Port of Spain, Trinidad

Crisis Management and Crisis PreparednessOctober 22, 2014

Presented at the 13th Annual IADI Conference

The views expressed in this presentation are the speaker’s and not those of the Federal Reserve Bank of New York and the Federal Reserve System.

Disclaimer

Reducing the Too Big to Fail problem and avoiding government bailouts: a two-pronged strategy. Reducing the probability of failure for such firms Increasing the ability to put complex firms into resolution

Increasing the likelihood that firms develop meaningful recovery plans and activate them early reduces losses and preserves value.

Breakthroughs have been made in achieving the resolution of a systemically important financial institution. . Publication of the Key Attributes of Effective Resolution Regimes Development of the single point of entry resolution strategy Emerging thinking on the means for recapitalization and funding

of a financial institution in resolution Efforts to improve cross-border recognition of resolution actions

and stays of financial contracts, especially derivatives

Work remains: progress on resolution is a journey.

Overview

Recent Advances—The Key Attributes

The Key Attributes of Effective Resolution Regimes (November 2011)

Makes the case for special insolvency regimes for financial institutions—all financial institutions, large, small, bank, nonbank

Sets out powers needed by financial resolution authorities Recommends that resolution regimes have the ability to use a “bridge bank” or

“bridge institution” Introduces the concept of “bail-in within resolution” of at least some financial

liabilities of the firm Sets out guidelines for recovery and resolution planning for G-SIFIs,

systemically important financial institutions designated by the Financial Stability Board.

Much progress in major jurisdictions in adopting legislation that implements the Key Attributes. Most notably in 2014, in the European Union,

The Key Attributes sets out objectives for recovery and resolution planning for those financial firms designated as G-SIFIs.

Each G-SIFI has a Crisis Management Group (CMG) made up of the lead and major home authorities and major jurisdictions in which the G-SIFI is active.

The Cross-Border Crisis Management Group (CBCM) is the forum where the key jurisdictions can bring forward issues of mutual interest for study and for coordinating their approaches.

CBCM reports to the Resolution Steering Group Recovery planning was completed for most G-SIFIs in 2011. Resolution strategies were chosen for most G-SIFIs in 2012.

Operational plans for resolution are being developed now.

▫ Likely to be an iterative process.

Recovery and Resolution Planning for G-SIFIs

Recovery plans for G-SIFIs are completed and have often been through a few iterations.

Resolution strategies have advanced substantially: High-level strategies were identified by each CMG last year. An operational plan was developed and approved by the

CMG this year. CMGs are making a resolvability assessment. Cooperative Agreements are being signed by parties within

the CMG and senior-level discussions of the resolution plan and the resolvability assessment (RAP) for each G-SIFI) are being discussed. The round of RAP discussions should end in the first half of next year.

Status of Recovery and Resolution Planning

Recovery Planning, a Key Risk Management Activity

Recovery planning by a financial firm identifies possible actions it can take when problems develop. Those actions are aimed first at stabilizing the firm and then at working toward a resumption of business health and profitability.

Historical experience suggests that financial firms minimize financial losses and other costs by identifying emerging problems early and taking prompt, proactive steps to address them.

Recovery planning relies on scenario analysis in order to identify stress points and the rough size of actions that may need to be taken.

Scenarios need to include both firm-specific and marketwide stresses.

Therefore, firms need to identify quantitative and qualitative triggers for consideration of options

and actions by the firm.

The triggers are not meant to automatically lead to specific actions, but they must lead to deliberation within the firm.

After reviewing the initial recovery planning done by G-SIFIs, the CBCM set out in a paper (July 2013) considerations for sound scenario analysis for recovery planning and the design and key features of recovery triggers.

Recent Advance on Resolution: Single Point of Entry

The failure of Lehman Brothers Holdings, Inc., in 2008 and the commencement of insolvency proceedings in multiple jurisdictions around the globe exemplified the problem of an uncoordinated resolution.

The FDIC put forward in its Journal a paper describing how a new resolution strategy, single point of entry (SPE), could have been used to resolve Lehman Bros. The FDIC further elaborated in speeches and a joint paper by the FDIC and Bank of England.

In the simplest form of single point of entry resolution, the resolution authority puts only the holding or parent company into resolution, and continues to operate the parent‘s subsidiaries as going concerns.

The resolution authority can fund the sole legal entity in resolution and that entity can fund the subsidiaries. The resolution authority can then restructure and/or sell the financial company as necessary.

SPE has been widely adopted by the CMGs for G-SIFIs.

Progress: Single Point of Entry Resolution

The Financial Stability Board published guidance on developing effective resolution strategies (July 2013). The guidance describes the conditions leading a resolution authority to choose a single point of entry strategy, a multiple points of entry strategy, or some combination of both.

Multiple points of entry (MPE) could cover a range of possibilities: regional breakup, business line breakup, good bank/bad bank, etc. Some prerequisites for MPE may be a large degree of financial and operational separation across legal entities/jurisdictions, as well as sufficient independent funding and loss-absorbing capacity at the potential points of entry.

Single point of entry may have as prerequisite sufficient ability to move losses upstream and capital downstream in the organization; sufficient loss-absorbing capacity at the parent or a subsidiary that the parent can access,

Supervisory and resolution authorities have expressed a strong desire to have flexibility in choosing the resolution strategy at the time of failure.

Key innovation: bail-in powers. Bail-in is intended to reduce the permanent capital/funding need from the public sector—to zero. Bail-in is the power to convert liabilities to equity or

write them down in value; in either case, bailing in liabilities creates new capital.

Bail-in avoids a capital injection by public sector and strengthens the entity in resolution for sale, and improves its access to funding markets.

Bail-in must be credible to not be destabilizing. In the failure of Washington Mutual, the FDIC wrote down senior debt, but the market assumed that senior debt would be protected in a failure.

The Innovation of Bail-in Powers

Bail-in is a mechanism to recapitalize a financial institution in resolution. Why do we need it now?

Traditional commercial banking involves the taking of deposits and the lending of funds. In concept, traditional commercial banking businesses can

be resolved, in part because the deposits generally have value, as do the “good” assets.

To have value, deposits must be “sticky”—not very sensitive to changes in interest rates or the institution’s health.

The stickiness comes from the account services (e.g., payment and liquidity services) that are intrinsic to the deposit.

In contrast, capital market activities and other non-deposit funding activities have liabilities generally without “stickiness”—one reason why bail-in is important.

Why Do We Need Bail-in Now?

The equity capital of the firm is meant to absorb losses that could lead to a firm’s failure and firms have generally depleted much of their capital as they enter resolution In resolution, other loss-absorbing liabilities are needed to recapitalize their firm and support its sale.

Loss-absorbing capacity (LAC) involves identifying liabilities of the firm that can be converted into equity or written down in resolution (bailed-in).

Liabilities can be rank-ordered by the effectiveness of their conversion and the absence of inducing further runs.

Work advancing to the 2014 Brisbane Summit on what qualifies as LAC, how much is required and where the LAC could be located in the organization.

Bail-in and Loss Absorbing Capacity in Resolution

Key features: needs to predictably provide loss-absorbing capacity; needs to avoid triggering runs; needs to avoid de-stabilizing funding markets.

Subordinated and senior debt most clearly bail-inable. Financial institutions may need to issue more.

Derivatives liabilities and short-term funding seen as less suitable.

Agreement that insured deposits should not be bailed in; also great reluctance to bail in uninsured deposits, reinforced by the Cyprus experience.

Some discussion of using or crediting the potential use of deposit insurance as part of LAC

What Kind of Liabilities Can be Bailed-in?

Resolution requires funding and liquidity Funding is necessary to support the balance sheet and

meet collateral requirements Liquidity takes many forms, but a key one is access to

trading markets, necessary in order to manage risk What problems can a firm face in funding in resolution?

History suggests that loss of funding capacity occurs in the run-up to failure and continues after. What is the potential gap between the firm’s resources and its funding needs?

Capital markets activities depend on credit in the settlement process. When the firm is no longer viewed as credit-worthy, it may restrictions on its access to markets.

Funding in Resolution

The CBCM has begun looking at funding in resolution. A review of previous cases of failure or near failure confirms

that funding needs rise in and even after resolution. While funding eventually is restored, funding needs temporarily become very large.

Improving the ability to estimate funding gaps prior to resolution taking into account bail-in is a clear need.

Working to develop principles for ways to sustain as much private sector funding as possible is also a clear imperative.

Principles to guide public sector funding when it is needed also look like they would be useful. In addition, much progress was made in identifying temporary funding approaches that minimize moral hazard.

We do not want to be prescriptive as to how countries meet that need.

Recent Work on Funding in Resolution

Cross-border recognition of actions by resolution authorities, such as temporary stays of derivatives contracts and exercise of bail-in powers. Discussions with industry and the legal community have made progress.

A paper has been written on resolution-related information sharing between home and host supervisors about financial firms whose operations in a host jurisdiction are locally systemic, but small relative to the overall firm’s size and activities. Regional supervisory groups have provided extensive

comments on the paper. The next step will be public consultation.

Other Noteworthy Areas of Progress

Considerable progress on resolution plans that do not require the taxpayer to bear losses, but much remains to be done.

Ensure continued progress in adopting the insolvency regime requirements of the Key Attributes.

With the first round of G-SIFI resolution planning nearing completion, a good time to assess the process and its integration into supervisory practice.

Develop further topics such as operational continuity of critical operations through the resolution process.

Further attention to the set of decisions that need to be made upon entry into resolution: management, valuation, strategies such as managing problematic assets.

More detailed planning of roles and responsibilities: supervisors, resolution authorities, and deposit insurers.

Progressing on the Journey: Future Work