IFLR Webinar:
Recovery and Resolution
Planning: a US and
European view
February 1, 2012
Presented By
Viral Acharya, New York University Stern School of Business
Peter Green, Morrison & Foerster, London
Jeremy Jennings-Mares, Morrison & Foerster, London
Dwight Smith, Morrison & Foerster, Washington DC
LN2-9566
Topics
1.
2.
3.
4.
Overview of the E.U. and U.K. planning regimes
European requirements
U.S. requirements
Does resolution planning address systemic risk?
2
G20 Commitments
 G20 Summit in Cannes in November 2011 endorsed implementation
of 3 policy measures proposed by Financial Stability Board/Basel
Committee to address risks to global financial system from
systemically important financial institutions (SIFIs), particularly in
respect of Global SIFIs
 Key Attributes of Effective Resolution Regimes for Financial Institutions
 Assessment Methodology and Additional Loss Absorbency Requirements for
G-SIFIs
 Progress Report on Intensity and Effectiveness of SIFI supervision
3
FSB – Key Attributes of Effective Resolution
Regimes
 Each jurisdiction:
 to have designated resolution authorities with a broad range of powers to
intervene and resolve a non-viable institution (incl. business transfers, creditorfinanced recapitalisations (or bail-in of debt)), which can allocate losses to
shareholders and unsecured/ uninsured creditors in their order of seniority
 to remove impediments to cross-border co-operation and provide national
resolution authorities with mandates and incentives to share information crossborder
 to ensure RRP’s put in place for all G-SIFIs, regularly reviewed and updated and
with annual assessments by authorities of feasibility of resolution strategies for
each G-SIFI
 to maintain crisis management groups for all G-SIFIs, to bring together home and
host competent authorities, by means of cross-border co-operation agreements.
4
Overview – Europe
 Expected European Commission Legislative Proposals
 Recovery Planning
 Early Intervention Options
 Objectives and Principles of Resolution
 Resolution Tools and Powers
 Ancillary Powers
 Recovery and Resolution Plans
5
Overview – UK
 FSA Consultation on Recovery and Resolution Planning
 Recovery Plan Options and Principles
 Resolution Plan Objectives
 Resolution Packs
 Resolution Tools
6
European Requirements
 Following various consultations on crisis management, the European
Commission is expected (shortly) to publish its legislative proposals for a
framework for crisis management and the recovery and resolution of banks
and investment firms – expected to be in the form of a directive requiring
separate implementation in each member state
 Each member state to designate a resolution authority for its jurisdiction, that
authority then empowered to exercise resolution powers and apply the
“resolution tools”
 Each member state to require each institution in its jurisdiction to draw up a
recovery plan, setting out possible measures it could take to address a
serious deterioration of its financial condition, risking its non-viability
 Group recovery plans for financial groups to be prepared by parent
undertaking and submitted to consolidated supervisor, as well as individual
plans for group members
7
European Requirements (cont.)
 Group entities to be permitted to enter into reciprocal advance
agreements to provide financial support (loans, guarantees, asset
transfers) to other group members in financial stress – subject to
shareholder approvals
 Resolution authorities to have early intervention powers when
institution fails, or is likely to fail, to meet its obligations under Capital
Requirements Directive e.g. power to direct institution’s management
to implement one or more of the measures in the recovery plan, to
direct convening of shareholders’ meetings, preparation of a plan to
negotiate a debt restructuring with creditors, or appoint a special
manager to assume powers of management to restore financial
health of the institution
 Resolution authorities to assess “resolvability” (without access to
public funds), and to be given broad powers to remove impediments
to resolvability if not remedied by the institution
8
European Requirements – Resolution
 Objectives of resolution:
 ensure continuity of basic banking functions
 minimise adverse effects on financial stability
 minimise reliance on public sector support
 protect depositors
 protect client funds and assets
• No one objective automatically considered more important, and
resolution authorities to have the ability to balance the weightings of
the objectives as circumstances require
9
European Requirements – Resolution (cont.)
 Resolution triggers to be conformed across member states and will
require determination by resolution authority (or national supervisor,
if different):
 of institution’s failure or likely failure
 that there is no reasonable prospect of preventing failure, e.g. by private sector
involvement or other supervisory action, except by resolution action
 that resolution action is necessary in the public interest
 Determination of Failure/Likely Failure if there are objective grounds
to conclude that the institution:
 is/will be in breach of its minimum capital requirements and has/will have incurred
losses too great to be absorbed by its own funds
 is/will be insolvent on balance sheet test or on cashflow test
 requires extraordinary public support in order to avoid one of the above
10
European Requirements – Principles of
Resolution
 Resolution authorities to be required to observe the following
principles when taking resolution action:
 shareholders/creditors bear “appropriate” shares of losses
 senior management is replaced and bear losses in proportion to their culpability
 creditors of the same class are treated equitably and do not incur greater losses
than they would in a winding-up
 Valuation of assets/ liabilities to be carried out by valuer independent
from institution/ resolution authority
11
European Requirements – Tools and Powers
 Sale of business tool – power to transfer shares or assets/liabilities,
or a combination, to a purchaser on commercial terms without
shareholder approval
 Bridge bank tool – power to transfer some or all assets/liabilities of
the institution to a publicly-owned bridge bank, without shareholder
approval, to be held temporarily with a view to returning those
assets, or the bridge bank, to the private sector
(both of the above options exercisable free from any company
law/securities law constraints)
 Asset separation tool – power to transfer assets/liabilities to a
publicly-owned asset management vehicle, to maximise their value
for eventual sale
 Debt write-down tool – power to write down or write off debt and/or to
convert debt obligations into ordinary shares
12
European Requirements – Ancillary Powers
 Ancillary to the main tools and powers, resolution authorities are to
have power to:
 make any transfers free from encumbrances/pre-emption rights
 de-list any instrument
 provide for recipient of any transfer to step into the shoes of the institution in
resolution, in respect of any contracts or arrangements
 provide for the institution under resolution to provide assistance/information to the
recipient
 modify, cancel or novate any contract entered into by the institution
 provide for business continuity arrangements, such as continuity of contracts
entered into by the institution
13
European Requirements – Ancillary Powers
(cont.)
 Member states must give effect to any transfer, by a resolution
authority of another member state, of assets/liabilities in their
jurisdiction and must ensure that:
 no creditors or third parties have the ability to prevent or set aside such
transactions under the laws of their jurisdiction and
 any use of the debt write-down tool becomes effective in respect of instruments
governed by the laws of their jurisdiction
 Resolution authorities to be able to:
 suspend payment/delivery obligations under contracts of the institution
 suspend rights to enforce security interests
 suspend for a short period the exercise of termination rights under “financial
contracts” e.g. derivatives, repos
14
European Requirements – Ancillary Powers
(cont.)
 Resolution authorities will be able to prevent parties to financial
contracts exercising termination rights:
 where the contract has been transferred to a purchaser/bridge bank which has
assumed the institution’s rights and obligations thereunder
 where debt has been written down/converted under the debt-write down tool, but
not the debt owing under that financial contract
 In those circumstances, they would also be able to prevent the use
of reliance on a clause which would otherwise modify the
counterparties’ obligations (e.g. Section 2(a)(iii) ISDA Master
Agreement)
15
European Requirements – Ancillary Powers
(cont.)
 Set-off rights of the counterparty would not be exercisable against a
purchaser/bridge bank to which the counterparty’s claims under a
contract have been transferred, and in the case of a debt write down
or conversion, would be extinguished to the extent of the write-down
conversion
16
European Requirements – Contents of
Recovery Plans
 Identification of critical functions
 Capital and liquidity actions required to maintain and fund operations
of critical functions and business lines
 Arrangements to conserve/restore the institution’s own funds
 Arrangements to ensure adequate access to contingency funding
sources
 Arrangements to reduce risk and leverage and to restructure
liabilities
 Arrangements to restructure business lines
 Arrangements to maintain continued access to financial market
infrastructure and functioning of IT services and other firm
infrastructure
 Estimate of timeframe for achieving each material part of the plan
 Description of obstacles to effective execution of the plan
17
European Requirements – Resolution Planning
 Resolution authorities can demand various information from
institutions for the purpose of drawing up and maintaining resolution
plans:
 legal/operational structures of the institution or its group
 mapping of business activities to the entities which perform them
 critical economic functions within the group, mapped to business lines
 for each critical economic function, details of market share, relevant balance
sheet information, number and location of customers
 infrastructure supporting critical economic functions e.g. staff, real property,
contracts, licences
 intra-group exposures and exposures to counterparties e.g. hedging liabilities,
collateral pledged
 intra-group contracts and guarantees
18
European Requirements – Resolution Planning
(cont.)
 Proportionality to be applied by member states to contents of
resolution plans, information able to be requested and measures
demanded to remove obstacles to resolvability
 Information for group resolution plans to be submitted to group-level
resolution authority (for parent and for all legal entities part of the
regulatory group)
 Group resolution authority will share information with EBA and
resolution authorities of subsidiaries
 Group resolution plan to be jointly decided on by all authorities
19
UK Progress
 FSA consultation on Recovery and Resolution Plans in August 2011
 Provisions intended to take effect in Q1 2012, with preparation of
RRPs by June 2012
 Applicable to banks and “full service” investment firms with assets of
at least £15bn, not applicable to UK branches of foreign banks
 Recovery plans to be developed and maintained, containing:
 comparative summary of the credible options to cope with various scenarios, both
institution-specific and group specific, but also market-wide stress
 options to address capital shortfalls/liquidity pressures and return the firm to a
stable, sustainable position
 appropriate governance processes, including conditions/procedures for
intervention to ensure prompt implementation of recovery options
20
UK Progress (cont.)
 details of how implementation of the recovery plan fits within the firm’s existing
risk management framework
 explanation of the triggers that would indicate when the plan should be invoked
 list of key executives who would be involved in each recovery action, and their
roles
 a communication plan (internal and external) to accompany the recovery options,
aiming to manage doubts over viability of the firm and preserve confidence of
market
21
UK Progress – Recovery Plans
 Likely recovery plan options include:
 disposals of assets/businesses
 raising additional unplanned–for equity capital
 ceasing payments of dividends, variable remuneration and other discretionary
distributions
 debt exchanges/other liability management action
 sale of whole firm to a third party
 plans to access central bank facilities
 Proportionality – smaller firms likely to have fewer options, therefore
simpler plans
 Recovery options must not prioritise short-term remedial actions over
long-term viability
22
UK Progress – Recovery Plans (cont.)
 Options must meet following minimum criteria:
 benefits of options to be capable of being realised within acceptable timeframe
(no more than 6 months?)
 benefits to be sufficiently material – must make a significant impact on financial
health
 should be sufficiently diverse to cope with both idiosyncratic and market-wide
stress events
 must be credible to stakeholders – depositors, debt holders, counterparties,
shareholders, authorities
23
UK Progress – Resolution Planning
 Firms to provide information in Resolution Pack to FSA (and PRA),
Treasury and Bank of England
 Authorities to prepare resolution plan with following aims:
 ensure resolution without public support
 minimise impact on financial stability
 minimise effect on depositors/consumers
 allow decisions/action to be taken over a “resolution weekend”
 identify those economic functions whose continuity critical to the
economy/financial system and those required to be wound up in an orderly
fashion
 identify/remove barriers to resolution
 for G-SIFIs, enhance international co-operation and crisis management planning
between international regulators
24
UK Progress – Resolution Packs
 Group structure and legal information:
 overall group structure diagram, showing significant legal entities, the group’s
approach to use of branches vs. subsidiaries in different jurisdictions and an idea
of business done in each branch/sub
 high-level understanding of the economic functions performed within, or in some
way dependent on, each significant legal entity and the scale of those activities
 breakdown of group balance sheet by significant legal entity, including details of
committed capital and requirements/restrictions by regulatory jurisdiction
 understanding of major financial dependencies between legal entities as they
affect funding and capital (e.g. intra-group guarantees, cross funding, cash
sweeping, cross-defaults)
 understanding of the firm’s inter connectedness with other banks
 for significant UK legal entities (and any non-UK legal entities that provide major
services to UK economy, details of operational dependencies (shared IT, premises
etc), shared staffing etc
25
UK Progress – Resolution Packs (cont.)
 Economic functions, e.g.
 payment services to facilitate “real economy” transactions
 intermediation of credit and capital to allow “real economy” participants to save,
invest and borrow efficiently
 risk management products and services, to facilitate risk pooling and protect “real
economy” participants against adverse events
 For each economic function:
 key metrics to help understand the scale of each economic function, such as
number of customers, market shares, balance sheet/P&L items attributable to the
economic function
 high level commentary on the impact of potential closure of the economic function
e.g. whether there is sufficient market capacity to fill the gap caused by the
closure
 key metrics for economic functions outside the UK, run through foreign branches
of UK entities
 explanation of which legal entity/entities the economic function sits in (and
alongside which other economic functions)
26
UK Progress – Resolution Packs (cont.)
 Each UK critical economic function to have a contingency analysis
(CFCA), analysing how that particular critical function can be
separated, while either preserving its continuity or preparing for its
orderly winding down
 Analysis would be used to allow the firm to identify barriers to a
resolution over a weekend, and ways to deal with the barriers
 Will lay out key steps required to unplug the economic function,
ready for a transfer
 Authorities will then discuss with the firm actions to address any
significant resolution barriers identified and the costs of these actions
27
UK Progress – Resolution Tools
 Transfer to private sector purchaser – Banking Act 2009
 Transfer to publicly-owned bridge bank – Banking Act 2009
 Debt-write down/ bail-in able debt proposed in ICB Report
 primary and secondary bail-in powers
 ICB acknowledgement that bail-in needs international agreement to
be fully effective
 Difficulties in relation to foreign law contracts, contracts with crossdefault/ termination provisions etc.
28
U.S. Requirements
29
Overview – U.S.
So if you are a big bank or financial institution, you’re no longer
allowed to make risky bets with your customers' deposits. You're
required to write out a "living will" that details exactly how you'll pay
the bills if you fail – because the rest of us are not bailing you out
ever again.
President Obama
State of the Union Address
Jan. 24, 2012
30
Overview – U.S.
 Purpose of the resolution plan
 “Orderly” resolution through existing bankruptcy process
 Avoidance of Lehman Brothers experience
 Roadmap for liquidation through orderly liquidation authority
 Resolution planning is integrated with other Dodd-Frank
requirements
 Capital planning
 Stress testing
 Credit exposure reports
31
Overview – U.S.
 Requirements apply to “covered companies:”
 U.S. bank holding companies with more than $50 billion in consolidated assets
 Nonbank financial companies designated by the Financial Stability Oversight
Council
 Foreign banking organizations with more $50 in worldwide consolidated assets
 Three tiers of institutions and timing requirements
 July 21, 2012: covered companies with more than $250 billion in total nonbank
assets. For foreign-based covered companies, threshold is $250 billion U.S. total
nonbank assets
 July 21, 2013: covered companies with more than $100 billion in total nonbank
assets. For foreign-based covered companies, $100 billion in U.S, nonbank
assets
 December 31, 2013: all other covered companies
 Separate planning requirement at bank level for banks with more than $50
billion in consolidated assets
32
Overview – U.S.
 Plan for “rapid and orderly resolution in the event of material financial
distress or failure.”
 How insured depository institution subsidiaries are protected from risks
arising from activities of nonbank affiliates
 Full description of ownership structure, assets, liabilities, and contractual
obligations
 Identification of cross-guarantees tied to different securities, identification
of major counterparties, and a process for determining to whom the
collateral of the company is pledged
Dodd-Frank Act § 165(d); 12 USC 1851(d)
33
Plan Content
 Scope of DFA Plan
 “Rapid and orderly resolution”
 Using the bankruptcy process to achieve that result
 FBOs: Scope of the DFA Plan is limited to the resolution of entities
based in the U.S.
 FRB and FDIC review of an FBO’s DFA Plan will include consideration of
“[t]he nature and extent of the home country’s related crisis management
and resolution planning requirements.”
 A DFA Plan for an FBO with limited assets or operations in the U.S.
“would be significantly limited in scope and complexity.”
34
Plan Content
 Access to liquidity
 Corporate governance structure and related policies and
procedures
 Credit/derivative exposures (domestic and worldwide)
 Organizational structure and entity-specific functions
 Core business lines
 On- and off-balance sheet exposures
 Core management and employees
 Interrelationships between corporate entities
 Management information systems
35
Plan Content

Content: Eight Minimum Requirements for DFA Plans (generally)
1. An executive summary describing key elements of the strategic plan for
rapid and orderly resolution in the event of material financial distress
2. A strategic analysis describing the plan for rapid and orderly resolution,
including a range of specific actions that would be taken, and a
description of the funding, liquidity, and capital needs of the filing
institution and its material entities
3. A detailed description of corporate governance related to resolution
planning, including how resolution planning is integrated into the
corporate governance structure of the covered company
4. A detailed description of organizational structure and related information,
including lists of all material entities, a mapping of the covered
company’s critical operations and core business lines, and identification
of major counterparties of the covered company
36
Plan Content

Minimum Requirements for DFA Plans (continued)
5. A detailed description of management information systems, including a
detailed inventory and description of systems and applications for risk
management, accounting, and financial regulatory reporting, and a
mapping of key management information systems to the material
entities, critical operations and core business lines of a covered
company
6. If not provided elsewhere, an identification and mapping to the material
entities of the interconnections and interdependencies among the
covered company and its material entities, including common or shared
personnel, capital, funding, or liquidity arrangements
7. Identification of supervisory and regulatory information, including U.S.
and foreign agencies or authorities, along with relevant contact
information
8. Contact information for a senior management official responsible for
serving as a point of contact regarding the resolution plan
37
Plan Content

Certain institutions may be eligible to file a “tailored” DFA Plan.
 The tailored plan option is available only to Covered Companies that
are bank holding companies that have less than $100 billion in total
nonbank assets (Group 3), and whose IDI assets comprise at least 85
percent of the total consolidated assets of the Covered Company.
 Foreign-based Covered Companies are eligible if (i) total U.S.
nonbanking assets are less than $100 billion, and (ii) the assets of any
U.S. IDI operations, branches and agencies constitute 85% or more of
the company’s U.S. total consolidated assets.
 Of the 124 Covered Companies, 104 would currently be eligible to file a
tailored plan.
38
Plan Content

Tailored Plans (continued)
 Tailored plans focus more on the nonbanking operations and
business lines subject to the U.S. Bankruptcy Code, and the
interconnections between the nonbanking operations and the IDI.
 Tailored plans are intended to reduce informational and analytical
burden on majority of filing institutions.
 The practical effect, however, is unclear as IDI Plans will still need to be
filed along with tailored plans.
 FBOs that do not control an IDI chartered in the U.S. should receive the
greatest benefit from the tailored plan option.
39
Agency Review


“Credible Plans” – DFA and IDI Plans must be “credible.”
For purposes of the IDI Plan, the FDIC explains that a plan is
credible if:
 Resolution strategies are well-founded and based on observable or
verifiable conditions.
 Detailed information required is verifiable.
 The plan employs reasonable projections from current and
historical conditions within the broader financial markets.

There is no similar provision in the DFA Plan. FRB and FDIC
acknowledge there is no “one-size-fits-all” approach.
 FRB and FDIC will consider variances in core business lines,
critical operations, foreign operations, capital structure, risk,
complexity, financial activities (including the financial activities of
their subsidiaries), size, and other relevant factors.
40
Agency Review
 Consequences of deficient Plans
 Underlying principle: iterative process and deficiencies can be remedied
 If deficiencies are not remedied, FRB and the FDIC may:
 Impose additional capital, leverage, or liquidity requirements
 Restrict the growth, activities, or operations of the covered company or its
subsidiaries
 Jointly require divestiture of assets or operations as necessary to
facilitate orderly resolution under the Bankruptcy Code, if a covered
company fails to remedy a deficient plan within two years of having been
subjected to such requirements or restrictions
Foreign regulators may be consulted in this circumstance.
41
Related Dodd-Frank Requirements

Work on a DFA Plan must take into account other Dodd-Frank
requirements and agency actions.
 Credit exposure (Dodd-Frank § 165)


New rule on credit exposures to be issued by FRB
Final rule on reports to be coordinated with rule on credit exposures

Interagency guidance released June 29, 2011 (S&R Letter 11-10)
 Stress testing (§ 165(i))




Proposed guidance for banking organizations with more than $10 billion in
consolidated assets, including foreign banking organizations. (76 FR 35072
(June 15, 2011))
Proposed annual capital plans for U.S.-domiciled “top-tier” bank holding
companies, issued June 17, 2011 (76 FR 35351)
Proposed new FR Y-14A, -14Q reports (76 FR 555288 (Sept. 7, 2011)
Included in proposal on enhanced prudential standards (77 Fed. Reg. 594
(Jan. 5, 2012)
42
Related Dodd-Frank Requirements

Other Dodd-Frank requirements and agency actions (cont’d)
 Capital requirements





Contingent capital (§ 165(c))
Collins amendment (§ 171)
Basel III
Inclusion of off-balance sheet assets (§ 165(k))
Countercyclical requirements (§ 616)
 Required restructuring


Volcker Rule (§ 619)
Lincoln Amendment (§ 716)
43
Overlapping Compliance

Other Dodd-Frank requirements and agency actions (cont’d)
 Early remediation (§ 166)


No proposed rule yet
Various remedies could mirror resolution plan elements
 Orderly Liquidation Authority (Title II)







Preventing agency findings that would trigger OLA
Roadmap for FDIC
Public disclosures (§ 165(f))
Short-term debt limits (§ 165(g))
Risk committee (§ 165(h))
Leverage limits (§ 165(j))
Inclusion of off-balance sheet assets in capital calculations (§ 165(k))
44
Annual Planning Cycle








Oct. 1: company begins to collect financial information as of Sept.
30.
Mid-November: company submits regulatory reports to FRB; FRB
supplies stress test scenarios
Mid-November to year end: company conducts internal stress
tests, prepares capital plan and resolution plan
Dec. 31: company submits annual resolution plan
Jan. 5: company submits capital plan and stress test results
Early March: FRB communicates its stress test results to company
March 31: FRB responds to capital plan; company has 30 calendar
days in which to revise plan.
Mid-April: Results of company and FRB stress tests published.
45
FBOs
 Purpose of plan for US regulators
 DFA Plan submitted by an FBO needs to comply with the minimum
required content discussed above, while also addressing:
 U.S. subsidiaries, branches, agencies and operations
 How resolution planning for its U.S. operations is integrated into the FBO’s
overall resolution or other contingency planning process
 Interconnections and interdependencies among its U.S. operations and its
foreign-based operations
46
FBOs (cont.)
 Regulators will “give due regard to the principle of national treatment
and equality of competitive opportunity” and take into account the
regulatory standards for consolidated supervision by the homecountry regulator.
 A possible mechanism to satisfy this “due regard” requirement is the
Crisis Management Group (CMG) that the FSB has discussed.
Each Covered Company would have its own CMG, which would
consist of representatives of all of the jurisdictions in which the
Covered Company had operations and would be led by the homecountry supervisor.
47
Cross-border Issues
 DFA and IDI Plan submissions should be synchronized
with resolution plan deadlines and requirements imposed
by foreign regulators.
 Specific deadlines may differ.
 Foreign regulators may require submissions in 2012 by
U.S. Group 2 institutions.
 UK Financial Services Authority: proposed initial
submissions are due June 2012.
 Financial Services Board: first drafts of recovery plans
are due by December 2011, and first drafts of resolution
plans by June 2012.
48
International Materials

Foreign developments
 Financial Stability Board



Consultative document (July 19, 2011)
Key Attributes of Effective Resolution Regimes for Financial Institutions (Oct. 2011)
Progress Report on Intensity and Effectiveness of SIFI Supervision (Nov. 2011)
 Financial Services Authority


Consultation Paper—CP 11/16 (Aug. 9, 2011)
Turner Review (Mar. 2009)
 Independent Commission on Banking (Vickers Commission)

Final Report (Sept. 2011)
 Basel Committee on Banking Supervision



Final Report of Cross-border Bank Resolution Group (Mar. 2010)
Progress Report (July 2011)
Assessment Methodology and Additional Loss Absorbency for G-SIBs (Nov. 2011)
 G20


Communiqué (Oct. 14-15, 2011)
Identification of G-SIBs (Nov. 2011)
49
RESOLUTION AUTHORITY
Presentation based on
Chapter 8,
“Resolution Authority”, by Acharya,
Adler, Richardson and Roubini
Chapter 11
“Repo Markets”, by Acharya and Oncu
“A Proposal to Resolve the Distress of
Large, Complex Financial Institutions”,
By Acharya, Adler and Richardson
50
An Important Ongoing Debate
 What is “systemic risk”?
 Macro-prudential view: Common factor exposures
 Several entities fail together
 Micro-prudential view: Contagion
 Failure of an entity leads to distress or failures of others
 The two views are not mutually exclusive
 However, much regulatory reform takes one view or the other
 The Dodd-Frank Act is primarily the “micro-prudential view”
51
Resolution Authority under the Act
 Hangs its hat on the creation of Orderly Liquidation Authority (OLA)
 Balancing act between two forces that (potentially) work against each other
 Mitigate moral hazard, bring back market discipline
 Manage systemic risk
 How well does the Dodd-frank do?
 We summarize briefly four problem areas
 We discuss a macro-prudential resolution approach (repos)
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Four Problems with Dodd-Frank OLA
1. Focused on the orderly liquidation of an individual
institution and not the system as a whole.
 Passing losses to SIFI creditors wipes out capital of other SIFIs
 Need an ex-ante Orderly Liquidation Fund (OLF)
2. If the system fails, and monies cannot be recovered from
creditors, surviving SIFIs must make up the difference ex
post.
 Increases moral hazard because of a free rider problem.
 Increases systemic risk as reduces incentives to deviate from the herd.
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Problems with Dodd-Frank OLA (cont.)
3. Restricts the Fed’s 13(3) LOLR ability to deal with nonbanks unless a system wide crisis emerges
 If we have multiple failures, how will an OLA deal with it?
 OLA and funeral plans fail the first time they are tried out…
 No emergency fire service just because we have sprinklers?!
4. Is receivership the right approach in systemic crisis?
 Prompt corrective action and “living wills” helpful
 Ability to set up a “bridge bank” helpful
 Who will run the bridge bank? What is the likelihood a bridge bank will be required for a
firm? Who will fund its operations?
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Fix I: Living Will Approach
 (Academic concept of) “Living will” - Barry Adler, NYU Law
 Divide a firm’s capital structure into priority tranches
 In the event of a default, equity would be eliminated, and lowest-priority debt tranche
would be converted to equity
 If this is isn’t sufficient, the process is repeated until all defaults are cured or the highest
tranche is converted to equity. Only at this point would senior debt-holders have reason
to foreclose on collateral.
 Creditors pay but the cost of financial distress is avoided.
 Issues like “what is the trigger?” and “what happens if the living will can’t stop the
collapse or contagion?” remain.
 “Bail-in” is akin to living will, but iterates just once…
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Fix II: Macro-prudential Resolution
 Systemically important liabilities
 Financier of a SIFI is another SIFI, an entity that is run-prone, or whose run will likely trigger
more runs
 Financial firms are each other’s creditors
 Each firm’s equity has value from credit claim on other firms
 Loss to capital of one firm erodes the capital of other firms
 Individually, firms do not internalize this externality
 System as a whole must put up capital to deal with failures on
systemically important liabilities
 Charge as per each firm’s contribution
 E.g. NYU Stern Systemic Risk Rankings
 For other liabilities, use bail-in or “living will” approach
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Resolution Method
Proposed by
How are systemic
liabilities dealt with?
Pros
Cons
Orderly Liquidation
Authority (OLA)
Dodd-Frank Act,
FDIC
Pass on losses;
Can use Orderly
Liquidation Fund
Deals with
incentives
Does not deal with
systemic risk /
contagion
Contingent capital
Flannery;
Squam Lake
Report
Protected through
CoCo’s that convert to
equity
Creates time for
orderly resolution
What next? Does
not spell out
resolution
Bail-in / Living will
Credit Suisse;
Adler
Progressive losses that
are pre-programmed
Spells out an
orderly resolution
Adequate to deal
with contagion?
Automatic stabilizers
+ Bail-in
Acharya, Adler,
Richardson
Deposit insurance, repo
resolution authority,
CCPs, LOLR, …, Bail-in
Pre-arranges
system-wide
capital for
resolution
Requires capital mgt
at DI Fund, CCH,…
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International Coordination of SIFI
Resolution
1. Identify classes of Systemically Important Liabilities (deposits, repos,
derivatives, SIFI exposures)
2. Require living-will (sequential bail-in) on non-SIL debt; harmonize on
living-will for non-SIL debt
SIL debt:
1. Ensure DI funds are pre-funded, counter-cyclically
2. Create system-wide resolution authorities for other SIL’s
3. Standards for initial and variation/stress-margin requirements at
clearinghouses; manage their risks
4. Require central banks to spell out a priori eligible collateral for LOLR
and charge for these liquidity facilities
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Contacts
 Viral Acharya
C.V. Starr Professor of Economics
NYU Stern School of Business
vacharya@stern.nyu.edu
 Peter Green
Partner, London
Morrison & Foerster (UK) LLP
pgreen@mofo.com
 Dwight Smith
Partner, Washington DC
Morrison & Foerster LLP
dsmith@mofo.com
 Jeremy Jennings-Mares
Partner, London
Morrison & Foerster (UK) LLP
jjenningsmares@mofo.com
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