Achieving Bank Resolution in PracticeAre We Nearly There Yet?

A report of the IIF Cross-Border Resolution Working Group

September 2014

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CONTENTSINTRODUCTION ................................................................................................................................................ 4

1. ARE WE NEARLY THERE YET? ....................................................................................................................... 6

2. BANK RESOLUTION TECHNIQUES – DO WE HAVE ALL THE TOOLS? ..................................................... 10

3. BRANCHING AND CROSS-BORDER RESOLVABILITY .................................................................................15

4. NEXT STEPS ..................................................................................................................................................17

APPENDIX I .......................................................................................................................................................19

APPENDIX II ..................................................................................................................................................... 22

APPENDIX III .................................................................................................................................................... 25

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Introduction

This paper, which has been developed by the IIF Cross-Border Resolution Working Group, argues two things. One is that a mechanism now exists that can be applied to resolve all financial institutions, including the largest, without calling upon capital support from the government. The second is that the objections normally raised about the application of this mechanism – lack of international cooperation, lack of information, complexity – are all capable of being overcome and that, in most cases, solutions to these problems are at an advanced stage of development. Consequently, in the relatively near future, we will be able to say without reservation that no institution is “too big to fail” (“TBTF”). Indeed, even before completion of all the measures now in train, good coordination of resolution measures by the relevant authorities should be able to achieve the common goal of allowing a major institution to fail without excessive market disruption and without capital support from the government.1

Banks are unlike commercial companies in many ways, but one of the most important differences is that they generally cannot continue their ordinary activities whilst insolvent. An ordinary company in insolvency can remain open and continue to trade, even though it may have ceased performing on its financial obligations, provided that it continues to pay its commercial obligations. The key difference between a commercial firm and a financial firm in this regard is that a financial firm has no such division among creditors: almost all its creditors are by definition financial creditors in some sense. For deposit-taking banks, an administrative regime such as that developed over many years in the United States, focused primarily on protecting depositors (and the deposit guarantee fund) provides a way forward, but for other types of firm, the crisis illustrates the danger that “failure” and “immediate cessation of business” are likely to be synonymous. This explains how the concept of TBTF has developed – what must be avoided at all costs is not “failure,” but disruptive cessation of service to customers. If it can be shown that it is possible for a bank to be resolved without such a cessation of service, the TBTF problem is solved.

Thus no institution is TBTF where, for any forecastable loss:

a. the institution could be restored to solvency without requiring any permanent government funding; and

b. such restoration could be effected without open-ended suspension of the institution’s activities or damage to the financial system.

The argument we present is that several such mechanisms for effective resolution have been developed and that at least one of these mechanisms can be executed for each major type of bank. In some cases the enabling law needs to be finalized; in other cases, institutions may need to adapt themselves for easier resolution under these procedures, but there are no insuperable barriers.

We believe that the toolkit which has been developed is sufficient to resolve not just a few banks but all of those bank business models which currently exist. The focus of resolution thinking is – correctly – on banks that are systemically significant for the international financial system (global systemically important financial institutions, or “G-SIFIs”).

The resolution of mainly deposit-funded banks is entirely possible within the developing regime, although the point has sometimes been challenged. However, we agree that it is necessary to include provisions providing some protections for small depositors and payment customers of such banks in order to ensure that their core functions are not impeded by resolution, as well as clear criteria for treatment of other deposits in resolution.

Home-host issues have been put forward as sources of disagreement between national resolution authorities.

1 This is exactly the objective set out by the Financial Stability Board in its Key Attributes of Effective Resolution Regimes for Financial Institutions: “The objective of an effective resolution regime is to make feasible the resolution of financial institutions without severe systemic disruption and without exposing taxpayers to loss while protecting vital economic functions through mechanisms which make it possible for shareholders and unsecured and uninsured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation.” Financial Stability Board, Key Attributes of Effective Resolution Regimes for Financial Institutions, Oct. 2011, p. 3.

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There is nothing in any of these issues that is not capable of resolution provided that the relevant resolution authorities have both the necessary powers and incentives to cooperate to achieve a mutually beneficial outcome. In particular, we show that there is no strong argument for resolution authorities to require restructuring of cross-border branches. Home-host issues arise in the case of both “Single Point of Entry” (“SPOE”) and “Multiple Point of Entry” (“MPOE”) group structures – for SPOE structures the question is whether host authorities are prepared to “stand back” and leave the home authority a free hand to resolve the group; for MPOE structures the question is whether the home authority should perform a role in coordinating the resolution authorities of the relevant subsidiaries.2 Both of these issues are sometimes put forward as a source of serious conflict, in particular as regards the application of resolution triggers. We show that the apparent conflicts which arise in this situation are capable of being addressed within the existing resolution framework.

2 MPOE is, of course, the name of a resolution approach, not a particular group type. When we speak of an “MPOE Bank,” what we mean is a bank whose group structure is best resolved on a subsidiary-by-subsidiary basis, and whose resolution plan reflects that structure. Conversely, when we speak of an SPOE bank, we mean a bank whose group structure would facilitate resolution at a single point of entry at the top of the group, and whose resolution plan reflects that.

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1. Are We Nearly There Yet?

“The US authorities have the technology … [for] top-down resolution on a group-wide basis. I don’t mean it would be completely smooth right now; it would be smoother in a year or as more progress is made. But in extremis, it could be done now. … Europe has not yet reached the same point, but contrary to some commentary is not far behind.”

- Paul Tucker, then Deputy Governor Financial Stability, Bank of England3

If by “there” we mean a resolution architecture that allows the largest institutions to be resolved in a fashion that does not result in major disruptions to users of the financial system, with no recourse to government bail-outs, the answer to this question is “yes, we are.” The Financial Stability Board (“FSB”) has achieved a great deal since the objective of ending TBTF was first endorsed by the Group of Twenty (“G20”) leaders at the Pittsburgh Summit in 2009.4 The FSB’s Key Attributes of Effective Resolution for Financial Institutions5 (the “Key Attributes”) and supporting documents have provided a thoughtful vision, and helped drive a practical and consistent approach to the critical issues. In addition to this, regulators in the major financial centers,6 especially the crucial transatlantic area, have made great progress in strengthening resolution procedures:7

• United States8 - The Orderly Liquidation Authority (the “OLA”), Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”),9 provides a detailed and credible legal framework for bail-in within resolution. Within this framework, the Federal Deposit Insurance Corporation (the “FDIC”) is developing a SPOE technique as its preferred resolution strategy, which essentially executes a bail-in via a bridge bank technique. The FDIC has provided considerable detail on its thinking.10 As a result, this procedure is now well understood by market participants and credit market pricing is adjusting to the implications of OLA loss imposition.11 Work is also being done to determine

3 Paul Tucker, Deputy Governor Financial Stability, Bank of England, Speech at the Institute of International Finance 2013 Annual Membership Meeting (Oct. 12, 2013) (available at http://www.bankofengland.co.uk/publications/Documents/speeches/2013/speech685.pdf). See also Paul Tucker, Senior Fellow, Mossavar-Rahmani Center for Business and Government, Harvard Kennedy School and Harvard Business School, Remarks at the European Summer Symposium in Economic Theory (July 3, 2014) (available at http://www.cepr.org/sites/default/files/events/papers/6708_TUCKER%20Essay.pdf); and see generally Paul Tucker, Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution, Regulatory Reform, Stability, and Central Banking, Jan. 16, 2014 (available at: http://www.brookings.edu/~/media/research/files/papers/2014/01/16%20regulatory%20reform%20stability%20central%20banking%20tucker/16%20regulatory%20reform%20stability%20central%20banking%20tucker.pdf). 4 See G20, Leaders’ Statement: The Pittsburgh Summit, Sept. 24-25, 2009 (available at https://www.g20.org/sites/default/files/g20_resources/library/Pittsburgh_Declaration_0.pdf). 5 Financial Stability Board, Key Attributes of Effective Resolution Regimes for Financial Institutions, Oct. 2011 (available at http://www.financialstabilityboard.org/publications/r_111104cc.pdf).6 We considered all the jurisdictions that house G-SIFI banks (excepting China). We treated the EU as a single entity for these purposes. See also Financial Stability Board, Thematic Review on Resolution Regimes: Peer Review Report, Apr. 11, 2013 (available at https://www.financialstabilityboard.org/publications/r_130411a.pdf). Important progress has also been made in other countries, which are not discussed in detail for reasons of brevity.7 See generally Thomas F. Huertas, Safe to Fail: How Resolution Will Revolutionize Banking 19 (2014).8 See generally Stanley Fischer, Vice Chairman, Fed. Reserve Bd., Martin Feldstein Lecture at the National Bureau of Economic Research (July 10, 2014) (available at http://www.federalreserve.gov/newsevents/speech/fischer20140710a.htm); and Martin J. Gruenberg, Chairman, Fed. Deposit Insurance Corp., Remarket to the 24th Special Seminar on International Banking and Finance (Nov. 13, 2013) (available at https://www.fdic.gov/news/news/speeches/archives/2013/spnov1313.html) (commenting on the Dodd-Frank Act and the framework for cooperation in resolution of systemically important financial institutions). 9 Dodd-Frank Wall Street Reform and Consumer Protection Act, 12 U.S.C. §5381-94 (2010). Title I of the Dodd-Frank Act requires that proceedings under the US Bankruptcy Code be considered before proceeding to Title II. Because of its greater congruence with the Key Attributes, this discussion will focus on Title II.10 See, e.g., Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy, 78 Fed. Reg. 76,614 (Dec. 18, 2013).11 See, e.g., Steve Strongin et al., Goldman Sachs Research Institute, Measuring the TBTF Effect on Bond Pricing, 2013 (available at http://www.goldmansachs.com/our-thinking/public-policy/regulatory-reform/measuring-tbtf-doc.pdf); and John Giordano and Dennis Hannan, Credit Suisse, U.S. Financial Institutions: Regulatory Reform Impact on Bank Credit Spreads (2013) (available at https://plus.credit-suisse.com/u/B37vEJ).

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whether the bankruptcy process can be modified to create an additional resolution procedure (e.g., “Chapter 14”) that would be more effective for financial institutions.12 In a speech as Chairman of the FSB Resolution Steering Group, Paul Tucker noted that considerable progress has been made: “in extremis, it [resolution of large US Banks] could be done now. That surely is a massive signal to bankers and markets.”13

• European Union – The EU has finalized the framework for the recovery and resolution of credit institutions and investment firms,14 known as the Bank Recovery and Resolution Directive (the “BRRD”), which requires all EU member states to have in place Key Attributes-compliant resolution regimes and to cooperate in implementing each other’s regimes.15 Also, a single bank resolution mechanism is being established within the Euro-zone, including progress towards a single resolution fund.16 We believe that this legislation will provide a sound legal and economic basis for effective resolution.

• Japan – A new orderly resolution regime – covering both deposit-taking institutions and financial holding companies – was set out in June 2013 in line with the FSB Key Attributes.17 The bill revised the Deposit Insurance Act, and became effective in March 2014. Under the new act, a non-viable bank will be resolved via a bridge bank power (that transfers certain assets and liabilities related to systemically important obligations, among other measures) together with financial assistance from the Deposit Insurance Corporation (the “DIC”). Systemically important obligations will also be transferred and fulfilled to prevent severe market turmoil. Any associated DIC expenses will be borne ex-post by the financial industry.

• Switzerland – A contractual bail-in regime is now fully established in Switzerland,18 including a clear presumptive path and adequate loss-absorbing capacity. In the Swiss case, the “double Basel equity requirement” for gone-concern loss absorbing capacity (“GLAC”)19 is met via a layer of contingent convertible debt on top of a common equity requirement. Together, these comprise approximately 19% of Basel III20 risk-weighted assets (“RWA”) for the two Swiss G-SIFIs. A statutory backstop (the Bank Insolvency Ordinance) has also been enacted for comprehensive bail-in; this provides a legal basis for

12 See, e.g., John F. Bovenzi, Randall D. Guynn, and Thomas H. Jackson, Bipartisan Policy Center, Too Big to Fail: The Path to a Solution, 2013 (available at http://bipartisanpolicy.org/sites/default/files/TooBigToFail.pdf) (analyzing both OLA and the Chapter 14 bankruptcy reform proposal). See also Ken Scott, Hoover Institution, The Context for Bankruptcy Resolutions, July 8, 2014 (available at http://www.hoover.org/sites/default/files/rp-14-final-ken-scott.pdf?_ga=1.27014077.1815658908.1407344447) (describing the current version of the Chapter 14 proposal); and see generally Darrell Duffie et al., Hoover Institution, The Resolution Project, http://www.hoover.org/research-teams/economic-policy-working-group/resolution-project).13 Paul Tucker, Deputy Governor Financial Stability, Bank of England, Speech at the Institute of International Finance 2013 Annual Membership Meeting (Oct. 12, 2013) (available at http://www.bankofengland.co.uk/publications/Documents/speeches/2013/speech685.pdf).14 Directive 2014/59/EU, of the European Parliament and of the Council of 15 May 2014, Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment, 2014 O.J. (L 173) 190; see also Draft Guidelines on the specification of measures to reduce or remove impediments to resolvability and the circumstances in which each measure may be applied under Directive 2014/59/EU, European Banking Authority (July 9, 2014), available at https://www.eba.europa.eu/documents/10180/751636/EBA-CP-2014-15+%28CP+on+draft+GL+on+measures+to+reduce+or+remove+impediments+to+resolvability%29.pdf; and Draft Regulatory Technical Standards on the content of resolution plans and the assessment of resolvability, European Banking Authority (July 9, 2013), available at https://www.eba.europa.eu/documents/10180/751477/EBA-CP-2014-16++%28CP+on+draft+RTS+on+Content+Res++Plans+and+Assessment+of+Resolvability%29.docx.pdf.15 Ibid, art. 87, 2014 O.J. (L 173) 311.16 See generally Vitor Constâncio, Vice-President, European Central Bank, Speech at the Banking Union Conference (Apr. 24, 2014) (available at http://www.ecb.europa.eu/press/key/date/2014/html/sp140424_1.en.html). 17 See Yokin hoken hō [Yohohō][Deposit Insurance Act], Law No. 45 of 2013 (Japan). The amendment was passed on June 19, 2013 to Law No.34 of 1971.4.1.18 See, e.g., Swiss Financial Market Supervisory Authority (FINMA), Resolution of global systemically important banks: FINMA position paper on Resolution of G-SIBs, Aug. 7, 2013 (available at http://www.finma.ch/e/finma/publikationen/Documents/pos-sanierung-abwicklung-20130807-e.pdf). 19 Various terms have been used to describe this concept. The Federal Reserve Board has used both “gone-concern loss absorbing capacity” and “loss absorbing capacity,” while UK participants have tended to refer to “primary loss absorbing capital.” We have chosen to use GLAC.20 Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems, Dec. 2010 (rev. June 2011) (available at http://www.bis.org/publ/bcbs189.pdf).

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the resolution powers of the Swiss Financial Market Supervisory Authority (“FINMA”) if the contractual system is not sufficient.

None of these regimes can yet be described as fully implemented, but the bulk of the work is well underway, the intention to implement the remainder is clear, and the FSB is providing leadership in identifying how the final steps can be taken. 21

If the drivers of the car think that we are nearly there, however, the passengers – in the form of the many otherwise-informed people who have not engaged in the international discussions on resolution – seem to doubt that we have even left home. Although the intense discussion of bank resolution over the last five years has left those involved in it clear as to what a workable resolution regime looks like, this clarity has not manifested itself outside that closed world. In some respects this is understandable – the issues are technical and some will only believe in resolution once a large institution has failed and been resolved successfully, if then. However, it is possible to identify and respond to some of the concerns that have been expressed.

First, public-sector authorities must make clear that resolution tools will be used. The FSB suggests that resolution authorities make public their “preferred resolution strategy” for large banks,22 and once this is done the credibility of resolution will receive a significant boost. The FSB also recommends that firms give complementary disclosure as to the existence and amount of the GLAC they hold,23 such that for each large bank there will be a public indication of the likely strategy and of what resources are available to support that plan.

Second, the issue of cross-border resolution is being addressed. For example, one important practical issue that some commentators have raised is the ability of a resolution authority to deter large-scale contract unwinds outside of its jurisdiction; here there are initiatives both to improve cross-border recognition in some cases, and also to avoid the issue entirely via a change in the standard contract terms. In our previous paper, we advocated as the ideal solution an approach based on international agreement, aimed at minimizing harm to the global economy of bank resolution, although even then we were convinced adequate alternatives were possible.24 We continue to believe that this would be the optimum approach, and that over time this outcome could be achieved with sufficient public-sector focus.

However, given the time required for such an international process, it will not likely be achieved in any short timeframe. The question, therefore, is how we can have confidence that the resolution structures and incentives for cross-border authorities are sufficiently well aligned that we can have confidence that orderly resolution of a cross-border institution can be achieved in the interim.

It is now clear that there are methods that can ensure global resolvability even in the absence of a formal, global resolution convention. The more feasible cross-border resolution appears, the greater the incentives are for national regulators to agree to participate in a collaborative resolution rather than adopting a nationalistic ring-fencing approach. Banks should be able to demonstrate to each national resolution authority a structure and a capital and a liquidity plan that will enable resolution of local activities. Provided that sufficient GLAC is available at the relevant level (across the group as a whole for SPOE banks; at the level of the relevant subsidiary for MPOE banks), it becomes possible to assure national regulators that resources can and will be deployed such that no national resolution authority feels itself unable to conduct (or rather to participate in) an effective resolution of the businesses within its remit.

21 See, e.g., Financial Stability Board, Progress and Next Steps Towards Ending “Too-Big-To-Fail” (TBTF): Report of the Financial Stability Board to the G-20, Sept. 2, 2013 (available at http://www.financialstabilityboard.org/publications/r_130902.pdf); see generally Sir Jon Cunliffe, Deputy Governor Financial Stability, Bank of England, Speech at the Barclays European Bank Capital Summit (May 13, 2014) (available at http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech727.pdf) (addressing the progress to date and remaining issues in ending TBTF). 22 Financial Stability Board, Recovery and Resolution Planning for Systemically Important Financial Institutions: Guidance on developing Effective resolution Strategies, July 16, 2013, p. 20-1 (available at http://www.financialstabilityboard.org/publications/r_130716b.pdf).23 Ibid.24 Institute of International Finance, Making Resolution Robust – Completing the Legal and Institutional Frameworks for Effective Cross-Border Resolution of Financial Institutions, June 2012. See, e.g., Making Resolution Robust, Annex I, p. 47-51.

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Banks’ disclosure of their capital condition is also important and major banks have been working through the Enhanced Disclosure Task Force (the “EDTF”), catalyzed by the FSB to improve their disclosures. Similarly, the recent proposals of the Basel Committee on Banking Supervision (the “Basel Committee”) to enhance the Pillar 3 disclosure requirements of the Basel Accord,25 recognize the need of the market for improved disclosure by banks on their obligations that will be subject to resolution procedures.

Although we are confident that substantial progress has been and is being made towards this objective, we remain sensitive to the threats that arise if this progress is not carried to fruition. Our major concern is that the ability to achieve systemic stability, and a loss-minimizing, coordinated resolution, will be impaired by erecting national barriers to the movement of capital, liquidity, or assets. There remains an acute danger that a lack of confidence in the resolvability of a cross-border firm will generate demands for rigid, inefficient allocation of capital and liquidity to specific countries. This paper clearly notes the dangers of forced subsidiarization. Although subsidiarization itself is an effective business strategy, a forced break-up of institutions designed to operate as single undertakings will damage the industry’s business success, lessen the overall efficiency of the international financial system, and preclude the level of repositioning of capital and liquidity necessary to prevent or limit a future crisis. This latter risk is a risk to us all.

Finally, it is sometimes asserted that, in a crisis, governments will decline the hard, untried road of resolution and opt for the apparently easier option of taxpayer-funded rescues. There is no reason to assert that this will never be the case – some legislation (such as the EU BRRD26) makes explicit provision for the use of taxpayer funds in bank resolution (after substantial bail-in of equity and debt and subject to strict “state-aid” requirements), although other jurisdictions, including the United States,27 prohibit this completely. However, the issue here is not whether government will ever resort to the use of taxpayer funds – that is, and will always be, a matter for the government concerned in the particular circumstances. The issue is whether a government has a viable alternative. The primary reason that governments felt the need to resort to taxpayer-funded bank resolutions during the most recent crisis was the concern that the alternatives to intervention were theoretical, untried and fraught with possible unintended consequences.28 The enormous amount of work that has been done on bank resolution since then means that, when the next crisis comes, the available alternative to bail-out will have been considered, properly researched, based on up-to-date and accurate information about the institution concerned, and include a global network of resolution authorities ready to implement it according to a pre-existing plan. As a result, and given the better outcomes for all claimants that an orderly, coordinated resolution can bring, national authorities should have substantial incentives to follow the plans that have been elaborated.

We believe that we are nearly at the point of conquering the problem of too big to fail, and on course to get there in the relatively near future.

25 Basel Committee on Banking Supervision, Review of the Pillar 3 disclosure requirements: Consultative Document, June 2014 (available at http://www.bis.org/publ/bcbs286.pdf).26 Directive 2014/59/EU, art. 56, 2014 O.J. (L 173) 287.27 Dodd-Frank Wall Street Reform and Consumer Protection Act, 12 U.S.C. §5394(c) (2010).28 See, e.g., Governor Jerome H. Powell, Fed. Reserve Bd., Speech at the Institute of International Bankers 2013 Washington Conference, Mar. 4, 2013 (available at http://www.federalreserve.gov/newsevents/speech/powell20130304a.htm) (“Faced with the failure of a large commercial bank, we chose to extend the safety net rather than run the very real risk of a systemic depositor run. Our ‘near miss’ with Salomon in 1991 presaged the enormous damage that would result from the failure of Lehman Brothers, another investment bank, in 2008”).

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2. Bank Resolution Techniques – Do We Have All The Tools?

There is no single mechanism that can resolve all types of banks, just as there is no single mechanism that can handle all distressed industrial situations. All resolution authorities look at their powers as a “toolkit,” with the determination of the appropriate tool for the job being one that in practice can only be made on an institution-specific basis.29

We believe that the best way to approach this issue is to create a matrix of contexts and to assess whether the tools currently in place would be effective across that matrix. We know that certain institutions – for example small US regional banks – can be resolved, because the relevant resolution authority has a long, successful track-record of doing so. We know that the US SPOE model is likely to work for certain US groups30 and so on. However, an important preliminary question is as to whether the suite of tools is complete.

NECESSARY COMPONENTS OF BANK RESOLUTION

Banks are required to have a certain minimum of capital, and in general are expected by markets and regulators to maintain a surplus of capital above that minimum. Capital requirements focus on going-concern capital levels. A good deal of attention has also been devoted to the means for a bank to recover from a capital problem if its position starts to deteriorate, but not to the point at or near insolvency, where resolution would be necessary (this paper will not address the “recovery” phase or the forms of official intervention and the financial instruments designed to facilitate it). The road to resolution begins when the accumulated losses of the institution cause capital to dip below the level of surplus that would ordinarily be required.31 The question this raises is as to how the necessary new capital is to be created.

Recapitalization or “bail-in” strategies have therefore been developed in response to the recent global crisis. This method borrows techniques from corporate “debt-for-equity” recapitalizations (e.g., a Chapter 11-type reorganization in the United States), and adapts them to banks. The primary adaptation is the need to separate normal unsecured capital structure instruments – which have a long history of bearing loss in distress – from critical systemic functions, which are mandated by the FSB,32 US,33 and EU34 resolution procedures to be protected or preferred in resolution.

In broad terms, the necessary capital to restore solvency to a bank that enters resolution is to be created by converting or writing down existing debt instruments. Where such instruments are contractually subordinated, the write-down process may be explicitly set out in their terms, along with the events that trigger it; similarly, applicable law may determine what would happen, either by its terms or as a consequence of structural subordination. However, the primary concern of resolution authorities is what happens if the conversion or write-down of existing subordinated debt proves insufficient, not only to cover losses but to restore the institution to compliance with capital requirements and expectations.

A variation is the US-style SPOE paradigm, where a holding company, which issues lots of equity and unsecured term debt, invests in an operating bank, which houses all of the systemically critical functions. The subsidiary bank in this case would be kept out of resolution and all of the restructuring done in the holding company. For the most part, the SPOE discussion in this paper can be applied to the holding company or a bank directly. Another variation is an MPOE strategy, where bail-in is likely to be done at the level of a sub-group or the affected group member directly.

29 This again is set out in the FSB Key Attributes: “Resolution authorities, should have at their disposal a broad range of resolution powers, which should include powers to …... transfer or sell assets…establish a temporary bridge institution… carry out bail-in.” Key Attribute 3.2.30 This is eloquently demonstrated in Too Big to Fail: The Path to a Solution, supra.31 This would, of course, only occur after the institution’s recovery plan had been implemented.32 See, e.g., Recovery and Resolution Planning for Systemically Important Financial Institutions, p. 7-8.33 See, e.g., 78 Fed. Reg. 76,618 (Dec. 18, 2013).34 See, e.g., Directive 2014/59/EU, art. 44, 2014 O.J. (L 173) 267-8.

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A resolution authority may specify that the institution must maintain a specified amount of GLAC. This resource may be composed of a mix of equity plus subordinated and unsecured debt (its appropriate composition is still being debated). However, if the total amount of equity and loss absorbing debt maintained by the institution is insufficient to meet the GLAC requirement, the institution must at a minimum be able to show that it has sufficient eligible resources, including senior funding subject to effective write-down in order to fully absorb any remaining losses and to recapitalize the institution in accordance with its resolution plan.

Resolution authorities may address this issue by requiring that the institution have senior debt capable of being converted or written-down35 – sometimes referred to as a “debt shield” providing GLAC. Since some liabilities may not be able to be written down in certain cases (for example, obligations that are preferred or otherwise protected upon insolvency), resolution authorities need to impose a consistent requirement that a certain percentage of banks’ balance sheets be funded by obligations that are clearly available for resolution purposes or capable of being converted or written down. The size of this requirement should be determined by reference to generally accepted factors (which are in the course of being determined). In the view of some, this may include the scope of the resolution plan – in particular, where the resolution plan envisages a significant shrinking of the institution after resolution, it is arguable that the requirement should not be greater than what is required to recapitalize the surviving institution for the period of reorganization.

The question of what liabilities should compose this debt requirement will need to be determined by reference to national law, and the available instruments may vary from jurisdiction to jurisdiction. Thus, there should be a globally agreed list of qualifying factors for determination of whether a firm has GLAC meeting resolvability requirements.

A resolution authority must be confident that debt obligations included in the debt shield or GLAC are capable of being written down effectively (i.e., without being subject to legal defenses). The responsibility for determining which obligations can be counted towards the debt shield or GLAC generally rests ultimately with the resolution authority concerned. In general, resolution authorities should only permit any obligation to count as GLAC if it is satisfied that several critical conditions are met. Several factors will clearly characterize liabilities as subject to bail-in, including:

• a clear legal basis to establish, to both the institution and the creditor, that the obligation would be subject to bail-in in resolution;

• “feasibility,” meaning that the instrument can be bailed-in without triggering undue legal or economic difficulties (such as situations where there would be systemic consequences, for example on the payment system);

• “non-runnability,” meaning effective legal provisions exist in the documentation of relevant obligations, or elsewhere, that prevent these funds from being withdrawn quickly (with a minimum remaining maturity being an obvious example) as a bank enters a period of stress and that ensure that these funds are available when it enters resolution; and

• clarity, whether on the basis of specific disclosures or generally applicable law, to creditors, including where relevant, depositors, that their funds are subject to risk.

All of the foregoing constitutes the “Debt Shield Conditions”.

An obligation should only be counted towards the debt shield if it is identifiable and identified in advance as subject to bail-in, but it is important to be clear that not all obligations subject to bail-in would meet the Debt Shield Conditions, which are intended to provide assurances that such resources would be present in an institution upon entry into resolution.

35 Conversion or write-down would occur after elimination or substantial dilution of equity.

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The conclusion from this is that all creditors’ claims will fall somewhere within the hierarchy below:

Protected Creditors Insured depositors; operational deposits as discussed below; payment systems; systemic counterparties, for example on financial contracts; employees

Ordinary Creditors Other creditors who do not meet the Debt Shield Conditions

“Debt Shield” Creditors Creditors who do meet the Debt Shield Conditions

It is not difficult to assign claims across this categorization, which reflects the FSB goal of protecting basic essential payment and market functions of banks while exposing financial creditors,36 regardless of how their claims are styled (e.g., bonds versus deposits that do not satisfy the Debt Shield Condition) that may be expected to exercise market discipline to bail-in risk or equivalent.

Not all bank groups are designed with a large amount of term wholesale debt, which raises the issue of what other liabilities could be bailed-in (as discussed in detail above). We understand that the FSB intends to issue consultative proposals after the 2014 G20 Leaders’ Summit in Brisbane regarding how to define the GLAC that systemically important banks should maintain. Deposit-funded banks, which are closer to classic retail banking, face specific issues, generally arising from less reliance on senior debt, as discussed in banks in Appendix I. In general we do not accept the argument sometimes heard that the resolution of deposit-funded banks is fundamentally different from the resolution of other forms of bank, nor should it be necessary for them to change their business models by requiring them to issue senior debt disproportionately. Obligations that are clearly pre-identified as being part of the Debt Shield should be recognized as such; others should not.

It should also be identified that although bail-in of eligible creditors is likely to be a preferred approach to resolution, it is not – and should not be – regarded as the sole available technique. Bank resolution authorities should have – and increasingly do have – a full range of available techniques, as foreseen in the Key Attributes,37 in addition to bail-in, as discussed above.

Liquidation of an entity is perhaps the simplest and oldest form of resolution. This can work reasonably well in some cases – e.g., for smaller institutions that have readily marketable assets. However, it means that any critical activities are ceased abruptly, so this path is not desirable for institutions whose activities are large enough or sensitive enough for this to create significant external distress. It also tends to be less efficient as the institution gets larger.38

An M&A sale is therefore perhaps the most traditional solution to a distressed bank and has been used frequently in prior crisis events. It preserves many of the going-concern operations (and franchise value) of the entity through the sale process. However, it is more difficult to use as institutions get larger, due both to concentration concerns and because the pool of potential purchasers who can effectively absorb a smaller institution gets smaller. There may be no effective purchaser for a very large bank in a systemic crisis, for example.

CAN THESE TECHNIQUES BE IMPLEMENTED?

It is one thing to say that we have a complete set of techniques in isolation, but another to say that they can be implemented in practice, and the argument is sometimes advanced that no matter how plausible bank resolution plans may seem in theory, complexity or political reality means that they can never be implemented in practice. However, these reservations are slowly being addressed. As Governor Powell of the Federal Reserve Board said in a speech in early 2013:

36 See Key Attributes, Preamble (i) and (iii), p. 3.37 See Key Attributes 2.1-2.7.38 For example, the FDIC reports significantly better recoveries for banks resolved using other techniques. See, e.g., Rosalind L. Bennett, Failure Resolution and Asset Liquidation: Results of an International Survey of Deposit Insurers, Fed. Deposit Insurance Corp. (June 20, 2002), http://www.fdic.gov/bank/analytical/banking/2001sep/article1.html. Larger corporations in the United States also typically choose Chapter 11 strategies over Chapter 7 liquidation strategies.

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“From the outset, my earlier experience had led me to be skeptical about the possibility of resolving one of the largest financial companies without destabilizing the financial system. Today’s global financial institutions are of staggering size and complexity . . . . however, I came around to the view that it is possible to resolve a large, global financial institution. What changed my mind was the FDIC’s innovative “single-point-of-entry” approach, which was just coming into focus in 2011. This approach is a classic simplifier, making theoretically possible something that seemed impossibly complex.”39

On the domestic level, there is a growing conviction that a combination of the very significant levels of new capital raised by banks around the world, effective recovery and resolution planning reflecting the Key Attributes, and the putting in place of the necessary legal structures for resolution have together addressed the factors that, in the past, placed governments in a position where they felt compelled to recapitalize institutions with taxpayers’ money. As to cross-border firms, this argument is based on the assumption that resolution of internationally active banks requires the active cooperation of multiple governments and resolution authorities around the world.

Although it is true that international resolution is likely to require multiple activities by multiple authorities, and it is certainly true that coordination between public-sector entities would enhance the efficiency of resolution, it is not true that a lack of optimum cooperation would be a complete barrier to resolution, although it is a significant impediment. At its simplest, where a SPOE approach to resolution is employed, the only resolution activities that require government intervention are those that take place at the group holding company level – once capital is created in the holding company, it can be down-streamed to the relevant subsidiary by private contract,40 and the improvement in credit standing of the subsidiary resulting from the resolution should facilitate renewed access to liquidity. Thus, any material operating subsidiary below the holding company will undergo a solvent recapitalization resulting from the creation of new equity by the holding company. The only request that the resolution authority in the home country would need to make of resolution authorities in other countries is that they do not interfere with the resolution process. It does not seem unreasonable to expect this level of cooperation provided that the authorities maintain a high level of confidence that businesses in their jurisdictions will remain solvent, creditworthy, and functioning.

It is true that a classical SPOE approach requires a particular corporate structure, and not all large institutions have that structure. But it is certainly possible to design other corporate structures that more easily accommodate pre-existing structures while still allowing bail-in and recapitalization of material operating entities, as long as it is clear that certain creditors’ claims are subject to bail-in in order to recapitalize a failing member of the group. This can be done through a variety of means, including contractually, as with contingent capital securities; by structural subordination; or by statute or regulation. It is important that the structure allow for the transfer of capital from strong entities to weaker ones, which may involve a further bail-in of intra-group debt. In principle, it is easier to bail-in the holding company and then recapitalize the material operating subsidiaries, but other structures may be possible. Essential functions can be housed either in the operating subsidiaries or in specialized service-company subsidiaries. Size of the institution is not in itself an obstacle to creating structures that credibly support resolution.

Banks and supervisors will need to develop valuation methods and reporting schemes to enable supervisors to more accurately judge both the point of non-viability and the extent of the capital deficit upon intervention that needs to be filled, and also to determine how to compensate investors who are over-written down. This work is now underway.

Moreover, banks and regulators have already made significant investments of time and money in recovery and resolution planning, and the process has already gone through multiple iterations in some countries. This creates growing confidence that necessary data and organizational information and well-considered plans

39 Speech at the Institute of International Bankers 2013 Washington Conference, supra.40 This would most likely be done through forgiveness of intercompany debt owed by the subsidiary to the parent. This can be characterized as a bail-in of the inter-company debt, but its effectiveness depends on – inter alia – the structure of that debt. See Part V for a full discussion of this issue.

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will be available if resolution ever needs to be carried out.

BANK RESOLUTION AND LIQUIDITY

A point which has been made in our earlier papers41 and which is repeated here is that there are two limbs to resolution: recapitalization and liquidity. Once the shape of the core business to be preserved has been established (and this may be very different from the shape of the bank that went into resolution), it is necessary to ensure that that entity: (a) has sufficient capital to be creditworthy; and (b) has access to sufficient liquidity to enable it to continue to operate. The argument presented above addresses only the first of these, the recapitalization of the entity.

The ultimate suppliers of liquidity – the relevant central banks – have hitherto typically declined to pre-commit to any obligation to apply liquidity in these circumstances, but generally indicate that they stand ready to provide it “where appropriate.” It may be argued that this is sufficient – after all, where a resolution authority in a particular jurisdiction has indicated that it is satisfied that an institution is sufficiently recapitalized, it would appear to be irrational for the central bank in that jurisdiction not to provide liquidity support to it. However, there are a number of open issues here. First, if the bank is a systemically important financial institution (“SIFI”), it is likely to require access to a specified number of currencies – notably US dollars - which its own central bank may not be able to provide, or which it can only provide with the active cooperation of other central banks.42 Second, by the time an institution enters resolution, it is likely to have exhausted its reserves of central bank-eligible collateral. Thus, the question may be whether and how the central bank or banks concerned are prepared to vary their usual financing criteria in order to accommodate the position of the entity concerned (although this should be facilitated by the fact that the successor entity should be recapitalized by operation of bail-in). On these issues, it would be exceptionally helpful if central banks were prepared to provide at least some indication of their likely policies in this regard.

In the United States, the Dodd-Frank Act allows the FDIC to use an “Orderly Liquidity Fund” (the “OLF”) to provide emergency assistance to a firm in resolution,43 subject to a super-priority lien over the firm. The OLF would draw upon a line of credit from the US Treasury, but without ultimate risk to the taxpayers because it can be recouped from the estate or, failing that, from an industry assessment.44 It is sometimes suggested that sources other than central banks or such special facilities might be capable of being drawn upon – for example the Hoover/Stanford Chapter 14 proposals45 would allow for debtor in possession-like arrangements although it has also been suggested that future legislation could extend an OLF-type of facility to streamlined bankruptcy procedures under Chapter 14, and the performance of this function is one of the primary purposes of the EU resolution fund. There are also hybrids: the FDIC might use its OLF powers to guarantee private funding, for example.

These options should be available in most cases to provide emergency assistance, but it remains true in practice that the viability of any large bank is measured by reference to access to the lender of last resort in the currency concerned. Thus, even if other sources of funding are available, the question of the restructured institution’s access to its central bank is likely to be key in determining the preparedness of counterparties to continue to deal with it.

41 See, e.g., Making Resolution Robust, supra.42 Such currencies could be provided, for example, by permitting or extending swap lines.43 12 U.S.C. §5390(n) (2010).44 12 U.S.C. §5390(o) (2010).45 See, e.g., Ken Scott, Hoover Institution, The Context for Bankruptcy Resolutions, July 8, 2014, at 6 (available at http://www.hoover.org/sites/default/files/rp-14-final-ken-scott.pdf?_ga=1.27014077.1815658908.1407344447); see generally Darrell Duffie et al., Hoover Institution, The Resolution Project, http://www.hoover.org/research-teams/economic-policy-working-group/resolution-project).

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3. Branching and Cross-Border Resolvability

We believe that much of the discussion about branching and resolution has proceeded on the basis of an erroneous understanding of the differences between branches and subsidiaries in practice. In particular, discussion of the issues that branching poses for host state resolution authorities tend to be based on an idea of a “pure” branch, which once authorized is completely outside the control of the host authority. In reality this sort of branch nowhere exists. In Appendix II, we examine the restrictions on branch activities that exist in some jurisdictions and conclude that the differences between branch and subsidiary status, although real, are by no means as great as the ideal model would suggest. Thus, we believe that current “branch versus subsidiary” arguments, and in particular suggestions that subsidiarization is the only way that a host state can control the resolution of business conducted in its territory, do not tie up with the reality of cross-border banking in practice.

We also note that if a host resolution authority wishes to maximize the probability of a banking business in its jurisdiction being resolved by the home authority on an SPOE basis, it will require that it be established as a branch. However, if the business is a branch, then the host authority would be reliant on any powers under domestic law in the event that it decided, despite those assurances, that it would be necessary to maintain assets within its jurisdiction or to take control of them in a group crisis. By requiring the local operation to subsidiarize, the host authority does extend its powers (including resolution powers) over it. However, the cost of this subsidiarization is that local creditors are potentially deprived of recourse to assets other than those of the local subsidiary if, in a failure of international cooperation, the home authority elected to “cut off” the subsidiary by unexpectedly failing to apply an SPOE resolution approach in the event of a group crisis (effectively switching to an MPOE strategy). This is why making the incentives to international cooperation as clear as possible is highly important, as further discussed below.

It is interesting that this idea of retaining the freedom to apply MPOE to an entity that forms part of an SPOE group is the basis of many arguments in favor of subsidiarization. This can clearly be seen in the International Monetary Fund (“IMF”) paper “Subsidiaries or Branches: Does One Size Fit All?”46 which concludes (in part) that:

“In the absence of effective international cooperation in [bank resolution], resolution of institutions, in the event of a failure within a banking group, may be less costly and less destabilizing if these entities are organized as subsidiaries.”47

The paper suggests that in general it should be possible for a home state to argue that it has a positive public interest in requiring global banks to operate locally through subsidiaries because:

“healthy subsidiaries that operate independently of the parent may, in principle, be better able to survive the failure of the parent or other affiliates.”48

Our primary view on these sorts of arguments is that they could be damaging, as they could lead to undesired consequences, such as a forced subsidiarization requirement. An essential element of a successful resolution is that the resolution authorities should cooperate to implement the agreed resolution strategy, and it is very unlikely that any last-minute departure from this strategy would be anything other than extremely damaging to the prospects of successful resolution. However, we accept that in the absence of a binding international framework, the prospect of disunity between resolution authorities cannot be assumed away and must be confronted. We therefore consider the issue of whether there is in fact any compelling argument for requiring subsidiarization of branch entities. We conclude that there is not.

46 Jonathan Fiechter et al., International Monetary Fund Staff Discussion Note, Subsidiaries or Branches: Does One Size Fit All?, Mar. 7, 2011 (available at http://www.imf.org/external/pubs/ft/sdn/2011/sdn1104.pdf). 47 Ibid, p. 4.48 Ibid.

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TRIGGERS AND INCENTIVES

A rational resolution authority begins with a simple choice: it can either cooperate with a global resolution plan, or seek to ring-fence local assets within its jurisdiction for the benefit of local creditors. Its motives for doing the latter might be: (a) protection of the local system; or (b) enhancement of local creditors. Thus, we can say that the structure of an institution provides incentives not to cooperate (i.e., to ring-fence) where the likely outcome for a ring-fenced resolution is better for these goals than participation in a global going-concern recapitalization through bail-in. Thus, in assessing whether to ring-fence or to cooperate with a global resolution, a national resolution authority will ask itself a series of questions:

a. How much bail-in capacity is there at the group level?

b. How likely is it that this capacity, once converted, can and will be down-streamed to troubled businesses quickly?

c. If this doesn’t happen, what is the next-best solution, and how much damage will be done to local creditors if ring-fencing is not imposed immediately?

d. Will the outcome of bail-in at the group level be more stable (or less value-destructive) for critical local functions than a ring-fenced wind-down?

With these criteria in mind, it is possible to design a resolution plan that is capable of addressing all of them. Specifically, the plan must give all relevant national resolution authorities a reasonable expectation that the procedures of participating in a global solution will be easier to execute and politically acceptable than the consequences of non-cooperation. Equally, it will be helpful in this regard if it is clear that non-cooperation will be a two-way street – that is, an authority that imposes a national ring-fence should understand that it is very unlikely to be able to access assets in other jurisdictions. More importantly, the planning process should reinforce the tremendous value-conservation power of orderly resolution via bail-in, as opposed to liquidation.

We believe that in this regard a public commitment by relevant authorities to working collectively with each other would be a useful and important factor in ensuring that this behavior works in practice.

In some respects the most important of these criteria is (c), since this determines the strength of the “prisoner’s dilemma” facing the national authority. If the potential loss arising from “stepping back” for a period to permit the group-wide resolution to take place is low, and the potential gains from an orderly resolution are substantial, then the authority concerned will be more likely to do this. Conversely, if the authority perceives that it faces a real risk of significant outflows from its jurisdiction during the period, resulting in detriment to customers in its jurisdiction, it may be considerably less willing to step back.

This issue, like many others, comes down to the issue of incentives. The primary goal of any host authority is likely to be to avoid detriment to its national economy and to customers of the failed institution in its jurisdiction. If the structure of the proposed resolution plan for the institution makes clear that the carrying out of that plan will not result in such detriment, and in fact will allow an overall result that is much less destructive of value and much less systemically destabilizing, then it will be more likely to cooperate with the implementation of the plan. This requires a credible plan, and a credible commitment by the home authority to conduct the resolution in accordance with the plan. Banks have done very large amounts of work since the crisis on developing resolution plans, and for most large bank groups credible resolution plans now exist.49

49 Although the Federal Reserve Board and the FDIC found what they considered shortcomings with the 2013 resolution plans of 11 firms, the agencies also noted improvements from the original plans submitted in 2012 and the need for more guidance as to expectations. Press Release, Board of Governors of the Fed. Reserve Sys. and the Fed. Deposit Insurance Corp., Agencies Provide Feedback on Second Round Resolution Plans of “First-Wave” Filers (Aug. 5, 2014) (available at http://www.federalreserve.gov/newsevents/press/bcreg/20140805a.htm); and Press Release, Board of Governors of the Fed. Reserve Sys., Statement of the Board of Governors of the Federal Reserve System regarding the 2013 resolution plans filed by 11 large banking organizations (Aug. 5, 2014) (available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20140805-statement.htm). US resolution plans have always been understood to be part of an iterative process and firms are working diligently toward completion of plans that can be found satisfactory by the July 1, 2015, deadline.

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4. Next Steps

The most important objective for all – banks and authorities alike – is to ensure the continuation of the real and substantial progress that has been made towards SIFI resolution. In particular, the ability to achieve systemic stability, and an optimal outcome of resolution at the national level, can both be impaired by erecting national barriers to the movement of capital, liquidity or assets. The paper clearly notes the dangers of forced subsidiarization, but any regulatory measures that damage the industry’s business success or preclude the level of repositioning of capital and liquidity necessary to prevent or limit a future crisis are a risk to us all.

More broadly, there is a danger that the progress to date may not be pursued with sufficient vigor and we could be left with this balkanized financial regulatory and capital framework, and less, rather than more, cooperation among regulators. The danger to the industry is that companies would be less resilient, have to hold significantly more capital and liquidity resources than otherwise, be subject to greater competition from those less fettered by these constraints, and operate in a more, not less, fragile business and market environment; beyond that, such balkanization would reduce the efficiency of capital and liquidity in the system, to the detriment of the global economy as a whole.

There is no reason why this danger of balkanization cannot be avoided: measures that increase information sharing, enhance planning and cooperation, and, at least, provide some flexibility for the movement of capital and liquidity actually will allow an effective cross-border resolution that meets the FSB standards without imposing the losses on taxpayers, and yet also achieve the FSB goals of strong and productive global markets supporting global growth.

However, more important than all of this is the need for resolution authorities to continue to develop plans for dealing with resolution situations. This must extend far beyond entry into institution-specific cross-border cooperation agreements. Regulators must press ahead on the path laid out in some areas (such as frameworks and planning), while engaging with greater efforts on the difficult tasks involved in: (a) developing robust Crisis Management Groups (“CMGs”) that can rely on true information-sharing during “peacetime” as a predicate for information sharing in a crisis; (b) development of fully elaborated (with the details) resolution plans in cooperation with home and host countries as well as the companies; and (c) conducting simulations and other testing of the plans with these stakeholders to make sure they can work. We would strongly support the idea of simulation exercises being conducted between the major European and US resolution authorities now that the legislative framework for the exercise of these powers has been finalized.

There are also additional steps that bear consideration. These would include, among others, the following:

a. Providing more granularity to the recommended statutory frameworks in some areas. Making the national statutory regimes, and regulatory interpretations and application, more consistent (and perhaps moving beyond simple harmonization) is important to improved predictability for stakeholders and the development of true, reliable guides to regulatory action. It should still provide flexibility, but perhaps within more constrained frameworks. This is also critical to a common approach to creditor rights. Harmonization of national legislative regimes (including insolvency regimes) is not impossible – it has been broadly achieved in – for example, netting legislation. The recently finalized BRRD includes explicit provisions for recognition of foreign actions in resolution50 (including stays of financial contracts and cross-defaults51); the authors of the US Chapter 14 proposal have discussed extending the existing provisions of Chapter 15 for recognition of foreign bankruptcy proceedings to Chapter 14 bank resolutions.52

b. Enhancing supervisors’, and resolution authorities’, ability to exchange information and the actual exchanging of such information. This seems to be a real area of difficulty now – as shown by the

50 See, e.g., Directive 2014/59/EU, art. 94, 2014 O.J. (L 173) 319-20.51 Ibid, art. 94(4), 2014 O.J. (L 173) 319-20.52 See, e.g., The Context for Bankruptcy Resolutions, supra, at 8.

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2013 peer review and recent discussions.53 Data privacy and confidentiality are very important, but regulators must establish bases for coordination now if such coordination is to be effective in a crisis.

c. Engaging in thorough-going simulations and testing of recovery and resolution plans with home and host supervisors, resolution authorities, central banks, finance ministries and judicial authorities (where needed) is essential. It will take time to develop the groundwork for participation by all of these groups, but it is essential that a strategy and timeline to get there be developed.

d. Opening up the regulatory process for consultation – on a more frequent and more detailed basis – with stakeholders. The regulators and standard-setters, such as the FSB, Basel Committee, the International Organization of Securities Commissions (“IOSCO”), and others, need to recognize that unless the market has confidence in the efficacy of these new resolution developments, there is a great risk of miscalculation or the misallocation of investment or liquidity in a crisis.

Considering areas of likely more simple common agreement – among other things in the area of creditor rights – where a consensus may exist, and trying to implement that consensus through specific protections as the foundation of some future common agreement. Examples might be priority rules, rights to set-off, netting protections (after a one- or two-day stay), etc. Greater alignment could help ensure compliance and give stakeholders the optimal confidence – short of a treaty – that everyone would abide by this consensus. More ambitiously, one could think about some type of industry or governmental consultation or mediation procedures to advance creating greater consistency in the process. There are processes like this today; both purely private sector, such as industry recognition of triggering events for financial contracts, and treaty-based processes such as the World Trade Organization (“WTO”). An active process aimed at ongoing convergence, perhaps with mediation options, may be a way to improve on “name and shame” as used by the FSB, and gradually move toward a common enforceable agreement on key issues.

53 See, e.g., Financial Stability Board, Information sharing for resolution purposes: Consultative Document, Aug. 12, 2013 (available at http://www.financialstabilityboard.org/publications/r_130812b.pdf).

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Appendix I

DEPOSIT FUNDED BANKS IN RESOLUTION

Deposit-funded banks, which remain close to the classic model of retail banking, face certain specific issues, arising primarily from less reliance no wholesale funding and senior debt. But that does not, as such, create unique problems for resolution, nor does it imply that they would need to change their deposit-funded business model by increasing wholesale funding disproportionately. It is true that such banks must, like all other banks, have appropriate GLAC in place, but its construction poses no insuperable difficulties. Obligations that are clearly pre-identified as being part of the Debt Shield should be recognized as such. Many deposit-funded banks are part of groups whose approach to resolution is multiple point of entry. An MPOE group is structured on the basis that each individual bank within the group should be capable of being resolved as a self-standing entity. Resolution of one subsidiary need not affect any others. In such groups, resolvability analysis must be undertaken at the level of the individual bank.

1. Insured Deposits in Resolution

In general, protected depositors are covered by deposit guarantee schemes (“DGS”), which have the effect of (ultimately) passing any loss that would otherwise be suffered by depositors through to other banks in the relevant banking system. Thus, from the perspective of a bank resolution authority, the fact that an insured depositor has recourse to a DGS is not a key concern.

In the event of institutional failure within a basically sound system, the DGS is the primary protection for smaller users of the system.

The fact that calls on a DGS are allocated to other banks also provides (in theory at least) another way to allocate losses to the bank sector and effect a resolution without the necessity for direct cash injection by a government. In effect, it transmutes excess losses from the critical part of a failing bank to the equity of the remaining part of the banking sector. While this does introduce moral hazard and some other issues, it could tap a deep pool of a known resolvable financial class. Resolution funds are a related, albeit less clear, version of this concept.54 Obviously, however, the mutualization of losses of failing banks by imposing them on stronger banks should only be a fallback for use in extremis, as would be the case under the Dodd-Frank OLF provisions, or under the BRRD.

It is, therefore, important to all systemic participants that the involvement of the DGS in a bank resolution be in a way that minimizes losses to its contributors. This is sometimes referred to as “bailing-in the DGS.” In fact, what is important is that the DGS should not be restricted only to bearing losses after failure, but should be able to deploy its resources – coequally with other parties – to reduce the magnitude of the losses actually suffered. Current FDIC practice, the provisions of the BRRD relating to the use of EU national deposit Guarantee Schemes in resolution, and the Japanese resolution provisions provide a model in this regard.

2. Uninsured Deposits in Resolution

Certain deposits may qualify for inclusion in GLAC. The key distinction in practice is that between those deposits that have been pre-identified as being exposed to bail-in, and those that should not be.

A principal goal of bank resolution is to avoid causing widespread disruption to the real economy – those deposits that relate to the payment business of banks should be protected. Companies and individuals pass very large sums through the banking system on a daily basis, and thereby acquire a substantial exposure to that system which is neither voluntary nor optional. People may elect not to use any particular bank, but do not have the ability to elect not to use the banking system at all. Thus, we need to be able to distinguish

54 See Thomas F. Huertas, What’s a Fund For?: The Case of Resolution Funds (June 24, 2014) (available on file at the Institute of International Finance).

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deposits arising out of a commercial payment or service relationship (“Operational Deposits” as defined further below) from deposits that represent a form of credit investment in the bank, which we will refer to as “Funding Deposits.” First, uninsured deposits that are placed on terms that they cannot run (i.e., are subject to limits on withdrawal) should be presumed to be Funding Deposits unless they can be clearly demonstrated to be operational – thus, the default classification for all uninsured deposits should be as Funding Deposits. Second, it is not proposed that these Operational Deposits should be excluded from bail-in but simply that they should be bailed-in only after other senior creditors have been bailed-in (and thus would not under any circumstances count toward GLAC). Third, Funding Deposits should not count towards the Debt Shield unless, in addition to their other characteristics, they meet the Debt Shield Conditions. The category of Operational Deposits of course needs to be defined rigorously to avoid moral hazard; the definition of Funding Deposits would aim to contribute to market discipline and avoid the regulatory arbitrage that would be possible if such deposits were advantaged over other types of senior debt.

3.1 Operational Deposits in Resolution

Operational Deposits are those deposits (above insured levels) maintained by businesses or other entities for cash-management, payments, payroll, and other such purposes. They are distinguished from Funding Deposits by the purpose for which they are kept, by the operational relationships with the bank that are typically found, and by the fact that such deposits are placed as part of the use of payment and other services offered by the bank rather than as free-standing investments.

It should be noted that the distinction between operational and long-term deposits already exists within the Basel framework. The Basel III Liquidity Coverage Ratio (“LCR”) makes a distinction between “operational” wholesale deposits and other wholesale deposits, which it draws thusly:

“Certain activities lead to financial and non-financial customers needing to place, or leave, deposits with a bank in order to facilitate their access and ability to use payment and settlement systems and otherwise make payments. These funds [qualify] only if the customer has a substantive dependency with the bank and the deposit is required for such activities …” 55

The basic idea here is that Operational Deposits are deposits that are made as part of the provision by the bank of essential services to the corporate, municipal, or other customer concerned.56

The basic LCR criteria that are relevant here are:

a. The deposits are by-products of the underlying services provided by the banking organization and not placed in the wholesale market on market terms; and

b. The deposits are held in specifically designated accounts and priced without giving an economic incentive to the customer (not limited to paying market interest rates) to leave any excess funds on these accounts.

This would lead to the conclusion that deposits that satisfy the following criteria should have the highest preference status and so, generally, should not be bailed-in until both the Debt Shield and any other class of un-preferred senior creditor has been bailed-in. These include:

a. All demand (sight) deposits

55 Basel Committee on Banking Supervision, Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, Jan. 2013, p. 24 (available at http://www.bis.org/publ/bcbs238.pdf).56 It is important to understand that the LCR test itself is aimed at a different policy objective. In particular, the LCR test is applied from the perspective of the deposit-taking bank, and assesses the likelihood of the balance concerned being withdrawn. Thus, the existence of a back-up service provider is sufficient to exclude a deposit from the definition of an operational deposit for LCR purposes. For the purpose of determining whether a deposit should be protected for the benefit of the depositor, however, we are not interested in the likelihood of the deposit being withdrawn, but in the reason why it was made and is maintained. However, beginning with the base of the LCR test it is possible to construct a meaningful set of criteria which a deposit must satisfy if it is to be considered an Operational Deposit.

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b. All deposits related to custody business

c. All deposits maintained as part of a broader, ongoing relationship with the bank (e.g., deposits held by a corporation to support its ordinary cash management, custody, clearing, operational foreign-exchange transactions, payroll, etc.; may be related to operational credit or liquidity lines; may include term deposits related to such operations or maintained in connection with standby credit lines or as collateral). In this context, we would propose following the LCR definitions of clearing, custody, and cash management relationships (paragraphs 101-103).

3.2. Funding Deposits

A Funding Deposit would be defined as a deposit under which a person provides term funding to a bank in exchange for a rate of interest determined by reference to market interest rates and the credit risk inherent in that deposit. However, for this purpose we would not propose to advance a definition of a Funding Deposit, but merely to propose that any deposit that is neither an insured deposit nor an Operational Deposit should be considered a Funding Deposit. The question of whether a particular deposit should be regarded as eligible in this regard is a matter of whether it satisfies the Debt Shield conditions as defined above.

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Appendix II

WHAT IS A BRANCH?

When discussing this issue, it is essential to define “branch.” The rules applicable to foreign branches vary considerably across jurisdictions, ranging from countries such as India and Brazil, where branches face local capital and liquidity charges identical to those applied to subsidiaries and are required to maintain boards with local representation, to the countries of the EU, amongst whom branching is an absolute right with no interference (in theory) permitted to the host regulator. Even between these extremes the position varies considerably – for example, the differences between the UK and the US57 rules remain substantial.

Current UK Treatment (non-EU Branches) Current US Treatment

Level of home state supervision required

No equivalence measure – UK authorities must satisfy themselves that the bank as a whole is compliant with UK capital requirements

US must find that a bank is subject to comprehensive consolidated supervision in its home state before approving a branch application

Requirement for initial branch capital

NoYes – banks must maintain a “capital equivalency deposit” with a depositary bank

Requirement for ongoing risk-based capital

No No

Ongoing liquidity requirement for the branch

Yes – branches must be self-sufficient in liquidity, although there is a power to permit group-wide liquidity management where the group is adequately supervised

Not currently, but proposals to impose liquidity requirements on US branches of non-US banks with combined US assets of $50 billion or more

Branch asset requirements No

New York State Department of Financial Services can require a branch to maintain assets

Central bank reserve requirements

Yes – cash ratio deposits with the Bank of England

Yes – reserve requirements with the Federal Reserve System

Restrictions on branch deposit-taking

NoYes – generally, US branches of non-US banks cannot take retail deposits or offer FDIC protection

Restrictions on other activities of the branch

No Yes – subject to the same restrictions as US banks (including underwriting securities)

57 See generally Cleary Gottlieb Steen & Hamilton LLP, Davis Polk & Wardwell LLP, and Sullivan & Cromwell LLP, White Paper on the Separate Entity Doctrine as Applied to the U.S. Branches of Foreign Headquartered (Non-U.S.) Banks, Apr. 18, 2013 (available at http://www.davispolk.com/files/uploads/Dodd-Frank%20documents/Dodd-Frank.white.paper.U.S.Branches.Foreign.Banksapr12.pdf).

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Current UK Treatment (non-EU Branches) Current US Treatment

Do local requirements apply to the bank as a whole

No

Yes – group’s activities in the US (excluding US branch) must be held in a US-incorporated Intermediate Holding Company (IHC). The IHC will be subject to US rules applicable to bank holding companies, including without limitation restrictions on non-bank activities (including – possibly the Volcker rule)

Are the branch’s deposits insured under the local scheme

Yes – although this may cease for non-European Economic Area (“EEA”) branches under the Vickers proposal

No

What are the host authority’s powers over the branch in the event of failure

None – ordinary bankruptcy law will apply. This will change when the BRRD is brought into force

US branches of foreign banks are subject to the special resolution regime to which US banks are subject. US authorities have the option to resolve the US branch of the foreign bank separately from the parent bank, using assets of the US branch to satisfy liabilities of the US branch with any excess remitted to the estate of the failed bank and any deficiency submitted as a general claim on the estate of the failed bank.

Are local assets reserved for local creditors on insolvency

No Yes

It should be clear from this that the concept of “branch” is not incompatible with a high degree of control over the activities of that branch being exercised by the host authorities in the jurisdiction where the branch is established. It is untrue that by permitting a bank to operate through a branch the host authority necessarily loses control either over the business or its assets and liabilities.

It may, therefore, be asked what exactly is the threat that is perceived as flowing from branching. The easiest way to address this is to begin with the taxonomy of banks put forward by the Federal Reserve in the discussion section of its notice of proposed rulemaking for foreign banking organizations (“FBOs”),58 which divides national branches into “aggregators” and “distributors.” An aggregator branch is established to accumulate deposits (or other forms of finance) and to remit those deposits to overseas operations of the bank. The basis advanced by the Federal Reserve for the FBO proposal is precisely that overseas branches in the US are aggregators and that they use US deposits to fund the accumulation of overseas assets. The concern with aggregators is that, in the event of a crisis, the assets financed by the deposits are outside the control of the resolution authority concerned, and if the home authority is not prepared to remit the assets (or their value) to the host authority, the host authority may be left to finance the shortfall. Requiring an aggregator branch to become a subsidiary may solve this problem if it has the effect of maintaining the assets in the jurisdiction concerned – that is, of disrupting the business model. However, if the problem to be addressed is simply that assets owned within the jurisdiction are located outside the jurisdiction, the legal entity of the asset’s owner seems less relevant. Put another way, it should be possible to require any asset owned by a branch to be returned in the same way and to the same extent that it would be possible to require an asset owned by a subsidiary to be returned.

58 Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies, 77 Fed. Reg. 76628 (proposed Dec. 28, 2012).

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Distributor branches are the mirror image of aggregator branches. A distributor branch exists to make loans and otherwise originate assets, deploying funding raised centrally to originate assets locally. A distributor branch is always “solvent,” to the extent that local assets generally exceed local liabilities. However, a distributor branch is not more likely to hold a separate pool of liquid assets, since a central model of funding is generally accompanied by centralized liquidity management. It is possible for a distributor branch to exist in subsidiary form, provided that the business is very small relative to that of the parent bank; if it is not, then exposure limits within the bank will cap its recourse to group funding. In general, regulators should prefer distributor branches to be branches, since otherwise limits on intra-group exposures will disrupt the business model.

Regulators’ concerns about distributor branches are generally focused on the withdrawal of credit. If a bank with a distributor branch comes under stress, the bank may cease to roll over credits booked in the distributor branch, repatriating assets to the parent to assuage the stress. Hence the argument that requiring a distributor branch to subsidiarize will prevent this happening, trapping resources within the local office.

It is, therefore, not at all clear that there is any advantage to a host regulator in requiring a local branch of a bank to become a subsidiary; by doing so he significantly increases the risk of divergent approaches to resolution catching him unprepared. The advantages of ring-fencing assets for local creditors are matched by the loss of the recourse of those local creditors to other assets in other jurisdictions, and the degree of control that the regulator acquires over the local business by requiring subsidiarization is matched by the increased risk of divergent approaches being applied by different resolution authorities to different parts of the same G-SIFI – an outcome that would almost certainly be detrimental to all creditors of that G-SIFI. We believe that the issue should be one of ensuring appropriate powers for host resolution authorities of branches, rather than requiring banks who are committed to an SPOE resolution strategy to adopt inefficient and potentially harmful multi-subsidiary structures.

We accept that in order to address the “aggregator branch” issue identified by the Federal Reserve, it may be necessary to enable local regulators to exercise some degree of control over the disposition of assets, and in particular a substantial branch is unlikely to be permitted to operate if the bank concerned has few or no significant assets in the jurisdiction. In some jurisdictions, authorities already have power to impose such obligations (or to impose them if needed). It may be that equivalent powers are regarded as necessary in others if branch banking is to continue. However, we would prefer to see an increase in host regulators control over branches than a move towards fragmentation, a move that can only harm the resilience of the global banking system.

We strongly believe that there are substantial benefits to the global economy from the existence of cross-border banking institutions operating as integrated businesses. The existence of such entities promotes efficiency in the deployment and use of capital and liquidity to the benefit of global real-economy markets. These benefits arise partly from the ability of such entities to transmit credit and capital around the global financial system to the point where it can be used most productively, but also from the ability of such entities to assume local risks backed by global capital. Ring-fencing and separating parts of the undertaking from each other will have the effect of increasing overall costs to end-users of the services provided to them, and will also increase systemic brittleness by restricting the extent to which the resources of a group as a whole may be committed to a particular part of it.

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Appendix III

TRIGGERING RESOLUTION WITHIN BANK GROUPS

All SIFIs exist as bank groups, and consequently for all SIFIs the issue of intra-group exposures will arise within the resolution process. Where there are home and host supervisors, the host supervisor may well demand independence in the triggering of resolution. However, the host cannot entirely disregard the fact that the triggering of resolution measures in respect of one part of a group could have potentially significant effects on other parts of the group, and it is highly arguable that a home resolution authority should be able to restrain the use of such a trigger by a host authority if risk to the host can be attenuated – or, at a minimum, to have a right of consultation and response. However, a host authority could equally argue that the home authority should have positive responsibilities to it to deploy resources.59

The key conclusions from this are that:

a. The home resolution authority should be obligated to consider the interests of all of the counterparties of group entities, and in particular the potential impact of resolution measures on financial stability in host countries; and

b. The host resolution authority should be obligated to consult closely with the home authorities, acting in coordination with them, to the extent possible, in taking any resolution action in its territory, and to take into account the broader stability effects of such actions outside the host jurisdiction.

For MPOE structures, these issues are more likely to arise around trigger issues, since in an MPOE structure, intra-group exposures are likely to be lower than in other groups,60 with subsidiary GLAC more likely to have been issued directly to third-party holders. In an SPOE group, by contrast, subsidiary GLAC is more likely to be held by the holding company, and the interaction between the home and host authorities is more likely to relate to the extent to which such GLAC is to be written down. It should be noted in this context that, for an MPOE bank, what matters is the amount of GLAC at the level of the subsidiary or sub-consolidated group, and GLAC at the holding company is less relevant. By contrast, for an SPOE approach, it is essential that GLAC exist at the top holding company level insofar as possible.

In general, a subsidiary of a SIFI that is relevant for this purpose is likely to be a bank itself, and host jurisdictions generally make no distinction in terms of basic capital requirements between free-standing banks and banks that are part of a larger bank group. Thus all banks – subsidiaries or otherwise – are likely to be required to have the legal minimum of equity, tier 1 and tier 2 capital. A question does arise, however, with respect to two issues; these being:

a. The extent to which the authority concerned requires the bank to hold a capital cushion above the regulatory minimum; and

b. The extent to which the authority concerned, in addition, requires the bank to hold GLAC.

In both of these matters, the extent to which the host authority will require the bank subsidiary to hold excess capital or GLAC will depend on the extent to which the home authority believes that the entity will be supported by the ultimate parent.

59 See, e.g., Key Attribute 7.2 and 7.3.60 The FSB provides in its July 2013 Recovery and Resolution Planning for Systemically Important Financial Institutions: Guidance on Developing Effective Resolution Strategies that for an MPOE group “[i]ntra-group financial interdependencies (for example, guarantees and contingent claims) and other exposures between group entities that would hamper a clean separation or risk the spread of contagion through the group should be limited.” Recovery and Resolution Planning for Systemically Important Financial Institutions at 18-9.

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Where a group’s structure involves the provision of intra-group senior debt to subsidiaries, there are broadly five ways in which a host regulator can be satisfied that that intra-group debt has “enhanced resolution” characteristics. These are:

a. Structuring the debt in the form of eligible regulatory capital – specifically, as subordinated debt having the full regulatory requirements for contingent convertibles, including pre-set conversion triggers;

b. Structuring the debt so that the host authority has an explicit power to write it down or convert it into equity on the occurrence of a specified trigger;

c. Structuring the debt so that it falls within the domestic bail-in power of the host resolution authority;

d. Structuring the debt as senior debt, on the basis of a formal (or semi-formal) agreement among the parent, the subsidiary and the home and host authorities that the debt can be written down or converted on the occurrence of a specified trigger; and

e. A formal agreement (such as a “keepwell” agreement) from the parent.

We do not believe there is any disagreement that resolution powers should only be used when the institution concerned is at the point of non-viability (“PONV”). Thus, the host authority should be able to use this power where the domestic subsidiary concerned has reached this point. The host authority, however, should not be able to exercise such a power on a pre-emptive basis – i.e., in circumstances where the domestic subsidiary remains solvent but the authority is concerned about the position of the group as a whole – since such circumstances would not trigger a PONV determination. Thus, subject to prior consultation and assuming cooperative intent, there seems no clear objection to the host authority having sole power to trigger the write-down or conversion, provided that its right to trigger is exercised in the same way (and only in that way) that a resolution power could be triggered if the institution were free-standing.

However, we remain of the view that it is highly undesirable for any individual resolution authority to exercise any resolution power over any part of an international group unless there is broad agreement within the relevant CMG that the problem concerned is a group-wide problem and should be addressed by coordinated action by the members of that CMG. Unilateral exercise of resolution power by an authority member of a CMG could potentially turn an orderly resolution into a disorderly default, and we believe that precautions should be created at a systemic level to prevent this from occurring.

Furthermore, we believe that host authorities should be able to derive some confidence from the assurances of home authorities. It would be unreasonable for any host authority to simply disregard the public position of a home authority as to how the relevant subsidiary would be dealt with in a group resolution – particularly where that position was expressed in a resolution plan agreed between (inter alia) the two authorities concerned, perhaps via the firm’s CMG. A good example of this situation would be where the resolution plan envisaged the write-down or conversion of debt issued by a holding company in the jurisdiction of the home authority, on terms where the resulting equity would be down-streamed to the subsidiary in the host jurisdiction. This is another area where public benefit would be derived from the disclosure of a presumptive path, as recommended by the FSB,61 and ultimately by the creation of a legally binding framework.

Finally, we note that although an MPOE bank is expected to be resolved on an entity-by-entity basis, an SPOE bank is structured to facilitate a single resolution process undertaken at the level of the top holding company in the group. Cooperation between national regulators is essential to facilitate an SPOE approach to resolution, but MPOE approaches can be implemented with a lower level of cross-border cooperation in this regard. subsidiary concerned has reached this point. The host authority, however, should not be able to exercise such a power on a pre-emptive basis – i.e., in circumstances where the domestic subsidiary remains solvent but the authority is concerned about the position of the group as a whole – since such circumstances would not trigger a PONV determination. Thus, subject to prior consultation and assuming cooperative intent, there seems no clear objection to the host authority having sole power to trigger the write-down

61 Id at 20-1.

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or conversion, provided that its right to trigger is exercised in the same way (and only in that way) that a resolution power could be triggered if the institution were free-standing.

However, we remain of the view that it is highly undesirable for any individual resolution authority to exercise any resolution power over any part of an international group unless there is broad agreement within the relevant CMG that the problem concerned is a group-wide problem and should be addressed by coordinated action by the members of that CMG. Unilateral exercise of resolution power by an authority member of a CMG could potentially turn an orderly resolution into a disorderly default, and we believe that precautions should be created at a systemic level to prevent this from occurring.

Furthermore, we believe that host authorities should be able to derive some confidence from the assurances of home authorities. It would be unreasonable for any host authority to simply disregard the public position of a home authority as to how the relevant subsidiary would be dealt with in a group resolution – particularly where that position was expressed in a resolution plan agreed between (inter alia) the two authorities concerned, perhaps via the firm’s CMG. A good example of this situation would be where the resolution plan envisaged the write-down or conversion of debt issued by a holding company in the jurisdiction of the home authority, on terms where the resulting equity would be down-streamed to the subsidiary in the host jurisdiction. This is another area where public benefit would be derived from the disclosure of a presumptive path, as recommended by the FSB, and ultimately by the creation of a legally binding framework.

Finally, we note that although an MPOE bank is expected to be resolved on an entity-by-entity basis, an SPOE bank is structured to facilitate a single resolution process undertaken at the level of the top holding company in the group. Cooperation between national regulators is essential to facilitate an SPOE approach to resolution, but MPOE approaches can be implemented with a lower level of cross-border cooperation in this regard.

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