Too Big To…Fail…or..Save…or what?

What has been achieved to cut the TBTF spiral and what still needs to be done

In order to avoid putting taxpayers’ money into a failing bank (i.e. to avoid buying and re-capitalising failing bank with public funds) you need to be able to resolve failing institution in a controlled and pre-programmed manner. This is called Banking Resolution Regime. Much has been said and written on this topic, but I would like to propose a fresh perspective — a truly international perspective. Is it possible today to dully resolve a failing global bank? This is the central question answer to which is also an answer to the question of do we already live in a world where failure of a banking institution does not result in taxpayers’ bailing it out and harming economic prospects of a given country.

You will find my answer to this very central question at the end of this note. But first things first…

Resolving a failing bank — cross-jurisdictional perspective

Following recent publication by FSB on how SIFIs should be resolved — we can draw a rather clear picture on available ways to resolve failing global banks. The aforementioned FSB guidance can be summarised as follows: there are basically two ways to resolve a failing bank: its either single point of entry or multiple point of entry scheme. The so called Single Point of Entry resolution regime is basically a top-down resolution, where all the losses from all the group are transferred upwards to the bank holding company towards which a ‘bailin’ tool is applied: equity written down and bonds converted into equity to absorb losses. On the other side there is a multiple point of entry scheme is where group is split into healthy and suffering parts allowing healthy parts to carry on business and using ‘bailin’ tools towards suffering parts (or regional holding companies).

How resolutions methods affect supervision/regulation of global banking

Above calls for some clearance on how different resolution schemes would affect the global banking business. First of all every banking group is now subject to preparing living wills in advance where they have to think about about and draft a plan how they should be resolved should they face major losses. Basically — banking groups should decide what is the most suited way to resolve the failing business, either through single point of entry or multiple point of entry mechanism. This should be quite obvious when one looks at the group structure. Nevertheless, the models should be purified and cross-company arrangement put in place. In case of SPE scheme — a top holding company should be the “cash box” issuing the debt and on-lending the proceeds down to the group. So first of all there should be bonds issues by the holding company in order to have bonds to ‘bailin’ and moreover, there should be a top-down debt instruments in existence to enable subsidiaries to pass losses top to the holding company. In case of MPE scheme — banking group should be organised in a way to reflect a legit commercial logic where each part of the group is “ring-fenced” based on operational business logic, not purely for e.g. tax purposes. This is necessary to ensure that a healthy part of a bank is perfectly capable to carry on trading when detached from the failing part of a banking group. If you detach a part that has been established without regard to underlying business and operational logic — such unit will most definitely struggle to do any banking business without external helping hand. Moreover, if in case of SPE a shared service center may be established without too much regard towards commercial sense of having such center (i.e. without giving thought how much such center is commercially viable on a stand-alone basis, without weighing the benefits it brings to the entire group), a different story is in case of MPE scheme. If part of the group is allowed to go down and a healthy part is detached — you need a shared service center that is robust and is able to keep on providing services to the healthy parts of the group. You need robust contracts, you need an arm’s length pricing system, you need a stand-alone commercial logic. In brief — banking groups have to consider their present structure and take decisions on how equity and loss-absorbing debt is to be distributed within a group. If the loss-absorbing debt is available at operating company level — MPE scheme may be applied, if all the losses are pushed to the top where all the loss-absorbing debt is issued from — this would be a SPE resolution scheme. FSB is currently working on clarifying which instruments are best suited for the going-concern resolution and which for the gone-concern. FSB will draw recommendations on which instruments should be applied for different situations (going and gone concern) and how equity and loss-absorbing debt should be distributed withing the group.

On the bright side of post-crisis developments pertaining to the TBTF problem, everyone agrees that historical setting and certain legislative initiatives within Dodd Frank created a soil for resolving all the US SIFIs. This rests due to fact that great majority of US SIFIs has been organised through holding companies, which allows to opt for top-down resolution. The picture in Europe is also getting brighter amid agreement on a second pillar of the so called Banking Union — single resolution mechanism. Without much of technical details not being yet available it is hard to draw any conclusion about particularities of this system, however when you couple a single supervisory mechanism with a harmonised deposit insurance scheme, single resolution mechanism — a sense of fully fledged banking union starts to emerge. Still a lot has to be done with regard to financial backstop to support this union, however political will gives some comfort that EU is finally moving away from the TBTF.

These are the immediate consideration one looks at when analysing the TBTF — Dodd Frank in US and Banking Union in EU. However, Sir. Paul Tucker (an ex BoE leader of thought in the field of financial stability) recently raised concerns about a bigger picture that everyone tends to forget. Namely is the global banking regulation/supervision framework fit for a smooth and painless resolution of SIFIs? Ding ding… of course, the SIFIs are global institutions with operations all over the place and usually subject to array of different regulatory and supervisory system. So yes — is the global framework fit for global banking resolution? Is there such thing as global resolution scheme at all?

To illustrate my point, I would like to firstly to point out how does the newly emerging resolution frameworks (as said either SPE or MPE) is affecting international banking integration and international supervision. I have already briefly mentioned, that choice of either SPE or MPE determines the way the banking group should be structured and the way capital (together with loss absorbing debt) should be distributed within a banking group. To simplify: in case of SPE majority of capital and loss absorbency capacity rests with the ultimate holding company, which absorbs the losses generated within operating companies; whereas, in case of MPE different operating companies (or their regional holding companies) should be separately capitalised to ensure regulator’s ability to shut down those parts of a gone-concern and revive those of still going concern.

Each jurisdiction where a global banking institution is active is concerned about losses arising within the exact jurisdiction. The most straightforward way to address such concern is to call for a sound capitalisation of institution’s part operating in that particular institution. The crisis of 2008 gave rise to such call in practice where “protectionist” approaches became the new normal. Consider US call for EU banks active in US to be separately capitalised, UK calls to require separate capitalisation of subsidiaries of foreign banks acting in UK. Those are only the most acute examples. I remember at the EUROFI 2013 a representative from the FDIC said that US cannot trust the global rules for banks’ capital adequacy unless the local regulators (for e.g. of EU banks active in US) prove to US that they are capable to implement and enforce those uniform rules in as quality way as US is doing. His argument was that uniform rules are only as good as the institutions implementing/enforcing them. I have many times already raised an issue that we are facing increasing de-globalisation of international banking with all the nasty downside effects it brings. The US approach clearly illustrates that.

The emerging banking resolution schemes are meant to release the pressure of such ‘national’ games as illustrates with the US example by giving comfort to local regulators that in case banks chooses a SPE resolution regime — the majority of capital could rest with the holding company. And it, indeed, makes a lot of sense as long as due structural arrangements within the group are present and mutual obligation from the down — up (enabling loss transfer up) are in place. And in case of banking institution has opted for the MPE resolution local regulators are justified to require capital and loss absorbing capacity within an operating company.

Truly international rules on banking — how fit are they?

However, any of this might only work if there is a robust framework of truly international rules and principles underpinning the above-mentioned rationale. So is there such backstop of international rules and principles in place?

The most acute problem is that despite common agreement on how the banking resolution should proceed (it is either SPE or MPE) — there is no international standard underpinning the should distribution of loss absorbency capacity across a banking group. This effectively prevents emergence of an international resolution scheme and emergence of sustainable and sound international banking.

The global banking regulation/supervision system rests on the work of BCBS and namely three sets of best practice: core principles of banking supervision; capital accord and Basel concordat for effective cross-border supervision. Sir Paul Tucker (the ex BoE chief of financial stability)is critical towards lack of truly international developments capable to ensure that there is no need for every regulator to take ultima ratio and require each operating company to be separately and fully capitalised in order to avoid losses within a given jurisdiction. In the words of Sir Paul Tucker “each of the three BCBS documents does an important job but none of them addresses the distribution of capital across a group. That is a gap”.

BCBS concordat is based on a principle of ‘consolidated supervision’. It means that as long as there is enough capital in the entire group — local regulators should not require separate capitalisation of operating local company. In effect host supervisor outsources supervision to the home supervisor and does not call for separate capitalisation (as long as of course it is satisfied with capabilities of home supervisor). Such standard of course does not prevent host from requiring separate capitalisation (and some jurisdictions are doing it already) — but in no way BCBS Concordat ensures that loss absorbency is dully distributed across the group.

BCBS core principles call stand-alone, consolidated and group wide supervision. Home supervisor should supervise group on a consolidated basis as well as a particular company in the group — falling under it jurisdiction. Moreover, it should understand relations between different companies in a group. In fact principle 16 states that supervisor may op in for assessment by IMF under the additional criterion, of which adequate distribution of capital is a part. Despite such seemingly effective tool embroiled into the Principles, considering its voluntary nature, Sir Paul Tucker makes such conclusion: “country’s prudential regime could be judged as complying with the Principles even though it does not ensure that the distribution of capital across a banking group leaves its individual entities adequately capitalised”. And I agree that this is a fair conclusion considering the toothless of such norm pertaining to distribution of capital across the banking group.

The latest capital accord (so called Basel III) now gives an option of applying capital adequacy requirements on a stand-alone basis as in contrast with universal consolidated basis. Bu this is an option for countries implementing BIII and not a hard rule. Again — capital distribution across the group is not addressed adequately.

Indeed nor principle for banking supervision, nor concordat, nor capital accord deals with the capital (and loss absorbency capacity) distribution across the banking group. The result is that despite much discussions on the topic we live in the world where the only truly global rules pertaining to banking regulation/supervision — fail to address capital distribution issues, empower effective (at least remotely) global resolution and avoid brake-down of a global banking system (countries choosing protectionism instead of a free flow of capital). Therefore, US position and its distrust of foreign counterparties may be vindicated. In a world where no global standard ensures due and rational allocation of loss absorbing capacity across a banking group there is not much to lean towards for a mutual trust.

All in all Sir Paul Tucker proposes a grim picture of prospects of international resolution scheme, which should help us brake the Too Bid To Fail cycle: “from a resolution perspective, the distribution of loss-absorbing capacity is crucial. Yet, from a regulatory and supervisory perspective, there is as yet no international standard that requires a banking group to ensure a sensible distribution of equity (and debt) within the group”.

Conculsion

During my recent visits to the IIF annual membership meeting and EUROFI I heard a one very worrying message: a unison NO by regulators/bankers/academics when asked — do you truly believe that a failure of a truly international bank today could be resolved without opting for taxpayer money (and probably of several countries — not one. As balance sheets of truly global banks are absolutely massive!).

Much has been done locally: (i) possibility of smooth resolution of any falling bank in US today; (ii) EU’s progress in building Banking Union; harmonising Banking Recovery and Resolution tools within all 28 member states; (iii) universal adoption of BIII capital accord (US rushed to implement; in EU the CRD/CRR IV package came into effect on the 1st January 2014). But there are still gaps in global banking regulation/supervision system. FSB is working tirelessly to address major issues of financial stability — but still much has to be done for a truly global resolution system to emerge and brake the TBTF problem globally.