70152 EUROPEAN AND BEST PRACTICE BANK RESOLUTION MECHANISMS AN ASSESSMENT AND RECOMMENDATIONS FOR POLICY AND LEGAL REFORMS OVERVIEW REPORT Private & Financial Sector Development Department Central Europe and the Baltics Country Department Europe and Central Asia Region The World Bank March 30, 2012 TABLE OF CONTENTS EXECUTIVE SUMMARY 3 SECTION I: BACKGROUND 8 SECTION II: BANK RESOLUTION – KEY PRINCIPLES 10 SECTION III: THE FUTURE EU RESOLUTION FRAMEWORK 13 Intervention Triggers 15 Resolution Tools 16 Resolution Powers 18 Funding of Resolution 18 The Cross-Border Dimension 19 RECOMMENDATIONS REGARDING THE EC PROPOSALS 20 SECTION IV: FINANCIAL MECHANISMS AND INSTRUMENTS FOR RESOLUTION 27 Mechanisms and Instruments for Implementing the Resolution Process 27 Categorization and Ranking of Bank Liabilities by Creditor 29 SECTION V: ANALYSIS OF SELECTED COUNTRIES’ RESOLUTION REGIMES 33 POLAND 33 CZECH REPUBLIC 38 GERMANY 42 SPAIN 45 UNITED KINGDOM 52 CROATIA 57 CANADA 61 UNITED STATES 66 SECTION VI: OBSERVATIONS BASED ON REVIEWS OF EU COUNTRIES’ LAWS 68 Importance of the Resolution Regime 68 Observations on Country Frameworks 71 Key Legal Provisions for Credit Institution Resolution 73 Criteria for Supervisory Intervention 73 The Objective of a Proceeding 74 The Governmental Authority Responsible for a Proceeding 75 The Powers of the Administrator of a Resolution Proceeding 75 The Mechanisms that could be used to Resolve an Institution 76 The Effect on Corporate Governance of the Affected Institution 77 CONCLUSIONS 79 This report on European Bank Resolution Mechanisms and proposals for reform, was jointly written by a team comprising John Pollner (Lead Financial Officer, ECSPF, World Bank), Henry N. Schiffman, (Consultant, World Bank), and Joaquin Gutierrez (Lead Financial Specialist, IMF). The Sector Managers were Sophie Sirtaine (ECSF2) and Lalit Raina (ECSF1). The Sector Director was Gerardo Corrochano, (ECSPF). The Country Director was Peter Harrold (ECCU5), and The Vice President was Philippe Le Houerou (ECAVP). 2 EXECUTIVE SUMMARY 1. The process of “bank resolution,� or the procedure for handling insolvency of banks using a range of tools including alternatives to standard bankruptcy processes, has gained major traction since the experience of the 2008-09 financial crisis. The crisis showed that the lack of sufficient flexibility in regulatory tools impeded the use of methods to resolve financial institutions in crisis, without resorting to unprecedented equity support from the State. 2. In this context, this report reviews models for bank resolution that provide increased flexibility and describes several of the supervisory, legal and instrumental tools that can be used under modernized bank resolution procedures. As well, it reviews the recent European Commission proposals on this matter which take into account international best practices experiences, and highlights areas of reform and areas where further regulatory considerations and priorities should be considered. The report also reviews the bank resolution regimes of a group of European countries as well as those of two non-EU countries to highlight advantages as well as gaps in the legal and regulatory frameworks. 3. The report is intended for financial sector policy makers in new EU member states and in countries involved in the EU Accession process as well as for other countries adopting EU regulatory frameworks for their banking sectors. The report will also assist policy makers in designing and drafting regulatory frameworks needed to adapt their national legislation, regulations and institutions to new requirements for conducting bank resolution. Several EU countries have already undertaken changes following the crisis and several others are in the process of adopting such changes. This report will serve as an in-depth source of legal and regulatory analysis and instruments related to these initiatives, which policy makers may use to put in place comprehensive, well conceived bank resolution frameworks. 4. The European Commission (EC) issued a Communication titled An EU Framework for Crisis Management in the Financial Sector that sets forth proposed policies to address failing financial institutions to be incorporated through amendments to laws of EU members.1 The Communication is currently a vehicle for discussion, and, based on country responses, a final version is expected to be issued in 2011. The objective is to provide powers and tools to supervisory authorities to enable them to restructure or resolve financial institutions in crisis without the fiscal budget 1 IP/10/1353 of 20 October 2010. This review speaks mainly of “banks� and “credit institutions� interchangeably, based on the nomenclature of the laws. The EU Communication is addressed to systemically significant as well as other financial institutions. 3 ultimately bearing the financial burden. The EC proposed policies include the possibility of using resolution tools that include:  a sale of business tool to effect a sale of the credit institution or parts of its balance sheet to one or more purchasers, without the consent of shareholders.  a bridge bank tool to transfer some or all the business of a failing credit institution to a temporary bank before final new ownership is arranged.  an asset separation tool to transfer underperforming assets to a separate vehicle to cleanse the balance sheet of a troubled institution.  a debt write-down tool where bank debt claims can be reduced and/or converted to equity.  use of funds of a deposit guarantee scheme to fill gaps in a bank resolution, requiring the transfer of deposits to another entity, provided that funds used do not exceed the amount that would have been necessary to repay insured depositors.  new crisis management measures that may extend the need for financing beyond measures aimed at preserving insured deposits. 5. In terms of recent European and international best practices on effective resolution frameworks, there are several issues that should be taken into account when designing a new approach.2 In this regard some additional thought should be given to certain assumptions or rules, some of which are discussed in the in the EC Communication, including:  The assumption that normally a failing credit institution should be liquidated under ordinary bank insolvency/bankruptcy proceedings with new resolution procedures reserved for special circumstances.  The assumption that the power to write down debt or convert it to equity should be a last resort rather than a more usual measure under bank resolution/insolvency. 2 Some of these issues, particularly the emphasis on a unique special insolvency/resolution regime for banks and international best practices, are discussed in An Overview of the Legal, Institutional and Regulatory Framework for Bank Insolvency, IMF / World Bank, April, 2009. 4  The assumption that it would be difficult to establish an EU integrated resolution model for cross-border banking groups in the absence of a harmonized insolvency regime and of a single European Supervisory authority for this purpose. 6. This report reviews the banking and deposit insurance laws of six European countries—Poland, the Czech Republic, Germany, Spain, the U.K., and Croatia. Remedial enforcement measures for distressed banks and for bank resolution reveals that adoption of the EU legislative proposals, as described in the EC Communication, would require significant changes in legislation in four of the six countries. The report also reviews the laws of Canada and the U.S. for comparison, as implementation of their laws has already utilized several of the resolution instruments and mechanisms being considered. 7. Areas in which some country laws are at variance with the EC Communication’s proposals:  Lack of a sole authority or uniform framework to exercise resolution powers. Some laws require advice or consent of other than the resolution authority and sometimes at various stages of the resolution process.  Lack of explicit resolution tools for: o the sale of the credit institution or parts of its business without the consent of shareholders. o an option to transfer some or all the business of a failing credit institution to a temporary bridge bank with a cleaned up balance sheet, and an asset separation tool to transfer underperforming assets to a separate vehicle (“bad bank�).  The absence of a debt reduction/conversion tool.  Lack of authority to use of the deposit insurance scheme’s funds for other than payment of insurance to depositors. 8. In addition, the analysis of country laws indicates that, based upon general principles of rule of law, in some jurisdictions the critical criteria for intervention to undertake resolution remain too indefinite. This lack of definition does not allow for the significant modification and/or elimination of property rights implied under a resolution process, which should be analogous to criteria for actions taken if there were economic insolvency. The objective of a resolution proceeding should be clear as a guide for a resolution authority to act decisively and minimize delays. 5 9. Resolution is, in essence, a more complex and phased sale & insolvency proceeding, and which aims to maintain an institution’s assets operating. Thus under such a proceeding the proper objective of resolution should be to protect the interests of creditors, including a key set: the depositors. This should be accomplished by preserving the value of the assets of a financial institution and providing an opportunity for a financial reorganization of the institution in appropriate cases, to maximize value. Additional challenges are raised with systemically important financial institutions3 where additional tools such as living wills, bail-in clauses, and resolution and recovery plans, would be required ex ante to assist in meeting capital requirements or facilitating resolution.4 10. Besides the procedures and powers identified by the EC and needed for undertaking modernized bank resolution, the report also discusses additional legal and financial instruments which can be used to carry out resolutions. While the asset separation tools leading to purchase and assumption (P&A) transactions, bridge banks, separated good and bad banks, and debt write-down and conversion instruments move a step forward in the modernization of flexible resolution instruments, other mechanisms can facilitate the process. These include:  Packaging of transferable assets into debt instruments as marketable bond securities, to allow easier distribution and sale (along with matching deposits) to several acquiring banks in good standing.  Differentiation between the role of different banks that take on risk sharing functions, including those banks that (i) absorb new assets and liabilities as indicated above, and those that (ii) perform off-balance sheet loan servicing functions for a fee, to manage the underlying assets transferred to the first set of banks as part of P&A transactions either using direct portfolio transfers or via the above listed bond instruments.  Ensuring legal certitude under banking law by establishing that a breach of regulatory insolvency are grounds for progressive pre-resolution corrective and interventionist actions by the authorities to reverse a bank’s deteriorating condition including invoking additional shareholder capital, rehabilitation plans 3 Such institutions abbreviated as SIFIs, are defined as global financial services firms – almost exclusively banks –that are so big that governments believe they will be forced to rescue these institutions rather than risk lasting damage to the world financial system from their collapse. 4 Also discussed in the report of the Financial Stability Board, Reducing the Moral Hazard Posed by Systemically Important Financial Institutions, FSB Recommendations and Time Lines, October, 2010; as well as in IMF Staff Discussion Note, The Too-Important-to-Fail Conundrum: Impossible to Ignore and Difficult to Resolve, May, 2011. 6 and/or temporary administration; to be followed by resolution actions if the previous measures fail and the bank evolves to materially below minimum capital adequacy requirements. In such a case, the latter are grounds for suspension of shareholder rights in order to invoke resolution to minimize losses, protect depositors, and prevent financial system contagion, and constitutes the basis for license revocation if third party acquiring banks are not available to take over the failing bank’s business or key parts of its asset and deposit base, and if the bank’s adjusted capital position is irreversible in the short term.  Pre-establishing the hierarchy of creditors’ rights for deciding on the allocation of viable assets, using sequential levels of creditor preferences and including the stratification of depositors beyond only those that are insured, to allow maximum protection of all depositors.5  Once a minimum-loss resolution process is achieved (versus the direct compensation by the government to insured depositors) and the main allocation of assets and liabilities in a resolution is implemented, the need to define a final stage for the disposition of residual non-transferable low quality assets, through collection efforts or liquidation of underlying collateral. 11. It should be re-stated, that besides the protection of depositors and creditors, and ensuring stable financial systems to avoid contagion, a modernized resolution process seeks to ensure an organized and fair treatment of all claimants, maximizing their recoveries, while minimizing the costs borne by deposit insurance agencies and fiscal budgets. 5 This topic is also discussed in the FSB consultative document, Effective Resolution of Systemically Important Financial Institutions, Annex 7, July 2011. 7 SECTION I: BACKGROUND 12. “The financial crisis of 2008-09 provided clear evidence of the need for more robust bank intervention and resolution measures at a national level, as well as the need to put in place arrangements for cross-border banking failures. There have been a number of high profile banking failures during the crisis (e.g., Fortis, Lehman Brothers, Icelandic banks, Anglo Irish Bank) which have revealed serious shortcomings in the existing arrangements. In the absence of mechanisms to organize an orderly wind down, EU Member States have had no choice other than to bail out their banking sector. State aid in support of banks has amounted to 13% of GDP.� 6 13. During the financial crisis, most European governments were forced to take emergency actions to stabilize their financial systems and provide support to some of their banks. EU governments acted based on their national legislative frameworks, but there was no common EU framework for managing crises. There was emergency liquidity harmonization and a mechanism for limited EU wide crisis coordination.7 However, the lack of a common EU regime to deal with problems in cross-border banks exacerbated the shortcomings that still exist in some national regimes, as well as the differences in supervisory practices, cultures and approaches in responding to risks, when these were accumulating, and including approaches for assessing, repairing, and preserving financial viability. 8 14. Since May 2010, the European Commission accelerated its work to expand and revise the European crisis resolution framework. 9 The Commission issued a series of consultations and technical documents presenting its proposals for “An EU Framework for Crisis Management in the Financial Sector� (the ‘Communication’); as well as Bank Resolution Funds; and Cross-Border Crisis Management in Banking. The proposed resolution mechanisms are not novel and have been available or used in some countries previously. When legislative changes are adopted, national resolution regimes in Europe will become harmonized which will facilitate cross-border resolution across the EU. 6 http://europa.eu/rapid/pressReleasesAction.do?reference=IP/11/10&format=HTML&aged=0&language=E N&guiLanguage=en. 7 In the run-up to the crisis efforts were already being put in place for crisis preparedness. ECB and ECFIN had organized several multi-country crisis simulations, and procedures for emergency liquidity assistance were harmonized. A weakness perhaps were cross-border MoUs on crisis management which were not very effective. 8 For example, it prompted a major overhaul in some countries whose previous official policies were less favorable to deploying a specialized resolution regime for failing banks, such as the UK (see 2009 Banking Law). 9 For details and summary see http://ec.europa.eu/internal_market/bank/crisis_management/index_en.htm 8 15. Following the publication of the Communication on October 20, 2010 (IP/10/1353), the Commission launched on January 6, 2011 a public consultation (IP/11/10) to bring forward a legislative proposal for a comprehensive framework for failed bank resolution. 16. The purpose of this report is to relate the known status of the bank resolution regimes in selected EU and other countries, evolving best practices, and to recommend frameworks and tools which final proposals should incorporate. The report expresses the views of the authors and does not necessarily reflect a final World Bank position on the matter. 17. The report covers mainly the post-intervention resolution stage of bank insolvency and its treatment. It does not cover the prior stages which may involve enhanced supervision supported by stronger supervisory orders, bank rehabilitation plans, and/or temporary official administration/conservatorship for the purpose of reversing a deteriorating financial condition of an institution and reducing governance and financial risks, and other pre-resolution actions. As well, the report does not address in detail which institution(s) are, or should be, mainly responsible for carrying out resolution as these can vary within the European country contexts based on different historical functions performed by several financial authorities (such as independent supervisory agencies, central banks, ministries of finance and deposit insurance agencies). 18. The following section of the report summarizes key principles which the World Bank observes as essential to assure an orderly and cost-minimizing resolution process along with the needed legal powers and mechanisms. Following that, the report describes the essential elements of the framework being discussed in the EU, as well as World Bank observations on this framework and areas to look into and develop further. 19. The subsequent section analyzes and compares the national regimes of the countries selected for review and assesses their resolution frameworks in line with the EU proposed new framework and best practice approaches in designing resolution regimes. The final section provides summary conclusions and focuses on the legal powers and mechanisms to optimize and assure predictability in an orderly, cost and loss minimizing process, during the process of resolution. 9 SECTION II: BANK RESOLUTION—KEY PRINCIPLES 20. Financial services firms, unlike ordinary commercial or industrial companies, are subject to comprehensive regulation and supervision to realize appropriate public policy objectives and for similar reasons their insolvency should be resolved by specially designed legislation if ordinary insolvency law does not fulfill the needs for resolution of financial institutions. 21. With respect to financial institutions that are funded by savings from the public and that extend credit, there are three basic criteria as to whether, from the standpoint of public policy regarding savings, payments, and credit, such institutions should be subject to comprehensive regulation and supervision to ensure their solvency. These are whether the type of institution is:  A significant repository of savings of the public such that the failure could cause a significant shock to financial stability;  A direct participant in the payments system such that the failure of a large institution could be disruptive of payments;  A source of credit to the economy that has macroeconomic significance. 22. The type of institutions that clearly satisfy all three criteria in most countries, are 10 banks. 23. Since banks use the public’s savings in their businesses for their own account, there is a moral hazard dimension because liabilities to third parties are a large multiple of their owners’ equity in the business. Therefore, unlike ordinary commercial or industrial companies that usually have debt to equity ratios close to 1:1, the insolvency of a bank may involve many more multiples of the public’s money. 24. The political reality may thus require as in the 2008-09 financial crisis, additional public money from taxpayers for maintaining financial or social stability when there is the failure of important financial institutions. Therefore, new bank resolution measures which aim to reduce the State’s (and taxpayers’) costs of funding bank failures, seek to minimize future outlays of this type as they can severely destabilize public finances. 10 The basic definition of a bank found in most banking laws is an institution that both takes deposits from the public and extends credit. Contractual savings institutions such as insurance companies and pension funds satisfy one or two of these criteria and are also subject to regulation and supervision for valid public policy reasons. 10 Implications for Financial Institution Insolvency Law 25. The application of the corporate insolvency framework, therefore, is generally unsuitable for banks (and potentially other financial companies) because:  The corporate insolvency framework does not recognize that banks and other financial companies, unlike industrial and commercial companies, can be prone to sudden losses of confidence, runs, contagion and other wider systemic consequences jeopardizing the public interest in financial stability. Speed in resolution is much more important than for non-financial companies, as even solvent banks can rapidly become insolvent once they experience a run due to real or perceived difficulties.  In many countries’ laws, corporate insolvency law can only be initiated at the point of economic insolvency, precluding any early and decisive pre-emptive intervention designed to forestall wider problems.  The corporate insolvency framework is not well suited to ensuring the continuity of key banking functions, especially payments to and from customer accounts and access to overdraft and other credit facilities, all of which will often be frozen by a moratorium that generally comes into effect in a corporate insolvency proceeding.  The corporate insolvency framework does not recognize the particular position of bank depositors, who – unlike the creditors of an industrial company – are numerous in number, are not professional market participants, are generally amenable to switch banks if their deposits are insured, and whose claims on a bank have a major role in the bank’s solvency and in the wider functioning of the economy. 26. Thus, the law that governs bank resolution should fulfill the following criteria: a. Expeditious action and administration by skilled insolvency practitioners to minimize the risk of contagion to the financial system as a whole and maintain vital banking services. b. Limitation of moral hazard in relation to diverging (and potentially opposite) motivations with respect to the interests of bank owners versus institutional creditors. 11 c. Rules and procedures that maximize the value of assets of a failed bank to protect the interest of depositors and other creditors. d. Rules and procedures that minimize losses and costs to the Government, in relation to its liabilities (i.e.: the payment of insured depositors). e. The law should be clear that owners will lose their equity interest in their bank and creditors may receive less than their claims if the bank becomes insolvent even if this primarily reflects regulatory insolvency (capital adequacy ratio below the minimum) versus economic insolvency (negative net worth, i.e., the value of liabilities exceeding that of assets). f. Since banks are licensed to operate based on regulatory solvency (and regulatory insolvency often occurs prior to economic insolvency), the noncompliance with sound capital adequacy or other regulatory requirements are valid grounds for suspension of the institution’s management and shareholders’ rights. g. The above suspension would result in official control of the bank to allow initiation of resolution actions, and maintaining the bank’s assets operating, with first attempts to find voluntary market solutions and purchasers to take over and/or merge the bank or parts of its asset base with another institution. h. Short of any market solutions within a very short circumscribed time period or a reversible capital situation, a revocation of the banking institution’s license to operate would need to be effected so as to conduct the resolution procedure using the available mechanisms described earlier. 12 SECTION III: THE FUTURE EU RESOLUTION FRAMEWORK 27. The structure of the reform being designed by the EU Commission includes substantive changes in several closely interconnected areas. 11 Legislative efforts at the EU and national levels are in development and the final details of implementation are expected this year. The changes are expected to include:12 Uniform and effective tools and powers to deal with failing banks at an early stage, and to minimize costs for taxpayers, including:  Pre-resolution measures, such as supervisory, preparatory and preventive measures, including requirements for stricter prudential norms, enhanced supervision, including more comprehensive oversight regimes (macroprudential supervision), enlarging the regulatory perimeter, and recovery and resolution plans (including “living wills�). These include powers for authorities to require banks to make changes to their financial structure, business organization or management, where such changes are deemed necessary to facilitate eventual resolution if needed. These powers would be a particularly important element in tackling banks that are deemed too big, complex or interconnected to fail as resolution procedures may be insufficient to always avoid losses. The general objective, however, is to ensure that the resolution tools can be used on all financial institutions, irrespective of their size, complexity or systemic importance;  Early intervention measures including powers for supervisors to take early action to remedy problems before they exacerbate the condition of an institution, such as the power to change directors and managers; and  Failed institution resolution tools, which empower authorities to take the necessary action, where bank failure cannot be avoided, to manage that failure in an orderly way such as powers to transfer assets and liabilities of a failing bank to another institution or to a bridge bank, and to write down debt of a failing bank to strengthen its financial position and/or allow it to continue as a going concern for market sale or after conducting appropriate restructuring.13 28. The overriding objective will be to ensure that banks can be resolved in ways which minimize the risks of contagion and ensure continuity of essential financial services, including continuous access to deposits, or prompt payment for insured depositors. The framework should provide a more effective alternative to the costly bank bail-outs which characterized the recent 11 The changes being designed had been preceded by the amendments to the Directive on Deposit Guarantee Schemes (DGS) 94/10/EC under Directive 2009/14/EC. 12 See web reference 1 above in http://europa.eu/rapid/pressReleasesAction 13 The resolution tools and the overall EU framework with some country comparators, are also discussed in ECB’s July 2011 Monthly Bulletin, The New EU Framework for Financial Crisis Management and Resolution. 13 crisis. It should nevertheless be recognized that if one very large or more than one systemically important institution fails, these tools may still require State support if third parties are not fully available nor able to absorb a failed bank’s or group’s assets and liabilities. However, the new sets of tools including for temporary bridge banks allow several options that were previously non-existent, which should help mitigate losses to the taxpayer. The consultation asks stakeholders to present their views on the effectiveness of these possible powers and tools. 29. Effective arrangements which ensure that authorities coordinate and cooperate as fully as possible in order to minimize any harmful effects of a cross-border bank failure. It is suggested to build on existing supervisory colleges and expand them to include resolution authorities for the purposes of crisis preparation and management. The EC Consultation seeks views from stakeholders on the most appropriate framework to ensure an effective resolution of cross border groups through the formation of resolution colleges. 30. Fair burden sharing by means of financing mechanisms which avoid use of taxpayer funds. This might include possible mechanisms to write down appropriate classes of the debt of a failing bank to ensure that its creditors bear losses. Any such proposals would not apply to existing bank debt currently in issue. It also includes setting up resolution funds financed by bank contributions. In particular the Consultation seeks views on how a mechanism for debt write down (or “bail-in�) might be best achieved, and on the feasibility of merging deposit guarantee funds with resolution funds. 31. The technical details of the proposed EU framework for enhanced supervision, recovery and resolution are provided in a comprehensive Working Document from the DG Internal Market and Services. 14 This Working Document includes six parts expanding the summary provided in the paragraphs above. The framework of the Document is used in this Note as the benchmark to compare the national systems reviewed, as well as to summarize their features. The following figure depicts the main elements of the EU remedial and resolution framework along the time lines that lead to liquidation. 14 http://ec.europa.eu/internal_market/consultations/docs/2011/crisis_management/consultation_paper_en.pdf 14 Figure 1: Remedial and Resolution Framework in the EU Low to medium risk profile: High-risk profile to contain: Failed/about to fail: Solvency/ Failed, non-viable: Sound on a micro-prudential basis Risks to solvency/viability detected. stability unlikely to be restored in Solvency/stability not expected to Standard supervisory program. Augmented onsite program. normal course. be restored in normal course. Prevention Early Intervention Resolution Liquidation Risk and viability assessment (onsite Escalation of intervention and Funding for resolution tools: bridge Liquidation/winding up of all or parts of inspection), preparation of recovery and implementation of recovery bank; good/bad bank; transfer of assets the failed institution. resolution plans. (rehabilitation) plans. and associated administrative costs. (Corporate) Insolvency Law Rated as problem (detected) Use of Bank Resolution Funds and/or Funds of Going-concern trigger Grounds for intervention Deposit Guarantee Scheme Panel of risk mitigation actions Triggers/conditions fulfilled Action plans with recovery benchmarks Gone-concern (failure) trigger for resolution (non-viable). Special management (contractual) Substantial failure of threshold conditions. Begin to explore resolution options Fails to achieve recovery benchmarks Source: World Bank and EC COM(2010) 579 final, Brussels, October, 2010. 32. Supervisors need tools and powers to effect remedies and resolution, including thresholds for intervention which trigger the conditions for taking action. There is also a need for supplemental powers to support the resolution activities, as well as funding mechanisms and safeguards to protect counterparties and arrangements, including mechanisms to compensate third parties. The following paragraphs briefly summarize the proposals made by the EU Commission in the Working Document put forward in the Consultation. Proposals for legislative changes at the EU level are planned during 2011, including on the pace and scope of implementation at the national level. This will help to start a round of legislative amendments in member countries. Intervention Triggers 33. A key element of the EU Consultation is the specificity and automatism with which the trigger/threshold conditions for intervention should be crafted. There are triggers at two stages of the process, at the going-concern point for remedial early intervention action, and at the gone- concern point of non-viability where resolution plans and actions are initiated (see Figure One, above). The EU Commission advocates balancing discretion and automatism by combining quantitative and qualitative threshold conditions that will trigger remedies and resolution. The decision on how to craft the triggers is crucial to commit policy makers and supervisors to act rather than forbear at the point where the risks to insolvency start to build-up. 34. Besides powers and tools (the “ability to act�), with the design of the triggers that provide the grounds for intervention, the supervisory agencies need to be provided adequate incentives (the “will to act�). There are different directions available to strengthen aspects that did not work during the current crisis including significantly enhancing Pillar 2 supervisory powers. Notwithstanding, the EU proposals will require more detail and guidance to solve the existing 15 incentive problem which has kept supervisors from acting based on more discretionary powers beyond solely regulatory non compliance. 35. The first direction is to provide supervisors with a clear mandate focused on the protection of depositors and ensuring stability and confidence in the system.15 The second direction is to orient supervisors towards risk aversion and early intervention with regard to problem banks, by explicitly including in their objectives, inter alia, the minimization of losses including resolution and systemic costs. 36. A third direction is to provide strong incentives for investors to monitor bank risk taking, so that market discipline, which also failed in this crisis, can contribute to stability by requiring contingent-capital and bail-in debt at the point of a going-concern triggered as a remedial tool (rather than a resolution tool or an addition to one). 16 The fourth direction is to mitigate the risk of supervisory uncertainty by improving interaction among safety net agencies to support decisions that mitigate insolvency risks and to adopt early remedial as well as resolution measures, including considering the separation of supervisory and resolution authorities. 17 37. Although important, the design of the triggers is not the only challenge. Even if a trigger is well designed, unintended regulatory forbearance can take place in other ways, such as (i) through interpretation of a trigger variable, e.g., subjectivity in loan classification, or assessing asset risk levels, (ii) lack of good on-site inspection capacity or of time to quantify insolvency risks leading to insufficient review of asset valuations, revenue streams and risks or (iii) subjectivity in other criteria and reported variables used to rate a bank’s condition affecting the supervisor’s view of risk and his/her judgment on the institution’s non-viability (and in a worst case scenario, potentially taken advantage by politicians dependent on financial industry support, to delay the day of reckoning). Resolution Tools 38. The resolution tools are the instruments and techniques, including legal powers for resolving failing and failed institutions. Resolution can in some circumstances be achieved by restructuring a failing institution, including measures used to maintain viable parts of entities, while remaining open (and at times with financial assistance by the deposit insurer or other authority). In effect the debate on open versus closed bank resolution procedures should be superseded by a more encompassing framework. This should assert that once a bank is in non- compliance from a regulatory solvency perspective, whatever action is taken by the resolution authorities should be considered as a legally authorized action because the institution has failed in its performance to justify its operating license. While the EC framework does not discuss this issue, a license revocation provides more legal certitude for undertaking resolution actions 15 See changes in the new Banking Act 2009 in the UK 16 See Dickson, J. 2010b, Too-big-to-fail and Embedded Contingent Capital. 17 There are other possible directions to strengthen the autonomy and effectiveness of supervision which are not currently being considered in the EU, or by the Basel Committee on Banking Supervision. See Dickson, J. 2010a, �Too focused on the rules; the importance of supervisory oversight in financial regulation.� 16 especially if the loss of capital seems unrecoverable and voluntary market solutions are not available – however, if interested third parties are forthcoming within a very short circumscribed time period, the bank’s operations should be kept running as going concern to ensure a prompt transfer of viable assets and liabilities or a potential merger. 39. Actual revocation of a license is not a necessary condition for allowing certain types of actions since resolution procedures themselves are triggered by, among other factors, non compliance with regulatory solvency requirements which are defined as valid reasons for license revocation, and this thus provides an equivalency to invoke resolution. If not handled in an efficient way with a seamless transition of bank services, formal bank closure can have the risk of generating deposit runs and contagion given the perceived finality of the closure action and this would complicate any recapitalization or acquisition of an institution by a new owner. Thus, even if license revocation is used to ensure legal clarity, the bank’s operations should be continued under temporary government control. 40. Restructuring activities can also take many forms. Institutions that are viable or even not viable but are too systemically significant to be closed (implying major costs to the State), are normally restructured rather than resolved by closure. Creditor “bail in� clauses are also important for too-big-to-fail banks as full asset absorption by third parties may not be possible. There is also an often opaque modality of restructuring in which, after an initial clean up, a bank is sold to a third party which finalizes the restructuring by divesting all the assets and businesses that are not viable. The acquirer in such cases, is paid for buying the negative present value of the portions of the problem bank. Such solutions presume a significantly lesser cost than either a public bail-out, payments to insured depositors or other State support. 41. The EU Framework does not recommend new tools unknown in past resolutions and restructuring by government agencies.18 What the EU framework proposes is to introduce them to Europe at-large to provide consistency among national regimes through common legislation and to provide additional flexibility and options for resolution of both large systemic institutions and other size institutions, including enabling more effective cross-border crisis management. The EU Consultation recommends the following tools:  A sale of business tool that would enable resolution authorities to effect a sale of the credit institution or the whole or part of its assets and liabilities to one or more purchasers on commercial terms, without requiring the consent of the shareholders or procedural requirements that would otherwise apply.  A bridge bank tool that would enable resolution authorities to transfer all or part of the business of the credit institution to a bridge bank under control of the resolution authority to be able to: (a) transfer rights, assets or liabilities from the affected credit institution to the bridge bank on more than one occasion; and (b) transfer rights, assets or liabilities back from 18 For example, procedures of the U.S. FDIC, the Canadian CDIC and the Spanish Fondo de Garantia de Depositos. 17 the bridge bank to the affected credit institution if this is necessary in view of the resolution objectives.  An asset separation tool that would enable resolution authorities to ‘carve-out’ and transfer certain toxic assets of a credit institution to an asset management vehicle for the purpose of facilitating the use of another resolution tool. In this context, an "asset management vehicle" refers to a legal entity which is wholly owned by one or more public authorities, which may include the resolution authority. The authority should be able to: (a) transfer assets from the affected credit institution on more than one occasion; and (b) transfer assets back from the asset management vehicle (if recoveries rise) to the affected credit institution or other acquiring institution, if advantageous.  A debt write down tool that would enable resolution authorities to write down the claims some or all of the unsecured creditors of a failing institution and to convert debt claims to equity, providing greater flexibility in responding to the failure of large, complex financial institutions, including to mitigate moral hazard created during the current crisis, as well as to promote “skin in the game� and achieve more effective market discipline19. Resolution Powers 42. The resolution powers are the various legal powers that, in different combination, the agency responsible for resolution can exercise when applying the resolution tools together with other ancillary powers designed to ensure due implementation of resolution according to the prevailing threshold conditions, including:  the powers to transfer shares in, or assets, rights or liabilities of, a failing bank to another entity such as another financial institution or a bridge bank;  the powers to write off or cancel shares, or write down or convert debt of a failing bank;  the power to replace senior management;  the power to impose a temporary moratorium on the payment of claims; and  the supplementary powers including a power to require continuity of essential services from other parts of a financial group. Funding of Resolution 43. Another essential component of the framework under discussion is the establishment of bank resolution funds for each EU country.20 Resolutions cost money and need financing. Without an explicit ex ante financing scheme resolution might fail to crystallize, because private 19 See Dickson, J. 2010b. “Too-big-to-fail and Embedded Contingent Capital 20 See COM(2010) 254 final, in http://ec.europa.eu/internal_market/bank/docs/crisis- management/funds/com2010_254_en.pdf 18 sector funds would be insufficient or unavailable. As a consequence, the EU framework might lose its credibility and the final cost would fall again on the Government to be ultimately borne by the taxpayer. Ex post fund raising from the banking industry, to pay off advances provide by the government or deposit insurance fund would constitute another modality for funding. 44. The Commission believes that a way to achieve better coordination and to ensure that a bank’s failure is managed in an orderly way is to implement the “polluter pays� principle. The Commission is planning to introduce requirements for Member States to establish resolution funds (according to uniform rules)to which banks are required to contribute. 45. These funds would be designed to provide funding to facilitate the types of measures outlined by the Commission for crisis management, which include: providing funds for ‘bridge bank’ operations; total or partial transfer of assets and/or liabilities; and financing a “good bank/bad bank� arrangement. The availability of ex-ante resolution funds would provide support to facilitate the orderly resolution of failing institutions in ways which could avoid contagion. However, they should not replace strong supervisory measures to mitigate losses prior to the resolution phase. The Cross-Border Dimension 46. The ongoing work and discussions of the EU Framework for Cross-border Crisis Management in the Banking Sector expands proposals covering group resolution.21 The objective is to ensure that resolution authorities have similar and consistent tools and powers at their disposal. This will facilitate coordinated action in the event of a failure of a cross-border group which appears necessary to promote cooperation and prevent fragmented national responses. 47. An integrated framework for resolution of cross border entities by a single European body would deliver a rapid, decisive and equitable resolution process for European financial groups, and better reflect the pan EU nature of banking markets. However, the Commission recognizes that it would be difficult to establish an EU integrated resolution model for cross- border banking groups in the absence of a harmonized insolvency regime and of a single European Supervisory Authority for those entities. The Commission considers that the European approach to resolution should mirror the broader approach to supervisory arrangements. 48. For that reason, the Commission favors,22 as a first step, a coordination framework based on harmonized resolution tools and a requirement for authorities to consult and cooperate when resolving affiliated entities. To this end, the Commission is considering two principal reforms: 21 http://ec.europa.eu/internal_market/bank/docs/crisis-management/091020_working_document_en.pdf 22 Extract from the Commission's Communication of October 2010. 19  First, establishing resolution colleges around the core of the existing supervisory colleges through the inclusion of resolution authorities for group entities, including specific role, membership and coordination; and  Second, providing group level resolution authorities the power to decide in cases of group failure whether a group resolution scheme is appropriate or not, including a process to determine the ramifications if individual countries ring-fence operating subsidiaries and resolve them on a national jurisdiction basis. 49. Rolling-out the Framework. The above description of the EC Proposals demonstrates that several advanced and modernized features and options are to be added to the EU’s bank insolvency framework and toolkit, allowing an increasingly balanced burden-sharing approach to failing banks. This should lead to cost minimization outcomes for the government and taxpayers. Such approaches would utilize viable market institutions to maintain productive financial assets in operation, versus traditional approaches to insolvency that might lead to less orderly liquidations and larger losses of asset value. 50. The EC proposals involve intricate implementation features still to be defined. However, there are some assumptions stated within the proposals which require closer scrutiny and fine- tuning to ensure that the new framework and tools may be implemented without undue obstacles. Some of these features and their proposed modifications are discussed below. RECOMMENDATIONS REGARDING THE EC PROPOSALS 51. This section reviews some of the features of the European Commission’s Communication on bank resolution reforms and provides comments based on the World Bank’s assessment of regulatory and implementation options that should be considered in more depth. The objective of such analysis is to optimize the effectiveness of the new model in line with past and recent experience in deploying such measures. Highlighted below are selected features of the Communication where specific observations are made. 52. For example, one section in the EC Communication states that: In addition to qualitative or quantitative triggers…….…the Commission proposes to include a further condition that resolution is necessary in the public interest. The public interest test would be met, for example, if winding up the institution under ordinary insolvency proceedings did not ensure the stability of the financial system or continuity of essential financial infrastructure services. If the public interest condition not satisfied, the institution should be wound up once the threshold for insolvent liquidation is reached.23 23 “Wound up� apparently means liquidated under the company law or ordinary bankruptcy law. 20 53. Recommendation: The “threshold for insolvent liquidation� may well be reached prior to or at the same time that credit institution supervisors become aware of the financial distress of an institution. Typically insolvency laws provide that one definition of insolvency is when an entity’s assets are less than its liabilities or a fair valuation of an institution's assets indicates they are less than its liabilities. It is difficult to project the effect on the public interest before or after a winding up proceeding is commenced. Liquidation may result in the sale of a significant part of an institution’s business in which case essential financial services may not be interrupted while they would be if there would be a piecemeal liquidation. This is not possible to determine before prospective buyers of a failed institution's businesses are indentified and prices for assets are negotiated. 54. Thus, as suggested below, consideration should be given to always excluding credit institutions from ordinary insolvency laws so that provisions can be made for the continuity of essential financial services since the outcome of a winding up cannot be clearly determined at the outset. Under ordinary insolvency laws the business of the insolvent entity usually ceases when a proceeding is commenced, something that would not necessarily occur under a resolution process. The criteria of “public interest� can be too general to be credible if used without further qualification. It should thus be based on observed adverse developments (based also on qualitative supervisory judgment) that may have chain-reaction or systemic effects and/or potential impacts on government or taxpayer losses. This should be clearly articulated. Thus, the test for resolution should be based both on whether capital adequacy requirements or other prudential indicators are met, as well as supervisory judgment on an institution’s observed and expected financial evolution. 55. The Communication also states: The general rule should be that failing credit institutions should be liquidated under ordinary insolvency proceedings. 56. Recommendation: It is questionable whether credit institutions of any significant size should ever be resolved by ordinary bankruptcy proceedings because of these institutions’ special nature, as discussed above.24 While some laws in the EU have been amended since the financial crisis to seek to fulfill the appropriate objectives for addressing credit institution failures, the majority have not. When the EC issues legislative proposals, EU members are to harmonize their legislation to implement the new rules. These should become standard for bank resolutions within national laws, but, according to the quoted paragraph above, the new rules may only become applicable if a public interest test is met. Thus, the indication of using ordinary insolvency procedures as the general rule, provides conflicting signals as to the direction of the new framework. 57. Ordinary bankruptcy laws usually are lengthy procedures that have a large role for judges who are not specialists in credit institution insolvencies. As indicated earlier, since the nature of 24 See Section II. 21 the business of ordinary commercial or industrial companies and the relative amount of their liabilities in relation to the equity are significantly different from those of credit institutions that are banks, bank resolution should be subject to different legal regimes that include expeditious action and administration by skilled insolvency practitioners. To provide for this, the proceeding should be administrative rather than judicial, unless a country has a well proven speedy and efficient judicial framework for processing bank resolutions or insolvencies. Administratie legal powers would require a supportive legal framework to fully endow them. Aggrieved parties would in any case retain the right of judicial review but in a way that would not halt the conduct of the administrative proceeding while it was in process. Institutions of all sizes should be candidates for resolution as this efficiently protects depositors within a going-concern context and helps protect the value of assets by avoiding losses usually associated with ordinary bankruptcy proceedings. 58. The Communication states: The Commission will consider what reform of bank insolvency law is necessary to ensure that failed banks can be liquidated as a second phase……….with the ultimate aim of ensuring that liquidation is a realistic option. 59. Recommendation: One of the major reforms in bankruptcy law since 1990 is to have “unitary proceedings� in which a process can result in either a financial reorganization or a liquidation, with variations on these major themes within the same proceeding. For example, in liquidation under a unitary process, a viable part of a business can be sold, as in a purchase and assumption transaction for a bank. This is distinguished from legally separate liquidations, on the one hand, and reorganization or rehabilitation proceedings, on the other.25 60. Thus, to speak of a two phase process, resolution and insolvency, is backtracking in respect of the evolution of bankruptcy law. Resolution is bankruptcy law in essence so all assets of a failing or failed institution should be allocated, and all creditor claims settled in one proceeding that can have different outcomes. Liquidation does not necessarily mean piecemeal liquidation of assets at salvage value. In the commercial liquidation context viable parts of a business are sold – in the case of banks, and due to a need for maintain market confidence, this should be done under a resolution (not bankruptcy) process. There can always remain a residual set of assets that need to be liquidated in the traditional sense, but authorities should always attempt to deal with these only as minimal residual unviable assets. 61. The Communication states: 25 However, separate reorganization proceedings makes sense in some contexts. See, Schiffman, H.N., “A Supplementary Legal Regime for Enterprise Financial Restructuring in China� in Journal of Comparative Law, China University of Politics and Law, No. 4, July 2003. 22 Measures aimed at maintaining the entity as a going concern - such as the power to write down debt or convert it to equity - should be a last resort, and only used in duly justified cases. This would help to underpin market discipline. 62. Recommendation: Relegating debt write-downs or conversions to equity as a last resort is questionable. Market discipline would be enhanced if the write down of debt or the conversion of debt to equity via contingent convertible debt instruments (COCOs) were more routine than extraordinary, especially with SIFIs where capital requirements may be so large that resolution and market mechanisms alone may be insufficient to address balance sheet gaps. 63. With COCOs, debt holders would seek to ensure that the institution in which they hold debt remains well capitalized so the conversion of debt to equity would not take place, since the value of equity in a financially challenged credit institution would be uncertain at best and perhaps of very low value or could become worthless if the institution were ultimately liquidated. Such market discipline would be in line with the provisions of Pillar 3 of Basel II which gained scant traction, and the possibility of conversion of debt to capital could constitute a mechanism for strengthening such discipline. If COCOs were contractually in place, it would be natural during a resolution process that new equity would come from this source if regulatory solvency was breached. 64. With respect to the coordinated resolution of banking groups, the Communication states: In principle, an integrated framework for resolution of cross border entities by a single European body would deliver a rapid, decisive and equitable resolution process for European financial groups, and better reflect the pan EU nature of banking markets. However, the Commission recognizes that it would be difficult to establish an EU integrated resolution model for cross-border banking groups in the absence of a harmonized insolvency regime and of a Single European Supervisory authority for those entities. The Commission considers that the European approach to resolution should mirror the broader approach to supervisory arrangements. 65. Recommendation: This raises several questions: first, there is scant discussion of non- bank elements of financial groups, how these would be resolved (e.g., insurance company assets and liabilities), their links to other parts of the group, and the nature of resolution tools for non- banking institutions. Second, it is not the case that a harmonized insolvency/resolution regime for financial institutions is only possible if a single European body executes such procedures. As indicated above, all banks of any significance should be resolved under new resolution procedures and there is no need for a separate insolvency regime except to execute residual non- viable assets. 66. As in any modern bankruptcy law, all assets of the distressed entity should be dealt with under one framework law that should lay out the principles and operating rules and that would be 23 the forthcoming EU legislative proposals.26 In other words, it is accepted that a single EU resolution body would be politically and administratively difficult, however, a single consistent resolution framework with very similar specific “rules of the game� should be the next minimum requirement across countries to, inter alia, avoid regulatory arbitrage and inconsistent treatment of creditors, shareholders, and cross-border institutions. 67. As well, there could be cases where a single authority designated to manage a banking group resolution was justified, such as cases in which a group’s headquarters was based in the home country, where most group assets were booked and where its overseas operations were primarily branches. It is not as if banking group resolutions will be so frequent that a single authority would be overwhelmed, but if many resolutions are required, it would mean that there was a crisis of significant proportions requiring a more consistent and coherent response by specific authorities. This most certainly should apply to overseas branches (not subsidiaries) of parent banks as they are part of a single legal entity and balance sheet. Separately, it would also make sense to ensure tight cross-border coordination if overseas subsidiaries (host country banks) were failing while being highly reliant on parent bank support and vice versa. 68. The Communication instead recommends a coordination framework based on the harmonized resolution tools and consultation and cooperation among authorities. This includes, according to the Communication, a requirement for group level resolution authorities to have the power to decide whether a group resolution scheme is appropriate. Such decision is supposed to be “taken quickly� but in such circumstances it would seem that, to assure celerity, the determination should be pre-ordained by set rules as to whether group resolution is appropriate based upon the size and allocation of assets among the group and the interdependence among group entities which would be disclosed under the “living will� exercise. 69. Thus, it seems that coordination and cooperation for a banking group’s resolution needs to go further and that creation of a central resolution coordinating authority or an initial “lead� designation of a national authority for group resolutions in a cross-border context, should be more carefully considered to improve on the recent past experience.27 There is precedent for this. Under well established principles of conflict of laws (called “private international law� in Europe), the law of the country which has the closest connection with the transaction in question (“center of main interests�) is applicable.28 This principle is recognized in EU Directive 2001/24/ EC of April 4th 2001 on the Reorganization and Winding Up of Credit Institutions that provides 26 This approach is also supported in Hagan, S. and Viñals, J., IMF, Resolution of Cross-Border Banks – A Proposed Framework for Enhanced Coordination, June 2010; and the Basel Committee on Banking Supervision, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010.. 27 See Hagan, S. and Viñals, J., Op Cit. 28 “In the realm of cross-border insolvency law and policy, as modified universalism has become ascendant over territorialism, the key concept of “center of main interests� has remained undefined. Now, however, with the issue over Eurofoods in the European Union and the filings of a couple of hedge funds in the Cayman Islands, courts are finally beginning the task of fleshing out the concept.� Texas International Law Journal, Vol. 43:14 (2008). 24 that the law of the home country of the credit institution is the applicable law for reorganization or winding up and that must be recognized in other EU member states. 70. Other Issues. The Communication does not go into much detail regarding financial groups with non-banking operations (e.g., insurance, asset management, pension funds) and how resolution would be treated. While these are typically stand-alone subsidiaries they may require different asset and liability separation tools, creditor hierarchies, and government support mechanisms, not to mention complications caused by intra-group and cross-border linkages. 71. The Communication also does not deal with systemic insolvency problems across a range of large institutions. While such is more unlikely, if this were to materialize, several of the new resolution tools involving third party purchasers of assets, would likely be unusable. The special levies for resolution funds might go a way toward addressing these issues along with the existence of “living wills,� but the implications of these scenarios requires much additional analysis. 72. Finally, on a technical/definitional point, the Communication defines the invoking of the Resolution phase as a stage where the financial institution is a “gone concern� (versus a “going concern during any phase prior to that). This cannot always defined as starkly. As a “gone concern� this would imply that the institution can no longer operate and therefore its license should be revoked immediately. However, under the principles of preserving asset value to sell to willing third parties, resolution can in fact take place within a “going concern� context if a large mass of the institution’s assets remain viable. 73. Thus, as discussed subsequently, if a voluntary market solution (i.e., existence of available buyers) is present to resolve a bank, then this would be conducted under the context of a “going concern� without the revocation of the banking license. If a market or voluntary solution does not materialize in the immediate short term (i.e., a matter of days and not more than a few weeks), that would then be cause for revoking the problem institution’s license as a “gone concern� to conduct a more officially-led resolution including the use of several options for burden sharing between the private sector and the state. 74. Going Forward. In conclusion, the EC framework sets the stage for deploying a wider array of more effective and flexible legal tools and instruments for bank resolution. Some of these features and their implementation details, as discussed above, require some reexamination to ensure that the mechanisms will reduce risks and function as intended. These mechanisms as well similar ones adopted elsewhere internationally (and further discussed in Sections V and VI) require careful calibration and procedural decision paths to meet the objectives of achieving least cost solutions and minimizing losses to depositors, the state, taxpayers, and creditors. 75. In this context, the figure below illustrates the sequence of procedures and actions that should be considered within an encompassing framework that utilizes defined legal powers and triggers for conducting resolution actions and deploying different tools for appropriate contexts. 25 Figure 2. Summary of the Context and Sequence for Applying Bank Resolution Actions Breach of prudential requirements, risk management practices, time-bound liquidity shortages, or minimum regulatory capital levels. Rehabilitation plan with Invoke resolution phase if intensified supervision, rehabilitation plan fails, and regulatory demand for capital injections, capital remains below required level or and/or official oversight & further declines (e.g.: to more than 2/3 administration of bank. below the minimum C.A.R.). Suspension of shareholder’s rights and Management/Board functions. Non systemic banks Systemic banks Are there available 3rd party institutional a. Are there available buyers of the bank or its assets, and/or can voluntary buyers? If yes, capital situation be restored, within 5-30 days? invoke options of sale or resolution mechanisms. b. Does the bank have Yes: Use No: existing COCOs? If yes, Asset transfer invoke legal conversion a. Revoke license. resolution of debt to equity. mechanisms b. Conduct forced resolution. c. If none of the above, invoke debt write-down c. Consider bridge of creditors, sale of bank option. selected assets, bridge d. Arm-twist 3rd bank option, with parties to accept remainder capital gap Once completed, send portions of assets supplemented by state any residual bad assets with deposits. 26 capital support. to final liquidation. SECTION IV: FINANCIAL MECHANISMS AND INSTRUMENTS FOR RESOLUTION 76. This Section elaborates on several of the financial and legal tools and instruments that can facilitate the execution of bank resolution processes under different conditions. These features are not, per se, prescriptive, but rather illustrative of financial mechanisms that have been successfully used internationally in different contexts. These can serve as useful options to consider for carrying out resolution processes under varying sectoral, industry, and economic conditions. A modern resolution framework should provide include various instruments that can be used to carry out a resolution procedure even if these instruments are not prescribed as the only ones nor are recommended in terms of priority of use. 77. Nevertheless for any resolution authorities, guidance on the financial engineering aspects of effecting a resolution can be important as the strength, size and quantity of market players can imply diametrically different sets of solutions to preserve the value of assets and reduce overall losses and costs of conducting a resolution. This section, therefore reviews some of the instruments and innovative mechanisms that have been utilized and which provide a broader menu of options for resolution authorities to consider. 78. Following the intervention by financial authorities in a banking institution subject to the resolution procedure, as indicated above, several of the institution’s stakeholders’ rights are to be suspended or revoked including those of shareholders, directors and management. Given that from a regulatory perspective if the capital adequacy ratio has fallen below the minimum (even if the bank is technically “economically� solvent) this breaches the bank’s prudential, operating and licensing criteria so the authorities have the right to intervene and if needed revoke the bank’s license (the latter in cases where a voluntary market solution is unavailable to resolve it). Resolution thus becomes the process that supplants outright bankruptcy and liquidation, in order to preserve the maximum value of assets, and optimize recoveries to creditors and shareholders. 79. As discussed above, the extent of bank capital has to be valued by the intervening financial authorities, including adding new loss provisions where these are deficient, effecting asset write offs, adding other required reserves and solvency capital, and ensuring that current liabilities on contractual and social benefits obligations (e.g., to ordinary employees) are properly accounted. Mechanisms for implementing the resolution process can include the following financial instruments for asset/liability transfer to other institutions: (a) A sale or direct transfer to an acquiring institution, of liabilities/deposits matched to assets with properly adjusted valuations; 27 (b) The use of trusts to securitize a loan portfolio or issue shares of securitized assets to sell these to acquiring institutions along with the assumption of matching deposits. (c) The issuance of bond securities through regulated securitization procedures including the use of a special purpose vehicle (SPV) under an established credit-protected bankruptcy-remote trust to transform loan portfolios or other assets, to negotiable securities. These can be differentiated with respect to underlying asset collateralization levels and risks accepted by acquiring banks. The levels of risk based on underlying assets can be matched against the rank of claimants in the creditor hierarchy. Alternatively, the bonds can be structured with a uniform underlying asset composition across the board, and matched against the liabilities according the creditor hierarchy with pro rata shares for those liabilities/creditors not fully covered. (d) capitalization of an institution to effect a change in shareholders or a new institutional buyer. 80. The use of some of the above instruments can include (in the case where a single acquiring bank is not forthcoming), the mentioned asset securitization mechanisms in the modality of issued bonds based on securitized loan portfolios, so as to distribute to several potential acquiring banks in “packets� along with corresponding packets of deposits. The use of such bonds can thus distribute the “load� of a resolved bank of significant size without burdening a single institution alone if such is not available. As well, such securitized bonds could be made marketable allowing initial acquiring banks to re-sell them if they find other assets to match their newly acquired deposits. 81. Since such bonds would have a known underlying portfolio, there is little risk of moral hazard and obfuscation regarding the underlying portfolios and their level of collateralization, as occurred with second and third generation collateralized mortgage debt obligations during the 2008-09 crisis. Thus, such securitization would be “plain vanilla,� that is they would be allowed to be backed only by specific loans and could not contain any other structured, securitized, derivative or other complex assets in such portfolio, thus making the underlying assets fully traceable for each bond issue. 82. Another feature that can be included in the distribution of matched assets (in the form of bonds) with liabilities to different institutions, is the use of “loan servicing banks� that would not place the underlying portfolio on their balance sheets but would charge a success fee once loan recoveries were made. Such institutions need not be the same as those acquiring the loan backed bonds and the incentives can be fully aligned by the separation of such loan servicing banks that do not place the assets on their balance sheet with those of bond purchasing banks that do not have the resources for the collection of a new portfolio of loans. 83. These are options within the broad menu of instruments and constitute burden sharing roles in the event that a single acquiring bank is not available and banks have differing 28 competencies and interests. Of course acquiring banks can also have the option to buy piecemeal portions of the loan portfolio, but if they do not wish to service such loans, the bond option would be more favorable. Whichever mechanism or instrument is used, an underlying rule should be that the cost of the deposit insurance agency to fund any gap in the matching asset/liability structures required to effectively complete such balance sheet transfers, should never exceed the costs that would have been incurred in paying out cash to insured depositors. 84. W Categorization and Ranking of Bank Liabilities by Creditor 85. The ranking of liabilities for payment of claims under the resolution procedure by type of creditor, should distinguish among obligations/creditors of first, second, third and fourth rank: First rank claims might include: (1) Cost of conducting the resolution. This is the contractual price of technical assistance and expert services to conduct resolution proceedings. (2) Private sector insured retail deposits. If authorities wish to optimize the protection of all deposits (insured and uninsured), these should be ranked starting from insured deposits first to other size-categorized deposits, for example based on a multiple of the minimum wage or a fraction of the per capita GDP. Thus a ranking for all deposits could include as an example, those of the latest per capita GDP level followed by those constituting a multiple of 2 times such amount, then 4 times and then 6 times the per capita GDP. In the event that all deposits cannot be assumed because they cannot be matched with viable assets for transfer to another bank, those above the per capita GDP threshold where all such deposits cannot be included, would constitute creditors’ claims to be paid from the proceeds from liquidation of residual assets. (3) Cash-based contracts, pre-payments for external trade transactions, sums withheld from salary payments for tax purposes, labor contract obligations, and other short term cash obligations. 29 Second order claims might include: (4) Loans from the Central Bank, Third order claims might include: (5) Deposits from public sector or government entities (6) Advances or loans from the deposit insurance agency (7) Claims of foreign external-based financial institutions (8) General tax obligations to the government Fourth order claims might include: (9) Other claims not included in the above categories. (10) Claims of shareholders or owners of the institution being resolved. 86. Once the asset valuation adjustments are completed under a bank under resolution procedure, the viable assets would be transferred to other institutions with matching liabilities in the order of the above-listed hierarchy of creditor claimants until all viable assets with continued earning potential were exhausted from the balance sheet of the bank being resolved. At that point all remaining creditors and shareholders in the above list would become claimants under the “residual assets� deemed to be sufficiently unperforming and in need of potential write-off and these would go to liquidation (e.g., including execution on collateral such as real estate, underlying such loans). 87. This liquidation phase would be the last stage of the resolution procedure following the phase of asset/liability transfers to acquiring banks. The liquidation process would be sub- contracted to liquidation or receivership specialists to carry out this function according to legal provisions established for liquidating residual assets not suitable for transfer. 30 91. 31 Figure 3. Tools, Mechanisms and Rules for Resolution Asset Transfer/ Sale Mechanisms Creditors – Order of Payment /Preference a. Sale/merger of entire institution. First Order Creditors b. Partial asset sale with matching a. Expenses for resolution deposits/liabilities. experts used. b. Private insured deposits. c. Private non-insured deposits. d. Cash contracts, labor a. Securitize assets as a bond. Sell payments due. securitized bond with matching liabilities. e. External trade/commerce payments due. b. Securitize assets into multiple bonds. Distribute bonds across several institutions (w/matched liabilities). c. Arrange bids from “loan servicing Second Order Creditors banks� (for off balance sheet operations) to collect funds on loan portfolios which a. Loans from the Central Bank. underlie the securitized bonds placed on other institutions’ balance sheets.. Compensation based on % success fee from collection on loans and/or on Third Order Creditors collateral. a. Public sector/government deposits. b. Loans/advances from deposit a. Structure a good-bank and a bad- insurance fund. bank. The good-bank to be sold to an c. Claims of foreign/external acquirer and has appropriate solvency financial institutions. capital. The bad-bank to be sold to a d. Tax obligations due. qualified distressed asset management company or assigned to a state agency for collection and/or liquidation. b. Set up a bridge bank. In case of no Fourth Order Creditors purchasers/acquirers, either voluntary or forced, have government operate a good- a. Other creditors, not listed bridge bank while a new buyer or investor above. is identified. b. Shareholders, owners. 32 SECTION V: ANALYSIS OF SELECTED COUNTRIES’ RESOLUTION REGIMES 92. This Section summarizes the legal regimes of six EU countries, as well as Canada, and recent legislation in the U.S., for bank resolution. The latter two non-EU countries are reviewed as they have had resolution frameworks in place for some time with some of the features being considered in a modified form, within the EU context. The Section focuses on the policy and legal framework for bank resolution and the role of deposit insurance in this process where relevant and is limited to the remedial and resolution provisions, without assessing actual practice in implementation. Corporate insolvency regimes, that are sometimes applicable to credit institutions, have not been reviewed.29 93. Bank resolution for purposes of this study means action by governmental authorities to address serious financial weakness such that solvency is at risk in one or more banks or credit institutions. The regimes for bank resolution in the six European countries studied are essentially of three types: (i) fairly recent financial system-wide approaches that are sympathetic to the plight of institutions caused by the 2008 financial crisis and provide for government funding for recapitalization, in addition to more traditional approaches to credit institution insolvency (Poland and Spain); (ii) fairly recent laws or amendments to laws that provide rather novel solutions for European countries for supervisory intervention and changing management of institutions at an early stage and transferring assets and liabilities of individual institutions to other institutions and that protect primarily insured deposits (Germany and the UK); and (iii) more traditional regimes that employ common precepts of credit institution supervision and corporate bankruptcy law (Czech Republic, Croatia). 94. As indicated in the reviews of individual countries, certain countries’ credit institution resolution regimes would change in important respects if the current EU Communication proposals for credit institution resolution were adopted for EU members for a harmonized resolution regime. POLAND The Banking Act of 1997 (BA) and the Bank Guarantee Fund Act of 1994 (BGFA), as amended, establish special procedures to deal with and to resolve failing banks in Poland. The provisions of these two laws provide a number of remedial and resolution powers to the Polish Financial Supervision Authority (PFSA) and to the Council of the Bank Guarantee Fund (BGF).30 These provisions are in addition to the general provisions of the Bankruptcy and Rehabilitation Law of 29 In some instances, the translation to English of the laws reviewed may have led to misinterpretation. 30 Due to the lack of precision of the English translations, understanding of the laws might be misconstrued. 33 2003 applicable to companies. The provisions of the bankruptcy law have not been part of this review. The remedial and resolution process in Poland has four distinct stages of escalation: (1) early remedial and rehabilitation actions; (2) provisional administration; (3) resolution by take-over; and (4) liquidation. Diagram 1 presents a synopsis of the combined remedial and resolution process. The paragraphs that follow summarize the mechanisms and powers available to the authorities under the two acts on banking and deposit insurance. Stage one (early remedial/self-rehabilitation): There are two types of early remedial actions provided in the Banking Act: (1) common enforcement procedures; and (2) rehabilitation proceedings. The first remedial procedures start at the point of lack of compliance with the PFSA’s recommendations (Art. 138). These are related to compliance with law and regulation, including an augmented Pillar 2 capital adequacy ratio, as well as in cases of deficiencies in risk management and control systems (Art. 138b). Lack of compliance empowers PFSA to apply a range of measures, although the enforcement action is not explicitly proportional to the gravity of the situation and the rehabilitation proceedings.31 Rehabilitation is required by certain triggers that are not explicitly related to capital deficiency.32 If a trigger occurs, management must so notify the PFSA and submit to a rehabilitation program. Its inadequacy or deficient implementation triggers further discretionary action by PFSA, including powers to summon a shareholders’ meeting to decide on absorbing net losses and increasing capital to required levels (Art. 143).33 These discretionary powers allow PFSA to nominate a trustee with limited powers to oversee the implementation of the program (Art. 144). Under the BGFA, nomination of the trustee falls into the BGF for those cases where it has granted its financial assistance (Art. 20 (2)). Stage two (provisional administration): FPSA has the discretionary power to institute formal administration if management fails to submit a rehabilitation program or its performance is ineffective (Art. 145). This compulsory administration suspends the powers of management and supervisory boards that are vested in the temporary administrator in order to: (i) ascertain the accounts; (ii) accounts for losses; (iii) develop a rehabilitation program with PFSA; and (iv) proceed to its implementation. Article 19.2 of the BGF Act foresees the provision of assistance by the BGF to an institution to mitigate insolvency risk and to support current or new owners to recapitalize the institution. It is unclear at which stage of the remedial and resolution measures assistance could be granted and 31 Art. 138.3 provides for limiting activities, imposing monetary penalties, dismissal and suspension of management, and revoking the license. 32 Article 142 triggers are a net loss, the threat of a net loss, or a risk of insolvency (See Figure 6). The threat of a net loss or a small net loss in any accounting period are unusual criterion for requiring a rehabilitation plan for a credit institution. 33 Asking shareholders to ratify a loss makes little sense and is a relic of company laws of former socialist countries. The accounts are what they are and there is no proper role for shareholders in P & L matters. 34 under which conditions. The amount of assistance is capped by Article 20 to the level of insured deposits. The Banking Act does not specify any concrete measures that should be taken by the temporary administrator or the span of time that administration can last. There are no further explicit relationships between both Acts in terms of coordinating action among the authorities and no further explicit powers and tools provided to restore solvency and preserve viability. Moreover, there are no explicit provisions to resolve failing banking groups or systemic non- bank institutions. Stage three (take-over): Based on three discretionary triggers, the PFSA has the right to decide: (1) the takeover by an acquiring bank; or (2) the withdrawal of the license and liquidation of the bank (Art. 147).34 The license revocation triggers the fourth stage of the resolution process discussed below. A takeover provides for a series of steps that can result in transferring the failing bank to a reputable party through: (i) takeover of management; (ii) due diligence audit; (iii) application of losses to capital; (iv) satisfaction or securing of creditors; and (v) payment of any residual value to shareholders (Articles 147 to 152). The Act does not provide further tools to execute partial transfers, carve-out of nonperforming assets, or assumption of liabilities and contingencies to compensate the acquiring bank for any losses above the net value acquired. Presumably, the provision of financial assistance by the BGF could achieve that up to the limit of guaranteed funds. Neither PFSA nor the BGF is provided explicit tools and powers to facilitate resolution. Stage four (insolvency): Insolvency is defined generally for companies by the Bankruptcy Law (Art. 11). However, for banks, insolvency is defined as a condition where assets are not sufficient to cover liabilities (Art. 158.1). The PFSA must decide whether to suspend bank operations and decide: (1) its takeover by another bank (stage 3 above); or (2) petition to the court to declare bankruptcy. There is no rule that precludes implementation of bankruptcy proceedings during rehabilitation and the Bankruptcy Act does not provide special procedures to liquidate banks, including tools to preserve value. In addition, the revocation of the license (Art. 138.3.4) determines liquidation. In both cases the PFSA must notify to the BGF its decision which constitutes the event for pay-off of the insured deposits (Arts. 138.3.4 and 158.1). Support for Institutions Unrelated to Imminent Insolvency The Act on Support of the State Treasury to Financial Institutions of 12 February 2009 provides for two categories of support measures, State Treasury guarantees for the issuance of new senior debt by banks and liquidity support measures in the form of Treasury bonds, either as a loan or to be sold with deferred payment. Unlike some government financial support schemes, the eligible institutions are many-- banks, credit unions, investment funds, brokerage houses, insurance 34 The triggers provide ample discretion to PFSA and may not limit the risk of forbearance. The first trigger is more objective although not fully precise (losses incurred exceed half the capital after six months of the date of an extraordinary meeting of shareholders). The other two triggers are general: (i) circumstances arose that threaten the viability of the bank; and (ii) capital may decrease to such an extent that it would no longer meet capital adequacy requirements. 35 companies, and investment funds. Assistance will be provided by the Minister of Finance, representing the State Treasury, at the request of a financial institution, after consultation with the chairman of the PFSA and the president of the central bank (NBP). The new support instruments bolster the interbank market by allowing institutions to maintain their liquidity. The law also provides for state guarantees for interbank deposits which will only be granted to banks considered “safe� and sufficiently strong in terms of capital. The new measures will also allow support to be given by the NBP. The State Treasury will be able to grant a guarantee of repayment of the refinancing facility granted by the NBP. In February 2010 Parliament enacted a law for the recapitalization of certain financial institutions. This recapitalization scheme guarantees the recapitalization of financial institutions that may be faced with capital inadequacy, by taking up shares, bonds and other securities that will strengthen the capital of troubled institutions. The Council of Ministers made the decision to pursue a recapitalization and partial nationalization strategy in line with similar strategies implemented across the industrialized world during the global financial crisis. This scheme envisions compulsory buyouts of capital enhancement securities at prices based on current valuations when recapitalized institutions regain their financial stability. Diagram 1. Remedial and Resolution Process in Poland - Suffered a net loss (unspecified) - Discretional decision by PFSA - Discretional decision by PFSA: - Threatened with such loss (same) - Management to call GA to vote - File objections with court - or, deficient implementation - In danger of insolvency (same) - or, GA summoned by PSFA to vote - Apeal decisions of GA (143.1) - R/P inappropriate (142) Submit a (R/P) (143) GA to absorb loss + (144) PSFA may nominate a rehabilitation program increase capital trustee BGF (20a §1) PFSA (145.1): triggers of "administration": BGF (20 §2) nominated as trustee if bank is to notify BGF the - Management fails to submit R/P granted assistance (4.2) need to Initiate R/P - Performance of R/P ineffective - (154.2) Suspension of management powers. (145) Administrtion: at PFSA - (145.2a) 'Balancing' the books, cover losses. PFSA discretional decisions: discretion - (145.4) Appeal by the Supervisory Board. (142.2) to set time limit to draw a R/P - (145.5) Draw and agree with PFSA a R/P. If R/P per (142.1) not submitted: (142.3) to institute 'rehab' procedures During implementation of 'rehabilitation': - Draws up a rehabilitation program (R/P) (142.4) earnings to cover loss and capital (145.5) Administration draws - Agrees R/P with PFSA BGF(19 §2) Provision of Not explicitly related R/P and agreed with PFSA - Administers R/P. assistance by BGF to eliminate - Reports quarterly to PFSA progress. insolvency risk per BGF (20). No explicit limits to forbearance ii) Circumstances threaten with insolvency (147) at PFSA's discretion, i) 6 months after GA and losses > 50% own funds iii) Own fund smay decrease and not meet requirements when i) to iii) are present (147.1.1) Take over by (147.1.2) Withdraw license another bank and liquidate - (147.3) Appeal by Supervisory Board (not suspense) (148) Take over management by (153) Appoitment of liquidator - Until reviewed by Court: acquirer by PFSA - no asset disposals - nor takeover by acquiring bank - Administrative Code applicable (127 §3) (149) Take over balance sheet (154) Liquidation principles and audit BGF (20) Conditions for assistance, inter-alia: assistance ≤ guaranteed funds 36 BGF(19 §2) Provision of (150) Acquiring bank to cover assistance by BGF to acquire (156) Liquidation procedures losses of acquired shares/stock by new owners. Summary Assessment Overall, the Polish remedial and resolution framework presents the following noteworthy elements: •Relatively clear stages for remedial intervention; •Power to summon a shareholders’ meeting at an early stage to consider a capital increase; 37 •Explicit takeover power and control of rehabilitation procedures during administration. Notwithstanding these features, there would be the need for substantial reforms to complete the current framework to adopt the resolution mechanisms advocated in the Communication of the EU, once new EU legislation is mandated, including: •Precise resolution tools and associated powers which are not now available; •Augment the precision of trigger conditions to mitigate discretion and forbearance risks; Provide explicit mechanisms to coordinate resolution of local entities parented by EU groups. CZECH REPUBLIC The Act on Banks No. 21/1992, as amended, of the Czech Republic establishes mainly remedial provisions to deal with problem banks and few elements to resolve those which fail (Arts. 26 to 36). These provisions are in addition to the general provisions of the Insolvency Act 182/2006 that contains special rules for the insolvency of banks, apparently essentially ordinary liquidation procedures, which have not been part of our review. The paragraphs that follow summarize the mechanisms and powers available to the authorities35 under the Act. Diagram 2 presents a summary flow of the combined remedial and resolution process which has four stages, as follows: Remedial Measures Stage One (discretionary remedies): Supervisory action with respect to a problem bank starts in the first remedial phase. Art. 26 empowers the CNB to adopt discretionary remedial measures, including restricting and suspending activities and replacing management and directors, as well as increasing minimum operational capital ratios and other risk mitigation measures. The Act provides a prescriptive list of triggers (set forth in Art. 26 (3)) for requiring remedial action, including a capital increase (Art. 26ba). One of the triggers is directly related to compliance with conditions approved at licensing. There is also a trigger condition related to compliance with minimum capital adequacy ratio, as well as conducting transactions that might be detrimental to depositors or which endanger the safety and soundness of the bank. Stage Two (formal remedies): The second remedial stage is not discretionary. It requires the CNB to start formal administrative proceedings with only one trigger condition being specified, solo capital below ⅔ the minimum level, (Art. 26a (1). There are no other quantitative and qualitative criteria for action provided by the Act. Five explicit remedial powers are provided to CNB in addition to those available under the first stage. The board must notify the CNB of the fact or the risk of insolvency, incurring of losses leading to the ⅔ below minimum capital trigger. 35 38 For both stages, the Banking Act provides procedures for the shareholders’ meeting to agree to a capital increase (Art. 26ba). However, the CNB does not appear to have authority to summon the meeting, or to require management or the board to do so, in order to consider absorbing loses, increasing capital, agreeing to an offer for the institution to merge or be acquired, or any other shareholder decision necessary to stabilize a problem institution. Diagram 2 – Remedial and Resolution Process in the Czech Republic CNB detects shortcomings (26 §3), inter-alia� a) failure to comply with licensing conditions; … h) fall of capital below minimum of (12a §1) CNB ‘entitled’ as per the ‘nature’ of shortcomings, inter-alia, to: (26) Discretional a) issue orders (restrict, replace directors/management), other; Remedial Measures b) change license; c) order audit; d) impose conservation; e) fine; f) reduce capital to absorb loss; and other. Bank: i) is or will become insolvent; ii) has incurred or will Solo capital < 2/3 minimum capital Capital < minimum (12a) incurred losses that reduce capital < 2/3 minimum. and bank increases capital (26a §1) Remedial and a ‘legal rule issued’ (26ba) Procedures for (26b) Notice to CNB by Measures via CNB’s increasing capital and supervisory board formal proceedings ‘invite’ GA to subscribe (30) Discretional decision of CNB to impose conservation when shortcomings endanger stability of (29 §2) Loss of preferential banking or financial system subscription rights if failure to increase capital within time limit Stability of banking or financial system jeopardized (27) Conservationship (26bb) Measure of CNB’s decision (reasons, nomination (1) powers of all bodies suspended; ‘general nature’ by CNB and restrictions) (2) powers of GM pass to conservator; (28) Nomination and (29) Legal effects (2) can exclude preferential rights; Employee of CNB Maximum span of 6 months dismissal by CNB of conservation (3) suspension of depositors’ rights; Temporary exemptions Temporary restrictions (4) suspension of payments to related; Change reporting duties Consent of CNB required (5) if bank insolvent notify to CNB. No need of creditors’ consent (29a) Take over “Special-purpose-bank� per agreement (of debts) (16 §1) with previous consent of CNB (1) purchase price per valuation rights/obligations; (29b) Sell of business (2) Features of the valuation; (16 §5) Transfer of and valuation (3) Public support not considered in the valuation; business to a company (4) Price = 1 CZK if value < 0 owned by CNB Nominated by CNB (29 §4) Unspecified compensation (29c) Appraiser for negative value Bridge Bank Powers Purchase & Assumption No contribution from DIF (34 § 1 to 3) CNB to revoke license if: Unspecified from Gov. - Serious shortcomings persist - Bank fails (undetermined) - By decision of CNB - False information at licensing (33) Termination of - Upon nominating a liquidator - Solo capital < 1/3 minimum conservationship - By declaration of bankruptcy Not obligatory if: - 24 months in conservation - Bank under conservationsip - Special-purpose-bank (34) Revocation of License Notification of insolvency to CNB CNB’s proposal to Court for winding-up Exclusive authority of CNB to propose to Course of action and (36) Bank liquidation the Court the nomination of the liquidator decisions by CNB? Resolution Measures 39 Stage Three (conservatorship): Articles 27 and 30 provide the CNB discretionary authority to impose conservatorship if it believes that a bank’s activities endanger the stability of the banking or the financial system. Thus, only in the event of a systemic threat may conservatorship be imposed. However, the law does not state the purpose of conservatorship or a primary objective. The law also does not contain special powers designed to facilitate efficient resolution of a bank. However, the conservator has the powers of the governing body of a bank and under Article 29b may sell the bank’s business and under Article 29a may arrange for the assumption of a bank’s liabilities. Therefore, a conservator could effect a P&A transaction. The conservator may also exercise the powers of the General Assembly to increase capital. All costs of the conservatorship are to be borne by the bank. However, without more explicit authority and explicit legal certainty as in the UK Banking Act, prospective counterparties may be reluctant to enter into transactions. The decision by the CNB to impose conservatorship must include appointing an employee of CNB as conservator and contain a rationale for the decision, and any restrictions or prohibitions on the conservatorship. There are other elements of the law that conceivably could be used for bank resolution. Article 26b provides that if the stability of the banking or financial system is threatened or if the banking or financial sector has already been disrupted, the CNB shall issue a measure of a general nature that is effective for a maximum period of six months. However, this would seem to be related to all banks such as liquidity support or a blanket guaranty of some or all banks’ liabilities and does not directly address tools for the resolution of individual banks. The Act also contains some powers that the CNB could use for bank resolution but which are not fully fleshed out for such purpose and therefore the provisions do not provide sufficient certitude on the range of options. For example, Article 16 authorizes the CNB to approve the creation of a “special-purpose bank� as well as the transfer of business of a bank to a company owned by CNB which provides a bridge bank tool, but this is not listed under the same process covering conservatorship, resolution or liquidation, but rather under the Section covering capital. Stage Four (winding-up): The last step of resolution starts when the conditions of Art. 34(1) to (3) are triggered. These conditions are a mix of specific (solo capital < ⅓ minimum capital) and general triggers (a bank fails or has serious shortcomings) and allow the CNB to request the court to wind-up the failed institution after the revocation of its license. The CNB retains the authority to propose to the court the nomination of the liquidator. The resolution of a failing bank which holds a valid license is conducted under the supervision of the CNB during conservatorship, under stage three. The liquidation of a bank that has failed, and whose license has been revoked by the CNB, is governed either under the Commercial Code or the Insolvency Act, depending on whether the (former) bank is a solvent institution and includes the liquidation of its assets and the distribution of proceeds among its creditors. 40 Insolvency proceedings are supervised by the court and regulated by Articles 365 to 378 of the Insolvency Act. It is not possible to reorganize or restructure a failed bank under this Act when its license has been revoked. The Czech Deposit Insurance Fund (DIF) plays no role in resolving failing banks. Its function is limited to reimbursing insured deposits in case of an insured event. Current legislation does not explicitly allow the DIF to support any form of restructuring or resolution except the payment of insurance for insured deposits. Summary Assessment Overall, the Czech remedial and resolution framework contains a few elements that are aligned to the proposals in the EU Communication: •Powers of CNB to adopt general measures for systemic events (Art. 26bb); •Triggers for action when an institution has capital above balance sheet insolvency (Art. 26 §3 and 26a (1)); •Rudimentary resolution tools of transfer of business in a conservatorship and creation of a bridge bank. The following additions to the resolution regime would be required for compliance with mechanisms advocated in the Communication of the EU Commission: •Clear objectives and thresholds for resolution; •An asset transfer (carve-out) and debt reduction tools and associated powers; •Authority to compel an institution’s owners to approve corporate changes; •Explicit least cost requirement and exemption for special cases; •Ex-ante resolution funding for resolution transactions; and •Mechanisms to coordinate resolution of local entities that are part of EU financial groups. In addition to these refinements in existing mechanisms, the following would seem advisable: (i) explore any need to expand intervention and resolution authority to systemic non-bank firms; and ii) consider whether the resolution and supervisory authorities need to be separated or whether vesting all powers in the same institution is effective and will prevent any regulatory forbearance; and (iii) include in the Banking Act provisions to strengthen the legal certainty of transactions with third parties, as in the U.K. and Canadian legislation. 41 GERMANY The Banking Act, as amended, establishes provisions for early intervention and remedial action in sections 45(1) to 46(a), including for the petition of insolvency (Sec.46b) and moratoria (Sec.47). Actions and associated procedures are conducted by the German Federal Financial Supervisory Authority (BaFin). Insolvency proceedings for winding-up an insolvent institution take place under the German Insolvency Code.36 In 2009, two laws refined the powers of BaFin to deal with problem and crisis situation institutions: (1) the Act on Strengthening the Supervision of the Financial Market and Insurance Sector; and (2) the Act on the Further Development of Financial Market Stabilization (the so- called Bad Bank Act) that supplemented the 2008 emergency package.37 The latter Act established a Financial Market Stabilization Fund. Effective January 1, 2011 the regime for resolution underwent a major change with the entry into force of the Act for the Restructuring and Orderly Liquidation of Credit Institutions, for the Establishment of Restructuring Fund for Credit Institutions and for the Extension of the Limitation Period of Corporate Law Management Liability (Restrukturierungsgesetz, the “German Restructuring Act�). Comments below are based on a draft of the Restructuring Act.38 From the review of the text of the Banking Act, early remedial and resolution actions can be grouped for the purposes of this summary into four distinct stages as described in the paragraphs that follow, including mechanisms and powers available the authorities.39 Stage one (early enforcement): Includes traditional enforcement powers whereby, in case of lack of compliance with prudential requirements in Sec. 10(1) of the Banking Act, BaFin may prohibit certain activities under Sec. 45(1) and issue specified orders. As part of early remedial action, Sec. 46 empowers BaFin to take temporary measures to avert risks to creditors and entrusted assets, including when grounds exist for suspecting that remedial supervision is not possible. Stage two (stricter holding actions): Section 46a escalates the measures that BaFin may adopt in cases of danger of insolvency, including banning sales of assets and payments, terminating business with customers and prohibiting payments not intended to satisfy debts. Sec.46a (2) also allows takeover of management by prohibiting existing managers from carrying out their activities and requests by BaFin to a competent court to appoint temporary administrators. Stage three: Section 46b requires managers to report to BaFin whether conditions of insolvency and over-indebtedness exist (Secs. 17 to 19 of the Insolvency Act). This relieves management of 36 The insolvency code procedures have not been part of this review. 37 The Financial Market Stabilization Act (FMStG) and the Financial Market Stabilization Fund Act (FMStG). 38 As of the date of this review, no English translation was available. 39 Conditions for intervention are drafted in very general terms providing considerable margin for discretion for each situation and thus seem to present opportunities for forbearance. 42 their obligation to file such a petition with a competent court. At this stage BaFin is the sole authority with discretionary powers to initiate an insolvency proceeding under the provisions of the Insolvency Act. In addition, if there are reasons to fear that a credit institution may encounter financial difficulties which are likely to pose grave dangers to the national economy and the proper functioning of the general payment system, the Federal Government may by regulation: (1) extend repayment obligations; or (2) order a temporary closure of the institution and of the stock exchanges. In order to restore confidence in the financial system, the October 2008 Bad Bank Act provided two new instruments to the Financial Market Stabilization Fund (SoFFIN) to enable financial institutions to strengthen their capital base and avoid liquidity shortages on a temporary basis. The Financial Market Stabilization Agency (FMSA), which administers SoFFin, can offer two temporary models: a special purpose model; and a consolidation model. Stage four (insolvency proceedings): Winding-up measures are regulated by the Insolvency Code and are independent of the remedial measures summarized above. In spite of the measures that BaFin may impose to prevent the insolvency of a credit institution under stages 1-3, in Germany before the new Restructuring Act there was no special procedure for resolution before insolvency proceedings. The insolvency proceedings were generally seen as too inflexible and are being adapted to provide more effective resolution mechanisms. The new German Restructuring Act (GRA) solves some of the difficulties of the German Insolvency Code. The GRA seems to have been inspired in important part by the U.K. Banking Act of 2009 in several of its significant provisions. The new GRA will impose a levy for banks to contribute to the costs of resolving future banking crises. It also introduces a Restructuring Fund (RF) financed by the levy for dealing with the restructuring of systematically relevant banks. The GRA foresees two procedures, “restructuring� and “reorganization.� It strengthens the authority of the German supervisor. BaFin may issue a transfer order forcing a bank to transfer its business (in whole or in part) to an existing bank or a bridge bank established by the RF. The Restructuring Procedure is voluntary, designed to be used before the onset of a crisis. The Reorganization Procedure is reserved for cases where the Restructuring proceedings are not attempted or were unsuccessful. Restructuring proceedings do not allow any interference with the rights of creditors and shareholders and are initiated by a bank with an important role for a restructuring adviser. The restructuring plan may incorporate a super senior facility to raise additional funds. These funds will rank senior to claims for debts incurred prior to the initiation of the restructuring proceedings. BaFin submits an application for proceedings to the competent court which, if found appropriate, approves the restructuring plan and the advisor proposed by the institution. At 43 the proposal of BaFin, the court may order additional measures if an institution’s obligations are at risk. Summary Assessment of Restructuring Act Analysis of the Act has indicated that some features of the restructuring procedure that could weaken its effectiveness, include: · Lack of definition regarding the triggers to initiate the procedures (left to institutions’ management’s discretion); · Absence of a moratorium period to protect a bank from actions by creditors to accelerate payment of a bank’s liabilities; · The restructuring plan does not include procedures to reduce or extinguish creditors’ and shareholders’ rights; · The restructuring procedures probably have to be disclosed under the securities law that could weaken confidence in the bank and trigger a run; · Restructuring advisors are liable for negligence if they harm third parties, which may deter prospective advisers who are not from within the bank; · The extent of court involvement is not clear, as distinguished from major decisions taken exclusively by BaFin. A reorganization proceeding is analogous in important respects to a Chapter 11 bankruptcy proceeding in the U.S. and modern insolvency laws that contain extensive provisions for reorganizations as an alternative to liquidations.40 Like a restructuring proceeding, a reorganization can be an option for a bank but has two threshold conditions: the institution must have a risk of failure and its failure would lead to systemic risk for the financial system.41 Given these conditions, the legal effects on property rights of stakeholders in such proceeding can be significant in aid of rescuing the bank: · Debt can be rescheduled or converted into equity; · Corporate documents of a bank can be amended (e.g., articles of incorporation) to modify shareholders’ rights; · Certain assets and liabilities of a bank can be sold and assumed to allow typical purchase and assumption transactions. The adoption of a reorganization plan depends upon a vote of groups of claimants, creditors of different classes and, if they would be affected by the plan, equity holders. A court must confirm 40 See Balz, M. and Schiffman, H.N., “Insolvency Law Reform in Economies in Transition—A Comparative Law Perspective,� Butterworths Journal of International Banking and Financial Law, 1996. 41 With the assistance of the Deutsche Bundesbank, BaFin determines whether a bank is at risk and whether its failure would lead to systemic risk. In this case, if the affected bank does not initiate a voluntary proceeding, BaFin takes control of the reorganization. 44 approval of the plan by claimants based on whether the procedural rules for voting by classes and approval have been met. The GRA contains a rule for confirmation of a plan of reorganization, as in a U.S. Chapter 11 proceeding for so-called “cram down,� whereby even if a class dissents, if they would receive as much in the reorganization as in a liquidation, they are deemed to have accepted the plan of reorganization, which promotes the adoption of such plans.42 An inducement to acceptance of a plan by certain stakeholders could be that if a plan is rejected, BaFin in the interest of financial stability can issue a transfer order in which certain liabilities would be transferred to another entity and the fate of those liabilities may be uncertain.43 As noted above, an important element of the GRA allows BaFin, at its own initiative, in the event of a systemic risk, to issue a transfer order by which assets and liabilities of a bank would be transferred to another entity. The remaining business stays with the failing bank and would be liquidated. The transferee entity need not be a bank and the license of the transferor bank is granted to the transferee. The transferee can be bridge bank established by the Restructuring Fund. The transfer does not require approval by the shareholders and the claims of a transferor are limited to what it would have received in liquidation. Restructuring Fund Act A new Restructuring Fund Act creates a fund contributed to by banks that is to be used to establish, participate in, or provide guarantees for obligations of bridge banks. The use of the fund is conditioned on a bank failure posing a systemic risk. The contribution is based on a bank’s liabilities and its derivatives activities but liabilities to depositors are not included so wholesale banks will have a relatively larger contribution. SPAIN Early remedial and resolution actions are regulated by a combination of laws and decrees. The Law 26/1988 on Discipline and Intervention of Credit Institutions, as amended, provides the Banco de España (BdE) enforcement and remedial powers, including takeover authority (suspension, removal or replacement of management and the board of directors). Under this law, revocation of a license is a prerogative of the Council of Minister pursuant to a proposal by the BdE. Revocation leads to winding-up of the institution under the two Laws indicated below and triggers deposit payoff under the provisions of Royal Decree 2606/1996, as amended, which governs the Deposit Guarantee Funds.44 Besides pay-off of insured deposits, Decree 2606/1996 authorizes financial support to reorganize problem institutions as a remedial action, facilitating 42 This is a rule of fairness. The U.K. Banking Act of 2009 in Section 60(2) contains an analogous provision. 43 In a transfer order, the claim by a creditor transferee is also limited to what it would have received in a liquidation so the creditor may prefer to have his claims remain in the reorganized bank rather than in an unknown entity. 44 There are three separate Funds for banks, saving banks, and cooperatives administered by the same Executive Council. 45 private sector transactions that result in selling the institution to reputable investors. More recently, Royal Decree-Law 9/2009 created a Fund for Orderly Bank Restructuring (Fondo de Reestructuracion Ordenada Bancaria or FROB) with two objectives: (1) to support resolution processes by restructuring credit institutions; and, in normal conditions (2) to assist in reinforcing their capital as well as contribute to the consolidation of institutions. The Bankruptcy Law 22/2003 provides two procedures for credit institutions: (1) settlement procedure supporting reorganization; and (2) a standard corporate liquidation procedure. In addition, Law 6/2005 on Reorganization and Liquidation of Credit Institutions implements the coordination of reorganization and liquidation of credit institutions of EU Directive 2001/24/EC. Law 6/2005 defines reorganization as administrative or judicial processes intended to preserve or restore the financial condition of an institution and that can affect rights of third parties by suspending payments, suspending debt recovery procedures, or reducing claims on an institution. However, this law contains no specific measures to be employed in reorganizations. It also contains no trigger criteria; presumably these are in Law 26/1988 that requires “a situation of exceptional gravity that places in danger the stability, liquidity or solvency of an institution.� A peculiar aspect of Law 6/2005 is that Article 6 states that only the judicial authorities have the authority to decide on the application of a reorganization measure to a credit institution or the initiation of its liquidation. While the main purpose of Law 6/2005 is to provide for notification to other EU authorities and to credit institution stakeholders of the initiation of a reorganization or liquidation when there are institutions with intra-EU offices or certain activities and for determination of the law applicable to such cases, in indicating that the judicial authorities are responsible for deciding on reorganizations or liquidations, its connection with other Spanish laws and decrees applicable to credit institutions resolution is not clear, especially in regard to the authority of the governmental authorities that have roles in deciding upon and overseeing reorganizations. The paragraphs that follow summarize the powers and mechanisms available to the authorities under the decrees and laws indicated. Diagram 3 presents a synopsis of the combined remedial and resolution process. The process has four distinctive stages of progressive escalating action: (1) self remedial and enforcement; (2) formal remediation with Deposit Guaranty Fund (DGF) or FROB support, or support of both; (3) restructuring by FROB; and (4) liquidation. Stage one (early remedial action): Early remedial action starts at the point of failure to comply with the required capital adequacy and risk limits, including the augmented Pillar 2 capital adequacy ratio, and certain cases of deficiencies in management and control systems (Art. 75 of RD 216/2008). This first trigger obliges a credit intuition in breach to notify BdE and to present a program to resolve the causes of the underlying violations, including actions to attain full 46 compliance.45 This remedial program must be approved by BdE and incorporate the latter’s requirements, including additional measures. Stage two (self-reorganization): Remedial action escalates further under the provisions of Law 26/1988 on Discipline and Intervention. This Law provides specific powers to enforce applicable laws and regulations depending upon whether there have been “grave� or “very grave� infractions, which include management intervention powers for exceptionally severe situations. Law 26/1988 characterizes infractions and establishes a response proportional to their gravity. Two particular very grave infractions are provided as triggers for escalated remedial action: (1) a balance sheet threshold--operating for more than six months with a capital ratio below 80% the minimum required (Art. 4.c); and (2) a qualitative threshold--operating with deficiencies in controls and processes that endanger stability (Art. 4.n). Before the point of balance sheet insolvency, Law 26/1988 provides an additional second trigger for exceptional severe situations that jeopardize stability, liquidity or solvency and empowers the BdE to take a broad range of actions. Among these actions, Article 32 empowers BdE to intervene in management and replace the board of directors. Related to this latter power, under Article 7.2.a of RDL 9/2009, the BdE can designate the Fund for Orderly Bank Restructuring (FROB) as the new credit institution administrator. In such case, under additional disposition (a.d.) number 3 of this decree, FROB acts as the sole authority empowered to request a declaration of judicial bankruptcy. Moreover, BdE is provided powers under Article 6 of RDL 9/2009 to formally require the presentation of a resolution plan under conditions that may endanger viability. As approved by BdE, this plan can provide the basis for financing directly by the relevant guaranty fund under Article 11 of Law 26/1996 or by the FROB under Article 6 of RDL 9/2009 to the relevant deposit guaranty fund to facilitate implementation of a reorganization plan. Use of FROB funds is to be guided by the principle of most efficient use of public funds, but in this context the relevant considerations to apply this principle are not clear. Stage three (formal restructuring): The resolution powers of FROB (Art. 7 of RDL 9/2009) are activated by triggers established in Art. 7.1, including: (i) failure to present or to implement successfully a reorganization plan; (ii) if the measures proposed are judged insufficient by the BdE to restore solvency and viability; and (iii) lack of progress or compliance with early intervention remedial measures.46 The restructuring process is de facto a resolution stage that starts with the removal of management and directors (Art. 32 of Law 26/1988) and the nomination of FROB as provisional administrator to develop a resolution plan through the use of the resolution tools provided to FROB (Arts. 7.2 and 7.4). These include financial injections or 45 All powers indicated are explicitly extended to groups of credit institutions under existing regulations. 46 In less “normal� conditions, under the plan required under Art. 75 of RD 216/2008; in more “abnormal� conditions, under Art. 7 of RDL 9/2009, as well as any plan under Art. 10 of RD 2606/1996 approved to provide assistance by the Deposit Guarantee Fund. 47 guaranties or the merger of the troubled institution with one or more sound institutions or the purchase of assets and assumption of liabilities by one or more other institutions. Stage four (liquidation): This stage includes the liquidation of any residual assets of an institution declared insolvent by the court for cases where restructuring fails to transfer all of an institution’s assets and liabilities to a third party. Liquidation takes place under the general Bankruptcy Law 22/2003 and Law 6/2005 on Reorganization and Liquidation of Credit Institutions. Law 22/2003 provides an initial reorganization procedure besides the standard liquidation procedures (Art. 104, Anticipated Settlement). These procedures are triggered by the revocation of a credit institution license reserved to the Council of Ministers at the proposal of BdE by Art. 9 of Law 26/1988 of Discipline and Intervention, as well as the request to a court reserved to FROB (a.d. number 3). Diagram 3. Remedial and Resolution Process in Spain Trigger (1): Per Art. 75, failure to comply with: 1) minimum CaR; 2) mandatory risk limits; 3) operate with additional capital > minimum CaR; Law 26/88 Art. 62 4) need to reinforce procedures, mechanisms, controls. Suspension shareholder’s voting rights for 3 years (if - Entity must notify to BE detrimental influence) RD 216/08 on capital If trigger (1) - Present ‘’remediation program’ to BE and risk limits, Art.(75) met - Program approved/adjusted by BE Law 26/88 of Discipline and Intervention Art. 4: Inventory of offenses (very grave/grave) Art. 4 very grave offenses (inter-alia): Art. 12: managers/directors found responsible Law 26/88 Art. 9, - 4ºc) CaR < 80% required CaR for 6 months a) monetary penalties; b) suspension; c) sanctions, inter-alia: - 4ºn) Control deficiencies endanger stability removal; d) barring (up to 10 years). “License revocation� - Other threshold and qualitative conditions. Trigger (2): Exceptional severe situation that jeopardizes stability, liquidity or solvency. RDL 9/2009 Art. 7.2.a) BdE to nominate Law 26/88 Art. 32 Intervention the FROB provisional administrator of SMG and replacement of BoD to replace SMG/BoD Trigger (6) per Art. 6: Weak Trigger (6): Art. 7.1, inter-alia financial condition might a) Plans per Art. 6.1 not presented/possible Trigger (3): per information of BdE b) BdE judges plan is not viable; changes not accepted endanger viability foreseeable risk of deposit pay-off by DGF c) Fail to comply with plan under Art. 6.1 Adoption of remedial measures d) Fail to comply with plan under Art. 75 RD 218/08 l m GF s Art. 6.1 Entity to: 1) notify BdE; Art. 7: Restructuring ure dia e D eas Art. 10.1: DGF may support me anc 2) present plan; 3) modify per procedure by FROM – Tools and t re fin preventative remedial measures por ay BdE approval Measures – Powers to exert tools sup B m to FRO Trigger (5): asset deterioration, capital level, Art. 7: Resolution Plan and Tools Powers of DGF to reorganize earning capacity, market confidence: ‘endanger viability’ 7.2: FROB submits resolution plan to BdE to apply: 7.2: Merger or transfer of business tool sse to Art. 11: Preventative and BdE informs entity of trigger y A ned ly 7.3: Financial support tool to apply plan mb al b itio remedial action per formal conditions and requires 7.4: Transfer tool: deposits, assets managed rov ond app lan c Approved Plan (content) ‘Remediation Plan’ 7.5: Asset carve-out tool P Deposit Guarantee Fund (DGF) Fund for Orderly Bank Restructuring (FROB) RDL 9/2009 RD 2606/1996 Art. 10.3. Limited test of Deposit Insurance Triggers least cost: consider, not Liquidation of the residual entity Out-of-Crisis situations binding. 48 Law 6/2005 RDL 9/2009 Art. 9/10 RD 2606/96 Art. 8.1.a) Reorganization (Art.5.1) FROB’s support to integration declared bankruptcy and Liquidation of Credit and recapitalization processes Institutions Only management and FRB can RDL 9/2009 D.A 3ª (bankruptcy) FROB Considerations The FROB is the most recent addition to the legislative framework for credit institution resolutions. Since both FROB and a deposit guaranty fund may support financially a reorganization in various ways including subordinated debt, equity, asset or liability guaranties, 49 including what may be necessary to promote a merger or acquisition, there is a question of whether the deposit insurance funds will become relatively passive in credit institution resolution with the ascendency of the FROB, given its ample resources and the relative flexibility that apply to its financial support.47 Under Article 7(6) of RDL 9/2009, the FROB is not subject to five statutory limitations regarding financial support that apply to the deposit guaranty funds that include amounts of financial support and amount of equity investments in institutions. The deposit insurance funds may prefer to maintain their funds for deposit payouts. RDL 9/2009 was issued following the financial crisis and takes a somewhat different and questionable approach than other resolution or credit institution insolvency laws with respect to the trigger, institutions affected, effect upon owners and managers of credit institutions, and on competition with sound institutions. The trigger is quite subjective. Under Article 6, when an institution has financial weaknesses that, taking into consideration market conditions, could put its viability at risk, it must present an action plan to remedy its situation. If it does not and the BdE determines that the asset quality of an institution is deteriorating, or its capacity to generate income to overcome its vulnerability is in doubt, or there is a loss of confidence by the public in its solvency, the institution must submit an action plan. Perhaps unrealistically, the plan must be implemented within three months. The plan must be approved by the BdE, but there are no criteria in the decree for such determination. As indicated above, if a plan has not been presented, the BdE believes it is not feasible, or the institution does not accept changes to the plan required by the BdE, obligatory restructuring is required. It is noteworthy that this applies to any credit institution, not only those of significant size or systemic significance based on other criteria. Thus, this decree, among the various other remedial and resolution laws in Spain, because of it subjective criteria for intervention, could become the new supervisory instrument for addressing weak credit institutions if there is a policy to support all or most weak credit institutions. This view is reinforced by the fact that Article 9 provides for financial support of credit institution consolidation and explicitly does not require a threat to the viability of an institution described in Article 6. In fact, FROB recently was instrumental in restructuring the Spanish saving banks and is supporting the consolidation of 38 of the 45 operating saving banks through Institutional Protection Schemes. In addition, Article 10 provides for recapitalization by the FROB of institutions, again without a finding of risk to viability required in Article 6, if the BdE determines that an institution needs to reinforce its capital. Equity investments by FROB are generally for a period of up to five years after which they must be repurchased by the institution or sold to third parties. Thus, the consequences of FROB intervention on institutions’ owners are not especially dire. With obligatory restructuring under Article 6, the FROB replaces provisionally the institution’s management or the governing board and seeks to improve its operations. As noted above, a range 47 FROB had an initial capital of € 9 billion, a sovereign guarantee up to € 27 billion, and authority to mobilize resources up to 10 times its initial capital. 50 of resolution approaches and financial support can be provided including investments in equity or debt of an institution, guaranties, mergers, and purchase of assets and assumption of liabilities by other institutions. Curiously, when the FROB makes an equity investment in an institution, the pre-emptive rights to subscribe to new equity issues of existing equity owners are abrogated. It would seem that new private sector equity participation would be desirable unless the FROB has a plan to sell the institution to new owners and the existence of certain other shareholders would complicate the proposed transaction. In terms of oversight, the FROB appoints the administrator of the restructuring plan for an institution, the BdE must approve the plan, and the FROB must present a memorandum to the Minister of Economy and Finance regarding the plan who can oppose it. Whether this tri-partite arrangement is efficient is a question. However, under Article 8, the implementation of a plan of restructuring led by the FROB benefits from a broad exemption from regulatory approvals that apply under laws on credit and banking, presumably those relating to prior approval of mergers, acquisitions, and sales of substantial assets. Summary Assessment Until the reforms of 2009 in the U.K., the Spanish remedial and resolution framework was one of the most comprehensive and proven in the EU, a product of the experience acquired during the 1974-84 and 1992-94 crises, and includes the following noteworthy elements among the various laws and decrees: •A broad range of trigger conditions and powers to conduct remedial early intervention; •Availability of explicit restructuring tools including asset and business transfers ; •Coordination between BdE and the DGF through the board composition of the latter; •FROB funding for resolutions (up to € 90 billion) in addition to funding by the deposit guarantee funds. Notwithstanding these positive elements, the following areas might deserve further development in order to implement all the mechanisms advocated in the Communication of the EU Commission, including the need for explicit: •Powers to require shareholders’ commitments and actions to support the institution; •Powers to effect changes in the ownership structure without shareholder approval of a credit institution in an resolution proceeding; •Powers to effect debt conversion and reduction; •A clear mandate and power for the BdE to initiate insolvency proceedings. The rationalization and harmonization of legislation related to credit institution resolution should be considered: Law 26/1988, Law 6/2005 and RDL 9/2009 as well as the deposit guaranty fund law, RD 2606/1996 and the bankruptcy law, Law 22/2003. In addition, providing BdE authority 51 to revoke a credit institution license may be desirable rather than having to request a political body that is the Council of Ministers to do so, as required by Law 26/1988. UNITED KINGDOM In the U.K., prior to the crisis of Northern Rock (NR) in mid-2007, there was no special legislation to enable the authorities to conduct an orderly resolution of a failing U.K. bank in a manner protecting the public interest, maintaining financial stability, preserving confidence in the banking sector, and protecting both depositors and taxpayers. The resolution of failing banks in the U.K. was mainly based on the application of the Insolvency Act of 1986.48 Under this regime, the authorities could not take control of NR from its shareholders and senior management while the bank was still “balance sheet solvent.� The result was that an early resolution of its situation was problematic; losses continued accruing and the franchise value dissipated, making the sale of its business increasingly difficult. In the end, absent a private sector solution that would preserve financial stability, NR was nationalized.49 After extensive consultation, in February 2009, the Banking Act of 2009 established a new Special Resolution Regime (SRR) which, with its implementing rules,50 provides a comprehensive regime for bank resolution including objectives, powers and tools, as well as the necessary conditions for the Bank of England, as the resolution authority to implement the SRR. The paragraphs that follow summarize the main features of the regime.51 Main Elements of the New SRR The Banking Act of 2009 has radically transformed the U.K. legal framework for resolving banking crises and is the most complete and advanced among European countries. It includes explicit statutory objectives that, in combination with the nomination of the Bank of England as a separate resolution authority (in addition to the FSA as supervisor), provides enhanced early intervention remedial and resolution measures, mitigating potential supervisory forbearance. In addition to its statutory objectives, the new regime provides for core elements which are briefly discussed below, including: (1) threshold conditions to trigger resolution powers and the application of tools; (2) a comprehensive resolution toolkit; (3) compensation for affected parties; and (4) special procedures to deal with banking groups. 48 A variation on the so-called “London� approach could also be used for financially distressed non-bank financial institutions. Under this approach, creditors of over indebted commercial companies and the company with the counsel of the Bank of England conclude an out-of-court agreement to enable the company to continue in business, usually involving the provision of additional credit. 49 Brierley, Peter, The UK Special Resolution Regimes for Failing Banks in an International Context. Financial Stability Paper No. 5, July 2009. Bank of England. 50 The Banking Act 2009 (Restrictions of Partial Property Transfers) Order 2009, S.I. 2009 No. 322; Banking Act (Third Party Compensation Arrangements for Partial Property Transfers) Regulations 2009, S.I. 2009 No. 319. 51 The HM Treasury, Banking Act 2009 SRR: Code of Practice provides further policy guidance on broad matters. 52 Statutory Objectives and Roles of the Authorities The Banking Act contains special resolution objectives that serve two purposes: (i) they reflect the purpose of the SRR measures in the Act; and (ii) they set out the objectives to which the Authorities must have regard when using or considering the use of their SRR powers in specific cases. The Act in Section 4 provides a list of five objectives for the authorities to balance in using the new SRR: (1) protect and enhance financial systems stability, including continuity of banking services; (2) protect and enhance public confidence in the banking sector; (3) protect depositors; (4) protect public funds; and (5) avoid interfering with property rights. Certain objectives become conditions. Under Section 8, for the BoE to use the resolution tools of sale of an institution to a private sector purchaser or establishment of a bridge bank, objectives 1, 2, and 3 above are conditions that must be satisfied and the BoE must consult with the FSA and the Treasury before making this determination. Consideration of the objectives is further supported by the extensive guidance provided through the Code of Practice published under Section 5 of the Act. The Code provides further explanation as to how the objectives may be achieved by outlining the factors that the Authorities may consider in applying them. The relative weighting and balancing of objectives will vary according to the particular circumstances of each failure, including both (i) circumstances specific to the failing institution; and (ii) general circumstances relating to the wider financial system. A Memorandum of Understanding between the authorities outlines how the authorities will coordinate with each other before and during the resolution. The FSA is responsible for determining that a bank is failing (or is likely to fail) to satisfy its threshold conditions, and that it is reasonably unlikely that action will be taken by or in respect of the institution that will enable the institution to meet those conditions. The FSA will also be responsible for the authorization of a bridge bank and ongoing supervision of entities subject to the SRR. The BoE is responsible for the operation of the SRR, including the decision of which SRR tools to use and their implementation with the exception of the power to take an institution into temporary public ownership. The BoE will also remain responsible for the provision of liquidity support under the BoE’s liquidity facilities. The Treasury is responsible for decisions with implications for public funds, for ensuring the U.K.’s ongoing compliance with its international obligations, and for matters relating to the wider public interest. The Treasury is also responsible for temporary public ownership of institutions, and it exercises a number of the ancillary powers under the SRR (including those where Parliamentary scrutiny is required), and the power to propose modification of the law and powers in relation to compensation. The Financial Services Compensation Scheme (FSCS) also works closely with the authorities. Under the compensation scheme, triggered by the insolvency procedure, the FSCS pays out to eligible depositors. Further, under Section 171 of the Act, the FSCS may contribute to the cost of 53 the SRR. The FSCS will need to assess and prepare for the payout, and its assessment of the possibilities for payout, or account transfer, will be a relevant factor in the selection of the SRR tool used by the BoE. For both a depositor payout or account transfer, or for any contribution to SRR costs, information-sharing protocols are to ensure that the FSCS has access to information relating to the failing institution and its systems at the appropriate time. Trigger Threshold Conditions Section 7 of the Banking Act establishes two broad triggers for initiating the resolution powers. Both conditions are to be satisfied simultaneously: (1) the bank must be failing or likely to fail satisfying its threshold conditions; and (2) it must be reasonably unlikely that action will be taken by or in respect of the bank (other than through the SRR) that would enable the bank once again to satisfy the threshold conditions. The threshold conditions are those specified in Section 41 of the Financial Services and Markets Act 2000, including: (1) legal status; (2) location of offices; (3) links with other institutions; (4) adequate liquidity, capital, provisioning, human resources and risk management processes; and (5) suitability (fit and proper management). The decision on whether the conditions are met are taken by the FSA as banking supervisor, and the risk of forbearance is mitigated by providing the BoE, as the resolution authority, with the right to make a non-binding recommendation to the FSA, to trigger the regime. However, this differs from the approach of other countries, since the FSA has considerable discretion, rather than mitigating the risk of forbearance, through the use of measures of capital deterioration that require increasingly intrusive supervisory intervention. Resolution Toolkit The Banking Act of 2009 provides the authorities with stabilization powers to apply three new resolution tools: (1) powers to exert a transfer of part or all of a failing bank’s business to a private sector purchaser (enabling purchase and assumption transactions); (2) powers to take control of part or all of a failing bank’s business through a bridge bank owned and controlled by the BoE; and (3) power to place a failing bank into temporary public ownership, where the Government acquires all the shares of the failing bank. In addition, the Banking Act provides a bank insolvency procedure for the BoE to close a failing bank and facilitate fast and orderly payout of depositors’ claims under the FSCS or transfer their insured deposits to a healthy private sector bank. To support the use of the tools, the nature of the FSCS has been changed to enable its funds to be used to support any other of the above mechanisms subject to a least cost requirement. The above four tools and supporting powers are in addition of other tools already available to the authorities, including public sector actions by means of capital and liquidity injections and the provision of guarantees of bank liabilities. 54 In the process of taking a decision for use of the special resolution regime, the BoE is to consult with the Treasury and the FSA. In choosing between the resolution tools, the BoE needs to consider the relative merits of the stabilization options and the bank insolvency procedure under the circumstances. There are additional general considerations that may be taken into account under the guidance provided by the Code of Practice, including governance arrangements both for bridge banks and for banks under temporary public ownership. In addition, the Treasury may bring a holding company of a banking institution into temporary public ownership, which action may only be taken if the FSA is satisfied that a bank in the group satisfies the general conditions set out in Section 7 of the Banking Act. Compensation The Banking Act makes provision for the assessment of any compensation due to those affected by an exercise of stabilization options, or where onward and reverse transfers are made to and from a failing bank to a private party or bridge bank. Provision is made for three types of orders listed below, which may be made for the purposes of assessing or providing compensation. The Act establishes a bank resolution fund and associated management duties as well as a clear process to nominate an independent appraiser and valuation criteria. These are further articulated in the Code of Practice. The three types of compensation orders are: (1) compensation orders, which establish a scheme to determine whether compensation should be paid to transferors; or provide for transferors to be paid, and establish a scheme for this purpose; (2) resolution fund orders, under which the transferors become entitled to the proceeds of resolution in specified circumstances and to a pre-specified extent; and (3) third party compensation orders, which establish a scheme for paying compensation to third parties (persons who are not transferors), for example counterparties of a bank who suffer interferences that might be subject to compensation of their property rights as a result of an exercise of the resolution powers. Summary Assessment Overall, the UK remedial and resolution framework is one of the most complete and advanced, and presents the following elements: •Precision in objectives, powers, tools and processes; and •A robust compensation regime with explicit provisions supporting legal certainty of transactions. Notwithstanding these advantages, the following areas might deserve further development to adopt all the mechanisms advocated in the EU Communication: •More explicit quantitative levels of under capitalization to further mitigate forbearance; •Explicit debt conversion and reduction mechanisms before exhausting the going-concern stage; 55 •Supplementing the current ex-post cost recovery with an ex-ante resolution fund. As indicated above, Section 7 of the Banking Act establishes two broad triggers for initiating the resolution powers. Both conditions are to be satisfied simultaneously, including: (1) the bank must be failing, or likely to fail, to satisfy its threshold conditions; and (2) it must not be reasonably likely that action will be taken by or in respect of the bank (other than through the SRR) that would enable the bank once again to satisfy the threshold conditions. In some cases the acquisition, merger or recapitalization of a distressed bank would become possible only after it is clear to a prospective acquirer or investors that the management that presided over a bank’s failure is on its way out. However, for a sale to a private sector purchaser, Section 8 contains strict conditions and requires consultation among three authorities. A less complex procedure could be envisioned whereby the FSA, once it identifies the dire straits of a bank, could facilitate a private sector solution without the superstructure in Section 8. In addition, the Banking Act contains other elements that perhaps could have been designed differently to make the regime more efficient:  There is divided authority among the Bank of England, the Financial Services Authority and the Treasury and by law they, and sometimes the FSCS also, must consult at various critical stages of determining whether and how the resolution regime would be implemented. Such multiparty consultations and coordination may cause inordinate delay or inaction and delay usually means loss in asset value of a distressed bank.  Section 15 of the Banking Act provides for the transfer by the Bank of England or the Treasury of shares issued by a bank, for example, to a new owner or to a bridge bank. However, “issued� usually means that unless there are treasury shares that have been bought back by the bank, shares of existing shareholders will be confiscated, albeit with compensation if applicable. It may be better if the Bank of England has the power to issue new shares of a bank to a new owner or bridge bank that would significantly dilute the interest of existing shareholders but would be less intrusive and possibly provide less cause for litigation. Sometimes in a financial reorganization in some countries, while the existing equity interests of shareholders become worthless because an entity has negative net worth, the shareholders are given a nominal interest in the reorganized entity to prevent litigation. Significant dilution that can occur with a new share issue can have the same effect. CROATIA The Credit Institutions Act of 2008 (CIA) and the Deposit Insurance Act of 2004 (DIA), both as amended, establish procedures to deal with and to resolve failing banks in Croatia. The provisions of these two laws grant certain powers to the Croatian National Bank (Hrvatska Narodna Banka or HNB) and to the State Deposit Insurance Agency (DIA). These provisions are 56 in addition to those in the Bankruptcy and Act that may be applicable to credit institutions. That Act has not been part of this review. The paragraphs that follow summarize the powers and mechanisms available to the authorities under the CIA and DIA. Diagram 4 presents a summary flow of the combined remedial and resolution process. For the purposes of this review, these processes can be organized into four distinctive stages of escalating action. Stage one (early remedial measures): The purpose of the standard enforcement measures in Article 229 of the CIA is to eliminate infractions of the law at an early stage, as well as to improve the safety of operations. Measures are implemented via memorandums of understanding (Art. 230) and decisions of the HNB (Art. 232). Failure to comply with the terms and conditions of a memorandum requires the HNB to adopt a decision and issue a warning to an institution’s management. There are three types of unilateral enforcement actions: First, a broad range of discretionary for risk mitigation (Art. 236(1)). Once an institution’s capital declines below the minimum required, there is a system of prompt corrective action by which the HNB is required to order remedial measures but with flexibility among the choice of actions (Articles 236(2) and 236(3)). Under Article 237 the HNB must require additional capital above the 12% minimum if HNB determines an institution’s capital is inadequate in light of the risks to which it is exposed and that there are deficiencies in its governance and risk management. If it deems it necessary, the HNB may appoint a trustee to oversee the implementation of its orders (Arts. 238 to 240). In 2008, an amendment to the Deposit Insurance Act (DIA) in Article 16a provided powers for the Deposit Insurance Agency to adopt measures for preventing an insurance event to improve the liquidity and solvency of a particular credit institution subject to a least cost option requirement. These measures must be part of a program of measures proposed by the institution to the Agency, on which the HNB will opine. The measures include: (1) an increase supplementary capital; (2) increase in shareholders’ equity investment; (3) repurchase of assets; and (4) provision of guarantees. The total financial support granted cannot exceed 50% of the insured deposits of the institution. Stage two (special administration): Article 241 provides to HNB additional discretionary powers: (1) to introduce special administration; (2) to revoke the license; (3) to initiate compulsory winding-up; and (4) to submit a request to initiate bankruptcy proceedings The trigger conditions for Article 241 actions are described in general terms and leave ample room for discretion to the HNB: (i) in cases of violation of laws and regulations; and (ii) when the financial position of an institution makes uncertain its continued operations. Moreover, under Article 242(1) The HNB must appoint a special administrator under the following circumstances: (i) the failure of the institution to implement the measures agreed or mandated in stage one; (ii) the failure to reach the minimum 12% capital adequacy level despite the supervisory measures; (iii) a capital ratio of 6% or lower; and (iv) when continued operations 57 would or could jeopardize its liquidity or solvency and administration is needed to protect the interest of the institution’s creditors. The HNB can postpone administration at its discretion if it determines facts indicating a high probability of improvement in the credit institution’s condition (Art. 242(2)). If the HNB decides to establish administration, it needs to provide the reasons, the identity of the special administrators, the scope of their activities, and the duration of their mandate which cannot exceed one year (Art. 242(3)). The Act contains details on powers, legal effects and remuneration during special administration. The goals of the administrator are to manage the institution and improve its financial condition, for which the explicit tools and powers granted are limited (Art. 248). They explicitly include selling assets and limiting asset growth and expenses which suggest an orderly exit rather than transformation to viability. Implicitly, the administrator may seek to negotiate a merger or acquisition. Under Article 240, when special administration is instituted, the powers of management and the supervisory board cease which would also indicate that sale of the institution in whole or in part or liquidation would be the only probable outcomes, rather than rehabilitation, since there would be no high level officials with the authority and stature to attract new capital investment in the institution. Within three months, the special administrator must provide to the HNB an assessment of the condition and viability of the institution including with regard to: (1) the willingness of shareholders to provide additional capital; (2) possible measures to eliminate its difficulties; and (3) whether the conditions exist for compulsory winding-up or for bankruptcy (Art. 249). Based on this report, the HNB may order the special administration to convene the shareholders’ general meeting to propose a capital increase, or to agree to the acquisition or the merger with another institution, as well as other appropriate actions (Arts. 251 and 252). Shareholders are to be formally warned that the HNB must initiate compulsory winding-up proceedings if shareholders refuse to agree to increase capital or approve a merger or acquisition under Article 263(1). The HNB must (Art. 253.4 and 253.5) initiate compulsory winding-up under the Company Act or submit a request to open bankruptcy proceedings if the special administration reports that: (a) the financial position cannot improve during administration to reach the minimum capital adequacy ratio; or (b) after 12 months of special administration the minimum capital adequacy ratio has not been attained. The HNB can in exceptional circumstances extend the administration for six months only if the conditions for bankruptcy have not been met. No further tools and powers are provided in the Acts for improving the financial condition of institutions or to restructure failing institutions before liquidation. Moreover, there are no further means and explicit coordination mechanisms between the HNB and DIA to remedy and resolve failing institutions. Stage three (compulsory winding-up): The HNB must initiate compulsory winding-up proceedings under Article 263(1) if: (1) there is lack of progress in implementing recovery 58 under special administration; (2) shareholders’ general meeting refuses to increase capital, approve a merger, or similar alternatives; or (3) the HNB revokes the institution’s license. Winding-up is to be performed by two liquidators nominated by the Deposit Insurance Agency under the procedures of the Company Act, subject to the instructions issued by the HNB (Art. 266).52 There are no additional legal provisions or implementing regulations to improve the prospects for asset recovery in compulsory winding-up proceedings. 52 These instructions were not available for review. 59 Diagram 4. – Remedial and Resolution Process in Croatia (229) Supervisory (230) Memorandum for Measures (CNB) (232) Decision for violations deficiencies not or deficiencies violations (236) Types of Sup. (237) CNB orders CaR Measures (238) CNB nominates a > minimum Trustee Set of specific grounds 12% > CaR ≥ 9% 9% > CaR > 6% (236.2) (236.3) Additional (236.1) Discretional CNB “may� Obligatory Measures CNB “shall� Obligatory Measures Measures (CNB) (CNB) (CNB) CNB “shall� impose Unspecified cases of supervisory measure violation and uncertain continued operations 1) Fails to implement measures (241) Discretional (242) Obligatory 2) Fails 12% despite measures “3� Unspecified outcomes Decision (CNB) Decision (CNB) 3) CaR ≤ 6% at the discretion of CNB. 4) Jeopardy to liquidity or solvency No explicit power to effect (242.2) Facts to postpone Special splits/Bride bank structures Administration: “high probability to improve� If not improved in 12 months (253.6), (243) Appeal to can extended 6 months per (253.6) if: for a private sector transaction Administrative Court (likely i) Would be able to meet (CaR) public known) ii) Bankruptcy conditions are not met (242) Special (251) Increase of Administration capital: convene GA (245) Entered into Company’s register Assessment report after 3 months Convene general assembly (GA) (252) M&A (convene Limited to 50% of LCS. Based on “Program of Measures�. Quarterly follow-up by CNB GA) No power to effect PST. 12 months duration 6 month renewal maximum (16a) DIA’s CNB only Exit: (winding-up; bankruptcy): (253.2) If improved, preventative consulted. No (253.4) cannot improve; measure further links. (253.5) has not improved (12 months) exit on compliance No tools to effect private sector solution Triggers to start Winding-up or Bankrupcy: (263.1.1) cannot improve and attain minimum CaR; (263.1.3) has not improved after 12/18 months; (263.1.4) license withdrawn per (67.1 and 67.2); (263.2) GA refuses to adopt decision to (263) Compulsory Increase capital, sell or merge: “no power Intervention by the Deposit Insurance Agency (DIA) to prevent occurrence of a deposit insurance event Winding-up (CNB) and tools to effect a private sector solution� Mutatis mutandis: (270.1) Company Act (266) DIF appoints (269) Test grounds for (265.1) CNB notify DIF (270) Procedures (270.2) Banking Act liquidators bankruptcy. (270.3) CNB special rules No additional provisions. (273.1) Unable to repay deposits due for 21 consecutive days Liquidators to request (273.2) Unable to meet due payable obligations for 60 days Court the proceedings (273.3) Assets cover not existing obligations and notify to CNB Mutatis mutandis: (273) Bankruptcy (274/275) Court request, (276a) Exam of (272) Bankruptcy Act Proceedings unless specified in B/A “Grounds� trustee and measures financial position DIA’s Act: (2a.2) Court decision or (8) CNB’s notice of failure to repay deposits (2a.2) Pay off Straight pay-off or, Transfer. (279) Decision of fudge’s to (278) Higher priority (276d) Decision and event for DIA No explicit carve out start and close proceedings claims nomination of trustee Unclear role of DIA in bankruptcy Stage four (bankruptcy proceedings): Bankruptcy proceedings are conducted according to the Bankruptcy Act with a few procedural provisions in Articles 274 to 279 of the Credit Institutions Act. The HNB as well as other parties has the right to petition for bankruptcy proceedings of a credit institution.53 The grounds for a bankruptcy proceeding are that the credit institution: (i) is unable to repay deposits for 21 consecutive days; (ii) is unable to meet its other financial obligations for 60 consecutive days; or (iii) assets do not cover its existing obligations. In the 53 The role of the Deposit Insurance Agency in the process is not explicit, but it is a creditor, presumably the largest and therefore influential, as subrogated to claims of depositors after insurance is paid. 60 case of an institution under special administration criterion (iii) would seem to usually be the case if a current balance sheet were established. Conditions (i) and (ii) would arise infrequently. Depending upon whether compulsory winding up or bankruptcy is conducted more efficiently and which is more suitable for credit institutions given the special nature of their liabilities, only one type of proceeding should apply to financially distressed credit institutions. Summary Assessment Overall, the Croatian remedial and resolution framework presents the following desirable elements: • A clear delineated process from the initial financial distress of an institution to the liquidation stage; •Presents a reasonable combination of objective triggers for intervention and margin for action based on HNB supervisory discretion; •Grants an explicit mandate to convene an institution’s shareholders’ general meeting to consider proposed capital increases and merger with or acquisition of the institution that may resolve its condition; The following areas deserve consideration in order to implement the mechanisms advocated in the Communication of the EU Commission, including the need to provide an appropriate combination of powers to the HNB and the DIA: •Explicit tools to effect resolution during special administration;54 •Powers to supersede shareholders’ and creditors’ rights in the special administration; •Means to finance resolutions, beyond the DIA 50% limit; •A mechanism to centralize crisis management in systemic and regional crisis situations; •Explicit expansion of the scope of resolution measures to financial groups and systemically significant non-bank firms; •Explicit mechanisms to coordinate resolution of local entities parented by EU groups. CANADA Due to a combination of factors, the financial system of Canada showed remarkable resilience in the global financial crisis. Among these factors, some commentators emphasize two key aspects: the will to act preventatively to mitigate accumulation of risks of losses and insolvency; and the availability of strong powers and tools to resolve failed banks at an early stage.55 Because of 54 For a complete list, see Section One EU Panel, as well as the summaries for Canada and the U.K. 55 Cf. Boone, Peter and Johnson, Simon, The Canadian Banking Fallacy, Economix, The New York Times, March 25, 2010. 61 this experience and whilst Canada is not a member of the EU, its resolution framework has been chosen as an illustration of good practice. In Canada, remedial and resolution procedures for problem banks taken by the Office of the Superintendent of Financial Institutions of Canada (OSFI) and the Canada Deposit Insurance Corporation (CDIC). The activities of both agencies are governed by three basic Acts that provide a wide range of discretionary intervention powers to address concerns that may arise with federally-regulated deposit-taking institutions. These acts are the Bank Act of 1991 (S.C. 1991, c. 46) and the CDIC Act (Chapter C-3), both as amended, and the Winding-up and Restructuring Act or “WURA� (Chapter W-11) for liquidation procedures. Also, OSFI’s statutes under its Act (R.S., 1985, c. 18. 3rd Supp.) provide provisions regarding, inter-alia, the duties and powers of the Superintendent. As for the other countries included in this review, the provisions of the Winding-up and Restructuring Act have not been part of this review. Moreover, the “Guide to Intervention for Federally Regulated Deposit-Taking Institutions,� provides the details of the intervention process followed by OSFI and CDIC, to identify areas of concern at an early stage, and to intervene effectively so as to minimize losses to depositors and other creditors in the case of OSFI, and to minimize the exposure of CDIC to loss. The paragraphs that follow summarize some of the relevant mechanisms and powers available to the authorities under their two Acts. The process has four stages of escalating intervention. Stage one (standard remedial procedures): The Bank Act provides OSFI with a broad panel of remedial powers (sections 644.1 to 647.1).56 These powers range from entering into prudential agreements with institutions’ management to maintain or improve safety and soundness, to issue directions of compliance, and application to a court for an order to an institution to comply with agreements and directions. Furthermore, OSFI has ample powers to disqualify, suspend and remove directors and officers of a bank that fails to comply with agreements, orders and directions. The Guide to Intervention contemplates four progressive measures by which problem institutions are “staged� towards resolution, when needed. Each intervention stage has pre-determined consequences and an increasing intervention stance by OSFI and CDIC. Under its risk assessment framework, OSFI rates institutions in four levels of progressively adverse condition, considering their risks to solvency and stability. The three first stages require the standard remedial procedures summarized above. The fourth stage involves resolution through restructuring and through liquidation under the Winding-up and Restructuring Act. Institutions that are not staged for intervention operate under a normal risk-based supervision program cycle with a focus and supervisory actions commensurate with their overall risk rating. Following indications of weaknesses, as the risks to solvency and stability accumulate, 56 All references to OSFI need to be construed as particular to the Superintendent in whom all powers and decisions are vested. 62 institutions are staged successively into to: (i) stage one or early warning; (ii) stage two or risk to stability or to solvency; and (iii) stage three or future financial viability in serious doubt. The fourth stage is assigned to failing, or about to fail, institutions, and designated below as intervention/take-over stage. Each of the three intervention stages for non-failing institutions involves increasing intervention from OSFI and CDIC, and includes coordination of their activities and plans within their respective roles. These activities include: (a) enhanced monitoring; (b) special audits and risk assessment of target businesses and asset and revenue validation; (c) contingency planning for rapid takeover; and (d) coordination with management and directors to implement restructuring and private sector solutions (divestiture, mergers, and acquisition). In the third stage of intervention, for institutions whose viability might be under serious doubt, and before the Superintendent might decide to take over the institution as described in the next paragraph, CDIC proceeds to evaluate resolution alternatives, including the potential design of a takeover plan. This includes planning a Financial Institution Restructuring Plan (FIRP), based on CDIC Act Sec. 39.1, if a restructuring transaction is likely to be the most expeditious remedy to mitigate stability concerns and to minimize loss to CDIC in the resolution. Stage Two (formal intervention): The objectives of intervention provide the mandate of OSFI to take prompt resolution action. These focus the Superintendent when taking control of the assets of a bank towards all things necessary or expedient to protect the rights and interests of the depositors and other creditors including its interaction with CDIC (Sec. 648.2). The Bank Act provides eight conditions for intervention (Sec. 648.1.1). These conditions include any state of affairs that in the opinion of the Superintendent may be materially prejudicial to the depositors and creditors. All the conditions provide ample margin for the Superintendent to exercise discretion in adopting the decision to intervene.57 Conditions are further specified in stage four of the Intervention Guide for cases of serious financial difficulties and imminent insolvency and non-viability, which trigger the initiation by the CDIC of a FIRP. The acts of intervention that the Bank Act provides to the Superintendent are broad and clearly framed in Section 648.1., including: (a) temporary control (up to 16 days) of an institution’s assets and assets under management; and (b) unless the Minister of Finance is of the opinion that it is not in the public interest: (i) control of assets of a bank for more than 16 days, I or (ii) to take control of the bank. The distinction between control of the assets and control of the bank is not clear, In the case of the latter, the powers and duties of directors and bank officers are suspended and transferred to the Superintendent who may appoint one or more persons at the expense of the bank to assist in its management (Sec. 649.1). 57 Other conditions for intervention include: (a) failure to pay liabilities or likelihood of failure to do so; (b) insufficient assets to adequately protect depositors and creditors; (c) any assets deemed to be unsatisfactorily accounted for; (d) regulatory capital of a level detrimental to depositors and creditors; (e) failure to comply with orders made by the Superintendent; and (f) termination by CDIC of deposit insurance. 63 The Superintendent may at any time: (1) relinquish control; or (2) request a winding-up under the WURA (Sec. 10.1). If none of these actions is taken in 30 days, if the bank’s board requests the Superintendent to relinquish control, the Superintendent must do so or request the Attorney General to apply for a winding-up order. Stage Three (restructuring): The Superintendent is to notify the CDIC if an institution has ceased or is about to cease to be viable and its viability cannot be restored or preserved by the exercise of her powers (CDIC Act Sec. 39.1).58 The Superintendent is also to report to the Corporation if she is of the opinion that the Superintendent could take control of the institution under the Bank Act and whether if such control were taken grounds for winding-up would exist. The notification may trigger a request by the Corporation to the Minister, if he believes it is in the public interest, under Sec. 39.12, to recommend to the Governor in Council that he issue one or more orders for action by the Corporation to: (1) vest the shares and subordinated debt of the institution in the CDIC and proceed to perform restructuring transactions (Sec. 39.13(1)(a)); (2) appoint CDIC as receiver for the institution (Sec. 39.13(1)(b)); or (3) direct her to incorporate a bridge institution (Sec. 39.13(1)(c)). Its Act provides to the Corporation restructuring powers , to effect a transaction or series of transactions involving: (a) the sale of all or part of the shares or subordinated debt of an institution; (b) the merger of the institution; (c) the sale or other disposition of all or part of its assets or the assumption of all or part of its liabilities, or both; (d) any other transactions whose purpose is to restructure a substantial part of the business of an institution (39.2 (1)). The Corporation may also be empowered as receiver to effect transactions similar to those under Sec. 39.2 (1)). Any transaction in restructuring or in receivership that is not with a bridge institution is subject to approval by the Minister (Sec. 39.2(5)).The CDIC Act provides comprehensive provisions for the organization and operation of bridge institutions (Secs. 39.201 and 39.371 to 39.3723). A bridge institution has an initial existence of up to two years that can be renewed for up to five years. The Corporation must apply to the court for a winding- up order under WURA if its opinion is that in absence of a bridge institution the restructuring actions are not substantially completed 60 days after the initiating order by the Governor in Council to vest shares in CDIC, or at the expiration of any extension granted by the Governor. Stage Four (winding-up): Insolvent banks are to be liquidated under the provisions of WURA. The Bank Act provides for priorities in payment of claims in the case of a bank insolvency (Sec. 369 (1)). Curiously there is no special provision for high priority for payment of the expense of the administration of a proceeding for the insolvency practitioners. Section 3 of the WURA provides the conditions for a company to be deemed insolvent. Besides inability to pay and other criteria of insolvency, the Act contains three additional criteria for banks, including those cases where the CDIC: (1) has been appointed as receiver and a transfer 58 This includes whether the institution: (a) depends excessively on funding by loans or other facilities to sustain its operations: (b) has lost the confidence of depositors; (c) has regulatory capital that is or is about to become substantially deficient; and (d) has failed to pay or will not be able to pay its liabilities. 64 of part of the business of a bank to a bridge institution has been substantially completed; (2) has been vested ownership of the shares and subordinated debt of a bank and, in its opinion, the restructuring transactions have not been substantially completed on or before 60 days after their initiation, including any extension granted; or (3) has been appointed receiver of a bank and, in its opinion, the specified transactions have not been substantially completed on or before 60 days after their initiation, including any extension granted. In addition, the CDIC Act contains a comprehensive set of provisions to support the implementation of restructuring and winding-up activities. These provisions include: (1) an explicit loss minimization mandate (with the exception noted below); (2) comprehensive procedure to govern compensation to affected parties (Secs. 39.23 to 39.37); and (4) provisions reinforcing the effect of orders and decisions which provide legal certainty to all resolution and winding-up transactions, including for third parties who acquire assets or assume liabilities from a restructured bank or from bridge institutions. Summary Assessment Overall, the Canadian remedial and resolution framework contains many of the powers and mechanisms that are being recommended in the EU Communication, including following: •Clear objectives provide incentives to minimize loss leading to early remedial and resolution actions; •Flexibility and precision of the powers provided to the OSFI and CDIC designed to limit regulatory forbearance; •Reasonable mix of triggers and margin for discretion guided by the stated objectives •Explicit authority to convene the general meeting of shareholder to approve changes required for restructuring at an early stage; •Strong tools to restructure business and preserve value before liquidating the residual activities; •Comprehensive set of provisions to provide legal certainty to third parties engaging in transactions with a failing bank or bank in receivership; •Explicit coordination framework between OSFI and CDIC for the resolution process. Notwithstanding the above, the following areas might be further developed in order to incorporate additional mechanisms advocated in the Communication of the EU Commission, including: •Lack of precise quantitative triggers of capital deterioration to cause prompt corrective action; •Lack of powers to convert and reduce debt before the gone-concern point; With respect to the criteria for early stage remedial action, under Sections 644.1 and 645 of the Canadian Bank Act these are “maintaining or improving safety and soundness� for a prudential agreement or the presence of an “unsafe or unsound practice� for a compliance direction. Such 65 vague terms as “unsafe or unsound� in some countries might be considered unconstitutionally vague and therefore not enforceable since a basic precept of law is that those subject to the law must have fair notice of their obligations under the law. In Canada as in the U.S., these terms may have derived more definite meanings from court decisions contesting their application but for other countries they may not be suitable. In all EU countries credit institutions are subject to so many prudential and market conduct requirements that to base enforcement actions on a violation of a provision of law, regulation or failure to comply with an order of the supervisor should provide ample bases for enforcement action. For credit institutions resolution, the failure to maintain adequate capital would provide a clear basis for supervisory intervention. With respect to the power of the Minister of Finance to prevent the Superintendent from taking control of the assets of a bank if the Minister declares that it is not in the public interest to do so, in a country with five banks that dominate the market, forbearance with respect to those five banks may be implicit and a regime that seeks to avoid having banks that are too big to fail should consider whether a politician should have the power to prevent a financial institution technocrat from taking enforcement action. The ability to support a failing bank is also authorized by Section 7.1 of the Deposit Insurance Corporation Act whereby the Governor in Council may suspend the requirement that in pursuing its objectives, the Corporation must minimize the exposure of the Corporation to loss. This leaves the Corporation with the objective to “promote and otherwise contribute to financial stability of the financial system� which could be financial support to a large failing bank beyond what would be required to pay deposit insurance if the bank failed. UNITED STATES The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“D-F Act�) has as an important objective resolution of systemically significant non-bank financial companies without the budget bearing the potential liability of the losses resulting from failures of financial institutions as had happened during the financial crisis of 2008-2009. The criteria for intervention, the powers of the receiver, the tools for resolution, and sources of funding a resolution in the D-F Act are illuminating and apply to credit institutions as well.59 Intervention under the provisions of the D-F Act is based upon determinations that include: (i) the company is in default or in danger of default;60 (ii) the failure of the company and its resolution 59 For complete details, a full summary of the Dodd-Frank Act is elaborated in Polk, Davis, Summary of the Dodd- Frank Wall Street Reform and Consumer Protection Act, Enacted into Law on July 21, 2010, July 2010. 60 “Default� is defined essentially as: (i) the financial company has incurred, or is likely to incur, losses that will deplete all or substantially all of its capital, and there is no reasonable prospect for the company to avoid such depletion; (ii) the assets of the company are, or are likely to be, less than its obligations to creditors and others; or (iii) the company is, or is likely to be, unable to pay its obligations in the normal course of business. 66 under otherwise applicable law would have serious adverse effects on financial stability in the United States; (iii) no viable private sector alternative is available to prevent the default of the company; (iv) any effect on the claims or interests of creditors, counterparties, and shareholders of the company and other market participants as a result of actions to be taken under this law is appropriate, given the impact that any action would have on financial stability in the United States; (v) any action under this law would mitigate potential adverse effects on the financial system, the cost to the Treasury, and the potential to increase excessive risk taking on the part of creditors, counterparties, and shareholders in the company; and (vi) the applicable regulatory authority has ordered the company to convert all of its convertible debt instruments. The Federal Deposit Insurance Corporation (FDIC) is appointed as receiver to conduct a resolution and once appointed does not have to consult with any other authority. With respect to its powers, it may: (i) take over the assets of the company with all of the powers of the shareholders, the directors, and the officers of the company, and conduct all business of the company; (ii) collect all obligations owed to the company; (iii) manage the assets and property of the company, consistent with maximization of the value of the assets in the context of the liquidation; and (iv) provide by contract for assistance in fulfilling any function or duty as receiver. The tools that may be used in a resolution include: (i) making loans to, or purchasing any debt obligation of, the company; (ii) purchasing or guaranteeing against loss the assets of the company directly or through an entity established by the receiver for such purpose; (iii) assuming or guaranteeing the obligations of the company to one or more third parties; (iv) taking a security interest on any assets of the company to secure repayment of any transactions conducted in the resolution; and (v) selling or transferring all, or any part, of assets, liabilities, or obligations of the company including merging the company with another company or transferring any assets and liabilities held by the company for customers, or any assets and liabilities associated with any trust or custody business without obtaining any assignment or consent for such transfer. With respect to funding of resolution activity of non-bank companies, the FDIC may require payments from large bank holding companies to defray the cost. In addition, while relatively insignificant in amount but perhaps important to prevent moral hazard, the receiver may recover from any current or former senior executive or director substantially responsible for the failed condition of the company any compensation received during the two-year period preceding the date on which the receiver was appointed (except that, in the case of fraud, no time limit applies). Despite the generally well articulated provisions in the areas noted above, the D-F Act could be more explicit on the principal objective of a resolution proceeding. The general objectives indicated of a resolution are to mitigate risk and minimize moral hazard resulting from failing financial companies that pose a significant risk to financial stability, but this does not provide clear guidance to the receiver unless reference to prior laws on resolution are invoked. 67 SECTION VI: OBSERVATIONS BASED ON REVIEWS OF EU COUNTRIES’ LAWS 95. This section presents recommendations based on the reviews of EU countries’ regulatory and legal frameworks presented in the previous section, and the EC Communication. The reviews analyze the mechanisms in law for remedial actions to address financially distressed credit institutions and for their resolution in the countries selected, to identify consistencies and divergences of existing law and procedures with the EU Commission’s proposals for credit institution resolution presented in the first Section. 96. Given its defined scope, the review has not the assessed implementation practices of existing legal regimes for financial crisis management and for resolving failing banks. The review has also not discussed in detail the proposed axis institution in EU countries that should lead the effort in carrying out resolution actions, as this may vary based on the institutional regulatory structure in each country. However, the institutional issue and its execution is a priority to consider and requires a clear assignment of responsibilities so that prompt resolution actions are not hampered by political indecision or dilution of functions, particularly as pertaining to individual bank failures. It is recognized that systemic issues require consultation among standing committees (supervisory authority, central bank, the ministry of finance, and sometimes the deposit insurance agency) but for “individual� transactions an axis institution should be designated to act more autonomously in accordance with legal provisions. 97. Practices overall depend upon the policy and legal traditions of each country as these influence the use of powers, including: (1) the reliability of the assessments made by supervisors of the financial condition of institutions and their viability; (2) the timeliness and adequacy of the response by decision makers to the signs of risk accumulation and financial deterioration; (3) the provision of liquidity at system-wide and individual entity levels; (4) the effectiveness of coordination among authorities in exchanging information and determining actions to be taken; and (5) the legal certainty for transactions such as the transfer of assets and protection of officials in charge of resolution proceedings. Importance of an Appropriate Resolution Regime 98. The resolution of failing credit institutions in many EU countries is governed by corporate and bankruptcy laws. There are not many countries whose bankruptcy laws provide for expeditious reorganizations or whose financial institution laws have pre-insolvency mechanisms to facilitate the sale of an institution or the transfer to third parties of parts of the business of a failing institution to maximize asset value and protect depositors and other creditors to an extent that is not possible in a delayed reorganization or piecemeal liquidation under bankruptcy laws.61 61 Lack of a pre-insolvency mechanism precluded resolution before balance sheet insolvency in the case of Northern Rock in the U.K. 68 99. Bankruptcy laws are set at the national level, and there is no uniform EU-level credit institution insolvency regime. Despite EU Directive 2001/24/ EC described earlier, the coordination of cross-border resolutions is difficult as the case of Fortis Bank in October 2008 demonstrated, and a uniform and compatible legal regime for credit institution resolution would be desirable, as proposed in the EU Communication. 100. The lack of more appropriate mechanisms to deal with failing institutions may dissuade supervisors from taking early remedial action when necessary, if there is no alternative to application of the corporate or bankruptcy laws. Without new legal authority, in some countries supervisors cannot extinguish or suspend corporate governance authority of shareholders and management while an institution is still economically and balance sheet solvent, even if it is insolvent from a regulatory perspective (i.e., below the minimum required regulatory capital adequacy ratio). Under most existing legal regimes, a determination of insolvency requires that actual losses substantially deplete the regulatory capital of the institution.62 101. However, once capital clearly declines below the minimum required, yet above negative net worth, new legal authority should be granted to an administrator to take control of an institution and expeditiously draw up a new balance sheet based on liquidation values of assets that could, as one likely outcome, demonstrate negative net worth and thereby extinguish rights of shareholders, directors and management. The EC proposal appears to allow such action if the bank is deemed to be failing or on a difficult course to reverse, but several national laws and regulations still need to incorporate this feature more explicitly. Once the assets are written down, and, to make liabilities equal to the assets, liabilities can be given haircuts in the reverse order in which creditors would be paid in liquidation, thus an institution would no longer be insolvent. It could then be more readily sold in whole, or its parts could be transferred to other institutions with an assumption of its liabilities in whole or in part.63 102. Under most existing regimes an early solution to the financial distress of institutions is not possible and the institution continues to incur losses and lose customers and franchise value, which makes the sale of its business more difficult as time goes on. Thus, as has been seen in the recent financial crisis, in the absence of a mechanism to effect a private sector solution that preserves stability or at least minimizes losses, a systemically significant institution eventually has to have equity shares contributed by the State, or, if the situation must be addressed under bankruptcy laws, increasing losses could result, escalating into contagion and systemic risk. 103. While failure at a systemic level, if this were to occur, would still not be solved by individual bank resolution procedures, such an eventuality (in terms of a capital deficit at a systemic level) would be unlikely, and, provided that the failure is circumscribed, the new 62 This is more likely when supervisors do not know the financial condition of an institution because of lack of capacity to inspect onsite to determine financial viability, as when supervisors rely to an excessive extent on the reports of external auditors. 63 Such a resolution regime, which is consistent with the policies in the EU Communication, is justified by first principles regarding public policy reasons for comprehensive regulation and supervision of banks that are described in Section II. 69 resolution tools can go further in mitigating further losses and costs to the taxpayer, than past solutions. 104. As a consequence, without the enactment of new measures the overall effectiveness of supervision in responding to risk accumulation and threats to solvency and stability will remain weak in many cases, whether or not laws and regulations are in substantial compliance with existing EU legislation and the Basel Core Principles for Effective Bank Supervision.64 105. An effective resolution regime is therefore essential to lessen forbearance risks and political interference, including the concerns that supervisory authorities may have about the systemic implications of closing an institution. Moreover, forbearance is less likely when the objectives and incentives of supervisors are exclusively and explicitly aimed at protecting depositors and other creditors of institutions, and minimizing losses. 106. The benefits that can be obtained from reinforcing early remedial and resolution actions reduce the probability that institutions with a high risk profile continue to operate when their viability is threatened and that those that are insolvent continue in operation while losses mount. Without appropriate remedial and resolution frameworks, supervision is less credible in the view of institutions because supervisors lack the incentives, willingness, and powers and tools to act preemptively. A proper resolution regime is thus likely to result in earlier intervention and resolution of nonviable institutions. 107. There are two basic approaches for the activation of resolution mechanisms. One is based on objective criteria and the other more discretionary. A combination of both approaches is suitable especially for jurisdictions where there is legal certainty for discretionary supervisory actions, and the protection of supervisors is well established. The Canadian regulatory framework is a non-EU example where such legal certainty for supervisors is available. 108. In most of the countries reviewed, there is a need for more decisive action especially based on declining levels of capitalization that should activate remedial enforcement actions and pre-insolvency resolution measures. To mitigate regulatory forbearance and to ensure that supervisors close institutions before they become irremediably insolvent, some laws have rules providing for the use of mandatory graduated corrective measures.65 In the U.S. and other countries, this approach is referred to as “prompt corrective action� in order to prevent supervisors from delaying appropriate action as was evident in the U.S. in the savings and loan institutions failures in the late 1980s and early 1990s. Specific levels of under-capitalization trigger specific remedial actions. 109. If enforcement action does not restore solvency and viability, and graduated levels of intervention by the financial authorities do not improve an institution’s condition (including prior 64 In general in the EU, supervision was weakened during the de-regulation in the 1980s and 1990s. The crisis that affected EU members in different degrees since 2007, demonstrated the ineffectiveness of regulation and supervision in some areas where it lacked preemptive forward-looking supervisory powers to achieve its ultimate objectives. 65 See Hupkes, Eva, 2002. “Bank intervention—basic criteria and comparative aspects. International Seminar on Comparative Experiences in Confronting Banking Sector Problems. Warsaw, Poland. 70 invoking of additional capital from shareholders, mandating improved risk management procedures, agreement on a time-bound bank rehabilitation plan, or use of temporary official administrators to reverse deteriorating trends) there is a subsequent short period to structure a solution that should result in fewer losses by invoking a resolution phase, prior to a full insolvency / bankruptcy phase. Observations on Country Frameworks 110. The laws reviewed do not always specify the situations in which the bank supervision authority may intervene. This provides a degree of discretion to decision makers to take action in accordance with the existing legal bases for intervention.66 Depending on the conditions in a particular country, in some cases this can provide opportunities to delay action as well, especially in cases such as in Croatia where the authorities might not have effective mechanisms to restructure and resolve failing banks at the pre-insolvency point because of the need for shareholder consents, and in countries that lack specific objectives in the law to protect creditors and minimize losses. 111. In the more complete regimes such as those of Canada, the U.K. and Germany, and in the proposals of the EU Communication, the country summaries underline the importance of appropriate resolution law and procedure as an essential component of the financial crisis management framework. The EU countries reviewed generally have ample remedial powers for early intervention, albeit in different degrees. With the exception of the U.K. and Germany, most other countries would benefit from more precise and versatile resolution mechanisms-- powers, tools, and funding arrangements—as those described below regarding key legal provisions. 112. In the case of Croatia and Poland there are more reasons to incorporate explicit resolution mechanisms, at both the going and the gone-concern points, which are not clearly present today in the legislation. Table 1 below illustrates the pertinent sections of the Polish banking law that would require modification to incorporate new features. The reform in Germany provides flexibility to supersede the prior reliance on the corporate insolvency regime, though it does not include the full set of elements proposed in the EU Communication. For example, it does not contain authority for resolution authorities to take over management of a failing institution. 113. The latest reforms of the Czech Republic have significantly modernized the tools for resolution that the CNB has available. Its resolution regime, as well as that of Spain, might still benefit from further refinements in a few areas.67 This includes powers to require major corporate changes, to convert and reduce claims of creditors, such as non-viability contingent capital, as well as other measures being explored in international fora.68 66 Terminology varies significantly among practitioners and academics. In the terminology of the EU Commission, borrowing from the terms in the U.K. 2009 Banking Act, the triggers are labeled as “threshold conditions.� 67 See the individual country assessments in Section V. 68 For example, see OSFI, Advisory: Non-Viability Contingent Capital, February 2011. 71 Table 1. Regulatory Measures for Adapting the Resolution Framework under Polish Banking Law Regulatory Specifications / Legal Powers Comments / Clarifications Pertinent Section to modify in the Banking Law of Poland 1. Replacement of Liquidation/Bankruptcy provisions by “Liquidation� phase in the law is Polish Banking Law, comprehensive Resolution Provisions. replaced by Resolution which Chapter 12, parts A incorporates all options as well as a and B, and moving residual “liquidation� phase that is Article 154 to Part C closer to current “bankruptcy� phase. as final stage/option. 2. Requirement to execute resolutions using a least cost / For all resolution/liquidation options Polish Banking Law, minimum loss criterion. not involving payments to insured Chapter 12, Part B, depositors, alternative methods should and relevant sections specify that State or deposit insurance of Deposit Insurance fund outlays require to be of lesser Law. amounts than a payout to cover insured deposits. 3. Specification of additional resolution tools available The law should specify that these Polish Banking Law, including: (a) partial asset transfers with liabilities to 3 rd party options, along with existing ones are Chapter 12, Part B, banks, (b) an asset separation tool (c) a bridge bank, (d) a good available for use by the financial Article 147, and bank and bad bank, (e) bail-in / debt write down powers authorities once the resolution phase is adaptation of all other (primarily for SIFIs) and (f) use of deposit insurance funding to triggered. The relevant Article should Articles in Part B. fill residual gaps under asset transfers. not limit the options of takeover by another bank or traditional liquidation. 4. Suspension/removal of shareholder rights: Powers to fully The triggers for intervening to conduct Polish Banking Law, take over the bank for resolution purposes should add additional resolution should also clearly state in Chapter 12, Part B, criteria including that of regulatory insolvency having reached a the Law that once such thresholds are Article 147, para. 1, critical level (e.g.: under 2/3 of C.A.R.) as well as other critical reached or regulatory solvency ratio not and Article 148. measures such as chronic liquidity problems, and other compliant, the subject bank has, under supervisory assessments of financial deterioration, poor banking law, forfeited its right to a management, fraud, or not meeting prudential requirements, to be banking license which the financial specified under Article 147 as additional triggers. Inclusion of authority now has the power to revoke; clause also stating that following resolution inception, license is and shareholder rights are suspended or revoked only when the capital level is precarious and voluntary terminated at the onset of resolution. 3rd party buyers are not immediately forthcoming (e.g.: 5-30 day period as a maximum). 5. Specify hierarchy/rights of creditors: the banking law should Additions to traditional creditor Polish Banking Law, reflect a special regime of creditor hierarchies differentiated from hierarchies to include preference for Chapter 12, at end of corporate bankruptcy law and include the hierarchy of rights as insured depositors and other depositors, Part B. described earlier. with mention of creditors including the State or its agencies. 6. Use of securitization options to transfer bond instruments The mechanism can include on-balance Optional, to add in (reflecting loan portfolios) as assets, with matching liabilities, to sheet transfers of underlying loan Banking Law. acquiring banks. assets, or separating these as transfers Securities Law should to off-balance sheet “collection� banks already include with acquiring banks holding the allowable bonds. mechanisms. 7. Defining of residual liquidation phase following exhaustion of The Bankruptcy phase/concept would Polish Banking Law to all Resolution options. no longer apply as all resolution respecify Part C of options would be first engaged, with Chapter 12 to reflect residual non-transferrable assets sent to the last residual receivership/liquidators for collection. collateral liquidation phase. 72 114. While there may be relevant implementing regulations which have not been part of this review, with the exception of Canada and the U.K., the level of detail in the legislation reviewed could be substantially enhanced in most cases. The Code of Practice adopted by the Bank of England to implement the 2009 U.K. Banking Act articulates most of the resolution mechanisms that the EU Communication recommends. Key Legal Provisions for Credit Institution Resolution 115. Based on the review of the laws of six European countries (five in the EU) as well as laws of Canada and the U.S., certain key areas for legislation for efficient and fair resolution of failing banks can be recommended in the areas of: (i) criteria for supervisory intervention; (ii) the objective of a proceeding; (iii) the governmental authority responsible for initiating and for oversight of a proceeding; (iv) the powers of the administrator of a resolution proceeding; (v) the several mechanisms that could be used to resolve an institution; and (vi) the effect on the corporate governance of the affected institution. Rules also need to be set, as per Section III, on the ranking of payments and assignment of claims under resolution, including expenses of resolution proceedings, insured and non-insured deposits, an institution’s employees, loans from the central bank, debt to public sector institutions, tax obligations, and other liabilities. Criteria for Supervisory Intervention 116. Because of the special nature of credit institutions, there is a legitimate public policy interest in intervening in a failing institution. Such intervention significantly affects the property rights of a credit institution’s owners, depositors, other creditors, employees, suppliers, and customers and therefore should be initiated only for valid reasons. Under commonly accepted precepts of law, it is only in the case of the actual or imminent insolvency of an institution that such impairment of rights of such stakeholders is considered appropriate. In order to prevent supervisory forbearance yet preclude actions that would impair property rights precipitously, it is appropriate to provide quantitative and therefore objective measures of financial distress for the initiation of a resolution proceeding. 117. Thus, the criteria for the initiation of a resolution proceeding should be based upon objective situations of actual or imminent insolvency such as material breach of capital adequacy ratios. Of course, this is not the only criteria and if more serious events occur prior to or following a dangerous decline in the capital adequacy ratio they would also constitute measurable triggers, including: (a) non payment of liabilities falling due, (b) lack of liquidity after using up temporary sources of emergency liquidity assistance (excepting widespread systemic situations), (c) fraudulent operations discovered, (d) established negative net worth (including net equity as determined by supervisors based on applicable provisioning and accounting standards), (e) overly low loan loss provisions or other measures of material undercapitalization including failure to improve a bank’s financial soundness following a government sanctioned rehabilitation plan. 73 118. Some laws and suggestions for legal reform for credit institution resolution have as an additional criterion the public interest. In some countries “public interest� might be considered unconstitutionally vague and therefore not enforceable since a basic precept of law in most countries is that those subject to the law must have fair notice of their obligations under the law. To base intervention on the basis of public interest without further qualification leaves a wide area of discretion to supervisory authorities and does not inform credit institutions’ owners or managers of the extent to which the public interest depends upon the condition of their institution. 119. Therefore, if issues are of a systemic or contagion nature or could cause losses to taxpayers, such issues should be articulated as falling in the realm of the “public interest� with information and supervisory judgments used to support such observations. Capital adequacy is a much better understood concept and basing intervention on deficient regulatory capital may be clearer. This implies, however, that the supervisors should have sufficient powers to adjust an institution’s capital levels based on their own assessment of asset quality and anticipated losses – this latter exercise involves some judgment but can be supported by expert analysis to adjust balance sheets to strict accounting standards and prudential regulations. This would lead to the adjustment of an institution’s reported financial ratios to a point where they can be reported as non-compliant, thus justifying subsequent resolution action. 120. On the other side of the coin, public interest could also be perversely used as a basis for forbearance since a supervisory authority may believe that intervention would lead to contagion and financial system instability, thus avoiding taking sufficient remedial or resolution actions. However, with new tools for efficient credit institution resolution, the potential disruptive effects on the system as a whole should be considerably lessened than in the absence of such tools. The Objective of a Proceeding 121. Some laws assume or articulate that an intervention in a distressed credit institution should have as its objective the restoration of the viability of that institution in its current form. However, at the resolution stage, this is unrealistic and not a proper basis on which to base policy and the law. It should be understood that when there is actual or imminent insolvency of a credit institution, the time is long past to take enforcement measures to remedy the situation. For example, in many countries, institutions will be subject to increasingly stringent enforcement actions as the level of their capital declines. When an institution is actually or imminently insolvent, ordinary enforcement action has been unsuccessful; for example, the owners have not recapitalized their institution or the institution has not remedied the reasons for its precarious financial condition. The owners should be under no illusion that their economic interests may be salvaged by the Government or by a miracle made possible by delaying the day of reckoning. 122. Under a resolution proceeding, notions of traditional insolvency law should also apply since resolution relates to the actual or imminent insolvency of an institution. Thus, the proper objective of a resolution should be to protect the interests of insured depositors, taxpayers, and, the interests of other creditors and State resources, by maximizing or preserving the value of the 74 assets of the insolvent institution and providing an opportunity for a financial reorganization or sale of the institution under a least cost criterion.69 One appropriate case might also be when the reorganization is the mechanism by which assets amounts would be maximized, as when a new shareholder recapitalizes an institution. The Governmental Authority Responsible for Initiating and having Oversight of a Proceeding 123. Some laws, for example, in those of Canada, the U.K. and Spain provide for a determination by more than one executive branch of government authority of whether and how a resolution proceeding is conducted. In financial institution insolvencies, celerity is often important to preserve asset values and to bolster public confidence. When multiple parties are involved in key decisions, it presents an opportunity for inaction or delay. Thus, consideration should be given to having, especially for one-off resolution cases, one principal decision maker – the bank supervisory authority or other authority, to initiate and oversee a proceeding. 124. It is of course appropriate to have the designated overseer report to other governmental and parliamentary bodies regarding the conduct of a resolution, particularly for systemically significant institutions and systemic crises where the existing standing committees (supervisor, MoF, central bank) would jointly decide. In particular if public funds are to be used, the MoF will need to give full approval – or if issues are systemic or the payment system is at risk, the Central Bank would need to agree. But in other circumstances without these characteristics, if action cannot be taken without the advice or consent of another body, particularly if it is headed by a political appointee, there is an opportunity for delay or for decisions to be taken on a basis other than the financial institution supervisory law and policy. 125. In some countries there is major a role for the judicial authorities for the conduct of a financial institution resolution. Efficient resolution as well as liquidation of a credit institution requires specialized skills that are usually possessed by the bank supervisory/resolution authorities rather than by the judiciary. This is due in large part to the relative infrequency of credit institution insolvencies before the courts. Thus, the entire credit institution resolution proceeding should be administrative in nature, rather than judicial while retaining the right of judicial review for aggrieved parties but in a way that does not halt or impede the conduct of the administrative proceeding. This latter issue is not addressed in the EC proposal. As well, the EC Communication posits a large scope for judicial involvement in financial institution resolution. The Powers of the Administrator of a Resolution Proceeding 126. To efficiently conduct a resolution proceeding, an administrator should have all the powers of the directors, officers, employees, and shareholders of the credit institution for which he has been appointed as well as extra official powers to would conduct the affairs of the institution in a manner to achieve the objective of a proceeding. Thus, the administrator should 69 To prevent moral hazard, preserving an institution does not mean maintaining its shareholders, board of directors, or senior management. It does mean preserving financial services to the communities that it serves. 75 have all necessary legal authority to proceed without shareholder consent. One legal basis for this is that this is necessary and appropriate for the efficient resolution of credit institutions that are special economic actors. Another possible basis is accounting. If an institution is economically insolvent (vs. illiquid) it would have negative net worth and its shareholders’ interest is thus extinguished.70 While commercial or industrial companies can have negative net worth, this is not acceptable for a credit institution. However, as discussed earlier, the bar should not be set so high, and regulatory insolvency below a specified level should be sufficient to allow triggering of resolution powers. 127. As some laws provide, the powers of the board of directors and management should be suspended. The laws could further provide that if the administrator determines that an institution's regulatory capital is below a certain level, or it liabilities exceed its assets, the rights of shareholders and directors are automatically extinguished. The Mechanisms that could be used to Resolve an Institution 128. The administrator of a proceeding should have a range of options to seek to achieve the objective of a proceeding. These should be explicit in the law as in some of the laws reviewed. The basic mechanisms are: (i) selling the institution to another institution; (ii) merging the institution with another institution; (iii) selling the institution’s assets, in whole or in part, with an assumption in whole or in part of its liabilities; (iv) selling some or all the assets and have some or all of the liabilities assumed by a new bridge institution; or (v) selling some of the institution’s assets and removing the more toxic assets for collection or liquidation.71 Section IV of this report elaborated on additional variations and applications of some of these mechanisms. 129. To seek to maintain viable parts of the business of a failing institution, it is appropriate to recognize embedded losses in the assets of an institution at an early stage, before dismantling of an institution either as part of a resolution process or a residual bankruptcy. Thus, creditors’ claims should be reduced to the extent of the gap generated by the recalculated value of assets. A new balance sheet of the institution should be prepared by the administrator based on his or her determination of liquidation values of the financial institution’s assets with a corresponding reduction in the institution’s liabilities in the reverse order of priority in payment of distributions to creditors in a liquidation of a financial institution’s assets. By this process a “clean� institution may be attractive to new shareholders or to another financial institution because its bad assets have already been discounted and its liabilities reduced accordingly. Thus, the institutions' assets and liabilities are of equal value but it requires capital. The institution may therefore be attractive to a financial institution that has excess capital or to new shareholders or strategic investors. 70 See Section II, “Bank Resolution – Key Principles.� 71 When certain assets are segregated and bought by a bridge institution, it is sometimes referred to as a “good� bank when largely performing assets are transferred. When largely nonperforming assets remain in an institution or are transferred to another institution for the purpose of liquidation, it is referred to as a “bad� bank. 76 130. The cleansing of the balance sheet is tantamount to reorganization in the commercial bankruptcy context where trade creditors reduce and reschedule their claims and bondholders may reschedule or convert their claims to equity. Thereby, the balance sheet may be repaired without incremental capital, or alternatively, new equity is contributed because of the improved financial condition of the institution. Trade creditors may be especially cooperative under corporate reorganization because of future business prospects with the troubled company but this is not the case with a credit institution. In the credit institution insolvency context, the majority of creditors are depositors who do not wish to convert their claims to equity in a distressed institution since the benefits to them from a continued relationship with the institution are limited. Financial services usually are easily substituted by another institution. 131. Of course, in addition to the more traditional tools for resolution, when there is system- wide credit institution financial distress, as during the 2008-2009 global financial crisis, extraordinary measures will be taken to promote financial stability such as the government providing funding for failing institutions as was done in several European countries. The Spanish and Polish resolutions regimes provide for this. The financial industry may also provide contingent funds for financial support to failing institutions as proposed in some countries. The Effect on Corporate Governance of the Affected Institution 132. Shareholders of a credit institution elect directors who appoint management, thus if an institution is insolvent, the chain of authority has lost legitimacy. While, as indicated above, ordinary commercial and industrial companies may operate with negative net worth, this is unacceptable for a financial institution that uses many more times other peoples’ money than their shareholders' investments. Thus, the powers of shareholders to elect directors and those of the incumbent board should be suspended if not extinguished so they cannot interfere with the work of the administrator in the resolution proceeding. 77 Figure 4. Repeat of Diagram on the Sequence for Applying Bank Resolution Actions Breach of prudential requirements, risk management practices, time-bound liquidity shortages, or minimum regulatory capital levels. Rehabilitation plan with Invoke resolution phase if intensified supervision, rehabilitation plan fails, and regulatory demand for capital injections, capital remains below required level or and/or official oversight & further declines (e.g.: to more than 2/3 administration of bank. below the minimum C.A.R.). Suspension of shareholder’s rights and Management/Board functions. Non systemic banks Systemic banks Are there available 3rd party institutional a. Are there available buyers of the bank or its assets, and/or can voluntary buyers? If yes, capital situation be restored, within 5-30 days? invoke options of sale or resolution mechanisms. b. Does the bank have Yes: Use No: existing COCOs? If yes, Asset transfer invoke legal conversion a. Revoke license. resolution of debt to equity. mechanisms b. Conduct forced resolution. c. If none of the above, invoke debt write-down c. Consider bridge of creditors, sale of bank option. selected assets, bridge d. Arm-twist 3rd bank option, with parties to accept remainder capital gap Once completed, send portions of assets supplemented by state any residual bad assets with deposits. capital support. to final liquidation. 78 CONCLUSIONS 133. Modernized bank resolution regimes should not be perceived as simply an add-on regulatory tool for the existing bank insolvency frameworks in force in several countries as suggested in the proposed EC framework. Rather, the bank resolution regimes should constitute a comprehensive replacement of existing insolvency frameworks. This is because the new resolution regimes are based on a different set of operating and financial criteria and include the following axiomatic features: A. A guiding principle for any solutions is to be effected at the lowest cost to the State and minimizing asset losses. B. A process, whereby resolution procedures are undertaken under full control of government authorities and including after license revocation when required, while the credit institution’s assets remain operating and viable to preserve their market value. C. A priority given to first consider transferring viable assets (and matching liabilities) to other sound financial market participants with interest in acquiring them. D. An attempt to optimize maintaining all depositors ‘whole,’ as well as other creditors, before considering the last resort option of final liquidation. E. Especially for systemically important institutions, rather than using as a last resort as per the EC proposal, the immediate use of creditor ‘bail-ins’ and debt write downs in the absence of third party market buyers would reduce an institution’s unsustainable burdens. Pre-arranged forms can entail COCOs or pre-contracted contingent convertible debt which can become equity under insolvency conditions.72 F. The principle that a banking license and shareholder/director rights are subject to revocation or suspension once a bank materially does not comply with regulatory capital adequacy requirements (i.e., technical insolvency versus economic negative net worth). G. Inclusion of a post-resolution phase of liquidation, mainly to dispose of residual left-over assets which are not absorbable as reliable assets on third party new balance sheets. H. Strengthening of supervisory powers during the pre-resolution stage in order to allow for preemptive action, supervisory judgment in valuation of assets, and permitting the eventual resolution phase to allow a successful outcome to be achieved before reaching a stage of complete institutional failure and economic insolvency. 72 A detailed discussion on “bail-in� instruments and design issues can be found in the FSB Consultative Document, Effective Resolution of Systemically Important Financial Institutions, July 19, 2011. 79