EU framework for Crisis Management in the Financial Sector - guide

21 October 2010
by eub2 -- last modified 21 October 2010

When problems hit one bank, they can spread to the whole financial sector and well beyond the borders of any one country. The financial crisis also showed that systems were not in place to manage financial institutions facing difficulties. Very few rules exist which determine which actions should be taken by authorities in the case of a banking crisis. That is why the G20 agreed that crisis prevention and crisis management frameworks had to be set up. The European Commission has today responded by setting out its plans for an EU framework for crisis management in the financial sector. These pave the way for legislation due by spring 2011 which will create a comprehensive crisis management framework for banks and investment firms.

1. Why is a new crisis management framework needed for the EU?

The financial crisis provided clear evidence of the need for more robust crisis management arrangements at national level, as well as the need to put in place arrangements better able to cater for cross-border banking failures.

There has been a number of high profile banking failures during the crisis (Fortis, Lehman Brothers, Icelandic banks, Anglo Irish Bank) which have revealed serious shortcomings in the existing arrangements.

In the absence of mechanisms to organise an orderly wind down, EU Member States have had no choice other than to bail out their banking sector. State aid to support banks has amounted to 13% of GDP. The impact on taxpayers is obvious.

A new crisis management framework is essential to complement other work streams aimed at making the financial system sounder, i.e. making banks stronger with higher levels of and better quality capital, greater protection of depositors, and better supervision.

2. What are the main issues that are under consideration?

The Communication describes the legal framework that the Commission intends to propose in Spring 2011, which will involve equipping authorities with common and effective tools and powers to tackle bank crises at the earliest possible moment, and minimize costs for taxpayers. These will include:

* Preparatory and preventative measures, such as a requirement for institutions and authorities to prepare recovery and resolution plans to ensure adequate planning for financial stress or failure (see also question 4);
* Powers to take early action to remedy problems before they get out of hand such as powers for supervisors to require the replacement of management, or to require an institution to implement a recovery plan or to divest itself of activities or business lines that pose an excessive risk to its financial soundness (see also question 5);
* Resolution tools, such as powers to effect the takeover of a failing bank or firm by sound institution, or to transfer all or part of its business to a temporary bridge bank, which enable authorities to ensure the continuity of essential services and to manage the failure in an orderly way (see also question 6).

The overriding aim is to put in place a framework that will allow a bank to fail – whatever its size - while ensuring the continuity of essential banking services, minimising the impact of that failure on the financial system and avoiding costs to taxpayers. This is essential to avoid the 'moral hazard' that arises from the perception that some banks are too big to fail.

3. Why didn't the EU have this framework in place before the crisis? And what has been done since the crisis?

Until the crisis, many felt that crisis management was best dealt with at national level especially if there was a risk that there would be budgetary implications and in view of the close connection of crisis measures with national insolvency regimes. Measures in place varied greatly between Member States.

However, the crisis has strengthened the case for action at EU level, since it clearly demonstrated that the absence of European arrangements could result in ad hoc national solutions, which might be less effective in resolving the situation and ultimately prove more costly for national taxpayers. Furthermore, the crisis highlighted there were no mechanisms in place to deal with banks in difficulty operating across borders.

4. What sort of preventative measures does the Commission consider necessary?

Preventative measures will include measures designed to ensure that developing problems will be identified and addressed at an early stage, and to enhance the preparedness of firms and authorities to deal effectively with serious difficulties. These will include reinforcing supervisory powers (e.g. tougher standards and more intrusive assessments, more systematic on-site examinations, etc.) and introducing a requirement for firm-specific recovery and resolution plans. The recovery part would be prepared by firms, and set out measures that the firm would take to deal with funding problems in a range of conceivable stressed scenarios.

The recovery part would be prepared by authorities with the cooperation of firms, and would put in place plans as to how the firm might be resolved, and its essential functions preserved, in the event of the firm's failure. Preventative measures might also include powers for authorities to take measures, or require a firm to make changes to its structure or business organisation, if the authorities assess that the firm is not resolvable with the available tools.

5. What about early intervention measures?

Early intervention measures will include measures by banking supervisors designed to address developing problems within individual banks and across banking groups at an early stage, to prevent them from aggravating and secure recovery. These will include expanding supervisors' powers of early intervention (e.g. powers to prohibit payment of dividends, requiring replacement of managers or directors, requiring the bank to divest itself of certain activities or business lines, etc.), the power to require implementation of a firm's recovery plan to address specific funding problems, and the appointment of special management for a limited period to take over control and run the bank with the objective of addressing its problems and restoring it to financial health).

6. What are resolution measures and how are they reflected in the Communication?

Resolution occurs at a point when the institution has reached a point of distress such that there are no realistic prospects of recovery over an appropriate time-frame and all other measures have been exhausted. Tools available to specially designated "resolution authorities" would include a sale of business tool (parts of the credit institution or parts of its business can be sold to one or more purchasers without the consent of shareholders); a bridge bank tool (authorities can transfer some or all of the business to a temporary bridge bank in order to preserve essential banking functions or facilitate continuous access to deposits); an assets separation tool (to remove toxic assets to a separate vehicle) and a debt write down tool (whereby all existing equity can be written off and the debt of the troubled institution can be converted into equity or written down, as a means of restoring the institution's capital position).

7. How is cross-border cooperation to work?

Beyond ensuring common tools in all Member States, the Commission considers that it will also be necessary to ensure smooth cooperation both in advance of and during a crisis. A cross-border coordination framework would entail building on the core of existing supervisory colleges (which are being established under the new Capital Requirements Directive (CRD III) by including resolution authorities into "resolution colleges". These colleges would be tasked with crisis planning (preparation of resolution plans, agreeing principles for burden sharing, etc.) and would be a forum for information exchange and coordination during a crisis. There would also be a role for group resolution authorities to decide on the appropriateness of a group resolution scheme. The newly established European Supervisory Authorities would also be expected to play a key role in the preparation, preventative, early intervention and coordination parts of the new framework.

8. How will resolution schemes be financed?

Financing is a key part of crisis resolution, and the Commission believes that a coordinated approach is needed in order to improve the prospects for effective cross-border cooperation. In May, the Commission set out its ideas for pre-funded bank resolution funds  to ensure that the banking sector, and not the taxpayer, pays the costs of future bank failures. This Communication further elaborates on the those ideas, in particular with respect to how the funds should be designed (ex ante funds backed by ex post financing arrangements), who should contribute, the appropriate basis for contributions), how resolution funds fit with the current legislative proposal on deposit guarantee schemes, and how the Commission intends to proceed in order to calibrate appropriate fund sizes.

9. Beyond this communication, what will be the next steps?

Future policy actions: beyond announcing a new legal framework on crisis management in the financial sector for adoption in Spring 2011, the Communication also outlines future work:

* In the medium term, this involves examining the desirability of administrative liquidation proceedings for banks in order to facilitate faster and more orderly liquidation and the need for further harmonisation of bank insolvency regimes (including core principles of bank insolvency such as priority rankings and rules on claw back actions).
* In the longer term, and alongside the review of the new EU supervisory authorities planned for 2014, the Commission also intends to assess how a more integrated framework for the resolution of cross-border groups might be best achieved.

10. Is this work intended to solve the current crisis?

The financial and economic crisis has called for extraordinary measures to be taken in order to avert a potential meltdown of the European banking industry. However the measures considered in the Communication are aimed at the management of future crises. Early supervisory intervention should assist in averting preventable bank failures, while an EU resolution framework would equip national authorities with adequate tools to manage the consequences of failures that could not otherwise be avoided. This is the missing link in an effective bank regulation framework.

11. Resolution measures may interfere with the rights of shareholders and creditors. How does the Communication propose to deal with this?

Bank resolution tools that involve transfer of assets may interfere with the rights of creditors and shareholders, and any EU resolution framework would need to incorporate adequate safeguards to protect those interests.

For example, EU company law contains a number of mandatory requirements that confer rights on shareholders. These include pre-emption rights, and the requirements that any increase or reduction of issued share capital is approved by the shareholders' general meeting. In addition to this, any transfer of ownership or assets of an ailing bank must comply with shareholders' right to property under the European Convention on Human Rights. A balance needs to be struck between protecting the legitimate interests of shareholders and enabling resolution authorities to intervene quickly and decisively to restructure a failing institution or group to minimise contagion and ensure the stability of the banking system in affected Member States. Where rights granted by EU law are affected, an EU resolution framework would also have to contain appropriate mechanisms for redress and compensation.

EU law does not currently specify the rights of creditors in the context of bank insolvency. Appropriate safeguards under a bank resolution framework might include compensation mechanisms to ensure that creditors are not left worse off than they would have been had the bank under resolution been wound up under the applicable insolvency law.

12. What kinds of financial institution would be covered by an EU regime?

The Communication focuses principally on crisis management in the banking sector. This focus is justified by the special nature of banks - their unique role as providers of credit, deposit-takers and payment intermediaries – which give rise to particular problems and public policy objectives in the event of a bank failure. However, the Commission is also considering options as to how to include certain investment firms whose failure might also risk financial stability. Beyond that, the Commission also recognises that different kinds of crisis management measures may be necessary to address the specific risks to market stability represented by other types of financial institution. It intends to carry out further work by the end of 2011 to consider which crisis management arrangements might be necessary for other types of financial institution, including insurance companies, investment firms and Central Counterparties.

13. Would a requirement for cross-border groups to prepare "living wills" help authorities to manage a cross-border banking crisis?

There are currently no harmonised powers for supervisors to require banking groups to prepare recovery and resolution plans, often referred to as "living wills". The idea is that systemically important cross-border financial institutions could be required to produce detailed plans to facilitate, in a period of severe financial stress or instability, the preservation of the firm as a going concern, the continuity of its financial infrastructure services, and the rapid resolution or winding down where necessary of the institution (or part of the institution).

14. What is the proposal to write down creditors and how would it work?

The objective is to develop a mechanism for recapitalising failing institutions so that it can continue to provide essential services, without the need for bail out by public funds. Fast recapitalisation would allow the institution to continue as a going concern, avoiding the disruption to the financial system that would be caused by stopping or interrupting its critical services, and giving the authorities time to reorganise it or wind down parts of its business in an orderly manner. A number of ideas for achieving this objective are being considered by policy makers and international bodies. These ideas include requirements for firms to hold contingent capital or 'bail in' debt – that is, debt that converts into common equity when a firm is financial distress to recapitalise it quickly; and a power for resolution authorities to impose a write down or 'haircut' on the creditors of a failing firm, or to convert their debt claim to equity, at the point of resolution. In every case, there would need to be clarity about the conditions or triggers for write down or conversion. In the case of a statutory power for authorities, the classes of debt covered would need to be clear.

The Commission Services consider that contractual and statutory approaches could be complementary. They are exploring these ideas further, and will consult later in the year.

15. How does all this relate to discussions at international level?

Discussions have taken place on crisis management in a number of international fora (G20, Financial Stability Board, Basel Committee). There is broad recognition that the problems of cross-border banking groups extend beyond the EU, and many significant financial groups are global in their organisation. While certain of the problems which need to be addressed are the same - for example, the difficulties of cooperation and coordination, information sharing, the lack of effective tools, the need for better advance planning, the territorial scope of national insolvency regimes when applied to a group - there are nevertheless significant distinctions between the progress that can be reasonably expected at international level and what can be achieved within the EU. The depth of integration of both banking business and the legal framework at European level both allows and requires greater cooperation and convergence in order to develop a more robust framework to underpin the Internal Market.

16. What are the main differences between what the EU is proposing and the US approach?

Both the EU and the US are working to develop mechanisms which should be capable of resolving or winding down failing financial institutions, and are actively engaged in discussions at international level. The US approach will entail putting an end to the problem of "too big to fail" banks by ensuring that failing institutions can be taken into receivership by the Federal Deposit Insurance Corporation (FDIC), under which their business will be transferred or wound down and the failed institution will be liquidated.

The Commission's proposed EU framework would also allow authorities to put banks into an orderly resolution in which their essential services could be preserved while the failed institution itself was ultimately wound down. However, the Commission is also considering equipping authorities with additional tools which would allow a troubled bank 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. These would include dilution of shareholders, changes to management, haircutting of creditors and re-structuring so as to ensure that the surviving entity was viable. Such operations would also need to adhere to strict EU state aid rules.

In terms of funding the cost of resolution measures, the new US rules foresee a system of ex-post financing, meaning that other financial institutions will be required to pay only when failures occur. However, with the FDIC, the US does already have a well-funded system for bank resolution, which applies to smaller and medium-sized deposit taking institutions. The Commission on the other hand, supports a system of ex-ante financing, which would require all banks to contribute to national funds set up to cover the cost of future bank resolutions. The Commission has argued that there is a need to coordinate an EU approach to financing resolution measures, and has expressed a preference for ex ante funding as more credible and less pro-cyclical.

More information

Source: European Commission