Bank financing in the resolution process

(401(K) 2012, CC BY-SA)

The Financial Stability Board (FSB) has concluded its consultations on the strategy of financing banks in the resolution process. The document contains the FSB recommendations for the development of plans in the resolution process.

They included:

  • ensuring the ability to monitor, report and assess the financial needs and to implement the financing strategies;
  • development of a financing plan by the responsible entities;
  • utilization of assets held by the entity in question, as well as private sources of financing;
  • access to temporary public sector support mechanisms and traditional central bank instruments;
  • information sharing and coordination between the responsible authorities.

Challenges for the financing strategy

The financing strategy is a key element of a forced restructuring plan, but various difficulties may arise during its implementation. The main difficulty lies in the assessment of liquidity needs. They are established with a future crisis situation in mind, based on past experience and historical market cases. However, when it comes to a future crisis, we do not currently know its background or its circumstances. The availability of the assumed sources of liquidity depends on many factors, whereas the financial needs of a given institution can change very dynamically and in an unpredictable manner.

As a result, an financing strategy developed ex ante may not include all the potential challenges, or may include them in an insufficient manner. Moreover, in the case of markets where there have been no bankruptcies of systemically important banks thus far, it is difficult to estimate the feasibility of the options for rescuing a struggling institution.

The determination of the liquidity needs of an entity undergoing the resolution process depends on the adopted scenario, and the behavioral and market elements are very difficult to model. Actual shocks may turn out to be stronger than projected. As a result, the accumulated liquidity reserves may be quickly exhausted and may turn out to be insufficient, while the assumed liquidity sources may be unavailable due to broader market problems.

Limited access, and in extreme situations even the lack of, to market sources of financing in a crisis situation will necessitate the use of non-standard central bank instruments. One problem emerging in such cases could be the lack of acceptable collateral assets: due to their utilization in the “recovery” phase, due to the lack of acceptance of certain types of assets, or a market scenario that is more acute than projected.

In the event non-standard central bank instruments are used, it is important that a proper information policy is developed on the part of both the resolution authority and the central bank as the ultimate liquidity provider. Such a policy should prevent panics, the severity of which is difficult to estimate, and which may result in the loss of liquidity by a SIB (systemically important bank) with a strong liquidity position. The information policy should be carried out not only through traditional media, but also with a wide use of social media.

In the event of a negative market scenario, challenges will include proper liquidity risk management, as well as monitoring of financial needs and appropriate reporting to the resolution authority. Data availability and coordination of information would allow better forecasting of liquidity needs in the future, would stimulate effective remedial actions regarding current liquidity and would contribute to the identification of other entities with a similar profile, so that pre-emptive remedial actions can be taken.

In the case of cross-border groups, challenges could include the diversity of central banks’ policies as well as the inconsistent expectations of the supervisory and resolution authorities. Reaching cross-border agreements regarding the distribution of costs of the forced restructuring process between the entities in a banking group could also be a challenge.

Legal risk is a separate issue. The national lawmaker may introduce regulations that make it difficult or even impossible to implement measures provided for in the financing strategy.

The funding strategy in the resolution process should be based on conservative assumptions, taking into account the behavior of market participants in unusual and stressful situations.

Unclear liquidity needs

It is important to clarify the meaning of the terms: standard and non-standard central bank liquidity support instruments. Potential beneficiaries should have a clear understanding of this issue before a crisis comes.

In a situation of forced restructuring of a systemically important bank we should expect the emergence of structural changes in the financial system, consisting the shrinking of the interbank network, along with a simultaneous strengthening of leading banks in this network. As a result, we can expect that differences in the access to liquidity for various participants would become more significant – depending on the given bank’s position in the interbank network.

The plan of funding the resolution process should take into account the risk of market liquidity. Under normal circumstances, the liquidation of assets at market price or close to market price is not a problem. However, in a situation of internal or external shock, some of the market participants may withdraw from that market, leading to a fall in demand. The liquidation of assets will be carried out at prices lower than market prices, thereby increasing losses and causing the detachment of the financial plans from the actual ability to obtain financing.

The estimation of liquidity needs should also include an internal control system ensuring correct and effective liquidity risk management.

Although the identification of underlying assets is not controversial, it may turn out that it is difficult to use them, in particular as a collateral for financing obtained from private sources.

Bank-funded private sources pose a risk of contagion and the transmission of large bank problems to a group of banks or even the entire sector. This solution should be eliminated in order to ensure that systemic risk threats are not created.

Financing from private sources may be limited or unavailable due to the fact that certain classes of assets would not be accepted, and the phenomenon of concentration may occur, along with limited tradability of certain assets. In such a situation, support from public sector institutions will be necessary.

However, there is currently no information available on the conditions for the provision of the central bank’s extraordinary liquidity support that the entity undergoing the resolution process could apply for. Therefore, banks should be informed earlier about the types of collateral that will be accepted by the central bank in extraordinary operations.

Banks should hold a sufficient amount of unencumbered assets that may constitute collateral in extraordinary transactions with the central bank. It is necessary to ensure the ongoing monitoring of the balance sheet items serving as a possible collateral. It would also be advisable to reduce the leverage ratio in SIBs.

Financing from public sources could be associated with the fear that it will be seen by the European Commission as prohibited state aid, which would result in the need to immediately return the received funds along with interest from the date of provision of an unauthorized aid. This problem can be solved by the application of the private investor test, proving that the assets of a struggling bank, which serve as the collateral, are credible and reliable, and that they could be used as standard collateral for private financing.

Strengthening activities related to financing

The development and implementation of the financing plans should be accompanied by a number of risk reduction and public relations activities. The risk-related activities should primarily include a significant limitation or temporary suspension of lending and the strengthening of the debt collection process. Lending activity should focus on transactions secured by assets with high recovery rates.

At the same time, it is necessary to create a communication plan. It should include templates of press releases and selected public and media relations tools. The objective of the media relations is to stabilize the bank’s situation and provide credibility to corrective actions, as well as to preserve the brand’s image.

It is necessary to develop guidelines covering the structure and methods of reporting, and other aspects of the operational activity of an entity under resolution. At present supervisory reports are based on audited data that are available with a long delay. We need a different reporting system based on regular, current data prepared by banks for the supervisory authorities. This would improve the timeliness of the data, their consistency and credibility.

The resolution authorities should be sensitive to actions proposed in the financing plans in the event of forced restructuring, which depend on legal regulations in foreign jurisdictions. Activities that were previously possible may not be available in a crisis situation.

In the financing plans, banks should adopt pessimistic assumptions concerning the possible depletion of funds. They have to ask themselves what the depositors’ tolerance for the banks’ problems is and whether the deposit guarantee system provides sufficient protection for depositors with funds deposited in the amount of up to the equivalent of EUR100,000 and what the possible outflow of depositors with funds exceeding that amount is.

Banks should have the right to become acquainted with the plans for forced restructuring. It is currently expected that they will only be provided with summaries of the key aspects of such plans.

In the case of a forced restructuring of a cross-border group in the single point of entry formula (SPE), it may be necessary to maintain the liquidity of the entity in the host country. Therefore, we are faced with the following dilemma: in a situation when it is necessary for liquidity to be supported by public entities, can it be assumed that this task will be performed by the central bank of the home country? And what about a situation when support must be provided in the currency of the host country? Unfortunately, there are no answers to these questions today.

It would be desirable to provide more structure to the communication with the banking sector through the ongoing sharing of information on threats to entities with a similar liquidity risk profile. Finally, it should be emphasized that bailing out endangered financial entities should be the overriding goal, even at the expense of the temporary suspension of prudential norms.

Andrzej Dżuryk is an Assistant Professor at the Banking Department of the University of Gdańsk and a director at the Polish branch of Société Générale.

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