Appendix III. Stylized Illustration of Liquidity Providing Operations by Central Banks
Appendix IV. Stylized Illustration of Potential Collateral Eligibility Per Operation1
1. Currently, the BoB has a relatively narrow list of eligible collateral for use in normal liquidity providing monetary policy operations. The list of collateral eligible for normal monetary operations should always be driven by the extent of liquidity that needs to be provided according to the monetary policy stance. Often, where low levels of liquidity need to be provided to the system as a whole, such as the current situation in Botswana, a narrow list of eligible collateral for normal operations is sufficient.
In particular, consideration needs to be given to whether the counterpart banks have sufficient quality collateral when the central bank needs to inject reserves into the system in order for the central bank to achieve its desired inflation target. If the BoB wishes to retain the existing narrow list of collateral eligible for normal market operations, then the remaining assets on banks’ balance sheets would be considered as potential ELA collateral, subject to the necessary risk control measures being taken.
2. Some central banks (e.g., the ECB and the Bank of England) have expanded the list of collateral eligible for normal liquidity providing monetary operations in response to the financial crisis, where larger amounts of liquidity needed to be injected into the wider banking system in order to achieve the required monetary stance. This is usually implemented in response to a systemic monetary and liquidity shock.
3. Expansion of such collateral eligibility for normal market operations is subject to the collateral being of sufficiently high quality and should not be confused with providing ELA liquidity to support individual banks. Therefore, if the BoB were to consider at any stage that banks should be able to borrow more funds through normal market operations in order to meet the monetary policy target, or if banks could not obtain sufficient quantities of assets on the existing narrow list of eligible collateral, then consideration could be given to expanding the list of eligible collateral for normal market operations. The remaining collateral would potentially be eligible for ELA.
4. For example, the proposed amendments to the BoBA in Part IX Section 46, subsection 2(b), envisage that the BoB may take government securities, with no time to maturity restrictions, as collateral—whereas these are currently restricted to <184 days. Any expanded list of collateral for normal operations should be comprised of assets that are generally available to banks across the system.2 Collateral for ELA would be chosen from suitable assets remaining on bank’s balance sheets.
Appendix V. High Level Overview of Central Bank Liquidity Responses
Appendix VI. ELA Governance and High-Level Procedures
Authority to approve ELA is often delegated to the governor. Generally, the decision whether to provide ELA or not resides with the Board of the central bank. However, it is not always possible to convene a Board meeting at short notice and, therefore, responsibility for the decision of the provision of ELA might be delegated to the governor.
The governor/Board will make the decision regarding the provision of ELA in accordance with BoB powers and the objectives of financial stability, solvency, and systemic importance of the bank, stipulating that ELA advancements should be against approved collateral adequacy, and taking the monetary policy stance into consideration.
A meeting of a FSCOM could be convened. This should be chaired by the governor and include the relevant directors and heads of department. They will advise on bank solvency, systemic importance, monetary policy, BoB risk management, and on market and bank-specific liquidity and flows developments.
A decision in principle to grant ELA should stipulate that funding up to a certain amount can be provided on a short-term basis over a specified period; e.g., to cover expected cash outflows over the next one month.
Approval could be given to provide ELA within these limits specified and subject to adequate collateral, as per risk specifications agreed by the Board. Shorter-term, one- or two-week ELA deals carried out within that month could be authorized by the director or at the department level.
Each month, the FSCOM/Board should meet to discuss the bank’s solvency, its progress to restore itself to normal market funding and exit out of ELA, the continued systemic importance of the bank, monetary policy consistency and its success in meeting targets, such as capital raising. Should important developments arise, ad hoc FSCOM meetings should be called urgently.
The governor/Board, in conjunction with the FSCOM, will discuss related issues such as resolution of banks and enforcement, and will make decisions as to whether a bank should be removed from ELA funding. These issues will require close cooperation with other national authorities to manage the processes and maintain
Appendix VII. Stylized Central Bank Lending Decision Tree
Appendix VIII. Key Concepts of Lender-of-Last-Resort Funding1
1. An appropriate monetary policy framework forms a good basis for an effective ELA framework. Monetary policy frameworks should have clear counterparty and collateral eligibility criteria, ensuring that only solvent counterparties can access these operations and that counterparties with capital or management difficulties are not supported. Monetary policy collateral frameworks should be confined to a limited set of liquid assets with clear eligibility criteria. Having clearly defined monetary policy and ELA frameworks ensures that both operations have separate monetary policy and financial stability objectives.
2. Central banks have a number of liquidity provision tools available. Through implementation of its monetary policy during normal times, central banks, at their initiative, can provide reserve money on a multilateral basis to the market, or at an institution’s initiative—and on a bilateral basis—to support the payment system. The objective of a central bank’s open market operations under conventional monetary policy is generally to steer short-term market rates. Central banks can also respond to idiosyncratic emergency needs or a market/systemic shock when normal market functioning is disrupted.
3. The emergency response role is one of the most important functions of a central bank. In a closed system of reserves supply, the central bank is the last lender an institution can resort to after exhausting all other funding options available to them. The demand for idiosyncratic lending may stem from a single bank, or a small group of banks, encountering immediate problems.
Systemic, multilateral lending at the central bank’s initiative: aggregate systemic liquidity needs can change the terms on which OMOs lending is provided; e.g., lengthening the tenure (e.g., the ECB’s three-year, long-term operations) where central banks focus on specific market issues rather than on a desired interest rate target. This may be to inject the necessary liquidity into the system in order to ensure market functioning, efficacy of the monetary transmission mechanism and, ultimately, to enhance the monetary base to enable the real economy to function so as to achieve the central bank’s inflation target.
Idiosyncratic, bilateral lending at the counterparty’s initiative: the provision of this liquidity is generally performed under the central bank’s financial stability mandate, with the aim of avoiding the institution’s default and therefore preventing disruption to the payments system. In such circumstances, the central bank is said to be acting in the capacity of ‘Lender of Last Resort.” This provision of ELA is strictly in response to a solvent and systemically important institution facing an urgent need for liquidity that cannot be sourced from anywhere else other than from the central bank.
4. LOLR is provided to temporarily illiquid but solvent institutions. It should not be the role of a central bank to support insolvent institutions. By doing so, it could lead to banks taking on excessive risks in the knowledge that the central bank will always be there to support them. Moreover, such an expectation could de-anchor medium-term price stability expectations. ELA should in no way be seen as a substitute for the resolution of problem banks.
5. Before ELA can be provided by a central bank, the central bank must first have the legal power to provide such liquidity. Legal acts generally stipulate that the central bank can lend in exceptional circumstances for financial stability purposes or to perform a lender-of-last-resort function.
6. LOLR practices vary across countries, but the key principles remain the same:
Solvency of counterparty: in order to avoid the banking system taking on excessive risks (creation of moral hazard risks). If a central bank is to use public funds and provide credit against non-standard collateral (which may be hard to value), it should be satisfied as far as possible that the bank in question is solvent.
Viability of the counterparty: While an institution is solvent, it may not have a viable business model or could be subject to liquidation in the near future. It is prudent for the central bank not to lend to such non-viable entities, as there is little chance the monies lent will be recouped. A viability assessment should be forward looking.2
Counterparty access: ELA access is generally limited to financial institutions that hold reserve accounts at the central bank (typically commercial banks), but some countries restrict or allow access to systemically important institutions whose default would cause contagion across the system.
Supervisory intrusion and conditionality: The provision of ELA should only be temporary and, therefore, institutions in receipt of ELA should be subject to enhanced supervision and conditionality, so that the central bank is always comfortable that the monies lent can be repaid and that the funding is being used for appropriate purposes. Moreover, any potential moral hazard associated with the potential weakening of market discipline is minimized through increased supervisory intrusion and even conditionality.
Collateral criteria: As institutions should always have explored all other options for funding, including the use of eligible collateral in normal monetary policy operations, it is generally expected that the ELA collateral will be less liquid. In the majority of cases, ELA lending is backed by loan collateral or securities that are not eligible for monetary policy operations, with the approach taken being very much dependent on what collateral is unencumbered on the institution’s balance sheet at the time of the liquidity need. This is always subject to the risk-control measures and risk limits that the central bank is willing to accept in consideration of its protecting its own capital levels.
Interest rate: ELA should apply a penalty interest rate in order to dissuade unnecessary market access. Central banks have different practices, but, in general, central banks should try to strike a balance between the incentives for a distressed institution to seek alternative funding and the issue of moral hazard. The upper bound should be considered in the context of whether the rate is too penal, so as to make repayment impractical, yet the rate should always be above the market-available rates.
Maturity: LOLR involves the temporary provision of liquidity and should not be provided for longer than absolutely necessary; i.e., long enough to address the underlying liquidity difficulty that has been caused due to a temporary shock. Should the liquidity need be prolonged, it could indicate more acute difficulties, such as insolvency or non-viability. There is no international consensus for how long ELA should remain outstanding. Generally, 90 days is an appropriate target, but in some circumstances it may need to be longer, even up to one year, such as where there is a broader shock to money markets or deep levels of market fragmentation. ELA must nonetheless only be provided where the bank is suffering from a liquidity shock relating to those conditions only, and not in response to non-viability, poor cash management, or mismanagement.
ELA is not an open facility: ELA should only be accessed in exceptional circumstances at the discretion of the central bank. Therefore, ELA is not an open facility. By not being “an open facility,” the perception (moral hazard) that the central bank always stands ready to support the institution is avoided. Where the central bank agrees in principle to provide ELA, it may decide to do so for a defined period initially, e.g., one-month, and review this decision each month. Individual ELA deals may be transacted for shorter periods within that month if collateral values are subject to volatility or as a tool to illustrate to the borrower that behavior that is susceptible to moral hazard will not be accepted by the central bank. In such circumstance, agreement to provide ELA for a specified period, in the form of a committed facility subject to adherence to the eligibility criteria and conditionality of the central bank, should not be confused with ELA being an ‘open facility.’ Furthermore, the carrying out of ELA trial runs or the incorporation of ELA into crisis-management exercises should not be viewed as a pre-commitment to providing ELA in response to a future request.
Exit plans are a key requirement: ELA should always be a temporary bridge to more stable funding, and a funding plan prepared by the bank should be detailed prior to receipt of ELA funds, detailing how the entity will exit ELA. Due to the time involved, it is not always possible to complete these in advance of ELA drawdown, and in such circumstances they should be completed not long after the ELA drawdown. From this plan it should be evident that the institution is able to repay the funding, or that additional liquidity needs will arise due to the continuation of the liquidity shock. In the case of doubt, conditionality should be enforced, such as limiting the institution’s exposure to certain risks, payment of dividends or staff bonuses, etc.3 Conditionality permits outlining key targets to ensure funding gaps are met and therefore ensuring long-run viability and the repayment of ELA.
Internal understanding and co-ordination is a necessary prerequisite: The provision of ELA involves a number of key areas, including banking, operations, legal, financial stability, and there is a reliance on key areas for input into the process. In general, the central bank should establish an internal working group to facilitate the sharing of information which should ensure all parties involved have a clear understanding of their respective roles.
7. In order to anticipate the need for ELA liquidity, the central bank should actively monitor liquidity flows. In general, a central bank should not be taken by surprise by an institution’s need for ELA and should actively monitor recent liquidity developments across individual counterparties and carry out liquidity projections under different specified stress assumptions. Such an exercise involves the input of the market operations area—given their proximity to market developments and the supervisory area—as they are best positioned to assess asset and liability management. Daily phone calls should be held with banks that are ‘on-watch’ for liquidity difficulties, so that most up-to-date figures on funding flows are available. Reports should be circulated daily within the BoB to inform key stakeholders. Weekly liquidity projections and analysis of the available collateral buffer of relevant banks should be compiled and circulated within the BoB, using specified data requests to the banks where necessary.
8. Central bank ELA support is a key component of the financial safety net, supported by strong supervision, enforcement and resolution frameworks, and is only provided after private sector solutions are first explored. The provision of ELA by the central bank is one of the main components of the crisis management framework. In order for the ELA framework to be effective, close cooperation is needed between the central bank and the government in the case that indemnities from the government are required and to plan coordinated actions such as restructuring or resolution of problem banks.
Appendix IX. Evaluating Collateral for Emergency Liquidity Assistance
Current BoB collateral eligibility
1. Current provisions in the BoBA (PART VII Relations with Financial Institutions (ss 36-43)) allow that:
38. Operations with account holders
(2) The Bank may, on such terms and conditions as the Board may from time to time determine:
(a) purchase from, sell to, discount and rediscount for account holders, bills of exchange and promissory notes drawn or made for commercial, industrial or agricultural purposes, bearing two or more good signatures, of which at least one shall be that of a bank, and maturing within 184 days from the date of their acquisition by the bank;
(b) purchase from, sell to, discount and rediscount for account holders any treasury bills or other securities issued or guaranteed by government, forming part of a public issue and maturing within 184 days of the date of their acquisition by the bank; and
(c) sell to, purchase from, discount and rediscount for account holders any securities issued by the BoB.
(3) The bank may, on such terms and conditions as the Board may determine from time to time, grant to account holders loans and advances for periods not exceeding 92 days
(a) secured by:
(i) instruments specified in paragraph (a), (b) or (c) of subsection (2);
(ii) other securities issued or guaranteed by government and forming part of a public issue;
(iii) warehouse receipts and documents of title issued in respect of staple commodities or other goods duly insured; or
(iv) holdings of any assets which the bank is permitted to buy, sell or deal in under section 31; or
(b) unsecured or secured by such other assets, on such special terms and conditions as the Board shall determine when, in its opinion, such a loan or advance is exceptionally necessary to meet the liquidity requirements of the borrower.
BoB Collateral Eligibility Proposed in BoBA Revision 4.
2. Part IX, S. 47 Lender of Last Resort
(1)(b) “The licensed bank… provides adequate collateral…”
(2) “The Bank shall determine the maximum percentage of the value of the surety deposited to guarantee each of the credit operations set forth in the previous subsection.”
Current risk control measures advised by the BoB
3. The bank accepts the BoBCs and government paper (184 days to maturity and below) as collateral for the credit facility (CF). The CF quota itself comprises up to 150 percent of core capital. Currently the facility is very short term (Intra-Day and Overnight).
4. The BoB states that the collateral carries almost zero-default risk, as the bulk of it is the BoBCs, and that the BoBCs and government notes are marked-to-market on an ongoing basis. It is important that accurate and up-to-date valuations are applied to tradable securities taken as collateral—particularly where the central bank believes the cash/nominal value of the asset to be 100 percent due to its being a government obligation.
5. Collateral in the form of the BoBCs, bonds, and treasury bills sit with the bank as the custodian. Furthermore, upon lending, the collateral is transferred to the entity that has lent out money to further reduce the default risk. In this way, the BoB notes that it has direct and immediate control of the collateral.
6. The bank is also the settlement agent and custodian of the BoBCs and government notes. Accordingly, the BoB believes that the requirement to apply haircuts does not arise, given that the facility is for central bank operations. However, the risk rests with the potential default of the issuer of the securities, and good practice would be to apply some form of haircut to even government-issued debt.
7. Nonetheless, the BoB states that the issue of haircut and pricing would apply in the event that a wide range of instruments is allowed. This is imperative to prudent lending and to ensuring the soundness of the BoB’s balance sheet. In particular, taking longer-term sovereign bonds, for example, should require a more detailed pricing and haircut framework than is applied currently to shorter-term treasury instruments.
Appendix X. Example of ELA Operational Structures and Work Flows
1. Ownership of the ELA process. Once the decision has been made by the governor to provide ELA, it is recommended that FMD take ownership of the process instead of supervision. Supervision will have important roles in advising the process on solvency, general assessment of the bank, and the ongoing monitoring of bank data, conditions, and management practices.
2. Establish a Liquidity Analysis Team. The market operations area should establish a designated team to lead the preparation and planning for ELA and to then carry out ELA transactions when necessary.
3. Establish a cross-departmental ELA working group (WG). This should include all the departments that are to be involved in the ELA operational process, including market operations, payments/back office, and legal and risk management personnel where appointed. FMD should chair and lead the group’s work, which will oversee end-to-end procedures and testing (trial-run operations). The procedures should include the description of ELA governance structure, including decision making and inter-departmental coordination policy.
4. Establish regular dialogue with banking supervision. The FMD (and risk management) should have regular dialogue with banking supervision to discuss the banks’ capital and funding developments. Contact should be daily where issues arise, but meetings should be held at least weekly.
5. Preparation of guidelines and criteria. The necessary legal powers to enable a sound ELA framework should be prepared by legal staff and reflected in the BoBA. Further internal rules and guidelines should be approved by the Board or the governor and assessed by legal staff. Legal frameworks should be drafted to enable all potential and adequate forms of assets to be taken as collateral under ELA operations with the relevant banks/entities.
6. Preparation of data base. The WG should prepare counterparty eligibility criteria (the FMD, with assistance of the BSD and, perhaps, Financial Stability) by establishing a data set in the form of an early warning system comprising supervisory and market data.
7. Collateral preparedness. The WG should preemptively engage in collateral identification on each bank’s balance sheet, establishment of haircuts, and risk control measures (operations and risk management, with assistance of supervisory area for balance sheet review, if necessary).
8. Documentation preparedness. Legal staff should be engaged by the FMD to ensure that the BoB understands the specific issues related to the collateral proposed and to ensure that the legal agreements to allow adequate mobilization of the collateral are effective, and to address any peculiarities in taking secured loans as collateral in particular.
9. ELA transaction details. The length of ELA operations and interest rate applicable should be outlined by the FMD. The rate should be agreed at the Board level at a margin over the O/N facility. However, the Liquidity Team performing the ELA operations, in conjunction with back office/payments, needs to consider how frequently it is feasible to carry out ELA deals; e.g., can they operationally handle transactions on a weekly basis.
10. Operational flow. The new Liquidity Team will be the primary interface with the banks and will receive the ELA deal request, and will process front office deal tickets and check that there are eligible collateral limits available. Risk management/middle office staff would normally check that the deal tickets correspond with agreed counterpart and collateral limits. Finally, back office/payments will receive any necessary signed collateral confirmations from the counterparty and will perform settlement of the deals.
11. Automation. The ad-hoc nature and checks required to authorize ELA necessitate that it remain a somewhat more manual operation than normal open market tenders. However, documents should be able to be signed in the respective institutions, scanned, and then emailed to each other in order to provide confirmation. Each party will have copies of other institutions’ authorized signatories to check the signatures against. Within the BoB, use of facilities such as a SharePoint page for ELA might aid the process, flow, and storage of documents between the departments that are involved in the ELA operations. ELA deals should generally see money transferred at T+1 from day of request, both for rollover deals and for the first deal when the counterparty makes its first request for ELA and the governor’s decision needs to be made.
12. Monitoring of flows and liquidity developments. The Liquidity Team shall set up liquidity flows monitoring based on daily phone calls and data returns from banks that are on watch for liquidity concerns, in order to prepare for likely ELA requests and to inform decision makers of developments. This should include:
(a) Daily calls with the institutions of concern to ascertain daily net flows in, e.g., retail and corporate deposits and collateral buffers. A daily report should be circulated to management showing these movements.
(b) Preparation of weekly projections, assuming institution-specific stress assumptions with regard to deposit retention and debt capital market rollover where applicable. The formulation of these assumptions should be done in close cooperation with the prudential area, and should include:
projected net liquidity (out)flows (e.g., retail and corporates, debt capital markets, interbank and market repos);
liquidity net flows related to collateral, such as fulfillment of margins in market repos;
loss of collateral under stress assumptions; and
projected cash buffer.
The net of (a) + (b) above should show anticipated recourse to monetary policy liquidity providing operations and, combined with the individual institutions’ collateral buffers, would show any shortfall and, therefore, the potential for recourse to ELA going forward. A weekly report outlining these projections should be circulated to the BoB’s senior management. Advance projections and exact T+1 ELA requirements should be advised to the FMD staff forming the liquidity forecasts for monetary targeting.
13. Decision on whether an indemnity from the minister is necessary. While it is sound practice for the BoB to seek a guarantee from the minister, there may be situations where the BoB is adequately collateralized and the guarantee is not required or could have negative consequences. The governor and Board should make the decision as to whether a guarantee from the minister is needed, on the basis of an assessment of projected funding requirements, the requesting bank’s condition and an assessment of collateral risks.
14. Communication and disclosure: Consideration needs to be given to central bank ELA communication strategy and co-ordinate this with external stakeholders such as the banks and the Minister for Finance. While transparency gives confidence to the public that the BoB and the market is reliable and safe, ELA is lender of last resort and the provision of ELA to individual named banks is not normally publicized by the central bank. Often, the central bank may announce ELA provision to banks in aggregate in its annual report only where, after it is up to individual banks to announce to the market that they are in receipt of ELA, there are disclosure requirements necessary for their own market or accounting reporting. Staff within the BoB needs to be cognizant of the delicate nature of ELA provision and only staff involved in the relevant operations and work should know the details.
15. Contingency: The departments involved in transacting ELA deals should periodically review and test the internal process and incorporate improvements and efficiencies where they are identified. They should prepare contingency operational arrangements should the normal conditions or business site where ELA is carried out be unavailable. It is recommended that an alternative contingency site be available and equipped to facilitate ELA deals.
Example of central bank operational duties regarding ELA transactions
Front Office (FMD Liquidity Analysis Team) duties
a. Following receipt of request for ELA, staff checks the liquidity need of the counterparty by cross-referencing the reserves balance, current collateral holdings, deposit and repo flows, and recent and forthcoming debt capital market maturities.
b. Following receipt of confirmation of approval of the size, term, and rate applicable to ELA, the Front Office liaises with the Back Office to inform of collateral to be mobilized.
c. Confirm with requesting institution the size, term, rate, and collateral for LOLR operation and request a written bid submission.
d. Confirm that the signatories on the ELA request are those as per agreed authorized list.
e. Check bid submitted for correctness and, once approved, forward to the Back Office.
Middle Office (Risk Management) duties
a. Establish order of preference of collateral to be accepted for the ELA operation.
b. Inform the Front Office of the maximum liquidity amount that can be provided per collateral type, specifying the nominal amount of the collateral, the valuation and haircut, and resultant maximum liquidity amount that can be provided.
c. Confirm receipt of an acceptable indemnity from the Minister for Finance, specifying the maximum amount covered, where applicable.
Back Office (Payments) duties
a. Receipt of checked counterparty bid from the Front Office.
b. Management confirmation to pay funds to the requesting institution.
c. Check that collateral exchange documents submitted contain correct authorized signatures and countersign any collateral exchange legal agreements where necessary.
d. Payment of funds to the counterparty.
Example set of ELA counterparty procedures
This section sets out the possible steps to be followed by a credit institution (the “Counterparty”) seeking ELA from the Bank of Botswana (the “Bank”). Failure by the counterparty to comply fully with these steps may result in delays or an inability of the bank to accommodate a counterparty request for ELA.
Initial high-level steps:
1. Request for ELA—a senior official duly authorized by the Board of the counterparty seeking ELA sends a formal request to the bank addressed to the governor and copied to the relevant deputy governor with a scanned copy sent to the BoB’s designated ELA email account.
2. Board minutes—The counterparty must furnish the bank with evidence (e.g., the minutes of the relevant Board meeting) that the application for ELA was duly authorized in accordance with its internal corporate governance procedures.
3. Other information—The counterparty must provide any other information the bank may require before it makes a decision on whether to grant ELA, including any information required to confirm the solvency of the counterparty or information on available collateral to secure ELA.
4. Receipt of letter approving ELA—If the bank decides to grant ELA to the counterparty, the governor (or someone else duly authorized) will write to the counterparty confirming this decision (letter scanned and to follow by hard copy).
5. List of authorized signatures—The counterparty must send a list of signatories for personnel authorized to request and sign documentation relating to ELA transactions, along with evidence of appropriate signing authorities and a set of sample signatures. Contact details for the BoB personnel who are dealing with ELA transactions should be documented and provided to the counterparty.
6. Collateral and haircuts—The bank will liaise with the counterparty in relation to what collateral is available to secure ELA.
7. Designated email addresses—In advance of any ELA transactions, the counterparty must notify the bank of a designated email address for ELA communications. All email correspondence with the bank in regard to ELA transactions should be sent to the BoB’s designated ELA email account (accessible by front and back office staff).
Sample steps for each ELA transaction subsequent to governor approval of initial request
1. Counterparty requests an advance of ELA by phone (FMD Liquidity Analysis team).
2. Counterparty forecasts liquidity needs and trades within the ELA transaction calendar to be specified by the bank where ELA is being rolled over.
3. The bank (Liquidity Analysis Team) responds to the counterparty’s ELA request by phone.
4. Once an ELA request is agreed by the bank, the counterparty will email a scanned copy of an ELA request form that has been signed by a duly authorized person or persons to the BoB’s ELA email account. The original signed request should be immediately forwarded by the counterparty to the BoB’s Liquidity Analysis Team.
5. The subject line of this email attaching the scan of the signed ELA request form should read [counterparty name], ELA request value dd/mm/yy.
6. Simultaneously, the counterparty will email details of the proposed ELA collateral for analysis to the BoB’s ELA email account.
7. The bank’s Back-Office team will contact the counterparty to identify specific collateral.
8. The bank will confirm to the counterparty when the transaction is complete via email from the Back Office to the counterparty’s designated email address.
9. The counterparty shall confirm receipt of funds via email to the BoB’s designated email address.
Paragraphs 10 to 12 below apply where ELA is provided by way of repo (or other mechanism requiring countersigning of a legal agreement to mobilize collateral), subject to the provisions of the relevant (master repurchase) agreement.
10. Where ELA is provided by way of repo, and, if required, by the relevant (master repurchase) agreement, the counterparty will send a scanned copy of a physically signed purchase confirmation to the BoB ELA email account. The subject line of this email attaching the scan of the signed purchase confirmation should read [counterparty name], Purchase Confirmation Form(s), ELA value dd/mm/yy.
11. If required by the relevant (master repurchase) agreement, the bank will arrange for any purchase confirmation to be countersigned on behalf of the bank and will send a scanned copy of same back to the counterparty.
12. Within three business days of an ELA repo transaction, the counterparty will deliver the original hard-copy version of any signed purchase confirmation to the bank (marked for the attention of a nominated person in the BoB’s Payments Department).
Appendix XI. Example of Counterparty Conditionality That May Be Attached to ELA Lending Arrangements
1. Legal agreements between the BoB and the borrower could, where possible and allowable, contain the types of clauses, actions, and conditions that the BoB would expect to see in the prospectus of a (mortgage-backed) bond issued on the market. The conditions should reflect market standards both in terms of general criteria relating to details regarding the underlying collateral, but also expectations regarding the behavior of the counterparty in terms of handling cash flows and notification of certain events to the lender (in this case to the BoB).
2. The exact terms and conditions included in the agreement thereafter may be stronger or less onerous to reflect the circumstances and risks. This will depend on the collateral taken and the balance to be struck between the BoB’s risk management, the need to advance liquidity, and the expected behavior of the borrowing bank’s management. A clause could be inserted to allow the BoB to receive any information it deems necessary to assess the counterparty. Collaboration with the Banking Supervision Department to help monitor the conditions is important.
3. The key concept of lender of last resort is that ELA funding is only provided where a solvent bank suffers a liquidity shortage, it cannot obtain funding elsewhere, and it needs funding from the central bank in order to pay depositors or interbank or debt market funding. It may also be used to allow for the continuation of the bank’s core functioning in its normal course of business, such as paying the bank’s normally accrued utilities bills, paying normal staff wages (not bonuses, or new wage agreements struck at above market rate to extract money for personal use), etc.
4. General clauses should be inserted to stress that funding can only be used to maintain the bank functioning as normal until it obtains alternative funding to repay ELA. After ELA has been repaid, the bank can then go about its business and increase its balance sheet etc., if it wishes. The onus should always be on the borrowing bank to report any non-normal transactions to the BoB in advance and to obtain the BoB’s agreement to carry out any transaction that is not clearly in the normal course of its business, and which would possibly reduce the ability of the BoB to recover its money.
5. The conditions may be inserted into each legal agreement relating to the exchange of each different type of collateral, or else the over-arching conditions relating to bank behavior could be signed as a separate undertaking by the borrowing bank at the time it initially applies for ELA. The latter case would see the CEO of the bank sign his personal undertaking that the bank will not engage in the stipulated, or other practices not specified, which could harm the central bank’s position in relation to its lending. Guidelines regarding prohibited behavior and transactions to be carried out by the bank and its management could be important criteria where concerns may exist.
Overview of potential high-level commitments for any entity in receipt of ELA
(i) ELA shall always be the recourse of last resort
(a) All requests for ELA funding should only be made when the requesting bank has explored and exhausted ALL other sources of funding. All market contacts should be tapped and all interbank lines should be explored before considering a request for ELA.
(b) The cost of alternative market funding should not be considered as a factor in deciding whether or not ELA is a more attractive source of funding. ELA should always be a last resort, and, generally, irrespective of the price of alternative funding.
(ii) Compliance with reserve requirements
(a) The ELA recipient bank should ensure compliance with minimum reserve requirements as set out by the BoB. The use of the reserve account should be in accordance with standard operating procedures and an average reserve account balance in excess of the average requirement at the end of the maintenance period (so-called ‘burnt reserves’) should be avoided.
(b) The bank should use the cash balance on its minimum reserve account in the event of small liquidity events, which can then be replenished before the end of the maintenance period.
(c) ELA cannot be provided to ‘frontload’ the reserve account.
(iii) Limited use of deposit facilities
The bank should only place funds in the BoB’s deposit/absorption facilities in exceptional circumstances, such as at the end of the maintenance period when the average reserve requirement has been met. The recipient bank’s liquidity position should be managed so as to ensure the minimum drawing of ELA, and excess funds available to the bank should be reflected in a reduced ELA balance. Proposed use of the deposit facility by a bank in receipt of ELA should be flagged to the Market Operations Department of the BoB no later than the morning of the intended placement.
(iv) Limited use of interbank deposit placements
Interbank deposit placements should be very limited, as any surplus funds should be used to maintain the reserve requirement or to reduce ELA.
(v) Overnight standing facility
Where eligible collateral for liquidity providing standing facility and refinancing operations becomes available to the ELA recipient bank, this should be notified to the Market Operations Department of the BoB. In general, the recipient bank should aim to utilize all available collateral in normal the BoB market operations and, subsequently, access the O/N facility, where collateral is available, during the time until the next normal the BoB liquidity providing open market operation.1 If necessary, the recipient bank may use the collateral for its intraday credit buffer (i.e., collateral placed with the central bank to give it credit with the central bank in order to allow it to process payments on its account during the day when the bank does not have matching inflows and outflows) in the O/N facility to be used to top up its minimum reserve account balance.
(vi) Use of ELA funds—senior management commitment
The Chairman or Chief Executive of the ELA recipient bank will provide a letter to the Market Operations Department of the BoB, stating that ELA will only be sought as a last resort and that all other sources of funding will constantly be explored with the aim to reduce ELA to the minimum level. It will also state that ELA funding will only be used to meet the recipient bank’s commitments in the ordinary course of business and will outline the business areas for which it is intended to use ELA. These steps should be in accordance with the roadmap agreed with the BoB, and as outlined in the liquidity plans agreed therewith.
(vii) Use of ELA funds—management of new and existing assets
The recipient bank will carry out all regular banking activities subject to the terms set out in any agreed restructuring plan.
(viii) Use of ELA funds—ban on acquisition
The recipient bank will, in general, not be authorized to use ELA to acquire or take participations in any other firm. Prior notification of such an interest and consultation with the BoB is necessary to allow the circumstance to be evaluated.
(ix) Use of ELA funds—subordinated debt and hybrid capital instruments
(a) The recipient bank will not pay coupons or exercise calls on subordinated debt instruments and hybrid capital instruments, unless it is legally obliged to do so.
(b) The bank cannot use ELA for the purpose of a liability management exercise.
(x) Use of ELA funds—notification to the BoB of non-standard activities
There is an onus on the recipient bank to notify the BoB of any proposed activity that is not a regular occurrence or not considered to be a normal activity, or is one that is not generally carried out in the normal course of business. This may arise from an unexpected change in the terms and conditions of previous arrangements, e.g., requirement to place cash collateral, guarantee amounts, etc. Where these activities require funding and the bank is in receipt of ELA, such intended activities must be notified to the Market Operations Department in advance.
(xi) Restrictions on payments to staff or related persons other than core wages
There could be a restriction that no bonuses or any other type of non-essential payment can be made to senior staff, management, or related persons or parties. Distribution of cash, assets, dividends or any other item of value to persons, which is not necessary in the ordinary course of business and which worsens the central bank’s position with regard to recovering its money at the earliest opportunity, should be disallowed. The obligation should be on the borrowing bank’s management to seek approval from the BoB where it is unsure.
ELA recipient banks may be requested to have a report prepared by its own external auditors as to the bank’s compliance with the guidelines issued for the use of ELA funds.
The mission comprised Messrs. Peter Lohmus (Mission Chief, MCM), Geof Mortlock (Independent Consultant), and David Doran (Central Bank of Ireland).
Banking Supervision Annual Report (2014).
We discuss this matter later in the report when considering the role of the MFDP in relation to bank resolution in the context of resolution funding.
The BoBA 1996, Part VII, Section 38 ‘Operations with account holders’ specifically sub-sections 3(a) and (b).
Throughout this report, the terms Emergency Liquidity Assistance (ELA) and Lender of Last Resort (LOLR) are used interchangeably.
The BoBA Revision 4 of 2015, June 16 2015, Part IX, Section 47 ‘Lender of last resort.’
The BoBA Revision 4 of 2015, June 16 2015, Part II, Section 4 ‘Objectives of the Bank.’
These assessments did not form part of the work of this TA mission.
A Draft Banking Act for the Bank of Botswana, dated July 2015, was also supplied to the mission team for review. The Draft Banking Act does not explicitly refer to ELA. However, there are two items that could potentially have an impact on ELA and liquidity. Part III, Section 24—Liquidity management in banks—sub-section (3) requires banks to prepare and submit to the BoB monthly liquidity reports. While other provisions may allow the BoB to request further data, it is suggested that, to avoid potential ambiguity or conflict in the Banking Act, wording along the lines of ‘or at higher frequency as may be directed by the central bank from time to time,” be inserted after the word ‘monthly.’ In addition, Section 24, sub-section (6) requires that a bank shall not pledge or encumber any portion of its liquid assets without prior authorization of the central bank. The motivation behind (and implications of) this clause should be explained more clearly. For example, is this intended to only apply to the 10 percent liquid assets ratio that the banks are required to hold for regulatory purposes? If it applies to all liquid assets, even where banks hold in excess of their regulatory requirement, then the reason for the BoB’s authorization should be clarified, as this will otherwise provide a hindrance to banks being able to easily mobilize liquid assets as collateral on the interbank market, for example.
Ninety-one-day paper is also auctioned once a month.
Although, in practice, the BoB has absorbed larger amounts than the maximum limit specified for the tender. See Paragraph 3.6 in the latest Bank of Botswana 2016 Monetary Policy Statement, released on February 25, 2016.
At time of writing, the repo rate is 5.5 percent, the Bank Rate is 6 percent, and the CF margin is 6 percent, equating to an overnight credit facility rate of 12 percent.
At the time of writing, the penal interest rate for borrowing under the extended credit facility in excess of one-third of the bank-specific limit, known as special repo or secured lending facility, is 50 percent.
Also, life insurance companies hold large amounts of the cash in the system.
In addition to this apparent fragmentation and the effect that the need for liquid assets appears to be having in distorting the money market cost of funding, the banks do not understand how the markets function exactly and cannot fully explain why there is excess liquidity, yet their average cost of funding is much higher than the interbank rates and the rates at which funds are placed with the BoB.
TA Report “Strengthening the Financial Stability Framework at the Bank of Botswana,” July 2012.
A detailed examination of the monetary policy framework was outside the scope of this mission. The suggestion of a 14-day secured credit providing operation is made here as it would complement the main 14-day liquidity absorption operation implemented by the BoB and having a two-sided main open market operation is recommended. However, secured credit providing facilities of different durations could be considered in accordance with the financial and monetary conditions experienced at a point in time—for example, many central banks have announced liquidity providing operations of various maturities in response to the recent financial crisis and subsequent low inflation environment (e.g., see https://www.ecb.europa.eu/press/pr/date/2011/html/pr111208_1.en.html and https://www.ecb.europa.eu/press/pr/date/2016/html/pr160310_1.en.html).
See Appendix III for a stylized illustration of how liquidity providing monetary policy operations may sit alongside ELA and offer banks a path of access to liquidity with escalating restrictions and criteria.
The list of collateral eligible for liquidity providing open market operations and overnight standing facilities are usually high-quality collateral. Other assets on a banks’ balance sheet could be considered for ELA collateral subject to adequate risk management. These options are illustrated in a stylized manner in Appendix IV.
The suggestions regarding examination of the BoB’s existing market operations are made in the context of assessing the consistency and suitability of the BoB liquidity providing operations alongside a proposal to introduce an ELA framework. There are other issues that could be examined in the context of a deeper analysis of the monetary policy framework and its interaction with interbank activity. For example, the BoBA limits certain eligible collateral for monetary policy operations to that which matures within 184 days of purchase. Collateral with longer maturities could be considered with various pricing and haircut categories devised to address the risks.
For example, the ECB offered LTRO funding for a number of years. See Appendix V for a high level overview of central bank liquidity responses.
These include objectives, transaction terms, and other disincentives and are outlined in Appendix VIII.
If an additional internal committee is not desired, the existing Regulatory Committee could be expanded into a Financial Stability Committee and be attended by senior representatives from regulation, financial stability, financial markets, monetary policy and risk and legal management where they exist.
This is different from the idea of a high level cross-organisational Financial Stability Council (FSC). Previous IMF TA reports (e.g., 2012 report on ‘Strengthening the Financial Stability Framework at the Bank of Botswana’ and 2014 report ‘Toward Financial Stability Analysis and Reporting’) have called for the establishment of an FSC and the need for such a forum is emphasized in this TA report also. It is recommended that the FSC comprises senior personnel from the BoB, the MFDP, the NBFIRA and potentially any other national authority with responsibility for parts of the financial sector. The FSCOM would discuss key issues of financial stability for Botswana that arise and would agree co-ordinated approaches to issues of importance.
See Appendix VII for an example of a stylized type of central bank lending decision system that could be applied to banks of different levels of strength.
Compliance with regulatory liquidity ratios can guide a liquidity assessment, but other qualitative elements are needed in the assessment, such as counterparty quotes obtained in the market and the supervisors’ and market participants’ assessment of the counterparty. In addition, the (prolonged) length of the liquidity need may indicate that there are more fundamental problems behind the scenes (e.g., bad business management).
In some circumstances entities other than banks can be considered for ELA. See IMF Working Paper, “The Lender of Last Resort Function after the Global Financial Crisis,” WP/16/10, for further discussion.
See IMF Working Paper “The Lender of Last Resort Function after the Global Financial Crisis,” WP/16/10, for further discussion.
The BoBA Revision 4 of 2015, June 16 2015, Part IX, Section 47, ‘Lender of last resort.’
See IMF Working Paper, “The Lender of Last Resort Function after the Global Financial Crisis,” WP/16/10, for further discussion on this issue.
An unsecured guarantee from the parent bank will usually not suffice as collateral for lending to a subsidiary, as it offers no recourse to tangible assets in the event of default and would likely be worthless if the liquidity issues being experienced by the subsidiary were to spread to the parent or group and result in default.
The role of legal counsel and assessments during the ELA planning, preparation, drafting and implementation stages should not be underestimated. Often there will be a need to quickly translate policy requirements into legal text and vice versa. There could be significant legal work required in examining what types of assets can legally be mobilized from banks’ balance sheets and preparing legal agreements to allow them to be taken as collateral. It is advisable that strong consideration be given to the BoB’s employing lawyers to assist the timely implementation of this work, and to assist in legal work relating to normal monetary policy agreements and the resolution and crisis management legal requirements.
Some central banks have designated risk management or middle office departments or units. If the BoB does not follow such a route, it may nonetheless be useful to task a particular FMD staff member, or as many as is required, to perform the risk management duties outlined in this report, which are distinct from the front office lending duties.
See ECB list of eligible collateral for normal monetary operations https://www.ecb.europa.eu/paym/coll/standards/marketable/html/index.en.html. The list of collateral that is eligible for normal monetary operations is determined by the monetary policy stance and the degree to which banks have sufficient collateral to access normal operations. ELA collateral will be determined by what other assets are left after monetary policy eligible collateral has been used, subject to additional risk control measures.
The Bank of England applies a price tiering in some of its Sterling Monetary Framework operations in order to encourage the market to hold higher quality assets.
See ECB’s ELA high level principles at https://www.ecb.europa.eu/mopo/ela/html/index.en.html.
“… the prudential supervisor’s assessment, over the short and medium term, of the liquidity position and solvency of the institution receiving the ELA, including the criteria used to come to a positive conclusion with respect to solvency” (ECB ELA Procedures, Updated February 2014, https://www.ecb.europa.eu/pub/pdf/other/201402_elaprocedures.en.pdf?10cc0e926699a1984161dc21722ca841)
It is up to the local central bank to decide on the extent of stipulations necessary—reflecting its perception of the risks involved in lending activities of the banks in question.
See “Guideline (EU) 2016/65 of the European Central Bank” of November 18, 2015 on the valuation haircuts applied in the implementation of the Eurosystem monetary policy framework (ECB/2015/35) at http://www.ecb.europa.eu/ecb/legal/pdf/oj_jol_2016_014_r_0006_en_txt.pdf. Note that this is intended as a guideline to the schedule of haircuts that could be applied and it does not refer to collateral used by National Central Banks of the euro area in ELA operations, as collateral for such operations and their risk control measures are not published. See also temporary measures at http://www.ecb.europa.eu/ecb/legal/pdf/oj_jol_2014_240_r_0012_en_txt.pdf.
See also Title VI - Risk Control and Valuation Framework of Marketable and Non-Marketable Assets – in Guideline (EU) 2015/510 of the European Central Bank of December 19, 2014 on the implementation of the Eurosystem monetary policy framework (ECB/2014/60) (recast) (http://www.ecb.europa.eu/ecb/legal/pdf/oj_jol_2015_091_r_0002_en_txt.pdf).
For example, see ECB loan level requirements in the context of asset-backed securities https://www.ecb.europa.eu/mopo/assets/loanlevel/html/index.en.html.
This scenario is based on comments earlier in this report relating to the possible need for two-sided OMO and less penal access to overnight credit facilities so that counterparties can access liquidity from the BoB, in the normal course of liquidity management, before then having to request ELA for additional liquidity beyond a certain level.