Bail-in liabilities: Replacing public subsidy with private insurance

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1 FINANCIAL SERVICES Bail-in liabilities: Replacing public subsidy with private insurance July 2012 kpmg.com

2 2 Bail-in liabilities: Replacing public subsidy with private insurance

3 Bail-in liabilities: Replacing public subsidy with private insurance Bail-in liabilities are on the way Most of the regulatory reform initiatives introduced in the wake of the financial crisis have been designed to make financial institutions safer. But there have also been moves to reduce the damage that would be caused by the failure of a financial institution. This resolution agenda focuses on: Preserving the continuity of critical economic functions and minimising disruption which will be easier if the authorities can put some failing financial institutions into resolution rather than liquidation; and Making creditors rather than taxpayers meet the costs of resolving a failing financial institution. Bail-in liabilities liabilities that could be written down or converted into equity when the authorities put a failing financial institution into resolution are being introduced as a key component of resolution regimes. The bailing-in of these liabilities can avoid losses falling on taxpayers and can be used to recapitalise failing financial institutions. The first protection for taxpayers when a financial institution is put into resolution is to absorb losses using the capital of that financial institution. But this may not be sufficient to meet all losses. The key question is how to source new capital for a failing institution. This is where the wider version of bail-in liabilities being proposed by the Financial Stability Board (FSB), the EU Commission and some national authorities enters the picture. Under these proposals, a wide range of unsecured and uninsured liabilities could be the subject of a haircut or converted into equity as part of a resolution. In effect, unsecured and uninsured creditors will provide insurance, or a buffer, against losses that cannot be covered by capital resources alone. The potential bailing-in of liabilities has key implications for financial institutions and for their funding providers. It will increase the cost and reduce the availability of funding. It will constrain the flexibility of funding if it imposes limits on the types of funding that can be raised and the location of funding across a group. Financial institutions and in particular systemically important banks need to plan for the introduction of bail-in liabilities, and to align this as far as possible with their responses to other regulatory initiatives. Although most of the discussion of bail-in liabilities has so far focused on systemically important banks, the EU intends to extend resolution regimes to all banks, while the FSB and the EU have indicated their interest in considering resolution regimes for other types of financial institution. The potential bailing-in of liabilities has key implications... It will increase the cost and reduce the availability of funding. Bail-in liabilities: Replacing public subsidy with private insurance 3

4 Implications for financial institutions As the policy proposals are developed, the full implications will become clear. So far the implications include: Institutions required to hold bail-in liabilities will face higher funding costs, as creditors demand higher yields to reflect the removal of implicit state support and the prospect of their claims being written down or converted into equity in the event of a resolution. These higher funding costs may be particularly acute for institutions with limited access to uninsured and unsecured funding. For example, a bank funded primarily by retail deposits could be required to replace some of these deposits with unsecured wholesale funding to provide liabilities that could be bailed-in. Institutions will have an incentive to minimise the amount of their liabilities that can be bailed in. This could be achieved by issuing secured debt and raising insured retail deposits and short-term wholesale deposits. But the first of these may be constrained by regulatory restrictions on asset encumbrance, while the last would run counter to the intentions of the two new liquidity requirements being introduced under Basel 3. If institutions are required to hold a minimum amount of bail-in liabilities expressed as a percentage of total liabilities (rather than as a percentage of risk weighted assets), this will impose higher costs on institutions with large amounts of assets with a low risk weighting (such as mortgages), because such institutions typically hold relatively small amounts of capital as a proportion of their total liabilities. Institutions will face constraints on their funding models and higher costs if they are required to hold bail-in liabilities in specific locations within a group (for example at group level when their funding is currently undertaken by their subsidiaries). Cross-border institutions face major uncertainties arising from the scope for national resolution authorities to take different views on how bail-in liabilities and other resolution tools should be used. Key considerations Institutions need to consider the cumulative impact of all the regulatory reform initiatives capital, liquidity, governance, market infrastructure, recovery and resolution planning, and structural reform on their strategies and business models, and on their legal and operational structures. Institutions can limit the downsides, by: Optimising their funding strategy and use of collateral within the many regulatory constraints. This might include changes to where funding is undertaken across a group and the balance between different types of funding. Reducing the cost of unsecured and uninsured funding, by issuing more capital (because capital instruments will be bailed-in first in a resolution, so a larger capital buffer will reduce the likelihood of other liabilities being bailed in) and by demonstrating to the market the effectiveness of their recovery and resolution planning (to minimise potential losses). Engaging with national and international authorities to ensure sensible and workable outcomes that preserve funding flexibility, avoid unnecessary and expensive restrictions on funding options, and recognise the case for trade-offs to reduce the overall impact of regulatory reform initiatives. These tradeoffs could be between bail-in liabilities and other resolution tools, and between measures to prevent failure and measures to reduce the cost of failure. Implications for creditors/funders Equity investors will receive a lower return on equity because bail-in will increase funding costs and reduce profitability, other things being equal. Unsecured and uninsured creditors will seek higher returns to compensate them for the possibility of being bailed-in, given the much reduced prospect of taxpayer-funded support for a financial institution. Some creditors may be unable to provide bail-in debt, either because they are restricted by their regulators from doing so, or because their mandates do not allow then to hold debt that could be converted into equity. The holders of bail-in liabilities could therefore become concentrated, which might itself pose systemic risk. 4 Bail-in liabilities: Replacing public subsidy with private insurance

5 Bail-in and resolution The resolution framework and loss absorbency The G20, FSB, Basel Committee on Banking Supervision, EU Commission and many national authorities have been developing regulatory change proposals to make financial institutions safer; and, in the event of failure, to provide a framework to resolve financial institutions 1. The FSB s key attributes 2 state that The objective of an effective resolution regime is to make feasible the resolution of financial institutions without severe systemic disruption and without exposing taxpayers to loss, while protecting vital economic functions through mechanisms which make it possible for shareholders and unsecured and uninsured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation. As a first step towards ensuring that loss-absorbing financial instruments are available when a failing financial institution is put into resolution, the Basel Committee proposed in that all tier 1 and tier 2 capital instruments should be capable of being bailed-in, even if the institution was not placed into liquidation. This would require every capital instrument issued by a bank to include contractual provisions to write off the equity of the institution, and to write down (or convert into new equity) any debt instruments eligible for inclusion in an institution s regulatory capital. These provisions would be triggered in the event of the institution receiving government support or being deemed to be non-viable by the relevant authority. However, regulatory capital may not be sufficient to meet all the actual and prospective losses of a failing financial institution and where deemed necessary as part of a resolution to recapitalise the institution. The bail-in procedure is therefore being extended to a wider range of liabilities so that it can act as a defence against tail risk. The simplest way to enable a wider range of liabilities to be converted to equity is for national authorities to be given statutory powers to bail-in liabilities as part of their resolution regime. The use of these powers would be determined by national authorities on a case-by-case basis, depending on the circumstances at the time and on the nature of the financial institution that is being resolved. Alternatively or in addition institutions could be required (as in the EU Recovery and Resolution Directive) to include the possibility of bail-in within the contractual provisions governing each eligible liability. The role of bail-in within the resolution framework Early thinking on bail-in tended to focus on its role in imposing losses on the creditors of a failing financial institution rather than on taxpayers. However, more recent discussions of bail-in have focused on how it could also support a range of options in a resolution: To meet losses arising from the immediate breaking-up and winding down of a financial institution, where the main emphasis is on the use of resolution tools such as the sale or transfer of assets and liabilities, or splitting the institution into good and bad entities. To recapitalise a financial institution, so that all (or a major part) of it could be re-launched as a going concern, under new management and new ownership. To stabilise the financial position of a major financial institution while the resolution options are considered, or before they can be fully implemented. 1 The Implications of Recovery and Resolution Plans, KPMG, May Key Attributes of Effective Resolution Regimes for Financial Institutions, Financial Stability Board, October Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability, Basel Committee on Banking Supervision, August Bail-in liabilities: Replacing public subsidy with private insurance 5

6 Minimum requirement to hold bail-in liabilities Various proposals have been put forward to ensure that a financial institution holds sufficient bail-in liabilities to avoid or reduce taxpayer losses during a resolution: In Switzerland 4, the two systemically important banks are required to hold at least a 10 percent common equity capital ratio and hold up to three percent of high trigger contingent convertible capital instruments and six percent of low trigger bail-in debt. In the UK, the Independent Commission on Banking 5 (ICB) recommended that the largest ringfenced UK retail banks should meet a 10 percent common equity capital ratio and hold additional equity, contingent convertible capital or bailin debt of at least seven percent of risk-weighted assets (rising to 10 percent if the supervisory authorities had concerns about the ability of the bank to be resolved at minimum risk to public finances). The UK Government has endorsed this approach and included it within the White Paper it issued in June The proposed EU Recovery and Resolution Directive would require national authorities to ensure that firms maintain a sufficient aggregate amount of own funds and eligible liabilities, expressed as a percentage of total liabilities of the firm excluding its own funds. The explanatory memorandum to the Directive suggests that a minimum requirement of 10 percent would be appropriate. The Directive itself does not set a minimum ratio, leaving national authorities to establish minimum requirements on an institution-by-institution basis, taking into account (i) the amount of bail-in liabilities that would be required to meet the resolution objectives and in particular to enable a firm to be recapitalised; and (ii) the size, business model, risk profile and systemic importance of the institution. A bail-in requirement based on total liabilities, rather than risk weighted assets, provides greater protection against extreme tail risk events. It also means that institutions holding large amounts of assets with a low risk weight (such as government bonds and mortgages) will generally have to hold more bail-in liabilities to meet the minimum requirement, since their own funds and subordinated debt will typically be a smaller proportion of their total liabilities. A minimum requirement to hold bail-in liabilities will also place a premium on the cost and availability of these liabilities, and constrain financial institutions funding strategies. Regulatory capital may not be sufficient to meet all the actual and prospective losses of a failing financial institution and where deemed necessary as part of a resolution to recapitalise the institution. 4 Addressing Too big to Fail, Swiss Financial Market Supervisory Authority (FINMA), June Final Report: Recommendations, Independent Commission on Banking, September Bail-in liabilities: Replacing public subsidy with private insurance

7 KPMG analysis Is bail-in a complement or substitute for other resolution tools? There are differences of view within the industry and among national resolution authorities on the extent to which bail-in can be regarded as a substitute for the use of other resolution powers and tools. The substitute argument The substitute argument is that an effective use of bail-in (together with the removal and replacement of the institution s board and senior management) would provide sufficient support to enable a financial institution to continue in business, without generating the costs and losses arising from runs by counterparties and from disorderly closures of business activities. This would stabilise the institution and enable all critical economic functions to continue to operate normally. Meanwhile, the use of bail-in liabilities to recapitalise the institution would restore market confidence so that any official liquidity support could be replaced by market funding, and prepare the institution for a return to private ownership. This would also reduce the need to restructure a financial institution ahead of any resolution to make it more resolvable, because bail-in would provide the time and resources to enable any necessary restructuring to be identified and implemented during resolution. The complement argument The complement argument is that bail-in is a core element of resolution, but could only be implemented as part of a broader resolution strategy. The key elements would be cleaning up the balance sheet of the failing institution; selling off parts of the institution; ensuring the continuation of critical economic functions; and unravelling complex trades and structures. There are four main reasons for this: 1. In a resolution where a bail-in has been triggered, it is highly likely that the financial institution would only be able to continue with emergency liquidity assistance. But: The amount of liquidity support that could be provided by central banks and resolution funds (such as the Orderly Liquidation Fund in the US) may be constrained by a lack of sufficient high quality collateral, and by restrictions on any support that might result in losses falling on taxpayers. This would be accentuated if a number of major financial institutions had to be resolved at the same time. A central bank or resolution fund would be seeking as much certainty as possible on a rapid and plausible exit strategy, based on a resolution plan that had been drawn up in advance. Liquidity could be limited to supporting critical economic functions while other parts of the business are resolved. Central banks and resolution funds will be reluctant to precommit to provide liquidity support in all circumstances. They will want to ensure that a plan B option is in place for an immediate winding down of a failing financial institution through rapid sales and transfers without liquidity support, which again would depend on a resolution plan drawn up in advance. 2. The substitute approach relies on two critical underlying assumptions. If either assumption proves unfounded then bail-in will need to be supplemented by other resolution measures. These assumptions are that: Bail-in liabilities: Replacing public subsidy with private insurance 7

8 Market confidence in the bailed-in institution will be quickly restored so the franchise value can be preserved and any official liquidity support can be repaid.this may be over-optimistic. An institution may look unattractive to the market for a long time after it has come close to liquidation. Indeed, it may enter a death spiral as its customers creditors, borrowers and other counterparties disappear. The failing institution is being subject to a large but temporary negative shock, while its underlying business model remains sound. Again this may be over-optimistic.the problems may prove to be more serious than this, so an initial bail-in might need to be followed by further bail-ins.this might both exhaust the capacity for bail-in and generate adverse confidence and contagion effects across the market more generally. This is not a purely theoretical point throughout the current financial crisis the losses at some financial institutions have been consistently underestimated. 3. If more than one institution needs to be bailed in at much the same time this could make the reliance on bailin alone more fragile. It would also amplify the impact on the creditors bearing the losses and make it more difficult to achieve a rapid private market solution. 4. Bail-in alone is unlikely to mitigate the broader threats to financial stability and to the real economy arising from the failure of a systemically important financial institution, and does not prevent the build-up of systemic risk across a sector.the authorities are therefore likely to continue to press for other measures to reduce systemic risk, including market-wide restructurings such as the Volcker Rule in the US on proprietary trading; the recommendations of the ICB in the UK on the ring-fencing of retail banks; and institution-specific restructuring to underpin the development of credible and effective resolution plans. Bail-in as an effective resolution tool? Bail-in is a valuable resolution tool. It may be a necessary element of the resolution of larger and more complex institutions, not least because of the importance of stabilising the position before using other resolution tools, either to restore them as a going concern or to break them up by winding down their activities and selling or transferring their assets to other institutions. However, it is not a perfect substitute for resolution planning, for some restructuring of institutions in advance of having to trigger resolution, or for the use of other resolution tools once a resolution is triggered. There is nevertheless a welcome and growing recognition that there is a degree of substitutability here. The authorities should take this into account when setting an appropriate balance among the demands of resolution planning, advance restructuring, bail-in, and other resolution tools. 8 Bail-in nl liabilities: iliti i ie Replacing public cs subsidy sidy with private ei insurance n

9 The details of bail-in Which creditors should be bailed in? In addition to capital instruments, all the published proposals include medium and long-term unsecured and uninsured liabilities (such as debt issues and wholesale funding) within bail-in liabilities. At the other end of the spectrum, it is generally accepted that the following types of creditor should not be subject to bail-in: Insured deposits covered by a Deposit Guarantee Scheme; Secured or collateralised liabilities, up to the value of the security or collateral; Liabilities arising from holding client assets, or from a fiduciary relationship; and Liabilities to employees, commercial or trade creditors, and tax and social security authorities. But this leaves a middle ground. It may be difficult to reach international agreement on the treatment of the following classes of liabilities: Short-term uninsured and unsecured liabilities short-term creditors may withdraw their funding if they believe that a firm is nearing the point of non-viability. To avoid this source of volatility, the EU Recovery and Resolution Directive excludes liabilities with an original maturity of less than one month from bail-in. Intra-group funding the bail-in of intra-group funding would reduce the liabilities of the institution in which the funds are deposited, at the expense of a matching reduction in the assets of the institution that had provided the funds. The EU Directive views this as an important source of bail-in liabilities for a banking subsidiary, where a parent bank or holding company provides funding to its own subsidiaries. Derivatives the EU Directive allows the liability arising from derivatives to be calculated on a net basis, and further consideration is being given in the EU to whether liabilities arising from derivatives cleared through a central counterparty should be excluded from bail-in. Deposit Guarantee Schemes (DGS) even if insured deposits are excluded from bail-in and paid out in full, a DGS could be required (as in the EU Directive) to reduce its claim on an institution in resolution by an amount equal to the amount that insured deposits would have been written down had they been bailed-in. This would provide the equivalent of bail-in liabilities for retail banks funded predominantly by insured deposits. However, this would also concentrate the cost of resolution on other financial institutions in the same sector as the failing institution, which could be problematic in a marketwide crisis with multiple institutions entering resolution. The authorities could also create an order of preference under which different types of bail-in liability would be activated sequentially in a resolution until current and prospective losses and any required recapitalisation of a failing financial institution have been met. For example, the EU Directive requires national resolution authorities to bail in liabilities in the following order until the required amount of write-down is met: Common equity capital and retained earnings; Other tier 1 capital instruments; Tier 2 capital instruments; Other subordinated debt; and Other eligible liabilities. The no creditor worse off than in liquidation principle A key principle underlying the proposals for bail-in is that no creditor should be left worse off than they would have been had a financial institution gone into liquidation rather than resolution. This protects the basic rights of creditors, supports the continuation of some types of contract (for example swaps), and should limit the impact of potential bail-in on the cost of funding (to the extent that creditors potentially subject to bail-in would otherwise demand a premium because they could be worse off under a resolution than in liquidation). Bail-in liabilities: Replacing public subsidy with private insurance 9

10 However, this principle may be difficult to deliver in practice. It may be difficult to calculate the losses that would have arisen under a liquidation, and it is not clear who should then pay any compensation due using taxpayer money for this would undermine one of the key objectives of bail-in. This is one reason why the EU Directive requires each national authority to establish a resolution fund that is pre-funded by the industry, or to use a Deposit Guarantee Scheme as a resolution fund. Should existing creditors be grandfathered? National authorities usually prefer not to introduce retrospective legislation. So one option when introducing statutory bail-in powers for national authorities would be to grandfather existing creditors, and to apply bail-in only to liabilities incurred (or rolled over) after a specific date. However, this would result in a slow building up of liabilities that could be bailed in, so bail-in would not be able to meet its purpose until a sufficient stock of bail-in liabilities debt had been established. It could also be argued that since creditors are already liable to loss in a liquidation, bail-in is not a major change from the existing position. The EU Directive addresses this issue by delaying the use of bail-in powers until 2018, giving time for institutions and their creditors to adjust. The valuation problem The amount of liabilities (including capital resources) bailed-in in a resolution will depend in part on whether the resolution is intended to recapitalise a failing institution and then restore it to private ownership under new management, or whether the main focus is to sell or transfer critical economic functions while winding down the rest of the institution. However, as became evident from the successive recapitalisations of some financial institutions during the current financial crisis, it may be difficult to estimate the amount of liabilities that need to be bailed-in, not least during a period of institution-specific and possible market-wide turmoil. The authorities may therefore seek to build in a margin of error up-front, on the basis that any surplus could later be returned to bailed-in creditors. But this may place a strain on the available bail-in liabilities, and may accentuate any knock-on impact on creditors and on market confidence more generally. A key principle underlying the proposals for bail-in is that no creditor should be left worse off than they would have been had a financial institution gone into liquidation rather than resolution. 10 Bail-in liabilities: Replacing public subsidy with private insurance

11 KPMG analysis Where in a group should bail-in liabilities be held? Where a financial institution is part of a group, possibly containing multiple financial subsidiaries, there is a choice of whether bail-in liabilities should be held in each financial entity, or at group level. There may be a tension here between a group s funding preferences and the demands of national authorities to ensure that bail-in can be used effectively to support a resolution. It remains unclear whether the authorities will adopt case-by-case approaches that reflect an institution s funding strategy, or whether institutions will be forced to adjust their funding strategies to meet specific national approaches to bail-in. In the US, the Federal Deposit Insurance Corporation (FDIC) 6 has been developing a single point of entry approach, under which the unsubordinated and unsecured creditors of the parent company of a group would be subject to bail-in as part of a group resolution, while creditors of the subsidiaries of the group would not be bailed-in. The FDIC considers this to be the best approach to large groups, which are likely to contain hundreds of subsidiaries, involved in multiple lines of business, and with significant intra-group transactions and other interdependencies. The objective would be to preserve value and to return the viable parts of the group to the private sector as soon as possible, either in whole or in parts. The central expectation is that most subsidiaries would be viable and would continue as before, with no need to trigger default in them. This top-down approach could also overcome or make easier to solve many of the cross-border issues identified with resolution and bail-in. The FDIC and the Bank of England have announced that they are working closely together on this, reflecting the large proportion of the overseas assets of systemically important US institutions that are held in the UK. 6 Remarks by Martin J. Gruenberg, Acting Chairman of the FDIC, to the Federal Reserve Bank of Chicago Bank Structure Conference, Chicago, 10 May Bail-in liabilities: Replacing public subsidy with private insurance 11

12 The FDIC s preferred single point of entity approach 1) At the point of resolution, the parent company would be placed into receivership and the assets of the parent company (mostly investments in its subsidiaries) would be transferred to a newly created bridge holding company. 2) The bridge holding company would be owned at this stage by the FDIC, who would appoint a temporary new chief executive and board of directors. 3) The equity claims of the parent s shareholders, the claims of unsecured subordinated debt holders, and the claims of unsubordinated and unsecured bail-in debt would be left initially in the parent company (which no longer holds any assets). 4) The FDIC would estimate the extent of losses and apportion these first to the parent s equity and subordinated debt holders according to their order of priority. Any remaining losses would be covered by writing down bail-in debt. 5) The bridge holding company would then need to be recapitalised, by converting sufficient debt into equity claims on the bridge holding company, and into subordinated debt of the bridge holding company. This subordinated debt would be convertible into equity and would thereby provide a cushion against further losses. 6) Any remaining debt in the parent company would then transfer to the bridge holding company as new unsecured bail-in debt. 7) Parent and holding company debt is already structurally subordinated to the debt and other obligations of the operating companies it owns, so this process would be consistent with existing preference orderings of creditors across the group. 8) If the bridge holding company was unable to fund itself directly from the market, the Orderly Liquidation Fund (OLF) created under the Dodd-Frank Act could be used to provide liquidity, or to guarantee the debt of the bridge holding company. 9) The bridge holding company could provide funding, liquidity, guarantees and recapitalisation to viable subsidiaries across the group, in the US and overseas, supported as necessary by other resolution tools, such as transferring/ selling assets and liabilities, and a temporary stay on the netting of derivatives. 10) Non-viable subsidiaries would be closed down, run off or sold by the bridge holding company. There are, however, a number of issues with the FDIC s preferred approach: Impact on an institution s funding strategy. The parent company would have to raise a significant amount of unsecured and uninsured funding to provide sufficient bail-in liabilities to support a bridge holding company. This could require some groups to change their funding strategies, and possibly their group structure. Minimum requirement for bail-in liabilities. It remains unclear how much of bail-in liabilities a parent company would have to hold. This would need to be sufficient to meet current and prospective losses, to recapitalise and provide new bail-in liabilities for the bridge holding company, and possibly to support subsidiaries. Consistency with other regulatory requirements. Parental and intra-group funding may make it more difficult to separate out critical economic functions in a resolution, while local regulators are putting pressure on subsidiaries of overseas institutions to be more self-sufficient in their funding. Inconsistent objectives. There could be a mismatch between preserving franchise value and addressing systemic risk concerns over the continuation of critical economic functions, especially if some of these critical economic functions are located in non-viable subsidiaries. 12 Bail-in liabilities: Replacing public subsidy with private insurance

13 International cooperation. International cooperation would be required to allow a top-down approach to operate effectively. A host resolution authority might be tempted to trigger its own resolution and bail-in powers if it was concerned that it might not receive sufficient support from the new bridge holding company to meet losses at, and/ or to preserve critical economic functions in, its local subsidiary. Indeed, the EU Directive explicitly extends this power beyond subsidiaries to branches of institutions from outside the EU, proposing that EU member states can apply resolution tools, including bail-in, to such branches to protect local depositors and to preserve financial stability, independent of any third country resolution procedure. Advance restructuring. The FDIC has not yet declared how much restructuring a complex group might need to undertake ahead of resolution, to make it easier to identify and to separate out critical economic functions during resolution. By contrast, although the EU Directive provides for a consolidated group approach, based on close cooperation and coordination through resolution colleges and on group level resolution plans that had been agreed in advance, this would operate on a legal entity basis. So in the event of a group resolution each national authority would apply bail-in (and other resolution tools) to each entity based in its jurisdiction. This would include the bailing-in of intra-group funding provided to a subsidiary by its parent. This reflects the different legal and operating structures across Europe, where the holding company concept is less prevalent than in the US and where parent companies usually have substantial business operations of their own. The EU also has different national insolvency regimes and each member state operates its own Deposit Guarantee Scheme. The legal entity by legal entity approach raises its own set of difficult issues: Cooperation and coordination. It will be difficult to coordinate the actions of each national authority. Burden sharing. It may be difficult to reach agreement on how bail-in will be allocated across legal entities in a group. For example, if losses fall unevenly in certain legal entities, this could be addressed either by bailing-in the liabilities of the relevant legal entities, or through the aggregation of losses across a group and the spreading of bailin across all group entities. The cost of recapitalising a group would have to be allocated on some basis to creditors across the group. Liquidity support. Liquidity support (from central banks or resolution funds) could be provided either to each legal entity, against the collateral available to that entity, or channelled through a parent company. International cooperation would be required to allow a top-down approach to operate effectively. Bail-in liabilities: Replacing public subsidy with private insurance 13

14 KPMG analysis Cross-border issues As with other resolution powers and tools, it remains unclear how bail-in will be operated in the resolution of a crossborder group. Key issues include: 1. National authorities may take different views of how and when to exercise their resolution powers and tools. Even if national authorities had common resolution powers and tools (as intended by the FSB and the EU, but currently far from being achieved), they might choose to exercise them in different ways: Requiring the legal and operational restructuring of financial institutions in advance to enable resolution authorities to construct credible resolution plans. This might be applied industry-wide, such as the Volcker rule in the US and the Independent Commission on Banking recommendations for retail ringfencing in the UK, or it might apply to individual institutions. Triggering a resolution and the bailing-in of liabilities. Resolution authorities have been keen to maintain a degree of discretion over when to trigger resolution, albeit within the high-level framework established by the FSB and the EU that resolution should only be triggered when a financial institution is failing or is likely to fail, when there is no prospect that alternative actions would prevent failure, and when resolution is in the public interest. This discretion could lead to national authorities taking different views on when resolution should be triggered, and the lead resolution authority for a group does not have the power to force all relevant national resolution authorities to trigger resolution at the same time. The basis on which losses are calculated and therefore the amount of liabilities that need to be bailed-in. Whether to use bail-in liabilities simply to meet the losses arising from a break-up of a financial institution (selling or transferring some parts of the business and winding down others) or to recapitalise and re-launch a financial institution as a going concern. 2. Remaining differences in legislation. Insolvency regimes and creditor preference will not be harmonised through the introduction of a common set of resolution powers, so national authorities may take different approaches in an attempt to preserve as far as possible the position that creditors would have been in under a liquidation. There may also be national legislative constraints on the transfer or sale of assets and thus on the range of available restructuring options. 3. Differences in the availability and design of public sector support. National authorities may differ in terms of the ability of their central banks to provide liquidity support to institutions in resolution; the availability of a resolution fund to provide support; and constraints on the extent to which public funds can be used to support insolvent financial institutions. 4. Local ring-fencing. Despite the G20 rhetoric on consistency in the implementation of regulatory reform, and on coordination and cooperation in the supervision and resolution of cross-border financial institutions, the practice on the ground has been for host country authorities to ring-fence local subsidiaries in terms of liquidity and capital requirements. This might extend to resolution and bail-in requirements as well. Indeed, the most difficult situation for crossborder resolution may be where a local subsidiary or branch is of systemic importance within the host country but this subsidiary is a small part of a wider group, or the parent is not of systemic importance in its home country. The effective resolution of a crossborder group requires national authorities to act collectively in a consistent and predictable manner, and that this is agreed in advance. This should include: An agreed resolution plan for each major cross-border financial institution, including how bail-in would operate; When resolution would be triggered; The use of resolution tools across a cross-border group, including bail-in; Valuation issues and how the amount of liabilities that would need to be bailed-in would be calculated; The types of bail-in liabilities that would be written-down or converted into equity, including the ordering across different liabilities, different group entities and different jurisdictions. The no creditor worse off than in liquidation principle might help to determine a consistent and fair treatment here, but it may not provide a complete solution; How any legislative differences across jurisdictions would be dealt with; and How any liquidity or other official support would be provided, and how this would be undertaken across jurisdictions. 14 Bail-in liabilities: Replacing public subsidy with private insurance

15 The demand for bail-in liabilities Demand for and pricing of bail-in liabilities The creditors of financial institutions have become increasingly aware of the risks they are taking, and the costs of funding have increased and become markedly more diverse across financial institutions. The market is taking a view on the likelihood of a financial institution failing and being put into liquidation. However, the introduction of bail-in powers for national authorities may accentuate this shift in pricing because: The availability of bail-in powers will make it easier for the authorities to put failing institutions into resolution rather than rescuing the institution through injections of public resources. As bail-in requirements become more specific, financial institutions may find that they need to issue more liabilities of a particular type, and possibly in a specific location. The supply of bail-in liabilities could be constrained because some institutional investors choose not to hold (or are constrained by their mandates from holding) debt that can convert into equity, or because bail-in debt is rated less favourably than existing debt. Large depositors may demand security or collateral against their lending, to remove the prospect of bail-in. But greater encumbrance of assets would have an adverse impact on the position of the remaining unsecured creditors and could therefore increase the cost of unsecured funding, while also increasing the pressures on financial institutions in managing their collateral. It will therefore be difficult to assess the full picture until national resolution and bail-in regimes are in place. Regulatory restrictions on holdings of bail-in liabilities Since writing down or conversion into equity will impose losses on the holders of bail-in liabilities, regulators will be concerned that such losses do not trigger problems at other regulated financial institutions either directly or, as occurred during the current financial crisis, through a loss of market confidence due to uncertainty about where the losses might fall. Regulators may therefore want to restrict the amount of bail-in liabilities that can be held by other financial institutions, just as banks are currently restricted by limits on the amount they can hold of other banks capital instruments (and by tough capital requirements if these limits are exceeded). Such restrictions could also be imposed across sectors for example to limit the extent to which insurance companies could suffer losses as a result of the bail-in of bank liabilities. However, restrictions could not easily be applied to liabilities such as wholesale funding, or to the use of Deposit Guarantee Schemes and resolution funds. Restrictions might therefore have to be limited to specific types of bail-in liabilities, such as debt instruments. Any such restrictions would have an adverse impact on the availability and price of bail-in liabilities, and lead to more concentrated holdings of bail-in liabilities. This could raise systemic risk issues, even if these holding were outside regulated financial institutions. There may also be circumstances where resolution authorities are reluctant to use the bail-in tool because of its adverse impact on specific groups of creditors. Losses and the costs of recapitalisation will have to fall somewhere, possibly with difficult consequences, even if they do not fall directly on taxpayers. Market discipline and potential market disruption Bail-in liabilities could reinforce market discipline on financial institutions, by increasing the likelihood that creditors rather than taxpayers will bear the cost of the failure of a financial institution. Creditors would therefore have a stronger incentive to influence the behaviour of financial institutions, to reduce the possibility of losses on their claims. However, such discipline may not be fully effective. Market discipline failed to operate effectively ahead of the current financial crisis; and holders of bail-in liabilities will face the same difficulties as other stakeholders in assessing which financial institutions are most likely to fail. There is also a possibility that bail-in liabilities could be a source of market disruption, because creditors would have an incentive to withdraw deposits, sell debt, or hedge their positions through the short-selling of equity or the purchase of credit protection. Such actions could be very damaging and disruptive, both to a single institution and potentially to wider market confidence. Taking Action... Institutions subject to the potential bailing-in of their liabilities should: Assess the potential impact of bail-in on the cost and location of funding. Consider options to switch to secured or insured funding. Consider how to optimise funding and the use of collateral in response to the multiplicity of regulatory initiatives, including liquidity, derivatives clearing, ring-fencing and bail-in. Engage with resolution authorities to facilitate predictable and coordinated cross-border resolution, including bail-in. Engage with supervisory and resolution authorities to maximise the potential trade-offs between the prevention and the resolution of failure, and between bail-in and prior restructuring. Bail-in liabilities: Replacing public subsidy with private insurance 15

16 Contact us Giles Williams Partner Financial Services Regulatory Centre of Excellence, EMA region KPMG in the UK T: E: Simon Topping Principal Financial Services Regulatory Centre of Excellence, ASPAC region KPMG in China T: E: Jim Low Partner Financial Services Regulatory Centre of Excellence, Americas region KPMG in the US T: E: Clive Briault Senior Advisor Financial Services Regulatory Centre of Excellence, EMA region KPMG in the UK T: E: Jon Pain Partner Head of UK Financial Services Risk Consulting KPMG in the UK T: E: Chris Dias Principal, Advisory Financial Services KPMG in the US T: E: The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation KPMG International Cooperative ( KPMG International ), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. RR Donnelley I RRD I July 2012

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