PRIMER: a comparison of EU and US bank resolution regimes
Bank failures have happened on both sides of the Atlantic - with different rules and outcomes
What is bank resolution?
The 2008 financial disaster resulted in several bank bailouts worldwide, with taxpayers unwillingly paying hundreds of billions of dollars to rescue banks from a liquidity crisis and collapse. In the US alone, the bill came to $700 billion, as the Treasury paid to salvage banks such as Lehman Brothers and AIG from ruin.
In the decade since, a number of international regulators and policy setters have established rules and guidelines to reduce the probability and impact of the failure of such systemically important financial institutions (Sifis) and firms. Bank resolution provides an insolvency process for a bank that is on the brink of collapse, and mitigates the potential for fallout risk.
The two regions most greatly affected, the US and the EU, have developed distinct approaches to bank resolution.
"It is like comparing apples and pears, both are fruits that share similar colours"
What are the bank resolutions systems in the two jurisdictions?
In the US, bank resolution depends on the legal entity in question. A bank holding company will be resolved under the bankruptcy law, a broker dealer will file for bankruptcy under the Securities Investor Protection Corporation (SIPC), any insured national or state bank will be resolved under by the Federal Deposit Insurance Corporation (FDIC) as provided by the Federal Deposit Insurance Act of 1950.
US banks that are subsidiaries of foreign banks will be resolved under state law or by the Office of the Comptroller of the Currency (OCC) under the International Banking Act. The US really has two systems for resolution with different rules for financial institutions with $50 billion or more of assets - these are currently designated as Sifis.
Keith Noreika, partner at Simpson Thacher, said that the US system operates like a big patchwork quilt.
“Congress enacted a resolution authority via the Dodd-Frank Act – the FDIC - and the Fed to require larger more complex firms to develop plans to facilitate their resolution,” he said.
As part of that system, regulators have developed a single point of entry approach to resolution, which involves funnelling losses to the top holding or parent company, which will then be placed in bankruptcy.
Similarly, in the EU, ‘a bank resolution occurs when authorities determine that a failing bank cannot go through normal insolvency proceedings without harming public interest and causing financial instability’. In order to ensure continuity of the bank's critical functions, maintain financial stability and restore the viability of parts or all of the bank, the EU introduced the Bank Recovery and Resolution Directive (BRRD) in 2014. The Directive requires banks to introduce recovery plans and introduces resolution funds to assist during the process of restructuring.
The European regime sets out a region-wide framework, while each national regime fleshes it out. In the UK, for example, a tripartite series of authorities is involved: the Treasury and the Bank of England are the main parties involved alongside the Financial Conduct Authority which actually decides whether or not that the bank can be considered to be in a resolution process, and if so, which process should be followed.
In the UK, there is a statutory backing against the government power in order to deal with resolution, although every country has unique processes. The BRRD however is separate from any bankruptcy and insolvency regime.
Are there many similarities?
There are indeed. At the G20 summit in Pittsburgh in 2009, the 20 constituent members committed to working towards a common regime.
‘We should develop resolution tools and frameworks for the effective resolution of financial groups to help mitigate the disruption of financial institution failures and reduce moral hazard in the future,’ reads the commitment.
The IMF too has a level of involvement in developing countries to help ensure that the common principles are followed.
According to Latham & Watkins partners Alan Avery and Rob Moulton, the firm’s approach to recovery resolution planning has been quite different in the two jurisdictions. One difference is that the resolution planning requirement has evolved over time.
“Although there is commitment by the countries that are members of the Financial Stability Board [FSB], the processes are very different in practice,” said Moulton.
“In the US, resolution planning requirements are different, depending on the nature of the institution," said Avery. "There is a resolution regime administered by the FDIC for institutions subject to their regulation, which includes all banks with FDIC-insured deposits."
There is a new resolution regime under the Dodd-Frank Act that would apply to any non-bank financial company that is determined to be systemically important. For non-US institutions with respect to their US banking activity conducted through branches, the resolution is typically handled under state banking laws.
“We hadn’t had a recovery planning component to our resolution planning recovery process here in the US until somewhat recently, when the OCC adopted recovery planning guidance that applies to a narrow set of the largest US banks,” said Avery.
What are the main differences between the two systems?
Although there are many similarities, the processes in the EU and the US are very distinct.
“It is like comparing apples and pears, both are fruits that share similar colours,” said Michael Huertas, partner at Dentons in Frankfurt. “The apple in the US has been formed, crafted, brought around in a manner that works in a way that everyone knows at every level what they are doing and how they are supposed to do it. Their Single Rulebook has had a longer time to form.”
In the EU however, there are national political interests at play that don’t exist in the US.
"US federal law will be supreme to all state laws, so it is relatively easier to implement a more uniform standard than in the EU"
“There would be no reason for a senator to say ‘Washington neutral is being wound up, and I don’t like that because of xyz,’” Huertas said. “There is a physical backstop.”
He added: “Even if both sides of the Atlantic have similar tools, you can’t compare one to the other without looking at the differences in approach, whom they supervise and the path of development. The EU would like to emulate some of the better parts of the US system, especially in terms of institutional resources.”
Equally the EU still has, despite its Single Resolution Mechanism in the eurozone and the BRRD across the EU, a number of national political pressures, rivalries and different legacies in supervisory culture, experience and willingness to cooperate.
“This can hamper efforts, mostly led by the EU and certain member states, to create a more level playing field in terms of resolution, depositor protection and a host of other measures designed to create a more resilient financial system with greater certainty," said Huertas. "This would lead to more liquid and better functioning national as well as cross-border markets."
On the other hand, US federal law and regulation will be supreme to all state laws, so it is fairly and relatively easier to implement a more uniform standard than in the EU where most matters are determined by the political entities in each country.
There are smaller differences like the way that bail-in capital is raised, which is used more in the European context than in the American context.
Another distinction is simply that in the US the process has been used significantly more often than in the EU. The FDIC's resolution regime of banks has been very frequently tested and - depending on which stakeholders are asked - has been quite effective. The process happens very quickly, throughout the financial crisis there were close to 500 banks that failed from between 2007 and 2014, with the FDIC handling each of them.
“In the UK for example, we have had historically fewer,” said Moulton. “These markets have been dominated by a small number of players that are too big to be allowed to fail, so the regime has been subject to much less of a road test over here.”
The Basel Committee on Banking Supervision (BCBS) conducted a fundamental review of the trading book (FRTB) framework in the EU, to establish the flaws of the existing rules that were born after the financial crisis. In 2016 new standards were adopted for the calculation of capital requirements and the counterparty credit risk.
“In practice, a critical point is that the FDIC as a resolution authority in the US is a behemoth compared to the SRB,” said Huertas. “If you have 6,000 bank examiners looking at the same amount of institutions as under the SRB's remit, with a staff of under 250 people, it is obvious that things will come down to the wire.”
What has been set up in Europe in the past four or five years is still in its infancy in comparison to the US powers, the infrastructure, the people, the training. In the US there is a single rulebook, 50 state jurisdictions and federal law. The EU won’t get to a similar position overnight but its supervisors will need to be more efficient and communicate with each other more across the national level of institutions.
“The US has had a longer time to work on it since the 1933 financial crash, when president Roosevelt redrew the physical landscape, and adopted an inward approach,” added Huertas. “We've come a long way through different crises to get an infrastructure that just gelled in a better way. There is no doubt in anyone’s mind that Europe will get there and at the senior level.”
What are the current issues?
The UK is implementing bank ring fencing for its largest domestic deposit taking banks, although the EU has been spared of this requirement for now. The country has a good record so far of not allowing a big bank to fail. Whether the outcome of this is a good one is up for debate - but there has not been a bank failure of significance.
The purpose of ring fencing is to separate a bank into the faith domestic retail part that is not undertaking activities that are subject to market risk and which have to be able to survive, if the other part of the bank which is taking legitimate market risk in riskier activities were to fail.
One part of a ring-fenced bank would go bust without the other part suffering the same fate because they would be separated, and the part that the average retail customer worries about would be able to continue to function if the other part failed.
“What no one knows is whether this premise is true,” said Moulton. “The big question is if the investment banking bit of one of our banks went bust, would it or would it not lead to a run on the retail bank?”
Whether or not a ring-fence has been established properly or not, if retail customers don’t understand that and think that if think one part is going bust the entire organisation will, then the exercise of ring fencing is futile.
The US approach to that same issue was basically to prohibit banks from carrying out activities that are deemed risky/with more market risk. Rather than ring-fence for purposes of resolution, the solution was to prohibit carrying out so-called risky activities under the Volcker rule.
There is a current effort in the US Congress to adopt changes to Dodd-Frank, including raising the threshold for enhanced prudential standards from $50 billion to $250 billion and the thresholds of resolution planning aspects.
It would leave about eight banks in the US that have to do resolution planning, and some foreign banks that have a large US presence over that amount as well.
“Even Dan Tarullo conceded that a $50 billion bank is not systemically important,” said Noreika. “The negatives effects far outweigh any potential benefit to financial stability, they basically act as competitive barriers to entry for midsize banks to compete with the largest lenders.”
The cost of crossing the $50 billion mark is fairly prohibitive: there have only been one or two banks that have ever crossed it because the scale of the costs cannot be justified unless a lender can ramp up their assets much higher than $50 billion to compete with the largest competitors, which are about 30 or 40 times bigger than the $50 billion limit.
The Crapo bill takes a measured approach by allowing some Fed digression between $100 and $250 billion. But even then the presumption is going to have be that those additional restrictions don’t kick in until the very highest limit, continued Noreika.
“There must be some glaring risk factors that justify the application of the highest standard below $250 billion,” he added.
A case in point: Greece’s bad bank for bad loans