«Financial Stability Board - by email New York/Copenhagen, February 2nd, 2015 Dear Sir or Madam, This letter is submitted by Jeffrey N. Gordon and W. ...»
Jeffrey N. Gordon, Richard Paul Richman Professor of Law,
Columbia Law School
Wolf-Georg Ringe, Professor of International Commercial Law,
Copenhagen Business School and University of Oxford
Financial Stability Board
- by email New York/Copenhagen, February 2nd, 2015
Dear Sir or Madam,
This letter is submitted by Jeffrey N. Gordon and W. Georg Ringe in connection with
the request for comments by the Financial Stability Board (FSB) in connection with its
Consultation on Loss-Absorbing Capacity of Global Systemically Important Banks in Resolution (“the TLAC Proposal”). Gordon is the Richard Paul Richman Professor at Columbia Law School and, among other responsibilities, co-director of the Millstein Center for Global Markets and Corporate Ownership. Ringe is Professor of International Commercial Law at the Copenhagen Business School. Neither of us represents clients and or has done consulting that would be affected by the outcome of the FBS’s consultation. We would like to submit two forthcoming papers that discuss aspects of the FSB’s TLAC Proposal. One paper, Bank Resolution in the European Banking Union: A Transatlantic Perspective on What It Would Take, will be published in the June 2015 issue of the COLUMBIA LAW REVIEW. Another, Bank Resolution in Europe: the Unfinished Agenda of Structural Reform, will be a chapter in Danny Busch & Guido Ferrarini, eds., EUROPEAN BANKING UNION (Oxford University Press 2015). Both papers are attached to this letter. They are both highly relevant to the FSB’s proposal and this letter may quote from them without specific further attribution.
The TLAC proposal is part of the core message of Basel III and the general FSB program: Banks should not look to sovereigns for rescue. At one level this is a response to taxpayer outrage at “bail-outs.” But even more importantly, Basel III/TLAC is shaped for a global financial environment in which no sovereign (except for the United States, as issuer of the world’s reserve currency) can credibly stand behind its banking system. Many banks, especially in Europe (or any other bank-dominated economy), are simply too large relative to the states that charter them. In the run up to the crisis the US may have permitted financial firms that were “too big to fail”; Europe was filled with banks that were “too big to save.” TLAC is a response to this dilemma, and a welcome and useful addition to the framework for a global resolution standard. On top of a balance sheet structured to reduce the risk of failure -- the capital and liquidity requirements specified in Basel III – a global systemically important bank (G-SIB) must carry a level of bailin-able term debt sufficient to recapitalize the bank even after the equity cushion is fully wiped out by losses. The previous mechanism of providing systemic stability through a crisis, namely, deposit insurance – a scheme by which banks pool risks in a mutual insurance scheme run by a particular government and receive backstopping by the government as a “reinsurer” – plays no frontline role in this regulatory plan. The point is to take sovereigns out of the picture and, through bail-in, to require banks to self-insure.
This set up will work only if the losses that are recognized in the resolution process are less than TLAC, if the resolution does not trigger an own-firm run, and if the own-firm resolution process does not trigger runs by credit suppliers at other financial firms. It is also important for a resolution scheme to facilitate cross-border financial stability, meaning that for transnational financial firms, the resolution system should not encourage opportunistic intra-firm “runs,” designed to reallocate losses within the firm on a national basis, which will in turn spur pre-emptive host country ring-fencing. For this reason, we think the FSB should come down more firmly on the side of a mandatory holding company structure for G-SIBs as part of the TLAC proposal, which should be coupled with a “single point of entry” (SPOE) approach to resolution. Together, these two elements would facilitate efficient resolution.
Where the banking group is organized in a holding company structure, the losses of a bank operating subsidiary can be upstreamed. If the equity layer is insufficient after the resulting write-down, a regulatory authority can trigger a resolution proceeding for the parent only, in which the layer of unsecured term debt can provide additional loss absorbency. Crucially, this avoids putting an operating bank or some other operating financial entity through a resolution procedure that will have unpredictable effects on the solvency of other subsidiaries which may not be put into resolution and will have unpredictable effects on the claims of various credit suppliers, counterparties, and customers of the bank or affiliated financial firm. Such uncertainty is the trigger for a destructive spiral that will destroy value for the bank under resolution with knock-on effects for the financial system.
In our view, the SPOE approach to resolution at the holding company level has at least two additional advantages. First, it makes resolution more transparent and credible, as the bailin-able debt at the holding company level is earmarked and effectively available for regulatory activation. Different from the situation at present, both bank and regulator would be aware of the liabilities available for bail-in, which would enhance transparency and foreseeability of resolution effects; besides, their specific separation for resolution purposes would make assets across the banking group more valuable for their respective purposes. And secondly, SPOE works much better in cross-border situations, facilitating an effective regulatory solution by one resolution authority and bundling the responsibility in one center of control. Indeed, one of the main points of critique of the rival “multiple point of entry” approach is that it would empower several regulators in various jurisdictions and thus create coordination problems, frictions, and a race to grab assets for the purpose of protecting national creditors. As a by-product, the proposed TLAC for material subsidiaries (“internal TLAC”) would thus become redundant.
Finally, resolution through conversion of TLAC in a holding company structure minimizes the risk of destructive runs and may thus reduce the importance of deposit insurance. Under national deposit guarantee schemes, the protection of short term credit providers is incomplete. For example, deposit insurance is usually capped, at EUR 100,000 or USD 250,000. Yet banks are commonly funded through deposits over the insurance cap and other short term credit issuances. Whatever the justice of “pari passu,” as a practical matter short-term creditors, to avoid the prospect of such losses, can “run” simply by refusing to rollover their credit claims. This will trigger the immediate need for a financially stressed bank or its financial affiliates to shrink their balance sheet to match the corresponding fall off in funding. This is how financial crises begin. Resolution run through a holding company offers such short term credit providers the protection of a structurally subordinated debt layer. This is the argument for a thick enough layer to provide assurance, if not insurance, of loss-protection. The other side of the argument is this: for a given level of TLAC, the holding company structure, because it facilitates efficient resolution, will provide greater systemic stability. If TLAC is costly, then increasing its systemic potency is cost-justified. Putting it differently: if all global SIBs were to use a holding company structure, the TLAC required as a worldwide standard would be significantly lower.
The superiority of the holding company approach to resolution becomes apparent in the TLAC consultative document itself, in which one of the specifically identified areas of concern is the “prepositioning” of TLAC in the various “material subsidiaries” of the bank, based not only on line of business but also to address home/host problems, so as to assure that “TLAC is readily and reliably available to recapitalize subsidiaries as necessary to support resolution.” Such efforts to place not just capital but also subordinated (by contract) term debt on the balance sheet of the different subsidiaries of a large bank is highly unlikely to lead to smooth resolution in a crisis. One “host” grabbing more TLAC than it strictly needs to resolve a failed subsidiary within its jurisdiction (meaning other subsidiaries of the banking group are now less secure), one court interpreting the complex subordinated provisions of a bond issuance – these are sufficient to inject uncertainty that will destabilize the entire system.
To return to the insurance analogy: the capital and the subordinated term debt that constitute TLAC should be understood as self-insurance for the credit claims that cannot be allowed to default, namely deposits and other short term credit claims. Avoiding default on such claims is a matter of practical necessity, not morality, because otherwise during times of financial distress, such default risk will produce runs, fire sales, and the negative spiral that transmutes distress into a financial crisis that damages the real economy. Some governments are simply not in a position to provide such insurance, both because of financial constraints at the single country level, and, as recent debates in the European Union have demonstrated, the challenges of credible transnational support. An approach that looks to resolve particular failing subsidiaries or affiliates within a banking group will require prepositioning of TLAC throughout the group. This is bound to be highly inefficient and will lead to destabilizing forbearance on how TLAC will be provided. Think of an industrial concern with multiple plants, each one of which is required to carry separate fire insurance sufficient to rebuild the plant – and the value of any particular plant will vary over time, given that the plant’s business activities may decline or increase depending on the business environment. Yet not all the plants will catch fire at the same time. The excess costs of this scheme if complied with literally are likely to lead to underinsurance at the individual plant level -- noncompliance -- and/or some sort of transferrable insurance rights or guarantees within the group that will lead to haggling and shortfalls at crunch time. So it is likely to be with prepositioned TLAC throughout a complex banking group, except that the consequences will be more dire.
Put otherwise, efficient resolution might be consistent with a banking group structured through multiple intermediate holding companies, but only for banking groups that operate in distinct functional or regional units, with little integration among the units, so that it is genuinely possible to address these units separately even in the heat of a crisis.
For banks that operate in a “single market” or find value as a world-wide integrated financial institution, a holding company structure, in which TLAC is located at the holding company level, offers the greatest chance for efficient resolution. Efficient resolution also means greater stability at a given level of TLAC.
We are grateful for very helpful comments on prior presentations of this work by participants at the European Banking Union conference that preceded this book, the ESSET seminar in Gerzensee, and the EU Financial Architecture session at the World Bank Law, Justice and Development Week Conference, and various EU and governmental officials who have given us informal reactions.
© Jeffrey N. Gordon and Wolf-Georg Ringe 2015. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.
Electronic copy available at: http://ssrn.com/abstract=2548251
AbstractThis chapter argues that the work of the European Banking Union remains incomplete in one important respect, the structural re-organization of large European financial firms that would make “resolution” of a systemically important financial firm a credible alternative to bail-out or some other sort of taxpayer assistance. A holding company structure in which the public parent holds unsecured term debt sufficient to cover losses at an operating financial subsidiary would facilitate a “Single Point of Entry” resolution procedure that would minimize knock-on effects from the failure of a systemically important financial institution.
Resolution through such a structure would minimize run risk from short term creditors and minimize destructive ringfencing by national regulators. Although structural reform in the EU could be achieved by supervisory implementation of the “living wills” requirement for effective resolution or irresistible incentives through capital charges, it would be best obtained through addition to the EU’s Proposed Structural Measures Regulation now under consideration.
Keywords: bank resolution, bank structural regulation, single point of entry, bank holding company JEL Classifications: G21, G33, K20
Bank Resolution in Europe: the Unfinished Agenda of Structural Reform [forthcoming in Danny Busch & Guido Ferrarini, eds., EUROPEAN BANKING UNION (Oxford University Press, 2015)]
This chapter argues that the work of the European Banking Union remains incomplete in one important respect, the structural re-organization of large European financial firms that would make “resolution” of a systemically important financial firm a credible alternative to bail-out or some other sort of taxpayer assistance. A holding company structure in which the public parent holds unsecured term debt sufficient to cover losses at an operating financial subsidiary would facilitate a “Single Point of Entry” resolution procedure that would minimize knock-on effects from the failure of a systemically important financial institution. Resolution through such a structure would minimize run risk from short term creditors and minimize destructive ringfencing by national regulators. Although structural reform in the EU could be achieved by supervisory implementation of the “living wills” requirement for effective resolution or irresistible incentives through capital charges, it would be best obtained through addition to the EU’s Proposed Structural Measures Regulation now under consideration.