Paul Tucker: Resolution and future of finance
Speech by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
at the INSOL International World Congress, The Hague, 20 May 2013.
* * *
Thank you very much for inviting me here today. The Bank of England has a long-standing
interest in insolvency arrangements, including collaboration with INSOL. Drawing on
techniques that the Bank had used in the 1930s and then again in the 1970s and '80s,
around twenty years ago we articulated the 'London Approach' to creditors collaborating on
restructuring firms that are financially distressed but could have a viable future. That was the
background to our previous Governor, Eddie George, putting the Bank's name to the INSOL
Lenders Principles on global corporate workouts.1 Those principles focus on large
international non-financial corporations. Today I want to update you on progress with the
bigger and even more important challenge of ensuring that large global financial groups can
be resolved in an orderly way without taxpayer solvency support.
Why resolution is so very important
I want to begin with why the work on bank resolution is so very very important.
First, we are not going to solve the deep problem of Too Big to Fail (TBTF) without effective,
credible resolution regimes.
To date the international community is addressing TBTF via a combination of capital
surcharges for the largest and most complex global firms, and an overhaul of resolution
regimes. The first is designed to reduce the probability of failure; the second to provide
society with the means to cope with the failure of systemically important financial institutions
(now known as SIFIs) without taxpayer solvency support. Amongst Financial Stability Board
members, this has informally been known as the 'bookends strategy'.2
Absent effective resolution regimes, we would be further from protecting society from the
risks posed by the failure of large and complex firms. To reduce the probability of failure,
capital requirements for SIFIs would end up being considerably higher - supplemented no
doubt by more radical restructuring of banking than planned to date by any of the major
countries.
While measures on capital resources and structure are vital complements to and enablers of
resolution, personally I doubt that an alternative route without a resolution component would
work in the end. As the years and decades passed, new types of financial intermediary would
emerge operating outside of those capital and structural restrictions; or the restrictions
themselves would eventually be relaxed or even lifted entirely as the spirit of the times
evolved, as happened around the world in the past. Sooner or later, society would find itself
regretting that it had not put in place the necessary resolution regime to cope with the failure
of systemically important financial institutions.
In short, there is no alternative to submitting banking and its investors to the disciplines of
capitalism - failure as well as success. We cannot afford to have banking, so central to the
allocation of capital in market economies, semi socialised. Moreover, we need to harness the
energies of bond holders to monitoring and helping to contain the tendency to excess
characteristic of bankers, over the generations, in the upswing of the credit cycle. That is not
in and of itself a guarantee of stability, but I would rather give asset managers incentives to
help the objectives of prudential supervisors than incentives to rely on a fiscal backstop.
Second, effective resolution regimes, capable of operating across national borders, are
necessary for a healthy international monetary and financial system (IMFS). As Mervyn King
has said, the large financial groups have been 'international in life, but national in death'.
Without effective cross-border resolution arrangements, domestic authorities are left with a
clear incentive to take steps to cap the contingent exposure of local taxpayers, who are local
voters. That is surely part of the backdrop to the series of measures taken by national and
regional authorities to restrict the range of activities or structure of banking. Those measures
need to be taken without the world slipping into a hard-to-reverse balkanisation of the
international financial system. Were that to happen, the breakdown in cooperation between
sovereign states could all too easily give encouragement to those around the world who
would like to use protectionist measures to shield their countries from the winds of global
trade. If the international monetary and financial system relies, as it has since at least the
collapse of Bretton Woods forty odd years ago, on the private banking system to supply the
cross-border liquidity needed to underpin expansion of world trade, then we must ensure that
the international banking system is safe and sound. That cannot rest solely on prophylactic
prudential supervision. It must include effective arrangements for cross-border resolution.
That has been an architectural faultline in the IMFS for decades.3
Third, across the world the operational independence of prudential supervisors4 from
shortterm politics depends on credible and effective resolution regimes. Unless we can handle the
failure of banks and other financial firms in an orderly way, it is hard for governments to tie
themselves to the mast of eschewing the temptations of 'bailout' using taxpayer's money.
That would give them an interest in the day-to-day operation of prudential supervision which,
as experience in some countries shows, all too easily morphs into attempts to promote and
protect 'national' champions; and to operate supervisory policy for short-term gain rather than
in the interests of medium-term stability. In any countries where that persists, we should
expect higher government bond yields than otherwise, reflecting the state's contingent
liability for the banking sector. Unless we deliver effective resolution regimes, public finances
will be under more pressure.
So, summing up why the resolution reforms are so important: if you believe in solving Too
Big To Fail, in an international financial system that is not only free but also safe, in shielding
taxpayers from the risks in banking, and in shielding banking from politics, you will be
committed to making a success of resolution.
Thankfully, the extent of progress since the 2008/09 bailouts, while still incomplete and
needing continuous political impetus, is good.
It has involved agreement on a global model for resolution regimes capable of handling the
largest and most complicated firms; legislation in some, but not yet enough, jurisdictions to
embed that regime; the development of high-level resolution strategies that can be applied to
different types of global group; concrete steps towards agreement between countries on how
to apply those strategies across borders to specific institutions; and plans for top-level
reviews of the adequacy of the resolution plans for each Global SIFI. If that progress has not
been faster, which is an understandable concern, it is for the good reason that the required
reforms involve an agency of the State, the resolution authority, having powers that affect
property rights. In democracies, that is rightly debated thoroughly to ensure that it has
legitimacy and is subject to the right checks and balances.5 The key process is, of course, the
vetting and passage of legislation. That process is well underway in the key jurisdictions.
Establishing the statutory regime
In November 2011, the G20 leaders endorsed the Financial Stability Board's Key Attributes
for Resolution as an 'international standard'. That term of art means that all the jurisdictions
of the G20 are committed to incorporate the Key Attributes (KAs) regime into their domestic
legislation. The US has largely done so. The EU is very close to doing so, through its
Recovery and Resolution Directive. Switzerland has largely done so. Between them, this will
account for the home countries of 24 of the 28 globally systemic banks listed by the FSB and
the Basel Supervisors Committee last year. It is unlikely that in future decades the West will
account for such a large share of the world's unequivocally systemic firms. In both Asia and
Latin America, a number of jurisdictions have made progress with putting the KA regime on
to a statutory footing. But it is probably fair to say that not a few emerging-market countries
are watching progress in the EU. Indeed, it is not an exaggeration to say that the EU's
Directive is the keystone to breaking the back of the TBTF problem.
How? The toolkit for Resolution Authorities established by the KAs obviously includes the
workhorse techniques for resolving standard commercial banks. Either: liquidation with
prompt payout to insured depositors by the Deposit Guarantee Scheme (DGS), commonly
known as Liquidation and Payout (L&P). Or: what the US call Purchase & Assumption (P&A)
- selling to a third party the distressed bank's deposit book together with some cash injected
by the DGS and perhaps some other good assets.
At its simplest, P&A involves splitting the distressed bank into 'good' and, let's say, 'not so
good' bits. The deposit book and cash might for a while be held in a Bridge Bank controlled
by the Resolution Authority (RA), pending sale to a purchaser. But whether or not a Bridge
Bank is employed as a holding position, the services to insured depositors are sustained.
Meanwhile, the rump goes into administration, with the administrators selling what they can
and winding down the rest.
Those techniques are tried and tested in the US, and are the basis for resolutions of regular
commercial banks in many other countries. They do not involve taxpayer solvency support.
I am doubtful, however, whether those established techniques would work for a complex
investment bank or a global commercial bank. Universal banks are typically run on an
integrated basis, across functions and regions, so that capital can be reallocated easily as
opportunities shift around. It would be a nightmare to execute over a weekend a split of any
of these groups, with multiple entities across scores of countries, into those parts providing
services that must be sustained at all costs and a remainder that could be wound down as
part of a resolution. Moreover, this is not just a matter of critical versus not-so-critical
services. Even if, contrary to my doubts, it were possible to execute that separation in the
midst of a crisis, winding down a complex trading book would be hugely hazardous, with very
nasty spillovers to the rest of the financial system.
Quite separately, P&A techniques might also fall short in handling the failure of
mediumsized commercial banks in highly concentrated banking systems. Crudely, there may be few
or even no potential buyers of the deposit book in such circumstances.
That is the background to the so-called 'bailin' technique which, within the official sector,
takes its inspiration from the way insolvency practitioners effect a capital restructuring of
distressed but viable non-financial firms - for example, Chapter XI in the US.
The critical difference from a standard corporate reconstruction is that for banks and dealers
there is not time for a negotiation lasting a month or so under the control of a judge. In the
wider public interest, swifter action is needed to stabilise banks, executing a resolution
strategy designed to contain the impact on stability in the financial system as a whole. Bailin
seeks to deliver that.
Such bailins do, of course, impose losses on creditors. But all - I repeat, all - resolution tools
involve creditors and the Deposit Guarantee Scheme, as well as equity holders, taking
losses. As this audience certainly knows, that is not an exotic proposition. The losses simply
have to go somewhere.
There is, however, a difference between 'bailin' and other resolution tools. Under most
traditional bank-resolution techniques - L&P or P&A - losses for uninsured creditors ,
including the DGS, are revealed only at the end of the administration of the rump, when all
assets have been sold or run off. 'Bailin' works by making an ex ante, up-front judgment of
the scale of expected losses, and by reconstructing the capital structure accordingly, without
the destruction of value entailed by winding down all portfolios associated with non-critical
services. Following the creditor hierarchy that would apply in liquidation, the various layers -
equity, subordinated debt, senior unsecured debt etc - are written down until the losses are
covered. And then the last surviving layer(s) of debt are partially converted into equity to
recapitalise the continuing parts of the business, which is thus under new ownership.
This has given rise to nothing short of a revolution in thinking about possible resolution
strategies for SIFIs.
Resolution strategies
Last November the FSB issued draft Guidance on resolution strategies. Big picture, there are
two basic strategies - Single Point of Entry and Multiple Point of Entry.
Single-Point-of-Entry Resolution
Single-point-of-entry resolution involves working downwards from the top company (Topco)
in the group in an exercise that resolves the group as a whole, wherever its problems began.
Think of it this way. Losses in subsidiaries are first transferred within the group to the Topco.
If Topco is bankrupt as a result, the group needs resolving. Bailin can then be applied to the
Topco's capital structure: writing off the equity and, most likely, subordinated debt; and
writing down and partially converting into equity the senior (bonded) debt issued by Topco.
Those bondholders become the new owners. If Topco is a pure holding company - its assets
comprising only investments in its subsidiaries - a number of advantages follow. The
creditors of the operating banks and dealers are left intact; what might be called the group's
'operating liabilities' are protected relative to the 'capital liabilities' of Topco. Cross-border
problems in resolving different subsidiaries or branches can also be sidestepped.6 Any
reorganistion of the operating companies to address the underlying causes of the group's
failure can be made in an orderly fashion after the solvency position has been stabilised via
the bailin.
Multiple-Point-of-Entry Resolution
Multiple-point-of-entry resolution is what it says on the tin. Rather than resolving the group as
a single whole, it would be split up into its parts. That is quite probably appealing for those
global groups comprising a bundle of regional, on-the-ground commercial and retail banks,
operated as separate businesses financially in distinct legal structures but with shared
operational and central services.
Of course, just saying 'break up the group along regional lines' does not amount to a
resolution strategy. What happens to those regional parts? Healthy parts might be sold or be
maintained as a residual group shorn of their distressed sister companies. Those distressed
parts would need to be resolved, either via P&A or via bailin of the local subsidiary (if it had
issued bonds to the market). I want to stress that last point because 'bailin' as a resolution
tool should not become synonymous with top-down SPE resolutions: an MPE resolution
could involve the bailin resolution-tool being applied to some parts of the group.
For those groups comprising a series of regional subgroups in a hub-and-spokes structure,
there may be intermediate holding companies for each region. The preference of some of the
regional authorities might be for a SPE resolution of 'their' subgroup. In other words, a MPE
resolution strategy can incorporate SPE resolution being planned for some parts of the
group.
The precise approach applied to the different regional/local subsidiaries would be a matter
for the relevant host authorities. But it should not be a mad scramble. Under the FSB KAs,
the home authority for the group has the important role of ensuring that the operation is well
co-ordinated and not competitive.
Preconditions for SPE and MPE resolutions
There is obviously a lot to be said about how to apply the two headline strategic options for
resolving SIFIs. The FSB plans to finalise its Guidance on implementation before the
summer holidays and so decently ahead of the Summit of G20 Leaders in September. I think
that will need to include in particular:
• groups having enough loss-absorbing capacity, and at the right locations in their
corporate structure;
• resolution authorities being able to enforce a write-down or conversion of bonds
issued in foreign jurisdictions;
• as much clarity as possible about the relative treatment of different categories of
creditor;
• regulatory measures to guard against contagion in a world where bank creditors
take losses;
• legal, operational and financial structures that are aligned with the preferred
resolution strategy for a group and with sustaining its most essential financial
services;
• effective co-ordination between home and host authorities;
• fall back plans, and frameworks for escalating preparations for resolution as a
group's condition deteriorates.
Enabling effective resolution: removing barriers and structuring financial groups for
resolution
For most if not all SIFIs, steps will need to be taken in order to ensure that the preferred
resolution strategy can be implemented.
Sufficient loss-absorbing capacity, and its terms
Perhaps the most obvious prerequisite is that SIFIs should have sufficient bonded debt in
issue for losses exceeding their equity base to be absorbed through the process of
resolution. This is gone-concern loss-absorbing capacity (LAC).
This gone-concern LAC could be senior unsecured bonds or subordinated bonds.7
Bonds issued outside the issuing firm's home jurisdiction are going to need to include legally
robust clauses under which holders unequivocally accept that the home Resolution Authority
can apply the bailin tool (and other resolution tools) to their investment. If that cannot be
achieved, gone concern LAC is going to have to be issued from each firm's country of
domicile.
There should not be cross-default clauses in other liabilities, including elsewhere in the group
that could be triggered by bailing in these bonds.8
Beyond the terms of bond issues, the authorities are going to need to decide how much
loss-absorbing capacity SIFIs need to have in issue. In Europe, the draft resolution directive
provides a framework for that. But a global discussion is needed.
My own provisional view is that the minimum for bonded debt might need to be equivalent to
the sum of the firm's regulatory equity requirement plus a margin (X) less any surplus equity.
That would mean that bailin could be used to cover losses beyond a firm's required equity
base up to an amount X and then to recapitalise back to the ab initio equity standard.
In summary, the authorities are going to need to establish minimum standards for the amount
of bonded debt - or gone-concern LAC - SIFIs have in issue, with a requirement that they
are capable of being bailed-in by the RA of the jurisdiction in which the issuing entity is
domiciled.
Containing contagion (1): holders of bank bonds
The purpose of resolution regimes is to contain disorderly disruption of the financial system.
Equally, in order to avoid taxpayers providing solvency support, losses must fall to creditors.
It is therefore important to ensure that the imposition of losses on creditors does not itself
cause systemic distress through contagion. That will depend heavily on who within the
financial system holds bank bonds.
It would be impractical to identify individual holders of bonds on the eve of resolution,
applying case-by-case discretion. This needs to be addressed through regulatory policy.
Most obviously, regulators need to ensure that banks do not hold each other's bonds, except
for example in small amounts as part of market-making.
Secondly, regulators are going to need to ensure that some investors, for example
lifeinsurance companies, do not have concentrated exposures to bonds issued by single banks
or to banking sectors.
7
For groups with a pure holding company, senior debt issued from holdco is structurally subordinated to claims on the
group's operating banks and dealers.
8
The trigger for statutory resolution would be, broadly, that the conditions for the group being authorised as a bank or dealer
were no longer met and there was no reasonable prospect of repair. It should be underlined that what is described here is
nothing to do with so-called 'contractual bailin', which has been a source of confusing distraction over the past year or so.
'Contractual bailin' typically refers to bonds that convert into equity or write down under a trigger establishes purely in the
contract documentation. But if the trigger is the firm's capital ratio dipping below a high threshold, the bond is in fact for
recovery not for handling abject distress. If, at the other end of the spectrum, the trigger is falling below a low capital ratio,
there can be no assurance that the firm would survive in the markets long enough for the bond to be triggered before the
firm had to go into statutory resolution. And if the suggestion were that the contractual trigger should give the regulators
discretion, most Resolution Authorities would want to avoid writing down or converting bonds outside the statutory resolution
process, since that provides protections for creditors, and gives the RA protections and powers for the achievement of a
clear statutory objective established by the legislature. Bailin is not about a specific type of bond - a so-called 'bailin bond'
- but about the application of a statutory resolution power to bonds of any kind within a statutory resolution. 'Bailin' is a verb
not a noun. Orderly resolution will not be achieved by drafting term sheets.
Looking back on the 2007-2009 part of the crisis, those precepts should have been in place
anyway. In the UK, it was alarming that many medium-sized domestic banks had been
allowed to hold each other's bonds in what were purportedly 'liquidity' portfolios.9
Contagion (2): the creditor hierarchy and depositor preference
Preparations for bailin, and even more the recent reconstruction of Cypriot banks, have
heightened awareness of the prospect of creditors of distressed banks losing money,
prompting calls for clarity about the relative standing of different types of creditor. Who
stands where in the creditor hierarchy affects the loss they incur in the event of default, and
therefore their behaviour before default, including the return they demand to compensate for
risk and whether they flee at the first signs of the firm weakening.
Insured depositors are insured, pure and simple - they are covered by the relevant Deposit
Guarantee Scheme. The details of the resolution regime do not affect that.10 Nor does
preference for insured deposits affect those depositors directly. Rather, it affects the
exposure to loss of the DGS and thus the share of the losses having to be covered by the
surviving parts of the industry.11
Amongst uninsured creditors, the position of bond holders will depend on whether they are
issued from a (pure) holding company, in which case they have a structurally subordinated
claim on the underlying business assets, or by operating companies that also have lots of
other unsecured creditors. The exposure to loss of bonds issued by operating companies
are, therefore, affected by whether or not they incorporate subordination clauses. For every
bank group, all of that will be clear.
The big issue, therefore, is about uninsured deposits. Should they rank alongside senior
unsecured bonds or should they be preferred?
In the US, all deposits are preferred. There is now an active debate in the EU about whether
or not it should introduce depositor preference and, if so, whether that should be for all or
only some uninsured deposits? Whatever the conclusion reached by the political authorities,
it is important that the creditor hierarchy is the same under bailin, other resolution tools, and
liquidation. Otherwise, pricing each piece of debt would depend upon time-varying
assessments of the probabilities of the various resolution tools being applied in the event of a
firm's bankruptcy.
On the substance of the issue, I can see a case for both insured and some uninsured
depositors being preferred. That would help to provide some protection, beyond the DGS, for
users of the monetary services that banks provide via overnight and short-term deposits; it
could provide a small degree of protection against runs; and there could be an element of
social justice in insulating, say, small firms and charities from the first line of loss.
But, I say 'some' uninsured deposits because I am doubtful whether very large, wholesale
deposits placed at term maturities (eg billions of pounds for six months or more) should be
preferred. They are not monetary deposits, in the sense of being transaction balances; and
they are not placed by households or small firms or charities. Moreover, if they were to be
preferred, it would be likely that a chunk of bonded finance would over time morph into
borrowing-instruments that had the legal form of 'deposits'. That would increase the cost of
any residual bond issuance.
Finally, whatever types of deposit end up being preferred, there should be no discrimination
on grounds of location or nationality. The chosen creditor hierarchy should apply the same
way to all branches of a bank throughout the world. The Financial Stability Board Key
Attributes are clear about that.12
I do not need to remind this audience that depositor preference would not be a guarantee
against the relevant uninsured deposits (or the DGS) ever taking losses. But they would be
exposed to loss only after bonds, as well as equity, had been wiped out. The greater the
gone-concern LAC requirement for bond issuance, the lower the probability of any preferred
deposits incurring loss.
Group structure: having LAC in the right place, and operational dependencies
It will have been apparent from my earlier description of high-level resolution strategies that
where and how a group maintains its LAC will vary somewhat according to whether the
preferred resolution strategy is SPE or MPE.
For SPE resolutions, sufficient loss-absorbing capacity must be at the topco. But more than
that, there has to be a mechanism for transferring losses from operating subsidiaries,
wherever they are in the world, to the topco. One way of doing that would be for Topco to
guarantee the performance of the obligations of its systemically significant and other key
operating subsidiaries. But that could not be a complete solution as it would leave the hosts
of the group's foreign subsidiaries with exposure to Topco being unwilling or unable to pay
when it mattered. For that reason, the LAC of Topco needs to be passed down to the
'systemic' or otherwise key operating subsidiaries, forming LAC in the subsidiaries
themselves. This should probably be in the form of subordinated debt issued to the Topco
with write down triggers that would enable losses exceeding the subsidiary's equity base to
be pushed up to the Topco. By transmitting the losses to Topco, the operating company is
recapitalised. If Topco itself is bankrupt as a result, it can be resolved in a
top-down bailin by the group's home resolution authority of its own debt. That is the model
set out in the paper FDIC/Bank of England issued last December.13
For MPE resolutions, there needs to be sufficient LAC in each of the key subsidiaries that
are manifestly relevant to global financial stability. Some of the gone-concern LAC should be
issued externally, so that bailin can effect a transfer of ownership. Beyond that, the host
authorities of other subsidiaries may want to require sufficient externally issued
goneconcern LAC, in order to be confident of being able to execute a local resolution if the
subsidiary they host is systemic locally, ie a domestic SIFI.
To a greater extent than with SPE, a MPE resolution can be impeded by financial
connections between different parts of the group, whether arising from intergroup loans or
from business lines, such as global payment services, that are integrated but spread across
different legal entities. In supporting MPE as a preferred strategy, the home and key host
resolution authorities will have to satisfy themselves robustly that such interlinkages would
not impede resolution via splitting up the group. In practice, that will mean reducing
intragroup exposures.
Operational dependencies between different parts of the group are another priority where
MPE is the preferred strategy. For example, some global commercial banking groups seek to
exploit economies of scale and scope by drawing on centralised operational services (in
particular related to IT and processing). MPE does not work unless those arrangements can
survive the breakup of the group. At the very least, that entails service-level agreements and
transitional support arrangements being effected via enforceable contracts. Any separate
group-service companies need to maintain sufficient capital and liquidity to continue to
support the principal operating companies before they are wound down or sold to third
parties. And it would probably be useful to have governance arrangements that give some
form of control rights to the operating companies over the service companies during that
transition.
In broad summary, it will be apparent that, even once the statutory resolution regime is in
place in all key jurisdictions, many financial groups are going to need to restructure
themselves in order to achieve resolvability - financially, legally, organisationally. Indeed, a
group's choice of financial and operational structure will influence which of a SPE or MPE
resolution strategy is preferred by the home and key host authorities. These will be bespoke
restructurings - and will be on top of the plans for systematic structural reforms of banking
around the world (Vickers, Volcker, Liikanen, and so on).
Cross-border co-operation
The final precondition for success I want to highlight is, of course, effective cross-border
co-operation.
For a SPE strategy, successful implementation will depend on the home authority providing
assurances to the key host authorities so that they refrain from taking independent action.
Instead the host authorities would rely on the home authority to give effect to a group-wide
resolution and, where necessary under the law, would take local action to help the home
authority. Host authorities are going to need to be clear about the assurances they need -
ahead of time and during the execution of the groupwide resolution.
For a MPE strategy, the successful implementation will require effective coordination of the
different resolution actions undertaken by home and host authorities. Each key host authority
needs to be open about its plans. The home authority needs to reciprocate, ensuring a
joined-up, collaborative approach with no surprises.
For both SPE and MPE resolutions, the FSB has stipulated that firm-specific cooperation
agreements (COAGs) must be agreed amongst home and host authorities. The FDIC/Bank
of England joint paper last year is by no means the only example of intensified co-operation
preparing the way for those COAGs. Over recent months there has been marked
convergence in how the world's key authorities plan to approach resolution. This will become
more apparent as more jurisdictions, including crucially the member states of the EU,
legislate the KAs into their local statutory regimes.14
Preferred paths, and fall backs
My exposition of how the resolution work programme will be taken forward has made it clear
that, as I at least envisage it, for each SIFI there will be a preferred path. There are two
points to make about this.
First, I favour the term 'preferred path' over 'presumptive path' because I am concerned that
too many people - perhaps particularly amongst asset managers - slip into thinking, and
even demanding, that a 'presumptive' path should offer certainty, with no room for the RA to
exercise any discretion in the public interest. I think that that is unrealistic. Take the case of a
bank with plenty of bonds in issue, but also tiny amounts owed to each of hundreds of trade
creditors or to hundreds or even thousands of market counterparties. In an emergency, it
would not be remotely sensible operationally for the RA to have to pin down each and every
tiny trade-credit or wholesale obligation on a Friday evening/Saturday morning so that they
could be bailed in, b