Paul Tucker: Resolution of large and complex financial institutions - the
big issues
Remarks by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
at the European Commission Conference "Building a Crisis Management Framework for the
Internal Market", Brussels, 19 March 2010.
* * *
Many thanks for input to Mark Adams, Andrew Bailey, Peter Brierley, Geoffrey Davies and Andrew Hewitt, and to
Financial Stability Board colleagues for discussions on resolution issues. For background work to Michael Grady
and for secretarial support to Sandra Bannister and Cheryl Feeney.
I am delighted to be at today's conference, the first major conference under Commissioner
Barnier.
As many colleagues here will know, I chair the Financial Stability Board's Working Group on
Cross-Border Crisis Management. But my remarks today are offered in a personal capacity,
albeit drawing on the international dialogue.
The conference is very well timed given the Commission's work on a possible EU directive
on resolution regimes. An increasing number of national authorities have already established
or are prospectively establishing Special Resolution Regimes for the resolution of
commercial banks, enabling the transfer of deposits and good assets to another bank, with
bad assets and other creditor claims going into an insolvency process. At a high level of
generality, a distressed bank is split into a continuing good bank, typically acquired by a
healthy bank; and a gone-concern bad bank, which goes into administration. Insured
deposits travel with the "good bank". All other creditors typically travel with the "bad bank"
and become claimants in the insolvency.
We can be confident that this will help to buttress stability. Encouragement from the EU to all
members states to establish such regimes would be really useful.
But we also know that, of itself, this is insufficient. It cannot cope with distressed LCFIs
("large and complex financial institutions") without injections of public money.
not
In the first place, every country having its own Special Resolution Regime does solve the
problem of resolving cross-border banking groups.
Second, such regimes cannot cope with investment banking, whether national or global, if a
buyer cannot be found. Even for a (hypothetical) LCFI operating entirely within a single
jurisdiction, with all of its counterparties, customers and contracts domiciled there, a standard
resolution regime could not effect an orderly run down of, for example, a massive, complex
derivatives portfolio. Putting over-the-counter derivatives though central counterparties would
help. But it would not securely solve the problem.
Today I want to surface those big issues, and to encourage the EU and the international
community more generally to explore possible solutions. In doing so, I take our objectives to
be twofold:
(i) First, to avoid a disorderly disruption to the provision of financial services to the
economy in the event of firm distress;
(ii) And second, to put market discipline back into the system, by having losses fall to
uninsured creditors as well as to equity holders, and without public sector solvency
support.
Bluntly, the challenge is how to sustain the provision of financial services during a crisis
without the state bailing out uninsured creditors.
Handling LCFI complex derivative/trading portfolios
Some types of business activity, particularly complex trading, do not lend themselves at all
well to the standard resolution tools I summarised just now. Not least, unwinding a
derivatives book is especially complicated; it typically requires dynamic hedging to preserve
value, and that would be very hard indeed in a liquidation. Counterparties flee. Funding flees.
The Lehman and AIG experiences demonstrate this. So, in a different context, does the time
it took Berkshire Hathaway to wind down the complex derivatives portfolio of its Gen Re
subsidiary; years, not months.
What can be done? One route, suggested by those examples, would be for the authorities to
finance the wind down of complex trading positions, in what would be in effect an analogue
to US-style debtor-in-possession financing. The authorities would be preferred creditors.
That kind of approach could be used either briefly, in order to bridge to an insolvency
procedure, which would amount to putting a framework around the kind of operation the
NYFed mounted for a week or so to contain disruption from the failure of Lehman's US
broker-dealer. Or, alternatively, it could in principle be used over a prolonged period, to
finance the run off of a whole book. In either case, however, it would expose the authorities
to risk of loss, and so would not always deliver the Objectives I think we share. It would not
be assured to preserve orderly markets in all cases. And it would be insufficient if a firm was
actually insolvent.
A quite different, and rather more profound approach would be to deploy a super special
resolution framework that permitted the authorities, on a rapid timetable, to haircut uninsured
creditors in a going concern.
By haircutting creditors in a going concern, there would be no need to close the business
immediately (or, if regulators wished, even at all). That is a very high-level description.
Variants obviously exist. Instead of haircuts, uninsured creditors could have part of their
claim converted into equity. And it would need to be clear how the regime applied to the
normal ranking in the capital structure, with common equity and subordinated debt being
wiped out before any senior unsecured debt was haircut (or converted) at all.
Precisely because investment banking is highly levered, relatively small percentage haircuts
(or conversions to equity) could materially recapitalise a distressed firm. Creditors would
recapitalise distressed LCFIs, not the state. In that, it shares some features of
contingentcapital bonds, but would be on a statutory basis and could apply to all unsecured creditors in
the extreme circumstances of systemic distress.
The crucial feature is that haircuts/conversion would be applied up front to creditors of a
going concern. By contrast, under standard commercial-banking resolution regimes, the "bad
bank" goes into an insolvency process as a gone concern, with de facto haircuts applied to
its creditors ex post, after realisation of the assets by the liquidator - a process that almost
always destroys value. A "going concern" approach would in effect combine features of
standard regimes for resolving commercial banks (rapidity, public policy objectives) with
some features of the US Chapter 11 for non-financial companies (haircuts for creditors in a
continuing business). Of course, the kind of super-special resolution regime I am airing could
not be an exact replica of Chapter 11 - if only because the capital structure of a distressed
LCFI would have to be restructured very quickly, over a weekend if not overnight, and so
could not rely on a negotiated settlement with creditors.
For that reason alone, in common with the existing commercial-bank resolution regimes,
there would plainly need to be safeguards.1 Perhaps the most important might be that such
super special resolution powers could be applied only where the authorities made a formal
determination that the firm's distress would otherwise seriously threaten systemic stability.
The modalities would, I suspect, end up varying according to countries' particular
circumstances. In some, the financial authorities might decide the scale of the
haircuts/conversions; perhaps in other countries, it might be thought that a senior judge
should decide on the basis of an application by the financial authorities.
It is also worth saying that maintaining an LCFI in business through such means would
neither preclude nor of itself require regulatory action against management or, once the crisis
had passed, to wind-down parts or all of the business over time.
Nor would a regime of the broad kind I have sketched exclude restructuring banking groups
into functional subsidiaries, with different resolution tools applied to, say,
deposittaking/payments; custody and global cash management; the business of illiquid lending to
small and medium-sized enterprises and households; trading/derivatives business or
wholesale banking more generally. That would not be inconsistent with reducing the number
of legal entities in LCFI groups, perhaps by an order of magnitude. The current
FSBsponsored work to develop "recovery and resolution plans" for the top 25 or so LCFIs is
designed to identify where those kind of steps are warranted. Resolution could, therefore,
take its place alongside structure and regulation as one of the key elements of a reform
package to strengthen the global financial system.
A super-special resolution regime along those lines would, on the face of it, go quite a long
way towards reintroducing market discipline - by putting uninsured creditors at risk even in
systemic situations. I am not innocent enough in the ways of the market to think that it
wouldn't affect behaviour. Of course, it would lead to changes, over time, in the capital
structure of investment banking operations. Proper transitional periods would be needed.
I suggest that it is worth debating. Maybe there is a fatal flaw. We should certainly search for
the flaws. But if we do not find a way of resolving massive and complex trading books, the
regulation of the business would probably have to be fiercer than otherwise in order to crush
the probability of failure. Resolution is a way of coping with failure. Key voices are the
nonbank financial sector and the corporate treasurers who finance the banking system. What
would they get out of it? They might benefit from avoiding the risk that the authorities choose
to liquidate a LCFI they had thought was too big to fail, with the depletion of value that
entails; think of Lehman. They would, in effect, be trading off losses in one part of their
portfolio against the prospect of protecting the rest of their investments from the fallout of a
credit crunch that would follow the disorderly demise of a distressed LCFI.
The cross-border dimension
The other big issue is how to handle the resolution of internationally active banks. This is a
challenge even for fairly vanilla commercial banking groups.
There has been a Basel Concordat on how home and host authorities should co-operate in
supervising international banks since 1975. It was updated in 1983 and 1992 to take account of
group-level consolidated supervision following the failures of Banco Ambrosiano and then
BCCI. But was the Concordat based on a false premiss: that the division of supervisory-labour
during peacetime can carry smoothly over to the only period that really matters, distress?
Because, as it happens, neither standard resolution regimes for commercial banks nor any
super-SRR of the kind I have just outlined for going-concern restructurings could be applied
easily to the cross-border activities of LCFIs. SRR tools cannot automatically be applied
extraterritorially.
It seems to me that policymakers need to face up to, and decide whether or not to fix, the
really big issues about how insolvency and resolution laws are applied to internationally
active financial companies.
Broadly speaking, countries' laws apply either territorial principles to international
insolvencies, consistent with separate procedures for each of a bank's entities in different
universal
jurisdictions (so-called "separate-entity resolution"); or principles, consistent with a
single procedure applying to the resolution of an international bank and its branches abroad,
wherever they are located ("single-entity resolution"). I believe that top-level policymakers
have to choose what kind of regime they want. This issue needs to be elevated above the
level of middle-ranking technocrats where, through no great fault of their own, it has
wallowed for too long. The issues were articulated as long as 20 years ago, following BCCI's
failure.2 Nothing much has been done globally.
So in the second half of my remarks today, I just want to sketch why this problem arises.
(i) Territoriality
Territorial approaches to resolution are adopted due to potential conflicts of interest between
home and host-state authorities. These may reflect, for example, host countries not wanting
to rely on home countries to act in the interests of financial stability in the host country; or
different or conflicting triggers and objectives for Special Resolution Regime powers.
There are a number of problems with territoriality. It undermines coordinated and cooperative
resolutions, and creates uncertainty by encouraging a race for assets and collateral across
jurisdictions. Related to that, it reduces the effectiveness of Special Resolution Regimes by
allowing host authorities to ring-fence local assets for the benefit of local creditors. And, it
can even render resolution infeasible if the legal structure of an LCFI differs substantially
from its operational structure, with local legal entities dependent on other parts of the group
for vital services.
Greater harmonisation of SRRs across the major jurisdictions might help to reduce distrust in
other countries' approaches. But harmonisation does not remove the potential conflict of
interests between home and host authorities.
The current debate around subsidiarisation of global commercial banking groups stems in
large part from these problems. The thought is that if policymakers cannot solve the territorial
problem, then they should embrace it - banking would go local, with a degree of ring fencing.
That course may conceivably have wider advantages - for example, in the area of
macroprudential regulation3 it might give authorities a greater degree of influence over
domestic credit conditions. But we do also need to consider whether there might be costs to
such an approach. For those policy issues to reach closure, we need to know the way
forward on resolution.
(ii) Pure universalism
What of the other end of the spectrum? In principle, an alternative approach would be to shift
to a more universal approach. A pure form of universalism would rule out separate resolution
or insolvency proceedings, ring-fencing and, therefore, a race for assets. It might encourage
a more cooperative approach to cross-border resolution. There would be one, global
resolution, led by the home authority.
But pure universalism also faces major obstacles. First, it would imply a surrender of national
sovereignty - replacing it with pre-defined and enforceable rules that determined the roles of
different authorities in different jurisdictions. Second, unless steps were taken to rule out the
need for sovereign Capital of Last Resort operations4, it might well need to be accompanied
by an ex ante burden-sharing mechanism, to facilitate a sharing of the costs of resolution
across the jurisdictions in which a bank had activities.
In
theory, that could be addressed by the main home and host authorities of each LCFI
agreeing a set of binding principles to govern the distribution of the costs of a universal
resolution across jurisdictions. An alternative would be to design a single resolution regime
for all LCFIs, to be implemented along universal lines by a supranational resolution authority.
But would countries be prepared to tolerate the loss of fiscal independence and the
overturning of national insolvency laws that this model would entail, especially if it required
governments to commit to recompense the agency for unlimited amounts in the future? That
is most definitely not a question for central bankers.
(iii) Modified universalism
Pure territoriality and pure universalism are corner solutions. We live in a world where some
countries are closer to one corner, others closer to the other.
Some have suggested that an intermediate solution might be feasible. This would involve
"territorial" countries deciding to resolve financial institutions headquartered in their own
jurisdictions on a universal basis. (A possible example of this approach in the recent crisis
was the FDIC's resolution of United Commercial Bank, which involved a "purchase and
assumption"5 that extended to the Chinese subsidiary and the Hong Kong branch following
coordination amongst the authorities in the US, China and Hong Kong.)
host choosing
A "modified" form of universalism would involve authorities to defer to and
cooperate with a resolution brought by the home country authorities, provided that certain
conditions held. Separate insolvency proceedings might be employed by host countries, but
allowing the proceeds to be remitted to the home country, "lead" resolution. Variations might
be needed for subsidiaries and branches. Subsidiaries are distinct legal entities, but they too
can have worldwide creditors and claims. So it would all need to be within some kind of
joined-up whole.
At a high level, the preconditions for something like this might include:
(1) equitable treatment of all creditors regardless of their jurisdiction, because if
creditors in host countries were likely to be penalised in a resolution brought by the
home country authorities, host authorities would have a strong incentive to
ring-fence;
(2) broad harmonisation of resolution regimes across the major jurisdictions.
Also, if governments do continue to contemplate the possibility of fiscal support in a crisis,
then there might need to be some kind of agreement - conceivably case by case - on
principles governing the contributions imposed on each country to meeting the costs of the
resolution. But the ideas I aired in the first part of the remarks were aimed at helping to take
that off the table.
A principle of equitable treatment of worldwide creditors and depositors would be consistent
with the imposition of losses on unsecured creditors or uninsured depositors, either in a
going-concern restructuring of the kind I outlined earlier or through the application of more
standard SRR tools to gone-concern bad banks. But it would require losses to be imposed
on an equitable basis, respecting the existing priority ranking regardless of the
jurisdictionallocation of creditors. That might require recognition across the main jurisdictions of certain
safeguards.6 And, such an approach would require binding agreements amongst home and
host resolution authorities. Vague assurances would not do the trick, as domestic authorities
could change their minds when it really mattered. Host and home authorities would need
"skin in the game" to underpin co-operation. And co-operation in distressed circumstances
could helpfully flow back to how supervisors work together in peacetime.
An obstacle to such an approach might be that in some countries, legislation mandates
preferential treatment of creditors and depositors of local entities of cross-border banks. But
that might be weighed by legislatures against the current reality that when the fiscal authority
finds itself injecting equity to save a bank and preserve stability, it protects worldwide
creditors not just its home creditors.
To be clear, I am not advocating any particular approach here. I just want the authorities to
articulate the issues clearly, so that our leaders can make a choice and think through the
consequences of that choice. I'm not sure that it has really been put to them up to now. And,
of course, whatever is done, within Europe we would need to find an EU version that sat
between national and global regimes.
Summary
My purpose today is not to advocate solutions. It is to identify the big issues and to float
some possible avenues for discussion in the EU and internationally.
The big question is clear enough. Can we resolve distressed LCFIs in an orderly way without
injecting public money?
One possible way to cut through Too-Big-To-Fail is to adjust our sense of what "Fail"
involves. Perhaps it does not have to involve liquidation or administration. Perhaps it does
not have to involve a binary shift from "going concern" to "gone concern". But it does have to
involve loss for equity holders and uninsured creditors. It does have to rekindle market
discipline. It does have to preserve the flow of financial services. Those are, surely, the
essential components of the resolution leg of the regulation, structure, resolution triangle that
make up the reform debate.
Individual countries or economic areas such as the EU can get only so far on their own. To
cope with distress in global banking, we need to decide whether or not we want international
collaboration in the resolution of cross-border banking groups. That is a question which, one
way or another, the highest reaches of the authorities should answer as part of the reform
debate. Once that is clear, some of the questions about structure and regulation might
become clearer.
A lot rests on whether we can resolve distressed LCFIs. We need to answer the big
questions.