Andrew Bailey: The UK bank resolution regime
Speech by Mr Andrew Bailey, Executive Director for Banking Services and Chief Cashier of
the Bank of England, at The Institute of Chartered Accountants in England and Wales
(ICAEW) Financial Services Faculty breakfast, London, 26 November 2009.
I am grateful to Peter Brierley, Victoria Cleland, Iain De Weymarn, Geoff Davies, Tony Foster, Andrew Hauser,
Orla May and Paul Tucker for their comments and assistance.
* * *
The UK bank resolution regime
Thank you for inviting me to speak this morning. One of the characteristics of bank
resolutions, to which I will return later, is that they have to be done quickly to a fixed deadline
and involve working through the night. They also require extensive involvement by
accountants and lawyers, so, I have had some experience with spending nights and early
mornings with accountants. The only, but important difference, is that I don't get to choose
when to spend my early mornings on resolutions, whereas you did choose to listen to me
early this morning, for which I am very grateful.
Some history
The 2009 Banking Act, passed in February, created the new bank resolution regime in the
UK. In its first nine months it has been used once, at the end of March for the Dunfermline
Building Society. There is a long history of involvement by the Bank of England in dealing
with the problems of banks in the UK in order to underpin the stability of the financial system,
much longer than the history of banking supervision. The history of the Bank in the
nineteenth century features quite a few such interventions. More recently, although none
came amid conditions comparable to those which occurred last autumn, the Bank was
extensively involved in resolving problems in the secondary banking crisis of the 1970s, in
Johnson Matthey Bankers in the 1980s, and then in the early 90s with a number of smaller
banks. My own first involvement with resolving banks came at that time, with the resolution of
National Mortgage Bank.
We now face a much bigger challenge in terms of building a more robust financial system.
There are three parts to this task: regulation, structure and resolution. Today, I am going to
talk about the last of these. In the past, our resolution toolkit was limited. We could use the
Bank of England's own financial resources, as we did with Johnson Matthey Bankers and
National Mortgage Bank. Or, we could determine that it was not necessary to provide
financial support on grounds of a threat to the financial system, but nonetheless that it would
be helpful to facilitate the orderly winding-up of an institution by undertaking what I would call
"mopping up activities" of a type which only a central bank can typically undertake because it
provides a safe house and neutral party. This was the case with Barings, in which I was also
heavily involved.
There is therefore nothing new about bank resolution.
Why have a resolution regime for banks?
Why do we need a special resolution regime for banks? The first reason is that at the point
when actions have to be taken to deal with a bank in difficulty, there will inevitably be a
considerable amount of uncertainty about how bad that bank's problems are. This is because
the scale of the problem will depend on how the future unfolds. But we will know at that point
that if the authorities don't act, the problems of the institution will quickly get much worse,
and a deposit run may well ensue. The second reason for a special resolution regime is that
the process of resolution itself must not add to the uncertainty and loss of confidence. Put
simply, it has to be fast and decisive. Most bank resolutions happen over weekends. My
overwhelming guiding principle is that by no later than first thing on Monday morning we
must be able to tell depositors that their money is safe and its new home is ...... There is a
simple test of this - the answer to the depositor's question "Is my money safe?" must be yes
- no hesitation or qualification can be added.
Normal corporate insolvency procedures are therefore inadequate for banks for a number of
reasons. First, because they can only be initiated at the point of insolvency, whereas a loss
of confidence in a bank by its depositors will often precede that point. Second, normal
insolvency procedures are not well suited to ensuring continuity of key banking functions,
particularly access of depositors to their funds, but also the provision of credit. Third, a bank
failure may involve substantial negative spill over and externalities - for instance to other
banks via their inter-connectedness. But in normal insolvency procedures these externalities
would not be taken into account when determining what to do in insolvency. Fourth,
depositors play a special role as creditors of a bank. Unlike the creditors of a typical
company, they are very numerous in number, most are not professional market participants,
and their claims in the bank are in the form of money.
The recent experience in the UK
These are therefore strong reasons for treating the resolution of banks differently. But we
didn't start in this position at the onset of the financial crisis in 2007. At the time of the start of
Northern Rock's problems, the UK did not have a special resolution regime; rather, we were
relying on the tools of the past. Northern Rock was a good example of a bank that had a
liquidity problem, caused by the closure of its major funding market, for residential mortgage
backed securities, and had a heightened probability of experiencing a solvency problem in
the future. In my view, if we were faced with the same problem today now that we have a
special resolution regime for banks, there is little doubt that Northern Rock could have failed
in an orderly way under the resolution regime. But this wasn't possible in September 2007.
And given the number and size of depositors, Northern Rock could not be allowed to fail in a
way that would have jeopardised the funds of those depositors. It was therefore a stark
illustration of the need for a resolution regime.
In February last year emergency legislation was introduced in the form of the Banking
Special Provisions Act, or BSPA, which created a temporary resolution regime, temporary
insofar as the BSPA had a one year sunset clause. The BSPA, which facilitated taking
Northern Rock into temporary public ownership, also contained broad powers for the
Treasury, as the lead authority in that regime, to protect financial stability and the public
interest by statutory transfers of the property of UK banks. The Treasury was also able to
override or modify contractual property rights in order to give itself more room for manoeuvre.
Creating this regime turned out to have been prescient, because in September of last year it
was used to resolve Bradford and Bingley by transferring part of its business, namely
Bradford and Bingley's deposit taking activities, to Santander, leaving the rest in public
ownership. The BSPA therefore enabled a new home to be found for the deposits over the
course of a weekend. It also included an important mechanism to ensure business continuity,
whereby a bank could be broken up over a weekend and this would not cause chaos in the
bank's operations because a clear agreement was reached over the weekend for the
continuing supply of services by the rump to Santander in order to make sure that it was
business as usual on Monday morning for the transferred business.
The new regime
The BSPA contained broad powers, on the basis that it was temporary. Thus in February this
year the new Banking Act came into force and created a permanent and more wide ranging
special resolution regime or SRR for deposit takers incorporated in the UK. It is therefore a
big and very welcome step forward.
The SRR has five objectives: to maintain financial stability; to protect confidence in the
banking sector; to protect depositors in banks; to protect public funds; and to avoid interfering
with property rights in contravention of the European Convention on Human Rights. These
five objectives are not ranked in order of importance; rather, in each resolution case, a
judgment needs to be made on how to balance these objectives taking into account the
particular circumstances of the case.
The SRR provides a number of tools to deal with a bank. The first test that must be applied is
to assess whether the public interest objectives could be met by implementing a rapid payout
of insured deposits, or any other definition of deposits which the authorities wish to protect
via a top-up extension of the deposit insurance scheme. The remainder of the bank would
then be put through something known as the bank insolvency procedure. The test of whether
this procedure could be used depends in large part on how long depositors would face
without access to their funds. At the moment I think few banks could meet an acceptable
timetable for payout. Moreover, for bigger banks this would always be too disruptive as an
approach. Work is underway to facilitate rapid payout of depositors under the Financial
Services Compensation Scheme and I hope that in the next year, banks will be able to meet
the objective that they have been given by the FSA to be able to make payouts to depositors
within seven days. This is not a trivial task as I readily recognise, and achieving it would not
mean that this approach would always be chosen in a resolution. That depends on the
situation at the time.
If the failure of a bank is determined to have wider systemic consequences that could
undermine financial stability, confidence in the banking system or depositor protection, then
the SRR provides a range of other tools to be used. It is possible to direct part or all of a
failing bank's business to a private sector purchaser after a sale process has been
undertaken. Second, it is possible for the Bank of England to take control of part or all of a
bank's business through a bridge bank controlled and owned by the Bank. A special bank
administration procedure can be used in combination with a partial property transfer or bridge
bank. This administration procedure is broadly the same as a conventional administration
save for the very important difference that the administrator has a statutory objective to
support the transferred business with any infrastructure left in the insolvent rump. Finally,
under the SRR provisions, it is possible to take a bank into temporary public ownership. For
this approach, the Treasury would be in the lead, and there is a higher test of systemic
importance to be passed (there must be a serious threat to financial stability) for this
approach to be used.
As I have indicated, the SRR contains important roles for all of the authorities. The FSA is
responsible for triggering the SRR by determining, broadly, that a bank no longer meets its
threshold conditions for authorisation, and there is no reasonable prospect of it taking actions
to correct the situation within an acceptable timeframe. The FSA is also responsible for
approving the transfer of business to another institution that it authorises.
The Bank of England is responsible for operation of the SRR (with the exception of
Temporary Public Ownership, where the Treasury is responsible). The Bank will consult the
FSA and Treasury before selecting the SRR tool to be used, and we need to obtain the
agreement of the Treasury to the implications of the chosen tool for the use of public funds.
Also, the Bank can make recommendations to the FSA when it feels that the SRR should be
triggered, though as I have said, the decision is for the FSA.
Finally the Financial Services Compensation Scheme (FSCS) plays an important role in the
resolution process. This would be very obvious if an actual payout of depositors was chosen
and the FSCS would work very closely with the administrator. They also have a prior role in
assessing whether payout is feasible in a reasonable time. But the FSCS can also be
requested to contribute to the cost of other forms of resolution up to the net amount it would
have failed to recover in insolvency if there was an actual payout. This approach can be
used, for example, where there has been a transfer of deposits - and the FSCS can provide
a suitable deposit to contribute to the immediate cost to the authorities. The FSCS does not
however operate a pre-funded scheme in which money is available on call to provide such a
substitute deposit. It may therefore have to borrow from the Treasury in order to contribute to
the immediate cost of the resolution (as in Bradford & Bingley), with the FSCS contribution
ultimately amounting to the cost of any eventual shortfall in recoveries. The FSCS is
therefore an important part of the overall resolution landscape, and I will come back at the
end of my remarks to consider how these arrangements might develop.
It is important to ensure that a regime like the SRR contains appropriate protections. At the
heart of it is the ability given to the Bank to alter the treatment of property rights from the
base of normal insolvency law. When the Act was being drafted, the lawyers talked a great
deal about avoiding "Henry VIII" powers. I thought that this might have something to do with
having the power to chop off heads. But that was not the case; rather, it derives from Henry's
dissolution and seizure of the monasteries, which was an extreme case of intervention in
property rights. The Bank of England's Special Resolution Unit takes on a more temporal role
in its treatment of property rights, and one - you will be pleased to hear - that is shaped by
secondary legislation to provide safeguards and a Code of Practice. I think we can be quite
confident that Henry VIII saw no need for a code of practice.
The safeguards in our regime were drawn up in consultation with practitioners. They can be
divided into two categories: restrictions on the use of the SRR powers; and mechanisms for
payment of compensation where property rights are unreasonably affected by the use of the
special resolution powers. In the case of the restrictions, there is protection for netting and
set-off arrangements, secured obligations and capital market instruments such as covered
bonds and securitisations, to ensure that they are not disrupted by the transfer powers. This
is an important part of the regime, and I want to emphasise that it is not in the interests of the
authorities to disrupt instruments and markets that are of course of great importance to other
banks. It would just be counterproductive to take that sort of action.
In the case of compensation, the framework established by the Act ensures that the
proceeds of the sale of a bank's business are returned to the failed bank's creditors and, if
any surplus remains, to the shareholders, after meeting the claims of creditors in priority
order. Moreover, creditors left behind in an insolvent entity - typically the rump of the
business after other parts are transferred - are entitled to receive compensation to the extent
that an independent valuer determines that they have received less than they would have
done if the bank had gone into insolvency without the SRR being used. This is the "No
creditor worse off" safeguard.
The Code of Practice provides guidance on a number of areas, including how the SRR
objectives are to be achieved, factors guiding the choice between different tools, how to
determine that it is not reasonably likely that action can be taken by or in respect of a bank to
bring it into compliance with the FSA's threshold conditions - ie how to determine that the
SRR should be triggered, how to determine the basis for calculating compensation where
applicable, and the principles by which the Bank of England should run a bridge bank.
Beyond all of these provisions, the Banking Liaison Panel, whose members include industry
bodies, lawyers and insolvency practitioners, in addition to HMT, the Bank and FSA is
responsible for providing advice on the wider effects of the resolution regime.
The resolution of the Dunfermline Building Society
The first, and so far only, use of the resolution regime was for the Dunfermline Building
Society at the end of March. Our tally of one is in sharp contrast to the US, where to date this
year the FDIC has carried out 124 resolutions of failing banks. The US does, of course, have
a much less concentrated banking industry.
Dunfermline was, almost needless to say, a very instructive first case to handle. We
achieved the key objective of a weekend transfer of depositors, branches and the head
office, on this occasion to Nationwide Building Society. We also managed to transfer the
prime mortgage assets over the weekend, also to Nationwide. This was an achievement,
because necessarily the due diligence process is more complex for assets than deposit
liabilities. The worse quality assets - mainly commercial property loans and bought-in
mortgages - were placed into a building society special administration procedure (the
building society version of a BAP). But the social housing loan book (for which Dunfermline
was the second largest provider in Scotland) and some associated deposits were taken into
a bridge bank owned and run by the Bank of England. We ran the bridge bank for three
months while a sale process took place.
Dunfermline was therefore a case where we managed to use three of our tools in one go -
the transfer powers, BAP and a bridge bank. To give you an idea of the pressure under
which resolutions are done, the Dunfermline weekend involved an M&A process, the
completion of around 50 legal agreements including a three-way transitional services
agreement, setting up a new bridge bank, and putting in place communications to depositors
and other stakeholders in order to ensure that branches and call centres etc opened for
business as usual on Monday morning. And, there is a very human dimension to all of this.
My own colleagues, our advisors and our colleagues in the other authorities have to work
under great stress to get a successful resolution in place. But we also have to remember that
we need to work with the staff of the bank, to help them to deal with the shock of the
resolution taking place, usually following a very difficult period in which the bank has been
under great stress, and through all of that ensure that the doors open on Monday morning. I
am lucky to have very talented colleagues in the Bank and the other authorities and advisors
who don't mind the stress and the risk, or at least that's what they tell me.
Issues arising
The resolution of Dunfermline was in my opinion a success: on Monday morning depositors
knew their money was safe. But it illustrated well the difficulties of resolving banks.
Resolution is after all invasive surgery on a bank. I want therefore to highlight a number of
areas where in my view more work is needed to hone our regime further.
The first concerns funding of the FSCS. In my view we should be doing everything we can to
minimise the reliance of the industry on public money, this is just not an acceptable state of
affairs. One thing that can be done over the coming years, but gradually, is to pre-fund the
FSCS with industry contributions. This would reduce the need for the FSCS to borrow from
government and would provide a larger bulwark before the use of public money has to be
contemplated. It is welcome that the Government supports pre-funding. There is a further
issue of whether and how this pre-funding should be calculated, and in particular whether it
should be done on a basis which takes into account the riskiness of each bank and thus the
probability of causing a call on the FSCS. Since the FSCS is an insurance scheme, there is
clearly a case for calculating the premium on a basis that reflects risk. But a lot more thinking
is needed before we can be sure that this can be done in an appropriate way.
The second area in which we need to work to ensure that the resolution regime is as good as
we can get it concerns the whole area of safeguards. There is a natural tension between the
desire for precision in defining the protection of property rights at a very detailed level and
the need for flexibility in a regime that has to be able to react to the situations that come our
way. We don't get to choose the problems we face. I recognise that tension. I don't have a
radical plan for changing the current regime, but I recognise that we have to keep a very
careful eye on striking the right balance between having the discretion to deal with problems
and ensuring that banks and markets know as much as they can about what we would, and
would not, do in a resolution. This is why the Code and the Liaison Panel are important parts
of the machinery.
The third area in which more work is needed concerns information and advance planning. In
recent years the Bank has been forcefully arguing the importance of information gathering to
the government and FSA. In my experience resolution work is like icebergs - I don't mean
that in the sense that banks are about to hit them. It is like icebergs in the sense that a vast
amount of the work done is beneath the surface, hidden from view. Because resolution is an
invasive form of surgery, it requires a very large amount of information to be carried out
safely. Moreover, the planning work has to be done quietly, out of sight in order to avoid
fuelling the failure of the bank, and it needs to start well in advance of the actual resolution
weekend. As the authority responsible for resolution operations, the Bank of England faces a
tension. In the ideal world, we want to work closely with the management of the bank to plan
a resolution, at a time when it remains a contingency option that management naturally wish
to avoid. But we also have to avoid the sense that a bank is receiving the attention of the
undertakers. A very important development here will be the production and maintenance of
resolution plans, as part of the overall recovery and resolution plans, or living wills. I spoke
on this subject last week, and the text is available on the Bank of England website, so I am
not going to labour the point today. But the general principle is that resolution is a very
information hungry activity. To give an example, the FDIC in the US has recently adopted a
rule requiring deposit takers to provide detailed information on their derivatives positions
within a 60-day period after being notified by the Authorities to do so. The rule was only
introduced earlier this year but it will be worth considering a similar approach in the UK.
Finally, there is a large missing piece to what I have said about the resolution regime, namely
how it would deal with banks that operate with branches or subsidiaries in other countries,
and likewise how foreign banks operating in the UK would be sorted out. There is now a
great deal of attention on this issue, in the G20, in the EU and via the FSB working group on
cross-border crisis management chaired by Paul Tucker, and rightly so. I think it is fair to say
that the regimes in the US, Canada, Japan and the UK come closest at present to meeting a
kite-mark standard, but more needs to be done in continental Europe. I therefore support the
recent European Commission consultation calling for EU countries to adopt resolution
regimes. Also, I think that we are much more likely to make progress in this field by agreeing
on how national regimes can fit together to deal with international banks, rather than trying to
devise an international resolution regime. The key issue then is burden-sharing, and that
together the national regimes provide for equitable treatment of creditors whatever their
domicile. A robust set of resolution regimes should not allow for bias in favour of domestic
creditors. The UK, I should stress, is not one of those countries, but we are keen to work to
produce a framework of resolution regimes that allows bias in favour of domestic creditors to
end.
Thank you for listening to an account of the UK resolution regime. It is an important
development as part of making our banks more robust to failure. It sits alongside enhanced
regulation and supervision, and whatever structural changes may take place in the industry.
But it remains work in progress, and in an important respect always will be because it needs
to be ready to respond to threats that will evolve as well. And, finally, I should tell you my
motto as head of the resolution unit, namely that I am happiest when we don't need to
perform a resolution.