Tolling the Bell for "Too-Big-to-Fail"? – A Comparison Between Four Special Bank Resolution Regimes

Iwasa, Yoichi; Vollmer, Uwe Article Tolling the Bell for "Too-Big-to-Fail"? – A Comparison Between Four Special Bank Resolution Regimes Credit and Capital Markets – Kredit und Kapital Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Iwasa, Yoichi; Vollmer, Uwe (2017) : Tolling the Bell for "Too-Big-to-Fail"? – A Comparison Between Four Special Bank Resolution Regimes, Credit and Capital Markets – Kredit und Kapital, ISSN 2199-1235, Duncker & Humblot, Berlin, Vol. 50, Iss. 4, pp. 509-543, https://doi.org/10.3790/ccm.50.4.509 This Version is available at: https://hdl.handle.net/10419/293822 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Credit and Capital Markets 4 / 2017 Tolling the Bell for “Too-Big-to-Fail”? – A Comparison Between Four Special Bank Resolution Regimes Yoichi Iwasa and Uwe Vollmer* Abstract In many countries, legislators have introduced special bank resolution regimes in order to handle the “too-big-to-fail”-(TBTF)-problem. Bank resolution schemes allow supervisors to restructure or liquidate an ailing bank, even without the consent of the bank owners. We identify key elements of bank resolution schemes and consider how they are implemented in Japan, the US, the Euro area, and in the UK. We compare the bank resolution regimes in these countries and evaluate whether they comply with the “Key Attributes” proposed by the Financial Stability Board. We also ask whether they are effective in addressing the TBTF-problem and promoting financial stability. Das Ende von “Too-Big-to-Fail”? – Ein Vergleich zwischen vier Bankabwicklungsregimen Zusammenfassung In vielen Ländern hat der Gesetzgeber spezielle Abwicklungsinstrumente für Banken geschaffen, um das „Too-big-to-fail“-(TBTF)-Problem zu lösen. Diese Instrumente erlauben es der Bankenaufsicht, in finanzielle Schwierigkeiten geratenen Banken zu sanieren oder zu liquidieren – auch ohne Zustimmung der Eigentümer. Wir identifizieren Kernelemente von Bankenabwicklungsregimen und prüfen, wie diese umgesetzt wurden in Japan, den USA, der Eurozone und in Großbritannien. Wir vergleichen die in diesen Ländern bestehenden Bankenabwicklungsregime und fragen, inwieweit sie den „Key Attributes“ genügen, die vom Financial Stability Board vorgegeben wurden. Wir fragen auch, inwieweit die nationalen Abwicklungsregime das TBTF-Problem lösen und zur finanziellen Stabilität beitragen können. Keywords: Bank resolution, too-big-to-fail, statutory bail-in, bank levy, resolution fund, single-point-of-entry, multiple-point-of-entry JEL Classification: G01, G21, G38 * Prof. (em.) Dr. Yoichi Iwasa, Kansai University, Faculty of Business and Commerce, 3-3-35, Yamate-cho, Suita-shi, Osaka, 564-8680, Japan, E-Mail: [email protected]. Prof. Dr. Uwe Vollmer, University of Leipzig, Economics Department, Institute for Theoretical Economics, Grimmaische Str. 12, D-04109 Leipzig, Germany, E-Mail: [email protected]pzig.de. Corresponding author. Credit and Capital Markets, Volume 50, Issue 4, pp. 509–543 Scientific Papers OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 510 Yoichi Iwasa and Uwe Vollmer Credit and Capital Markets 4 / 2017 I. Introduction In reaction to the recent financial crisis, legislators in many countries amended their banking legislation in order to increase the stability of the financial system. One of the most far-reaching reforms was the introduction of special bank resolution regimes. They allow supervisors to intervene in the business of a bank before balance sheet insolvency has occurred – even without the consent of the bank owners. Such amendments to banking laws became necessary, because general corporate bankruptcy procedures often need too much time, inhibit any pre-emptive intervention and do not take into account the systemic effects of a bank failure (Hüpkes 2005; Brierley 2009; Alexander 2009). Supervisors very often had only the choice between permitting disorderly bank insolvency or approving a bank-bailout and injecting taxpayer money into banks. Because the macroeconomic costs of disorderly bank insolvency were regarded as excessive, politicians were tempted to choose a bail-out of ailing banks (Çihak / Near 2012).2 Special bank resolution schemes offer bank regulators a new instrument for handling the failure of banks and other financial institutions, which are regarded as “too-big-to fail” (TBTF) or “too-interconnected-to-fail” (TITF).3 They allow supervisors to withdraw property rights from bank owners and to reorganize or liquidate the bank before balance sheet insolvency has occurred. This is expected to enable the market exit of large financial firms without severe systemic disruptions and without exposing taxpayers to loss (Financial Stability Board 2014a). Moreover, bank resolution regimes may also induce bank owners to take less risk, so that the banking system becomes more stable ex ante (Dewatripont etal. 2010).4 The paper compares and evaluates the special bank resolution schemes in four different countries.5 The focus is on bank resolution schemes, because they are 2 Examples are the bail-outs of Northern Rock in the UK, Commerzbank AG and West-LB in Germany, Goldman-Sachs in the USA, or the Long Term Credit Bank in Japan. The liquidation of Lehman Brothers constitutes a case of a disorderly insolvency; as explained in Bernanke (2015), the US Government had no bank resolution instruments at its disposal at that time. 3 The term “special bank resolution” refers to the fact that the resolution process is different from an ordinary insolvency procedure and that it is applied only in a special case, namely in case of resolution of large, systemically important financial institutions. The new resolution regimes are denoted “Orderly Resolution Scheme” in Japan, “Orderly Liquidation Authority” in the US, “Special Resolution Regime” in the UK, and “Bank Recovery and Resolution Scheme” in the EU. 4 For evidence on the influence of special resolution scheme on risk-taking of US banks, see Ignatowski / Kor te (2014). 5 We use the term “countries”, although we are of course aware that the Euro area is a community of national states. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 Tolling the Bell for “Too-Big-to-Fail”? 511 Credit and Capital Markets 4 / 2017 a major regulatory innovation and form the most significant policy reaction to the recent financial crisis. We take a comparative perspective because there is some evidence that regulatory differences between countries are determinants of cross-border financial flows and that an incomplete financial integration may destabilize financial markets.6 We use the “Key Attributes” proposed by the Financial Stability Board (2014) as a benchmark for evaluating the different resolution regimes. We consider Japan, the US, the Euro area, and the UK, which have well-organized and highly-developed financial systems.7 Moreover, their financial sectors are among the largest in the world and are significant from the viewpoint of systemic risk. The main purpose of the paper is to find out which elements of a bank resolution regime are indispensable and which are supplemental for financial stability. We do not explain why different countries chose different resolution regimes nor evaluate how differences in bank resolution regimes reflect differences in national banking systems. Instead, we pose the following questions: What are the key elements of a bank resolution scheme and how do they contribute to financial stability? How are bank resolution schemes currently designed in the four countries? Do they comply with the “Key Attributes” proposed by the FSB? What are the strengths and the weaknesses of these regimes? Do they help promote financial stability without inducing banks to become “Too-big-to-fail”? We find that bank resolution regimes differ significantly among the four countries under review. While we are not able to provide a rigid “rank-order” between resolution regimes, we identify several strengths and deficiencies in the resolution regimes. Other research also compares bank regulatory regimes in Japan, the US, and Europe, but does not explicitly take into account special bank resolution schemes, since these are rather new (Barth etal. 2006; Bebenroth etal. 2009; Konoe 2014). Some papers analyze the crisis resolution instruments in Japan and in the Nordic countries during the financial crises of the 1990s (Honkapohja 2009; Diemer / Vollmer 2015). They mention the bank resolution regimes introduced in Japan during the 1990s, but do not analyze the current resolution schemes. Finally, some papers focus on bank resolution regimes and take a comparative perspective (Brierley 2009), but only few of them consider the recent European legislation (Haentjens / Janssen 2015). 6 For evidence that multinational banks conduct “regulatory arbitrage” and react to regulatory differences, see Houston etal. (2012), Karolyi etal. (2015), and Reinhardt / Sowerbutts (2015). Acharya (2003) and Draghi (2014) argue that incomplete financial integration may endanger financial stability. 7 We exclude China from the sample because it does not have a special bank resolution regime. Instead banks, are subject to resolution under a combination of general insolvency law and certain special rules in the Commercial Bank Law. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 512 Yoichi Iwasa and Uwe Vollmer Credit and Capital Markets 4 / 2017 The remainder of the paper is organized as follows. Section 2 reviews the literature in order to identify key elements of a bank resolution regime. Section 3 describes the design of bank resolution schemes in the countries under consideration. Section 4 compares, and section 5 assesses the four resolution regimes. Section 6 concludes. II. What Do We Know About Special Bank Resolution Schemes? 1. Key Elements of Special Bank Resolution Procedures In general, a bank resolution scheme enables a specified authority to intervene in the business of a bank, even if the bank has not violated any law or broken other rules. The intervention could be a restructuring or a liquidation of the bank, and consent by the bank owners is often not even necessary. The intervention may occur immediately after the bank has become insolvent and liabilities have begun to exceed assets (“post-insolvency resolution”). This will usually be declared on the Friday after the insolvency has occurred, so that the resolution procedure will be wound-up over the weekend. The intervention may also start even before balance-sheet-insolvency, that is, when resolution authorities receive signals that this could happen or is likely to happen in the near future (“pre-insolvency resolution”). Since the time window for a post-insolvency resolution procedure is often very small, resolution authorities may require banks to write recovery and resolution plans (“living wills”) and lay open their most fundamental financial relationships with other institutions. The resolution authority in turn has to continue the business of the resolved bank and continue with deposit payments, even if the bank will eventually be liquidated. For that purpose, some financial inflows have to be made into the ailing bank in order to maintain its necessary ongoing business. This financial inflow could comprise taxpayer money or come from a special bank resolution fund financed by a bank levy paid by all banks in advance. If the bank is liquidated, depositors are protected under a deposit insurance scheme, at least up to a covered amount. All other creditors may lose their investment in the bank whenever a bail-in mechanism is stipulated. Such bail-in mechanisms may or may not apply to all liabilities (such as interbank liabilities) and may follow a hierarchy. The bank resolution scheme must stipulate in advance, which authority in which country has to make the final resolution decision and who is responsible for triggering and implementing the resolution mechanism. This could be a specialized banking authority, the deposit insurance agency, or the central bank. The scheme must also codify the conditions under which a resolution procedure is triggered and decide whether or not the bank owner’s consent is necesOPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 Tolling the Bell for “Too-Big-to-Fail”? 513 Credit and Capital Markets 4 / 2017 sary in order to start the resolution procedure. If consent is not necessary, bank owners must have the right to take legal action. In addition, the resolution scheme must codify whether a conversion of debt in equity is permitted. In such cases, the resolution scheme must guarantee that no creditor is worse off in comparison with a (counterfactual) regular insolvency procedure. Finally, in cases of multinational banks or banking groups dealing with cross-border activities, agreements have to be reached about how losses are shared between home-country and host-country stakeholders. 2. Choice of Resolution Authority The authority in charge of triggering and implementing the resolution procedure should have access to supervisory information about the banks. It should also possess enough funds to finance a resolution process. Moreover, the authority should be concerned primarily with making resolution decisions in order to avoid conflicts of interest. Seen from this perspective, a first-best choice would be a specialized resolution authority equipped with its own resolution fund (financed by a bank levy) and sufficient supervisory resources. However, if the authority co-exists together with a central bank and with a deposit insurance authority, this solution would be very expensive. Hence, as a second best choice, bank resolution tasks might be combined with other regulatory tasks in the financial sector, because in this constellation, conflicts of interests may be important. One option could be the transfer of bank resolution powers to the central bank, which is often also engaged in bank supervision and, as a centre of money market operations, is well informed about the liquidity flows of commercial banks. Yet, conflicts of interest could emerge between the functions of a central bank as a resolution authority and its monetary policy functions (Goodhard / Schoenmakers 1993, 1995; Haubricht 1997). It is conceivable that a central bank refrains from increasing interest rates in order to avoid this threatening the solvency of major commercial banks (which later have to be resolved and recapitalized by the same central bank). In addition, the function of a resolution authority could endanger central bank independence, if resolution decisions are subject to legal actions taken by bank owners (Vieten / Neyer 2014). 3. Which Resolution Tool Should be Used? Authorities have different tools available for a bank resolution procedure and can use them individually or in combination (Dewatripont etal. 2010). The first tool is to sell the bank in toto or in part to an assuming bank (“sale of business tool”, “purchase and assumption transaction”, P&A). If no buyer is available, the OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 514 Yoichi Iwasa and Uwe Vollmer Credit and Capital Markets 4 / 2017 authorities may nationalize the bank and transfer it in entirety or in part to a bridge institution, which maintains the bank’s vital functions and is controlled by the resolution authority (“bridge bank tool”). Alternatively, the ailing bank’s assets may be transferred to an asset management vehicle, which is also controlled by the resolution authority. The asset management vehicle maintains not only the selected bank’s vital functions, but sells the other junk assets or winds them down in an orderly fashion (“asset management tool” or “bad bank tool”). It may be suited to avoid a credit crunch (Hauck / Neyer / Vieten 2015). Since, in any case, the bank is liquidated as a legal entity and thus its franchise value is gone, all three resolution instruments may be regarded as “gone-concern” tools. This is different for the last resolution tool, which is a bail-in procedure and can be used as a means of recapitalizing the bank. Bail-in comprises a statutory power of a resolution authority to restructure the liabilities of a bank by writing down liabilities and / or converting the unsecured debt into equity. As a “going-concern” form of resolution, the bank remains open and retains its legal entity (Zhou etal. 2012). The bail-in using statutory powers differs from contractual arrangements, such as the use of contingent convertible bonds (“coco bonds”). While the management of the bank responsible for the loss of capital is usually removed, the risk of contagion in consequence of disorderly liquidations is mitigated, since the bank is deleveraged without its assets being liquidated. On the other hand, however, a statutory bail-in renders difficult financing by issuing such eligible debts in markets. Moreover, if it is applied to a failed bank, creditors of other banks who hold the same kind of debts may run to the bank in order to cancel the debts before maturity. This could indeed lead to contagion (Okina 2015). In order to form an effective tool, (i.) existing equity shares should be eliminated before the bail-in process of debt is started, and (ii.) debt restructuring should take into account the order of priorities applicable in a liquidation procedure. Debt restructuring should not be subject to the consent of debtors, because that would be too time-consuming. However, for fairness reasons, a “no creditor worse off” safeguard (NCWO-clause) should be incorporated, which guarantees that no creditor is worse off than with an ordinary insolvency procedure. Moreover, it may be appropriate to eliminate some types of unsecured debt from the bail-in process, such as inter-bank deposits, because they may be of systemic importance (Zhou etal. 2012; Schwödiauer 2013). A bail-in procedure has the advantage that no fire sales of assets are needed. Moreover, there is no need to find a purchaser for the bank, which could be difficult, due to time constraints. This contrasts with an asset management tool, which may destroy some of the franchise value of the bank, and with a P&A transaction which could take a very long time to find a buyer for an ailing bank. Even a bridge bank tool is only a temporary instrument, because the bridge OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 Tolling the Bell for “Too-Big-to-Fail”? 515 Credit and Capital Markets 4 / 2017 bank eventually has to be sold to an assuming bank. The weakness of a bail-in procedure is that the bank retains its loss-making business lines and that bad assets remain on its balance sheet, which could undermine investor confidence. Moreover, if the bank’s operations are fundamentally unsound and need to be restructured, bail-in capital could then simply delay the inevitable failure. Finally, a bail-in may not be applicable if there is the threat of systemic collapse (Avgoulaeas / Goodhart 2014; Zhou etal. 2014).8 4. How Useful are a Bank Levy and a Bank Resolution Fund? Even though a major goal of any bank resolution regime is to prevent the reappearance of government-funded bail-outs, some capital injections will be necessary during resolution. There are two reasons for this. First, under a gone-concern procedure, bank assets have to be written down or the ailing bank has to be recapitalized before it can be sold to an assuming bank. Second, under a going-concern procedure, a NCWO-clause has to be honoured. Subsequent payments to creditors may then become necessary if they could prove that they were made worse off compared to a regular insolvency procedure. In order to make the payments, resolution authorities may build up a resolution fund ex ante or alternatively may collect ex post the necessary amount from the banking industry. The build-up of a frontloaded resolution fund may imply that some cash-management abilities are needed. In addition, there is either the risk that the fund is too small to cover all expenses or the possibility that bank contributions become a huge burden and harm financial stability. On the other hand, the collection of payments from the industry ex post may not be time-consistent and the resolution authority may lack effective means of pressure to force banks to pay. A natural way to finance a resolution fund is to charge a bank levy. This is a tax either on the bank’s assets or on its liabilities (Schweikhardt / Wahrenburg 2014; Buch / Hilber / Tonzer 2016).9 Ideally, the bank levy should work like a Pigovian tax and internalize the externalities caused by contagion in reaction to a bank failure. To this end, the levy should be charged on the liabilities of the bank in order to penalize excessive leveraging. Equity and covered deposits should be excluded from contribution-relevant positions. This also prevents a 8 Klimek etal. (2015) compare P&A, bail-out, and bail-in as a resolution mechanism and find in their simulations that bail-out schemes never outperform bail-ins with private sector involvement. 9 A “bank levy” should not be confused with either a “finance transaction tax”, which imposes a tax on financial transactions, or with a “financial activity tax”, which penalizes the bank’s profits or remunerations. See Buch etal. (2016). All types of levies could be charged side by side at the same time. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 516 Yoichi Iwasa and Uwe Vollmer Credit and Capital Markets 4 / 2017 double charging of deposits under the bank levy and by the deposit insurance, and it avoids conflicts with capital regulation. Larger banks and those which are more interconnected with other banks should be charged a larger bank levy in order to cope with the TBTF and TITF problems; the same applies to banks which are more involved in trading with risky derivatives (Buch etal. 2016). This implies that the charge should be risk-based, as well as size-based. 5. How Efficient are Pre-insolvency Resolution Procedures? Unlike post-insolvency resolution procedures, pre-insolvency procedures give the resolution authority more time to prepare and to implement the resolution process. The flipside, however, is that the authority has to rely on supervisory information about the likelihood that the bank concerned is going to fail in the near future. This information may be of good quality only when supervision is by the resolution authority itself. Otherwise, information leakages may occur and cause two types of mistake. The resolution authority could close a bank that should be left open (“type-1-mistake”) or vice versa (“type-2-mistake”). In this scenario, the usefulness of a pre-insolvency resolution mechanism as an instrument for preventing excess risk-taking by banks may depend on the quality of the supervisory information available to the resolution authority (Vollmer / Wiese 2013). 6. Cross-border Challenges to the Resolution Process of G-SIFIs In case of resolving multinational banks with subsidiaries in different countries (G-SIFIs), authorities have to allocate decision-making powers and enter ex ante into an international burden-sharing arrangement. As of November 2016, there were 30 SIBS worldwide, mostly in the US and the Euro area (Table 1). For G-SIFIS, authorities have to decide how losses are to be divided among stakeholders from the different countries involved. It is possible to differentiate between two alternative stylised resolution strategies (Financial Stability Board 2013; Faia / Weder di Mauro 2015). Under a single-point-of-entry (SPE) approach, the resolution procedure is executed by the authority of the country in which the multinational bank’s holding company is located. The resolution procedure is carried out top down, beginning with the holding company, independently of where the problems originate. In such cases, the loss-absorbing capacity of stakeholders is shared across jurisdictions. By contrast, under a multiple-point-of-entry (MPE) approach, the authorities from the host country of the multinational bank’s subsidiaries are in charge of the resolution procedure. This implies that stakeholders in the host-countries where the subsidiaries are located carry the financial burden. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 Tolling the Bell for “Too-Big-to-Fail”? 523 Credit and Capital Markets 4 / 2017 start of receivership. If FDIC and the Secretary of the Treasury agree to the specific plan and schedule of the debt repayment, the remaining 90 % of the funds can be raised in a similar manner. In any event, all debt to the Treasury must be repaid within 60 months after issuing the debts (except where there is a serious risk of an adverse effect on the financial system). If contributions from shareholders and creditors are ultimately insufficient for the liquidation procedure, “risk-based assessment” will be charged on “eligible financial companies”. They include bank holding companies with consolidated assets of more than 50 bn. dollars and non-bank financial companies both of which are under regulation by the FRB. Financial resources required for the Orderly Liquidation Assistance procedure are deposited at the “Orderly Liquidation Fund” (OLF). They are used by the receiver (FDIC) with the agreement of the Secretary of the Treasury to the liquidation plan. The OLF does not collect money from the covered financial companies in advance, but charges money later if necessary, after the liquidation procedure has started, as described above. 3. Euro Area Several countries from the Euro area enacted national special bank recovery and resolution laws immediately after the breakout of the subprime crisis (Haentjens / Janssen 2015). These laws allow regulators to deal with systemically important banks in case of financial distress. National legislators followed proposals made earlier by the Basel Committee on Bank Supervision and by the Financial Stability Board, which had proposed the development of national resolution regimes and an improved coordination between national supervisors. Within the European Union, the commission also started to introduce a common resolution framework as part of the European Banking Union (EBU). With the start of EBU in November 2014, bank supervisory responsibility was transferred from the national to the European level.12 The EBU consists of three pillars, namely the “Single Supervisory Mechanism“ (SSM), the “Single Resolution Mechanism“ (SRM) and a common European deposit guarantee scheme (“European Deposit Insurance System“ – EDIS). According to the SSM, the European Central Bank (ECB) supervises all systemically important banks within the Euro area. This covers all large banks with a total balance sheet exceeding 30 bn. Euros or of more than 20 percent of the GDP of their home 12 All Member Countries of the Euro area are automatically also members of the European Banking Union. EU Member States which have not yet introduced the Euro have the opportunity to “opt-in” and to establish “close cooperation” with the European Central Bank, i. e., they may adopt the mechanisms of the EBU. Currently, only Denmark is interested in making this decision. See, e. g., Vollmer (2016). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 524 Yoichi Iwasa and Uwe Vollmer Credit and Capital Markets 4 / 2017 country (at least 5 bn. Euros). In addition, banks that receive financial assistance from the European Stability Mechanism (ESM) and the three largest banks within every member country are also supervised by the ECB; a bank with cross-border activity can also be declared as systemically significant. Smaller and less significant banks are still supervised by National Competent Authorities (Deutsche Bundesbank 2013; European Commission 2013; European Central Bank 2014). The “Single Resolution Mechanism” (SRM), which started operation in early 2015, supplements the SSM. The SRM consists out of two parts, an “institutional framework” and a “financial fundament” (European Commission 2014; German Federal Ministry of Finance 2014). The “institutional framework” comprises a bank resolution authority (“Single Resolution Board”, SRB), which is a fully independent authority of the European Union and is financed by contributions from the banking sector.13 Upon notification from the ECB that a bank is failing or likely to fail, the Single Resolution Board will prepare and implement the restructuring or resolution of the ailing institution. The Single Resolution Board also decides whether resources from the “Single Resolution Fund” are to be used for resolution. While the SRB is the European Resolution Authority, the final decision on whether or not an ailing bank is resolved lies with the European Commission and the European Council. Once the SRB has decided about the adoption of the resolution scheme, it has to inform the European Commission (EC). The EC in turn has to accept the resolution plan (within 24 hours) or to propose to the European Council (within 12 hours) either to object to the resolution scheme or to submit a substantial revision. The resolution concept may enter into force if neither the EC nor the European Council has objected within a time period of 24 hours.14 In case of objection, the SRB has to modify the resolution scheme within eight hours (Deutsche Bundesbank 2014). Once resolution has been decided, SRB possesses four resolution tools: A sale of business (or P&A) tool, a bridge institution tool, an asset separation tool, and finally, a bail-in tool. A government financial assistance tool may also be used, 13 The SRB is located in Brussels and has a staff of around 250. The board operates in two sessions. The executive session makes preparatory and operational decisions for resolving individual banks; participants are the chairperson of the board, the four permanent members and representatives of the national authorities where the bank is established. Only decisions involving financial support of up to 5 bn. Euros are discussed. In the plenary session, individual resolution cases are decided, if the support for a bank exceeds 5 bn. Euros. A single majority representing 30 % of the contributions to the fund takes decisions, involving the use of existing financial means of the fund; in other cases, a larger majority is needed. 14 The EC is entitled to base its objections on the discretionary elements of the resolution scheme; the Council may object to an SRB decision if resolution is not in the public interest. See Deutsche Bundesbank (2014). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 Tolling the Bell for “Too-Big-to-Fail”? 525 Credit and Capital Markets 4 / 2017 but only as a last resort (Deutsche Bundesbank 2014). With the sale of business tool, the ailing bank is sold and transferred to an assuming bank; the consent of the former bank owners is not necessary (the consent of the buyer is required, however). If no recipient is available, assets and liabilities of the ailing bank may be transferred to a bridge institution, which is established and operated specifically for this purpose by the resolution authority. The bridge bank should be sold as soon as possible (within two years). While both the sale of business tool and the bridge bank tool treat the bank as a going concern, the bank is wound down under the asset-separation tool. In such cases, assets are sold individually, while assets not worthy of being maintained are transferred to an asset management vehicle or a “bad bank”. Under the bail-in tool, the resolution authority determines the bank’s cumulative losses and assesses the amount needed to return the bank’s net asset value to zero. In order to absorb losses, the resolution authority either writes down unsecured debt instruments or converts them into equity capital, using a pecking order or liability cascade (Benczur etal. 2016). This encompasses all of an institution’s unsecured liabilities and not just instruments subject to an explicit subordination agreement. The first instrument to be written down is regulatory capital (common equity tier-1 capital, additional tier-1 capital instruments, tier-2 capital), followed by subordinated debt, other eligible liabilities and finally, deposits held by households and small companies that are not covered by deposit insurance schemes (“depositor preference”). This scheme has to make cash contributions in the amount by which deposits would have been written down without the exemption. Some claims (such as short-term interbank liabilities with an initial maturity of less than seven days) are excluded from the liability cascade by law (Deutsche Bundesbank 2014).15 The “financial fundament” of the resolution mechanism is formed by a ”Single Resolution Fund” (SRF), which was mentioned above, and is used only after the liability cascade has ended. The resolution fund is built up within eight years and shall be administered by the SRB. The ultimate capacity (i. e., target funding) shall be 1 % of all insured deposits which will be 55 bn. Euros, measured by the current volume of deposits. The Resolution Fund will be financed by an ex ante bank levy which has to be paid by all banks within the European Banking Union. The Fund may also raise money from the capital markets. As long as the common European Bank Resolution Fund has not been implemented, the financial fundament starts with a system of national resolution funds, which are financed by national bank levies. Starting in 2016, these levies are transferred to national compartments within the SRF, where they will be merged progressively 15 This gives helps to prevent contagion in the interbank markets, but also gives banks an incentive to borrow short-term on the interbank markets, which is less stable than long-term lending (Deutsche Bundesbank 2014). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 526 Yoichi Iwasa and Uwe Vollmer Credit and Capital Markets 4 / 2017 into a single mutualized fund; lending between the national funds will be possible (German Federal Ministry of Finance 2014, European Commission 2014). Funds from the Single Resolution Fund can only be used for financing the resolution after a bail-in of equity and debt of at least 8 per cent of the bank’s balance sheet total has been applied. The maximum amount for the SRF to be injected into a bank resolution process is 5 per cent of the bank’s total balance sheet. After all components of the liability cascade have been exhausted, the SRF will be able to borrow from the ESM (Deutsche Bundesbank 2014). Within the European Banking Union, national deposit insurance schemes will gradually (step-by-step) be transferred into a common single deposit guarantee scheme, “European Deposit Insurance Scheme” (EDIS). Transformation will be completed by 2024. The common deposit insurance scheme will be managed by the Single Resolution Board, which will administer EDIS together with the Single Resolution Fund (European Commission 2014). 4. United Kingdom The UK was the first country that introduced a special bank resolution regime during the recent financial crisis. The main reason was the failure of “Northern Rock” in 2007, which received special loan funds from the Bank of England (BOE). On February 17, 2008, the BOE temporally nationalized Northern Rock and (unsuccessfully) searched for an assuming bank (Shin 2008). Since a P&A transaction failed, the resolution of Northern Rock was implemented under the Banking (Special Provisions) Act 2008; yet, the ex-owner appealed to the court, arguing that the procedure was illegitimate, because it violated the owner’s rights, using an improper estimation of the company’s value. The owner eventually lost the lawsuit. In reaction to this case, the UK Banking Act was amended in February 2009, which incorporated a special resolution regime. The regime was subsequently amended and further strengthened, reflecting the FSBs “Key Attributes” and the provisions of the European legislation, namely BRRD (Bank of England 2014). The scope of the UK resolution regime is not limited to SIFIs, but applies to various types of ailing financial institutions, including deposit-taking institutions (such as banks and building societies) and investment firms. It aims at resolving these financial institutions without causing severe financial instability and without exposing taxpayers to losses, which should be covered by equity holders and unsecured creditors. Under the UK resolution regime, the responsibility for resolving a failing financial firm is with the BOE. The BOE decides, after consultation with the prudential regulator (which is either the “Prudential Regulation Authority”, PRA, or the “Financial Conduct Authority”, FCA) whether a financial firm is subject OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 Tolling the Bell for “Too-Big-to-Fail”? 527 Credit and Capital Markets 4 / 2017 to a resolution procedure.16 The BOE also decides which resolution tools will be applied and conducts the resolution procedure. This is conducted together with HM Treasury (HMT) if a bank is put under temporary public financial ownership or if a public equity injection is made. Two key conditions must be fulfilled before a financial firm can be put into resolution. The first is that the firm must be failing, or likely to fail. The assessment of whether this is the case is made by the PRA or by the FCA, after consultation with the BOE. The second condition is that financial firm most likely cannot avoid failing without the resolution regime. This condition is assessed by the BOE, after consultation with the PRA, or the FCA, and HMT. In a run-up of a resolution procedure, the banking firm is likely to be subject to intense and heightened supervision by the PRA or the FCA. Under the Proactive Intervention Framework, PRA judges how close the financial firm is to failure and supervisors will expect the firm’s management to take more appropriate action, as the conditions of the firm deteriorates. The actions should not impede the authorities’ ability to resolve the bank, should that become necessary. HMT, BOE, and the PRA have to sign a memorandum of understanding about how they will cooperate with each other before and during the resolution of an institution. The UK resolution regime seeks to strike a balance between starting a resolution procedure before all the franchise value of the bank has been eroded and avoiding the situation of a bank being resolved before all possible private sector solutions have been exhausted. After consultation among PRA, BOE, and HMT, a public interest test has to be made, because a resolution procedure implies substantial interference in private property rights. Once the public interest test has been met, BOE may apply one or more of the following resolution tools (Bank of England 2014): • P&Atool:Transferallorpartsofafirm’sbusinesstoanappropriateandwilling private sector purchaser. • Bridgebanktool:Transferallorpartsofafirm’sbusinesstothebridgebank established as a subsidiary of BOE, with the intention of selling it later. • Bail-intool:Restoringsolvencyofthefailingfirmwiththelossbeingcovered by shareholders and unsecured creditors, and recapitalization being done through converting of some part of the unsecured creditors, at least if necessary. The creditor preference hierarchy is to be respected with this bail-in procedure and NCWO safeguard is secured. 16 The PRA is a subsidiary of the Bank of England and regulates deposit-taking firms and major investment firms. The FCA regulates the majority of the investment firms independently of the BOE. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 528 Yoichi Iwasa and Uwe Vollmer Credit and Capital Markets 4 / 2017 For those parts17 of the firm that will not be maintained and have to be wound-down, two tools can be used, but only together with one or more of the above stabilization tools. • AssetSeparationTool:Toallowassetsandliabilitiesofthefailedfirmtobe transferred to and managed by a separate asset management vehicle (AMV) or a bad bank. This part of the firm or the AMV is to be sold eventually or written down later in an orderly manner. • Bank Administration Procedure: To administer the part of the failed bank (including building society), which was transferred neither to a private sector purchaser nor to the bridge bank. This part is called the “Residual Bank”. This will be maintained as far as its services are necessary, to the new owner of any transferred business and until a permanent arrangement makes the services unnecessary, when the residual bank is subject to a normal bank administration procedure. Each procedure is subject to a NCWO-clause, which is guaranteed by an independent valuator, who is appointed by HMT. In case of a shortfall, shareholders and creditors are entitled to receive compensation, which must be financed by the banking industry (Bank of England 2014). In line with European legislation, public funds may be used when necessary to stabilize the financial system, provided that unsecured liabilities of at least 8 % of the bank’s total balance sheet (as valued at the time of resolution) have been used to cover losses (and have been bailed-in).18 The government makes the decision and possible only as a last resort, when the stability of the financial system is in danger. If public assistance is granted, the funds come from the general budget, since the UK has not established (and will not establish) a prepaid bank resolution fund.19 Since the beginning of 2011, banks (temporarily) have to pay a bank levy with the proceeds going into the general government budget. The levy is charged annually on balance sheets and has to be paid by both UK resident entities and permanent UK branches of foreign banks. 17 Activities and services that do not seem worth maintaining and continuing to offer customers, from the perspective of systemic importance. 18 As a member of the European Union (though not of the Euro area and the EBU), Great Britain has fulfilled the BRRD, which sets the 8 % limit. For the transposition of BRRD into UK Law, see HM Treasury (2014). 19 The UK Treasury objected to pre-funding resolution schemes, because the unused pot of money would act as a drag on growth, create a moral hazard for banks and reduce the credibility of the bail-in tools (Financial Times 2013). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 Tolling the Bell for “Too-Big-to-Fail”? 529 Credit and Capital Markets 4 / 2017 IV. Comparisons Table 2 highlights the main characteristics of the four bank resolution regimes. As common features, all countries under consideration allow for early interventions and apply pre-insolvency bank resolution procedures. They also require banks to write “living wills” and enforce an institutional separation between the bank resolution instrument and the deposit insurance. Looking at subsamples, the special bank resolution regimes in Japan and in the US share major similarities but differ in important aspects from the two European regimes. In both Japan and the US, there are neither resolution funds and ex-ante bank levy systems, nor statutory bail-in powers. In Japan, the central bank hardly plays any role at all during the resolution procedure. There is thus a strict separation between monetary policy and bank supervision. Moreover, the Japanese legislation does not provide for a statutory bail-in instrument. In case of a bank failure, all liabilities will be protected, except for the failure of a very small institution where a pay-off cost limit will be implemented. Finally, Japan does not charge a bank levy and will not build up a frontloaded bank-resolution fund. However, the authorities are able to inject public money into banks through various types of measures offered by the amended DIAs of 2001 and of 2014. Public money injection is allowed, provided that an ex post collection of funds from the finance industry is likely to endanger financial stability. When financial institutions fail, purchasing institutions can, in almost all cases, obtain financial support in the form of public money, and even in the case of solvent financial institutions, public money can be injected to increase the bank’s capital. Japan also allows borrowing from the BOJ and / or from the Treasury with government guarantees.20 In this respect, the Japanese resolution scheme differs fundamentally from the US legislation, which prohibits any public solvency assistance during a resolution procedure. The Dodd Frank Act only allows for liquidity assistance from the FDIC in order to enable continuation of the ailing bank’s fundamental functions and to maintain asset values. A recapitalization of the bank with taxpayers’ money is not possible. For the purpose of liquidity assistance, the FDIC may 20 Izu (2015) gives three (socio-cultural) reasons why proactive resolution measures, depending more upon public money injection and less upon bail-ins, are preferable for the Japanese public. Firstly, economic recession was long-lasting and seemingly due to a “too-late-too-small” reaction to the crisis. This caused people to lose sight of proper standards for judging what constitutes an appropriate policy, and made them tired of thinking about it. Secondly, Japan has a long history of financial regulation by the government and the Japanese people do not much like being controlled by an “Okami” (which means “authorities” or the “government”). Third, the Japanese mostly have a tendency to regard humans as good not as evil, and therefore do not take the possibility of moral hazard as seriously as in Europe. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 530 Yoichi Iwasa and Uwe Vollmer Credit and Capital Markets 4 / 2017 Table 2 Key Features of Special Bank Resolution Schemes in Japan, the US, the Euro Area, and the UK Japan United States Euro Area United Kingdom Legislation • DepositInsuranceAct • GeneralBankruptcy Laws • FederalDepositInsurance Act • FederalBankingAct • Dodd-FrankWall Street Reform and Consumer Protection Act • BankRecoveryand Resolution Directive (BRRD) • SingleResolution Mechanism Regulation • Nationallaws • Banking(SpecialProvisions) Act of 2008 • UKBankingActof 2009 • FinancialServices (Banking Reform) Act 2013 Resolution authority • Triggering(T) • Finaldecisionmaking (DM) • Implementation(I) • FinancialServices Agency FSA (T) • Prime-Minister (DM) • DepositInsurance Corporation of Japan DICJ (I) • BoardofGovernorsof the Federal Reserve System / Federal Deposit Insurance Corporation (FDIC) (T) • FinancialStability Oversight Council (FSOC, chaired by Secretary of the Treasury (DM) • FDIC(I) • EuropeanCentral Bank / Single Res olution Board (T) • EuropeanCommission / European C ouncil (DM) • NationalCompetent Authorities / Single Resolution Board (I) • BankofEngland/Prudential Regulation Authority PRA / Financial Conduct Authority FCA (T, DM, I) • HMTreasuryincaseof public funding being used (DM) Criteria for resolution • Bankisinsolvent/likely to become insolvent • Suspensionofdeposit payments has occurred / is likely to occur • Bankisindefault/in danger of default • Orderlyinsolvency likely to create systemic instability • Noprivatesectoralternative is available • Institutionisfailing / likely to fail • Noreasonableprospect that alternative measures would prevent failure • Resolutionisnecessary in the public interest • Bankisfailing/likelyto fail • Financialfirmprobability cannot avoid failing outside the resolution regime • Resolutionisnecessary in the public interest OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 Tolling the Bell for “Too-Big-to-Fail”? 531 Credit and Capital Markets 4 / 2017 Ex-ante bank levy? • No • No • Yes(proceedsgotothe Resolution Fund) • Yes(proceedsgotothe General Budget) Resolution fund? • No • No • Yes • No Ex-post funds collections? • Yes • Yes • No • No Public fund injections allowed? • Yes • No • Yes • Yes Statutory bail-in power? • No • No • Yes • Yes No-creditor-worse-off clause? • No • No • Yes • Yes Separation between resolution instrument and deposit insurance? • Separateaccounts; both managed at DICJ • Separateaccounts; both managed at FDIC • Yes • Yes Source: Own compilations. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.50.4.509 | Generated on 2023-01-16 13:27:16 532 Yoichi Iwasa and Uwe Vollmer Credit and Capital Markets 4 / 2017 borrow funds from the Treasury. In the event that the bank cannot repay the liquidity assistance, the financial industry has to fill into the gap. The US does not charge an ex ante bank levy, and there is no paid-in bank resolution fund (Federal Deposit Insurance Corporation 2011). Like Japan (but unlike the Euro area), the US legislation does not have a statutory bail-in instrument. Bank resolution schemes in the UK and in the Euro area share major similarities, because they are based on the same EU Directive 2014 / 59 / EU (Bank Recovery and Resolution Directive, BRRD).21 Firstly, in both countries the central bank plays an important role during the resolution procedure. Secondly, BRRD demands all Member States of the EU to ensure that the bank resolution is truly in the public interest. Thirdly, in case of seriously deteriorating financial conditions, national competent authorities have to apply early intervention measures and to require members of the bank management body to be removed. Fourthly, in case of a resolution action, statutory bail-in must be applied to all uninsured and non-guaranteed debt instruments with a clear hierarchy of claims. Finally, the NCWO-principle has to be respected. Despite the common legislative origins, the resolution schemes in the UK and in the Euro area reveal two major differences. The first is that the resolution scheme in the Euro area provides access to a bank resolution fund (financed from proceeds of a bank levy) and offers a fiscal backstop from the European Stability Mechanism (ESM). In contrast, while the UK also charges a bank levy, the proceedings go into the General Budget. A bank resolution fund does not exist and the UK does not participate in the ESM. The second difference is of course, that the resolution decision is taken at the national level in the case of the UK, but on the supranational level for the Euro area. This makes it easier to apply the SPE approach for the resolution of multinational bank holding companies with subsidiaries located within the Member States of the Euro area (while the problem still remains as how to handle the resolution of multinational banks with subsidiaries located outside the EBU). 21 The legislative procedure within the European Union rests on two pillars and uses either regulations or directives. Regulations are binding in entirety and directly applicable in all EU-Member States with no decision-making leeway. 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