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Julian D. A. Wiseman
Abstract: commercial banks might be compelled to devise plans to wind down their operations in the event of problems. The making of such plans has several advantages, but the plans themselves may well be unusable.
Publication history: only at www.jdawiseman.com/papers/finmkts/wind-down_plans.html. Usual disclaimer and copyright terms apply.
Contents: Introduction; Contact with the enemy; Legal entities old and new; Conclusion; Afterword.
A new consensus seems to be developing, namely that commercial banks should be compelled to devise plans to wind down their operations in the event of problems.
From the BoE’s Financial Stability Report, June 2009, pages 43-44:
The Bank believes firms should also develop and maintain contingency plans for dealing with their own wind-down or restructuring in the event of problems. In effect, this would be asking banks to ‘write a will’. The authorities should review these plans regularly to ensure they are up to date and feasible. Resolution authorities and insolvency practitioners should specify what information they would expect to see in these plans. Firms should provide the data underlying these plans to the authorities on an ongoing basis. They should be based on information on a legal entity, rather than business line, basis and should include information that could be used by insolvency practitioners or resolution authorities in a wind-down.
Developing contingent wind-down plans could help to incentivise firms to avoid complex group structures and discourage practices, such as not segregating clients’ assets and funds from those of the firm, that make wind-down more difficult and costly. They would force management to contemplate failure in good times and would thus encourage them to prepare better for risks. They would also provide the authorities with a richer data set with which to assess the systemic impact of a firm’s failure. Disclosing wind-down plans would mean investors would be less likely to adopt investment strategies that assume the liabilities of large banks have government support.
As the BoE says, this is not a new idea, having been mentioned in the G10 report of January 2001 Consolidation in the Financial Sector (page 146 of full report):
What are the highest priority areas that policymakers should pursue…? … First, management of [large, complex banking organisations] should develop contingency plans for winding down their organisations under conditions of severe stress. It seems likely that such plans, which should be reviewed as part of the examination process, could greatly reduce the costs and risks of an actual wind-down.
The requirement for banks to have a wind-down plan will do little harm and much good. If senior management have to present to regulators a plan for the winding down of their institution, that would provide a strong incentive to keep things simple. Such an incentive would have a number of desirable consequences, including greater manageability, simplified resolution in bankruptcy, and perhaps reduced tax avoidance. It would also, as the BoE says, “force management to contemplate failure”, though for the next decade or so that’s probably redundant.
But the BoE does not acknowledge that such plans, however well prepared, may well not survive contact with actual insolvency. The plans will provide a good incentive prior to insolvency, but at insolvency may well be useless—indeed, might typically be useless. For example, consider the following ways in which a large commercial bank could become insolvent.
The old-fashioned way of going under—lending money that isn’t repaid.
Rogue trader: a trader has hidden losses, accumulated recently or over time, in a legal entity somewhere, that entity having outstanding transactions with other parts of the group.
The bank has debts to some entity in an offshore financial centre, the entity having similar obligations to the end-customer, those debts of the entity being guaranteed by the commercial bank. Then that jurisdiction becomes ‘hostile’: assets or outgoing payments are confiscated, but the new People’s Government still enforces contracts requiring incoming payments.
The bankruptcy, perhaps for a surprise theft-type reason, of the clearing house via which the otherwise-conservative bank has hedged its assets and liabilities.
These different modes of failure could require starkly different resolutions, and other different modes of failure can be devised. In other words, every unhappy bank might be unpredictably unhappy in its own way.
Given the range of possible problems that could take down different parts of a banking group, and the range of possible purchasers, counterparties and clients affected or not by the same problems or their other consequences, it would be unwise to rely on the usability of any pre-cooked wind-down plans.
However, even if the plans are unusable, the data accompanying the plans, describing the entities and their relationships, might be helpful.
There is a separate problem with the incentive to simplify.
Legal entities already in place may well have debts payable over a timeframe of years, and such legal entities cannot be closed without the consent of the creditors. If the regulators were to punish such existing complexity very harshly, those creditors could make consent conditional upon a substantial financial penalty. So, in practice, many of the existing special-purpose vehicles might have to remain in existence awhile: they are ‘stuck’.
Next turn to a speech entitled Regimes for Handling Bank Failures, given on 30th June 2009 by Paul Tucker, the BoE’s Deputy Governor for Financial Stability:
… it would help greatly if your banks could write a ‘will’ for how they could be wound down in an orderly way in the face of distress. …
It must surely entail a radical simplification of some group structures. Moving from, say, two thousand legal entities to one thousand would, somehow, miss the point.
This will not be easy. We do understand that.
So consider the position of a bank with 2000 entities, of which 50 are stuck. A regulator would wish to penalise harshly the existence of more than 50 entities. But if 1500 are actually stuck, harshly penalising the existence of the ‘extra’ 1450 achieves nothing but the impoverishment of the bank. And, of course, a regulator has no way of knowing how many are really stuck. An incentive might be too light, and so achieve too little, or too harsh, by punishing a failure to do the impossible.
Even a no-new-entities requirement causes problems. Banks sometimes might need an entity for some purpose. If they can’t be created, a bank may well choose not to dismantle the existing stock of entities—needlessly prolonging the current complexity.
So it will not be easy for banks, nor for regulators. Hopefully the BoE will, in time, say more about the combination of incentive and regulation that minimises these problems.
Pre-cooked wind-down plans have merits, but also have problems as yet unacknowledged by the authorities.
— Julian D. A. Wiseman
Paris, 27th July 2009
• This article was uploaded on 27th July 2009, on which date the link was sent to a journalist at the FT and a contact at the BoE, and shown to Google. As the author was then moving house and did not have access to his own computer the index pages were not updated at the same time, this task being forgotten until late November 2009. The author regrets this error.
• From Thirty financial groups on systemic risk list, appearing in the Financial Times on 30th November 2009: “Regulators are keen to see living wills prepared for all systemically important financial groups, but the concept has split the banking world, with the more complex groups arguing that such documents will be almost impossible to draft without knowing the cause of any future crisis”. If the purpose of the rules is to simplify insolvency, this is objection is fair. If the purpose of the rules is to change pre-insolvency incentives, then not so. Perhaps the authorities could be clearer about the purpose.
• Improve banks’ survival with living wills appeared on the Financial Times website on 9th August 2010, in which Charles Goodhart and Dirk Schoenmaker advocate living wills to “reduce moral hazard and reduce expectations of future bail-outs”, and “to curtail too-big-to-fail”.
• Resistance to living wills could prove futile appeared on the Financial Times website on 22nd August 2011, discussing progress with rule-making and will-writing.
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