Tuesday, January 11, 2011

European Commission Proposes Liquidation Authority for Financial Firms Similar to Dodd-Frank Title II

The European Commission has begun a consultation leading to legislation on a liquidation authority to wind down failing financial firms similar to Title II of the Dodd-Frank Act, but with an important difference. The consultation is a significant step in delivering the commitment made to the G-20 to ensure that authorities across the EU have the powers and tools to restructure or resolve all types of financial institution in crisis, without taxpayers ultimately bearing the burden. They are also consistent with the principles for ensuring that resolution is a viable option for systemically important financial institutions that are being developed by the Financial Stability Board. The Consultation focuses on measures for banks and investment firms. Currently, there are very few rules at EU level which determine which actions can and should be taken by authorities when financial firms fail and, for reasons of financial stability, cannot be wound down under ordinary insolvency rules. Public comment on the proposal is invited until March 3, 2011.

The proposed EU legislation and the Dodd-Frank Act both provide for a resolution framework for systemic institutions at group level. Both the EU and the US are accordingly working to develop mechanisms which should be capable of resolving or winding down failing financial institutions. The US approach intends to address systemic risk by taking failing institutions into receivership by the FDIC, under which their business will be transferred or wound down and the failed institution will be liquidated.

The EU framework would also allow authorities to put firms into an orderly resolution in which their essential services could be preserved while the failed institution itself was ultimately wound down. However, in the cases where an institution is too large, complex or interconnected to be wound down in an orderly manner, the Commission is also considering equipping authorities with ambitious additional tools which would, under stringent conditions, allow a troubled firm to continue as a going concern, through write down of its debt, in order to preserve its economically important functions and buy time for authorities to sell or wind down its business in an orderly manner. In order to prevent moral hazard, there would need to be strict conditions accompanying any such approach, including the dilution of shareholders, changes to management, haircutting of creditors, and re-structuring so as to ensure that the surviving entity was viable.

The Commission proposal would require firms to prepare resolution plans, often called living wills, and powers for authorities to require firms to make changes to their structure or business organization where such are necessary to ensure that the institution can be resolved under the regime. These powers would be an important element in tackling financial institutions that have been deemed too big, complex or interconnected to fail.

The legislation would also authorize regulators to take early action to remedy problems before they get out of hand such as the power to change the managers or directors, to require the firm to divest itself of certain activities or business lines, to require implementation of a firm's recovery plan to address specific funding problems, and the power to appoint a special manager for a limited period to take over control and run the firm with the objective of addressing its problems and restoring it to financial health.

But primarily, regulators would be given resolution tools authorizing them to take the necessary action, where failure cannot be avoided, to manage that failure in an orderly way, including the powers to transfer assets and liabilities of a failing firm to another institution or to a bridge bank, and to write down debt of a failing firm to strengthen its financial position and allow it to continue as a going concern subject to appropriate restructuring. Resolution of a financial firm will occur when there are no realistic prospects of recovery over an appropriate timeframe and all other measures have been exhausted.

A key power for regulators under this regime would be to write down debt. The consultation seeks views on two broad approaches to achieving this objective. The first approach would involve a broad statutory power for authorities to write down or convert unsecured debt, including senior debt, subject to possible exclusions for classes of senior debt that may be necessary to preserve the proper functioning of credit markets. It is not envisaged that such a power would apply to existing debt that is currently in issue, as that could be disruptive. The second approach would require financial firms to issue a fixed amount of ``bail-in’’ debt that could be written off or converted into equity on a specified trigger linked to the firm’s failure. This requirement would be phased in over an appropriate period and, again, it is not envisaged that any existing debt already in issue would be subject to write down.

An overriding objective of the eventual legislation will be to ensure that financial firms can be resolved in a way that minimizes the risks of contagion and ensures the continuity of essential financial services, including continuous access to deposits for insured depositors. In the Commission’s view, the framework should provide a credible alternative to the expensive bail-outs which have characterized the recent crisis.

It is also important that the legislation enshrine effective arrangements ensuring that authorities coordinate and cooperate as fully as possible in order to minimize any harmful effects of a cross-border failure. It is envisioned that the legislation will build on existing supervisory colleges, expanding them to include resolution authorities for the purposes of crisis preparation and management.

The legislation will also incorporate financing mechanisms that avoid the use of taxpayer funds, including mechanisms to write down appropriate classes of the debt of a failing firm to ensure that its creditors bear losses and setting up resolution funds financed by industry contributions.