The Bank of England’s Presumptive Path

Last week, the Bank of England updated its public disclosure about how it would use its resolution powers to ensure that systemically important banks can be allowed to fail without destabilizing the financial system or using public funds to bail out their private sector shareholders or bondholders. See 'The Bank of England’s approach to resolution' (Oct. 2017), updating its 2014 publication by the same name.

Public Disclosure of Preferred Strategy. While the Bank of England has reserved the right to respond differently to unforeseen circumstances, it has now clearly identified the single-point-of-entry bail-in strategy as its ‘preferred resolution strategy,’ and the one most likely to be used, for most of ‘the largest UK firms, including all UK G-SIBs and D-SIBs.’[1]

Public Disclosure of Individual Resolution Plans. It has also said that it ‘will publish summaries of major UK banks’ resolution plans’ starting in 2019.

Secured Liquidity. Just as significantly, the booklet contains a section called ‘The Bank’s approach to providing liquidity in resolution.’ That section confirms that ‘a firm in resolution would have access to the Bank’s published [lender-of-last-resort] facilities . . . subject to meeting the necessary eligibility criteria.’ It also notes that the Bank has the discretionary power to supplement its published lender-of-last-resort facilities under a ‘flexible Resolution Liquidity Framework.’ Under that framework, the Bank has the power to provide secured liquidity to ‘banks, building societies or investment firms subject to the resolution regime, where the entity or its holding company is in a Bank of England led resolution. Such liquidity support may be secured against a wide range of collateral . . . . The Bank’s objective would be to provide liquidity in sterling or foreign currency as required, in the necessary scale and for a sufficient period of time to allow the firm to make the transition to market-based funding. The terms and conditions of any lending, including the cost of drawing, would be set in a way designed to support the effectiveness of the resolution regime, incentivise the transition of the firm back to market-based funding, and protect public money.’

Promoting Certainty and Predictability. One goal of public disclosures of this type is to put shareholders and bondholders on notice that they cannot expect to be bailed out in the future. Another goal is to provide both the market and host authorities with confidence that the home authority will exercise its resolution powers in a reasonable, predictable way. Such confidence should reduce the tendency of the market to panic or host authorities to ring-fence local assets or take other self-protective measures in the event of material financial distress.

Safeguards for Creditors. The updated disclosure states that the Bank will exercise its resolution powers in a manner that provides appropriate safeguards for creditors that are expected to bear losses once a firm’s equity has been wiped out. These safeguards include independent valuations over a realistic time horizon, a clear creditor hierarchy, equal treatment of creditors at the same level within the hierarchy, and the ‘no creditor worse off’ safeguard when exceptions are made to the equal treatment rule.

Continuity of Banking Services and Critical Operations. The updated disclosure states that one of the Bank’s principal objectives will be to ‘[e]nsure the continuity of banking services and critical functions in the United Kingdom.’ To advance this objective, the Bank will require firms to have provisions in their service contracts that require counterparties to continue performing obligations during resolution as long as they are paid. Firms must also have robust management information systems, sufficient financial resources at group service companies, robust cost and transparent pricing structures for services, appropriate governance and reporting lines for the delivery of critical services and adequate rights of continued access to operational assets.

Preservation of Financial Contracts. The UK resolution regime prevents the counterparties of a failed firm from terminating their financial contracts with the firm solely because the firm enters into resolution, as long as the firm continues to perform its payment and other obligations on the contracts. The Bank may stay the failed firm’s payment and delivery obligations, but only for up to one business day. This limitation on the Bank’s power to stay performance minimizes potential disruption to markets and reinforces bail-in as a credible resolution strategy. In contrast, a recent proposal by the European Commission would allow resolution authorities to impose a much longer moratorium of up to 5 business days and, under certain conditions, up to 12 business days, which is likely to reduce confidence in firms, accelerate runs and make the orderly resolution of distressed firms more difficult to accomplish.

International Coordination. The 2017 update seems to have walked back what seemed like a soft commitment by the Bank of England in its 2014 report to exercise its resolution powers in a manner designed ‘to ensure that financial stability is maintained in both home and host jurisdictions’ when acting as home authority in the resolution of a UK G-SIB or D-SIB.

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While there continues to be room for improvement in the Bank of England’s approach to resolution, its public disclosures about how it would use its resolution powers are now substantially more comprehensive and useful than those of any other home authority. The resolution process would be more certain and predictable, and the financial system more resilient, if other home authorities would follow the Bank of England’s example and provide public disclosures about how they intend to exercise their resolution powers. Such increased certainty and predictability would reduce the tendency of the market to panic or host authorities to ring-fence local assets or take other self-protective measures in the event of material financial distress.

This post comes to us from Davis Polk and has been co-authored by Randall D. Guynn and Andrew B. Samuel.