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Single point of entry resolution: a milestone for regulators: a millstone for banks?

The Financial Stability Board (the FSB) has issued guidance on the future development of bank resolution strategies. The guidance, published in July 2013, derives primarily from work done by the Bank of England and the U.S. authorities.

It will have significant long-term structural ramifications for systemically important banks as and when adopted.

The guidance seeks to help find an answer to the question of how systemic banks can be resolved without taxpayer bail-outs or systemic disruption. Resolution authorities face fundamental challenges in resolving systemic banks: even with wide-ranging resolution tools, the resolution of a systemic bank involves substantial risks. Resolution disrupts the bank’s balance sheet, potentially triggering expulsion from payment and clearing systems. Banks are integrated, but their legal structures often are not: resolution de-groups the failed bank, depriving it of access to the central resources of the group (such as central treasury functions, staff, operations and IP and IT resources around the world). Resolution may not be recognised in respect of foreign law debts, preventing successful resolution. In short, resolution of the bank is too complex, and too risky, for the regulators.

In response, the FSB unveils a new solution: single point of entry (SPE) resolution. (There is also a second option, of multiple point of entry (MPE) resolution, proposed for less integrated banks – but it is a less innovative, and ultimately less attractive tool.) The sleight of hand behind an SPE approach is to resolve the banking group at the level of its ultimate parent, rather than the operating company in difficulty (the bank). As a solution, this is highly attractive for a resolution authority: it enables continuity of service on the part of the bank, avoids disrupting the bank’s balance sheet (the authority would merely bail in the ultimate parent company), and keeps the group together. Further, it is argued this could mitigate the problems of cross-border recognition.

The position in practice is more nuanced. If one were designing a banking system from scratch with a view to resolvability, requiring banks to structure themselves with highly capitalised and bail-in debt-funded holding companies would undoubtedly be sensible. But that is not the world we live in, and that is not how banking groups are structured in most parts of the world. Outside of the U.S., many banking groups do not have bank holding companies, and even among those that do, most do not raise substantial amounts of wholesale “bail-inable” debt at holding company level (and some do not raise wholesale debt at all). For those banks, moving to an SPE-friendly structure would be a major transition, potentially involving reorganisation of their corporate legal structure, capital structure and liability structure.

There is also a transitional cost in terms of the higher risk premium for new holding company debt. A bank creditor would legitimately consider that if its debt were moved to the parent company, then the probability of default (bail-in) and loss-given default would be increased – both through structural subordination, and because its debt would now effectively be supporting all of the banks in the group. The risk premium would increase, to the detriment of customers and shareholder returns.

Perhaps most importantly, the success of an SPE approach for a major international banking group wholly depends on a high level of trust between the resolution authorities of each jurisdiction in which the group has a bank. The resolution authorities in the jurisdiction of a subsidiary have to have complete confidence that the authorities in the holding company jurisdiction will ride to the rescue if a local emergency breaks out. As matters stand, it is not clear that they will have that confidence. In particular, as noted in the April/May 2013 edition of the Legal & Regulatory Risk Note, every indication to date suggests that the U.S. regulators may not (yet) hold such a view (and indeed may be pulling in the opposite direction in relation to European banks with U.S. presences). If this is the case, it may yet render the FSB’s proposal a very expensive failed experiment.

The work done by the FSB on SPE resolution is a useful development of the evolving discipline of bank resolution, and the objective of creating a global solution to the resolution of international banks is laudable. But it is hard to avoid the feeling that the guidance papers over the deeper, more fundamental chasm that runs through the regulatory system: the lack of a binding international framework for bank resolution.

The remaining question is how far, and how fast, the regulators will seek to make banks align their structures to the new solution. The Bank of England is, as expected, leading the charge. Paul Tucker, the outgoing deputy governor of the Bank, has indicated in Parliament that the scale of reorganisation required to achieve resolvability will go “beyond ringfencing” – a particularly ominous thought for those UK banks already planning for a post-ICB world.

The sleight of hand behind an SPE approach is to resolve the banking group at the level of its ultimate parent, rather than the operating company in difficulty (the bank).

Bob Penn, Partner (United Kingdom)

Legal and Regulatory Risk Note
United Kingdom