Law and Financial Stability 1513523007, 9781513523002

This volume comprises a selection of papers prepared in connection with a high-level seminar on Law and Financial Stabil

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Table of contents :
Cover
Contents
Preface
Contributors
I: RESOLUTION OF FINANCIAL INSTITUTIONS: IMPLEMENTATION OF THE KEY ATTRIBUTES AND REMAINING CHALLENGES
1 Keep Calm, Carry On . . . and Complete the Regulatory Reform Agenda
2 Bank Resolution within the European Banking Union: From Bail-Out to Bail-In
3 Too Big to Fail: Where Are We Now?
II: CROSS-BORDER RESOLUTION: CHALLENGES IN CROSS-BORDER EFFECTIVENESS
4 Cross-Border Resolution between Cooperation and Ring-Fencing
5 Cross-Border Resolution: Progress and Challenges in Cross-Border Enforcement
6 Cross-Border Resolution: A Global Solution to a Global Problem
III: THE LEGAL FRAMEWORK FOR THE RESOLUTION OF CENTRAL COUNTERPARTIES: A SPECIAL CASE?
7 The New Frontier of Resolution Frameworks: Central Clearing Counterparties
IV: CORPORATE DEBT RESTRUCTURING AND ECONOMIC RECOVERY
8 Debt Restructurings and Corporate Insolvencies
V: CENTRAL BANK FUNCTIONS AND THE GROWING IMPORTANCE OF MACROPRUDENTIAL POLICY
9 New Tasks for the European Central Bank: Between Separation, Synergies, and the Preservation of Independence
10 Central Bank Legal Mandates and the Growing Importance of Macroprudential Arrangements: The Latin American Experience
11 The Central Bank as Macroprudential Supervisor
VI: LEGAL FRAMEWORK FOR ISLAMIC BANKING
12 Promoting Financial Stability: Issues and Challenges in Islamic Finance
13 Prudential and Liquidity Management Frameworks for Islamic Banks in Arab Countries
14 Financial Stability and Legal Frameworks for Islamic Bank Resolution and Anti–Money-Laundering/Combating the Financing of Terrorism
15 International Efforts toward More Resilient Conventional and Islamic Banking Sectors: Implementation Challenges
Seminar Summary: Discussion on Corporate Debt
VII: RECENT TRENDS IN FINANCIAL SECTOR REGULATION: THE PROBLEM OF DE-RISKING
16 Pressures on Correspondent Banking: Impact, Drivers, and Responses
Seminar Summary: Discussion on De-Risking
Index
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I N T E R N AT I O N A L M O N E TA R Y F U N D

Law & Financial Stability

©International Monetary Fund. Not for Redistribution

© 2020 International Monetary Fund Cover design: IMF CSF Creative Solutions Division Cataloging-in-Publication Data IMF Library Names: International Monetary Fund, publisher. Title: Law & financial stability. Other titles: Law and financial stability. Description: Washington, DC : International Monetary Fund, 2020. | Includes bibliographical references and index. Identifiers: ISBN ISBN 978-1-51352-300-2 (paper) | ISBN 978-1-51351-631-3 (web PDF) | ISBN 978-1-51351-689-9 (ePub) Subjects: LCSH: Economic stabilization—Law and legislation. | Finance— Law and legislation. | Financial risk management. Classification: LCC HB3732.L39 2020 DISCLAIMER: The views expressed in this book are those of the authors and do not necessarily represent the views of the IMF’s Executive Directors, its management, or any of its members. The boundaries, colors, denominations, and any other information shown on the maps do not imply, on the part of the International Monetary Fund, any judgment on the legal status of any territory or any endorsement or acceptance of such boundaries. Recommended citation: International Monetary Fund. 2020. Law & Financial Stability. Washington, DC: International Monetary Fund. ISBN: 978-1-51352-300-2 (paper) 978-1-51351-689-9 (ePub) 978-1-51351-631-3 (PDF) Please send orders to: International Monetary Fund, Publication Services P.O. Box 92780, Washington, DC 20090, USA Telephone: (202) 623–7430 Fax: (202) 623–7201 E-mail: [email protected] Internet: www.elibrary.imf.org www.bookstore.imf.org

©International Monetary Fund. Not for Redistribution

Contents

Preface

vii

Contributors

ix

I

1

2

RESOLUTION OF FINANCIAL INSTITUTIONS: IMPLEMENTATION OF THE KEY ATTRIBUTES AND REMAINING CHALLENGES Keep Calm, Carry On . . . and Complete the Regulatory Reform Agenda José Viñals and Aditya Narain Bank Resolution within the European Banking Union: From Bail-Out to Bail-In A. Joanne Kellermann and Myrte Meijer Timmerman Thijssen

3

Too Big to Fail: Where Are We Now? Michael H. Krimminger

II

CROSS-BORDER RESOLUTION: CHALLENGES IN CROSS-BORDER EFFECTIVENESS

4

5

6

3

10 27

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Cross-Border Resolution between Cooperation and Ring-Fencing Andrea Enria

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Cross-Border Resolution: Progress and Challenges in Cross-Border Enforcement Ross Leckow and Ender Emre

69

Cross-Border Resolution: A Global Solution to a Global Problem Eva H. G. Hüpkes

83

III THE LEGAL FRAMEWORK FOR THE RESOLUTION OF CENTRAL COUNTERPARTIES: A SPECIAL CASE? 7

1

The New Frontier of Resolution Frameworks: Central Clearing Counterparties Alessandro Gullo

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105 107

Contents

IV CORPORATE DEBT RESTRUCTURING AND ECONOMIC RECOVERY

123

8

Debt Restructurings and Corporate Insolvencies Luis Manuel C. Méjan

125

V

CENTRAL BANK FUNCTIONS AND THE GROWING IMPORTANCE OF MACROPRUDENTIAL POLICY

9

New Tasks for the European Central Bank: Between Separation, Synergies, and the Preservation of Independence Chiara Zilioli

10 C entral Bank Legal Mandates and the Growing Importance of Macroprudential Arrangements: The Latin American Experience Manuel Monteagudo

141 143

157

11 The Central Bank as Macroprudential Supervisor François Gianviti

171

VI LEGAL FRAMEWORK FOR ISLAMIC BANKING

191

12 Promoting Financial Stability: Issues and Challenges in Islamic Finance Jaseem Ahmed

193

13 Prudential and Liquidity Management Frameworks for Islamic Banks in Arab Countries Inutu Lukonga

208

14 Financial Stability and Legal Frameworks for Islamic Bank Resolution and Anti–Money-Laundering/Combating the Financing of Terrorism Elsie Addo Awadzi and Chady Adel El Khoury 15 International Efforts toward More Resilient Conventional and Islamic Banking Sectors: Implementation Challenges Mehmet Siddik Yurtcicek and Mehmet Sefik Yurtcicek Seminar Summary: Discussion on Corporate Debt Panelists: Sean Hagan, A. Unnikrishnan, Sijmen de Ranitz, Richard Gitlin, and Luis Méjan

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236 251

Contents

VII RECENT TRENDS IN FINANCIAL SECTOR REGULATION: THE PROBLEM OF DE-RISKING 16 Pressures on Correspondent Banking: Impact, Drivers, and Responses Yan Liu and Francisca Fernando Seminar Summary: Discussion on De-Risking Panelists: Adel Al Qulish, Michaela Erbenova, Grovetta Gardineer, Sally Scutt, and Jose Luis Stein   Index

259 261 275

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Preface

The papers included in this publication are based on presentations given at the IMF Legal Department’s flagship high-level seminar on Law and Financial Stability held on May 16–18, 2016, at the IMF headquarters in Washington, DC. While the topics discussed during the seminar and in this publication cover a broad spectrum of issues, they all illustrate the important role that the law plays in contributing to financial stability at the international, regional, and national levels. Indeed, major steps have been taken by the international community and IMF member countries in strengthening financial sector legal frameworks since the global financial crisis. A key achievement has been the recognition, now embodied in the new standards for resolution regimes approved by the Financial Stability Board, that public authorities need strong and clear mandates and powers to resolve issues in financial institutions. The seminar provided an important opportunity to review, from a legal perspective, the progress made in strengthening financial regulatory systems. In particular, it delved into the enhancement of resolution regimes for financial institutions and the key role played by legal regimes for insolvency. In this respect, as the distress of systemically significant financial institutions can create cross-border problems, the seminar also examined the development of a coherent international policy framework for resolution and resolution planning. It also examined the most effective legal models for the conduct of macroprudential policies and the implications for the governance and autonomy of central banks that arise from their macroprudential mandates. At the same time, the seminar sought to examine emerging legal issues and to identify what remains to be done in the global financial regulatory agenda. Of the many emerging legal issues discussed in the seminar, the subject of the legal aspects of Islamic banking received particular attention. The seminar also focused on the withdrawal of global banks from correspondent banking and other high-risk business relationships, dedicating a session to the issue of de-risking and ways to ensure that emerging markets and developing economies remain integrated within the international financial system. In identifying what remains to be done, the seminar featured a high-level panel chaired by then Governor of the Board of Governors of the Federal Reserve, Daniel Tarullo. The panel laid out a vision for the road ahead, including the need to improve ethical conduct by financial market participants and public authorities. The agenda, indeed, is unfinished. It remains important to monitor whether international standards can help us deal with new risks and vulnerabilities, and to ensure that the global regulatory framework adequately takes into account the specific circumstances and needs of all IMF member countries, including emerging markets and developing economies.

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Preface

The timing of the seminar coincided with a very important milestone for the IMF’s Legal Department: its 70th anniversary. This provided an ideal opportunity not only to reflect on the work done but also to lay out an agenda for the Legal Department going forward. Strengthening financial sector legal frameworks remains an issue of critical importance for the IMF, and part of its mandate to promote macroeconomic and financial stability. The IMF Legal Department works very closely with our members and other international organizations toward this objective and will continue to assist in the design and implementation of legal reforms that can foster financial stability. The seminar represented an important step in this ongoing process of engagement with our membership, as demonstrated by the stimulating and productive discussions held among the speakers and participants, and further reflected by the diversity and high quality of the papers collected in this publication. By convening senior legal experts and policymakers from more than 80 countries, as well as from international organizations, academia, and private practice, the seminar reaffirmed that the process of legal reform is a cooperative endeavor, in which the IMF can also serve as a platform to share cross-country experiences. Many IMF colleagues contributed to the design, planning, and organization of the seminar and the preparation of this volume. I wish to express our gratitude especially to a team led by Ross Leckow, previous Deputy General Counsel, and comprising Alessandro Gullo, Cristina Hayashi, Kajal Jagatsing, Laura Lorenzo, Mark Milford, Eric Robert, and Hans Weenink. Rhoda Weeks-Brown General Counsel and Director IMF Legal Department

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Contributors

Elsie Addo Awadzi is the Second Deputy Governor of the Bank of Ghana as of February 2018, managing financial regulation and financial stability, among other responsibilities. Before her appointment, she was Senior Counsel in the Financial and Fiscal Law Unit of the IMF’s Legal Department. In that role, she helped to assess the stability of financial systems in a number of Group of Twenty (G20) countries and provided technical assistance to help strengthen financial systems and manage financial crises in a variety of IMF member countries. She also advised on legal and institutional aspects of public financial management, public debt management, and fiscal responsibility frameworks. She is the coauthor of the 2015 IMF Working Paper, “Resolution Frameworks for Islamic Banks,” the 2017 IMF Board Paper, “Ensuring Financial Stability in Countries with Islamic Banking,” and the 2018 IMF Staff Discussion Note, “Trade-offs in Bank Resolution,” among others. She has spoken on Islamic bank resolution at a number of forums including the Law, Justice, and Development Conference hosted by the World Bank in 2015. She has taught courses at the IMF financial law seminars in Mauritius, Singapore, and Vienna. Before joining the IMF in 2012, Ms. Addo Awadzi was a two-term Commissioner of Ghana’s Securities and Exchange Commission, worked on key financial sector legal reforms in Ghana and other countries in Africa, worked briefly as a senior ­treasury dealer in Barclays Bank Ghana Limited, and worked in private law practice. She earned an LL.M. from the Georgetown University Law Center in Washington, DC, as well as an M.B.A. (in finance) and an LL.B. from the University of Ghana. Jaseem Ahmed has 25 years of experience in financial sector reform issues and in the fields of public governance, expenditure management, and fiscal decentralization. He has extensive experience in macroeconomic and financial sector stabilization programs in Asia. He assumed the position of Secretary-General of the Islamic Financial Services Board (IFSB) on May 1, 2011. As Secretary-General, he is responsible for the formulation, issuance, dissemination, and adoption of IFSB standards for the prudential regulation and supervision of Islamic finance covering banking, insurance, and capital markets. Also as Secretary-General, Mr. Ahmed contributes to the development of global standards for ethical conduct and regulation of the financial sector through his participation in international bodies. He is a member of the Consultative Group of the Basel Committee on Banking Supervision and sits on the Consultative Advisory Groups of the International Auditing and Assurance Standards Board and the International Ethics Standards Board for Accountants. In addition, Mr. Ahmed is a member of the IMF External Advisory Group on Islamic Finance and a member of the Global Islamic Finance and Investment Group, a UK government advisory body.

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Before his appointment to the IFSB, Mr. Ahmed served as Director of the Public Management, Financial Sector, and Trade Division of the Southeast Asia Department of the Asian Development Bank, where he managed the lending, technical assistance, and capacity-building operations in Southeast Asia for the banking sectors and nonbank financial institutions, and for the strengthening of supervision and regulatory capacities. Mr. Ahmed also led the Asian Development Bank’s response to the global financial crisis in Southeast Asia. Mr. Ahmed was a member of the IFSB High-Level Task Force on Liquidity Management, which proposed the establishment of the International Islamic Liquidity Management Corporation. He is the coeditor of a book on Islamic finance and the editor of a book on regional economic cooperation in South Asia. Mr. Ahmed contributes to the development of educational standards as a member of the Governing Council of the International Centre for Education in Islamic Finance, a global university for Islamic finance. He is a pro bono external adviser of the Art Acquisition Committee of Bank Negara Malaysia Museum and Art Gallery. Mr. Ahmed earned a B.A. in economics from the University of Sussex and an M.A. in economics and M.Phil. in ­economics from Yale University. Chady Adel El-Khoury joined the IMF in 2007 and is currently Senior Counsel in the Financial Integrity Group in the Legal Department of the IMF. He specializes in anti–money laundering/combating the financing of terrorism (AML/ CFT), anticorruption, governance, and broader integrity issues. His responsibilities include participation in surveillance, financing programs, and assessment missions; and the delivery of technical assistance projects related to these areas. He also works regularly on policy and research issues. Before joining the IMF, Mr. El-Khoury worked as an analyst and legal expert at the Lebanese Financial Intelligence Unit (Special Investigation Commission). In this capacity, he regularly conducted financial analysis of money-laundering, associated offenses, and terrorist-financing cases. He also assisted the AML and CFT National Committees in developing and implementing policy decisions to enhance the effectiveness of the AML/CFT, anti corruption, governance regime in Lebanon. Mr. El-Khoury holds a master’s degree in banking and finance law from Saint Joseph University in Lebanon and a master’s degree in finance from ESCP Europe in France. Andrea Enria became the first Chairman of the European Banking Authority on March 1, 2011. He previously served as Secretary-General of CEBS, dealing with technical aspects of EU banking legislation, supervisory convergence, and cooperation within the European Union. He was also previously Head of Financial Supervision Division at the European Central Bank and worked for several years in the Research Department and as Head of the Supervisory Policy Department of the Bank of Italy. Mr. Enria earned a B.A. in economics from Bocconi University and an M.Phil. in economics from Cambridge University.

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Contributors

Francisca Fernando is a counsel with the Financial Integrity Group of the Legal Department at the IMF, working on AML/CFT-related issues in the context of IMF technical assistance, surveillance, and policy work. Before joining the IMF, she worked on related issues with the Financial Market Integrity Unit of the World Bank Group, for the Stolen Asset Recovery Initiative of the World Bank, and the United Nations Office of Drugs and Crime. She has coauthored publications on related topics in areas such as the withdrawal of correspondent banking relationships, settlements in foreign bribery cases, and illicit financial flows. She holds a Master of Laws from the University of Toronto, a Bachelor of Laws from the London School of Economics and Political Science, and is called to the Bar of England and Wales. François Gianviti was Director of the Legal Department from January 1986 and General Counsel since 1987, until his retirement from the IMF in December 2004. He studied at the Sorbonne, the Paris School of Law, and the New York University School of Law. He obtained a licence ès lettres in 1959, a licence en droit in 1960, a diplôme d’études supérieures de droit pénal et science criminelle in 1961, a diplôme d’études supérieures de droit privé in 1962, and a doctorat d’Etat en droit in 1967. He was lauréat de la Faculté de droit de Paris and lauréat du concours général des Facultés de droit. From 1967 to 1969, Mr. Gianviti was a lecturer in law, first at the Nancy School of Law, and subsequently at the Caen School of Law. In 1968, he was admitted to the Paris Bar. In 1969, he obtained the “agrégation de droit privé et science criminelle” of French universities and was appointed Professor of Law at the University of Besançon. From 1970 through 1974, he was seconded to the IMF Legal Department, as counsel, and later, Senior Counsel. In 1974, Mr. Gianviti became Professor of Law at the University of Paris XII. He was Dean of the School of Law from 1979 through 1985. He is a member of the Monetary Committee of the International Law Association. He has received such decorations as a Chevalier des Palmes Académiques (France) and a Chevalier dans l’Ordre National du Mérite (France). Alessandro Gullo is Senior Counsel in the Financial and Fiscal Law Unit in the Legal Department of the IMF, where he provides legal advice on supervisory and resolution regimes of financial institutions, crisis management, and public financial management issues. He has been extensively involved in advising IMF member countries on legal reforms to their financial and fiscal law frameworks in the context of IMF financial assistance programs, financial sector assessment programs, and technical assistance projects. Before joining the IMF in 2008, he worked in international law firms in Europe and in the United States. He has published and lectured on banking and financial law matters, such as on resolution frameworks of financial institutions, OTC derivatives clearing, credit rating agencies, and the EU crisis management regime. He received an LL.M. with distinction in international legal studies from Georgetown University and a J.D. from the University of Rome. He has been admitted to the New York Bar and to the Italian Bar.

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Eva H. G. Hüpkes is Acting Head of Regulatory and Supervisory Policies at the Financial Stability Board. Before assuming her position in September 2009, she served as Head of Policy and Regulation with the Swiss Financial Market Supervisory Authority. Dr. Hüpkes joined its predecessor, the Swiss Federal Banking Commission, in 1999. Before that, she worked in the Legal Department of the IMF. She is a member of the New York Bar and holds degrees in law and international relations from the University of Geneva, the Graduate Institute of International Studies, Geneva, and Georgetown University (LL.M., with distinction), and a doctorate in law (magna cum laude) from the University of Berne. Dr. Hüpkes played a pivotal role in promoting effective resolution of financial institutions as Secretary to the Financial Stability Board’s groups working on resolution, as Co-Chair of the Basel Committee Working Group on Cross-Border Bank Resolution, and as member of the Advisory Panel of the International Association of Deposit Insurers. She also served as Consulting Counsel to the IMF, advising national authorities on the implementation of international standards relating to banking regulation, supervision, and crisis management, and is a lecturer in international financial regulation at the University of Zurich and Frankfurt Goethe University. Joanne Kellermann was a board member of the Single Resolution Board in Brussels from its inception until early 2018. Before that, she was an Executive Member of the Governing Board of the Netherlands Central Bank, responsible for supervision. After receiving a master’s degree in civil law from Leyden University, she started her career as a lawyer in one of the Netherlands’ largest law firms, NautaDutilh. Having become a partner in 1992, she specialized in banking regulation and cross-border financial transactions and then headed the firm’s financial practice in London until 2005. After that, she moved to the public sector and joined the Netherlands Central Bank, initially as General Counsel. In 2007, she became a member of the Governing Board of the Netherlands Central Bank and was a­ ctively involved in all major crisis interventions in the Netherlands’ financial sector. During her term, she chaired the Financial Expertise Centre, the body coordinating the fight against fraud and financial crime in the Netherlands, and was a member of the Board of Supervisors of the European Insurance and Occupational Pensions Authority, EIOPA. She is currently Chairperson of the Board of Pensioenfonds Zorg en Welzijn and a nonexecutive member of the board of the University of Utrecht. Michael H. Krimminger is a partner based in the Washington, DC, office of Cleary Gottlieb Steen & Hamilton LLP. Mr. Krimminger advises domestic and international banking and financial institutions on the challenges and opportunities stemming from global statutory and regulatory reforms, as well as a variety of restructuring and insolvency matters. Mr. Krimminger joined Cleary Gottlieb in 2012 after more than two decades in numerous leadership positions with the Federal Deposit Insurance Corporation, including most recently as its General Counsel. As General Counsel, he served as

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Contributors

the Principal Legal and Policy Adviser to the Chairman and Board of Directors regarding the legislative development and later implementation of the Dodd-Frank Act, including its systemically important financial institution resolution, living wills, capital markets and capital, and structured finance requirements. Mr. Krimminger’s international experience includes serving as the cochair of the Basel Committee’s Cross Border Resolutions Group and representing the Federal Deposit Insurance Corporation on the FSB’s Resolution Steering Group. He has played a central role in bilateral and multilateral discussions with regulators around the world on legal reform, resolution planning, capital and liquidity requirements, and strategies for implementation of financial market reforms for derivatives and other financial market contracts. Ross Leckow is is Senior Adviser at the Bank for International Settlements and was previously Deputy General Counsel of the Legal Department of the IMF. A national of Canada, Mr. Leckow has extensive experience in IMF regulatory and financial operations and currently leads the work of IMF lawyers on issues of financial sector law reform in member countries. He has also contributed to the IMF’s efforts to develop an international legal framework for the resolution of cross-border financial institutions. Before joining the IMF in 1990, Mr. Leckow practiced law in the private and public sectors in Canada. He lectures frequently in the United States and abroad on issues of international finance law. Yan Liu is Assistant General Counsel in the Legal Department of the IMF, where she heads the Financial Integrity Group that deals with AML/CFT, tax evasion, and anticorruption issues at both the policy and the individual member-country level in the context of the IMF’s surveillance, program, and capacity-building activities. She also supervises the work of the Legal Department on the development and implementation of policies on sovereign debt restructurings. She leads a team of lawyers who provide advice on private sector debt resolution with a focus on corporate, household, and small- and medium-sized enterprises’ insolvency reform and enforcement of creditor rights. Before joining the IMF Legal Department in 1999, Ms. Liu was in private practice at Fried Frank Harris Shriver & Jacobson, and Milbank Tweed Hadley & McCloy, in the United States. A native of China, Ms. Liu received her legal education in China and the United States. Luis Manuel C. Méjan is currently a part-time professor and researcher at the Law School of Instituto Tecnológico Autónomo de México. He worked at Banco Nacional de México for 30 years, occupying positions such as Executive Vice President–Legal Counselor to the chief executive officer, and Deputy Secretary of the Administrative Boards of the Bank and the Financial Group. He was President of Mexico’s Federal Institute of Commercial Insolvency Specialists (“Instituto Federal de Especialistas Mercantiles”) from 2000 to 2009. Dr. Méjan is the author of several books, mainly in financial and insolvency law, and has

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been a speaker at multiple organizations and forums. He is a member of several international associations in the insolvency field, including the Institute of International Insolvency, the American College of Bankruptcy, the International Exchange of Experience in Insolvency, and the Instituto Iberoamericano de Derecho Concursal. Manuel Monteagudo has been General Counsel of the Central Bank of Peru since 1994. During his career at the Central Bank, he has held other positions, including Secretary General and Assistant Lawyer for the board’s counsel. Mr. Monteagudo obtained a law degree from the Pontifical Catholic University of Peru and an LL.M. from the University of Houston. He received a Ph.D. in law from the University of Paris 1 Pantheon-Sorbonne, with a thesis on the independence of central banks. Mr. Monteagudo is a member of the Committee on International Monetary Law of the International Law Association and of the Society International Economic Law. He is also a professor at the Pontifical Catholic University of Peru and Director of the LLM Program of International Economic Law of the University of Peru. His publications on international law issues include “Peru’s Experience in Sovereign Debt Management and Litigation: Some Lessons for the Legal Approach to Sovereign Indebtedness” (Law and Contemporary Problems 2010), Neutrality of Money and Central Bank Independence in International Monetary and Financial Law the Global Crisis (Oxford University Press 2010), “La Independencia del Banco Central: Aspectos Legales” (IEP, BCRP, and UP 2011), and “The Right to Property in Human Rights and Investment Law: A Latin American Perspective of an Unavoidable Connection” (World Trade Institute 2013). Aditya Narain is Deputy Director of the Monetary and Capital Markets Department of the IMF, where he oversees the work on financial supervision and regulation and fintech, as well as its overall technical assistance function. In his IMF career, he has worked extensively with IMF member countries in promoting financial sector reforms. In this regard, he has led several Financial Sector Assessment Program (FSAP) missions (including to the United States, Canada, and Malaysia), conducted assessments of bank supervision in several other FSAPs (including China), and has led technical assistance missions on a range of financial sector topics around the world. He has been closely involved with various international regulatory reform initiatives and currently represents the IMF on the Basel Committee on Banking Supervision, in addition to attending the Plenary meetings of the FSB. He also serves as the Vice-Chair of the FIRST Initiative and as a Member of the Board of the Toronto Centre. He joined the IMF after working at the Reserve Bank of India, where he was Chief General Manager of the Department of Banking Supervision. He holds master’s degrees in physics from Delhi University and in public administration from Harvard University.

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Contributors

Myrte Meijer Timmerman Thijssen started her career in the Legal Service of the Netherlands Central Bank (Supervision & Regulation Department). She was involved inter alia in the setup of the national resolution authority within the Netherlands Central Bank. In 2015, she joined the Single Resolution Board, and since then has been working in its Legal Services, providing legal advice in crisis cases and dealing with litigation before the Appeal Panel and the Court of Justice of the European Union. She completed her law studies at the University of Amsterdam and New York University. José Viñals has been the Group Chairman of the Standard Chartered Bank since the end of 2016. Between 2009 and 2016, he was Financial Counsellor and Director of the Monetary and Capital Markets Department of the IMF. During that time, he was a member of the FSB, representing the IMF. His previous professional career has been closely tied to the Central Bank of Spain, where he served as Deputy Governor after holding successive positions. He has also held the positions of Chairman of the European Central Bank International Relations Committee and Chairman of Spain’s Deposit Guarantee Funds. He has been a member of the Bank for International Settlements Committee on the Global Financial System, the European Central Bank Monetary Policy Committee, and the high-level group appointed by the president of the European Commission to examine economic challenges in the European Union. He was a member of the EU Economic and Financial Committee and a board member of the Spanish Securities Authority, the Comisión Nacional del Mercado de Valores. He holds a Ph.D. in economics from Harvard University and is a former ­faculty member in the Economics Department at Stanford University. His awards include the Premio Rey Jaime I (King James I Prize) in economics. Rhoda Weeks-Brown is General Counsel and Director of the IMF’s Legal Department. She advises the IMF’s Executive Board, management, staff, and country membership on all legal aspects of the IMF’s operations, including its lending, regulatory, and advisory functions. Over her career at the IMF, she has led the Legal Department’s work on a wide range of significant policy and country matters. She has written articles and many IMF board papers on all aspects of the law of the IMF and co-taught a Tulane University seminar on that topic. Ms. Weeks-Brown has also served as Deputy Director in the IMF’s Communications Department, where she led IMF communications and outreach in Africa, Asia, and Europe; played a key role in the transformation of the IMF’s communications strategy; and led IMF strategic policy communications on key legal and financial topics. Ms. Weeks-Brown has a J.D. from Harvard Law School and a B.A. in economics (summa cum laude) from Howard University. Before joining the IMF, she worked in Skadden’s Washington, DC, office. She is a member of the Bar in New York, Massachusetts, and the District of Columbia, and a member of the Supreme Court Bar. Ms. Weeks-Brown serves on the Board of TalentNomics, Inc., a nonprofit organization focused on developing women leaders globally.

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Mehmet Siddik Yurtcicek is Senior Counsel and Manager at BaFin Consultancy where he consults businesses on banking and financial services. Before that, he worked at the Banking Regulation and Supervision Agency of Turkey, where he served as Head of the Legal Affairs Department and coordinated the FSB team. Dr. Yurtcicek was a member of the Technical Committee of the Islamic Financial Services Board and worked as Consulting Counsel in the Legal Department of the IMF. He has given lectures on banking resolution and Islamic banking and is a frequent speaker at many national and international conferences. He earned a law degree, a master’s degree in EU law, and a Ph.D. in private law from Marmara University; and he has an LL.M. in banking and finance law from the Queen Mary University of London. His book, Electronic Money from the Legal Perspective, was published in June 2013 (and a second edition in May 2015). Mehmet Sefik Yurtcicek is an Islamic finance consultant and Middle East ­specialist. He holds a master’s degree from Georgetown University’s Center for Contemporary Arab Studies and a bachelor’s degree in business administration from Istanbul University. He worked as a career diplomat at the Ministry of Foreign Affairs of Turkey, where he served in the departments of Central Asia and Middle East, as well as in the embassies of Damascus/Syria and Tripoli/Libya, focusing on the political and economic aspects of bilateral and multilateral relations with countries of the region. Throughout these assignments, he analyzed the political and economic structures of most of the Islamic world. Moreover, as a project director at the Turkic Council, he coordinated relations and joint projects with the Islamic Development Bank, the Organization of Islamic Cooperation, and World Customs Organization. Mr. Yurtcicek currently consults on compliance (including AML/CFT), financial due diligence, and valuation. Chiara Zilioli has worked for the European integration project, in particular for the monetary union, for much of her career. She earned an LL.M. from Harvard Law School and a Ph.D. from the European University Institute. She worked in the Legal Service of the EU Council, where she started in 1989, and moved to the European Monetary Institute in 1995 and to the European Central Bank in 1998, where she was appointed first as Head of Division and then as Director General of Legal Services (General Counsel). Ms. Zilioli has been appointed Professor at the Law Faculty of the J-W Goethe Universität Frankfurt. She has published three books and several articles, mainly on the position of the European Central Bank within the EU institutional framework and on the functions of the European Central Bank. For several years, she has been a lecturer at the Institute for Law and Finance of the J-W Goethe Universität Frankfurt and at the Collegio Europeo di Parma in Italy. In 2012, she taught a course at the Academy of European Law of the European University Institute. She is a member of the Italian Bar.

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I RESOLUTION OF FINANCIAL INSTITUTIONS: IMPLEMENTATION OF THE KEY ATTRIBUTES AND REMAINING CHALLENGES

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CHAPTER 1

Keep Calm, Carry On . . . and Complete the Regulatory Reform Agenda José Viñals and Aditya Narain

Support for the postfinancial crisis reform agenda has been waning in recent years, resulting in part from three assertions by critics in the financial industry. The first is that much of regulation is unnecessary and detrimental. The second is that regulation is necessary, but it’s gone too far and therefore is excessive. The third is that the postcrisis regulatory reforms were necessary, but the uncertainty caused by continuing discussions on the scope and timelines of the agenda is turning out to be counterproductive. In our view, the regulatory revolution that has taken place since the crisis has not just been necessary but has been essential to underscore the safety of the global financial system and for reviving a sustainable global economy over the medium and long term. As to whether it’s gone too far, the work has not yet been completed, as some parts of the agreed reforms still have not been fully implemented and agreement still has to be reached on some reforms, although a decade has now passed since the events that triggered the financial crisis. One aspect of the reform process that has been truly unprecedented, and often forgotten, is how it has changed the established approach to regulatory design and implementation in an inclusive and meaningful manner in at least four dimensions. First, the process has been truly global in the sense that not only advanced economics, but emerging markets and developing economies (EMDEs) have been sitting together at the table and designing the global regulatory framework. The Group of Twenty (G20), which has driven the agenda, has the major EMDEs as its members, and both the Financial Stability Board (FSB) and the Basel Committee have expanded their membership to include the major EMDEs. In addition, the FSB has used its Regional Consultative Groups, which comprise

At the time this seminar was held, José Viñals was Financial Counselor and Director of the Monetary and Capital Markets Department of the IMF. Aditya Narain is currently Deputy Director in the Monetary and Capital Markets Department.



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other countries not around the main table, to bring a more global perspective to the discussions. Widening the standard-setting table has been an impressive gain for the international financial architecture, given that both providers and users of finance are no longer confined to national boundaries. Many financial institutions are global in their presence and their activities, and in many cases EMDEs represent their major markets. Having their input into the design of global financial policies can help encourage greater inclusion and a more-level playing field. However, it is not necessary that the regulatory standards be implemented mutatis mutandis across all countries. Their implementation requires both an application of proportionality and of common sense, and a distinction needs to be made between adaptation and rigor. The objectives of the regulations being developed by global standard-setting bodies have a purpose that should be shared by all countries. But in terms of adapting the regulations to a specific national context, one needs to look at the economic and financial reality of that country and then adopt an approach that makes sense for that country. Being flexible on the adaptation of international standards does not mean that the standards applied in a particular country should be weaker for that country. Some EMDEs ask why they should adopt the postcrisis reform agenda when the crisis did not originate in their jurisdictions or even, in some cases, did not affect them directly. The answer is that EMDEs could be subject to more risks in general because the preconditions necessary for safe, sound, and efficient financial systems may still be developing. For example, the IMF Financial Sector Assessment Programs’ work suggests that legal frameworks in many EMDEs cannot yet provide quick relief in the case of infringement of creditor rights or contractual certainty. These countries may also face capacity constraints in the development of independent professions that support the conduct of finance, including auditing and accounting. In addition, EMDEs may face certain macrorisks like those associated with reversals of international capital flows. Such reasons argue for a level of rigor that is consistent with ensuring the resilience needed in a high-risk environment. This rigor is required not only from the point of view of the country but also as a global public good, because if some constituencies or jurisdictions are subject to lower rigor in terms of standards, they could end up importing high-risk activities. This arbitrage could lead to an additional accumulation of risk in those jurisdictions with lower standards. Hence, it is important to combine the adaptation and the flexibility dictated by common sense as well as preserve the level of rigor to ensure the resilience of these financial systems. There is also the question of developing adequate institutional capacity in these countries. This is an area where both the IMF and the World Bank provide a lot of technical assistance to help countries adopt these global regulatory standards after appropriately adapting them to their national contexts. The analysis that we’ve conducted at the IMF in terms of EMDEs on the role of the interaction between regulation and financial deepening, and regulation and financial

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Chapter 1  Keep Calm, Carry On . . . and Complete the Regulatory Reform Agenda

inclusion, shows that for financial deepening to be consistent with financial stability, it must be accompanied by strong prudential frameworks. And for financial inclusion not to give rise to problems in terms of systemic stability down the road, it is better if accompanied by a sound regulatory framework. For all of these reasons, having sensible, flexible, but rigorous regulation is critical in EMDEs. The second major dimension of regulatory change is that the scope of the reform agenda has been broad and not just confined to a few areas like banking. Given the origins and channels of transmission of the shocks of the crisis, reform has covered many areas of financial activity that probably have not been looked at in such an integrated manner. In terms of areas of intervention, it has covered banks and nonbanks (including the shadow banks that lie in between), financial institutions and financial markets, financial inclusion and consumer protection, accounting and auditing standards, and incentives and compensation. One of the defining features of this crisis has been the role played by shadow banks. This area had not been well studied or understood previously. Shadow banking is especially tricky to handle from a regulatory point of view, given the diversity of activities and players, with the playing field constantly mutating and even gaining ground. If one looks at the growth rate of so-called shadow banking activities—understood as those outside of the banking system that entail either maturity or liquidity transformation or the buildup of leverage, and which are not adequately or sufficiently regulated—at the global level, it is 10 times faster than that of banking activities. Why is this happening? Based on work at the IMF, in terms of understanding the drivers of shadow banking at the global level, we come up with three fundamental drivers. The first is the regulation put in place in banking, leading to a shift in activity toward nonbanks and particularly shadow banks. The second is the accommodative monetary policies of recent years in advanced economies, which are appropriate but have led many investors to move from banks to nonbanks to gain higher rates of return. But, of course, with high rates of return also come associated higher risk and, in particular, higher liquidity risk, which is important in shadow banking and, especially, in asset management. The third driver, which is most important for EMDEs, is financial development, which has led to a proliferation of nonbank activities and shadow banking activities. China is a quintessential example of an EMDE where shadow banking has been gathering strength significantly. The role of shadow banking in finance can be likened to the role that cholesterol plays in human biology. There is a good part and a bad part. The good part supports market-based finance and should be maximized. At the same time, the bad cholesterol has to be minimized given its contribution to systemic risk. In the case of shadow banking, systemic risk is embedded in the characteristics or functions that shadow banks perform, but which are not adequately regulated. The challenge facing policymakers and the FSB has been deciding which approach should be followed. Should it be the same approach as in banking and be entity-based? Or given that shadow banking is so heterogeneous and so constantly mutating, should not regulation be primarily an activity-based approach?

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These questions highlight the big difference between the regulation of banking and of shadow banking, and increasingly there is support for a focus on activity-based rather entity-based regulation for shadow banking. Such an approach affords the flexibility in addressing the boundary problem—posed, for example, by financial technology, whose activities are, in some cases, in the shadows of the shadow banking system. One segment of the shadow banking space that poses special policy challenges is the regulation of the asset management industry. The application of the activity-based framework means that one needs to first gather better and more granular information regarding the liquidity of the underlining assets. Second, progress has to be made in having adequate management of liquidity inside mutual funds and having adequately developed stress-testing techniques for mutual funds that take into account not only partial equilibrium approaches but also general equilibrium approaches. What happens when there is a largescale withdrawal from just one fund that triggers withdrawals from other funds, leading to everyone trying to sell and exit? Finding a good response to this is important, as the first-mover advantage problem poses grave potential for runs on mutual funds. These risks are among those that the FSB is discussing. We expect to see the appropriate regulatory response to dealing with them while keeping in mind that some investors are expected to have a greater risk tolerance than others. Many initiatives are in the pipeline and will lead to a safer shadow banking system by transforming shadow banking into a resilient, stable source of market-based finance. The third dimension of change is that regulatory reform has been deep, with very fundamental changes in how the financial system is now regulated compared to the past. Probably the most salient example of this has been the focus on systemic risk and systemically important financial institutions. This focus has come from the shared objective of ending the “too-big-to-fail” syndrome, given the moral hazard associated with it and the burden that this potentially places on the taxpayers in the event of their failure. The dimensions of the response, in addition to regulation, has also included guidance on supervision, governance, and resolution of the systemically important financial institutions, although with differing emphases and results. One of the most salient and controversial issues surrounding the global financial crisis is the “too-big-to-fail” problem. Given the very serious difficulties that systemically important financial institutions had during the crisis, the authorities were put in an extremely challenging position. They had to choose between letting these institutions fail, with the associated adverse impacts on the economy and on society, or rescuing them by using taxpayers’ money and paving the way to the consolidation of moral hazard, in the sense that profits are privatized in good times and socialized in bad times. It is no wonder that one of the key goals of the regulatory reform process, launched at the peak of the crisis and coordinated by the FSB at the behest of the G20 leaders, has been to address and, if possible, to end the too-big-to-fail problem, which has been re-baptized in more

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Chapter 1  Keep Calm, Carry On . . . and Complete the Regulatory Reform Agenda

politically correct terms as dealing with systemically important financial institutions. There is no doubt that a lot has been achieved. The approach toward the too-big-to-fail issue has advanced significantly across four domains. The first is in terms of regulation, which requires, for example, that systemically important institutions hold more high-quality capital as a surcharge for their enhanced contribution to systemic risk. This has resulted in much stronger financial institutions, particularly banks, regarding both solvency and liquidity. The second is more effective supervision, led by the work of the Supervisory Intensity and Effectiveness work stream of the FSB, which has laid out the framework for more intrusive supervision for the systemically important institutions. Third, there have also been improvements—though not as numerous as many of us would have liked—in terms of corporate governance of financial institutions and particularly of banks. Last, but certainly not least, there has been considerable movement on resolution. And there, the progress has come together with the establishment of “living wills” and the focus on the recovery and resolvability of financial institutions and particularly of global systemically important banks. What has also been revolutionary has been the agreement on the total loss-absorbing capacity, which is a welcome step toward reinforcing the capacity of big banks to be resolved without causing problems for the economy or costing taxpayers money. Also important is the agreement on the Key Attributes for Effective Resolution, which represents the first-ever international code of best practices on cross-border resolution, an area in which the IMF and the World Bank have long been interested. However, having said that, there is still more work to be done on resolution, particularly at two levels. The first is further advancing the policy development at the international level to deal with resolution of nonbanks such as insurance companies and financial market infrastructures like central counterparties, which can concentrate systemic risk. Second, gaps remain in the national regional frameworks in implementing the agreed-upon international standards on resolution. The application is rather uneven and significant obstacles remain regarding cross-border resolution. There also is a need for a fuller alignment of the national and regional frameworks with the Key Attributes for Effective Resolution, both in terms of both technical and legal changes. Another area where more still needs to be done is addressing misconduct in finance. This area is not confined to systemic institutions but has been discussed most often in their context, given the key role they play in setting global benchmarks, making key markets, and in the sheer headline number of losses attributed to excessive risk taking, mis-selling, and misconduct. While stricter enforcement of violations is one element of the response, a broader issue to be addressed is how to move from just enforcing a culture of compliance to promoting a culture of ethical conduct guiding the provision of finance. When we talk about culture and human behavior, we have to find ways to get beyond incentives, sanctions, and exhortations to move actions in the right direction. In the end, this is an issue that transcends our regulatory approaches, which has to do with setting the tone

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at the top and with identifying subcultures that encourage excesses. This is going to be extremely difficult, but setting the right objectives and reinforcing them through constant public discourse will help get us to a better place than the current situation. The goal is that people do the right thing even when no one is watching. And last, but certainly not least, the reforms have been done in a compressed time period, compared to earlier efforts, especially considering the reach, scope, breadth, and depth of the changes. There has also been a conscious attempt to provide for a longer implementation period, driven both by the external environment but also to allow industry the time needed to bring about meaningful change. Although the regulatory revolution has taken place in a short period of time, it has been more realistic in terms of the speed with which implementation can be expected. Take the example of the Basel capital framework. The official discussions on the Basel II framework began in 1998, and the final rules text was issued in 2004 with an implementation date of 2006. Basel III, on the other hand, was issued in December 2010, just two years after the crisis took on a full-blown form, but allowed for the rules to be implemented in a phased manner over a seven-year period, starting in January 2013. This has proved helpful in finalizing the efforts to strengthen the banking system, which is the core of the financial system, and to make it truly resilient. Yet, it also needs to be recognized that often market pressure often has led to faster de facto implementation of the reforms by the industry than envisaged in the original official timetable. The phased-in period has allowed also for the quality of the implementation to be assessed. The Regulatory Consistency Assessment Program, launched by the Basel Committee, looked at how implementation was progressing and found excessive variability in the risk-weighted assets—computed using internal models of some of the Group I banks—that could not be explained by national differences. Allowing this to continue would have put the entire capital reform in jeopardy and could have triggered a race to the bottom in a fiercely competitive environment. The consequent focus on the denominator of the capital ratios (getting the risk-weighted assets right) has been a key instrument in the quest for a level playing field, now that so much progress has been made on the numerator of the capital ratio (the amount of loss-absorbing capital) in enhancing the quantity and the quality of capital. A sensible approach to this issue will allow credibility to be restored to the risk-weighted assets framework, which is the basis for many of the bank-based reforms, while maintaining the risk-sensitive approach that was introduced by Basel II.1 However, this has meant reopening some of the issues that had been dealt with by Basel III and has led to calls for regulatory certainty. Such certainty 1 Agreement has since been reached on necessary enhancements to the Basel III framework, which limit the use of the output of banks’ internal models in regulatory capital calculations that were the source of much of the excessive variability. These enhancements are required to be implemented in a phased manner between 2022 and 2027.

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Chapter 1  Keep Calm, Carry On . . . and Complete the Regulatory Reform Agenda

is indeed important for finance to function with a longer-term perspective, but it is also important to adapt the framework to the lessons learned from implementation, so that in the end we have a robust framework. And, of course, while certainty is desirable and a goal worth striving for, it can be an elusive construct given the dynamic dialectic that exists between regulation and innovation. Without a doubt, there has been a substantial change in the regulatory landscape, and this has been warranted. What is most important is that each and every one of these changes can be mapped back to a deficiency or gap in the regulatory framework that was exposed in the crisis. Not to address these gaps would not just be an omission—it would put the global financial system at risk. On the other hand, while much distress has been expressed on how capital requirements are affecting the ability of banks to lend, several studies have concluded that well-capitalized banks do better in performing the intermediation function, underscoring a key objective of the reforms, which was to build resilient, well-capitalized financial institutions. What is important, however, is to continuously monitor and periodically assess how these multiple changes are playing out and to correct for any unintended effects that may run counter to the objectives of the reforms. Efforts are underway to take a comprehensive view of the effects of the reforms, but what we can already see in terms of the ultimate objective of regulation—which is to move the financial system toward a safer place—is that the banking system is now considerably safer than it was a few years ago. Further, while more still needs to be done in securing the safety of nonbanks, overall the major financial systems have demonstrated resilience in the face of the recent global shocks, and the volatility associated with these episodes has been short-term and has not adversely affected them. So what is clear is that the financial system is on the right path to achieving the goals of the reform agenda. All in all, we conclude that the financial system is in a much better place than it was a few years ago. And the regulatory reform agenda has been necessary to getting us here. Now it is important to complete and implement that agenda swiftly so a robust framework is in place that can address existing and emerging risks and vulnerabilities. In doing so, we need to keep in mind the need to safeguard the stability of the financial system while allowing it to play its role in supporting sustainable economic growth.

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CHAPTER 2

Bank Resolution within the European Banking Union: From Bail-Out to Bail-In A. Joanne Kellermann and Myrte Meijer Timmerman Thijssen

The Single Resolution Board (SRB) is the resolution authority within the European Banking Union.1 Its mission is to resolve failing banks in an orderly manner, thus minimizing negative impacts on the real economy and on public finances. The SRB was established in 2015 and functions within the framework of the Single Resolution Mechanism (SRM), together with the national resolution authorities within the Eurozone (NRAs), the Council of the European Union, the European Commission, and the European Central Bank (ECB). The rationale for the establishment of the SRM is centralizing decision-making on the resolution of failing banks at the European Banking Union level and thereby aligning it with the centralized model of banking supervision within the Eurozone that commenced in 2014. The first section of this chapter provides background information on the establishment of the European resolution framework. The second section discusses the cooperation between the SRB and its stakeholders within the SRM, with a particular focus on the division of tasks between the SRB and the NRAs. The third section touches upon the resolution tools that are available within the SRM and the safeguards accompanying the application of those tools. Section four describes the cooperation between the SRB and other authorities at the international level.

A. Joanne Kellermann was a full-time member of the Single Resolution Board (2015–18). Myrte Meijer Timmerman Thijssen is Legal Expert to the Single Resolution Board. The views expressed in this chapter are those of the authors and do not necessarily represent the views of the Single Resolution Board. The authors are very grateful for the input received from Chiara Giussani. 1 It currently consists of the 19 member-states of the European Union that have adopted the euro. A member-state whose currency is not the euro may decide to join the Banking Union by establishing a close cooperation. See infra footnote 17.

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Chapter 2  Bank Resolution within the European Banking Union: From Bail-Out to Bail-In

ESTABLISHMENT OF THE EUROPEAN RESOLUTION FRAMEWORK The market for banks in Europe was originally based on the principle of “minimum harmonization and mutual recognition” of national banking licenses and supervision. While this principle served the goal of opening the national banking markets to cross-border competition in the last part of the twentieth century, when the global financial crisis first hit in 2008 this approach was found to be wanting. The lack of common rules for European banks resulted in regulatory arbitrage, obstacles to cross-border business activities, and inconsistencies in risk management. National requirements were not geared toward the consolidated management of banks. It emerged that fully harmonized European rules were needed to address the drawbacks of divergences in national rules.

The Need for Common European Rules: The Single Rulebook In the wake of the financial crisis, the European Council in 2009 called for the establishment of a “Single Rulebook”—a single set of European rules that would apply to all banks and investment firms in the European Union (Babis 2015; Ferrarini and Recine 2015)—and recommended establishing a European system of financial supervisors.2 With a view to achieving that objective, a European System of Financial Supervision was set up in 2010, comprising the European Banking Authority (EBA)3 and two other European Supervisory Agencies (ESAs),4 as well as a European macroprudential authority.5 In parallel, in 2011, the European Commission brought forward proposals to strengthen the resilience and regulation of the European banking sector. The legislative package consisted of two parts that should, however, be read together: the Capital Requirements Directive (CRDIV)— governing the access to deposit-taking activities and providing for principles on prudential supervision—and the Capital Requirements Regulation (CRR)—setting out detailed prudential requirements for banks and investment firms. While the proposals for the CRDIV and CRR were still making their way through the legislative process, the European Commission in 2012 adopted another legislative proposal, providing for European rules for bank recovery and resolution: the Bank Recovery and Resolution Directive (BRRD). The BRRD was adopted with a view to addressing another regulatory gap that had become apparent during the financial crisis, namely the lack of adequate tools to deal effectively with ailing banks while preserving systemically important functions

2 Presidency Conclusions of the Brussels European Council. June 18–19, 2009. https://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/108622.pdf. 3 On the “quasi-enforcement powers” conferred to the EBA and the issues related to the institutional interplay between the SRB and the EBA, see Georgosouli 2016; and Cappiello 2015. 4 The European Securities and Markets Authorities and the European Insurance and Occupational Pensions Authority. For a comprehensive view on the ESAs, see Wymeersch 2012. 5 The European Systemic Risk Board.

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and avoiding, as much as possible, the injecting of public money.6 Meanwhile, the European Commission also decided to revisit the existing rules on deposit guarantee schemes and to improve those rules, where necessary, by adopting a proposal for a revised Deposit Guarantee Schemes Directive (DGSD).

The Need for a Common Institutional Framework: The Banking Union While the creation of the Single Rulebook was well on its way, the financial crisis evolved and the subsequent Eurozone debt crisis put the spotlight on the interdependency between banks and national governments. Europe lacked centralized decision-making in the supervision and resolution of cross-border banks,7 and the crisis showed that this resulted in a vicious circle between member-states’ finances and their financial sector, the ring-fencing of bank assets, and the provision of taxpayer-funded lifelines—the so-called bail-outs. It became clear that the single currency could be threatened by differing national responses, leading to fragmentation in the Eurozone financial sector. A deeper, institutional integration of the banking system was considered necessary. Therefore, in 2012, the European institutions agreed to unify European supervisory and resolution systems by establishing a Banking Union.8 The Banking Union consists of three pillars. The first pillar is the Single Supervisory Mechanism (SSM), headed by the ECB as the central prudential supervisor of banks in the Euro area.9 The ECB assumed its tasks on November 4, 2014. The SRM, established by the Single Resolution Mechanism Regulation10 and headed by the SRB as central resolution authority, is the second pillar of the Banking Union.11 The third and final pillar of the Banking Union, the proposed For a comprehensive overview of the BRRD provisions, see Babis 2014; and Hu 2015. On the concept and objectives of “banking resolution,” see, inter alia, Binder 2015; Chiti 2014; and Huertas and Lastra 2011. 8 See the European Council’s Euro Area Summit Statement of June 29, 2012; the Report by the President of the European Council of June 26, 2012; and the European Commission communication of November 30, 2012. For an academic point of view, see, inter alia, Ferran 2014; Ferran 2015; and Gordon and Ringe 2014. 9 The legal basis is Council Regulation (EU) No. 1024/2013 of October 15, 2013, conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions, OJ L 287, 29.10.2013, p. 63 (“SSM Regulation”). On the SSM framework in detail see, inter alia, Ferran and Babis 2013; Gortsos 2015; Neumann 2014; Schuster 2014; Tröger 2014; Wymeersch 2014; Wymeersch 2015a or 2015b?; and Wolfers and Voland 2014. 10 Regulation (EU) No. 806/2014 of the European Parliament and of the Council of July 15, 2014, establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of an SRM and a Single Resolution Fund and amending Regulation (EU) No. 1093/2010, OJ L 225, 30.7.2014, p. 1. 11 For a comprehensive analysis of the SRM legal framework see, inter alia, Busch 2015; Gortsos 2016; Howarth and Quaglia 2014; Kern 2015; Wiggins, Wedow, and Metrick 2014; and Zavos and Kaltsouni 2015. For a comparison between the legal and operational framework of the SSM and the SRM, see Wymeersch 2015a or 2015b? 6 7

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Chapter 2  Bank Resolution within the European Banking Union: From Bail-Out to Bail-In

European Deposit Insurance Scheme, has not yet been established. In November 2015, the European Commission published a proposal for this European Deposit Insurance system, according to which the SRB would become the authority in charge of a centralized European Deposit Insurance Fund.12 If that proposal were to be turned into legislation, the SRB would have tasks related to resolution as well as to deposit insurance, which would to some extent be similar to the Federal Deposit Insurance Corporation in the United States. The Single Rulebook can be seen as the foundation of the Banking Union, but the latter goes well beyond having common rules. The Single Rulebook applies in all 28 member-states of the European Union and thus also within the Banking Union. The main texts of the Single Rulebook—consisting of the CRR,13 CRDIV,14 BRRD,15 and DGSD16—had been finalized and were in force when the first two pillars of the Banking Union were created. The ESAs continue to contribute to the development of the Single Rulebook and its uniform application across the European Union, mainly by drafting technical standards and guidelines that further specify the contents of the aforementioned legislation. Within the 19 countries of the Eurozone (participating member-states),17 the rules of the Single Rulebook are complemented by Banking Union–specific rules and institutional mechanisms that allow for further integration and centralized decision-making.

Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No. 806/2014 to establish a European Deposit Insurance Scheme, COM(2015) 586 final, see http://​eur​-lex​.europa​.eu/​legal​-content/​EN/​TXT/​?uri​=​CELEX:​52015PC0586. For a critical review of the proposal, see Gros 2015. 13 Regulation (EU) No. 575/2013 of the European Parliament and of the Council of 26 June 2013, on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No. 648/2012, OJ L 176, 27.6.2013, p. 1. 14 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013, on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC, OJ L 176, 27.6.2013, p. 338. 15 Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014, establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU, and 2013/36/EU, and Regulations (EU) No. 1093/2010 and (EU) No. 648/2012, of the European Parliament and of the Council, OJ L 173, 12.6.2014, p. 190. 16 Directive 2014/49/EU of the European Parliament and of the Council of 16 April 2014, on deposit guarantee schemes (recast), OJ L 173, 12.6.2014, p. 149. 17 Other European member-states (so-called nonparticipating member-states) may decide to join the SSM. Therefore, according to Article 2(1) SSM Regulation, “participating member state” means “a member state whose currency is the euro or a member state whose currency is not the euro which has established a close cooperation in accordance with Article 7.” According to Article 4(1) SRM Regulation, member-states participating in the SSM shall be considered to be also participating member-states within the SRM, thereby aligning the scope. 12

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THE EU RESOLUTION FRAMEWORK The EU resolution framework consists of the BRRD and SRM Regulation. The BRRD applies to the European Union as a whole and was transposed into national legislation in its 28 member-states. The BRRD establishes common resolution rules and tools, including the bail-in tool, and it provides for the establishment of national resolution authorities and national resolution funds. Moreover, the BRRD requires that resolution colleges are established as platforms for coordination and cooperation with respect to banks with cross-border activities. Banking Union–specific rules—contained in the SRM Regulation—provide the infrastructure as well as the institutional framework for the operation of the BRRD in the Banking Union.18 The SRM Regulation builds on the BRRD by enabling more effective cross-border resolution. Resolution decision-making is centralized within the SRB, in coordination with the NRAs.19 Furthermore, the SRM Regulation created a Single Resolution Fund that replaces and comprises the national resolution funds.20 The ultimate goal of the BRRD and SRM Regulation is taking into account the lessons learned from the crisis and achieving the orderly resolution of banks without recourse to taxpayer’s money. In a nutshell: from bail-out to bail-in.

FUNCTIONING OF THE SRM: THE SRB AND NRAS The Single Resolution Board The SRB was established by the SRM Regulation. It is an independent agency of the European Union with a specific structure, located in Brussels.21 The SRB started its activities on January 1, 2015, and had a full set of resolution powers at

There is a difference in scope between the BRRD and the SRM Regulation. The EU-wide regulatory framework covers a broad spectrum of entities: banks, investment firms, and holding companies within the European Union, as well as European branches of banks and investment firms that are established outside the European Union. Within the Banking Union, all banks established in the Eurozone fall within the scope of the SRM. Investment firms and holding companies are also included, where they are subject to the consolidated supervision by the ECB. European branches of banks and investment firms that are based outside the European Union are included in the BRRD but are outside the scope of the SRM Regulation. Neither the BRRD nor the SRM Regulation is applicable to other financial firms, such as insurance companies and central counterparties. Recovery and resolution of such firms is still subject to rules at the national level. It is noted, however, that the European Commission adopted, in November 2016, a proposal for a European Regulation on the recovery and resolution of central counterparties. Although discussions have also taken place on a possible European recovery and resolution framework for (re)insurers, this has so far not resulted in any legislative proposal. 19 Whenever a decision is taken to place a bank under resolution, the ECB, the Commission and, possibly, the Council of the European Union, play an important role. 20 National resolution funds continue to exist for stand-alone investment firms and European branches of banks and investment firms that are based outside the European Union. On the Single Resolution Fund see, inter alia, Burke 2015; and Gortsos 2016, in particular 53–56 and 139. 21 Article 42(1), Article 47, and Article 48 SRM Regulation. 18

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its disposal as of January 1, 2016, when the SRM Regulation became fully applicable.22 It is composed of six full-time board members: a chair, a vice chair, and four members.23 As of early 2019, the SRB had around 300 staff members with diverse backgrounds in terms of nationality and professional experience (from the private and public sectors). The SRB’s key responsibilities are to establish uniform rules and procedures for bank resolution; to establish a unified, credible, and feasible resolution regime; and to remove obstacles to resolution to ensure that all banks are capable of being resolved, without recourse to public funds. The role of the SRB is not limited to crisis situations but is forward looking and primarily focused on preparatory and proactive measures, such as drawing up resolution plans, setting appropriate levels of minimum requirements for own funds and eligible liabilities (MREL), and addressing impediments to resolvability. A resolution plan consists of a comprehensive description of credible and feasible resolution actions that may be implemented if a bank meets the conditions for resolution.24 Within the SRB, the resolution-planning and crisis-management activities are carried out in three directorates, each responsible for a number of banking groups clustered by their country of establishment. Every directorate is headed by a full-time board member.

Cooperation between the SRB and NRAs The SRB cooperates closely with the ECB,25 the national supervisors, the Commission, the Council of the European Union, and the NRAs.26 This section focuses on the division of tasks and cooperation between the SRB and the NRAs in the Banking Union, as laid down in the SRM Regulation and as further specified in the Cooperation Framework between the SRB and the NRAs (Cooperation Framework).27 Indeed, the SRB is the central body of a hub-and-spoke system in which the NRAs have a key role, both in resolution planning and in execution of resolution actions (see infra). The SRM is built on a combination of local, in-depth knowledge In 2015, in accordance with Article 99(3) SRM Regulation, the SRB started its work on resolution planning. However, in 2015, the SRB was not yet competent to place institutions under resolution and make use of the various resolution powers. 23 Article 43(1)(a) and (b) SRM Regulation. 24 See “The Single Resolution Mechanism – Introduction to Resolution Planning” on the SRB’s official website, https://​srb​.europa​.eu/​en/​node/​163. 25 The SRB and the ECB have concluded a Memorandum of Understanding, “In Respect of Cooperation and Information Exchange,” https://​srb​.europa​.eu/​sites/​srbsite/​files/​en​_mou​_ecb​_srb​ _cooperation​_information​_exchange​_f​_sign​_.pdf. 26 Article 30(2) SRM Regulation. 27 Decision of the Board of 17 December 2018 establishing the framework for the practical arrangements for the cooperation within the Single Resolution Mechanism between the Single Resolution Board and national resolution authorities (SRB/PS/2018/15), which replaced the Decision of 28 June 2016, https://srb.europa.eu/sites/srbsite/files/decision_of_the_srb_on_cofra.pdf. 22

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and centralized decision-making, in line with the motto of the EU: “United in diversity.” The allocation of responsibilities is similar to the division of tasks within the SSM, which is headed by the ECB. The SRB and the ECB are directly responsible for the largest, so-called significant banks established in the Banking Union.28 National supervisors and NRAs are primarily in charge of smaller banks. The direct remit of the SRB is not, however, completely identical to that of the ECB. Unlike the ECB, the SRB is not only directly responsible for significant banks but also for “other cross-border groups,” meaning banking groups that have group entities in at least two member-states participating in the Banking Union.29 As of January 1, 2018, the SRB’s responsibility covers a total of 128 banks, including 120 banking groups (among them are all seven global systemically important banks [G-SIBs] established in the Banking Union). The number of banks under the SRB’s direct responsibility is subject to change, as new banks may be established and existing banks may cease to exist or may be classified differently over time. As previously indicated, the SRB works closely with the NRAs regarding the banks under its direct remit. Internal resolution teams have been established, which are composed of SRB staff and NRA staff.30 Each team is coordinated by a senior staff member of the SRB, in cooperation with one or more subcoordinators from the relevant NRAs.31 In these teams, the SRB and NRAs cooperate in the day-to-day work for the banks under the SRB’s direct responsibility. The tasks of a team include, inter alia, assisting the SRB in the drawing up of resolution plans, performing resolvability assessments, determining measures to address or remove impediments to resolvability, and assisting in the preparation of resolution schemes.32 Where the SRB is responsible for drawing up resolution plans and adopting all decisions relating to resolution for the above-mentioned banks under its direct remit, the NRAs are responsible for the resolution planning and decision-making for all other banks in the Banking Union.33 However, coordination also takes place between the SRB and NRAs. For specific measures in relation to these banks, such as the establishment of the MREL and the adoption of a resolution scheme, the NRAs must inform the SRB in advance and send draft decisions to the SRB.34 The SRB may then express its views on the draft decision. The SRB

See the list of supervised entities at https://​www​.bankingsupervision​.europa​.eu/​banking/​list/​who/​ html/​index​.en​.html. 29 Article 7(2)(b) and Article 3(1)(24) SRM Regulation. See the SRB’s website for the list of other cross-border groups under the SRB’s direct responsibility; the list is updated on a regular basis. 30 Article 83(3) SRM Regulation and Article 24 Cooperation Framework. 31 Article 25(1) Cooperation Framework. 32 Article 24 Cooperation Framework. 33 The NRAs are also fully responsible for the resolution tasks relating to firms that are outside the scope of the SRM. 34 Article 7(3)(fifth subparagraph) and Article 31(1)(d) SRM Regulation, Article 33–34 Cooperation Framework. 28

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can also request information from NRAs on the performance of their tasks, on a regular or ad hoc basis.35 The SRB has the ultimate responsibility for the proper functioning of the SRM as a whole, similar to the ECB’s ultimate responsibility for the proper functioning of the SSM. As such, the SRB may issue guidelines and general instructions to the NRAs.36 Guidelines and general instructions are of a general nature; they are not related to a specific entity or group and are not addressed to a specific NRA or group of NRAs.37 The SRB may also issue warnings to NRAs.38 In contrast to guidelines and general instructions, warnings are addressed to a specific NRA and are related to a specific bank under that NRA’s direct remit. A warning can be issued if the SRB considers that a draft decision of an NRA does not comply with the SRM Regulation or with the SRB’s general instructions. As a last resort, the SRB is empowered to “take over” the direct responsibility for specific banks within the purview of an NRA, to ensure the consistent application of high resolution standards.39 A participating member-state may also request the SRB to take over responsibility for entities and groups in that member-state.40 Moreover, if a resolution action requires the use of the Single Resolution Fund, the SRB is always responsible for the adoption of the resolution scheme, even if it concerns a bank under an NRA’s direct responsibility.41 Apart from the close cooperation between the SRB and the NRAs in day-to-day work, the NRAs also play an important role in the formal decision-making structure. The SRB has a specific governance where the decision-making process differentiates between the types of decisions to be taken. It is designed in a way that accommodates swift decision making in resolution cases. Therefore, the SRB operates in two different compositions: an Executive and a Plenary Session.42 The Plenary Session, in which all the NRAs are represented, takes certain general decisions that are not related to a particular resolution action.43 The Executive Session takes all decisions to implement the Article 31(1)(c) SRM Regulation and Article 35 Cooperation Framework. Article 31(1)(a) SRM Regulation and Article 5 Cooperation Framework. 37 Article 5a(2) Cooperation Framework. 38 Article 7(4)(a) SRM Regulation and Article 7 Cooperation Framework. 39 Article 7(4)(b) SRM Regulation. 40 Article 7(5) SRM Regulation. To date, no participating member-state has done so. 41 Article 7(3)(second subparagraph) SRM Regulation. 42 Article 43(5)(a) and (b) SRM Regulation. Representatives of the ECB and of the Commission are entitled to participate as permanent observers in both Sessions (Article 43(3) SRM Regulation). For an analysis of the relevant legal provisions, see also Busch 2015, 289. 43 See Article 50 SRM Regulation for the list of tasks of the Plenary Session. An exception is provided in case a specific resolution action requires support of the SRF above the threshold of €5 billion, for which the weighting of liquidity support is 0.5. In such a case, according to Article 50(1)(c) SRM Regulation in conjunction with Article 50(2) SRM Regulation, the resolution scheme prepared by the Executive Session is deemed to be adopted unless, within three hours after the submission to the Plenary Session, at least one member of the Plenary Session calls for a meeting. In the latter case, the Plenary Session decides on the resolution scheme. 35 36

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SRM Regulation, unless the Regulation provides otherwise.44 This includes all decisions on resolution actions of the entities and groups under the SRB’s direct responsibility. In the Executive Session, the Board consists only of the chair, the vice chair,45 and the four full-time members of the Board (“Restricted Executive Session”).46 When deliberating on a specific bank or group, the relevant representatives of the NRAs in the Banking Union participate as well (“Extended Executive Session”),47 meaning the appointed representatives of the NRAs of those participating member-states in which the bank on which a decision is to be taken is located. Representatives of NRAs of nonparticipating member-states are invited to participate as observers when deliberating on a group that has subsidiaries or significant branches in those nonparticipating member-states. The Executive Session should strive for consensus when taking its decisions. If, however, consensus cannot be reached, the chair and the four full-time board members take the decision by simple majority.48 As a result, there are only five voting members in the Executive Session, even if relevant NRA representatives participate. The idea behind the restricted composition and functioning of the Executive Session is to reflect the institution-specific nature of preparing and adopting decisions on resolution procedures and to allow for swift and independent decision-making, which is crucial in crisis situations. In addition, there is a specific division of tasks between the SRB and the NRAs when it comes to taking resolution actions in relation to banks under the SRB’s direct remit. The SRB is responsible for the adoption of a resolution scheme in the Extended Executive Session, for example, deciding to place a bank under resolution and applying certain resolution tools.49 As soon as the decision enters into force—which only happens if no objection is expressed by the European Commission or the Council of the European Union within a period of 24 hours50—the decision is implemented at the national level by the NRAs concerned. The SRB’s resolution scheme is addressed to the relevant NRAs in the form of a specific instruction, requiring the NRAs to take the necessary measures to implement the scheme by exercising their resolution

Article 54(1)(b) SRM Regulation. As a nonvoting member, who carries out the chair’s function in their absence. 46 Article 2(m) Cooperation Framework. 47 Article 2(n) Cooperation Framework. 48 Article 55(1) and (2) SRM Regulation. 49 The decision to place a bank under resolution is made in close cooperation and consultation with the ECB, in accordance with Article 18 SRM Regulation and the memorandum of understanding between the SRB and the ECB (see supra footnote 25). In case it is foreseen to use the Single Resolution Fund, or if the resolution action involves the granting of state aid, the resolution scheme cannot be adopted before the European Commission has adopted a positive or conditional decision concerning the compatibility of such aid with the internal market, in accordance with Article 19 SRM Regulation. 50 Article 18(7) SRM Regulation. 44 45

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powers under national law transposing the BRRD.51 Thus, the NRAs are in charge of the execution of the resolution scheme as adopted by the SRB, and it must report to the SRB on its progress.52

RESOLUTION TOOLS AND SAFEGUARDS Resolution Tools The SRB and NRAs have several resolution tools at their disposal. However, it should be noted that not all banks will be placed under resolution if they are “failing” or “likely to fail.” In fact, it could be derived from the legal framework that a failing bank should in principle be wound up under normal insolvency proceedings.53 Resolution actions will only be taken if this is necessary in the public interest.54 That is one of the three conditions that must be met before an entity is placed under resolution,55 which serves as a justification for the interference with the rights of shareholders and creditors that the use of resolution tools inevitably entails.56 In the early stages of the resolution planning phase for each bank, an initial determination is made as to whether it can undergo normal insolvency procedures or whether resolution must be carried out.57 There are four resolution tools that the SRB—or the NRAs—might use: (1) sale of business,58 (2) bridge bank,59 (3) asset separation,60 and (4) bail-in.61 The sale of business tools and bridge bank tools both entail a full or partial transfer of instruments of ownership or the assets, rights, or liabilities of a bank. The difference between the two is that the business is transferred to another private entity (which may be another bank) in the case of the sale of business tool, whereas it is temporarily transferred to an especially created, newly licensed bank in the case of the bridge bank tool. The bridge bank can be wholly or partially owned by one

Article 18(9) SRM Regulation and Article 29 SRM Regulation. Article 28 SRM Regulation. 53 See, for instance, Recital (59) and (61) SRM Regulation. 54 Article 18(1)(c) in conjunction with Article 18(5) SRM Regulation. See also “Public Interest Assessment: SRB Approach,” available on the SRB website. 55 Article 18(1)(a), (b), and (c) SRM Regulation. 56 Recital (13) BRRD. 57 Article 10(3)-(5) and Article 11(3) SRM Regulation. 58 Article 24 SRM Regulation and Articles 38–39 BRRD. 59 Article 25 SRM Regulation and Articles 40–41 BRRD. 60 Article 26 SRM Regulation and Article 42 BRRD. 61 Article 27 SRM Regulation and Articles 43–44 BRRD. Resolution action can be combined with the exercise of the power to write down and convert relevant capital instruments as referred to in Article 21 SRM Regulation. The latter power can also be applied independently of resolution action and must in such case be applied when the institution or group will no longer be viable unless that power is exercised. For a comprehensive analysis of all the resolution tools, see also also Busch 2015, 316. On bail-in, see, inter alia, Avgouleas and Goodhart 2015; and Gardella 2015, 373. 51 52

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or more public authorities and is controlled by the resolution authority. The bridge bank is a temporary solution: the resolution authority in principle has to terminate the operation of a bridge bank two years after the date on which the last transfer from the institution under resolution took place.62 The asset separation tool provides for the transfer of assets, rights, or liabilities to one or more asset management vehicles. Like the bridge institution, the asset management vehicle is wholly or partially owned by one or more public authorities. It manages the assets and liabilities it received from an institution under resolution or from a bridge institution, with the purpose of maximizing its value through an eventual sale or orderly wind-down.63 The asset separation tool cannot be used independently. In order to avoid moral hazard implications, it may only be applied together with another resolution tool. Finally, a cornerstone of the European resolution regime is the bail-in tool. The latter can be used in two possible ways: open-bank bail-in and closed-bank bail-in. In the first scenario, the bail-in tool is used to absorb the losses and recapitalize the bank while it continues to operate. Restructuring actions will take place only later, according to a bank reorganization plan that is prepared by the management body of the bank within one month of the application of the bail-in tool, which sets out measures aiming to restore the long-term viability.64 In the second scenario, the bail-in is used in conjunction with immediate structural changes of the bank, for example, to convert to equity or reduce the amount of claims or debt instruments that are transferred when the bridge bank tool is used (in other words, capitalizing another institution to harbor essential functions). In order to effectively make use of the bail-in tool, banks will be required to always meet the MREL, which will be determined for each entity during the resolution planning process.65 The MREL could be seen as the European version of total loss-absorbing capacity,66 although there are divergences. Moreover, the MREL not only applies to G-SIBs but to all banks.67 When the bail-in tool is applied, losses are first absorbed by shareholders either through the cancellation or transfer of shares or through severe dilution. Where a write-down and conversion of those instruments is not sufficient, subordinated debt is converted or written down (additional Tier 1 instruments and Tier 2

Article 41(5) BRRD. Article 42(3) BRRD. 64 Article 27(16) SRM Regulation and Article 52 BRRD. 65 Article 12 SRM Regulation and Article 45 BRRD. 66 Total loss-absorbing capacity is an international standard introduced by the Financial Stability Board (FSB) with a view to ensure adequacy of total loss absorbing capacity for G-SIBs; see the FSB’s Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution-Total Loss-absorbing Capacity (TLAC) Term Sheet, November 9, 2015, http://​www​.fsb​.org/​wp​-content /​uploads/​TLAC​-Principles​-and​-Term​-Sheet​-for​-publication​-final​.pdf. See also the FSB’s Guiding Principles on the Internal Total Loss-absorbing Capacity of G-SIBs (Internal TLAC), July 6, 2017, http://​ www​.fsb​.org/​wp​-content/​uploads/​P060717​-1​.pdf. 67 For a comprehensive overview on MREL, see Maragopoulos 2016, www​.ecefil​.eu. 62 63

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instruments).68 Senior liabilities may be bailed-in when the subordinate classes have been converted or written down entirely. In principle, all liabilities are subject to bail-in, not just those liabilities that are identified as MREL. However, certain liabilities are excluded from bail-in by law. This category includes, for instance, covered deposits,69 liabilities arising in short-term interbank lending (that is, liabilities to other banks with an original maturity of less than seven days), and certain liabilities to employees.70 Resolution authorities also have the ability to exclude or partially exclude certain other liabilities from the application of the bail-in tool. However, this is only possible under exceptional circumstances.71 For example, certain liabilities can be excluded if this is strictly necessary to avoid widespread contagion that could otherwise cause a serious disturbance of the economy of a European Union member-state or the European Union itself.

Safeguards The resolution tools, and the bail-in tool in particular, are powerful tools that may have a serious impact on the position and property rights of creditors and shareholders. Therefore, several legal safeguards have been provided in the legislation to counteract this impact. This section highlights some of the main safeguards. First, the so-called public interest assessment provides for a safeguard. Before placing an institution under resolution, the SRB must assess whether resolution action is necessary and proportionate to the resolution objectives—such as ensuring financial stability and the continuity of critical functions—and whether the winding up of the institution under normal insolvency proceedings would meet those resolution objectives to the same extent. If the public interest assessment is negative, the SRB cannot adopt a resolution scheme and the bank will be wound up in an orderly manner in accordance with the applicable national law. A second important safeguard is the compliance with the ranking of capital instruments and other liabilities while applying the bail-in. As part of the general principles governing resolution, the BRRD and SRM Regulation provide that the shareholders of an institution under resolution should bear the first losses—akin to the insolvency creditor hierarchy—and that the creditors of the bank under resolution should bear losses after the shareholders in accordance with the order This is done by exercising the power to write down and convert relevant capital instruments as referred to in Article 21 SRM Regulation. The scope of this power is to be distinguished from the scope of the bail-in tool: While the former applies to capital instruments, the latter applies to “eligible liabilities” as defined in Article 2(1)(71) BRRD. Concretely, a resolution authority must first exercise the power to write down and convert relevant capital instruments before using (if necessary) the bail-in tool. 69 As defined in Article 2(1)(5) of the DGSD, that part of deposits that are protected by a deposit guarantee scheme not exceeding the coverage level of €100,000. 70 Article 27(3) SRM Regulation. 71 Article 27(5) SRM Regulation. While the bail-in tool provides this possibility to exempt certain liabilities in exceptional cases, the write down and conversion power does not allow any exception. 68

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of priority of their claims under normal national insolvency proceedings, unless provided otherwise.72 Third, creditors of the same class should be treated equally, except where otherwise provided in the SRM Regulation.73 Thus, resolution authorities should in principle apply the bail-in tool and other resolution tools in a way that respects the pari passu treatment of creditors and the statutory ranking of claims under the applicable insolvency law. Fourth, no creditor may incur greater losses than would have been incurred if the bank had been liquidated under normal insolvency proceedings (the “no creditor worse off ” principle).74 For this purpose, the SRM Regulation and BRRD provide for an ex post valuation that must be undertaken by an independent party to make a comparison between the treatment of shareholders and creditors under resolution and their hypothetical treatment under insolvency proceedings.75 Should the outcome of the valuation be that creditors are worse off than they would have been under liquidation, they are entitled to the payment of the difference from the national resolution funds or, within the Banking Union, from the Single Resolution Fund.76 Last, but not least, the BRRD provides specific safeguards for counterparties in case of a partial transfer of assets, rights, or liabilities.77 These ensure an appropriate protection of, for example, security arrangements and set-off and netting arrangements. As regards the possibilities for legal redress, the SRB has established an independent appeal panel to decide on appeals against certain decisions taken by the SRB, such as the determination of the MREL or the imposition of a fine.78 Such appeals do not have suspensive effect. Where there is no right of appeal to the appeal panel, decisions by the SRB can be contested before the Court of Justice in Luxembourg.79 Decisions can be contested within two months by member-states, European institutions, as well as by natural and legal persons if the decision is addressed to them or is of direct and individual concern to them. Such legal action before the Court of Justice does not automatically suspend the SRB’s decision.

Article 15(1)(a) and (b) SRM Regulation. Article 15(1)(f ) SRM Regulation. 74 Article 15(1)(g) SRM Regulation. See also de Serière and van der Houwen 2016. 75 Article 20(16)-(18) SRM Regulation and Article 74 BRRD. 76 Article 75 BRRD and Article 76(1)(e) SRM Regulation. 77 Article 76 to 80 BRRD. 78 Article 85 SRM Regulation. 79 Article 86 SRM Regulation. On the judicial protection system within both the SSM and SRM, see Arons 2015. 72 73

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INTERNATIONAL COOPERATION The SRB cooperates with many stakeholders. Strengthening international cooperation is essential, especially beyond the borders of the Banking Union. Building trust and cooperation is needed in order to strengthen the global financial system. From this perspective, one should see the establishment of the Banking Union as a stepping stone for achieving a smooth process for cross-border resolution on a global basis. Within the European Union, following the FSB initiative, several crisis management groups are now active for G-SIBs. Until 2015, this was done at the national level: relevant national resolution authorities established crisis management groups for the Banking Union institutions that were identified as G-SIBs. The SRB has stepped in as the home resolution authority for these G-SIBs and is, in general, responsible for representing the NRAs for the cooperation with countries outside the Banking Union.80 In addition to these international platforms for cooperation and coordination, the BRRD provides for the establishment of two types of European cooperation fora: resolution colleges and European resolution colleges. Resolution colleges are established for banking groups headquartered in the European Union.81 Members are inter alia the resolution authorities of the subsidiaries and large branches, the relevant supervisory authorities, and authorities responsible for deposit guarantee schemes. Resolution colleges are European fora, but resolution authorities of non-EU countries can, on their request, be invited to participate as observers as well, to ensure cooperation and coordination with those authorities.82 Within resolution colleges, the resolution authorities should strive to take joint decisions on all aspects concerning the resolution of the group, including resolution planning and the assessment of resolvability, the determination of MREL and resolution strategies, and tools to be applied. The resolution authority of the European member-state, in which the parent undertaking is established, chairs the resolution college.83 The SRB is chairing many resolution colleges, as it represents the NRAs within the Banking Union for the banks under its responsibility. In case the SRB is a member of the college, the relevant NRA can still participate as an observer to ensure the effective cooperation between the European and national levels. The division of tasks within resolution colleges is further specified in the Cooperation Framework.84 In addition to the resolution colleges, the BRRD provides for the establishment of European resolution colleges for banking groups in which the parent undertaking is located outside Europe, if such a parent undertaking has at least two

Article 32(1) SRM Regulation. Article 88 BRRD. 82 Article 88(3) BRRD. 83 Article 88(5) BRRD. 84 Article 36a to Article 38 Cooperation Framework. 80 81

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subsidiaries or large branches within the European Union. The idea behind European resolution colleges is that the European resolution authorities involved would speak with a single voice and take a unified position.

CONCLUSION Looking back at the regulatory and institutional banking developments in Europe over the last several years, incredible progress has been made. A number of years ago, in the midst of the sovereign debt crisis, no one could have imagined that we would establish harmonized rules for banking supervision and resolution, accompanied by a Banking Union–specific institutional infrastructure at all—let alone in such a short timeframe. Nevertheless, banking resolution remains a complex process, with many different public and private stakeholders all over the world that have different interests and perspectives. Transparency, predictability, and creating an understanding of the applicable rules are essential for the effective and successful interaction between the various stakeholders, and initiatives such as the IMF’s Law and Financial Stability Seminar are key to achieve this. In general, international cooperation is fundamental for achieving effective cross-border resolution.

REFERENCES Arons, Tomas M. C. 2015. “Judicial Protection of Supervised Credit Institutions in the European Banking Union.” In European Banking Union, edited by Danny Busch and Guido Ferrarini, 433. New York: Oxford. Avgouleas, Emilios, and Charles Goodhart. 2015. “Critical Reflections on Bank Bail-Ins.” Journal of Financial Regulation 1 (1): 3–29. Babis, Valia S. G. 2015. “Single Rulebook for Prudential Regulation of Banks: Mission Accomplished?” European Business Law Review 26 (6): 779–80. ———. 2014. “European Bank Recovery and Resolution Directive, Recovery Proceedings for Cross-Border Banking Groups.” European Business Law Review 2 (3). Binder, Jens-Hinrich. 2015. “Resolution: Concepts, Requirements and Tools.” In Bank Resolution: The European Regime, edited by Dalvinder Singh and Jens-Hinrich Binder. New York: Oxford. Burke, Javiet Villar. 2015. “Building a Bank Resolution Fund Over Time: When Should Each Individual Bank Contribute?” SSRN. https://ssrn.com/abstract=2535722. Busch, Danny. 2015. “Governance of the Single Resolution Mechanism.” In European Banking Union, edited by Danny Busch and Guido Ferrarini, 182. New York: Oxford. Cappiello, Stefano. 2015. “The EBA and the Banking Union.” European Business Organization Law Review 16 (3): 421–37. Chiti, Mario P. 2014. “The New Banking Union, the Passage from Banking Supervision to Banking Resolution. Players, Competences, Guarantees.” Rivista Italiana di Diritto Pubblico Comunitario 608. European Commission. 2012. “A Blueprint for a Deep and Genuine Economic and Monetary Union.” https://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2012:0777:FIN:EN :PDF. European Council. 2012. “Euro Area Summit Statement.” June 29. European Council 2012. “Towards a Genuine Economic and Monetary Union.” Report of the President, June 26th. https://www.consilium.europa.eu/media/33785/131201.pdf.

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Ferran, Ellis. 2015. “Banking Union: Imperfect, But It Can Work.” In European Banking Union, edited by Danny Busch and Guido Ferrarini, 56. New York: Oxford. ———. 2014. “European Banking Union and the EU Single Financial Market: More Differentiated Integration or Disintegration?” University of Cambridge Faculty Law Research Paper 29. ———, and V. Babis. 2013. “The European Single Supervisory Mechanism.” University of Cambridge Legal Studies Research Paper Series 10, Cambridge. Ferrarini, Guido, and F. Recine. 2015. “The Single Rulebook and the SSM: Should the ECB Have More Say in Prudential Rule Making?” In European Banking Union, edited by Danny Busch and Guido Ferrarini, 118. New York: Oxford. Gardella, Anna. 2015. “Bail-In and the Financing of Resolution within the SRM Framework.” In European Banking Union, edited by Danny Busch and Guido Ferrarini, 373. New York: Oxford. Georgosouli, Andromachi. 2016. “Regulatory Incentive Realignment and the EU Legal Framework of Bank Resolution.” Brooklyn Journal of Corporate, Financial & Commercial Law 10 (2): 343–82. Gordon, Jeffrey N., and Wolf-Georg Ringe. 2014. “Bank Resolution in the European Banking Union: A Transatlantic Perspective on What It Would Take.” Oxford Legal Studies Research Paper 18, New York. Gortsos, Christos V. 2016. “The Single Resolution Mechanism (SRM) and the Single Resolution Fund (SRF): A Comprehensive Review of the Second Main Pillar of the European Banking Union.” European Center of Economic and Financial Law, Leiden, The Netherlands. ———. 2015. The Single Supervisory Mechanism (SSM): Legal Aspects of the First Pillar of the European Banking Union. Athens: Nomiki Bibliothiki. Gros, Daniel. 2015. “Completing the Banking Union: Deposit Insurance.” Centre for European Policy Studies Policy Brief 335, Brussels. Howarth, David, and Lucia Quaglia. 2014. “The Steep Road to European Banking Union: Constructing the Single Resolution Mechanism.” Journal of Common Market Studies 52: 125–40. Hu, Chen Chen. 2015. “The Recovery Framework in the BRRD and Its Effectiveness.” International Company and Commercial Law Review 26 (10). Huertas, T. F., and R. M. Lastra. 2011. “The Perimeter Issue: To What Extent Should Lex Specialis be Extended to Systematically Significant Financial Institutions? An Exit Strategy from Too Big to Fail.” In Cross-Border Bank Insolvency, edited by Rosa M. Lastra, 250–80. New York: Oxford University Press. Kern, A. 2015. “European Banking Union: A Legal and Institutional Analysis of the Single Supervisory Mechanism and the Single Resolution Mechanism.” European Law Review 40 (2): 154. Maragopoulos, N. G. 2016. “Minimum Requirement and Eligible Liabilities (MREL): A Comprehensive Analysis of the New Prudential Requirement for Credit Institutions.” ECEFIL Working Paper Series 16, European Centre for Economic and Financial Law, Athens, Greece. Neumann, L. 2014. “The Supervisory Powers of National Authorities and Cooperation with the ECB—A New Epoch of Banking Supervision.” Europäische Zeitschrift für Wirtschaftsrecht 9 (Special Issue 1). Schuster, G. 2014. “The Banking Supervisory Competences and Powers of the ECB.” Europäische Zeitschrift für Wirtschaftsrecht 3 (Special Issue 1). de Serière, Victor P. G., and Daphne M. van der Houwen. 2016. “No Creditor Worse Off in Case of Bank Resolution: Food for Litigation?” Journal of International Banking Law and Regulation 31 (7): 376–84. Tröger, Tobias H. 2014. “The Single Supervisory Mechanism—Panacea or Quack Banking Regulation?” European Business Organization Law Review 15 (4): 449–97.

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Wiggins, Rosalind Z., Michael Wedow, and Andrew Metrick. 2014. “European Banking Union B: The Single Resolution Mechanism.” Yale Program on Financial Stability, Case Study 2014–5B-V1. Wolfers, Benedikt, and Thomas Voland. 2014. “Level the Playing Field: The New Supervision of Credit Institutions by the European Central Bank.” Common Market Law Review 51 (5): 1463–95. Wymeersch, Eddy. 2012. “The European Financial Supervisory Authorities or ESAs.” In Financial Regulation and Supervision, A Post Crisis Analysis, edited by Eddy Wymeersch, K. J. Hopt, and Guido Ferrarini, 232. New York: Oxford University Press. ———. 2014. “The Single Supervisory Mechanism or SSM, Part One of the Banking Union.” Ghent University Financial Law Institute Working Paper 1, Ghent, Belgium. ———. 2015a. “Banking Union; Aspects of the Single Supervisory Mechanism and the Single Resolution Mechanism Compared.” ECGI Working Paper Series in Law 290, Brussels. ———. 2015b. “The Single Supervisory Mechanism: Institutional Aspects.” In European Banking Union, edited by Danny Busch and Guido Ferrarini, 93. New York: Oxford. Zavos, George S., and Stella Kaltsouni. 2015. “The Single Resolution Mechanism in the European Banking Union: Legal Foundation, Governance Structure and Financing.” In Research Handbooks on Crisis Management in the Banking Sector, edited by Matthias Haentjens and Bob Wessels. Cheltenham: Edward Elgar.

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CHAPTER 3

Too Big to Fail: Where Are We Now? Michael Krimminger

The recent global financial crisis created havoc in the financial markets and dramatically affected the lives of millions of people across the globe. Quite naturally, it also triggered a reconsideration of the proper role of regulation and the best way to deal with so-called global systemically important banks (G-SIBs) or systemically important financial institutions (SIFIs).1 “Too-big-to-fail” became a rallying cry for greater restrictions on SIFIs in order to prevent a recurrence of the crisis— as well as the title of a book by Andrew Ross Sorkin—and the focus of a string of books analyzing the causes and responses to the crisis (Lewis 2010; Sorkin 2009). The crisis equally pointed out the inadequacies of legal frameworks and of the existing plans on how to deal with SIFIs under stress, and particularly those unable to continue operating. This chapter focuses on this latter issue and examines how the process of reform has changed legal frameworks and planning for regulators and SIFIs alike. What began as a process to address the evident inadequacies of insolvency laws has now evolved into a process that affects how SIFIs operate every day and their fundamental structure, operations, and funding. Initially, it is useful to consider how the process of reform has developed. In the interest of simplicity, we can consider the process of reform as having proceeded through several overlapping phases.2 The author is a Partner with Cleary Gottlieb Steen & Hamilton and former General Counsel and Deputy to the Chairman for Policy at the US Federal Deposit Insurance Corporation. The views expressed in this chapter are solely those of the author and do not necessarily represent the policies or views of Cleary Gottlieb or any of its partners. 1 As in most areas of human endeavor, jargon and acronyms continue to separate those “in the know” from those less focused on the topic. While unfortunate, acronyms do have the merit of promoting brevity in references. So I will use those that have achieved some level of common usage in policy, regulatory, and legal discussions. For ease of deciphering these acronyms, rather than use the common term “G-SIB,” I will refer to “global SIFIs” except where G-SIB is used in the title of an article or regulatory publication. 2 Please note that by using the term “reform” I do not mean to imply that all of the changes during the “reform process” have been unmitigated positive achievements. In many areas, it is likely that quite a substantial number of the changes have improved resiliency and resolvability. However, even in some of these areas of reform, the difficulty of fully understanding the interaction of one “reform” within the broader market environment makes any judgment difficult. Unquestionably, and unfortunately, the political environment has made mid-course corrections—which are common for any major legislative reform—much more difficult to achieve.



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During the crisis, regulators and the industry took a series of ad hoc steps designed to gain some measure of control over the rapidly declining spiral of real estate–related assets and loss of liquidity in the market (Scott 2016). This first phase of adaptive applications of preexisting laws—supplemented by a few hasty improvisations—fundamentally affected the future framework of reform either by framing what should not recur or what must be available. The crisis responses saw a great expansion of the government’s role in the markets and quite creative applications of then-existing laws under the necessity of addressing a potentially existential threat to financial stability. The second phase of the process of reform began while regulators, SIFIs, and markets were still struggling to stem the crisis. This phase included far-reaching changes to the statutes and regulations governing all financial institutions, financial markets, and the resolution of insolvent financial institutions, with a natural focus on SIFIs. This phase continues today, though the speed of statutory and regulatory changes has varied both by subject matter and jurisdiction. The third phase of reform—in which we are immersed today—is the implementation of those broad and deep changes to statutes and regulations. While one could subdivide these phases into many subphases, I believe that examining the interaction between three major groupings of events provides a valuable conceptual tool for understanding how they interact and how the process has affected financial companies and markets. Another more recent phase in the responses to the crisis also bears note, particularly following the 2016 US presidential election. That pattern, which continues in many countries affected by the crisis, is a profound change in the policy dialogue and political debate. While a thorough description is far beyond the scope of this article, the significance of the changes to the policy and political dynamic since 2008 cannot be overstated. The 2016 election, like Brexit, was a direct product of the discontent that arose from the competing storylines following the financial crisis because it dovetails with a theme of populist anger at the governing and financial “class,” which has swirled around movements as diverse as the US “Tea Party” movement and the “Occupy” movement. For our present purposes, this discontent has made sober policy discussions almost impossible in the United States because they are consistently overwhelmed by cries of Wall Street “bail-out” or corruption. With the election, the United States potentially could see a rolling back of many reforms designed to improve resiliency and resolution for SIFIs—ironically yielding a regulatory framework much like that existing on the cusp of the crisis. This chapter focuses on the first three of these phases.

THE PROCESS OF REFORM While there are many interpretations (and stories) about the origins of the crisis and the efforts of central banks, regulators, and financial institutions to stem the crisis, those events did lead to profound consequences for virtually every

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institution associated with financial regulation, clearly including the SIFIs themselves. To consider the question posed in my title requires a recognition—for good as well as bad—of the role of the logic of events: the steps to halt the crisis created an interpretative framework through which future reforms were judged. The crisis responses drove many portions of the reform agenda, but other parts of that agenda involved longstanding recommendations to improve resiliency of financial institutions and markets that had been debated for many years. The postcrisis reforms of the derivative markets, including requirements for central clearing for much greater proportions of financial market contracts, fall into this category. Others, such as increased capital and liquidity requirements, are probably a mixture of the logic of the crisis responses along with a more traditional emphasis on increasing the quantity and quality of capital as a buffer against future stress. Nonetheless, substantial portions of the postcrisis reform agenda unmistakably bear the marks of the lessons drawn by policymakers from the crisis. In the United States, those lessons included a need for improved consumer protection, reform of the mortgage markets3 (this no doubt wins the award for the most ignored reform agenda), and addressing the problems of too-big-to-fail. One of the key steps, although not the only element in reform, was to mandate improved resiliency and to develop the tools and strategies to make resolution a realistic tool in a future crisis. It is clear that the initial focus on developing new statutory frameworks for the insolvency of SIFIs, resolution planning by SIFIs, and new resolution strategies to use those new frameworks bear the hallmarks of the lessons drawn from the necessarily ad hoc responses to the crisis in 2008–09. At the time of the financial crisis, virtually no country had an adequate insolvency process to address failing financial conglomerates. The judicial bankruptcy framework then available to resolve large, complex nonbank financial entities and financial holding companies was not designed to protect the stability of the financial system or even efficiently address the failure of large financial companies. In contrast, the United States had a clearly defined and proven statutory framework to resolve an insured bank, principally by using an administrative process that relied upon prompt action by its deposit insurer, the Federal Deposit Insurance Corporation (FDIC). This process emphasized immediate authority to take over the bank’s business and operate it if need be, transfer assets and liabilities either to another privately owned bank or to a FDIC-created bridge bank, limit termination of key contracts, and address the potential for instability from the termination of derivative contracts—all without requiring prior approval by a court. Under this process, the imperative for quick action to maintain value and 3 While there have been reforms of mortgage origination and, to a lesser degree, securitization standards, there have been no material reforms in the secondary mortgage market framework. Today, the US secondary mortgage market remains dominated by the federal government, following the 2008 collapse of the private mortgage securitization market and the federal conservatorships of Freddie Mac and Fannie Mae. The political deadlock and the uncertainties about the impact of any reform in the federal role in this market has prevented further steps.

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continue key operations takes precedence over ex ante court approval. Judicial authority remains available to adjudicate claims and award damages, but it is limited to ex post decision-making and is severely constrained from intervening in the ongoing FDIC receivership processes. This dichotomy between a judicial process for nonbank corporate debtors and an administrative receivership process for insured banks was, before the financial crisis, almost unique to the United States. In virtually all other countries, banks and nonbanks were resolved through the court-based normal insolvency procedures, which focused on liquidation rather than reorganization. Not surprisingly, when faced with bank failures, most countries preferred a bailout to a liquidation with its normally significant negative impact on depositors. The financial crisis highlighted the imperative for reform while providing the incentive to pass significant legislation in many countries to provide for more flexible and stronger authorities to resolve failing financial firms. The impulse to legislate grew out of the ineffectiveness of the procedures outlined here, and the recognition that inadequate resolution authorities led inexorably to a simple, politically problematic, and economically troublesome bail-out.

INTERNATIONAL RESPONSES In the wake of the crisis, in 2009 the G20 leaders called on the Financial Stability Board (FSB) to develop “internationally-consistent firm-specific contingency and resolution plans” and a framework for recommended legal changes. In response, the FSB in March 2017 developed the “Key Attributes of Effective Resolution Regimes for Financial Institutions.”4 The Key Attributes seek to address the too-big-to-fail problem by setting out a common set of principles and resolution tools that should be in place to resolve SIFIs in an orderly manner and without exposing taxpayers to the risk of loss, all while protecting vital financial functions. The importance of the Key Attributes lies both in establishing an internationally recognized set of resolution tools and principles and, perhaps most important, in its endorsement by the G20 and the extensive efforts made to codify the Key Attributes into national or, in the case of the European Union (EU), into a multilateral legal framework.

The US Response In the wake of the financial crisis, the United States created a special insolvency regime for failing SIFIs under the Orderly Liquidation Authority (OLA) provisions of Title II of the Dodd-Frank “Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”). OLA is designed exclusively to address the failure of SIFIs in cases where such an insolvency would have serious adverse effects on the financial 4 FSB, March 10, 2017, Letter by Chairman Mark Carney “To G20 Finance Ministers and Central Bank Governors,” http://​www​.fsb​.org/​wp​-content/​uploads/​FSB​-Chairs​-letter​-to​-G20​-FMCBG​ -March​-2017​.pdf.

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stability of the United States.5 It is important to note that OLA supplements— rather than replaces—existing insolvency regimes. Unless a decision is made to place a SIFI into OLA resolution, the normal insolvency laws—such as the Bankruptcy Code—continue to apply.6 The resolution of a SIFI under OLA requires a determination by the secretary of the Treasury, in consultation with the president and based on the recommendations of the Federal Reserve and the FDIC (or other designated regulators in the cases of broker dealers or insurance companies), that the resolution of the SIFI under otherwise applicable insolvency law would have systemic consequences. Of course, FDIC-insured banks remain subject exclusively to resolution under the Federal Deposit Insurance Act. The FDIC’s powers under OLA draw heavily from those long-used by the FDIC as receiver for failed insured banks and thrifts. Under OLA, the FDIC as receiver for a SIFI has the power to transfer assets and liabilities of the company either to a third-party acquirer or to one or more specially chartered bridge financial companies. OLA can be helpfully viewed as combining four key powers in the resolution of systemically important companies that follow the guidance provided in the Basel Committee on Banking Supervision’s Cross Border Resolution Group (CBRG) report as well as in the FSB’s Key Attributes.7 Those four powers are: • The ability to conduct advance resolution planning for SIFIs through a variety of mechanisms similar to those used for problem banks (these mechanisms will be enhanced by the supervisory authority and the resolution plans, or “living wills,” required under section  165(d) of Title I of the Dodd-Frank Act); • An immediate source of liquidity for an orderly liquidation, which allows continuation of essential functions and maintains asset values; • The ability to continue key, systemically important operations, including through the formation of one or more bridge financial companies; and • The ability to temporarily stay (for one business day) and then transfer all qualified financial contracts8 with a given counterparty to another entity 5 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Title II—Orderly Liquidation Authority, codified at 12 U.S.C. §§5381–5397. 6 OLA § 210(a)(11), 12 U.S.C. §5390(A)(11) makes eligible for resolution any company that is incorporated or organized in the United States; a bank holding company; a nonbank financial company supervised by the Federal Reserve; predominantly engaged (defined as 85 percent or more of its consolidated revenues) in financial activities, as defined by the Federal Reserve; a subsidiary of a company in the foregoing categories that also is predominantly engaged in financial activities; and not a Farm Credit System institution a governmental entity, or a Federal Home Loan Bank or housing-related government sponsored enterprise. 7 Basel Committee on Banking Supervision, Report and Recommendations of the Cross-border Bank Resolution Group, March 2010, The author co-chaired the Cross Border Resolution Group with Eva Hupkes. 8 Generally, qualified financial contracts are financial instruments such as securities contracts, commodities contracts, forwards contracts, swaps, repurchase agreements, and any similar agreements. See section 210(c)(8)(D)(i) of the Dodd-Frank Act, 12 U.S.C. § 5390(c)(8)(D)(i).

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(such as a bridge financial company) and avoid their immediate termination and liquidation to preserve value and promote stability.9 The overall goal of OLA is to resolve a SIFI by facilitating continuity for that institution’s systemically important operations as a means to stabilize the financial system, while imposing all of the costs for the resolution on the institution’s shareholders and creditors.

The EU and the UK Response The EU Response At the time of the financial crisis there was no harmonization of the insolvency regimes for resolving banks or other financial institutions in the EU, and the crisis underscored a lack of adequate tools both at the EU level and in the member-states to deal effectively with unsound or failing banks.10 The Bank Recovery and Resolution Directive (BRRD) is designed to fill this gap by laying out a harmonized toolbox of resolution powers that will be available to national authorities in each member-state.11 The BRRD provides national authorities with four resolution tools: the sale of business tool, the bridge institution tool, the bail-in tool, and the asset separation tool. In common with other directives, the BRRD sets out a “floor” and memberstates are free to introduce or maintain stricter or additional rules in their resolution schemes as long as they are not inconsistent with the BRRD. The implementation process will inevitably introduce some variations in how certain principles and rules laid out in the BRRD will be addressed by national law.

The United Kingdom’s Response The United Kingdom’s initial response to the financial crisis was focused on putting in place emergency measures, in response to the failure of a number of financial institutions. The Banking Act 2009 in February 2009 introduced a Special Resolution Regime that allows failing or collapsed banks to be transferred into public ownership or into the hands of other market participants under exigent circumstances. The Financial Services Act 2012 then restructured the United Kingdom’s financial services’ regulatory framework by giving the Bank of England (BoE) responsibility for macroprudential oversight for the financial system,

9 See generally section 165 of Title I of the Dodd-Frank Act, 12 U.S.C. § 5365 and “The Orderly Resolution of Covered Financial Companies—Special Powers under Title II—Oversight and Advanced Planning,” infra. 10 A directive dealing with reorganization and winding up of credit institutions having branches in several member-states was adopted in 2001 (Directive 2001/24/EC), but its purpose was essentially to determine applicable laws and to provide for some coordination between member-states. 11 As a practical matter, national authorities will be replaced by the Single Resolution Board under the Single Resolution Mechanism in certain cases.

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supervisory authority for systemically important financial services companies, and authority for implementation of the Special Resolution Regime. The United Kingdom adopted a further reform through the Banking Reform Act 2013 to provide for a bail-in tool. This tool gives the BoE the power to impose losses on shareholders and creditors of certain banks and other SIFIs before initiation of insolvency proceedings in order to prevent them from becoming insolvent. The aim is to ensure that critical banking services continue to be provided while imposing recapitalization costs on shareholders and creditors rather than meeting this cost out of UK Government funds. Perhaps most significantly, the United Kingdom has developed a resolution strategy to resolve its largest financial institutions, which is built around bail-in. Starting with a paper released by the BoE on October 23, 2014, entitled “The BoE’s Approach to Resolution” (BoE Resolution Paper), and subsequent publications and speeches, the BoE has described how it plans to use its authority under UK law to initiate a bail-in of a failing company without initiating a formal insolvency proceeding for a systemically important financial company in the future.12 Of course, many of these developments preceded the June 2016 referendum in favor of the United Kingdom exiting from the EU, the Brexit vote. While the timing and precise parameters for any Brexit remain to be resolved, it is highly likely that the basic resolution framework, although implementing the BRRD, will remain in place after any exit. The BoE was a prime engineer of the development of bail-in strategies for the resolution of SIFIs and adopted many of its legal reforms prior to BRRD. While the United Kingdom may modify some components of its law that would have been required by BRRD, it is unlikely that wholesale changes will be made.

RESOLUTION STRATEGIES AND THE ROLE OF BAIL-IN With the adoption of new statutory frameworks to support the resolution of SIFIs, the authorities now have a basic set of tools that provide significant flexibility to design resolution strategies. The challenge was, and remains, to develop resolution strategies that fulfill the statutory mandates to achieve the orderly resolution of large, complex financial institutions with business operations in multiple countries without relying on a bail-out from taxpayers and without exposing the financial system to undue systemic risks.

See Andrew Gracie, “Ending Too Big to Fail: Getting the Job Done,” Speech at Deloitte, London (May 26, 2016), at 3­–4, http://​www​.bankofengland​.co​.uk/​publications/​Documents/​speeches/​2016/​ speech912​.pdf. Also, BoE, “The BoE’s Approach to Resolution,” October 2014, www​.bankofengland​ .co​.uk/​financialstability/​Documents/​resolution/​apr231014​.pdf, which will be updated periodically. Another important recent paper released in the United Kingdom is the Prudential Regulation Authority’s paper, “Ensuring Operational Continuity in Resolution - DP1/14” published on October 6, 2014, at https://​www​.bankofengland​.co​.uk/​prudential​-regulation/​publication/​2014/​ensuring​ -operational​ -continuity​ -in​ -resolution. This paper discusses, and seeks comment, on operational arrangements that may be necessary to facilitate operational continuity. 12

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While the role of public funding for resolutions remains a hotly debated issue, the statutory frameworks were designed to impose the losses principally, if not wholly, on shareholders and debt holders of the SIFIs. For example, the Orderly Liquidation Authority, under the Dodd-Frank Act, includes express provisions prohibiting the imposition of losses on taxpayers and requiring repayment of any public funds used in the resolution from the assets of the failed SIFI and, if a shortfall remains, from assessments on the industry. Applying the new resolution tools to achieve an orderly resolution that mitigates any systemic risks poses significant challenges. Two issues are paramount. One is the continuity of systemically important operations or, failing that, an orderly wind-down of those operations in a manner that avoids creating risks of illiquidity or insolvency for other financial institutions. Achieving an orderly resolution becomes even more complex when the institution’s systemically important operations occur in multiple jurisdictions. The second issue is liquidity. SIFIs fail because they cannot fund their operations. An orderly resolution requires liquidity resources of sufficient size to reassure the markets that the failed SIFI’s systemically important operations can continue or can be gradually wound down without transmitting shocks that could render other market participants insolvent or illiquid in turn. These issues can be addressed through three basic approaches. The first is the traditional bail-out approach in which the government injects sufficient liquidity and capital into the SIFI in order to prevent its insolvency. The merits and problems with this approach in 2008 have been well-demonstrated (see Scott 2016, 265–72). The second is to use the new resolution tools put in place after the crisis to achieve an orderly wind-down of each insolvent company within a SIFI. This so-called multiple point of entry (MPOE) approach leverages past experience of separate proceedings for insolvent parts of a company and, in the case of cross-border operations, seizure of subsidiaries by host regulators. Under the MPOE strategy, the parent and its subsidiaries would be wound down or recapitalized separately. Some SIFIs, such as Santander, are organized around relatively independently capitalized and funded subsidiaries in host jurisdictions. For these SIFIs, the MPOE approach is consistent with their normal operational and corporate structure and follows past experience of separate resolutions. The third approach seeks to resolve only the top-level holding company, whereas the operating subsidiaries remain out of insolvency proceedings and are recapitalized, if necessary, through resources provided by the parent holding company. This approach is called the single point of entry (SPOE) strategy. Although the SPOE strategy may not be suitable for some financial companies, it has dominated the international debate since 2011 about the best resolution strategies to apply to complex, global financial companies. Quite obviously, the SPOE strategy works best where the holding company does not perform any material business operations and serves principally as an issuer of equity and debt to investors. Whereas the SPOE strategy was developed to implement OLA under the Dodd-Frank Act, it has come to be viewed as the most promising approach for the resolution of SIFIs from other jurisdictions as well.

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Summary of the SPOE Strategy Under the SPOE strategy, the operating subsidiaries, in which the systemically important financial businesses are conducted, would remain open and operating and would not be placed into insolvency proceedings. Under OLA, the SPOE strategy would be implemented immediately after appointment of the FDIC as receiver by the transfer of all of the SIFI’s assets, including ownership of its subsidiaries, to a newly chartered bridge financial company (Bridge). Following the transfer, the Bridge would become the new top-tier holding company of all of the operating subsidiaries of the failed SIFI. The SPOE strategy has a number of key advantages, including: • Greatly reducing the likelihood of systemically destabilizing disruptions to subsidiary operations; • Imposing losses on the equity holders and creditors of the holding company, who are structurally subordinated to the creditors of operating subsidiaries; • Mitigating potential cross-border coordination issues by keeping foreign subsidiaries open and operating; and • Preserving the going-concern value of the SIFI, which should minimize losses for creditors and lessen the impact of the failure on the broader economy. The SPOE strategy builds on several interrelated factors. First, US financial holding companies are not operating companies and instead provide funding for their subsidiaries by issuing equity and debt. As a result, the receivership of the holding company likely would not affect continuity in the systemically important financial operations that could spread instability, including the settlement of payment transactions. Second, the potential systemic consequences of a failure of a SIFI derive principally from the operations of the holding company’s subsidiaries. If those subsidiaries continue to operate unimpaired, the systemic effects on financial stability are likely to be mitigated. Third, because the parent holding company serves principally as a source of capital and liquidity, if it can continue to fulfill those functions in resolution, it can provide liquidity and sources for the recapitalization of its subsidiaries, and it can continue to facilitate their continued operations. Funding for the Bridge operations would be available from private sector sources or through the Orderly Liquidation Fund.13 The FDIC has stated a strong preference for private sector funding when available. A central component of the SPOE strategy is the exit strategy designed around an eventual swap of creditor claims for equity in a new company that will emerge from the Bridge. This achieves a bail-in of creditor claims after the SIFI is placed into insolvency proceedings. The FDIC has indicated that it anticipates that the

13

12 U.S.C. §5390(h)(2)(G)(iv).

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bail-in of the Bridge would occur in approximately six to nine months through the exchange of creditor claims for equity or debt of the restructured Bridge (or one or more successors to the Bridge) in satisfaction of the claims of creditors left behind in the receivership.14 In its 2013 paper, the FDIC noted that this timeframe is driven by the time needed to complete a reliable valuation, achieve systemic stabilization, and comply with Securities and Exchange Commission standards for the issuance and trading of the new equity and debt. Ownership and control of the newly capitalized Bridge would thereby be transferred to its former holding company creditors. This result would be similar in effect to a restructuring under Chapter 11 of the Bankruptcy Code. Similarly, the SPOE Notice states that the FDIC plans to use the “fresh start” accounting model commonly used for companies emerging from bankruptcy. One particularly notable recent step forward is the international industry and regulator agreement on a new protocol for stays in termination of derivatives contracts. The stay protocol involved complex negotiations between major global banks, the International Swaps and Derivatives Association, and regulators. The protocol will allow imposition of a stay on cross-default and early termination rights within standard International Swaps and Derivatives Association derivatives contracts with the eighteen largest global financial firms in the event one of them is subject to resolution action in its jurisdiction. The stay is intended to give resolution authorities time to facilitate an orderly resolution of a troubled bank. Under the stay protocol, counterparties will opt into certain overseas resolution regimes by modifying the default provisions of their derivatives contracts. This is particularly important because the existing statutory stays may only apply to domestic counterparties trading under domestic law agreements. As a result, the ability to stay contracts involving cross-border parties could be challenged. The inclusion of modified default provisions along with the statutory stays is significant. First, the protocol will help prevent the unwinding of a financial group if a global SIFI’s holding company is closed by barring the termination of contracts with its subsidiaries under the commonly used “cross-default” provisions. Second, once regulations are adopted in the United States, the extension to the US Bankruptcy Code will help prevent direct defaults and the termination of contracts otherwise permitted under the current code. This will significantly improve the effectiveness of the code in resolving financial companies.

Summary of the UK Approach to SPOE The BoE’s Approach to SPOE In its Resolution Paper, the BoE provided insight into its approach to using the SPOE strategy. While the Resolution Paper does not discuss SPOE by name, it is clear from the BoE’s prior public pronouncements, as well as through its citation

14 FDIC, December 2013, “The Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy,” https://​www​.fdic​.gov/​news/​board/​2013/​2013​-12​-10​_notice​_dis​-b​_fr​.pdf.

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of its 2012 joint paper with the FDIC, that its preference is to use SPOE to resolve most UK global SIFIs.15 The BoE Resolution Paper builds on the new authority provided in the BRRD while providing additional details. First, the BoE Resolution Paper describes bail-in as a preferred resolution strategy for global SIFIs compared to use of its transfer powers, which include the power to transfer operations of the failing SIFI to a Bridge. The reason lies in the BoE’s concern that it will be exceedingly difficult to separate the critical economic functions of the SIFI from those that are less critical in making the transfer.16 In contrast, the FDIC plainly considers that a transfer to a Bridge will involve nearly all (other than equity, litigation, and matters under investigation) of the operations of the failed SIFI, while noting that one advantage of applying the SPOE at the holding company level is that there are few, if any, critical operations actually conducted by the holding company. Second, the bail-in strategy is perceived as having the advantage of better facilitating continuity in critical operations. To the extent it is effective at recapitalizing the SIFI and achieving renewed market confidence, this could prove an advantage. However, absent market disruption from the insolvency “event” itself, if the transfer to the Bridge involves all key operations of the SIFI or if the “point of entry” is at a holding company level where there are few, if any, operating facilities, the United Kingdom’s preinsolvency bail-in strategy may not produce a significant difference. Third, the bail-in strategy is viewed as presenting an advantage because it can potentially operate before insolvency as well as after initiation of resolution actions.17 However, as is clear from the discussion in the BoE Resolution Paper, the decision to impose any official action will likely be only at the moment just before insolvency—if beforehand at all—given the issues that must be addressed regarding safeguards for equity holders under the European Convention of Human Rights.18 If bail-in occurs at that time, the need for central bank or governmental liquidity will be clear, because the SIFI most likely will be on the doorstep of failure due to its inability to obtain sufficient market liquidity. Fourth, the BoE Resolution Paper discusses a further issue that continues to create challenges in implementing a bail-in approach before resolution, as well as after resolution under some proposals. This issue revolves around the reliability of valuations of the assets of the failing SIFI in order to determine the extent of necessary write-downs for creditor claims and the resulting terms of the bail-in.19 If the bail-in occurs before resolution, this issue becomes more difficult as obtaining accurate valuations in the midst of a near-failure scenario will prove

BoE Resolution Paper, 12, footnote 2, in reference to holding company bail-in strategies. The 2012 BoE-FDIC paper at https://​www​.fdic​.gov/​about/​srac/​2012/​gsifi​.pdf. 16 See BoE Resolution Paper, 18. 17 See BoE Resolution Paper, 9–10. 18 See BoE Resolution Paper, 8. 19 See BoE Resolution Paper, 18–19. 15

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complex, at best. The BoE and the FDIC have noted that this may be addressed by issuing new equity based on an estimated valuation while providing “warrants” or “certificates of entitlement” to creditors so that a true-up of the value of their claims can be completed when more complete market valuations are available. In its paper, the BoE said that it would address the uncertainty of the valuations through creation of a draft resolution instrument that would give legal effect to the bail-in, including the write-down and/or conversion of outstanding regulatory capital instruments. As part of this preparation, the BoE would identify those liabilities that may be within scope for the bail-in on the basis of an initial valuation exercise (for example, shares, subordinated debt, and unsecured senior creditors). Over the resolution weekend, the BoE would identify the liabilities to be bailed-in, and the Financial Conduct Authority likely would suspend trading in those instruments. Certificates of entitlement would be issued by the firm to investors in bailed-in liabilities. The certificates would represent a potential right to compensation and provide a mechanism for former creditors to be provided with shares or other instruments in due course. During the period immediately after the resolution weekend, the BoE would seek to refine the valuations so that it could determine the final terms of the bail-in. Then the BoE would announce the final terms of the bail-in, including how the certificates of entitlement will be exchanged for shares in the firm. Because one of the goals of the UK process is to return the firm to “normal” trading activity almost immediately after the bail-in weekend, the legal title to the shares may be transferred to a third-party commercial bank appointed by the BoE to act as a depositary. There, the shares could be held in trust until a final valuation and distribution to claimants. The BoE and the FDIC clearly agree that the exit strategy would likely involve a bail-in of creditors of the failed SIFI to recapitalize the SIFI (or more properly in a Bridge scenario, to capitalize this newly chartered entity for the first time). This inherently demands that the SIFI hold sufficient loss-absorbing capacity to provide sufficient bail-inable creditor claims to provide a strong base of capital for future operations that, at the least, fully complies with Basel capital standards and, perhaps more important, meets market expectations for sufficient capital.20

Total Loss-Absorbing Capacity and Bail-in As can be seen from this brief summary of the principal US and UK strategies, the existence of sufficient equity and long-term debt in the SIFI at the time of failure is critical. These strategies are all based on recapitalizing the SIFI by converting or bailing in capital instruments, including longer-term debt instruments,

It is appropriate to note that there are many discussions around the issue of what liabilities should be eligible for bail-in. This is one of the reasons that regulators have sought to require a likely sufficient level of long-term debt so that shorter-term liabilities—more often used for liquidity rather than loss absorbance—are not bailed in. 20

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to create a new capital base that is sufficient to meet both regulatory and market capital requirements. This requires that existing equity absorb all of the losses that led to the failure, and that the SIFI have enough additional, eligible capital and/ or debt instruments outstanding so that when these instruments are converted into equity, the SIFI will meet its capital requirements. Because the goal is to maintain ongoing operations, it is imperative that other creditors, such as liquidity providers and ongoing operational vendors, not be impaired. If the SIFI can be recapitalized in this manner, it will also be critical to address losses and capital deficits in any subordinate operating companies. For US holding companies, the operations likely to lead to losses that could impair the survival of the financial group will almost always arise in an operating subsidiary. This is also true for many non-US financial groups. As a result, if the financial group is to continue its systemically important business operations, there must be a way of recapitalizing the impaired operating subsidiary to meet its own market and regulatory capital requirements. If the holding company is to retain control over the impaired operating subsidiary and continue to receive the future value in that subsidiary, the holding company’s equity and creditors must absorb those losses and quickly recapitalize the subsidiary and return it to normal operations. This means that not only is the SIFI holding company’s loss-absorbing equity and debt important, but so is the loss-absorbing equity and debt between the holding company and a systemically important subsidiary. This dynamic, of course, can raise a dilemma: is the subsidiary worth salvaging, or should it be liquidated to preserve the value of other holding company subsidiaries (Gordon and Ringe 2015)? Among the most significant developments toward ultimately ending too-big-to-fail has been the extensive progress in establishing international standards and beginning the practical implementation to require cushions of debt and equity to permit the recapitalization, rather than the unwinding, of a troubled SIFI. As discussed previously, the availability of sufficient bail-inable debt can allow a SIFI to reestablish a sound capital foundation and serve as a source of strength to its operating subsidiaries by providing resources to recapitalize subsidiaries that may have incurred losses that impair their compliance with regulatory requirements and/or lead to their inability to maintain market-based funding. Obviously, the quantum of bail-inable debt at the parent company level, along with cancellable obligations from the subsidiaries to the parent, must be sufficient to absorb the losses of the parent and subsidiaries. To achieve these objectives, the FSB—as well as the regulators in the United States, the EU, and the United Kingdom—has concluded that all SIFIs must maintain levels of equity capital and debt as total loss-absorbing capacity (TLAC). The EU has framed its requirements in terms of a “minimum requirement for own funds and eligible liabilities” (MREL), but has only recently addressed how banks within the EU should comply with the differing requirements for MREL and TLAC, as discussed subsequently. In November 2015, the FSB released its final “Principles on Loss-absorbing and Recapitalization Capacity of G-SIBs in Resolution” and related TLAC Term

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Sheet (collectively, the “FSB TLAC Principles”).21 The FSB TLAC Principles are designed to achieve broadly common requirements to ensure that global SIFIs maintain sufficient debt and equity cushions to permit their recapitalization in resolution. The FSB TLAC Principles set minimum standards both for the quality of the debt or equity as well as its quantity. These principles address the availability of sufficient loss-absorbing debt and equity, both at the top-tier parent (external TLAC) as well as at material subgroups (internal TLAC). Internal TLAC is an important piece of the puzzle for implementation of resources for resolutions, because it allows for prepositioned resources to be available to recapitalize the operating subsidiaries of a SIFI and prevent a cascade of failures within the SIFI’s financial group. As recently observed by the FSB, many of the home jurisdictions of global SIFIs have either developed, proposed, or adopted national standards.22 On December 15, 2016, the Federal Reserve Board issued its final rule to define US requirements for TLAC (“Federal Reserve Rule”).23 The rule, among other things, imposes TLAC and long-term debt requirements on global SIFIs and on the US intermediate holding companies of non-US global SIFIs. The Federal Reserve Rule clarifies the required resources targeted to achieve both loss absorption and recapitalization. The rule includes the following key elements: • Minimum external TLAC requirements for the bank holding companies of US global SIFIs, which include a minimum level of long-term debt and related TLAC buffers; • Minimum internal TLAC and long-term debt requirements for the US intermediate holding companies of non-US global SIFIs, which differentiate between SPOE and MPOE groups. In response to comments, the Federal Reserve Rule will allow MPOE intermediate holding companies to issue TLAC and long-term debt to external parties; and • “Clean holding company” requirements that impose stringent limitations on the ability of covered bank holding companies and intermediate holding companies to incur common types of non—TLAC-related liabilities. While the rule is largely consistent with the proposal, it has been modified to address some of the comments—principally to provide for grandfathering of debt

Financial Stability Board, November 9, 2015, http://​www​.fsb​.org/​wp​-content/​uploads/​TLAC​ -Principles​-and​-Term​-Sheet​-for​-publication​-final​.pdf. 22 Financial Stability Board, 2016, “Resilience through Resolvability – Moving from Policy Design to Implementation,” 15–16, http://​www​.fsb​.org/​2016/​08/​resilience​-through​-resolvability​-moving​-from​ -policy​-design​-to​-implementation/​. 23 The Federal Reserve Rule is codified at 12 C.F.R. 252. The proposed rule is at: https://​www​.gpo​.gov/​fdsys/​pkg/​FR​-2015​-11​-30/​pdf/​2015​-29740​.pdf. See also Cleary Gottlieb Alert Memorandum, “Final TLAC Rule: Effect on US GSIB Debt” (December 15, 2016); and Cleary Gottlieb Alert Memorandum, “Final TLAC Rule: Federal Reserve Responses to FBO Comments” (December 15, 2016). 21

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issued before December 31, 2016, and to permit intermediate holding companies of MPOE firms to issue TLAC and eligible external long-term debt to third parties. While the Federal Reserve Rule did reduce somewhat the overall long-term debt requirements applicable to intermediate holding companies, it does require higher levels of TLAC for those of MPOEs than for those of SPOEs. The policy behind the Federal Reserve Rule is clear: to facilitate the recapitalization of the troubled bank holding company or foreign-owned intermediate holding company. The key features focus on ensuring that long-term debt will be available in stress for conversion into new equity for the bank holding company or intermediate holding company. This is achieved by narrowly defining what qualifies as long-term debt by strictly limiting the amount of non-long-term debt that the holding company can issue (so that it is a “clean” nonoperating entity), and by requiring a calibration of the amount of TLAC that must be issued so that the holding company can be fully recapitalized after it has exhausted its prior equity base. In addition, the Federal Reserve Rule places the Federal Reserve squarely in control of the triggers for conversion of the long-term debt into new equity. In effect, the Federal Reserve Rule doubles the required equity and debt requirements for US global SIFIs and for those portions of non-US global SIFIs operating in the United States. These standards are designed to ensure that both US SIFIs and foreign SIFIs operating in the United States retain sufficient resources to permit recapitalization and resolution without relying on US public capital resources. While the Federal Reserve Rule, like the original proposed rule published for public comment, is broadly consistent with the framework of the FSB’s TLAC Standards, the Federal Reserve Rule is much more restrictive than, and deviates from, the FSB TLAC Standards in several meaningful ways. First, while calibration of the risk-weighted assets component of the Federal Reserve’s proposed minimum TLAC requirement is aligned with the FSB TLAC Standards, the additional constraints on eligible liabilities, along with other elements, make the Federal Reserve Rule more stringent. Among the key elements making the Federal Reserve Rule more stringent are the formal long-term debt requirement, TLAC buffer, and clean holding company limitations. There are no comparable requirements in the FSB TLAC Standards. Second, the standards for eligible debt under the Federal Reserve Rule are much more stringent than the FSB TLAC Standards and current Tier 2 standards. Tier 2 capital instruments would be eligible for inclusion in TLAC under the FSB TLAC Standards, but not in the Federal Reserve Rule. By contrast, and as only one example, much of the existing long-term debt issued by bank and intermediate holding companies includes acceleration clauses that are barred for eligible debt under the Federal Reserve Rule. Third, the Federal Reserve Rule’s treatment of intermediate holding companies of foreign SIFIs deviates significantly from the FSB TLAC Standards applied to entities in host jurisdictions in a number of ways. It imposes more onerous requirements for internal TLAC, significantly increases the required proportion of long-term debt required, and severely limits the financing and operational flexibility allowed for intermediate holding companies.

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The TLAC Standards are only one component in a multilayered structure of capital, bail-inable debt, enhanced liquidity, and improvements in internal corporate structures, services, and operations for large financial companies that has created greatly enhanced resiliency and resolvability. For this reason, any assessment of where we are today in ending too-big-to-fail has to consider these overlapping improvements. Among the principal components of this structure are: • Legal entity restructuring to facilitate an SPOE strategy, often referred to as “legal entity rationalization”; • Strengthened capital requirements; • Stringent liquidity standards to require the availability of large reservoirs of high-quality liquid assets that can support liquidity under stress; • Internal operational reforms to rationalize and strengthen services, risk management, and management information systems, and to create so-called playbooks defining the quantitative and qualitative triggers leading to escalating responses to stress by management and regulators; • International protocols and requirements limiting cross-defaults in derivative contracts to prevent cascading defaults under stress; • Supporting contractual structures to facilitate the transfer of capital and liquidity resources to operating subsidiaries; • The “Volcker Rule” in the United States and “ring fencing” in the United Kingdom to limit the perceived impact that certain trading activities might have on banks; and • Of course, the TLAC and MREL standards discussed previously. While this litany illustrates some of the key reforms, many other regulatory initiatives have been pursued in an effort to improve resiliency and resolvability, such as greater margin requirements and mandatory central clearing for many derivative transactions. Financial institutions themselves have responded with enormously expensive steps to implement these reforms. As a product of internal reviews, and the combination of regulatory pressure and a reassessment of the value of certain businesses subject to increased regulatory requirements, many global SIFIs have reassessed whether some business lines should be continued. In short, the steps taken since the financial crisis have created potentially more resilient and fundamentally different global financial institutions. However, the question of whether these reforms and the resulting transformations will be successful in fending off the next crisis can only be answered then. To state a cliché, if history is any guide, past performance cannot predict future results. Nonetheless, while some argue that the obvious future unknowables confirm their skepticism about the value of the reforms, this posture itself ignores experience and delves into the realm of the pseudo-sophisticate who doubts everything so as to be possibly proven right about something. History and experience both prove that greater resilience and redundancy around the key components of risk—here asset quality (and its effect on capital solidity), liquidity, and

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operational continuity—provide a cushion that prevents sudden collapse and gives time to respond with countermeasures. Better and more rigorous planning provide the basis for well-developed countermeasures to be deployed during the additional time bought by this cushion to respond to differing sources of the risk. Does this planning provide a guarantee? No, that would be a fantasy akin to the unsinkable Titanic. However, it does focus improvements on those areas that experience proves are the linchpins of potential SIFI destabilization. The multilayered structure created by the reform process does create its own risks. These include measurable risks from the great expense of these reforms and from some features that, if not flexibly applied, can create sclerotic corporate and transactional structures that could impair the deployment of capital and liquidity during a crisis. For example, as noted by the comment letters of the trade associations, many of the requirements ultimately implemented in the Federal Reserve Rule, which exceed those mandated by the FSB, tend toward requiring more narrowly defined eligible instruments, more limited potential investors (including requiring intermediate holding companies to issue all of their internal TLAC to their foreign parents), fewer funding options, and significant constraints on the ability to redeploy resources where it might be needed in a crisis. These issues could lead to SIFIs with large, theoretical resources of TLAC but also with more limited capabilities to survive liquidity stress or use the TLAC where it is needed. These risks are illustrated in the internal TLAC requirement imposed by the FDIC and Federal Reserve on the largest US global SIFIs through the resolution planning process.24 The April 2016 Guidance for future resolution plans emphasized that future capital analyses must focus on “appropriate positioning of additional loss-absorbing capacity within the firm (internal TLAC).”25 The FDIC and Federal Reserve noted that such internal TLAC could be achieved by prepositioning recapitalization resources at the subsidiary or at the parent, but that firms should not rely exclusively on either option. The guidance also created a direct link between the internal TLAC, triggers based on specific quantitative and qualitative criteria, and specific binding contractual mechanisms to push the TLAC down to operating subsidiaries. It also required firms to quantitatively analyze their required capital and liquidity resources under stress conditions to ensure that these contractual mechanisms operated to recapitalize and reliquify the operating subsidiaries. As a result, the granular and specific capital and liquidity requirements are tied closely to the requisite structured governance framework, but give less discretion to SIFI management. While this approach provides a contractual framework that gives greater assurance that TLAC resources could be See FDIC and Federal Reserve, “Guidance for 2017 §165(d) Annual Resolution Plan Submissions by Domestic Covered Companies That Submitted Resolution Plans in July 2015,” April 13, 2016 (referenced below as “April 2016 Guidance”), https://​www​.fdic​.gov/​news/​news/​ press/​2016/​pr16031b​.pdf; Cleary Gottlieb, “Judgment on 2015 Domestic First Wave Resolution Plans: Five Deemed ‘Not Credible,’ and Along with Mixed Progress Comes a More Prescriptive Process” (April 29, 2016). 25 April 2016 Guidance, 4. 24

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down-streamed from parent to subsidiary, the highly structured nature of the arrangements runs the risk of limiting the resources that can be deployed by management to where they are most needed in a crisis. As a result of the April 2016 Guidance, US global SIFIs have developed detailed analyses for their capital and liquidity requirements under stress and in resolution.26 In effect, the resolution-planning guidance has become a parallel set of requirements for long-term debt, capital, and liquidity buffers. As described in the April 2016 Guidance, contributable resources from the parent will require structured capital contribution agreements, also referred to as a contractually binding mechanism, in order to meet the governance standards that require specific triggers linked to escalating stress that permit the recapitalization of subsidiaries before the parent’s failure. The guidance also required detailed legal analyses of potential challenges to these structures from creditors of the parent bank holding company. As a result, the US global SIFIs have undertaken corporate realignments to create intermediate holding companies, detailed legal analyses of possible creditor challenges, implemented capital contribution agreements, and ongoing analytical efforts to meet the resolution-planning requirements. As a result, while TLAC is a regulatory requirement, the resolution-planning regime has put in place new standards that carry the regulatory requirements to additional levels of granularity. This illustrates the close relationships between the different components of reform. While foreign global SIFIs active in the United States have not received precisely the same US resolution planning guidance as the US global SIFIs, these foreign companies also have taken major steps to improve resiliency and resolvability. As described previously, the Federal Reserve Rule imposes internal TLAC requirements on the intermediate holding companies of foreign global SIFIs. The rule mandates that this internal debt include a contractual provision permitting its conversion into common equity outside insolvency proceedings—which the Federal Reserve can trigger if it determines that the intermediate holding company is in default, or in danger of default, or certain other circumstances apply.27 This creates a key dynamic in the relationship between the foreign global SIFI’s home country supervisor and the Federal Reserve. In effect, for any foreign global SIFI with major operations in the United States, the Federal Reserve controls the timing and decision to initiate resolution in the United States as well as in the home country. The former is clear on the face of the regulation, but the latter is

The April 2016 Guidance coined additional acronyms for these analyses: Resolution Capital Execution Need (CEN), Resolution Capital Adequacy and Positioning (RCAP), Resolution Liquidity Execution Need (RLEN), and Resolution Liquidity Adequacy and Positioning (RLAP). RCEN and RLEN are analyses designed to evaluate the capital and liquidity resources, respectively, required in resolution. RCAP and RLAP are analyses to support identification of the capital and liquidity needs of entities and position those resources where needed. 27 See 12 C.F.R. 252.163. The other circumstances include the intervention by the home authorities to initiate resolution of the foreign SIFI or recommendation by the Federal Reserve to place the intermediate holding company into receivership under the OLA. 26

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a byproduct of the impact that the Federal Reserve triggering a US resolution would have on the stability and market access of the home country, or other global, operations of the foreign SIFI. Once the Federal Reserve pulls the US trigger, it is hard to imagine that the home country supervisor could manage the ensuing market chaos without intervening in the home country as well. This symbiotic relationship may lead to greater stability by necessitating close cooperation by the home country authorities with the Federal Reserve, but it also may lead to destabilization if the Federal Reserve ever felt compelled to act due to an idiosyncratic event in the United States that did not have similar dire effects in other jurisdictions. The answer may simply be that the home country authorities will always have to ensure that the foreign global SIFI’s operations in the United States are well-supported to avoid this risk. At a minimum, this choice places the onus on the home country supervisor to ensure that the global SIFI’s US operations remain stable and supported, while limiting that supervisor’s ability to control activities in the United States. On the other hand, the internal TLAC and other reforms also provide resources to allow foreign global SIFIs active in the United States to recapitalize their US operations by conversion of the internal TLAC into new equity. This should mean that both US branches and US intermediate holding companies will not need to enter into bankruptcy because the conversion of the bail-inable debt at the parent and at the intermediate holding company will restore those entities to a sound capital condition. Because this will predominantly or exclusively involve the conversion of debt owned by the parent foreign SIFI, the process also transfers the preconversion losses to the foreign parent. In a future crisis, the now-required regulatory liquidity resources will provide an internal buffer to help weather stress and avoid the potential death-spiral that can result from an overreliance during a crisis on market-based liquidity resources. However, it will also be essential for central banks to maintain their traditional role as lenders of last resort to ensure that the market understands that ample liquidity is available both internally and through the central bank (or perhaps in the future through a market-based facility) to address any possible liquidity stress. This is the clear, practical meaning of the concept that having more than adequate resources available usually means fewer resources actually must be used. Once the intermediate holding company is recapitalized, the issue remains of providing capital and liquidity to the US operating subsidiaries. US resolution planning guidance to the foreign global SIFIs, issued in 2017, similarly includes requirements for detailed analyses of capital and liquidity requirements along with transactional and other structures to allow for the down-streaming of capital and liquidity from the Intermediate Holding Company to the operating subsidiaries. Foreign global SIFIs are developing transaction structures similar to those being implemented by the US ­global SIFIs, such as capital contribution agreements and contractual frameworks to assure that financial resources can be downstreamed to operating subsidiaries. In ­comparison to the US global SIFI bank holding companies, the risk of successful creditor challenges to the downstreaming of resources from the intermediate holding company to the operating subsidiaries is substantially reduced, given that the foreign

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intermediate holding companies are wholly owned by foreign parents. The parent’s ultimate value is based on its ability to continue the operations of its subsidiaries, and the use of contractually binding mechanisms between the now recapitalized intermediate holding company and its subordinate operating subsidiaries significantly ameliorates any potential risk that could arise from direct transfers between a insolvent bank holding company and its direct subsidiaries. In summary, great progress has been made in creating much more resilient and resolvable global SIFIs, and major contributors to that progress have been the new strategic insights on strategies and discoveries of and responses to address previously unappreciated vulnerabilities. There are risks created by this process as well. While there is no question that larger buffers of equity, debt, and liquidity are important components of more resilient financial companies, the US drive to tie specific actions to binding playbooks that are built around presumed or automatic responses through recapitalization or other deployment of those resources may provide a false sense of predictability and reliability. Though appearing to create reliability, this approach could lead to a much more mechanical structure that sacrifices needed flexibility to deploy resources at key pressure points in a timely manner. Experience also shows that some supervisory or company responses can lead to overcompensating market reactions during periods of stress. If the regulators mandate a too prescribed set of responses with prepositioned resources, thus leaving few resources for a more flexible deployment, we may create a series of predefined, mandated trigger events that cause the market to overreact in fear of the next preplanned response. This could increase, rather than reduce, company and market stress and instability, while impairing or undercutting a response that may be more effective. In another realm, we only have to look at the series of predictable, but self-interested, responses to mobilization by different contesting powers in August 1914 to see the catastrophe that can occur from inflexibility interacting with anxiety under stress.28 Recent European initiatives continue to pursue the implementation of the BRRD by creating greater clarity in the relationship between MREL and TLAC, as well as defining more clearly the liabilities to be written down in a future bail-in. The original Article 45 of the BRRD requires an institution to maintain at all times a minimum amount of its own funds and eligible liabilities (that is, liabilities that may be written down or converted under the bail-in tool). The MREL is to be calculated as the amount of own funds and eligible liabilities (including subordinated debt and senior unsecured debt with a remaining maturity of at least 12 months that are subject to the bail-in power) expressed as a percentage of the total liabilities and own funds of the institution. Resolution authorities, after consultation with the supervising authorities, are tasked with determining the minimum requirement for each institution based on a number of criteria taking into account the size, the business model, the funding model,

28

See Barbara W. Tuchman, The Guns of August (MacMillan 1963).

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and the risk profile as well as the potential effect of the institution’s failure on the financial markets. Article 55, in turn, helped implement the requirements by requiring inclusion of a contractual term providing that the party to the instrument recognized that it may be subject to write-down and conversion by a resolution authority. On November 23, 2016, the European Commission published legislative proposals to amend the BRRD in several ways. Two particularly important proposals would (1) modify the creditor hierarchy in insolvency in order to better implement a bail-in strategy for resolution, and (2) adopt widespread revisions to the EU prudential regulatory framework for banks and investment banks (the BRRD Proposals).29 First, the BRRD proposals introduce a new rank in insolvency (“senior nonpreferred”) for long-term debt instruments, which will rank senior to regulatory capital and subordinated debt, but junior to other unsecured liabilities. These debt instruments would therefore be bailed-in before other unsecured liabilities (such as operational liabilities, derivatives, and deposits), which is designed to improve the resolvability of EU institutions and facilitate compliance with the FSB’s TLAC standard. This proposal builds upon legislation recently enacted in certain EU member-states, including France, Germany, and Italy, and closely aligns with the French “Sapin 2” law enacted on December 9, 2016. In effect, it will allow the EU global SIFIs to issue debt that complies both with their MREL requirements as well as their TLAC requirements. Second, among the proposed revisions to the EU prudential regulatory framework, the BRRD proposals would require certain non-EU financial institutions to establish an EU intermediate holding company where they have two or more banks or investment firms in the EU. This is certainly controversial among non-EU banks and other financial firms. This late addition to the proposal prompted commentary highlighting its apparent “retaliatory” nature as a response to regulations issued by the Federal Reserve requiring all non-US banking organizations with US nonbranch assets of $50 billion or more to establish a US intermediate holding company to hold all of their US subsidiaries (banking and nonbanking). These US regulations were strongly opposed by non-US banking organizations and criticized by numerous government officials, including representatives of the European Commission, who expressed concern that the US Intermediate Holding Company requirement

European Commission, November 23, 2016, “Proposal for a Directive of the European Parliament and of the Council amending Directive 2013/36/EU as Regards Exempted Entities, Financial Holding Companies, Mixed Financial Holding Companies, Remuneration, Supervisory Measures and Powers and Capital Conservation Measures,” http://​ec​.europa​.eu/​transparency/​regdoc/​rep/​1/​2016/​ EN/​COM​-2016​-854​-F1​-EN​-MAIN​.PDF; and European Commission, November 23, 2016. “Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 806/2014 Regards Loss-Absorbing and Recapitalization Capacity for Credit Institutions and Investment Firms,” http://​eur​-lex​.europa​.eu/​legal​-content/​EN/​TXT/​PDF/​?uri​=​CELEX:​52016PC0851​&​ qid​=​1513190659261​&​from​=​EN. 29

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“could spark a protectionist reaction from other jurisdictions.”30 A US intermediate holding company is subject to US capital and liquidity, stress testing, and other prudential requirements as if it were a US bank holding company. If adopted as proposed, the EU intermediate holding company requirement would impose similar requirements and create certain conflicts with home country regulations, including the US requirement that broker dealer subsidiaries be under a separate ownership branch from US banking subsidiaries. The EU intermediate holding companies also would be subject to the BRRD resolution process as well as the EU internal TLAC and discretionary MREL requirements. These EU developments point out the complex interplay of still-developing regulatory and supervisory standards and how they can differentially affect domestic and foreign banking operations. As noted, the US intermediate holding company requirements were very controversial in Europe, and the EU proposal is likewise controversial outside the EU. These developments do not give great comfort about the likely consistency of regulation and supervision for global SIFIs or for the likely cooperation between regulators in a future crisis. All of the reforms since the financial crisis must be premised on improved cooperation in order to avoid an isolated financial problem from once again becoming a global crisis. The political and policy winds do not seem to be blowing favorably.

Further Implementation Steps The development of new insolvency laws, creative resolution strategies to address some of the key conceptual problems in SIFI resolutions, and the first phases of putting in place sufficient bail-inable resources to allow a timely and effective bail-in strategy (whether SPOE or MPOE) are promising steps toward ending too-big-to-fail. These steps build on a foundation of real measurable progress in building more resilient SIFIs. First, the SIFIs today hold much greater required capital and liquidity resources under regulatory capital and liquidity standards than did similar institutions at the time of the crisis. These capital levels are augmented in the United States by annual stress-testing requirements for the eight US global SIFIs, which effectively establish an additional required level of capital protection. The requirement that global SIFIs hold larger resources of high-quality liquid assets provides substantial liquidity resources to allow them to weather significant stress. Further requirements have been proposed by the Federal Reserve, but whether those will be implemented is more uncertain given the priorities of the current US administration.31 In addition, SIFIs are required to prepare recovery plans to Letter from Michel Barnier, European Commissioner for Internal Market and Services, to Federal Reserve Chairman Ben Bernanke, dated April 18, 2013. http://​www​.federalreserve​.gov/​SECRS/​2013/​ April/​20130422/​R​-1438/​R​-1438​_041913​_111076​_515131431183​_1​.pdf. 31 The imposition of effective capital measures in normal times through analyses based on stress tests from more troubled times calls to mind my friend Charles Goodhart’s famous, and true, aphorism: “When a measure becomes a target, it ceases to be a good measure.” See Cleary Gottlieb, October 5, 2016, “Significant Increase in Capital Requirements for US GSIBs Relief from Qualitative Stress Test Objections for Smaller Banking Organizations.” 30

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provide well-developed strategies for recovering required capital and liquidity levels in periods of stress. These are joined with additional requirements under the rubric of enhanced prudential standards.32 Second, SIFIs have undertaken real corporate reorganizations and restructuring of their funding and operational infrastructures to make them more resolvable. These changes have greatly reduced the reliance on short-term funding; they also have provided a much more granular understanding of shared services, financial interconnections both between SIFIs and within the companies, and the effectiveness of funding strategies during periods of stress. Finally, we should not forget that implementation of the TLAC requirements remains to be completed. When those resources are in place, we will have cushions that should be sufficient to allow for the recapitalization of SIFIs even after their regulatory capital buffers are exhausted. While these steps are not complete, the way forward to final TLAC implementation is now relatively set. But all of these steps are only the foundational elements for a viable and actionable resolution plan for SIFIs. Much additional work is required on the granular issues that will determine whether any future resolution can be successful. This work must be accompanied by a much more extensive interaction with market participants to engender a greater understanding of the strengths and weaknesses of the resolution strategies by the regulators, SIFIs, and market participants as well. Only a rigorous process of testing, challenges to assumptions and analyses, and corrective steps can give real confidence that the resolution strategies can be implemented. If there is insufficient confidence by the markets, policymakers, or politicians that the resolution strategies can actually be implemented successfully, there will be no resolution, and we will return to the default measure of a full governmental bail-out or, even worse, we will do nothing and allow a small crisis to cascade into a major catastrophe for the financial system and the economy. It is wise always to be skeptical because how the reformed system will respond to the stress of a new crisis is virtually impossible to know. More information, more probing, and more testing of assumptions, plans, and internal strategies is essential. A transparent appraisal of the challenges and possible solutions is the only response.33 Unfortunately, and perhaps even more importantly, how will future regulators, politicians, bankers, and market participants respond in some future crisis? International cooperation is essential to successfully respond to any future crisis, because the best-designed resolution frameworks, strategies, and capital and liquidity resources can be undone if improperly used or not used at

80 Fed. Reg. at 74927; Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking Organizations (Regulation YY), 12 C.F.R. § 252. 33 Darrell Duffie, June 2016, “Financial Regulatory Reform After the Crisis: An Assessment,” ECB Forum on Central Banking, https://​ www​ .darrellduffie​ .com/​ uploads/​ policy/​ DuffieSintraJune2016​.pdf. Also, Stijn Claessens and Laura Kodres, 2014, “The Regulatory Responses to the Global Financial Crisis: Some Uncomfortable Questions.” IMF Working Paper 14/46, International Monetary Fund, Washington, DC, https://​www​.imf​.org/​external/​pubs/​ft/​ wp/​2014/​wp1446​.pdf. 32

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all. The headwinds today of nascent protectionism and resurgent nationalism give cause for pause and concern. We have made great progress, but if the most valuable components of that progress are unwound, we may be laying the groundwork for a future dislocation with unpredictable consequences.

WHERE ARE WE AFTER ALL? There is no question that we have made great progress in implementing reforms designed to end too-big-to-fail in the years since the financial crisis. The ultimate question—have we ended too-big-to-fail?—may be impossible to answer until the strengthened SIFIs, legal frameworks, and resolution strategies are tested in a crisis. As noted by a number of commentators, the individual impact of many regulatory reforms is very difficult to measure, and their cumulative impact is even more difficult to assess. One clear result of the regulatory reforms has been that the implementation costs have been enormous by any measure. Tens of billions of dollars are spent each year on meeting the new standards under the Dodd-Frank Act and other new regulatory requirements.34 The costs and rewards of new cushions of capital and liquidity alone are hard to assess. Those costs have led some European regulators to challenge the need to further strengthen requirements and have led the new US president to decry the impact of regulations on the availability of credit and to support legislative and regulatory steps to modify or undo many of the regulatory reforms since 2008.35 Today, we appear to have entered a part of the implementation phase of the postcrisis regulatory reform where real questions are being raised about the value of further reform measures and about whether the Western economies can afford further steps to create a more resilient financial system. The consensus in favor of reform seems to have been overtaken by fatigue. Where are we, after all?

Duffie at 8, fn. 6 (citing Kristen Glind and Emily Glazer, Wall Street Journal, May 30, 2016, based on estimates provided by Federated Financial Analytics, Inc., http://​ www​ .wsj​ .com/​articles/​nuns​-with​-guns​-the​-strange​-day​-to​-day​-struggles​-between​-bankers​-and​-regulators​ -1464627601​?mod​=​e2tw). 35 White House, February 24, 2017, “Presidential Executive Order on Enforcing the Regulatory Reform Agenda,” https://​www​.whitehouse​.gov/​the​-press​-office/​2017/​02/​24/​presidential​-executive​ -order​ -enforcing​ -regulatory​ -reform​ -agenda; European Commission, September 29, 2016, Speech by European Commission Vice President Valdis Dombrovskis, “Embracing Disruption,” before the European Banking Federation Conference, https://​ec​.europa​.eu/​commission/​commissioners/​ 2014​-2019/​dombrovskis/​announcements/​speech​-vp​-dombrovskis​-european​-banking​-federation​ -conference​-embracing​-disruption​_en; see also Catherine Contiguglia, September 29, 2016, “Regulatory Fragmentation Drives Basel RWA Impasse,” Risk.net, https://​www​.risk​.net/​regulation/​basel​ -committee/​2472331/​regulatory​-fragmentation​-drives​-basel​-rwa​-impasse. 34

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REFERENCES Gordon, Jeffrey N., and Wolf-Georg Ringe. 2015. “Bank Resolution in The European Banking Union: A Transatlantic Perspective on What It Would Take.” Columbia Law Review 115 (1297): 1352–53. Lewis, Michael. 2010. The Big Short: Inside the Doomsday Machine. New York: Norton. Scott, Hal S. 2016. Connectedness and Contagion: Protecting the Financial System from Panics. Cambridge, MA: MIT Press, 75–78. Sorkin, Andrew Ross. 2009. Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves. New York: Viking. Tuchman, Barbara W. 1963. The Guns of August. New York: MacMillan.

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II CROSS-BORDER RESOLUTION: CHALLENGES IN CROSS-BORDER EFFECTIVENESS

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CHAPTER 4

Cross-Border Resolution between Cooperation and Ring-Fencing Andrea Enria

THE INTERNATIONAL APPROACH TO CROSS-BORDER RESOLUTION The financial crisis started in 2008 has brought to the fore the imbalance between the growth in cross-border banking business and structures in the run-up to the crisis and the national framework dealing with bank crisis management. As Mervyn King—and before him, Thomas Huertas—argued, banks proved to be international in life and national in death. In the midst of the crisis, national concerns on the potential fallout in local markets translated into ring-fencing practices, which in turn prevented liquidity and capital to flow freely within cross-border groups, ultimately resulting in a deepening of the crisis. Obviously, such unilateralism and lack of coordination paved the way for the enforcement of the implied state guarantee via massive state bail-outs. Ring-fencing practices have also generated adverse consequences on the transmission channels of the single monetary policy within the euro area, as they created a negative, self-reinforcing loop between banks and their sovereign. The regulatory challenge to end the too-big-to-fail problem proved daunting. There was unanimous consensus among policymakers that the solution to the troubles originating from cross-border interconnectedness had to be found at the international level. To avoid the imbalance identified by King, some international mechanisms had to be put in place to coordinate crisis management and make banks more international also in their death. The Financial Stability Board (FSB) has, therefore, been entrusted with the task of developing a set of substantive principles on crisis management and resolution, aimed at resolving financial institutions in an orderly fashion, to preserve financial stability and minimize the use

Andrea Enria is Chairperson of the European Banking Authority. He thanks Anna Gardella for her contribution to this chapter. He remains solely responsible for the ­opinions contained herein. The chapter was finalized in April 2017, and the references were updated in March 2018.



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of taxpayers’ money under an international cooperation framework. Such a policy mix of harmonization and creation of a coordinated infrastructure is intended to discourage behaviors pursuing purely national objectives and to tackle the collective action problems experienced during the crisis. Absent confidence that a cooperative solution would prevail in a cross-border crisis, each authority faces a strong incentive to ring-fence local operations as a means to provide additional safeguards to domestic depositors and operations. Along these lines, the FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” (“Key Attributes”) identified in 2011 a body of agreed substantive principles on crisis management.1 These include the establishment of a new authority responsible for resolution matters and endowed with a specific resolution toolkit, as well as the establishment—for global systemically important banks (G-SIBs)—of firm-specific, cross-border networks of national authorities, the crisis management groups (CMGs), governed by an ad hoc Cooperation Agreement. These principles are complemented by guidance on the coordination of legal systems to ensure cooperation and recognition of cross-border resolution actions. Resolution, however, cannot be orderly without a clear view on its financing, including in the cross-border context. This aspect directly touches upon the adequacy of the loss-absorption capacity and the regulatory response to ring-fencing practices experienced in the course of the financial crisis. The FSB response laid down in the total loss absorbing capacity (TLAC) Term Sheet (TLAC Standard), published on November 9, 2015,2 attempts to strike a balance between international cooperation and domestic comfort on the sufficiency of loss-absorption capacity at the local level. In general, an adequate level, quality, and distribution of TLAC will be key to reinforce the mutual trust between home and host authorities on the fact that G-SIB failure can be managed without endangering the local depositors and the local economies. The capacity of banks to stand on their own legs is essential to overcome legal obstacles to cross-border flows. In particular, the internationally agreed criteria on the internal distribution of TLAC across the various subsidiaries of the G-SIBs represent an important incentive-based mechanism to make cooperation between home and host more credible. By ensuring that parent companies have sufficient “skin in the game” in the various subsidiaries, these criteria might provide adequate reassurance to host authorities, and hence persuade the latter against triggering uncoordinated ring-fencing measures. The progress accomplished by international standard-setting bodies is highly commendable. Strengthened exchanges of information, enhanced preparedness

1 FSB, November 2011 (updated October 15, 2014), “Key Attributes of Effective Resolution Regimes for Financial Institutions,” http://​www​.fsb​.org/​wp​-content/​uploads/​r​_141015​.pdf. 2 FSB, November 9, 2015, “Total Loss-Absorbing Capacity (TLAC) Principles and Term Sheet,” http://​www​.fsb​.org/​2015/​11/​total​-loss​-absorbing​-capacity​-tlac​-principles​-and​-term​-sheet/​.

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and coordination among authorities are key to ensuring predictability of behavior and the pursuance of common objectives by national authorities.3 Good intentions and good results, however, should not exempt us from asking the fundamental question of whether the regulatory plan was ambitious enough as regards cross-border resolution or whether, leveraging on the momentum generated by regulatory reforms, the development of an international treaty should have been considered. After a financial crisis of such proportions, with widespread international ramifications, the possibility of putting cross-border crisis management and bank resolution on more firm legal grounds should have been given some consideration. Legal uncertainty on the enforceability of informal agreements based on soft law might still lead national authorities to prefer the solid reassurance provided by sizable local capital and liquidity buffers to the informal commitments to cooperate in a crisis. In the European Union, high-level memoranda of understanding had been agreed in the early 2000s but did not prove effective in fostering cooperative solutions during the crisis. The European response to the crisis was to build a stronger legal framework for cross-border resolution. But it is understandable that at the international level, reaching consensus on the complex and newly conceptualized resolution goals and toolkit retained full priority, whereas the pursuit of legally binding international treaties would have been a much more demanding and uncertain endeavor. The foundations for future work on cross-border coordination and enforcement of resolution actions have been laid down and should not be abandoned, but rather be maintained in the regulatory agenda. The continuous FSB engagement in cross-border aspects of resolution, including the development of the Principles for Cross-Border Effectiveness of Resolution Actions,4 and the current analysis on the implementation of the resolution framework in the cross-border context, show the need for further refinements in order to achieve proper effectiveness. In line with these considerations, this chapter will first illustrate the regulatory overhaul undertaken at the EU level, focusing in particular on the cooperative infrastructure and the cross-border financing of resolution, arguing that by ­relying on hard law, European authorities, mechanisms for the settlement of disagreements, and the European Treaty umbrella, the EU resolution regime is the most advanced implementation of the FSB cross-border crisis management 3 The European Banking Authority has signed a Framework Cooperation Arrangement with five US agencies (Board of Governors of the Federal Reserve System, the Federal Deposit I­nsurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange ­Commission, and the New York State Department of Financial Services) on September 29, 2017, with the objective to promote resolution planning and cooperation for cross-border ­institutions. It lays out the basis for subsequent cooperation arrangements on bank crisis m ­ anagement and r­ esolution between any of the EU Supervisory or Resolution Authorities and any of the ­participating US Agencies. The framework is available at https://​www​.eba​.europa​.eu/​-/​eba​-and​-us​-agencies​-conclude​-framework​-cooperation​ -arrangement​-on​-bank​-resolution. 4 FSB, November 3, 2015b “Principles for Cross-border Effectiveness of Resolution Actionsb” http://​ www​.fsb​.org/​2015/​11/​principles​-for​-cross​-border​-effectiveness​-of​-resolution​-actions/​.

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framework. I will then turn to the global dimension to note that countering ring-fencing practices through cooperative behavior is a major challenge: it requires that national authorities build sufficient reciprocal trust and strictly abide by their commitments to cooperation in a cross-border crisis, even when the national interest seems to point in a different direction. As will be illustrated, recent regulatory measures and initiatives seem to signal that authorities may instead be tempted to segment business along jurisdictional lines, so as to make banks less international in life and allow their crises to be better managed with national tools.

THE EU RESOLUTION FRAMEWORK AND COOPERATION ARCHITECTURE The EU framework implementing the FSB Key Attributes is set out in Directive 2014/59/EU on recovery and resolution of credit institutions and investment firms (Bank Recovery and Resolution Directive [BRRD]). It lays down an EU-wide substantive crisis-management regime for both the going and the gone concern phases; it relies on ex ante preparedness via the development of recovery and resolution plans and on a powerful resolution toolkit conferred upon the newly established resolution authorities. The BRRD regime has been further specified in numerous technical standards and guidelines developed by the European Banking Authority (EBA) providing for specific guidance to resolution authorities and firms on topical parts of the BRRD.5 A Single Rulebook for the whole European Union is, therefore, in place and is further clarified through the EBA’s Q&A tool.6 The crisis management framework marks a significant step making banks cognizant of the need to consider, when developing their business models, how to remedy crisis scenarios in a way to preserve the critical functions and the core business lines. The ex ante preparatory work is key to the credibility of the new regime and the feasibility of orderly resolution or, to put it differently, to the removal of the implicit state guarantee. A forward-looking approach should also be part of supervisory practices at the time of licensing of a subsidiary or of a branch of an international group. The current EBA draft Regulatory Technical Standards on authorization of credit institutions move in this direction by requiring the applicant to submit the recovery plan for the bank to be licensed.7 In line with the FSB Key Attributes, the BRRD substantive provisions are complemented by a cross-border administrative structure aimed at ensuring authorities’

EBA, “Recovery, Resolution and DGS,” http://​www​.eba​.europa​.eu/​regulation​-and​-policy/​recovery​and​-resolution. 6 EBA, “Single Rulebook Q&A,” http://​www​.eba​.europa​.eu/​single​-rule​-book​-qa. 7 EBA, November 8, 2016, Consultation Paper 2016/19, https://​www​.eba​.europa​.eu/​documents/​ 10180/​1652933/​Consultation+Paper+on+RTS+and+ITS+on+the+authorisation+of+credit +institutions+​%28EBA​-CP​-2016​-19​%29​.pdf/​9014220a​-2bea​-414e​-964c​-aa6a8c38da1f. 5

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cooperation and at overcoming collective action problems. Finally, the EU framework is completed by the umbrella regime of mutual recognition enshrined in Directive 2001/24/EC on the reorganization and winding-up of credit institutions (“Directive 2001/24/EC”). This principle ensures that reorganization measures enjoy automatic effects throughout the European Union. Given that resolution tools and resolution powers are included in the definition of reorganization measures, the overarching principle of mutual recognition is a powerful tool to ensure the cross-border effectiveness of resolution actions and to bridge the gaps where coordination of legal systems is insufficient.

EU ADMINISTRATIVE COOPERATIVE NETWORKS Unlike the FSB regime where CMGs are envisaged to be set up only for G-SIBs, at the European level such networks of authorities have been extended to all cross-border groups regardless of their size and have been expressly disciplined in binding legislation. The resolution college is the platform for European cooperation, open also to non-EU authorities, both in the preparatory phase of resolution planning and in actual resolution. Drawing from the parallel experience of ­supervisory colleges, cooperation is epitomized in the legal requirement that for each cross-border bank, relevant resolution authorities achieve joint decisions on certain significant elements of the preparatory phase such as the resolution plan, including the resolution strategy, the removal of impediments to resolvability, and the setting of the minimum requirements for own funds and eligible liabilities (MREL). Whereas CMGs rest on nonbinding memoranda of understanding among authorities embodying a mutual intention to cooperate in accordance with the terms of the memorandum, the functioning of the resolution college is governed by the BRRD and is further specified in Commission Delegated Regulation (EU) 2016/1075, endorsing the EBA regulatory technical standards on resolution colleges. Procedural requirements, including steps and deadlines, are not a goal per se but instruments to strengthen cooperative approaches. To mark the importance of coordinated action to ensure orderly resolution—as well as to preserve the integrity of the internal market and financial stability across the European Union—the EBA is entrusted with a mediation role to facilitate the reaching of a joint decision in case of disagreement between the relevant authorities. When requested to provide assistance, the EBA’s mediation function has proven effective. Mediation cases usually find an amicable solution in the conciliation phase, thus minimizing potential conflicts and optimizing sincere cooperation between the authorities concerned. But if home and host resolution authorities fail to achieve an agreement, the EBA could issue a binding decision requiring them to take specific action or to refrain from action in order to settle the matter. The latest step in the move toward the strengthening of the cross-border resolution framework in the European Union is the institutionalization of the authorities’ administrative cooperation in the context of the Banking Union,

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which includes all the member-states adopting the euro. A new authority, the Single Resolution Board, has been established within the Single Resolution Mechanism, thus complementing the Single Supervisory Mechanism, which has centralized supervisory responsibilities at the ECB. Whereas the Single Resolution Mechanism relies on the cooperation network of the national resolution authorities, both in the preparation phase and in the execution of its resolution decisions, the centralized decision-making power at the European level is major step forward.8 This momentous change in the institutional setup for crisis management was achieved by designing a delicate balance between national and European interests. The involvement of several EU and national institutions in the decision-making process may be a source of complexity and of potential challenge in time constraints. Some streamlining could be considered, in light of recent interpretations of the European Treaty by the European Court of Justice, which would allow a framed exercise of discretionary powers by European agencies.9

RESOLUTION PLANNING: PREFERRED RESOLUTION STRATEGY AND FINANCING With the legal framework now in place, the focus has shifted from regulation to implementation and operationalization—a fresh challenge for both the recently established authorities and firms. The preparatory phase is essential, as orderly resolution can only be achieved if it is planned in advance, and all authorities involved are committed to implementing the preferred resolution strategy when a bank is failing or likely to fail. The experience gained during the crisis has matured the conviction that the only way to prevent future repatriation of business, ring-fencing of capital and liquidity, and the segmentation of the internal market is to prepare in advance and lay down precise commitments to cooperation in legally binding decisions. Until an effective preparatory phase is carried out, it is premature to say that the “too-big-to-fail” issue has been properly addressed. The EBA participates in several resolution colleges and CMGs and has gained a broad perspective on the state of the art as regards the preparatory phase.

See the recent decisions of the Single Resolution Board relating to the resolution or the l­iquidation of cross-border groups, notably the resolution of Banco Popular Español of June 7, 2017 (https://​ srb​.europa​.eu/​sites/​srbsite/​files/​resolution​_decision​.pdf ), and on the liquidation of Banca Popolare di Vicenza (https://​srb​.europa​.eu/​sites/​srbsite/​files/​srb​-ees​-2017​-12​_non​-confidential​.pdf ) and of Veneto Banca (https://​srb​.europa​.eu/​sites/​srbsite/​files/​srb​-ees​-2017​-11​_non​-confidential​.pdf ) both of June 23, 2017, as well as of the Latvian ABLV Bank AS and of its Luxembourg subsidiary of February 23, 2018 (https://​srb​.europa​.eu/​en/​node/​495). 9 Court of Justice of the European Union, January 22, 2014, C-270/12, United Kingdom of Great Britain and Northern Ireland v European Parliament and Council of the European Union (ESMA “short selling”). In paragraphs 41–54 the Court assesses the nature and scope of discretion exercised by ESMA, the European Union agency for securities markets, under Regulation EU N. 236/2012 on Short selling, ECLI:​EU:​C:​2014:​18. 8

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Broadly speaking, the preparatory phase relies on two critical features: (1) the determination of the resolution strategy identifying the resolution point(s) of entry, and (2) the determination of the TLAC/MREL and related allocation within the group. The planning exercise (including the choice of the preferred resolution strategy) is underpinned by an in-depth analysis of the bank’s critical functions, core business lines, and funding structure, as well as of the assessment of the separability of parts of its business and functions. We appreciate the efforts made by the authorities so far in the European Union. At the same time, we are mindful that resolution planning is an iterative process. More efforts are required in the months and years to come to achieve a proper operational plan. We are urging resolution authorities to intensify their work in order to reach a satisfactory steady state in the short term. The achievement of joint decisions on the preferred resolution strategy is a tangible implementation of the cooperation framework enshrined in the new legislation. However, the delay in the adoption of decisions on the TLAC/MREL requirement, due also to the instability of the regulatory framework, signals that there is still some distance to the finishing line and that speed has to be increased in order to achieve effective resolution planning. There is no one-size-fits-all, and depending on the group structure, funding model, interconnectedness, and centralization of functions, a single point of entry (SPOE) or a multiple point of entry (MPOE) strategy may be appropriate. The SPOE is particularly suitable for those banking groups that are highly interconnected and operationally and financially centralized. Under this strategy, the resolution action is in principle concentrated only at the top level of the group, without affecting the operating subsidiaries. The underlying rationale is precisely to ensure that such operating subsidiaries are able to continue running their business without being put under resolution. The view from the top is meant to ensure the smooth implementation of the strategy and the preservation of the group’s functions and value. To be successful, this strategy must rely on an intragroup funding model enabling the up-streaming of losses from the operating subsidiaries and the downstreaming of capital. External bail-inable debt is issued at the group’s top level, to ensure the smooth write-down of capital instruments and absorption of losses by minimizing the interference in the operational continuity of the distressed institution. The SPOE is not inconsistent with a corporate structure where an operating company (rather than a holding company) is at the top; however, the write-down of capital instruments and of eligible liabilities can be better achieved by making the eligible liabilities subordinate to the operating liabilities in order to minimize disruption and to respect the “no creditor worse off ” safeguard. The introduction of a new EU harmonized creditor class of senior nonpreferred claims ranking above subordinated and below senior debt marks an important step for the operationalization of the resolution strategy.10 In a cross-border scenario, the SPOE

Directive (EU) 2017/2399 of the European Parliament and of the Council of 12 December 2017 amending Directive 2014/59/EU as regards the ranking of unsecured debt instruments in insolvency hierarchy, in the Official Journal of the European Union L 345 of 27 December 2017, p. 96. 10

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strategy is likely to reduce the legal risk intrinsic in multijurisdictional contexts, as resolution action—notably the write-down and conversion of capital instruments and eligible liabilities—is predominantly concentrated in the home authority jurisdiction. The existence of an SPOE curtails the need for recognition and enforcement of resolution measures in other countries. The MPOE strategy envisages more than one point of entry for resolution actions and is better suited for the less financially and operationally interconnected groups, where treasury, liquidity, and support functions are carried out in an autonomous rather than a centralized manner. The rationale underlying the MPOE strategy is the low level of interconnectedness with the rest of the group, making it in principle more “territorial” in scope. However, given that the MPOE entails the decentralization of the resolution strategy, a high level of coordination and cooperation is needed among the authorities responsible for the various resolution subgroups, both those affected by the resolution and those that are not. The group-level resolution authority must be satisfied with the mechanisms put in place to control any adverse impact—including on financial stability—of the resolution of one part of the group on the rest of the group. Such analysis and coordination planning should be established ex ante in the context of the resolution college and laid down in the resolution plan. The plan should also clearly set the perimeter and the separability of the reach of each point of entry to ensure the achievement of the resolution objectives.

FINANCING OF RESOLUTION IN CROSS-BORDER GROUPS AND CONTROLLED RING-FENCING Viewed from the ring-fencing perspective, the SPOE and MPOE strategies are neutral, given that they reflect the operational and funding organization of the group and their degree of centralization of functions—to the extent the subsidiaries subject to MPOE strategy are truly independent from the group, it hardly results in ring-fencing. Where the SPOE is adopted for group resolution strategy, it is well-suited to ensure cross-border group orderly resolution. This is because the existence of one exclusive point of entry for the whole group suggests that the view from the top provides the possibility and flexibility to efficiently manage an internal group crisis regardless of where such entities are located. To be effective, the SPOE must rely either on internal group coordination to make sure that asymmetric shocks are absorbed or on cross-border administrative cooperation to ensure that sufficient capital and loss-absorbing capacity is present or transferred where needed. The availability of internal financial resources is central to resolution, as the success of the whole process rests on the bank’s own capacity to absorb losses and regain market confidence. The internalization of losses represents the paradigm shift of the new crisis management regime, which excludes any ex ante reliance on public financial support. The BRRD MREL that has been better specified in the EBA regulatory technical standard, endorsed by the Commission

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Delegated Regulation (EU) No. 2016/1450, lays down the criteria for setting such a firm-specific requirement. MREL is composed of a loss-absorption amount and of a recapitalization amount to be determined on the basis of the capital requirements, having regard to the main features of the firm, and in accordance with the preferred resolution strategy indicated in the plan. The rationale of this EU requirement reflects the global policy on loss absorption for the G-SIBs, developed by the FSB TLAC term sheet. But at the same time it is flexible enough to be adapted to the specific features of banks of all sizes and with very different business models. The European Commission in November 2016 submitted a Proposal of Directive to implement such TLAC standards within the European framework, integrating it within the MREL requirement with a view to ensuring that both requirements are met in a consistent manner and with largely similar instruments.11 This chapter will briefly make reference to the group and the intragroup allocation of the eligible liabilities with a view to furthering the analysis of the cross-border aspects of the preferred resolution strategy and the tension between cooperation and ring-fencing. The BRRD provides that MREL has to be complied both at the consolidated and at the solo level. The solo requirement is to be determined having regard, inter alia, to “the size, business model and risk profile of the subsidiary, including its own funds” and to the level set at the consolidated basis. The current version of the BRRD does not distinguish between external and internal MREL—that is, between loss-absorbing instruments issued to external investors and financing from the parent company. The distinction has been introduced by the Commission Proposal of November 2016, following the FSB’s guidance on TLAC. Where a resolution college for cross-border groups is established, both the consolidated and the solo levels of MREL should be determined by a joint decision of the resolution authorities within the college. Only in the absence of an agreement or a request for EBA’s mediation are the parties allowed to take individual decisions. Needless to say, these are crucial steps of the resolution planning exercise, setting the balance between controlled ex ante ring-fencing and smooth intragroup cooperation. Such a trade-off is present also in the current version of the BRRD providing for waivers of the requirement at the solo level when the subsidiary and the parent company belong to the same member-state and the other conditions set out in Article 45(12) are met. The Commission Proposal of November 2016 introduces the notion of internal MREL as a means to ensure that losses are absorbed and up-streamed to the parent resolution entity

European Commission, November 23, 2016, “Proposal for a Directive of the European Parliament and of the Council Amending Directive 2014/59/EU on Loss-Absorbing and Recapitalisation Capacity of Credit Institutions and Investment Firms and Amending Directive 98/26/EC, Directive 2002/47/EC, Directive 2012/30/EU, Directive 2011/35/EU, Directive 2005/56/EC, Directive 2004/25/EC and Directive 2007/36/EC,” https://​ec​.europa​.eu/​transparency/​regdoc/​rep/​1/​2016/​EN /​COM​-2016​-852​-F1​-EN​-MAIN​.PDF. 11

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under the preferred resolution strategy. In this context, the Commission Proposal expands the reach and modality of intra-EU cooperation for intra group cross-border matters. In particular, the Commission Proposal envisages that the internal MREL may be replaced by a collateralized commitment by the parent to the subsidiary, provided that certain conditions are met, subject to the partial collateralization of such commitment replacing the internal MREL. It is regrettable that the proposal does not go further in relaxing the ex ante controlled ring-fencing to banking groups established in the Banking Union that are subject to single supervision of the European Central Bank and to the single resolution mechanism with the Single Resolution Board at its center. The balancing exercise between host authorities’ comfort against potential adverse fiscal impacts of bank failures and a smooth and cooperative setup allowing for the transfer of capital and liquidity within the group where the circumstances so require, is still too unbalanced in favor of ex ante-controlled ring-fencing. The earmarking of capital and liquidity along jurisdictional borders, instead of its free movement within the group to absorb asymmetric shocks, ends up hindering the benefits of the “singleness” of new institutional architecture.

ADMINISTRATIVE COOPERATION AND RESOLUTION PLANNING IN THE GLOBAL DIMENSION The resolution framework in the global dimension reflects the FSB Key Attributes, but unlike the EU regime, it rests on soft law rather than on binding legal sources and procedures. A cooperation infrastructure—in the form of a network of administrative authorities—the CMG is envisaged to be set up for each firm and be governed by an ad hoc memorandum of understanding. This is the forum for discussion and agreement of the resolution-planning activities, including the preferred resolution strategy, and TLAC matters. No formal decision is taken, however, and in the absence of supranational authorities tasked with a monitoring and coordination function, defective behaviors are more likely than in the EU financial architecture. At the global level, therefore, collective action problems are still more likely than in the binding coordinated setting in place in the European Union. It is not surprising that the “soft” cooperative setup has inspired recent regulatory developments on both sides of the Atlantic to introduce (or proposed, in the case of the European Union) an intermediate parent company on top of the entities operating in the United States or the European Union, respectively, when certain conditions are met. The Foreign Bank Organization rules in the United States have already implied a significant restructuring of the legal structures of European banks conducting business there. Similarly, under new legislation proposed by the European Commission, a European intermediate parent undertaking would have to be established by non-EU G-SIBs or when the total value of assets of the third country group is at least

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Chapter 4  Cross-Border Resolution between Cooperation and Ring-Fencing

€30 billion.12 Such an entity would have to be licensed as an institution or as a financial holding company and ­consequently required to comply with all the local regulatory requirements on a consolidated basis. Although such requirements are supposed to support the resolution strategy and to provide confidence to the host authorities, they clearly entail a trade-off with the group’s central funding management of liquidity and capital, potentially affecting cross-border business strategy.

EFFECTIVENESS OF THE IMPLEMENTATION OF CROSS-BORDER RESOLUTION ACTIONS: THE LEGAL TOOLS In a multi-jurisdictional context, legal risk may hinder the effectiveness of resolution actions where regulatory asymmetries give rise to unenforceable actions. Along with harmonization of the substantive regime and cooperation between authorities, coordination of legal systems is the third pillar of the resolution framework. This is essential to ensure that measures taken in the home jurisdiction deploy effects in the host jurisdiction. The classic technique to achieve this result is the judicial or administrative recognition process, aimed at ascertaining whether certain legislative conditions are met, and the effects of the measure are consistent with national law. In insolvency matters, a key factor determining whether a measure may be recognized relates to the treatment of (local) creditors, which is often an aspect of the general clause of public policy. Under the EU regime, such a recognition process is discarded in favor of automatic mutual recognition of the resolution action that is adopted by the resolution authority of one member-state in the territory of other member-states. This effect has been achieved by including the resolution tools and the resolution powers within the definition of “reorganisation measure” covered by Directive 2001/24/ EC on the reorganization and winding-up of credit institutions, which enjoy automatic effects throughout the European Union in accordance with the law of the home jurisdiction. Needless to say, mutual recognition is a powerful technique that brings mutual trust and cooperation at its peak by dismissing, from the outset, potential claims stemming from the extraterritorial exercise of sovereign powers. This entails the outright exclusion of any interference of local laws with the law of the home jurisdiction. For this purpose, the BRRD clarifies that the creditors cannot raise claims on the basis of the law governing the financial instruments that have been written down or the law where the assets are located (Article 66(3)). This provision is complemented by the requirement that the host jurisdiction

European Commission, November 23, 2016, “Proposal for a Directive of the European Parliament and of the Council Amending Directive 2013/36/EU as Regards Exempted Entities, Financial Holding Companies, Mixed Financial Holding Companies, Remuneration, Supervisory Measures and Powers and Capital Conservation Measures,” http://​ec​.europa​.eu/​transparency/​regdoc/​rep/​1/​2016 /​EN/​COM​-2016​-854​-F1​-EN​-MAIN​.PDF. 12

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must ensure that the write-down and conversion of the principal amount is effective on the basis of the law of the resolution authority that has adopted the measure, and that creditors are prevented from filing challenges on the basis of the law of the host jurisdiction (Article 66(4) ad (5)). Along the same lines, it is specified that the “safeguards for partial transfers” (no creditor worse off ) are governed by the law of the member-state of the home resolution authority. The central role of the home authority jurisdiction is further confirmed by the provision that challenges that the measures adopted by the home resolution authority are governed by the law of that home jurisdiction (and have to be filed in that forum). All these elements concur in pointing to one single jurisdiction, the home member-state, as the only competent one to achieve cross-border effectiveness. This to some extent fills (potential) flaws of harmonization with the extended application of the lex fori. It is clear that such architecture has to stay waterproof as gaps may jeopardize the whole cross-border construction. A stepping stone in this direction was a 2016 judgment of the UK Court of Appeal.13 That judgment reversed the ruling of the High Court in Goldman Sachs v. Novo Banco, where the claimant, on the basis of a contractual choice of venue in favor of the English court, tried to be exempted from the jurisdiction of the Portuguese administrative courts in relation to a claim pertaining to the effects of the resolution action adopted by the Bank of Portugal in the context of the resolution of Banco Espirito Santo. The Court of Appeal’s ruling emphasized the relevance of mutual recognition of resolution actions and provided a broad, result-oriented interpretation of reorganization measures, favorable to maximize the effectiveness of cross-border resolution, along the lines of the Court of Justice decision in the Kotnik case.14

CONTRACTUAL RECOGNITION CLAUSES The hurdles of recognition of resolution proceedings may be even higher in the relationship between countries not belonging to regional organizations. Authorities are working on the best legal way to ensure recognition of the effects of resolution actions in such cases. The FSB Key Attributes provide guidance for the judicial or administrative recognition of foreign resolution actions. Admittedly, recognition of extraterritorial effects to the kinds of administrative measures that may also affect the fundamental right to property

England and Wales Court of Appeals (Civil Division) Decisions, November 4, 2016, Guardians of New Zealand Superannuation Fund & Ors v. Novo Banco, S.A., ([2016] EWCA Civ 1092, http://​www​ .bailii​.org/​cgi​-bin/​format​.cgi​?doc​=/​ew/​cases/​EWCA/​Civ/​2016/​1092​.html​&​query​=​([2016])+AND+ (EWCA)+AND+(Civ)+AND+(1092), reversing the High Court decision in Goldman Sachs v. Novo Banco ([2015]) EWHC 2371 (Comm), http://​www​.bailii​.org/​cgi​-bin/​format​.cgi​?doc​=/​ew/​cases /​EWHC/​Comm/​2015/​2371​.html​&​query​=​ (goldman)+AND+(sachs)+AND+(v)+AND+(Novo)+AND+(banco). 14 Court of Justice of the European Union, July 19, 2016, C-526/14, Kotnik and Others, paragraphs 103–114, ECLI:​EU:​C:​2016:​570. 13

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is a new and complex process. By expressly including provisions aimed at this result, legislators have taken a stance in favor of coordination of legal systems. However, the extent of such coordination is still untested. The inclusion of contractual terms is a pragmatic solution to manage the risks of gaps between legal systems. This technique is provided in Article 55 BRRD requiring, for those contracts governed by the law of a third country, the inclusion of a clause whereby the counterparty of the financial institution acknowledges and accepts that the home resolution authority, when conditions are met, may use the bail-in tool and write down and convert the principal amount of the liability.15 Similar clauses have been elaborated by the International Swaps and Derivatives Association, in close cooperation with the FSB, to ensure the contractual recognition of suspension orders adopted by the resolution authority. The goal is ensuring full cross-border effectiveness of such resolution stays and avoiding the triggering of default or cross-default clauses upon the financial counterparty’s entry in resolution. In the current state of development of resolution practice, the use of contractual recognition clauses has the undisputed potential of minimizing legal risks, by confining the legal impact of the resolution action to one single jurisdiction. This does not mean that the home resolution authority may abstain from requesting any kind of support from the authorities in host countries. For instance, it might need supervisory approval for the change in control of a subsidiary in the host jurisdiction or for other supervisory measures. Unlike resolution actions, however, the adoption of measures may not necessarily entail going through a judicial or administrative recognition process, even in a resolution scenario. In those jurisdictions where this is possible, such a combination of contractual recognition clauses and support measures may greatly enhance the chances of cross-border effectiveness of resolution actions.

REFERENCES Binder, Jens-Hinrich. 2015. “Cross-Border Coordination of Bank Resolution in the EU: All Problems Resolved?” European Company and Financial Law Review 13 (4): 575–98. Gardella, Anna. 2015. “Bail-In and the Two Dimensions of Burden-Sharing.” In From Monetary Union to Banking Union on the Way to Capital Markets Union, New Opportunities for European Integration. Frankfurt am Mai: European Central Bank. ———. 2016a. “La risoluzione dei gruppi finanziari cross-border nell’Unione europea.” In Scritti sull’Unione Bancaria, Quaderni di ricerca giuridica di Banca d’Italia, edited by Raffaele d’Ambrosio. n. 83, edited by R. D’Ambrosio, 155–78. Rome: Banca d’Italia. ———. 2016b. “The Court of Appeal Rules in Favor of Mutual Recognition and Rescues Cross-Border Resolution.” Oxford Business Law Blog, November 24, 2016. https://www.law .ox.ac.uk/business-law-blog/blog/2016/11/court-appeal-rules-favor-mutual-recognition-andrescues-cross-border.

The requirements of the contractual term are better specified in the EBA Regulatory Technical Standards endorsed by the Commission Delegated Regulation 2016/1075. 15

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Gordon, Jeffrey N., and Wolf-Georg Ringe. 2014. “Bank Resolution in the European Banking Union: A Transatlantic Perspective on What It Would Take.” Oxford Legal Studies Research Paper 18, New York. Gracie, Andrew. 2015. “TLAC and MREL: From Design to Implementation.” Speech given at British Bankers’ Association Loss-absorbing Capacity Forum, London, July 17, 2015. Grünewald, Seraina N. 2014. The Resolution of Cross-Border Banking Crises in the European Union: A Legal Study from the Perspective of Burden Sharing. London: Kluwer Law International. Hadjiemmanuil, Christos. 2015. “Bank Resolution Financing in the Banking Union.” LSE Legal Studies Working Paper 6/2015, The London School of Economics and Political Science, London. Hüpkes, Eva H. G. 2009. “‘Form Follows Function’—A New Architecture for Regulating and Resolving Global Financial Institutions.’” European Business Organization Law Review 10 (3): 369, 377. ———. 2010. “Rivalry in Resolution. How to Reconcile Local Responsibilities and Global Interests?” European Company and Financial Law Review 7: 216. Lehmann, Matthias. 2016. “Bail-In and Private International Law: How to Make Bank Resolution Measures Effective Across Borders.” International and Comparative Law Quarterly 107. Schillig, Michael. 2016. Resolution and Insolvency of Banks and Financial Institutions. Oxford: Oxford University Press.

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CHAPTER 5

Cross-Border Resolution: Progress and Challenges in Cross-Border Enforcement Ross Leckow and Ender Emre

INTRODUCTION This chapter examines the cross-border resolution framework recommended in the Financial Stability Board’s (FSB’s) Key Attributes of Effective Resolution Regimes for Financial Institutions (“Key Attributes”), particularly focusing on the legal mechanisms for the cross-border effectiveness of resolution decisions. In doing so, it will focus on the cross-border resolution framework for large international banks or groups, which may generally include global systemically important banks (G-SIBs) and global systemically important financial institutions (G-SIFIs), as well as banks or groups that are not designated as G-SIBs or G-SIFIs but that operate in multiple jurisdictions with systemic significance in some of those jurisdictions. The chapter is organized as follows. The first section discusses the three pillars of the cross-border cooperation framework laid out in the Key Attributes and the issues that this framework seeks to resolve. The second section focuses on the legal mechanism to give effect to foreign resolution measures, which is the third pillar of this framework. This analysis is completed, in the third section, by examining the challenges in giving effect to foreign resolution measures, including those based on the experience of IMF staff in their work with member countries. The chapter ends with a brief conclusion.

CROSS-BORDER COOPERATION FRAMEWORK OF THE KEY ATTRIBUTES As a result of financial globalization, many banking groups expanded their geographical remit and the scope of their activities.1 These banking groups have Ross Leckow is currently at the Bank for International Settlements and was previously Deputy General Counsel of the IMF Legal Department. Ender Emre is Counsel of the IMF Legal Department. 1 For a brief account of the emergence of international banking groups and the cross-border arrangements in place before the global financial crisis, see IMF 2010.



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global networks of branches and subsidiaries that span multiple jurisdictions, with systemic significance in some of these countries. Their activities often include nonbank financial intermediation (for example, securities and insurance brokerage). Financial, operational, and reputational interdependencies increased among the group entities, giving rise to the spillover of the effects of an entity’s problems in one jurisdiction to other entities in other jurisdictions, with potential systemic implications. Despite these significant changes, the resolution of banks primarily remained a domestic matter. In many jurisdictions, domestic resolution frameworks lacked effective tools to enable the authorities to resolve a failing bank in a timely manner and differed considerably across jurisdictions. From a cross-border perspective, information sharing and cooperation arrangements between jurisdictions, particularly relevant in handling the failure of complex international banking groups, proved inadequate. Moreover, countries lacked legal mechanisms to give prompt effect to foreign resolution measures. When confronted with the failure of a cross-border banking group, the home and host authorities’ incentives were misaligned. The protection of domestic interests (for example, safeguarding local depositors and creditors, domestic financial stability, and public funds) often prevailed over the option of a globally coordinated solution that could preserve the benefits of international business lines, financial links, and operational dependencies. National authorities had an incentive to prefer unilateral action, although this carried risks and costs, over the uncertain benefits of a proposed global solution (IMF 2014, 5). Against this backdrop, it is not surprising that at the time of the 2008 global financial crisis, the resolution of large international banks was carried out in a disorderly fashion even among close-knit jurisdictions. Uncoordinated actions resulted in costly delays and ultimately involved large bailouts of the financial sector at the expense of taxpayers. For this reason, the international policy community endorsed, through the Key Attributes,2 a new comprehensive framework for cross-border cooperation (FSB 2014). Referencing the resolution of a cross-border bank in particular, this framework seeks to enhance cooperation among jurisdictions based on the following three pillars.

Cooperation Mandate and the Removal of Barriers to Cooperation The Key Attributes recommend that resolution authorities are empowered and strongly encouraged to cooperate with their foreign counterparts. This overarching

2 The Key Attributes were endorsed by the G20 at the Cannes Summit in November 2011 as “a new international standard for resolution regimes.” While the FSB adopted in 2014 some additional guidance in relation to information sharing and sector-specific implementation, no changes were made to the original formulation of Key Attributes.

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principle entails assigning a mandate3 to national resolution authorities to achieve cooperative solutions where possible. To support this principle, the Key Attributes recommend that a national resolution authority, as part of its “statutory objectives and functions,” should duly consider the effect of its resolution actions in other jurisdictions.4 Yet, even where a resolution authority is willing to cooperate with foreign resolution authorities, barriers in the national framework may hinder its efforts. To address this, the Key Attributes call on jurisdictions to eliminate such barriers. These may include impediments to information sharing, the trigger of an automatic action in a jurisdiction when a resolution decision is taken by a foreign authority, discrimination against foreign creditors, and inadequate legal protection for the resolution authority and its staff when enforcing foreign resolution measures (FSB 2016a, Explanatory Note 7[b]).

Ex Ante Cooperation Arrangements for G-SIFIs For G-SIFIs, the Key Attributes recommend establishing crisis management groups (CMGs),5 including the relevant authorities of key jurisdictions. CMGs are also supported by the setup of institution-specific cooperation agreements (COAGs). Because bilateral arrangements among relevant jurisdictions might culminate in a complex web of arrangements that are misaligned and difficult to implement, the Key Attributes contemplate COAGs as multinational arrangements involving the home jurisdiction and all key jurisdictions (FSB 2016a, Annex 2). COAGs would facilitate cooperation through the ex ante commitments of the authorities from all relevant jurisdictions to cooperate in the preparation of recovery and resolution plans, and in the effective implementation of resolution measures.

Cross-Border Enforcement of Resolution Decisions The Key Attributes seek to ensure that countries have transparent and expedited processes to give effect to foreign resolution measures. The following

3 For example, the Dodd-Frank Act requires the Federal Deposit Insurance Corporation to coordinate, to the maximum extent possible, with foreign regulatory authorities regarding the resolution of any failed financial company. In Switzerland, the Financial Market Supervisory Authority is required to coordinate the bank’s bankruptcy proceedings with the competent foreign authorities to the maximum extent possible. In Japan, the Financial Services Agency is empowered to promote international cooperation relating to its functions. However, assigning such an explicit duty is not common among the FSB jurisdictions; when it is provided, there are limitations. For example, under the EU framework, member-states have a duty to cooperate with other ­member-states only, whereas the Federal Deposit Insurance Corporation’s mandate is limited to cases in which resolution is commenced in the United States. 4 Key Attributes 2.2 and 3.9. 5 CMGs are recommended by the Key Attributes 8.1 for G-SIFIs with the objective of enhancing preparedness for, and facilitating the management and resolution of, a cross-border financial crisis affecting the firm. In addition to home authorities, a CMG will include the authorities from jurisdictions host to the entities that are material to the resolution of the group.

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hypothetical example illustrates why having such processes is important for cross-border resolution. After the failure of a large Utopian bank that has a branch in Atlantis, the Utopian resolution authority seeks to implement a bail-in resolution strategy through the write-down of the claims of certain classes of Utopian bank’s creditors, including those booked in the Atlantis branch. In a simplified world, at least the following scenarios seem possible: First, the creditors of the branch may launch proceedings in Atlantis to seek to collect the full amount of their claims. Whether and how the Utopian resolution authority can obtain a stay on the actions commenced by the creditors of the branch in Atlantis may impact the success of its bail-in strategy. Second, the resolution authority in Atlantis may decide that it is not in the interest of its jurisdiction to support the resolution strategy of Utopian authorities, and could rather launch its own separate liquidation proceedings in Atlantis and ring-fence the assets of the branch for the primary satisfaction of local creditors. This will again frustrate, at least in part, the Utopia’s bail-in strategy. Even in a different scenario in which the Utopian bank does not have any physical presence in Atlantis, its orderly resolution may still depend on the effectiveness of Utopian authorities’ decisions in Atlantis. This could be the case when the financial contracts entered into by the Utopian bank are governed by the law of Atlantis. In this situation, the effectiveness of the Utopian authorities’ decision to bail in the liabilities under these contracts would depend on the recognition or support of this measure by the Atlantis authorities. As illustrated previously, the home resolution authorities’ decisions are effective within their territory. Their decisions do not automatically allow them to assume the control over the bank’s entities or assets in other jurisdictions or to take other resolution measures affecting liabilities governed by the law of those jurisdictions. Addressing this problem is critical in the case of large international banks because these typically operate in multiple jurisdictions6 through a complex web of branches and subsidiaries and have assets and liabilities subject to the laws of different jurisdictions. For this reason, the Key Attributes call for jurisdictions to ensure that their legal frameworks have expedited processes through which a resolution measure taken by a foreign resolution authority can be given legal effect by the host country.

CROSS-BORDER ENFORCEMENT MECHANISM UNDER THE KEY ATTRIBUTES As one of the building blocks of the Key Attributes’ cross-border cooperation framework, enforcement of foreign resolution measures presents certain specific features. This section will discuss the general approach adopted and legal mechanisms suggested by the Key Attributes in order to facilitate and encourage giving effect to such foreign measures. 6

For example, Lehman Brothers Holdings operated in 50 countries with 2,985 subsidiaries.

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Key Attributes’ Approach to Cross-Border Enforcement In the resolution of a cross-border bank, three different approaches are, in principle, conceivable.7 At one end of the spectrum of possible approaches, under a territorial approach, the host jurisdiction commences a local liquidation or resolution proceeding over the establishment located in its territory.8 For example, in the United States, the liquidation of the branches of foreign banks is carried out territorially. In the European Union/European Economic Area (EEA), ­member-states can adopt this approach in relation to the insolvency of the branches of non-EU/EEA banks. At the other extreme, under the universal approach a cross-border bank is treated as a single entity and its resolution is conducted under a single resolution proceeding in the home jurisdiction. For example, the US bank liquidation framework purports to cover all foreign branches of the liquidated bank. The liquidation or restructuring of a Swiss bank covers all the assets and liabilities of the bank wherever they are located. The EU/EEA Winding Up Directive adopts a universal approach in that the liquidation or reorganization decisions of a member-state are given automatic and mutual recognition in other member-states in which the credit institution has branches. The universal approach does not apply to subsidiaries; it is mostly relevant only when a large international bank operates as a single global entity through branches (Hupkes 2010). However, the corporate structure of international banks is a complex web of branches and subsidiaries; therefore, neither the universalist nor the territorial approaches are fully adequate to tackle the challenges arising from the resolution of these banks. In addition, the universality principle is based on the prerequisite of a degree of harmonization that can facilitate the recognition of home authorities’ decisions in other jurisdictions. Between the territorial and universalist models lies the middle ground approach, by which the home resolution authority takes the lead in resolving the bank, and other jurisdictions are encouraged to cooperate with the home authority but retain the discretion not to do so if necessary to protect domestic interests. This middle ground approach is enshrined in the Key Attributes and reflects the earlier work undertaken by the Basel Committee and the IMF in the wake of the global financial crisis. 7 These approaches are more relevant for the treatment of foreign branches of a cross-border bank, rather than for such a bank’s foreign subsidiaries. Subsidiaries are in any event subject to local insolvency proceedings due to their separate legal personality governed by the place of incorporation. 8 This approach does not constitute a discriminatory action per se. Some jurisdictions may, under their legal framework, distribute the assets to all creditors of the branch, irrespective of their residence, domicile, nationality, or other factors. However, the legal provisions of other jurisdictions would focus on the identity of the creditors (for example, by giving priority to the residents) to ensure that the liquidation procedure ultimately benefits local interests. Because the effectiveness of the territorial approach relies on the existence of a sufficient amount of assets within the reach of the domestic authorities, it may be supported by supervisory rules requiring the branch to maintain sufficient local assets relative to their local liabilities.

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The Basel Committee’s Cross-Border Resolution Group notes that the discussions on territoriality and universality are theoretical (Bank for International Settlements 2010). A realistic approach is one that not only recognizes the possibility of ring-fencing in a crisis but also seeks to ensure that national frameworks improve the ability of home and host authorities to facilitate the continuity of critical cross-border operations. This model requires greater convergence in national laws, which would likely improve cooperation by promoting a common understanding, predictability, and reliability. Shortly after the Cross-Border Resolution Group’s report (Bank for International Settlements 2010), the IMF proposed9 a middle ground approach built on an enhanced coordination framework. This approach is based on the premise that adherence by jurisdictions to certain core standards would instill confidence in their willingness and capacity to cooperate while maintaining discretion to take independent action when necessary to protect national interests. These core coordination standards include, among others, a minimum level of harmonization of national frameworks on nondiscrimination against foreign creditors, effective resolution powers, and appropriate creditor safeguards. In line with the Basel Committee and IMF proposals, the Key Attributes’ middle ground approach relies on the convergence of national frameworks toward effective resolution standards and on enhanced cooperation among national authorities, through, ex ante, formal arrangements. Finally, it requires that jurisdictions have legal mechanisms in place to give effect to the decisions of foreign authorities while retaining discretion to observe their national interests.

Legal Mechanisms for Cross-Border Enforcement The Key Attributes contemplate two legal mechanisms that establish “transparent” and “expedited” processes to give effect to foreign resolution measures through recognition and support. These are statutory mechanisms rather than purely contractual mechanisms.10

Recognition Recognition implies that “a jurisdiction would accept the commencement of a foreign resolution proceeding domestically and thereby empower the relevant domestic authority (either a court or an administrative agency) to enforce the foreign resolution measure or grant other forms of domestic relief, for example, a stay on domestic creditor proceedings” (FSB 2016a, Explanatory Note 7[e]). Recognition, as a cross-border enforcement mechanism, has distinctive features that can be usefully deployed in a cross-border resolution context (FSB 2014, 5). It is not provisional on the initiation of domestic resolution proceedings or the exercise of resolution powers under the domestic law. Thus it can

9

See IMF 2010, footnote 1, for further information. For a discussion of contractual approaches, see the “Challenges in Implementation” section.

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be used to give effect to foreign measures even if the conditions for resolution over the local entity are not met. Also, foreign authorities may seek recognition from the jurisdictions in which the bank under resolution does not have any physical ­presence, especially in cases when the relevant bank’s assets are located in, or its liabilities are governed by, such a jurisdiction. The legal effects of recognition will be determined by domestic law. For example, in Hong Kong Special Administrative Region and the United Kingdom, a recognized foreign measure has substantially the same legal effect as it would have if it were made under the laws of these jurisdictions.11 The Bank Recovery and Resolution Directive (BRRD) in the European Union, on the other hand, does not include a specific provision to prescribe the effect of recognition.12 Because jurisdictional approaches may differ, a clear understanding on the legal effects of recognition between the home and host authorities is essential during the resolution planning stage. From a procedural perspective, recognition can be granted by administrative authorities (for example, France, Germany, Hong Kong Special Administrative Region, Italy, Spain, Sweden, Switzerland, and United Kingdom) or by courts (for example, Australia, Canada, India, Japan, Mexico, South Africa, and United States). Court-based proceedings may be provided in a corporate insolvency regime that is also applicable to banks or under a special recognition framework in the bank resolution law.

Support In contrast to recognition, the concept of support envisages host resolution authorities giving effect to foreign resolution measures by taking supervisory or resolution measures under their domestic law. These measures aim to achieve in the domestic legal system outcomes that are consistent with the foreign resolution actions (FSB 2016a, Essential Criteria 7.4). Because it relies on the exercise of domestic authorities’ supervisory and resolution powers, this mechanism can apply only in jurisdictions in which the bank under resolution has a regulated presence (for example, branch, subsidiary, or listed securities). Supporting a foreign resolution action can take different forms. Support can be provided to foreign authorities through the exercise of domestic resolution powers. For example, the host resolution authority can exercise its powers to transfer local assets and liabilities to a private purchaser or bridge bank, or impose a stay on legal actions brought by local creditors, in the context of a resolution measure taken by the home authorities and to support its outcome. This form of support can apply only under certain circumstances (FSB 2015, 6). First, resolution powers under the domestic framework can in principle be exercised only for an entity that meets resolution conditions. Second, the ability of host authorities to support foreign actions relies on the existence in the national The United Kingdom’s Banking Act 2009, sec. 89I, and Hong Kong Special Administrative Region’s Financial Institutions (Resolution) Ordinance, sec. 188. 12 BRRD, art. 94(4). 11

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framework of appropriate powers. In the absence of powers that are necessary to support a foreign measure (for example, transfer powers), this form of enforcement would not work. The exercise of supervisory powers under the domestic law can also support a foreign action in certain cases. For example, it could be expressed through the supervisory approval (FSB 2015, 6) of management or ownership changes in the local entity, arising from the home country’s resolution measures, or through exemptions from the application of certain regulatory requirements that might be triggered by such measures (for example, market disclosure requirements for bail-in). Support to foreign resolution authorities could additionally take the form of forbearance from taking domestic action.13 In particular, host jurisdictions can support a single point of entry (SPOE) strategy by exercising their discretion not to take any action when the home country’s resolution authority adopts a resolution measure over the parent bank. Yet, limitations on this form of support exist, too. In ­particular, domestic insolvency frameworks may still allow creditors to initiate insolvency procedures themselves. Hence, even if the supervisory and resolution authorities refrain from taking an action against the bank to support the SPOE strategy, their efforts to support the home resolution strategy may be undermined by actions taken by creditors in the host jurisdiction.

Key Features of Cross-Border Enforcement Mechanisms Recognition and support are not mutually exclusive, but rather complementary (FSB 2016a, Explanatory Note 7[e]). They may be used on a stand-alone basis or in combination, depending on the circumstances. At the same time, the Key Attributes prescribe a common set of recommendations and safeguards for both recognition and support. First, the processes by which jurisdictions give effect to foreign measures should be expedited so they can be completed quickly. Second, cross-border enforcement mechanisms in a jurisdiction should be transparent. This entails having in place ex ante mechanisms that are readily accessible by stakeholders and sufficiently predictable in terms of their conditions and outcomes: well-designed statutory regimes for recognition and support may fit these requirements. Moreover, in several jurisdictions, administrative cross-border enforcement processes may provide greater speed compared to court-based processes. Consistent with the middle ground approach, giving effect to foreign measures is subject to conditions. While there are some exceptions, jurisdictions would rarely provide for the automatic and mutual recognition of resolution measures.14

Key Attribute 7.2 requires that resolution or insolvency in a jurisdiction should not be triggered automatically as a result of a resolution or insolvency action taken in another jurisdiction. Rather, domestic action should be discretionary. 14 For instance, the EU’s Winding-Up and Reorganization Directive contemplates automatic and mutual recognition of a member-state’s resolution decision within the EU/EEA. 13

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Under the Key Attributes, host countries could decline to enforce a foreign resolution measure if that would (1) have adverse effects on domestic financial stability, (2) have material fiscal implications, (3) contravene their public policy, or (4) result in the inequitable treatment of local creditors (FSB 2016a, Explanatory Note 7[g]). However, the formulation of these conditions and the limits of the domestic authorities’ discretion not to enforce foreign measures may differ across jurisdictions. For example, the enforcement of foreign measures under the Key Attributes is provisional on the “equitable treatment” of domestic creditors in foreign proceedings, but there is no universal understanding of the meaning of this concept or how it applies. For example, the concept of equitable treatment may be germane to certain common law countries, whereas civil law countries would focus more on the “equal” treatment of creditors.15 Similarly, it is not clear whether a high threshold should apply to the “public policy” test in a resolution context.16 A clear understanding of these differences and their impact on cross-border enforcement is necessary as part of adequate resolution planning.

CHALLENGES IN IMPLEMENTATION The implementation of the framework envisaged in the Key Attributes, examined previously, gives rise to a number of challenges. First, having effective cross-border enforcement processes often requires legislative reforms, which have yet to be undertaken in many jurisdictions. Some jurisdictions—for example, the European Union (through the BRRD and the Single Resolution Mechanism Regulation), Singapore, and Switzerland—have made progress in adopting statutory frameworks for the recognition of foreign resolution measures (FSB 2014, 17). However, such statutory frameworks are missing in many other countries, including some FSB members. The establishment of adequate statutory processes for recognition and support appears to be a long-term goal. In the interim, jurisdictions can employ different strategies for the swift cross-border enforcement of resolution decisions. These are based on contractual approaches and the implementation of an SPOE strategy. The contractual approach is based upon the principle that courts in most countries will recognize and enforce a foreign resolution measure if the parties to the relevant contract have agreed to be bound by the laws of that foreign jurisdiction. This approach may in particular be useful in achieving an extra-territorial effect in two cases: (1) while temporarily staying early termination rights (including as a result of BRRD, art. 95. Under private international law and cross-border insolvency frameworks, the “public policy” test sets a high bar, such as contraventions to fundamental principles of law, for the denial of recognition. Please see the Hague Convention on Recognition and Enforcement of Foreign Judgments on Civil and Commercial Matters and the UNCITRAL Model Law on Cross-Border Insolvency. In contrast, when prescribing the grounds for the refusal of enforcement, the BRRD refers to contravention to “local law,” a notion that may be broader than “public policy” (art. 95[e]). 15 16

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cross-defaults) in financial contracts that are subject to a foreign law; and (2) when subjecting liabilities governed by a foreign law to bail-in. While this approach relies on parties voluntarily agreeing to such provisions, legal frameworks can also empower resolution authorities to require banks to include clauses increasing cross-border enforceability of their resolution actions.17 Important steps have been taken to implement the contractual approach, particularly by the International Swap Dealers Association, in cooperation with the FSB. “ISDA’s “Resolution Stay Protocol” enables parties to amend their master agreements in order to contractually recognize the cross-border effect of temporary stays imposed under the resolution regime applicable to their counterparty or to this counterparty’s certain affiliates, irrespective of the law governing these agreements. However, the contractual approach is not a perfect substitute for effective cross-border enforcement frameworks enshrined in law (FSB 2014, 11). Although statutory regimes can play a role in encouraging or even requiring contractual arrangements, the effectiveness of this approach is limited by the willingness of market participants to use it. To improve resolvability and prevent the different treatment of similarly situated creditors, the contractual solution needs to be adopted by a firm and its counterparties in relation to all relevant cross-border contracts, including nonstandard contracts. Contractual approaches are generally relevant for a limited set of resolution actions, that is, temporary stays on early termination rights and bail-in. Even in the case of bail-in, certain aspects of a bail-in tool (for example, suspension of trading and automatic cancellation of shares) cannot be implemented only through contractual clauses. When firms are required to incorporate recognition clauses into their contracts, this would apply only prospectively, which means that such clauses are not applicable to the existing arrangements, unless these are modified. The need for cross-border recognition frameworks may be lower when an SPOE strategy is pursued because, in this case, resolution powers are applied only to the parent or holding company at the top of the group (FSB 2013). However, the SPOE may not always be the strategy adopted by the authorities; this will depend on many factors, such as the group structure of the institution under resolution. Also, even when it is adopted, some forms of recognition measures in the host countries may still be needed, such as preventing the counterparties of the local subsidiaries from exercising their early termination rights arising under cross-default clauses. The second challenge relates to jurisdictional discrepancies. Greater harmonization is needed between national resolution regimes. The FSB has called for countries to achieve greater harmonization by fully ­implementing the Key Attributes. Yet the FSB has noted that only a subset of its members has a resolution regime containing the comprehensive powers recommended by the Key Attributes (FSB 2016b, 10). In addition, many non-FSB members do not have resolution frameworks aligned with the Key Attributes. To enhance the ability of jurisdictions to enforce foreign resolution measures, For example, under the BRRD, art. 55, member-states should impose a requirement on banks to insert such recognition clauses in the contracts that creates a liability eligible for bail-in and governed by the law of a third country. A similar provision was introduced recently to the BRRD for the contractual recognition of resolution stays (art. 71a). 17

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Chapter 5  Cross-Border Resolution: Progress and Challenges in Cross-Border Enforcement

convergence on a number of important features of domestic resolution regimes— including triggers, resolution powers, and safeguards—would be needed.18 With respect to triggers for the initiation of resolution proceedings, significant differences persist among jurisdictions. These substantial divergences may impede coordinated actions in resolving a cross-border bank (FSB 2016b, 22). The degree of alignment across jurisdictions regarding resolution powers may have implications for cross-border enforcement. Even when countries have effective cross-border enforcement frameworks, a jurisdiction may be reluctant to recognize a foreign resolution measure that does not exist within its own legal framework. In addition, the host authorities’ abilities to support a foreign action may be limited to the powers available under the domestic regime. A host authority that lacks bail-in powers cannot support the home authority by writing down the liabilities of the branch in its jurisdiction. Hence, the existence of divergent powers of the home and host authorities may lead to suboptimal and inefficient outcomes in a cross-border resolution (FSB 2015, 6). Alignment with the Key Attributes’ standards on safeguards is critical. Without such safeguards (that is, the equal treatment rule, “no creditor worse off than in liquidation” safeguard, and the protection of set-off and netting rights) in the home jurisdiction, there is a heightened risk that the host authorities will not give effect to the foreign measure on the grounds that it contravenes their public policy or the equitable treatment rule. This issue also affects contractual approaches. Under the International Swap Dealers Association Protocol, only a resolution measure taken under a resolution framework providing certain safeguards (notably, “no creditor worse off than in liquidation” and no cherry-picking) may benefit from a contractual recognition clause (FSB 2014, Annex II). In that regard, convergence to the Key Attributes’ safeguards would increase the usefulness of contractual approaches for cross-border enforcement. The third challenge concerns incentives. Adequate incentives need to be in place for jurisdictions to cooperate. Many factors and misincentives can discourage cooperation. Differences in creditor hierarchies between jurisdictions can hinder the cross-border effectiveness of a resolution measure (IMF 2014, 13 et seq). Creditor hierarchy determines how losses would be allocated upon failure of a bank. Significant differences in the creditor hierarchy rules of the home and host jurisdictions, including with respect to the ranking of insured deposits, could mean that the host creditors would receive less in the home proceeding compared to the treatment they would have if a separate proceeding were to be commenced in the host country. In such cases, the host authority may decline to give effect to foreign measures and launch a separate resolution or liquidation proceedings against the branch operating in its jurisdiction. Moreover, material divergences in the hierarchy of claims may even give rise to a public policy consideration in some jurisdictions. Unfortunately, except for limited harmonization within the European See also recital 102 of the BRRD: “Cooperation will be facilitated if the resolution regimes of third countries are based on common principles and approaches that are being developed by the Financial Stability Board and the G20.” 18

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Union on the ranking of covered and eligible deposits,19 as well as senior unsecured debt instruments, there is no uniform approach across jurisdictions on creditor hierarchy. The Key Attributes do not provide any guidance on this issue either. In the case of subsidiaries, the host authorities’ incentive to cooperate would be shaped by the availability of sufficient loss-absorbing capacity at the parent bank or holding company level. Host authorities would also seek assurances that resources generated through bail-in at the parent bank can be downstreamed to local subsidiaries for capital and liquidity (FSB 2013, 15).20 Internal total loss-absorbing capacity requirements may give to the host authorities the necessary comfort that, if needed, they will have capacity to resolve subsidiaries on an ongoing basis without disruption to domestic financial stability or taxpayers’ expense. Therefore, the design of appropriate amount and location of these requirements could align the incentives of home and host authorities (IMF 2014). The resolution planning process is an important forum through which obstacles to cooperation can be identified and incentives aligned. Fourth, the effective implementation of cross-border cooperation frameworks will depend, to some degree, on how courts will interpret them at the national level. Courts can be involved in giving effect to foreign resolution measures in different ways. Courts can be the competent authorities to adjudicate on recognition requests made by foreign authorities. In the case of support, the host resolution authority’s decision may be subject to a court approval (for example, imposing a stay on creditor actions), as envisaged by the national resolution framework. Moreover, when the recognition framework for the enforcement of foreign measure is led by an administrative authority, interested parties may apply to courts for the judicial review of the authorities’ enforcement decisions or simply for the collection of their claims by seeking to set aside the legal effect of a foreign measure. Given the significant role played by courts, it is therefore not surprising that the effectiveness of a cross-border enforcement framework will depend on the approaches that courts take. Initial experience with the courts’ interpretation of the BRRD demonstrates the challenges in this respect, even in the context of a framework that envisages automatic recognition.21 In addition, when the power to grant recognition or approve a supportive measure lies with the courts, home resolution authorities will still need to engage during BRRD, art. 108. To that end, they would need to be assured that the intragroup exposure limits, concentration rules, or set-off rules applied to the parent company would not prevent such flow. 21 In Goldman Sachs International v. Novo Banco S.A., the UK court had to decide whether the Portuguese authorities’ two decisions transferring the liabilities from the resolved bank to a bridge bank under the national law transposing the BRRD were effective in the United Kingdom, which was the governing jurisdiction under the relevant contracts. While the outcome of the judicial process was ultimately in favor of the recognition, the process indicated that the matter of recognition in a bank resolution context raises highly difficult questions to resolve. In Bayerische Landesbank v. Heta Asset Resolution, the German court decided that the Austrian authorities’ decision to impose a moratorium and restructure the liabilities of an asset management company was not effective in Germany. 19 20

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Chapter 5  Cross-Border Resolution: Progress and Challenges in Cross-Border Enforcement

the resolution planning phase with their foreign administrative counterparties in the host jurisdiction, seeking to identify legal impediments to recognition or support. The involvement of different authorities in planning and implementation stages may add a degree of uncertainty as to the extent which the desired outcomes in the resolution plans can be achieved in practice. Fifth, the limits of cooperation and the extent to which cooperation can meet the needs of all affected jurisdictions must be recognized. The resolution strategies being developed for G-SIFIs in CMGs include authorities from home authority and key host jurisdictions. Key host jurisdictions will be determined by the home authority based on the significant or critical operations of the G-SIB, including its material operating entities or the holding company.22 It is possible that the CMGs would not include authorities from smaller jurisdictions, such as low-income countries, where the bank has a presence, including through operations systemically important for that jurisdiction but that are not material for the resolution of group. Whereas the FSB has developed guidance for cooperation and information sharing between CMGs and non-CMG host authorities in jurisdictions where a G-SIFI has a systemic presence, there could still be cases in which the interests of the CMG and non-CMG members are not aligned. In these circumstances, the incentives for such non-CMG jurisdictions to protect their domestic interests by ring-fencing local operations may be higher (IMF 2014, 23). This demonstrates the challenges of cooperation, particularly when a global bank is active in dozens of jurisdictions.

CONCLUSION The Key Attributes represent a major achievement in enhancing cooperation in cross-border resolution. A key component of this enhanced cooperation framework is the establishment of expedited and transparent recognition and support mechanisms to give effect to foreign resolution measures. These mechanisms reflect a middle ground approach in which the host authorities are encouraged to defer to the home authority while retaining discretion to take a different action when this is necessary to protect their national interests. However, a great deal of work remains to be done to implement cross-border enforcement mechanisms suggested by the Key Attributes. Legislative reforms to establish these mechanisms and greater harmonization of national resolution regimes are essential. The successful implementation of these legal mechanisms also depends on the existence of adequate incentives for the authorities to cooperate and on the predictability of courts’ role in cross-border resolution. Through its lending, surveillance, and technical assistance activity, the IMF is uniquely positioned to promote adherence to the Key Attributes’ cross-border resolution framework by its members, accounting for the characteristics of their The home authority will consider various factors, such as the size of the group’s activities in the host jurisdiction and the impact of those activities on the continuity of the group’s global operations (FSB 2016a, Explanatory Note 8[a]). 22

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financial systems. Given the challenges ahead, the IMF is deeply committed to working with its members and the FSB to identify the legal impediments to cross-border resolution and to develop solutions to address them.

REFERENCES Bank for International Settlements (BIS). 2010. Report and Recommendations of the Cross-border Bank Resolution Group. Basel, Switzerland. https:/​/​www​​.bis​​.org/​publ/​bcbs169​​.pdf. Financial Stability Board (FSB). 2013. Recovery and Resolution Planning for Systemically Important Financial Institutions: Guidance on Developing Effective Resolution Strategies. Basel, Switzerland. http:/​/​www​​.fsb​​.org/​wp​​-content/​uploads/​r​​_130716b​​.pdf​​?page​​_moved​​=​​1. ———. 2014. “Key Attributes of Effective Resolution Regimes for Financial Institutions.” Basil, Switzerland. https://www.fsb.org/work-of-the-fsb/policy-development/effective-resolution-regimes-and-policies/key-attributes-of-effective-resolution-regimes-for-financialinstitutions/. ———. 2015. Principles for Cross-Border Effectiveness of Resolution Actions. Basel, Switzerland. http:/​/ ​w ww​​. fsb​​. org/​w p​​- content/​u ploads/​Principles​​- for​​- Cross​​-border​​- Effectiveness​​- of​​ -Resolution​​-Actions​​.pdf. ———. 2016a. Key Attributes Assessment Methodology for the Banking Sector: Methodology for Assessing the Implementation of the Key Attributes of Effective Resolution Regimes for Financial Institutions in the Banking Sector. Basel, Switzerland. https:/​/​www​​.fsb​​.org/​wp​​-content/​ uploads/​Key​​-Attributes​​-Assessment​​-Methodology​​-for​​-the​​-Banking​​-Sector​​.pdf. ———. 2016b. Second Thematic Review on Resolution Regimes: Peer Review Report. Basel, Switzerland. https:/​/​www​​.fsb​​.org/​wp​​-content/​uploads/​Second​​-peer​​-review​​-report​​-on​​ -resolution​​-regimes​​.pdf. Hüpkes, Eva. 2010. “Rivalry in Resolution—How to Reconcile Local Responsibilities and Global Interests.” European Company and Financial Law Review 7 (2): 210-39. International Monetary Fund (IMF). 2010. Resolution of Cross-Border Banks: A Proposed Framework for Enhanced Coordination. Washington, DC. https:/​/​www​​.imf​​.org/​external/​np/​ pp/​eng/​2010/​061110​​.pdf. ———. 2014. Cross-Border Bank Resolution: Recent Developments. Washington, DC. https:/​/​ www​​.imf​​.org/​external/​np/​pp/​eng/​2014/​060214​​.pdf.

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CHAPTER 6

Cross-Border Resolution: A Global Solution to a Global Problem Eva H. G. Hüpkes INTRODUCTION After the financial crisis of 2007–09, the G20 and the Financial Stability Board (FSB) undertook to put in place a global framework for regulating and resolving global financial institutions (FSB 2010b). The development of common crisis management and resolution policies by authorities from the home and key host jurisdictions of globally active financial institutions was a sea change from the precrisis world. In 2011, the FSB adopted an international minimum standard for resolution (“The Key Attributes of Effective Resolution Regimes for Financial Institutions,” hereinafter “Key Attributes”) that sets out the core elements of an effective resolution framework (FSB 2011a).1 It identifies the powers and tools that should be available to authorities to resolve failing financial institutions in a manner that maintains the continuity of the vital economic functions that those firms perform for the financial system and the economy as a whole. The underlying premise is that losses should be absorbed by the firm’s owners and creditors, not taxpayers. In subsequent years, the FSB developed further guidance to assist jurisdictions and authorities in implementing the Key Attributes.2 A centerpiece is the Eva H. G. Hüpkes is Acting Head of Regulatory and Supervisory Policies at the Financial Stability Board (FSB). The views expressed are those of the author and do not necessarily reflect the views of the FSB or its members. 1 The 2014 document of the Key Attributes contains additional sector-specific guidance for insurers, financial market infrastructures, and the protection of client assets in resolution. 2 Including “Guidance on Recovery Triggers and Stress Scenarios,” July 2013; “Guidance on Identification of Critical Functions and Critical Shared Services,” July 2013; “Guidance on Developing Effective Resolution Strategies,” July 2013; “Guidance on Cooperation and Information Sharing with Host Authorities of Jurisdictions where a G-SIFI has a Systemic Presence that is Not Represented on its CMG,” November 2015; “Principles for Cross-border Effectiveness of Resolution Actions,” November 2015; “Guiding Principles on the Temporary Funding Needed to Support the Orderly Resolution of a Global Systemically Important Bank (“G-SIB”),” August 2016; “Guidance on Arrangements to Support Operational Continuity in Resolution,” August 2016; “Guiding Principles on the Internal Total Loss-Absorbing Capacity of G-SIBs (‘Internal TLAC’),” July 2017; “Guidance on Continuity of Access to Financial Market Infrastructures (FMIs) for a Firm in Resolution,” July 2017; “Principles on Bail-in Execution,” 2018; and “Funding Strategy Elements of an Implementable Resolution Plan,” 2018.



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requirement for minimum loss-absorbing capacity (FSB 2015e). All global systemically important banks (G-SIBs)3 should have in place at all times this minimum of financial resources so that a resolution can be implemented in a manner that ensures the continuity of critical functions and without exposing public funds to loss. This chapter offers some reflections on the paradigm shift that occurred with the introduction of special resolution regimes and resolution planning for the largest financial institutions and on the progress made toward resolving the cross-jurisdictional challenges that arise when a globally systemic financial institution fails. The first part of this chapter discusses the features of resolution regimes that distinguish them from ordinary court-based corporate bankruptcy. It focuses in particular on bail-in powers and the FSB’s total loss-absorbing capacity (TLAC) standard that seeks to ensure that a sufficient amount of resources remains available to be “bailed-in” in resolution. The second part of this chapter focuses on the cross-border dimensions of resolution. It discusses how the Key Attributes and TLAC seek to reconcile the interests of both home and host jurisdictions in preserving financial stability and the continuity of critical functions in their respective jurisdictions and minimize the risk of costly defensive ring-fencing along jurisdictional borders. The chapter concludes by discussing how the focus on resolvability and the introduction of resolution regimes with bail-in powers are leading to changes over time in firms’ legal and operational structures and business models and in the authorities’ approaches to their regulation and supervision.

RESOLUTION: THE PARADIGM SHIFT Financial institutions are special because they perform a number of vital economic functions.4 If the institution that performs such functions is large, even a 3 In November 2011, the FSB published an integrated set of policy measures to address the systemic and moral hazard risks associated with systemically important financial institutions (SIFIs). See FSB 2011b. In that publication, the FSB identified as global systemically important financial institutions (G-SIFIs) an initial group of G-SIBs, using a methodology developed by the Basel Committee on Banking Supervision. The list is updated annually based on new data and published by the FSB each November. In 2016, 30 banks were identified as G-SIBs as part of the annual identification process of G-SIFIs. See FSB 2017c. 4 The FSB defines these functions as “critical functions,” that is, “activities performed for third parties where failure would lead to the disruption of services that are vital for the functioning of the real economy and for financial stability due to the banking group’s size or market share, external and internal interconnectedness, complexity and cross-border activities. Examples include payments, custody, certain lending and deposit-taking activities in the commercial or retail sector, clearing and settling, limited segments of wholesale markets, market-making in certain securities and highly concentrated specialist lending sectors.” See “Recovery and Resolution Planning for Systemically Important Financial Institutions: Guidance on Identification of Critical Functions and Critical Shared Services,” July 16, 2013. Functions that may be deemed critical include functions, such as credit extension, continued access to demand deposits, the provision of facilities for trading securities and for taking positions or hedging, and infrastructure-like functions, such as custody, clearing, settlement, and payment processing services.

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Chapter 6  Cross-Border Resolution: A Global Solution to a Global Problem

temporary suspension of any of these functions could seriously disrupt economic activity. A primary objective of resolution is therefore to maintain the continuity of critical functions for the financial system, minimizing contagion and containing the social costs associated with financial panic.5 As a result, resolution differs fundamentally from standard bankruptcy processes.

Bankruptcy versus Resolution Corporate bankruptcy procedures are primarily aimed at protecting individual stakeholders’ interests and seek to maximize value for individual creditors. These procedures are not designed to take account of externalities and the costs that the failure of a financial institution could impose on the broader economy. And they are not well suited for dealing with financial failures (Hüpkes 2005a, 2005b). Typical corporate bankruptcy procedures result in stays that block creditors’ access to funds. Financial institutions, if subject to stays, are not able to conduct financial transactions, and market participants are not able to make and receive payments or engage in hedging strategies. The lengthy process of initiating a bankruptcy process, negotiating a reorganization or liquidation plan, and obtaining court approval is lethal for a financial institution whose life or death depends on the trust of financial markets. Just as regulation needs to have a macroprudential dimension,6 failure resolution needs to take into account systemic considerations. Ordinary bankruptcy actions may be optimal from the perspective of maximizing the residual value of the firm for all of the firm’s stakeholders. However, bankruptcy judges do not typically have a mandate to consider the structural economic effects of their decisions and any unintended and possibly adverse systemic consequences. They also cannot coordinate their actions with foreign regulatory authorities given their need to retain full independence.

Bail-In versus Bail-Out Bail-in is core to the new resolution paradigm. The term “bail-in” is generally used to refer to shareholders and creditors bearing a bank’s losses, as opposed to “bail-out,” which refers to absorption of private creditors’ losses with public money. Under the FSB Key Attributes, bail-in is more narrowly defined and refers 5 At the Toronto Summit in June 2010, the G20 leaders agreed that resolution regimes should provide for “continuity of critical financial services, including uninterrupted service for insured depositors.” See also the FSB interim report: “All jurisdictions should have effective resolution tools that enable the authorities to resolve financial firms without systemic disruptions and without taxpayer losses. These should include powers that facilitate a “going concern” capital and liability restructuring as well as “gone concern” restructuring and wind-down measures, including the establishment of a temporary bridge bank to take over and continue operating certain essential functions.” 6 The G20 recommended that “national financial regulatory frameworks should be reinforced with a macro-prudential overlay that promotes a system-wide approach to financial regulation and oversight and mitigates the buildup of excess risks across the system.” “G20 Working Group on Enhancing Sound Regulation and Strengthening Transparency – Final Report,” March 6, 2009.

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to the power to “write down equity or other instruments of ownership of the firm, unsecured and uninsured creditor claims to the extent necessary to absorb the losses; and to convert into equity or other instruments of ownership of the firm under resolution (or any successor in resolution or the parent company within the same jurisdiction), all or parts of unsecured and uninsured creditor claims in a manner that respects the hierarchy of claims in liquidation.”7 A debt-to-equity conversion can provide creditors with an upward potential if the bank survives and its value recovers. It also supports a recapitalization and reduces the need to find a new buyer or investor.

Operating Liabilities versus Capital Structure Liabilities Resolution distinguishes between operating liabilities—demand deposits, client money, short-term funding, and financial contract liabilities that are directly linked to the bank’s provision of critical functions—and capital structure liabilities—liabilities linked to the bank’s capital structure, such as long-term unsecured debt. The objective of resolution is to ensure to the extent possible that operating liabilities are not compromised and to rely on capital structure liabilities to achieve a creditor-financed recapitalization that supports the continued performance of critical functions. A crucial consideration in resolution and resolution planning is therefore the availability of sufficient amounts of bail-inable capital structure liabilities. If upon failure of a G-SIB, resolution becomes inevitable, the firm’s equity and capital structure bailout should be first in line to absorb losses. They should be bailed-in before any of the operational liabilities are exposed to loss.8

A COMPREHENSIVE RESOLUTION TOOLKIT Key Attributes The FSB’s Key Attributes set out a range of other powers that resolution authorities should have that may be applied in addition to or instead of bail-in. They distinguish between stabilization or continuity powers and wind-down powers. Stabilization powers are aimed at achieving continuity and include powers to: • Replace the senior management and directors and appoint an administrator to take control and operate the firm in resolution; • Establish a temporary bridge institution to take over and continue operating certain critical functions and viable operations of the failed firm or transfer the operations, including assets and liabilities, legal rights and obligations, Key Attribute 3.5. This requires capital structure liabilities to rank junior to operational liabilities in the creditor hierarchy (or conversely operating liabilities to be senior to the capital structure liabilities). See the section titled “Subordination requirement.” 7 8

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deposit liabilities, and ownership in shares, to a solvent third party, notwithstanding any requirements for consent from shareholders or counterparties, or novation that would otherwise apply; and • Temporarily stay the exercise of contractual early termination rights that would otherwise be triggered upon entry of a firm into resolution in order to facilitate the implementation of resolution measures aimed at achieving continuity, such as the transfer of the contracts to another firm or bridge institution.9 Wind-down powers include, in particular, powers to: • Liquidate those parts of the firm’s business whose continued operation is no longer systemically important or critical; • Suspend payments to unsecured creditors and customers and stay creditor actions to attach assets or otherwise collect money or property from the firm (while protecting the enforceability of eligible netting and collateral agreements);10 • Protect insured depositors, insurance policyholders, and other retail customers by facilitating a timely payout or the transfer of insured deposit and client assets.

The TLAC Standard A Requirement for Loss-Absorbing Resources in Resolution The FSB’s TLAC Standard implements the general premise that there must be sufficient resources for bail-in available on the firm’s balance sheet to achieve a recapitalization or orderly (solvent) wind-down of operations (FSB 2015e). The standard is composed of a set of principles and of a term sheet that elaborates the principles. The TLAC term sheet stipulates a minimum TLAC requirement for G-SIBs11 and specifies the types of instrument that are eligible to serve as TLAC as well as those that are not.12 TLAC-eligible instruments include common equity (that is, equity capital, retained earnings, reserves, subordinated debt, Tier 1 and Tier 2 securities, and Key Attributes 4.3 and Annex IV. Key Attribute 3. 11 For G-SIBs headquartered in advanced economies, the FSB’s common minimum TLAC requirement has been set as follows: from January 1, 2019, resolution entities must hold TLAC instruments at least equivalent in value to 16 percent of the resolution group’s risk-weighted assets (RWAs) and 6 percent of unweighted exposures; from January 1, 2022, resolution entities must hold TLAC instruments of at least 18 percent of the resolution group’s RWAs and 6.75 percent of unweighted exposures. G-SIBs headquartered in emerging market economies, where capital markets are less well-developed, are expected to meet the lower requirement by January 1, 2025, and the higher requirement by January 1, 2028, at the latest. The FSB’s minimum TLAC requirement is set with reference to both RWAs and unweighted balance sheet assets, as defined by the Basel III leverage ratio exposure measure. 12 TLAC Term Sheet Section 9-10. 9

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certain senior unsecured debt). Short-term liabilities do not qualify as TLAC even though they may be bailed-in on entry into resolution. This is because they may not be renewed and may no longer be available once the firm approaches the point of entry into resolution. Liabilities that are directly linked to critical functions provided by the G-SIB, such as the deposit-taking or payment functions or derivatives, also do not qualify as TLAC because any write-down or conversion of such liabilities could interfere with the critical economic functions that the firm performs. To ensure that TLAC is likely to be available at the point of entry into resolution and fully loss-absorbing, eligible instruments must have a minimum remaining maturity of at least one year, be paid-in, unsecured, not be funded directly or indirectly by the resolution entity or a related party, and not be subject to any set-off or netting rights. In the European Union, a similar concept is the minimum requirement for own funds and eligible liabilities (MREL).13 Though both TLAC and MREL share the same objectives, they differ in a number of important ways, such as their scope of application and the eligibility criteria, including the requirement of subordination as a criterion for eligibility.14

Subordination to Operational Liabilities A critical feature of TLAC is that it should absorb losses ahead of operational liabilities. This means that TLAC needs to be subordinated to such liabilities in the creditor hierarchy or, conversely, that operational liabilities should rank senior to TLAC.15 If operational liabilities ranked pari passu with TLAC-eligible instruments and if the resolution authority had the ability to exclude certain of those operational liabilities from the bail-in scope, there could be a legal challenge based on the “no creditor worse off than in liquidation” (NCWOL) safeguard by those non-excluded creditors and TLAC holders.16 Those creditors could argue that they had to absorb more losses than they would have had to absorb had the bank been liquidated. They could claim that an insolvency court would have applied Article 45 of the Directive 2014/59/EU of the European Parliament and of the Council of May 15, 2014, establishing a framework for the recovery and resolution of credit institutions and investment firms (known as Bank Recovery and Resolution Directive [BRRD]). 14 The TLAC standard applies only to G-SIBs, whereas the MREL framework applies to a much broader set of institutions. MREL is set by the resolution authorities on a firm-specific basis, making it a more flexible tool in terms of the amount and eligibility of instruments to be held. A set of qualitative criteria, specified in the Regulatory Technical Standards of the European Banking Authority, are intended to guide the determination of the MREL and ensure a comparable approach and consistent interpretation of the BRRD provision across the European Union. 15 The TLAC standard provides for an exception to the subordination requirement and allows TLAC-eligible instruments to count toward the TLAC minimum requirement if they rank pari passu with excluded liabilities, as long as they do not exceed a minimum threshold. 16 Key Attribute 5.2. The NCWOL safeguard provides that shareholders and creditors should not incur greater losses than those which they would have incurred had the institution been wound up under normal insolvency proceedings. Shareholders and creditors that do suffer such greater losses should be entitled to compensation in an amount equivalent to the shortfall they have suffered. 13

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the pari passu principle and spread losses evenly across all creditors within the same class rather than exempting some creditors within that class from loss and shifting that loss on others. The FSB standard is not prescriptive on the way to achieve subordination. Subordination can be achieved in one of three ways: • Incorporating a contractual subordination clause into the debt instrument (subordination by contract); • Providing in statute for a ranking of TLAC-eligible liabilities junior to operational liabilities (statutory subordination); or • Issuing TLAC out of a nonoperating holding company that funds and owns subsidiaries that hold operating liabilities (structural subordination). The nonoperating holding company would be expected to act as source of strength and downstream funds to its operational subsidiaries to absorb losses and recapitalize them as necessary. The mechanism for this is internal TLAC (see section titled “Internal TLAC—Distribution of TLAC within groups”). Losses will be absorbed by the TLAC issued out of the holding company before any liabilities of the operating subsidiaries will be exposed to loss. A number of jurisdictions have amended the creditor hierarchy under their insolvency law: • In Germany, a new category of claims was created for unsecured, nonstructured debt instruments issued by banks. These instruments rank senior to subordinated debt instruments but junior to general creditors’ claims.17 • In Switzerland, a new class for debt that is to be issued for the purpose of resolution measures (“bail-in bonds”) has been created by statute.18 Such bonds rank senior to subordinated debt but junior to other debt and all deposits (including nonpreferred deposits). • The European Union amended the European BRRD so that liabilities that have been issued for the purpose of complying with the TLAC requirements fall within a new class of senior nonpreferred debt.19 The amendment adopts a combination of a statutory and contractual approach. Instruments in this new class of senior nonpreferred debt would be junior to all senior liabilities but would be senior to subordinated debt. However, the subordination would only be effective if, when issued, the instruments explicitly refer to the “nonpreferred” senior ranking in their terms and conditions.

17 Section 46f(5) to (8) of the Kreditwesengesetz, as amended by the Abwicklungsmechanismusgesetz (Resolution Mechanism Act) of November 2, 2015. 18 Article 30 b of the Swiss Banking Act of November 8, 1934 (as updated on January 1, 2016). 19 Directive (EU) 2017/2399 of the European Parliament and of the Council of 12 December 2017 amending Directive 2014/59/EU as regards the ranking of unsecured debt instruments in insolvency hierarchy.

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Location of TLAC: Resolution Entities and Resolution Groups To provide the necessary loss-absorbing and recapitalization capacity and to achieve the continuity objective, TLAC must be not only of the right quality and quantity, it also must be available at the right locations within a group’s legal entity and capital structure. The appropriate issuance location will be determined by the preferred resolution strategy. G-SIBs have complex group structures with a large number of legal entities.20 The objective of resolution planning is to ensure—to the extent possible—that those material legal entities that operate critical functions have access to sufficient loss-absorbing and recapitalization capacity so that their operations can continue as usual and be insulated from disruptive resolution or bankruptcy processes. The approach adopted by most G-SIB home authorities is to resolve the firm by applying resolution tools to a single entity, the ultimate parent entity (single point of entry into resolution, SPOE)21 For a majority of the G-SIBs, that parent entity is a nonoperating (“clean”) holding company. For others, the ultimate parent is a regulated bank. The entity to which the resolution powers would be applied and which is also expected to hold the minimum TLAC is referred to as “resolution entity.”22 Losses at operational subsidiaries that caused the distress would be passed up to the resolution entity and, on its entry into resolution, be absorbed by the holders of the resolution entity’s TLAC. Alternatively, entry into resolution may occur at two or more resolution entities at the subholding level, for example, regional intermediate holding companies or operational subsidiaries (multiple points of entry into resolution [MPOE]).23 For G-SIBs that operate through subsidiaries with a high degree of autonomy, the preferred resolution strategy may be MPOE. Each resolution entity or subsidiary would be subjected to a separate resolution process, and be required to have sufficient loss-absorbing capacity at the individual level. For banks with more centralized operations, SPOE would be the more natural strategy. The resolution entities to which resolution powers are presumed to be applied should be identified ex ante through the resolution planning process. This involves consultation and coordination by the home resolution authorities with key host authorities through institution-specific crisis management groups.24 Herring and Carmassi 2012. FSB 2013a; “Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy”, 78 Fed. Reg. 76614, December 18, 2013. 22 TLAC Term Sheet Section 3. 23 FSB, 2013, Strategies, July, Section 3. 24 The FSB Key Attributes (8.1) require “Home and key host authorities of all G-SIFIs should maintain CMGs with the objective of enhancing preparedness for, and facilitating the management and resolution of, a cross-border financial crisis affecting the firm. CMGs should include the supervisory authorities, central banks, resolution authorities, finance ministries, and the public authorities responsible for guarantee schemes of jurisdictions that are home or host to entities of the group that are material to its resolution, and should cooperate closely with authorities in other jurisdictions where firms have a systemic presence.” See the “Home Host Cooperation” section. 20 21

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The group consisting of the resolution entity and the subsidiaries that sit under it and that are not themselves resolution entities is referred to as “resolution group.”25 The TLAC requirement applies to the resolution entity and is determined by reference to the Basel III leverage ratio denominator and the RWAs of the resolution group. Every entity within a G-SIB that is identified as resolution entity is expected to issue to external third parties a minimum amount of TLAC that could be bailed-in should the resolution entity enter resolution. It is also referred to as the “external TLAC.” Both the SPOE and MPOE resolution strategies involve maintaining a minimum amount of external TLAC at the resolution entity.

Internal TLAC: Distribution of TLAC within Groups External TLAC at the resolution entity should provide loss-absorbing resources to the resolution group as a whole. Whereas in good times a firm can generally exercise central control over capital and liquidity and move resources from one group entity to another when needed, this flexibility evaporates in a crisis. In the absence of a statutory source of strength requirement that extends to subsidiaries in foreign jurisdictions, unconditional support of a parent (resolution) entity for its subsidiaries does not exist.26 The boards of the individual corporate entities within a group may be subject to fiduciary duties that constrain them in their ability to transfer funds to a troubled affiliate. Local regulators may seek to protect local operations, for example by imposing restrictions on fund transfers or asset maintenance requirements to secure local liabilities. To provide assurances to host authorities that loss-absorbing resources will be effectively available to a material subsidiary of a foreign G-SIB in times of stress, the TLAC standard requires foreign subsidiaries or groups of subsidiaries that are deemed material to have on their balance sheet (“prepositioned”) capital instruments or liabilities issued to the parent (the “internal TLAC”). The bail-in of internal TLAC passes the losses to the parent’s equity holders and its unsecured creditors without necessitating the subsidiary’s entry into resolution. When developing a resolution strategy the resolution authorities need to define the scope of the strategy and determine for each legal entity within the group whether it can be wound down or whether it should be recapitalized to support the continued performance of critical functions.

TLAC Term Sheet Section 3. For example, US law provides for a requirement that the holding company owning an insured depository institution serves as a source of financial strength and provides financial assistance to such institution in the event of the financial distress. See Sec. 38A of the Federal Deposit Insurance Act (12 U.S.C. 1811 et seq.) as amended by the Dodd-Frank Act, which provides: “The appropriate Federal banking agency for a bank holding company or savings and loan holding company shall require the bank holding company or savings and loan holding company to serve as a source of financial strength for any subsidiary of the bank holding company or savings and loan holding company that is a depository institution.” 25 26

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The TLAC standard defines a set of principles to identify subsidiaries that could be deemed material to the group as a whole. They are referred to as “material subgroups.”27 A material subgroup could be, for example, an intermediate holding company that consolidates a G-SIB’s operating subsidiaries in the host jurisdiction under a common holding, or it can be a single operating subsidiary or an operating subsidiary with one or more subsidiaries under its control. Such foreign material subgroups are expected to have prepositioned a minimum amount of internal TLAC that is issued to the resolution entity.28 Different internal TLAC issuance strategies may be adopted. For example, internal TLAC could be issued directly from the subsidiaries within the material subgroup to the resolution entity or indirectly through the ownership chain of multiple subsidiaries (“daisy chain”).29 If a material subsidiary or subgroup approaches the point of nonviability, the host authorities will expect the parent entity to recapitalize the distressed subsidiary. If parental support is not forthcoming or not sufficient, the bail-in of internal TLAC serves as a last resort resource to recapitalize the subsidiary or subgroup. It results in the write-down of the parent’s equity holdings in the subsidiary and conversion of the parent’s claims on the subsidiary into new equity. Under the “direct bail-in approach,” the failed holding company would retain ownership of the subsidiaries and have the claims of the holders of the holding company’s external TLAC written down and converted into new equity in the holding company. The new equity that is generated through the bail-in of internal TLAC is held by the recapitalized parent holding company in the case of a “direct” or “open bank bail-in” approach, or a newly established bridge or successor entity in the case of an “indirect bail-in” or “bridge-bail-in” approach.

Pursuant to the TLAC term sheet Sections 16 and 17, a material subgroup consists of one or more direct or indirect subsidiaries of a resolution entity that: (1) are not themselves resolution entities; (2) do not form part of another material subgroup of the G-SIB; (3) are incorporated in the same jurisdiction outside of their resolution entity’s home jurisdiction unless the crisis management group agrees that including subsidiaries incorporated in multiple jurisdictions is necessary to support the agreed resolution strategy and ensure that internal TLAC is distributed appropriately within the material subgroup; and that (4) either on a solo or a subconsolidated basis meet at least one of the of the following criteria: (1) have more than 5 percent of the consolidated RWAs of the G-SIB group; (2) generate more than 5 percent of the total operating income of the G-SIB group; (3) have a total leverage exposure measure larger than 5 percent of the G-SIB group’s consolidated leverage exposure measure; or (4) have been identified by the firm’s crisis management group as material to the exercise of the firm’s critical functions (irrespective of whether any other criteria of this section are met). 28 The FSB TLAC term sheet stipulates that a material subgroup maintain internal TLAC of 75 percent to 90 percent of the external minimum TLAC requirement that would apply to the material subgroup if it were a resolution group, as calculated by the host authority and that the actual minimum internal TLAC requirement within that range be determined by the host authority of the material subgroup in consultation with the home authority of the resolution group. TLAC term sheet Sections 16 to 18. 29 Internal TLAC Guiding Principle 10. 27

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Surplus TLAC TLAC should be distributed within resolution groups as internal TLAC in a manner proportionate to the size and risk exposures of the material subgroups. However, not all external TLAC should be distributed and prepositioned. A proportion of the external TLAC should remain at the parent entity to cover risk on the resolution entity’s solo balance sheet, including exposures of domestic and foreign branches, and to be available so that it can be deployed flexibly to subsidiaries as needed (“surplus TLAC”).30 To ensure that surplus TLAC resources at the parent entity can be downstreamed to operating entities, including foreign subsidiaries, in a resolution scenario, some G-SIBs have adopted contractual arrangements in the form of secured support agreements to make intragroup transfers less vulnerable to legal challenge.31

Restrictions on TLAC Holdings Limiting bail-in powers a priori to capital structure liabilities should reduce the risk of contagion effects. This aim needs to be supported by appropriate limits on holdings within the financial system and restrictions on interbank cross-holdings of TLAC (BCBS 2016). Investor protection considerations and the desire to enhance resolvability may also justify limitations of direct retail investments. Alternatively, high minimum denominations for TLAC instruments combined with strengthened disclosure requirements may also help address concerns with the investor base.

Disclosure of TLAC Holdings G-SIBs will be expected to disclose the amount, maturity, and composition of their TLAC, as well as their position in the creditor hierarchy and the form of their subordination to operational liabilities and presence of any such liabilities that rank pari passu or junior to eligible TLAC.32 Disclosure should enhance market awareness of a resolution and the implications for shareholders and Internal TLAC Guiding Principle 7. Secured support agreements impose a legally binding, secured obligation on a parent holding to its material subgroups during periods of financial distress before it reaches its point of nonviability. The agreement requires the parent to use its assets to provide capital support to all of its material subsidiaries or subgroups, and the material subsidiaries would have a legal right to enforce the agreement and seize any collateral if the parent did not voluntarily honor its secured obligations. The triggers are defined by criteria based on ratios of the group’s capital and liquidity resources and are designed to occur before the top-tier parent would become balance-sheet insolvent or unable to pay its debts when due. See the public executive summaries of the 2015 resolution plans of Bank of America Corporation, Bank of New York Mellon Corporation, Citigroup Inc., Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley, and State Street Corporation, as updated by their October 2016 submissions, at https://​www​.fdic​.gov/​regulations/​reform/​resplans/​. 32 See Section 20 of the TLAC term sheet in relation to public disclosures by G-SIBs of their eligible TLAC. The Basel Committee specified the provisions in Section 20 of the TLAC term sheet and published a consultation document in 2016. See BCBS 2017. 30 31

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creditors of a bail-in and also help them to make investment decisions based on an informed understanding of the associated risks.33

Bail-In Execution Unless a bail-in of TLAC resources can be effectively executed, resolution will not be credible. Bail-in requires advance planning and preparation for a series of actions to be undertaken in a short timeframe. For example, the recapitalization by the parent will take many steps and need multiple regulatory and board of director approvals. Authorities will need to prepare for carrying out a valuation of the assets and liabilities of the distressed firm to determine the write-down and conversion rates and to estimate the treatment that shareholders and creditors could have expected in ordinary insolvency proceedings so as to ensure that the potential resolution actions do not impose a disproportionate burden on them and violate the NCWOL safeguard.34 Execution of the bail-in will require coordinating the processes for suspending or canceling of affected securities and issuing new securities or tradable certificates following entry into resolution with relevant securities exchanges and central securities depositories, custodians, and regulatory authorities. Capital instruments and liabilities may be partially or fully written down or converted into new equity or other instruments of ownership. To the extent that equity is written down and the existing shares canceled, existing shareholders may be left with a residual financial claims at the bottom of the creditor hierarchy, but lose their control rights and associated rights.35 Control of the firm’s operations during the bail-in phase may be temporarily assumed by the authorities or an appointed administrator. Once the bail-in transaction is completed, ownership and control and the associated rights will be transferred to the bailed-in creditors as the new owners of the recapitalized firm or a newly established firm.36 G-SIBs are likely to have securities issued in multiple jurisdictions and be subject to different requirements from market integrity regulators, including

The Basel Committee included disclosure requirements in the revised Pillar 3 framework. For purposes of such a valuation, the question is what assumptions would need to be made about market conditions and the value of contracts, the applicable insolvency laws, and remedies available under such laws (for example, set-off or avoidance actions). For a list of questions that arise in connection with the valuation, see de Serière and van der Houwen 2016. 35 Shareholder rights fall into several categories, including economic rights (for example, the right to receive dividends and to sell the shares), control rights (for example, the right to vote on important matters relating to the business, such as mergers, acquisitions, and changes to the capital structure), the right to elect the directors who manage the business; information rights (for example, the right to receive the accounts and annual report); and legal rights (for example, the right to seek redress for breach of management’s fiduciary duties to the company and its shareholders). See Velasco 2006. 36 However, before any new qualified and controlling shareholders can exercise their control rights, they need to obtain the required “fit and proper” approvals in relevant applicable supervisory regimes. 33 34

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regular reporting and ad hoc disclosure requirements.37 These are likely to arise already in the time period leading up to resolution. A successful bail-in resolution and reducing the risk of legal liability and investor suits also requires effective public communications that give confidence to market participants that a bail-in will be implemented in a predictable manner (FSB 2018c).

Other Resolvability Conditions To achieve the resolution objective of maintaining the continuity of critical economic functions,38 a number of other conditions need to be met.

Operational Continuity For example, the firm in resolution needs to be able to continue to rely on access to critical financial market infrastructure services, such as payment systems, central securities depositories, securities settlement systems, and central counterparties, as well as on the provision of an array of support functions, either in-house, by an affiliate entity, or by a third party. The FSB has issued guidance on arrangements and service delivery models that support the continuity of critical shared services (FSB 2016a). and on arrangements to support continuity of access to critical financial market infrastructure services (FSB 2017b).

Funding in Resolution Another key resolvability condition is access to temporary liquidity in resolution. As a firm approaches and enters resolution, termination of contracts, depositor behavior, and increased collateral and margin requirements imposed by financial market infrastructures and other counterparties will likely give rise to substantially increased liquidity needs. Thus, there is a need to identify sources of private sector funding and public sector–liquidity back-stop mechanisms to address those funding requirements (FSB 2016b). Material subsidiaries that are not themselves in resolution should continue to have access to ordinary central bank facilities and central bank– and noncentral bank–operated payment and settlement systems, in home and host jurisdictions if the local requirements and conditions for access are met (FSB 2018b).

These include ad hoc disclosure obligations that require a firm to disclose material nonpublic or inside information. There may be exemptions or an ability to delay disclosures, for example if the disclosure is likely to prejudice the legitimate interests of the issuer or if it risks undermining financial stability in some jurisdictions. See, for example, Article 17(5) of Regulation (EU) No 596/2014 of the European Parliament and of the European Council of April 16, 2014, on market abuse (market abuse regulation). For a discussion of the tension between financial stability and investor protection objectives, see Spatt 2010.  38 Defined as “the activities performed for third parties, the failure of which would lead to the disruption of services that are vital for the functioning of the real economy and for financial stability.” See FSB 2013b. 37

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Cross-Border Effectiveness of Resolution Actions Statutory versus Contractual Cross-Border Recognition An effective domestic legal framework is a necessary but not sufficient condition for effective resolution. Global banks operate globally. SPOE and MPOE resolution strategies help minimize cross-border frictions by reducing the number of resolution proceedings to one or a few. However, they do not eliminate all potential conflicts that may arise between different jurisdictional legal frameworks and resolution regimes. For example, can a resolution authority effectively bail-in debt that is issued under the law of a different (“foreign”) jurisdiction? Will the courts in the jurisdiction where the debt was issued recognize the bail-in? The case National Bank of Greece v Metliss is often cited to show that this will not necessarily be the case.39 Creditors could argue that a foreign resolution authority cannot modify the parties’ obligations under a debt instrument governed by the law of another jurisdiction by writing down or converting the debt into equity. In the absence of a binding treaty framework, such as within the European Union,40 there is no automatic cross-border recognition of bail-in or other resolution actions. In some jurisdictions, courts have the power to recognize foreign authorities’ resolution actions. Many jurisdictions rely on comity41 and judicial recognition processes for insolvency proceedings enacted in accordance with the United Nations Commission on International Trade Law “Model Law” on cross-border insolvency.42 Jurisdictions that recently introduced or modernized their resolution regimes conferred an administrative “recognition power” on the resolution authority.43 Such recognition power enables the resolution authority to recognize a foreign resolution proceeding and take local actions to support or give effect to foreign resolution actions.

In National Bank of Greece v Metliss, the English courts decided that where a Greek bank owed money under bonds governed by English law, a Greek statute passed for the purpose of varying liability on the bonds would not be recognized by English courts, because English legal rights cannot be altered by Greek statute. See Gleeson and Guynn 2016, 213. 40 The European Union’s “Credit Institutions Winding Up Directives” (Article 3) provides that reorganization measures applied to an EU credit institution in one member-state will be effective throughout the European Union. In addition, the BRRD provides for the effectiveness of bail-in and transfer powers within the European Union. 41 Comity is a set of general principles governing when the courts and legal rules of a particular country pay deference to legal rules or proceedings of another country. See Bernstein and others 2013, “Recognition and Comity in Cross-Border Insolvency Proceedings,” The International Insolvency Review 1 (1). The Model Law is designed to assist states to equip their insolvency laws with a modern legal framework to more effectively address cross-border insolvency proceedings concerning debtors experiencing severe financial distress or insolvency. It focuses on authorizing and encouraging cooperation and coordination between jurisdictions, rather than attempting the unification of substantive insolvency law, and respects the differences among national procedural laws. 42 United Nations Commission on International Trade Law 1997. 43 For example, the EU jurisdictions and Hong Kong Special Administrative Region, Singapore, and Switzerland. 39

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The conditions for recognition (and grounds for refusal) typically relate to consistency with public policy objectives, the absence of adverse effects on domestic financial stability as a result of recognizing and enforcing a foreign resolution action, and the equitable treatment of creditors (FSB 2015c). Resolution authorities generally are afforded broad discretion in deciding on recognition of foreign resolution actions. Thus, for resolution planning purposes, there remains some uncertainty about the enforceability of a bail-in under the laws of a foreign jurisdiction. Authorities have responded to this in one of two ways. One way has required firms to issue TLAC instruments exclusively under domestic law to make sure that no cross-border recognition issues arise.44 The other way has required firms to include contractual recognition clauses in TLAC instruments whereby the holder of the instrument recognizes and agrees that the instrument may become subject to bail-in by the relevant home resolution authority.45 Contractual recognition can help ensure that financial contracts and instruments governed by third-country law can be subjected to resolution measures in the same way as contracts governed by domestic law. The aim is to ensure that all holders of TLAC, whether domestic or foreign, will be subject to bail-in to the same extent, regardless of the governing law of the agreement under which the liability arises.46

Cross-Border Stays on Early Termination Rights A key challenge in resolution can arise from the effect of close-out rights and cross-default rights under the International Swaps and Derivatives Association (ISDA) Master Agreement. The FSB Key Attributes state that authorities should have the power to temporarily stay the exercise of such termination rights to support the implementation of measures aimed at achieving continuity and maintaining the risk management function of the financial contracts.47 Overriding cross-defaults should prevent termination and the associated liquidity runs in the case of failure of a parent entity of a direct counterparty that is still performing on the contract. However, the cross-border enforceability of such temporary stay powers is not certain. ISDA member institutions in coordination with the FSB therefore

For example, under the Federal Reserve Board rule: In the summary of comments accompanying the release of the rule, it is noted that long-term debt subject to foreign law does not qualify as eligible external TLAC, because there is no guarantee that foreign courts defer to actions of US courts or US resolution authorities requiring the debt be converted into equity, for example, where the conversion negatively impacts foreign bondholders or foreign shareholders. 45 Article 55 of the BRRD requires the inclusion in agreements “creating” an unsecured liability that are “governed by the law of a third country,” a clause by which the “creditor or party to the agreement” recognizes that this liability may be subject to public authorities’ write-down and conversion powers. 46 See also TLAC term sheet, Section 13. 47 Key Attribute 4.3. 44

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developed a protocol that contractually opts adhering parties into provisions that limit the exercise of termination rights.48 Unless the protocols are adhered to by all market participants with significant derivatives and securities finance exposures, there is a risk that a fragmented adoption will further increase complexity and cost and give rise to level playing field issues, for instance, if some counterparties were to be stayed while others would be in a position to exercise their termination rights. The international community therefore agreed to promote, by way of regulation or other enforceable measures, the broad adherence to the protocol (FSB 2015a), for example, by issuing regulations that prohibit regulated institutions from entering into financial contracts unless the counterparty contractually opts into the home country’s resolution stay laws.49

Home-Host Cooperation Cross-Border Crisis Management Groups and Cooperation Agreements Crisis management groups have now been established for all firms identified as G-SIBs. They bring together the G-SIB home and key host authorities and include supervisory authorities, central banks, resolution authorities, and finance ministries.50 The regular engagement among home and key host authorities within the crisis management groups helps enhance preparedness for the management and resolution of a cross-border financial failure. Crisis management groups should be underpinned by firm-specific cooperation agreements that set out processes for coordination and information-sharing to support cooperation in resolution planning and in an actual crisis.

Allocating Costs across Borders SPOE and MPOE resolution strategies and the TLAC standard have been designed with the view to facilitating cross-border cooperation by aligning more closely home and host authorities’ interests and mitigating the pressure on host authorities to ring-fence local assets or seize collateral as a preemptive measure in

ISDA 2015. Twenty-one global banks had adhered to the protocol in November 2015. Whereas the Universal Stay Protocol is aimed at sell-side institutions, the ISDA Resolution Stay Jurisdictional Modular Protocol offers an approach tailored to jurisdiction-specific regulatory requirements and is aimed at buy-side firms. See ISDA 2016. 49 For example, for the United States, see “Restrictions on Qualified Financial Contracts of Systemically Important US Banking Organizations and the US Operations of Systemically Important Foreign Banking Organizations,” September 12, 2017; for the United Kingdom, see the “PRA Supervisory Statement Contractual stays in financial contracts governed by third-country law” at http://​www​ .bankofengland​.co​.uk/​pra/​Pages/​publications/​ss/​2015/​ss4215​.aspx. For Germany, see the “Act on the Reorganization and Liquidation of Credit Institutions as Amended September 2015” at https://​www​ .gesetze​-im​-internet​.de/​bundesrecht/​sag/​gesamt​.pdf. 50 Key Attribute 8.1. 48

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a crisis. The pre-positioning of internal TLAC should give confidence to host authorities that the material subgroups have sufficient loss-absorbing and recapitalization capacity available to maintain the continuity of local material operations and should reduce the incentives for imposing ex post ring-fencing in a crisis.51 To curb such incentives for host authorities, home and host authorities need to cooperate closely through the resolution planning and crisis management group process, and have a clear understanding of their respective roles and responsibilities, including in regard to their preferred resolution strategy (either MPOE or SPOE), the appropriate amount, composition, location, and triggers of internal TLAC.52 The FSB standard sets out an expectation that the host authority will not act without the consent of the home authority, except in exceptional circumstances where the conditions for initiating domestic resolution proceedings are met, and consent of the home authority is not forthcoming.53 However, in the absence of coordinated resolution planning, in particular those host authorities of global systemically important financial institutions (G-SIFIs), which are not part of the respective crisis management group, may look for increased self-sufficiency of local operations of G-SIFIs in their jurisdiction, which may negatively impact the efficiency of the global banking system and also cause increased uncertainty for investors.

The TLAC term sheet provides that, subject to conditions set out in the term sheet and agreement among home and relevant host authorities, on-balance-sheet internal TLAC may be replaced with internal TLAC in the form of collateralized guarantees. 52 The Federal Reserve Board issued a rule to implement the internal TLAC requirement in national law and defined the terms for the internal TLAC trigger that provides for an internal TLAC requirement for US intermediate holding companies that are controlled by a foreign G-SIB. Under the rule, the contractual trigger would enable the Federal Reserve Board to bail-in internal TLAC if the intermediate holding company is in default or in danger of default and if any of the following circumstances apply: (1) the parent or any subsidiary outside the United States is placed into resolution; (2) the home authority consents to the internal TLAC bail-in, or does not object following 24 hours’ prior notice from the Federal Reserve Board; or (3) the Federal Reserve Board has made a written recommendation to the secretary of the Treasury that the Orderly Liquidation Authority provisions of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd– Frank”) are invoked. The contract terms would ensure that bail-in would be used only as measure of last resort in times of severe stress when the foreign parent enters resolution or the home resolution authority consents or does not object or when there is a threat to domestic financial stability as evidenced by an application for resolution under Orderly Liquidation Authority. See Federal Register, November 30, 2016, “Total Loss-Absorbing Capacity, Long-Term Debt, and Clean Holding Company Requirements for Systemically Important US Bank Holding Companies and Intermediate Holding Companies of Systemically Important Foreign Banking Organizations,” 12 CFR 252, https://​www​.federalregister​.gov/​documents/​2015/​11/​30/​2015​-29740/​total​-loss​-absorbing​-capacity​ -long​-term​-debt​-and​-clean​-holding​-company​-requirements​-for​-systemically. 53 TLAC Term Sheet Section 19. 51

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IMPACT ON FIRMS: LEGAL AND OPERATIONAL STRUCTURES AND BUSINESS MODELS The implementation of the resolution policies and of the FSB’s TLAC standard is affecting the ways firms operate and organize their legal entity structures. It is also affecting the way in which firms are regulated and supervised as it shifts the focus on ensuring that firms can be resolved without wider disruptions. Resolution planning has emerged as a new function that is distinct from supervision. Firms search for a rationalization of their structures to meet the various resolvability requirements in the most efficient and cost-effective way, for example, by eliminating legal entities through merger or wind-down, aligning critical services with legal form, regrouping legal entities under a single subholding, insulating risky market activities with potential of contagion in a crisis from retail activities, and reducing intercompany transactions. Whether integrated global operations can be maintained or whether structures will increasingly be subsidiarized or compartmentalized with a holding structure composed of “independent” subsidiaries (Huertas 2015), will in part depend on how resolution strategies are implemented. Building up loss-absorbing capacity within firms will take time and effort and require the restructuring of legal entities and creation and positioning of lossabsorbing resources. For the internal TLAC mechanism to work and effectively channel losses from the subsidiaries to the resolution entity, group operations need to be structured in such a way that they do not result in reverse financial linkages through intragroup exposures, such as uncollateralized exposures of a subsidiary on its resolution entity. Structures and operations will need to conform to local rules that seek to make firms more resolvable so that corporate structures can be taken apart without disrupting the continuity of any vital economic functions. To ensure the continuity of critical services in resolution, banks need to map their network of critical services. Service contracts with internal service companies should be at arm’s length through the use of service-level agreements so that services can continue to be provided by the same operating company or an external alternative provider under a contract with similar terms. Terms for intercompany trades may need to be revised so that they are performed in the same manner as third-party trades and can be replaced in resolution.

CONCLUSION The distress of a G-SIFI creates global problems that require a global solution. Significant progress has been made toward achieving a pragmatic and credible global solution in the form of a coherent international policy framework for resolution and resolution planning. Rather than calling for an international

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Chapter 6  Cross-Border Resolution: A Global Solution to a Global Problem

treaty and the global harmonization of bank resolution regimes, the framework relies on a combination of new resolution powers, ex ante resolution planning, that minimizes cross-border frictions and contractual approaches to address and mitigate cross-border challenges. Legislatures in a number of important jurisdictions have demonstrated their willingness to make significant changes in national laws and regulatory structures. The principal jurisdictions now have an alternative to relying on ordinary corporate insolvency procedures to address distress in financial firms. Cross-border cooperation and coordination have significantly intensified and strengthened. However, sustained efforts are needed to make the framework and policies fully operational. G-SIBs need to build up their TLAC resources and fully implement changes in legal, operational, and funding structures to improve their resolvability. It will be possible to demonstrate the effectiveness of the framework only when it is used to address serious financial distress. Even now, however, there are signs that it has enhanced market discipline and made financial firms more aware of the risks they face. Further work and analysis are needed to understand how the framework will operate in times of stress and what the impact of resolution actions might be in light of the interdependencies between major market participants and the concentration of essential financial system functions, in particular financial market infrastructure services, in a relative small number of firms. With mandatory central clearing, central counterparties now play a pivotal role in the financial system and must have in place robust recovery and resolution plans that ensure the continued performance of their critical functions in times of stress (FSB 2017a). Effective resolution planning by central counterparty members will support the success of resolution arrangements for those counterparties and vice versa. Work on these issues continues at the international level (FSB 2017d). Cross-border resolution planning will need to evolve and adapt to changes arising from the use of new products and technologies, such as digital tokens and distributed ledger technology. The greater speed associated with the automation of business processes and services that support the provision of critical functions, combined with increased interlinkages through networks and systems, could transmit failure still more rapidly. Increasing reliance on third-party providers of information technology and data processes will need to be underpinned by robust arrangements that support the operational continuity of such services when a failure occurs. However, such arrangements may be more difficult to put in place when the provider is unregulated and located in a foreign jurisdiction. The use of new products and technologies may raise operational challenges and complex legal issues if the cause of the distress involves some combination of cyberattacks, fraud, and technological failure. Although new technologies involve risks, they may also offer new opportunities that can support the objectives of resilience and resolvability.

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REFERENCES Basel Committee on Banking Supervision (BCBS). 2016. “TLAC Holding Standard,” October. http://www.bis.org/bcbs/publ/d387.htm. ———. 2017. “Pillar 3 Disclosure Requirements—Consolidated and Enhanced Framework,” March. https://www.bis.org/bcbs/publ/d400.pdf. Bernstein, Donald S., Timothy Graulich, Damon P. Meyer, and Robert Stewart. 2013. “Recognition and Comity in Cross-Border Insolvency Proceedings.” In The International Insolvency Review, edited by Donald S. Bernstein, 1–14. Derbyshire: Gideon Roberton. de Serière, Victor, and Daphne van der Houwen. 2016. “No Creditor Worse Off ” in Case of Bank Resolution: Food for Litigation?” Journal of International Banking Law and Regulation 7: 376–81. Gleeson, Simon, and Randall Guynn. 2016. Bank Resolution and Crisis Management: Law and Practice. Oxford: Oxford University Press. European Union (EU). 2014. “Directive 2014/59/EU of the European Parliament and of the Council of May 15, 2014, Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms (known as BRRD).” http://eur-lex.europa.eu/ legal-content/EN/TXT/?uri=celex%3A32014L0059. ———. 2017. “Directive (EU) 2017/2399 of the European Parliament and of the Council of 12 December 2017 Amending Directive 2014/59/EU as Regards the Ranking of Unsecured Debt Instruments in Insolvency Hierarchy.” http://eur-lex.europa.eu/eli/dir/2017/2399/oj. Financial Stability Board (FSB). 2010a. “Reducing the Moral Hazard Posed by Systemically Important Financial Institutions,” interim report to G20 Leaders, June 18. http://www.financialstabilityboard.org/publications/r100627b.pdf. ———. 2010b. “Reducing the Moral Hazard Posed by Systemically Important Financial Institutions,” November 11. http://www.fsb.org/2010/11/r101111a/. ———. 2011a. “Key Attributes of Effective Resolution Regimes for Financial Institutions (as Updated with Sector-specific Annexes in November 2014).” http://www.fsb.org/wp-content/ uploads/r141015.pdf. ——. 2011b. “Policy Measures to Address Systemically Important Financial Institutions,” November. http://www.fsb.org/2011/11/r111104bb/. ———. 2013a. “Guidance on Developing Effective Resolution Strategies,” July. http://www. fsb.org/2013/07/r130716b/. ———. 2013b. “Guidance on Identification of Critical Functions and Critical Shared Services,” July. http://www.fsb.org/2013/07/r130716b/. ———. 2013c. “Guidance on Recovery Triggers and Stress Scenarios,” July. http://www.fsb. org/2013/07/r130716c/. ———. 2015a. “FSB Welcomes Extension of Industry Initiative to Promote Orderly CrossBorder Resolution of G-SIBs,” November 12. ———. 2015b. “Guidance on Cooperation and Information Sharing with Host Authorities of Jurisdictions where a G-SIFI has a Systemic Presence that are Not Represented on its Crisis Management Group,” November. http://www.fsb.org/2015/11/guidance-on-cooperationand-information-sharing-with-host-authorities-of-jurisdictions-where-a-g-sifi-has-a-systemic-presence-that-are-not-represented-on-its-cmg/. ———. 2015c. “Principles for Cross-border Effectiveness of Resolution Actions,” November. http://www.fsb.org/2015/11/guidance-on-cooperation-and-information-sharingwith-host-authorities-of-jurisdictions-where-a-g-sifi-has-a-systemic-presence-that-are-notrepresented-on-its-cmg/. ———. 2015d. “Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution and Total Loss-absorbing Capacity (TLAC) Term Sheet,” November. http://www. fsb.org/2015/11/total-loss-absorbing-capacity-tlac-principles-and-term-sheet/. ———. 2015e. “Total Loss-Absorbing Capacity (TLAC) Principles and Term Sheet,” November 9.

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———. 2016a. “Guidance on Arrangements to Support Operational Continuity in Resolution,” August. http://www.fsb.org/2016/08/guidance-on-arrangements-to-support-operationalcontinuity-in-resolution/. ———. 2016b. “Guiding Principles on the Temporary Funding Needed to Support the Orderly Resolution of a Global Systemically Important Bank,” August 16. ———. 2017a. “Guidance on Central Counterparty Resolution and Resolution Planning,” July 5. http://www.fsb.org/2017/07/guidance-on-central-counterparty-resolution-and-resolutionplanning-2/. ———. 2017b. “Guidance on Continuity of Access to Financial Market Infrastructures (FMIs) foraFirminResolution,”July.http://www.fsb.org/2017/07/guidance-on-continuity-of-access-to-financialmarket-infrastructures-fmis-for-a-firm-in-resolution-2/. ———. 2017c. “List of Global Systemically Important Banks (G-SIBs),” November 21. http:// www.fsb.org/2017/11/2017-list-of-global-systemically-important-banks-g-sibs/. ———. 2017d. “Ten Years On—Taking Stock of Post Crisis Resolution Reforms,” Sixth Report on the Implementation of Resolution Reforms, July. http://www.fsb.org/2017/07/ ten-years-on-taking-stock-of-post-crisis-resolution-reforms/. ———. 2018a. “Funding Strategy Elements of an Implementable Resolution Plan.” https:// www.fsb.org/2018/06/funding-strategy-elements-of-an-implementable-resolution-plan-2/. ———. 2018b. “Guidance on Funding Strategy Elements of an Implementable Resolution Plan.” ———. 2018c. “Principles on Bail-in Execution.” https://www.fsb.org/2018/06/ principles-on-bail-in-execution-2/. G20. 2010. “The G20 Toronto Summit Declaration,” June. http://www.fsb.org/wp-content/ uploads/g20leadersdeclarationtoronto2010.pdf. Gleeson, Simon, and Randall Guynn. 2016. Bank Resolution and Crisis Management: Law and Practice. Oxford: Oxford University Press. Herring, Richard, and Jacopo Carmassi. 2012. “The Corporate Structure of International Financial Conglomerates: Complexity and its Implications for Safety and Soundness.” In The Oxford Handbook of Banking, edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson. Oxford: Oxford University Press, 2012. Huertas, Thomas. December 15, 2015. “Global Banks: Good or Good-Bye?” The Future of Large, Internationally Active Banks.” Proceedings of the 18th Annual International Banking Conference, Federal Reserve Bank of Chicago 67–75. Hüpkes, Eva H. G. 2005a. “Insolvency—Why a Special Regime for Banks?” Current Developments in Monetary and Financial Law 3. ———. 2005b. “Too Big to Save”—Towards a Functional Approach to Resolving Crises in Global Financial Institutions.” In Systemic Financial Crisis: Resolving Large Bank Insolvencies, edited by Douglas Evanoff and George Kaufman. Singapore: World Scientific Publishing. International Swaps and Derivatives Association. 2015. “ISDA 2015 Universal Resolution Stay Protocol.” http://www2.isda.org/functional-areas/protocol-management/protocol/22. ———. 2016. “ISDA Resolution Stay Jurisdictional Modular Protocol.” https://www2.isda. org/functional-areas/protocol-management/protocol/24. Spatt, Chester S. 2010. “Regulatory Conflict: Market Integrity vs. Financial Stability.” University of Pittsburgh Law Review 71: 625–39. United Nations Commission on International Trade Law. 1997. “Model Law for Cross-Border Insolvency.” http://www.uncitral.org/uncitral/en/uncitraltexts/insolvency/1997Model.html. Velasco, Julian. 2006. “The Fundamental Rights of the Shareholder.” University of California Davis Law Review 40 (2): 407.

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III THE LEGAL FRAMEWORK FOR THE RESOLUTION OF CENTRAL COUNTERPARTIES: A SPECIAL CASE?

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CHAPTER 7

The New Frontier of Resolution Frameworks: Central Clearing Counterparties Alessandro Gullo

Central clearing counterparties (CCPs) have played a longstanding role in financial markets. However, their systemic importance has been amplified by the reforms promoted in response to the global financial crisis, such as the “central clearing mandate” agreed upon at the Group of Twenty Pittsburgh summit in September 2009. In that summit, it was decided that all standardized, over-thecounter (OTC) derivatives contracts should be traded on exchanges or electronic trading platforms, when appropriate, and cleared through CCPs. To implement this policy commitment, many jurisdictions have since enacted legislative and regulatory frameworks establishing rules and criteria for the mandatory central clearing of OTC transactions.1 Because of the broader use and increased systemic importance of CCPs, policymakers have turned their attention to measures that could enhance their resiliency, recovery planning, and resolvability. In particular, it has become necessary to connect the dots between two key reforms of the global financial regulatory agenda promoted over the past years: the central clearing mandate and the adoption of effective resolution regimes for financial institutions conforming with the Key Attributes, which aim to preserve financial stability and minimize taxpayers’ exposure to loss (Financial Stability Board [FSB] 2014). Efforts have thus been undertaken by the policy community—under the aegis of the FSB—to Alessandro Gullo is Senior Counsel of the IMF Legal Department. The author thanks Ross Leckow and David Blache for their valuable suggestions. While the views expressed in this chapter are to some extent based on the author’s experience as an IMF staff representative with the Financial Stability Board Cross-Border Crisis Management Group for Financial Markets Infrastructures, and on the fruitful discussions held at this forum, the views expressed herein are his own and should not be attributed to the IMF. 1 The underlying rationale of the central clearing mandate is that CCPs can not only facilitate multilateral netting and improve collateral policies but also serve a key role for systemic risk management (see Tucker 2011).



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develop international guidance on the key elements that should underpin resolution regimes for CCPs.2 The design of special resolution regimes for CCPs is complex. The absence of recent failures by CCPs makes it impossible to draw lessons from practical experience.3 More fundamentally, a number of legal, economic, and regulatory features markedly distinguish CCPs from banks or other financial institutions. A key factor is that CCPs are designed to withstand the risks associated with the failure of large, systemic institutions. They do so through loss allocation rules established in multilateral contractual arrangements between the CCP and its participants—the so-called CCP rulebook—that effectively mutualize counterparty credit risk.4 Putting in place resolution regimes for CCPs requires a thorough understanding of these distinctive features, including how the loss mutualization function performed by CCPs unfolds when a CCP is on the verge of failure.5 This chapter analyzes how certain fundamental legal features of CCPs can inform the design of their resolution regime. The first section describes the “default waterfall,” a key building block of CCPs. The second section examines the interaction between the loss allocation rules agreed in CCP rulebooks and the resolution regime of a CCP, and the relevance of this interaction in several circumstances. The third section discusses the extent to which certain legal aspects, embedded in the structure and function of CCPs, may affect their resolution processes. The fourth section examines cross-border aspects relevant in the resolution of a CCP. The fifth section concludes. Where appropriate, the chapter refers to the guidance adopted by the FSB, which will be critical in assisting jurisdictions to develop and implement resolution regimes specific to CCPs.6

2 See the implementation guidance on financial market infrastructure (FMI) resolution (FSB 2014, Appendix II, Annex I) and the more recent “Guidance on Central Counterparty Resolution and Resolution Planning” (the “CCP Resolution Guidance”), adopted on July 5, 2017 (FSB 2017). The latter document complements the Key Attributes (FSB 2014) and the FMI Annex by providing more specific guidance on implementing them in resolution arrangements for CCPs. Its preparation was preceded by two consultations with stakeholders: first in August 2016 on a high-level discussion note on “Essential Aspects of CCP Resolution Planning” (FSB 2016) and then in a consultative document on “Guidance on Central Counterparty Resolution and Resolution Planning” (FSB 2017). 3 For an analysis of previous CCP failures and near-misses, see Gregory 2014. 4 Elliot (2013) states: “One of the key ways in which CCPs are distinguished from most other financial firms is that their obligations to their members, and vice versa, are governed by a central rulebook.” 5 Papathanassiou (2016) points to the asymmetries surrounding FMI rules on default procedures in their interaction with crisis management regimes. 6 A legislative proposal on resolution regimes specific to CCPs was put forward by the European Commission in November 2016, “Proposal for a Regulation of the European Parliament and of the Council on a Framework for the Recovery and Resolution of Central Counterparties and Amending Regulations (EU) No. 1095/2010, (EU) No. 648/2012, and (EU) 2015/2365” (EC 2016).

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Chapter 7  The New Frontier of Resolution Frameworks: Central Clearing Counterparties

KEY CONSIDERATIONS ON CCPs’ WATERFALL CCPs interpose themselves between counterparties to contracts traded in financial markets by assuming the rights and obligations of each side to a transaction. In doing so, CCPs run a matched book, whereby payments owed by the CCP to the counterparty on one trade are matched by payments due to the CCP from the other counterparty on the matching trade.7 In case of default of one of its participants, the CCP performs a loss mutualization function by satisfying the claims of nondefaulting participants against the defaulting counterparty, drawing from the waterfall of resources set out in the CCP rulebook.8 Typically, the pecking order established in the waterfall allocates losses: to the defaulting counterparty, first by using the collateral (“margin”) provided by it through the initial margin; and, if this is not sufficient, through its contribution to the mutualized default fund.9 Collateral may be provided in the form of cash, securities, or instruments of credit held by the CCP through different legal arrangements (for example, deposit, pledge, or outright title transfer). If losses exceed the defaulter’s margin and contribution, the CCP will draw from the resources provided by the other CCP participants into the mutualized default fund and from its resources. Although in all cases losses are first attributed to the defaulting participant, the size and pecking order of the remaining waterfall resources may vary across CCPs, also given that there is no internationally prescribed waterfall structure (Wendt 2015). A common structure provides for a first 7 This feature plays a crucial role in CCPs’ recovery and resolution arrangements. As in the case of default of a CCP participant, the CCP will need to close out its unmatched positions and return to a matched book by offsetting or hedging transactions or by auctioning the positions to nondefaulting participants. If these options are not available or fail, the CCP would apply several tools under its rulebook (as examined later in this section), lest its own financial soundness be endangered. 8 Although in this specific instance the term CCP participant refers to a clearing member of the CCP, the expression is used throughout the chapter to include more generally the users of a CCP’s clearing service, either directly as a clearing member of the CCP, or indirectly as a client of clearing member. For a similar definition, see the glossary attached to the CCP Resolution Guidance (FSB 2017). 9 Initial margin is defined by the Principles for Financial Market Infrastructures (Committee on Payments and Market Infrastructures [CPMI]/International Organization of Securities Commission [IOSCO] 2012) as the “collateral that is collected to cover potential changes in the value of each participant’s position (that is, potential future exposure) over the appropriate close-out period in the event the participant defaults.” To reflect the exposure from changes in market prices over the life of a cleared contract (which may be sizable in the case of derivatives contracts), “variation margin” payments are made, whereby a CCP participant whose net position has fallen in value pays to the CCP the value of this decrease (and, conversely, a variation margin is paid by the CCP to participants whose net positions have increased in value). Upon a participant’s default and failure to pay variation margin, the CCP will be exposed to changes in the market value of its unmatched positions. The initial margin serves to protect it against this contingent market risk for losses that may be incurred between the point that a CCP participant defaults and fails to provide variation margin and the point at which the CCP returns to a matched book by offsetting/hedging transactions or by auctioning the defaulting participant’s position.” Initial margin is a good faith deposit on future performance, typically considered to be client money; this is a key reason why its “haircutting” is viewed as problematic, as explained in Box 7.1.

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Box 7.1. CCP End-of-the Waterfall Loss Allocation Tools If the prefunded resources are exhausted, loss allocation arrangements provide for further contributions by the nondefaulting central clearing counterparty (CCP) participants and the CCP to preserve the continuity of critical clearing functions and, where appropriate, return to a matched book. Although such arrangements and the pecking order for their utilization in the waterfall may vary across CCPs (also in the function of products subject to clearing), they can be generally grouped as follows:1 • Rights of assessment. CCPs may require nondefaulting CCP participants to contribute additional financial resources through a cash call. In most cases, such calls are capped to a predetermined limit, because unlimited contingent exposures may not be allowed under the legal framework of a CCP or of its participants and may be unfavorable from a capital adequacy point of view. • Variation margin gains haircutting. The CCP may reduce the variation margin payments because of the nondefaulting CCP participants whose positions have increased in value since the default of a CCP participant. Generally, the haircut would be applied pro rata in relation to the relevant CCP participants trading a particular class of products or clearing service. The haircut would not operate symmetrically, in the sense that the CCP participants whose positions have decreased in value would still be required to pay variation margin to the CCP. • Tear-up. Under this tool, open contracts would be settled and terminated by the CCP. Tear-up could be applied to some contracts (partial tear-up) or all contracts (full tear-up) of the CCP or of the affected clearing service. The preconditions for the partial and full tear-up are different, with the former generally being considered in the absence of available options to return to a matched book, and the latter to be possibly used in extreme scenarios and subject to financial stability not being jeopardized. • Initial margin haircutting. This tool entails the haircutting of the initial margin provided by the nondefaulting CCP participants. Initial margin haircutting, however, is considered problematic in many jurisdictions, particularly when the margin is “bankruptcy remote,” that is, protected from the insolvency of the CCP. In some legal ­frameworks, it is explicitly prohibited (see, for example, EU Regulation, art. 45(4), on ­over-the-counter derivatives, central counterparties, and trade repositories). Initial margin haircutting may have negative repercussions from a financial stability point of view, in that CCP participants would have to promptly replace it to preserve the financial resilience of the CCP against possible additional defaults. 1 For a comprehensive analysis of these loss allocation arrangements and the economic incentives underlying their use, see Elliott 2013.

layer of skin in the game by the CCP before the mutualized default fund is drawn, and for a second contribution after the default fund has been exhausted.10 The defaulting participant’s margin, the mutualized default fund, and the CCP contribution(s) represent the prefunded resources. Because the size of losses may exceed the prefunded resources, the Principles for Financial Market Infrastructures (PFMIs) recommend that CCPs address “how potentially

See also Regulation 648/2012, art. 45 (4), of the European Parliament and of the Council on OTC derivatives, central counterparties, and trade repositories: “a CCP shall use dedicated own resources before using the default fund contributions of the non-defaulting clearing members.” 10

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Chapter 7  The New Frontier of Resolution Frameworks: Central Clearing Counterparties

uncovered credit losses would be allocated . . . [and] should also indicate the FMI’s process to replenish any financial resources that the FMI may employ during a stress event, so that the FMI can continue to operate in a safe and sound manner.”11 The CCP rulebook would therefore typically provide for the allocation, among its participants and the CCP, of unfunded losses, as part of CCP’s recovery plans.12 Box 7.1 describes loss allocation tools available for losses exceeding the CCP’s prefunded resources.13

INTERACTION BETWEEN CCP RECOVERY AND RESOLUTION Loss Allocation Rules and Resolution The waterfall structure—along with the adequacy of the CCP financial resources—is designed to ensure that the CCP can absorb losses arising from the default of its participants, thus preserving its solvency and viability.14 In other words, the robustness of the CCP loss allocation arrangements should mitigate the risk that the CCP itself would default. However, it cannot be excluded that the failure of systemic CCP participants (or the multiple, cascading failure of various CCP participants) would put the CCP under stress and destabilize its financial condition. In that case, and when the conditions for entry into resolution are met, the authorities should be empowered to resolve the CCP to ensure the continuity of the clearing services or the orderly wind-down of the CCP that preserves financial stability and mitigates taxpayer costs. The trigger to initiate resolution proceedings over financial institutions— including CCPs—is based on an assessment by the authorities of their nonviability (or likelihood thereof ). Therefore, resolution regimes should provide for a 11 The PFMIs were published in April 2012 by the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions (CPMI/ IOSCO 2012).

See the report on “Recovery of financial market infrastructures” (the “Recovery Report”), published in October 2014 by the CPMI and the Board of the IOSCO. “Recovery is defined as the actions of an FMI, consistent with its rules, procedures, and ex ante contractual arrangements, to address any uncovered loss, liquidity shortfall or capital inadequacy, whether arising from participant default or other causes . . . to restore and maintain the FMI’s viability as a going concern.” 12

Elliott (2013) defines loss allocation rules (or end-of-the-waterfall rules) as the rules setting out—in the CCP rulebook—how losses exceeding the CCP’s prefunded default resources are to be allocated between participants. For the purposes of this chapter, loss allocation rules include prefunded default resources and the arrangements relating to uncovered losses. 13

Principle 4 of the PFMIs requires that CCPs involved in activities with more complex risk profiles or that are systemically important in multiple jurisdictions should maintain financial resources sufficient to cover at least the default of their two largest participants in extreme but plausible market conditions. Furthermore, the Recovery Report (CPMI/IOSCO 2014) requires FMIs to have a set of recovery tools that is comprehensive and effective in allowing the FMI, where relevant, to allocate any uncovered losses and cover liquidity shortfalls. 14

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timely and early entry into resolution. When the supervisory and resolution functions are performed by two different agencies, the supervisory authority would be naturally in charge of making the assessment on the nonviability of the CCP, while the resolution authority would exercise the relevant resolution tools and powers and implement the resolution strategy. Even in this scenario adequate coordination arrangements should be in place to ensure that action is not unduly delayed. For instance, the resolution authority should be able to request that an assessment on the viability (or lack thereof ) of the CCP is made by the supervisor. Under the international standards of the Key Attributes, CCPs may be placed into resolution when the available recovery measures (including the resources examined in the preceding paragraph) are not yet exhausted and fully applied.15 In that case, the resolution authority would be able to enforce the rights and obligations of the resolved CCP, including under its loss allocation arrangements. Several questions on the interaction between recovery and resolution would then arise.16 If CCPs’ loss allocation arrangements ensure their resilience and recovery, a key issue is to what extent these arrangements would continue to apply when the authorities intervene to resolve a CCP. If they continue to apply, the question is how resolution differs from recovery. If they do not apply, it would need to be examined what is the scope and degree of departure, and what are the consequences of this departure for transparency and predictability, as well as for legal certainty. Very different approaches may be followed in principle under the legal frameworks for resolving CCPs. On one hand, the resolution authority could be empowered to apply the loss allocation arrangements provided (or fixed) in the CCP rulebook, without being allowed to depart from them. This option would provide a high level of certainty to CCP participants, who would be able to measure their exposures to the CCP. Arguably, it would also bring clarity on the incentives driving CCP participants in the CCP default management and recovery process applied before resolution is commenced. This is because there would be predictability on the order of allocation of losses both in recovery and in resolution. On the other end of the spectrum, resolution authorities could be authorized to apply the loss allocation arrangements in the order and manner that best fit the This may also ensure that there are sufficient loss-absorbing resources available in resolution. See the FMI Annex (FSB 2014, Annex, para. 4.3) and the CCP Resolution Guidance (FSB 2017, para. 3), according to which entry into resolution should be possible if recovery measures are not likely to return the FMI to viability or they are otherwise likely to compromise financial stability. The FSB August 2016 Discussion Note on “Essential Aspects of CCP Resolution Planning” (FSB 2016) recognizes that recovery may fail at any point in the waterfall, or there may be confidence or financial stability issues at any point in the waterfall, so that resolution becomes the necessary option. 16 The FSB, CPMI, and IOSCO have paid attention to the interaction between the CPMI-IOSCO standards on CCP recovery and recovery planning, on the one hand, and those of the FSB on resolution and resolution planning, on the other hand, to ensure consistency between these two sets of guidance. See their common statement, dated July 5, 2017 (“Chairs’ Report on the Implementation of the Joint Workplan for Strengthening the Resilience, Recovery and Resolvability of Central Counterparties”). 15

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circumstances, as considered necessary to safeguard financial stability and regardless of the provisions of the CCP rulebook.17 Enabling a wide degree of flexibility may be crucial in extreme scenarios—such as those likely to be in place when a CCP is resolved—when the authorities need to take urgent actions to stabilize the financial system and avoid contagion.18 Each approach bears significant legal implications, including from the perspective of the legal risks involved. Moreover, vesting resolution authorities with a wide discretion in the selection and application of loss allocation arrangements have far-reaching economic consequences, because each arrangement can affect CCP participants very differently. For example, although cash calls are generally applied in proportion to the contribution to the mutualized default fund, variation margin haircutting of payments owed by the resolved CCPs can more closely reflect the scenario of a CCP insolvency and the resulting losses. Also, these tools have different repercussions for end users, in view of the possibility to shift losses from clearing members to their clients.19 Clearly, this is a complex issue, the intricacies of which are exacerbated by the circumstance that the resolution of CCPs is uncharted territory.20 The merits of the different approaches, including their possible variations, have been extensively debated by the industry and policymakers alike. The FSB (2017) seeks a balanced stance, recognizing the merits of flexibility within certain bounds. The guidance establishes a presumption that the resolution authority will continue to “follow the steps and processes under the CCP’s rules and arrangements where it intervenes before these have been exhausted.” The presumption is, however, qualified by the Under a variant of this approach, the CCP and its participants would consent in the CCP rulebook to an unbounded flexibility governing the CCP resolution process. 18 These approaches may give rise to different implications on the compensation under the “no creditor worse off than in liquidation” (NCWOL) safeguard. In principle, when the resolution authority departs from the loss allocation arrangements contractually agreed in the CCP rulebook—unless such departure is contemplated in the rulebook or in the statutory resolution framework—the risk of successful compensation claims under the NCWOL safeguard may be higher. Adapting the NCWOL safeguard to resolution of CCPs is complex, given the existence for CCPs of loss allocation arrangements and the need to determine how they would interact with the safeguard and with the evaluation of the counterfactual liquidation scenario. The CCP Resolution Guidance (FSB 2017) provides that, for the purposes of determining whether a participant, equity holder, or creditor is worse off as a result of resolution measures than in liquidation of the CCP under applicable insolvency law, the assessment of the losses that would have been incurred or the recoveries that would have been made if the CCP had been subject to liquidation should assume the full application of the CCP’s rules and arrangements for loss allocation. 19 The question of whether the resolution authority should follow the order of allocation of losses set out in the CCP rulebook is heavily influenced by the analysis of whether the financial resources available under the CCPs’ rules and arrangements are adequate to achieve the objectives of resolution. In the CCP Resolution Guidance (FSB 2017), the FSB states that it will continue its work on financial resources for CCP resolution and determine by the end of 2018 the need for any additional guidance. On the latest developments, see the discussion paper: FSB 2018. 20 Singh and Turing (2017) have observed how the current policy debate has difficulty in distinguishing the two concepts of recovery and resolution. These authors propose alternative proposals to CCP resolution, which include an enhanced layer of loss-absorbing capital. 17

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possibility of departing from CCP rules and arrangements, if necessary, to achieve the resolution objectives and to avoid significant adverse effects on the financial system, and subject to the limits and safeguards consistent with the Key Attributes and the FMI (FSB 2014, Annex).21 To some extent, this approach resembles the power that, in a bank resolution, the resolution authority has to depart from the pari passu treatment of creditors when this is necessary to protect financial stability (FSB 2014, EC 5.1). Although it is difficult to draw conclusions on such an untested matter, some general considerations can be made. First, a key difference between recovery and resolution is that the commencement of a resolution proceeding entails a change of control over the resolved entity; it is no longer in the private hands of the CCP and its shareholders and management, but under the administrative powers of the resolution authority. Even when the order of allocation of losses, as fixed in the CCP rulebook, is followed in resolution, the CCP’s contractual rights and obligations, including loss allocation arrangements, would be exercised by the resolution authority rather than by the CCP, with the former stepping into the shoes of the latter. In principle, the authorities’ intervention should instill public confidence in the resolution process and in the preservation of financial stability. Second, regardless of whether a fixed order of allocation of losses is followed, resolution regimes should leave to the resolution authority a certain degree of discretionary judgment. Flexibility is needed, for example, in relation to the timing and price applied in the use of the tools to return to a matched book, or to the selection of the relevant resolution tool (for example, transfers to a private purchaser or to a bridge bank).22 Third, as resolution regimes for CCPs are being developed, it will be important to ensure, ex ante, the clarity and transparency of any discretion conferred to the resolution authority to depart from the CCP’s loss allocation arrangements. This would also help mitigate legal risks arising from resolution processes.

Nondefault Losses CCPs may face financial difficulties for reasons other than the default of their participants. Fraud, operational risks (for example, cyberattacks), or litigation may jeopardize their financial condition. CCPs could also incur investment losses, or their custody or settlement bank may fail. Although CPMI/IOSCO (2014) requires CCPs to have sufficient capital to absorb losses from general business, custody, and investment risks, it cannot be excluded that such losses may threaten the viability of the CCP and lead to its resolution.23 As loss allocation arrangements set out in the CCP rulebook typically apply to default losses, the contribution of CCP participants through initial margin or See the CCP Resolution Guidance (FSB 2017, para. 2.2). Certain tools may also be reserved specifically for resolution processes, such as statutory cash calls in resolution. See the CCP Resolution Guidance (FSB 2017, para. 2.9). 23 See the Recovery Report (CPMI/IOSCO 2014, sec. 4.6). 21 22

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default fund could not be called upon in case of a nondefault loss.24 The rationale underlying this legal construct is that while for default losses the deployment of the waterfall resources is in line with a “mutuality” principle among CCP participants, for nondefault losses CCP participants are not in a position to exercise risk management over the CCPs.25 Losses would therefore fall on the CCP’s unsecured creditors (including, in some cases, CCP participants, such as for variation margin payments owed by the CCP to them) once its equity has been written down. Therefore, legal frameworks for resolution of CCPs should set out clear rules for the allocation of losses for nondefault events, particularly among the CCP’s unsecured creditors.26 Several policy and financial stability considerations are relevant in the design of such rules. For example, the imposition of losses to certain classes of creditors could be justified based on their influence over the governance of the CCP or for the risks they bring to the CCP. In contrast, financial stability and resolution objectives may be undermined if losses are imposed on certain classes of creditors (for example, providers of critical services or of liquidity to the CCP). Mechanisms to achieve these goals may include statutory bail-in tools, providing for the subordination of the unsecured liabilities that would first absorb losses through write-down or conversion into equity, as well as statutory cash calls to the clearing members.27 Both tools could ensure the replenishment of equity so the CCP can meet its regulatory capital requirements and restore its viability. A different issue arises when the resolution of a CCP originates from a combination of default and nondefault losses; there, the triggers for initiating the resolution proceedings have a mixed nature. To cater for such possibility, adequate flexibility should be provided in the design of resolution regimes for CCPs so the authorities could apply loss allocation arrangements—attuned to the specific circumstances at hand—in a single resolution measure.

Equity Write-Down In line with creditor hierarchy rules under insolvency laws, resolution regimes typically provide that shareholders sit at the bottom of the hierarchy and that Some CCP rulebooks, however, provide for loss allocation arrangements among CCP participants, but only for certain limited cases of nondefault losses (for example, investment losses). 25 Moreover, from a financial stability perspective, the imposition of losses (such as through haircutting variation margin payments) on those CCP participants that are in the money may have destabilizing effects. 26 Particularly in the absence of loss allocation arrangements, the general liability regime applicable in the relevant jurisdiction (including with respect to rules on willful misconduct, negligence, and force majeure) would be relevant to apportion any liability arising from the nondefault loss. 27 See the CCP Resolution Guidance (FSB 2017, para. 2.13 and 2.14). The features of a resolution cash call have not yet been fully developed. As an ex post mandatory contribution, the resolution cash call may, to some extent, resemble the function of a resolution fund in a bank resolution, with the CCP participants (as opposed to the banking industry) being levied. 24

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equity is written down first before losses are allocated to other creditors. Imposing losses on owners can create appropriate incentives to ensure that shareholders put in place adequate governance and risk management controls. The specific features of CCPs give rise to certain challenges in the application of this key principle. As examined in the preceding sections, CCP rulebooks provide for an order of allocation of waterfall resources, whereby CCPs’ contribution (or skin in the game) may not be the first loss-absorbing layer and may be drawn at different stages, and in different amounts, under the waterfall.28 CCP shareholders may also be shielded from losses by means of contractual limited recourse provisions, particularly with nondefault losses. The contractual arrangements in the legal structure of CCPs could complicate the imposition of losses on shareholders and may expose the resolution authorities to compensation claims under the “no creditor worse off than in liquidation” (NCWOL) safeguard. Moreover, unless existing shareholders are written down, it may be difficult to award newly issued equity to the CCP participants and creditors who have contributed resources beyond their obligations under the CCP rules and arrangements, or who have otherwise contributed resources to restore the financial soundness of the CCP. To address these challenges, authorities should have the legal authority to allocate losses on shareholders and make equity fully absorbing in resolution. The simpler way to achieve this goal is by providing for a full write-down of equity upon entry into resolution. At the same time, such a full write-down may have implications on the effectiveness of the loss allocation arrangements examined previously, on the incentives driving the recovery and resolution process, and on the NCWOL safeguard.29 Clarity is needed, therefore, as to when the full write-down of equity would occur in the resolution process.30

STRUCTURAL ELEMENTS OF CCPs Certain elements inherent in CCP legal structures and function may impact the design of their resolution regime. Attention is given here to three issues: (1) the existence of silos and limited recourse provisions in CCP rules and arrangements, (2) the impact of resolution actions on netting sets, and (3) the interaction between the resolution of a CCP and that of its participants. For an analysis of the interaction between the CCP default management process in recovery, including through write-down of equity, and the CCP resolution, see Duffie 2014. 29 The Recovery Report (CPMI/IOSCO 2014) requires FMI to have “a set of recovery tools that is comprehensive and effective in allowing the FMI to, where relevant, allocate any uncovered losses and cover liquidity shortfalls.” 30 See the CCP Resolution Guidance (FSB 2017, para. 4.1): “[It] should be clear and transparent at which point in resolution any remaining equity would be written down, for example, no later than at the point at which prefunded and committed financial resources such as cash calls in recovery available under the CCPs’ rules and arrangements would have been exhausted.” The introduction to the CCP Resolution Guidance states that the FSB will consider the need for further guidance on the treatment of CCP equity in resolution. For the latest developments, see the discussion paper: FSB 2018. 28

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Silo Structures and Limited Recourse Provisions Many CCPs operate through silo structures, whereby losses are allocated only within a clearing service offered by the CCP, and CCP participants not active in such a service are insulated from losses.31 The case may arise in which, whereas losses are contained in only one siloed service, they would be so severe to threaten the overall viability of the CCP, thereby justifying the intervention of the authorities to resolve the CCP. In this case and notwithstanding such limited recourse provisions, it seems reasonable to assume that the resolution authority would take control of the CCP, rather than just intervene on one specific clearing service. Resolution processes are indeed “legal-entity-driven.” Presumably, the NCWOL safeguard would also be determined by comparing the treatment of the CCP creditors (including CCP participants active in the affected clearing service) with the counterfactual of the liquidation of the CCP as a legal entity.32 The choice of resolution tools may be based on whether losses have occurred only in a siloed clearing service to ensure continuity of the CCPs’ clearing services not affected by the losses. For example, tear-up may be applied selectively only to the affected clearing services.

Netting Sets The CCP would generally enter with its participants into transactions that compose a “netting set” of transactions subject to a legally enforceable close-out netting agreement if one of the counterparties—including the CCP—defaults. Netting may apply on a cross-product basis, that is, contracts may relate to different asset classes and CCPs’ clearing services. This may offer benefits from several points of view, including for capital adequacy purposes. The question arises as to the possible consequences of resolution actions on netting sets. For example, the resolution authority may transfer to a private purchaser or bridge bank only assets in a specific, siloed service, leaving behind other assets. Possibly, the exercise of selective tear-up, through the termination of some but not all contracts, may lead to similar consequences. These actions may hinder cross-product netting across the different silos, and thus break up netting sets.33 The implications of resolution actions for netting sets should therefore be Conversely, once the CCP has paid the final termination amounts to the relevant participants in the affected siloed clearing service, its obligations would be extinguished and the participants would have no further recourse to the CCP (International Swaps and Derivatives Association [ISDA] 2013). ISDA also examines the existence of “full recourse clearing service structures,” in which a separate legal entity is established for a specific product. 32 The CCP Resolution Guidance (FSB 2017, para. 5.5) recommends that the assessment of the counterfactual relevant for the NCWOL should take into account the limited recourse provisions on the segregation of clearing services. 33 The FMI Annex (FSB 2014, Annex 4.13 and 11.6[vii]) seems to contemplate the possibility that resolution measures could split netting sets, while recommending that the impact of that splitting on liquidity and collateral requirements is considered, and subject to, the observance of legal safeguards. A 31

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examined by resolution authorities, particularly at the stage of resolution planning. Possible actions may include structural measures that would minimize cross-product netting across different siloed clearing services, so that a single netting set would apply within a specific clearing silo.34

Interaction between Resolution Regimes of the CCP and of Its Participants The financial difficulties of one or more of the CCP participants that give rise to default losses and to the resolution of the CCP may also be the triggering event of a resolution proceeding over the CCP participants, as governed by the relevant resolution regime. In this case, the resolution of a CCP could be concomitant with the resolution of one or more of its participants. Depending on where the CCP participants are established, their resolution process may be initiated in the home jurisdiction of the CCP—which also governs the resolution of the CCP— or in foreign jurisdictions. In either case, the question arises about how the resolution regimes and processes would interact, and how the CCP rules and arrangements—also applicable when the CCP is in resolution—are aligned to the key objective of preserving the continuity of critical clearing functions. Where CCP participants are subject to resolution, it is important to ensure the operational continuity of their access to the CCP services.35 Continuity is conditioned on the ongoing fulfillment by the firm under resolution of its obligations toward the CCP. If the obligations are not fulfilled, the CCP would be entitled to initiate a default management process. The same conclusion applies if the CCP is under resolution. In this case, it would be the responsibility of the resolution authority, stepping into the shoes of the CCP and exercising its contractual rights, to ensure the continuity of access to FMI services, or to terminate the positions of the participant that, while being subject to resolution, is not fulfilling its obligations to the CCP. The same need for continuity would also arise when a firm in resolution is a provider of critical services (such as custody or settlement) to a CCP in resolution. Resolution authorities will need to identify and monitor in resolution planning any possible conflicting objectives that may emerge between the resolution regimes and processes applicable to the CCP and to its participants or providers of critical services, with a view to putting in place appropriate coordination and cooperation arrangements. different and seemingly unexplored issue relates to selective tear-up in recovery, and to its possible enforceability in case of insolvency of the defaulting member. 34 See also International Swaps and Derivatives Association/The Clearing House (2016): “[I]t is important that CCPs structure clearing silos to include all contracts for which the CCP permits cross-margining or portfolio margining and that are eligible for treatment by clearing participants as a single netting set for CCP margin and regulatory capital purposes.” 35 Continuity of critical services, including through access to FMIs, is a key objective of resolution processes, as recognized by the Key Attributes, and efforts are underway to achieve this by aligning CCP rules and arrangements to resolution regimes. See the “Guidance on Continuity of Access to Financial Market Infrastructures (‘FMIs’) for a Firm in Resolution” (FSB 2017).

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Chapter 7  The New Frontier of Resolution Frameworks: Central Clearing Counterparties

CROSS-BORDER ASPECTS CCPs are internationally active firms because their participants and service providers typically operate in different jurisdictions. Therefore, effective cross-border frameworks for a CCP’s resolution must be in place so that actions taken by the resolution authority in the home jurisdiction of the CCP are given effect in other jurisdictions (for example, where CCP participants are established).36 Also in this context the features of CCPs, including those of a legal nature, assume relevance because they may have an impact on the cross-border effectiveness of the resolution actions. In particular, certain challenges generally arising in the cross-border resolution of financial institutions may not emerge in a resolution of a CCP. CCPs do not operate through foreign branches, and their rules and arrangements are included in the CCP rulebook: a single, multilateral contract uniformly agreed upon by the CCP, with its participants and subject to regulatory approval by the CCP regulator and supervisor. As examined in the preceding sections, such a contract includes rules on the default management process and on loss allocation among CCP participants. Typically, the CCP rulebook is governed by the laws of the jurisdiction in which the CCP is established—which is the same as the CCP resolution authority—and defers to the jurisdiction of the local courts in case of disputes between the CCP and its participants. Furthermore, in line with the Principles for Financial Market Infrastructures’ (CPMI/ IOSCO 2012) margin posted by CCP participants with the CCP (for example, into the default fund contribution) should be held under legal arrangements that ensure the enforceability of its use, including when the collateral forming part of the margin is held in foreign jurisdictions or through global custodians.37 All of these elements may simplify the cross-border resolution of a CCP by containing the effects of the CCP resolution in the home country of the resolution proceeding. There would be no need to enforce the resolution actions in foreign jurisdictions, because the CCP participant has contractually agreed to be bound by the laws of the CCP home resolution authority, in which the resolution measure deploys its legal effects. However, challenges from a cross-border perspective may still arise. First, resolution losses are allocated not by the CCP according to contractual arrangements but by an administrative authority. CCP participants, including foreign ones, agree in the rulebook to the decision-making process initiated by the CCP, but not necessarily by the administrative authority. Moreover, there might be a disconnect between the CCP rules and arrangements and the statutory resolution Key Attribute 7 recommends jurisdictions have in place transparent and expedited mechanisms to give prompt legal effects to foreign resolution actions, either by a recognition process or by taking measures that support the resolution actions adopted by the foreign resolution authority. 37 Under the PFMI (Principle 1), FMIs are required to have rules, procedures, and contracts that are enforceable in all relevant jurisdictions, and FMIs with cross-border business should identify and mitigate risks arising from any potential conflict of laws across jurisdictions. Under the concept of legal basis relevant for Principle 1, the legal framework of an FMI includes laws and regulations governing default procedures and the resolution of a CCP. Observance by FMIs of Principle 1 would therefore help ensure the cross-border effectiveness of resolution actions over a CCP. 36

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tools. For example, the resolution authority may exercise resolution tools and actions that are not reflected in the CCP rulebook or may otherwise depart from the loss allocation arrangements provided under the rulebook. CCP contractual arrangements may also be governed by a law different from that of the CCP home jurisdiction. The question arises whether any of these grounds may lead to a challenge of the cross-border effectiveness of the resolution action in jurisdictions in which the CCP foreign participants are established or in other jurisdictions (such as where the collateral is held). These concerns could be mitigated by incorporating into the CCP rulebook an explicit clause whereby the CCP and its participants would agree to be bound by the resolution regime of the CCP home country. This would help align the contractual loss allocation arrangements provided under the rulebook with the statutory regime for resolution. Further, through such a clause the CCP participants would adhere to the decision-making process provided under the statutory regime, led by the authority rather than by the CCP. CCP home jurisdictions might require that CCP contracts governed by foreign law include a clause recognizing contractually the resolution powers vested in the CCP home resolution authority. This contractual approach—leveraging on the simpler group and legal structure of CCPs and on the existence of a single rulebook—would help enhance the cross-border effectiveness of resolution actions over a CCP.38

CONCLUSION CCPs have become more systemic as a result of the reforms promoted in the global financial regulatory agenda. Effective arrangements should therefore be put in place for their possible resolution so CCPs do not become sources of financial stability. The policy community, under the aegis of the FSB, has taken steps to develop international guidance on the key features that should underpin CCP resolution regimes, and a key milestone has been achieved through the adoption of the Guidance on Central Counterparty Resolution and Resolution Planning (FSB 2017). As evidenced by the FSB guidance, the design of resolution regimes for CCPs should be heavily informed by their legal, economic, and regulatory features, which make CCPs very different from banks and other financial institutions. A key distinctive factor is that CCPs are systemic risk managers and perform this function by mutualizing counterparty credit risk through the CCP rulebook, a single, uniform multilateral contractual arrangement concluded between the CCP and its participants. This chapter has discussed how this loss-mutualization function performed through the single rulebook interacts with CCPs’ resolution processes, by reviewing the powers of resolution authorities to enforce, or to depart from, the 38

See the Consultative Guidance (FSB 2017, sec. xx).

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Chapter 7  The New Frontier of Resolution Frameworks: Central Clearing Counterparties

rulebook, by looking at the scenario whereby the resolution of a CCP originates from “nondefault losses,” and by examining how CCPs’ specific features pose certain challenges in allocating losses to equity. The chapter has also examined a number of elements inherent in CCPs’ legal structures and function that may have an impact on the design of their resolution regime, and has then turned to cross-border aspects, where the existence of a single rulebook may arguably contribute to enhance the effectiveness of resolution actions over CCPs. As resolution regimes for CCPs are developed in coming years, it will be important to take into account all of these legal features—and the role each can play in enhancing the resolvability of CCPs.

REFERENCES Bignon, Vincent, and Vuillemey, Guillaime. 2017. “The Failure of a Clearing House: Empirical Evidence.” CEPS, Policy Contribution. https://www.ceps.eu/ceps-publications/ failure-clearinghouse-empirical-evidence/. BlackRock. 2016. “Resiliency, Recovery and Resolution: Revisiting the 3 R’s for Central Clearing Counterparties.” Viewpoint (blog), October. https://www.blackrock.com/corporate/ literature/whitepaper/viewpoint-ccps-resiliency-recovery-resolution-october-2016.pdf. Braithwaite, Jo, and Murphy, David. 2016. “Got to Be Certain: The Legal Framework for CCP Default Management Processes.” Bank of England Financial Stability Paper 37, Bank of England, London, United Kingdom. Coeuré, Benoît. 2017. “Central Clearing: Reaping the Benefits, Controlling the Risks.” Financial Stability Review 21. Committee on Payments and Market Infrastructures (CPMI)/International Organization of Securities Commissions (IOSCO). 2012. Principles for Financial Market Infrastructures. Basel, Switzerland. ———. 2014. Recovery of Financial Market Infrastructures. Basel, Switzerland. ———. 2016. Resilience and Recovery of Central Counterparties (CCPs): Further Guidance on the PFMI—Consultative Report. Basel, Switzerland. Cooper, Jonathan. 2014. “The Korea Exchange: A Cautionary Tale on CCP Waterfalls and Non-defaulting Members Taking the Loss.” Securities Finance Monitor March 18. http:// finadium.com/the-korea-exchange-a-cautionary-tale-on-ccp-waterfalls-and-non-defaultingmembers-taking-the-loss/. Cox, Robert T., and Robert S. Steigerwald. 2017. “A CCP is a CCP is a CCP.” Working Paper PDP 2017–01, Federal Reserve Bank of Chicago, Chicago, Illinois. Duffie, Darrell. 2014. “Resolution of Failing Central Counterparties.” Graduate School of Business, Stanford University, Stanford, California. Elliott, David. 2013. “Central Counterparty Loss-Allocation Rules.” Bank of England Financial Stability Paper 20, Bank of England, London, UK. European Commission (EC). 2016. Proposal for a Regulation of the European Parliament and of the Council on a Framework for the Recovery and Resolution of Central Counterparties and Amending Regulations (EU) No 1095/2010, (EU) No 648/2012, and (EU) 2015/2365. Brussels, Belgium. Financial Stability Board (FSB). 2014. Key Attributes of Effective Resolution Regimes for Financial Institutions. Basel, Switzerland. ———. 2016. “Essential Aspects of CCP Resolution Planning.” FSB Discussion Note, Basel, Switzerland. ———. 2017. Guidance on Central Counterparty Resolution and Resolution Planning. Basel, Switzerland.

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———. 2018. “Financial Resources to Support CCP Resolution and the Treatment of CCP Equity in Resolution.” https://www.fsb.org/2018/11/financial-resources-to-support-ccpresolution-and-the-treatment-of-ccp-equity-in-resolution/. Gibson, Matt. 2013. “Recovery and Resolution of Central Counterparties.” Bulletin (December quarter). http://www.rba.gov.au/publications/bulletin/2013/dec/5.html. Gregory, Jon. 2014. Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives. Hoboken, NJ: Wiley. International Monetary Fund (IMF). 2010. “Making Over-the-Counter Derivatives Safer: The Role of Central Counterparties.” Global Financial Stability Report. Washington, DC, May. International Swaps and Derivatives Association (ISDA). 2013. “CCP Loss Allocation at the End of the Waterfall.” ISDA Paper, August. https://www.isda.org/a/jTDDE/ccp-loss-allocation-waterfall-0807.pdf. ———. The Clearing House. 2016. “Considerations for CCP Resolution.” https://www.isda. org/a/YjDDE/20160523-tch-isda-white-paper-considerations-for-ccp-resolution1.pdf. JPMorgan Chase. 2014. “What is the Resolution Plan for CCPs?” Perspectives (September). https://www.jpmorganchase.com/corporate/About-JPMC/document/resolution-plan-ccps. pdf. ———. 2017. “A balancing Act: Aligning Incentives through Financial Resources for Effective CCP Resilience, Recovery and Resolution.” Regulatory Policy Insights, Office of Regulatory Affairs, New York, NY. LCH. 2014. “CCP Risk Management, Recovery and Resolution: An LCH White Paper.” https://www.lch.com/node/391. Lubben, Stephen J. 2015. “Failure of the Clearinghouse: Dodd-Frank’s Fatal Flaw?” CLS Blue Sky Blog October 9. http://clsbluesky.law.columbia.edu/2015/10/09/ failure-of-the-clearinghouse-dodd-franks-fatal-flaw/. Norman, Peter. 2011. The Risk Controllers: Central Counterparty Clearing in Globalized Financial Markets. Hoboken, NJ: Wiley. Papathanassiou, Chryssa. 2016. “Financial Market Infrastructures in Stress Scenarios.” In Bank Resolution: The European Regime, edited by Jens-Hinrich Binder and Dalvinder Singh. Oxford, UK: Oxford University Press. Powell, Jerome H. 2017. “Central Clearing and Liquidity.” Paper presented at the Federal Reserve Bank of Chicago Symposium on Central Clearing, Chicago, IL, June. https://www. federalreserve.gov/newsevents/speech/powell20170623a.htm. Rehlon, Amandeep, and Dan Nixon. 2013. “Central Counterparties: What Are They, Why Do They Matter and How Does the Bank Supervise Them?” Quarterly Bulletin June 13. Singh, Manmohan. 2014. “Limiting Taxpayer ‘Puts’—An Example from Central Counterparties.” IMF Working Paper 14/203, International Monetary Fund, Washington, DC. ———, and Dermot Turing. 2017. “Central Counterparties—An Unresolved Problem.” IMF Working Paper 18/65, International Monetary Fund, Washington, DC. Skeel, David. 2017. What if a Clearinghouse Fails? Series on Financial Markets and Regulation. Washington, DC: Brookings Center on Regulation and Markets. Steigerwald, Robert. 2015. “Central Counterparty Clearing and Systemic Risk Regulation.” In The World Scientific Handbook of Futures Markets, edited by Anastasios G. Malliaris and William T. Ziemba. Singapore: World Scientific. Tucker, Paul. 2011. “Clearing Houses as System Risk Managers.” Paper presented at the Depository Trust & Clearing Corporation Centre for the Study of Financial Innovation Post Trade Fellowship Launch, London, UK, June 1. https://www.bis.org/review/r110608g.pdf. Turing, Dermot. 2016. Clearing and Settlement. London, UK: Bloomsbury. United Kingdom, HM Treasury. 2014. “Secondary Legislation for Non-Bank Resolution Regimes.” Consultation outcome, June 9, London, United Kingdom. https://www.gov.uk/ government/consultations/secondary-legislation-for-non-bank-resolution-regimes. Wendt, Froukelien, 2015. “Central Counterparties: Addressing their Too Important to Fail Nature.” IMF Working Paper 15/21, International Monetary Fund, Washington, DC.

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IV CORPORATE DEBT RESTRUCTURING AND ECONOMIC RECOVERY

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CHAPTER 8

Debt Restructurings and Corporate Insolvencies Luis Manuel C. Méjan

IMPORTANCE OF MECHANISMS OF CORPORATE DEBT RESTRUCTURING FOR ECONOMIC RECOVERY As a preliminary basis for this analysis, it must be admitted that access to financing from companies is positively correlated with economic growth, allowing companies to channel resources into productive investment. Having access to credit also promotes innovation because the companies obtain resources to invest in new technologies and processes, improving their productivity.

The Beginning of the Problem It is common that financial problems arise in companies as the result of financial mismanagement, operational decisions, sectoral threats, or changes in economic cycles. These problems can lead companies to default on their payment obligations. This situation of widespread failure is what is known as “insolvency,” and its treatment should be extraordinary because it is a situation that is also extraordinary and because it refers to the entire universe of legal situations of a company in this situation. Laws that deal with insolvency are called insolvency laws, bankruptcy laws, or similar titles. In the case of Mexico, the law is called the Ley de Concursos Mercantiles (Bankruptcy Act). The increase in nonperforming loans—which often lead to bankruptcy— affects the development of the economy as a whole—from production processes to distribution and consumption—because it alters the flow of funding and, ultimately, causes a decrease in social welfare. The increase in overdue loans produces two other negative effects: the increase in the cost of financing for borrowers who bear the risk of those not meeting their obligations, and an astringency in the flow of credit because financial lenders have less incentive to provide resources and therefore increase the requirements for loans.

Dr. Méjan is a professor and researcher at Instituto Tecnológico Autónomo de México.



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Relevance of a Global and Orderly Strategy Debt restructuring is a financial mechanism through which the terms of financial commitments (acquired by granting credit or by suppliers of goods and services and others) are modified. Such modifications usually comprise the term and interest rate, increased guarantees, and access to other sources of liquidity, among others, as financial engineering can provide many tools. Restructurings can be achieved through bank financing, financing through bonds or debt instrument, business combinations and joint ventures, and through a process of restructuring of the accounting assets. Any of these restructurings may occur within a bankruptcy proceeding or outside it. As a preventive measure, restructuring is an important mechanism within the economy that allows agents to have a better management of their strategies and resources to avoid insolvency. The bankruptcy procedure is designed to ensure that the reorganization is an essential part of the same. The use of bankruptcy proceedings is not, however, the only measure that companies can use; informal groups can be assembled, direct negotiations with creditors, use of financial advisors, and use of professional mediators are among the other possible tools. In some jurisdictions such tools have received formalized legal treatment. The first step in determining whether a restructuring is possible is to detect whether the company is viable; if a company’s liquidation value is greater than its value as a going concern, it is considered nonviable. In that case, the best solution may be to close that business and do it as quickly as possible because the value of assets tends to decrease rapidly as time passes. In the case of a company that reaches insolvency, this is a decision that must be taken during the first stage of the procedure: the conciliation. This is the point where the conciliator, together with the merchant debtor and creditors, must arrive at a business plan that will allow the continuity of the company. If the conclusion is that the company is not viable, it will have to pass to the stage of bankruptcy, where the assets of the company will be liquidated to make the best-possible payments to the creditors. In fact, this analysis should be done prior to the commencement of insolvency proceedings to allow either preparation of a prepackaged agreement or definition of the lines on which the conciliation shall elapse; otherwise, it will be necessary to go directly to the stage of bankruptcy and liquidation. Normally, restructuring includes a requirement that all creditors, including commercial banks, waive their right to demand forced recovery of defaulted payments. This would be in exchange for the debtor (or creditor) agreeing that the debts in question will be repaid according to a new agreed-upon program (Stein and Luis 2011). As a rule, it is much easier for both parties, in the process of debt restructuring, to follow the legal proceedings. The procedures seem to be easier and more controllable by the debtor. If creditors were obliged to always go to judicial authorities to obtain payment of their claims, without being able to opt for another choice but to classify the loan as uncollectible, the financial institutions’ operating

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costs would rise extremely, thus producing a shortage of credit, which will be costly, in the end, to those debtors that pay their loans. When companies become insolvent, creditors have three possible ways forward: the use of ordinary judicial mechanisms for forced payment, invoking the insolvency law, or using extraordinary mechanisms implemented by the government to help to resolve a crisis. A thorough examination of those three possibilities show: • Ordinary mechanisms are insufficient. • The state design and implementing mechanisms and special programs designed to address a crisis situation should be the last resort to use.1 • The solution should be a system of legal treatment of insolvency to allow the restructuring of liabilities of enterprises, reintegration of their assets in the economy, and the maintenance of the jobs and the gross domestic product. This can be accomplished either through the use of judicial or administrative means. A global strategy, if we are not talking about a systemic crisis, should include a system providing the following: • If companies are not viable, there is an ability to sell them very quickly in order to preserve assets before they lose more value. • If companies are viable, there is an ability to restructure them expeditiously, if necessary, by facilitating the post-bankruptcy financing of the enterprises that remain in operation (known as debtor in possession [DIP] financing). Another measure in the strategy includes the enforcement of the liability of the company’s directors. The aim is to create awareness of the measures to be taken when approaching insolvency.

In the Event of a Systemic Crisis When a bad financial situation is not adequately addressed—that is, when financial institutions have accumulated unsustainable levels of debt and have waited too long to address them—the solvency of these institutions will be harmed. This also can produce a systemic effect by producing a contagion to other companies in the same industry, or in the geographical area where the troubled company operates, and in the overall economy, thus compromising the welfare of the people, the country, and, in some cases, the international community. A systemic crisis needs to be addressed with the participation of the corporate, financial, and government sectors. Proper analysis of corporate debt issues is essential and includes asset quality tests and reviews of the legal and institutional 1 These kinds of mechanisms were implemented in Mexico during the currency crisis of the 1980s with the program called “FICORCA” or during the financial crisis of the 1990s with the ADE, UCABE, and Final Point program; in the United Kingdom, the so-called London approach in Japan’s Civil Rehabilitation Act; Act No. 225 of December 22, 1999, as amended by Act No. 87 of 2005; and in Colombia Law 222 of 1995, to cite a few examples.

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insolvency, the debt-enforcement framework, and aspects of regulation and supervision. A systemic crisis requires strong government involvement (because it is beyond the scope of the corporate sector and even the banks themselves) and consideration of standardized solutions for debt restructuring. It is difficult to design an effective scheme beforehand to deal with systemic crises, because each crisis is unique. Even so, the lessons learned from the last crisis must be taken into account when designing insolvency regimes or bank funding schemes. The first essential element in a comprehensive strategy to tackle the loans in an overdue portfolio deal is, above all, to prevent them in the first place. Therefore, the correct sequence in the adoption of measures to restructure companies with overdue portfolios should begin with the precautionary and prophylactic measures, that is, how not to get to the situation of an overdue portfolio. The regulatory framework for banks should be strict enough to prevent the origination of loans that borrowers do not intend to, or cannot, repay, while being, at the same time, a tool to promote bank lending. Too much rigidity or too many requirements may discourage the practice of granting credit. Then will come the design of efficient systems for ordinary recovery, insolvency law, and regulations and supervision of credit institutions. Finally, it seems necessary that the judicial and prosecutorial system will also be reviewed in order to facilitate all recoveries. Coordination between the actors and the creation of a forum where players can interact seems to be important. The business sector must assume its responsibility in the crisis and not play by the perverse incentive of the concept “too-big-to-fail,” under which entrepreneurs of certain companies or sectors expect the government to come to their aid with fiscal resources and therefore fail to avoid the crisis or work for a solution after a crisis has occurred.2 In short, when there is a crisis, the problem arises from the corporate and financial sectors. Therefore, the interest groups are the companies (perhaps chambers of commerce and the like), bankers, and regulators. Coordination among key stakeholders is essential to implement any strategy to deal with the crisis. The more serious the problem of nonperforming loans, the greater must be the support of the government, the central bank, and the banking supervisor to deal with overdue loans.

Informal or Out-of-Court Restructurings One of the main reasons companies avoid using insolvency regimes is having to be involved in a complicated legal process that normally delays the arrival of solutions and thereby further deteriorates the value of assets. An ideal seems to be a system that allows the reorganization of companies without having to go to court. However, the participation of a court of law usually is necessary because, at least according to Mexican law constitutional principles, a creditor may not be forced to accept a restructuring plan simply because other creditors have done so. 2

This happened historically in the case of the sugar industry in Mexico.

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It therefore is necessary that due process allows creditors the opportunity to participate and be heard. Thus, the approval by the court of a reorganization plan is mandatory. The only way to avoid this is to obtain the agreement of 100 percent of creditors, which can be difficult. The establishment of a hybrid system could be a solution: let creditors and the debtor reach a fundamental agreement that may be imposed on creditors who have not participated, and then take the agreement to court for approval. This gives the judge an important role, although often with only a limited amount of time in which to make a decision.

Key Features of a Robust Insolvency Regime To begin with, it is necessary to think that the legal system provides sufficient tools to creditors to achieve effective recovery of funds. A legal regime, whatever its style or location in the physical or ideological map, cannot afford to allow that obligations are not met (pacta sunt servanda) or tolerate the negligence of obligations. To do so destroys the rule of law and leaves the fate of all to the law of the strongest. The document prepared by the World Bank in consultation with experts from around the world, the “World Bank Revised Principles for Effective Creditor Rights and Insolvency Regimes,” begins with the following statement: “Effective insolvency and creditor rights systems are an important element of financial system stability” (World Bank 2015). These systems help to ensure effective access to credit and the allocation of resources, improving productivity and growth. They also allow market players to better manage financial risk and other difficulties in the business sectors in a timely manner in order to minimize systemic risk, particularly in the banking system. The aim is to assure a creditor with the possibility of making use of the assets of the debtor in a fast and effective manner. Whether or not the credits are backed with a real guarantee, gaining access to the firm’s assets would be more effective than the threat of resorting to an insolvency proceeding. However, it is necessary to understand that when the negligence of a debtor is generalized, there can be no question that the ordinary means of recovery of the debts are efficient. In addition, this assumption is no longer just about the interests of a creditor with its debtor: it is an economic problem that affects the life of a community. This is where the insolvency regime must appear. Developing and maintaining a strong insolvency regime is the fundamental basis under which companies suffering problems can get proper treatment. If the system has proved to be effective, all concerned stakeholders will have confidence in its future use when needed. The crisis in Mexico in the 1990s, for example, would have been very different if the country had an insolvency regime similar to that in place today.

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Key features of a robust insolvency regime include the following: • The first is the creation of a new paradigm in insolvency law. This will maximize the value of companies, either in achieving a reorganization or efficient liquidation, and will stop the deterioration of a company and avoid the systemic effect of its failure on the economy of a country. The overall goals are replacing the assets of troubled firms in the bloodstream of the economy, keeping jobs, and generating GDP. • The second element is that the insolvency regimes should be transparent, with reduced costs and accessible to both large and small companies. • A third element is the impact of the priority of claims. Whereas par condicio creditoris is a universal principle of insolvency law, providing that creditors should be given similar treatment, in reality credits are not similar and priorities must be set. The most common priorities are usually given to workers’ credits, credits that have a security, and tax credits. Also, the credits placed at the end of the list usually are those of related parties and credits held by shareholders or owners of the company. This priority system plays a key role in the debt restructuring with creditors because it determines who should be prioritized for the negotiation. For example, the super-priority of wage claims by Mexican legislation deters employers from using the insolvency system to solve their labor problems. Secured loans should have the priority usually given to them because giving them another degree would discourage the extension of credit. Leaving related credits at the end makes sense in terms of good governance for the company. With regard to the tax credits, the question is whether they should be given a specific priority or should be considered among the common creditors or even subordinated to them. The state must understand that tax collection should not be driven by short-term greed, because in the long term it is better for the state if taxpayers remain in operation. • Another key element in the design of an insolvency regime is its brevity and speed. The saying “time is money” is never truer than when it comes to achieving the financial restructuring of a debtor. The passage of time deteriorates the value of assets inexorably, especially if the company has ceased to operate.

Design of Mechanisms for Debt Restructuring Any restructuring should be made following a business plan. In a systemic situation it is necessary, furthermore, to take into account the global economic processes. Usually there are three general ways to orient restructurings: the direct participation of the state, via the market, or a hybrid method that combines elements of the previous two. The implementation of each method depends on the circumstances and gravity of the situation. The intertwining of the corporate and financial sectors that defines a systemic crisis is unique and requires that the restructuring will be addressed by both sectors regardless of the actions of the debtor and its creditors. For a debt

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restructuring mechanism to have the desired economic results, it is necessary to create an appropriate and well-specified legal framework, in which there are no gaps that would enable any party to either take advantage or deviate from the desired result. There is also a need for incentives created by the authorities through the appropriate economic policies in a country, starting with the question of who takes the initiative. Companies in trouble need a push in the right direction, but it is difficult for a credit institution to be the one forcing that push. Part of the regulatory approach of the state authorities that dictate the economic policies should take this into account.

Consequences of Not Restructuring The failure to restructure a failing financial situation leads to deterioration and the need for liquidation of a company. But the risk is not limited to that company because its insolvency can produce a contagion effect on other companies that interact with it.3 Contagion may even lead to a systemic effect throughout an industry or even in an entire national economy. From the standpoint of the financial system, not to achieve an orderly and predictable restructuring of unsustainable debt owed by one company would result in financial institutions also accumulating unsustainable levels of debt because they waited too long before coping with the problem. This situation adversely affects not only the solvency of those financial institutions, but also can compromise the welfare of the people, the country, and, in some cases, the international community. The financial crisis of 2008 occurred because financial institutions had no way of reacting to nonperforming loans in the underlying securities, which then collapsed the entire building erected above them.4

Legal Framework Although insolvency regimes were built for a long time on the basis of supporting creditors, sometimes and in some regimes the regulations seem to be tilted toward the side of those who do not pay, thus creating incentives for nonpayment. Neither of these exclusive approaches is appropriate; without neglecting the rights of participants in an insolvency problem, the legal framework should seek broader goals than serving the mere interests of those involved in the problem. The legal framework and financial policy should aim to limit the impacts of a crisis on the credit markets to the least extent possible and avoid the slowing down of development resulting from the lack of lending. The legal framework and regulatory

3 That is why Mexican law places as a key objective of the bankruptcy proceedings to prevent the deterioration of a company leading to negative impacts on the companies with which it is interrelated (Article 1 of the Law on Commercial Competitions). 4 The Mexican financial crisis of the 1990s was caused by an accumulation of excessive overdue portfolios in consumer credit, mortgages, and businesses. The individual difficulties led to the systemic crisis.

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approach must be constructed and specified in a complementary manner to achieve an efficient and effective financial system so the benefits are realized correctly. As stated by Mexican authorities, “A regulatory approach’s overall mission is to propose, direct and control the economic policy of the government in financial matters, taxes, spending, income and public debt, in order to consolidate a country with quality economic growth, equitable, inclusive and sustained, to strengthen the welfare of Mexicans.”5 The purpose of debt restructuring mechanisms is to ensure a reasonable return of credit. Those mechanisms will make sure that credit is available and rates (the cost of credit) are maintained at an affordable level for potential borrowers.

Miscellaneous Incentives To these mechanisms should be added various incentives that encourage the financial system to keep credit offered and at a reasonable cost. These incentives may come from a state policy, regulatory aspects, or the contractual agreements themselves. A good incentive, for example, would be to treat the tax credits without any specific priority, but as a common credit. Another incentive may come when the regulatory bodies of the financial system lift some barriers and requirements. When there are too many requirements and too much bureaucracy, actors tend to avoid formal means, which leads to out-of-control solutions. Another incentive is to include in the restructuring plans a clause prohibiting the advance payment of the restructured debt; doing this can avoid the perverse incentive to prepay on terms more favorable than those for debt that not been restructured.

The Role of the State A question arises: Does the state have a role to play in the restructuring of debts of companies? The answer is yes, and it should be analyzed through the different roles that the state assumes according to its operation. The more serious the debt problem is, the more active the state must be in becoming the solution to the problem—or at least an important part of the solution. The state (such as tax authorities) should play an active role in resolving the debt by participating in the debt restructuring with the aim of maximizing tax revenue. Officials involved in the debt restructuring should be protected from liability when they act in good faith.

As a Supervisor and Regulator of the Financial System The state should set out all the regulations to ensure that banks and other credit providers carry out their activities within a framework of precautionary measures in order to achieve the lowest percentage of delinquency possible. The state should carry out the necessary supervision of financial institutions to ensure that 5

Secretariat of Finance and Public Credit 2016.

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the rules are complied with in practice and to avoid a collapse of the “bubbles” created by bad loans. The state must also allow and encourage financial institutions to create and develop new loan products to promote economic activity. Although these principles might appear to be contradictory, the state should maintain a balance between its powers of regulation and supervision and its role as a promoter of economic activity.

As a Creditor The role the state plays in a crisis must maintain a position beyond its particular interests as a creditor and allow it to concentrate on the overall situation and the future. In Mexico, for example, we have some state-owned banks, the so-called development banks, whose purpose is to promote credit in those areas that, according to economic policies, should be promoted: for example, exporting small and medium-sized enterprises, large public projects, popular savings, and others. This role of acting from a “second tier” has proved a success.

As an Entrepreneur State-owned enterprises have not always proven to be efficient. When such firms fall into serious trouble, it is necessary for the state to rescue them using, of course, taxpayers’ money, which is neither popular nor economically convenient. It is necessary for the state to determine which of these troubled companies should remain under public ownership and which should go into private hands. Sovereign insolvencies have proven a useful means in getting rid of state-owned enterprises because of their need to obtain the necessary liquidity to meet their debt obligations.

As a Debtor If we consider the state itself as debtor, then we are in another field: the sovereign insolvency. As illustrated by recent debt crises in Europe, this is a concern that has not yet found an entirely satisfactory solution.

The Responsibility of Public Officials Generally, the legal system provides that officials, when acting within their public roles, must not be held responsible unless they have acted in bad faith. Otherwise, they might feel that failure to act is more secure for them personally than taking actions, even responsible ones, that might later come into question.

International Contributions Ever since the Asian financial crisis in the 1990s and right up to recent cases of corporate insolvencies, international organizations have been working on a review of best practices and standards to achieve robust insolvency regimes that can provide an essential basis for the treatment of the problems of corporate debt. The

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greatest contributions have come from the United Nations Commission on International Trade Law (UNCITRAL) and the World Bank, without belittling the efforts that other governmental and nongovernmental organizations have been making, including the regional banks, the Organisation for Economic Co-operation and Development, the European Union, [MENA], the Organization for the Harmonization of Business Law in Africa, and many others. The World Bank in 2001 developed the “Principles and Guidelines for Effective Insolvency and Creditor Rights Systems.” These principles, which bring together the best practices in the field, have set the standard for the conduct throughout the world of various review and valuation exercises called Reports on the Observance of Standards and Codes, which have provided countries with suggestions and practical tools for improving their legal systems. In the case of UNCITRAL the first important step was the “Model Law on Cross-Border Insolvency” that has been adopted by more than 30 countries. It provides a basis of equality of treatment to insolvency problems that involve multiple jurisdictions.6 This document has been added with another that provides the vision of judges who have been in charge of the implementation of the Model Law, as has been adopted and adapted in their countries. UNCITRAL took a second step in 2005 with the creation of the “Legislative Guide on Insolvency Law.”7 The purpose of this guide is to contribute to the creation of an efficient and effective legal framework to regulate the situation of debtors that have financial difficulties. The guide has been designed as an instrument of reference for national authorities and legislative bodies when preparing new laws and regulations or when considering a revision of existing ones. Part three of the legislative guide focuses on the treatment of enterprise groups in insolvency. It states that “where an approach different to that taken in part two [of the guide] might be required with respect to a particular issue as it affects an enterprise group or where the treatment of enterprise groups in insolvency raises issues additional to those discussed in part two, they are addressed in this part. Where the treatment of an issue in the context of an enterprise group is the same as discussed above, it is not repeated in this part. The substance of part two is therefore applicable to enterprise groups unless indicated otherwise in this part.” The fourth part of the legislative guide focuses on “the obligations that might be imposed upon those responsible for making decisions with respect to the management of an enterprise when that enterprise faces imminent insolvency or insolvency becomes unavoidable. The aim of imposing such obligations, which are enforceable once insolvency proceedings commence, is to protect the legitimate interests of creditors and other stakeholders and to provide incentives for timely action to minimize the effects of financial distress experienced by the enterprise.”

6 7

United Nations Commission on International Trade Law 1997. United Nations Commission on International Trade Law 2005.

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This is a document close to another one created by the International Association of Restructuring Insolvency & Bankruptcy Professionals “Directors in the Twilight Zone.” Currently UNCITRAL’s Working Group V is working to complete some ideas related to the previous documents about the issues that arise in the context of groups of enterprises operating in different jurisdictions. The group is also working on the preparation of a Model Law on cross-border recognition and enforcement of judgments relating to insolvency. In addition, there is currently a project within the working group of UNCITRAL V to develop the basis for a treaty covering all issues arising from insolvency. All these international efforts aim to offer everyone the best criteria to understand the problem of insolvency.

The Mexican Experience The debt restructuring experience in Mexico generally has been good. Admittedly, very few cases have appeared under the law. The official figure for November 2015 was 636. For a country with around 1 million businesses, the figure of bankruptcy issues seems very low. Why so few? The main reasons for this drought are as follows: • Costs; • Ignorance; and, above all, • Reluctance to participate in a court of law, where lawyers and legal procedures, which are tedious and bureaucratic, are involved. If Mexico could foster a system in which the involvement of the courts is significantly reduced, the number of firms in difficulty using the law of insolvency as a means to achieve restructuring, would increase. Examples worthy of attention include planning legislation in Italy that ­facilitates the process of recovering credit and could reduce the required time to seven or eight months. As explained previously, there are pure systems that allow restructurings totally outside of the courts and mixed systems that involve the courts on a reduced basis. In Mexico a hybrid system was created in 2007 called insolvency with pre-agreed agreement (also known as “pre-packaged”). New provisions were enacted in 2014. A new bankruptcy law (Ley de Concursos Mercantiles) was enacted in Mexico in 2000. This law welcomes all the new principles of insolvency that were being established in the world at that time, especially as a result of the crisis in Asia. Mexico took into account the studies and ideas that at that time were being collected by the World Bank, the IMF, and the United Nations. Subsequently, two amendments to the law were taken from the experience and the pace of progress both nationally and internationally. Famous cases as Satmex, Mexicana, and Vitro were a valuable input in these reforms. It is expected that these rules will significantly increase the efficiency and reliability of the restructuring tools to allow debtors and creditors to achieve

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settlement agreements. So far, the system has proven to be effective. The main idea of this hybrid regime is that a debtor, along with creditors representing at least 50 percent of total liabilities, can design a reorganization plan and start the insolvency process by filing the proposed plan. The court then continues the insolvency process by calling in all creditors to apprise them of the plan. This is called a prepackaged agreement. Creditors who do not participate in the formation of the prepackaged agreement may voluntarily join it afterwards, and if the plan meets the requirements of law, especially that of the votes that approve the agreement, the court will approve the plan, making it mandatory for all (cram down). Therefore, the conclusion of the insolvency proceedings may come faster than under normal conditions. Major cases in Mexico have been resolved through this procedure. In total, since the beginning of the new bankruptcy law, 35 percent of insolvency cases (223 of 636) have been concluded through an agreement between the parties involved.8

Companies and Credit In Mexico, every year about 200,000 companies are created, of which 50 percent disappear in the first year and 30 percent in the second.9 One of the main reasons for this high rate of failure is the lack of access to finance that might have allowed

TABLE 8.1.

Formal Companies Using Banking Credit Country

Up to 100 Employees (%)

More than 100 Employees (%)

Chile Peru Colombia Brazil Uruguay Argentina Bolivia Average Venezuela Honduras Mexico Panama

78 63 53.1 57 46.5 46.5 44.9 45.4 29.5 30.3 29.5 21

81.7 92.7 92.2 89.6 75.2 75.3 78.6 67.5 85.4 31.7 54 10.1

Sources: Enterprise Survey IFC; and World Bank. Note: Figures are through 2010 for all countries, except Brazil, which is through 2009.

8 According to the website of the Instituto Federal de Especialistas de Concursos Mercantiles (“Federal Institute of Insolvency Professionals”), the administrative agency in charge of administrating the insolvency processes, of 636 total cases as of the end of report number 31, 223 issues (35 percent) have been completed through achieving an agreement. 9

http://​www​.cnbv​.gob​.mx/​Prensa/​Estudios/​Reporte​%20de​%20la​%20ENAFIN​.pdf.

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companies to grow or to overcome the difficulties of repaying their debts. Poorly functioning credit markets represent one of the most important economic brakes on growth. Indeed, only 43 percent of companies in Mexico are reported to have used credit from financial intermediaries. This factor is worrying, even when comparing the situation of Mexico with the rest of Latin America, as only 29 percent of formal companies with 100 or fewer employees have some bank financing, whereas the average in Latin America is 45 percent. A similar lag is present for companies with more than 100 employees (table 8.1). A problem lies in one of the financial policies followed by many of the financial intermediaries: grant credit only to companies with at least two years in business. The mistrust in the credit capacity of small and medium-sized enterprises limits their access to finance. An economy that is based largely on fragile companies is constantly confronted with bankruptcies, and this directly affects the employment of people, undermining the economic situation of families and thus affecting the entire society. The problem illustrates the economic and social importance of mechanisms of debt restructuring. Certainly it is necessary to admit that there is a rise in schemes and strategies of financial support for micro and small businesses to encourage entrepreneurship. These efforts should be observed carefully to determine the rate of nonperforming loans, although world experience has shown that financing of micro entrepreneurs is usually successful.

Using Post-Commencement Financing An example of how the legal or regulatory framework helps in the treatment of restructurings is the experience in Mexico regarding the financing of companies that are already in a bankruptcy proceeding and require financial assistance. This type of credit is known internationally as post commencement financing (or DIP). This source of financing is an increasingly important development, although one that is still in its infancy in many jurisdictions. Examples in Latin America include the following: in Brazil for the first time a DIP financing agreement was prenegotiated with creditors as part of the reorganization plan rather than being sought by lenders after the plan was approved by the court. A Canadian/ Colombian oil company, Exploración del Pacífico, is currently in the process of restructuring its debt in the United States with the use of DIP funds from a Canadian investment group. Alejandro Sainz, a Mexican lawyer, has stated: “The name of the game in insolvency is to get access to finance. The faster and cheaper is available, the better for investors.”10 Funding for companies that are in insolvency proceedings is logically a high-risk operation for the lender. However, it can provide a strong assist for the attainment of a restructuring, even if it is not the only way to achieve it. For this, 10

Davies 2016.

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the Mexican Insolvency Law has established provisions that facilitate such funding. In the latest reform, changes were introduced for that purpose to Articles 37, 43, 75, 224 of the act (see extracted material below). These reforms expressly authorized contracting loans, even after the filing of bankruptcy, which are essential to maintaining the regular operation of the company and the necessary liquidity at any time during the bankruptcy procedure. These credits may have guarantees. The merchant debtor must file a request for authorization to the bankruptcy judge, who must take into account the view of the insolvency representative (visitor or conciliator, depending on the stage of the procedure). Repayments of loans are not included in the automatic stay. They are credits against the estate and will be paid in the order given and before any of the others (except wage claims). Article 37 ... Since the application for insolvency, or once admitted, Merchant may ask the judge for permission to immediate recruitment of credits essential to maintain the regular operation of the company and the necessary liquidity during the pendency of the bankruptcy. For the processing of the aforementioned loans, the judge may authorize the creation of security that may result from, if so requested by, the Merchant. Filed the request of the Merchant and given the urgency and necessity of financing, the judge, after hearing the opinion of the inspector, will decide on the approval of the financing with the objective mentioned before, proceeding to issue the guidelines on which will be authorized the respective credit and its repayment during the bankruptcy, taking into consideration their preferred priority in terms of Article 224 of the Act. Article 43. The business reorganization judgment will include: ... VIII. (REFORM 10 / I / 14) VIII. The order to the Merchant to stop the payment of any debts assumed prior to the effective date of the business reorganization judgment, other than those that may be essential for the enterprise’s regular business, including any necessary credit to maintain the regular operation of the company and the liquidity required during the pendency of the bankruptcy, for which it must inform the judge within seventy-two hours following the date on which he makes the payments; Article 75. If the Merchant keeps on managing his enterprise, In the case of hiring necessary credits to maintain ordinary operation of the company and the necessary liquidity during the pendency of the bankruptcy proceedings, which have been authorized in terms of this article, the conciliator will define the guidelines for which will be authorized by the respective credit, taking

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into consideration their preferred priority in terms of Article 224 of the Act, including the provision of guarantees that may result from, if so requested by Merchant. Article 224. The following are credits against the Estate and shall be paid in the indicated order and before any of the credits to which Article 217 of this Act refers: ... II. Those assumed by the Merchant to manage the Estate, with the conciliator’s or receiver’s authorization or, where appropriate, the necessary credits to maintain the regular operation of the company and the necessary liquidity during the pendency of the bankruptcy. In the latter case, All privileges and preference in payment will be lost in case of granting such loans in violation of the decision by the court or authorized by the conciliator or when it is resolved by a judgment that the loans were contracted in fraud to the detriment of creditors and the estate; III. Those assumed to attend to the regular expenses for the protection of the properties of the Estate, their repair, preservation and management, and ...

In reinforcing these reforms, the regulatory authorities of the financial system established accounting standards that give proper treatment to loans granted to companies facing insolvency. Previously, all credits granted to a company in insolvency were considered as part of the overdue portfolio, which forced banks to require very high reserves, thus serving as an incentive to deny the granting of credit. The rules issued by the banking authorities provide that credit institutions must qualify, form, and register in their accounts preventive reserves corresponding to each of the loans in its portfolio.11 To accomplish this, banks must develop a complex calculation including indexes of “Probability of Default,” “Loss Severity,” and “Exposure to Breach.” Such terms are defined and provided with the necessary formulas for their calculation. The indexes listed here have a special treatment for loans to companies in insolvency, during the life of the procedure, to maintain the regular operations of the company and the necessary liquidity, and to meet the normal costs for the safety of the goods of the estate, its renovation, conservation, and management. The factor “Probability of Default” is fixed at its highest level, but in calculating the factor “Severity of Loss” in cases of prepackaged insolvency proceedings, favorable variants have been introduced. If additional guarantees have been granted for such loans, the calculation is even more beneficial.12

11 12

The regulation is called “Circular Única de Bancos,” or CUB. CUB articles 111, 113, and 114, and Annex 33 Bulletin 6.

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With this we can conclude that in Mexico, loans to DIP during insolvency proceedings are possible and provide a valuable tool for achieving financial restructuring.

CONCLUSION What are the desirable things that need to happen in order to achieve an efficient reorganization of the financial structures of firms? As shown in this chapter, they include: • Some relaxation of the procedural provisions for debt recovery, including of course in the insolvency proceedings; • A serious educational effort among entrepreneurs and lenders to help them understand and use the insolvency regimes’ mechanisms; and • A joint effort between financial authorities and private financial institutions, with the understanding that they are not enemies, because they work at the end of the day for the same purpose.

REFERENCES Davies, Tom Rhys. 2016. “DIP Financing has Broken Ground in Latin America but Remains Dysfunctional.” Global Restructuring Review. June 10. http://globalrestructuringreview.com/. Secretariat of Finance and Public Credit. 2016. “Organization Manual General.” Secretariat of Finance and Public Credit. http://www.shcp.gob.mx/lashcp/marcojuridico/ MarcoJuridicoGlobal/Otros/338otrosmoshcp.pdf. Stein, Velasco, and José Luis. 2011. “The Legal Instruments for the Restructuring of Public Debt.” Legal Research Institute of the National Autonomous University of Mexico. Federal District, Mexico. United Nations Commission on International Trade Law. 1997. UNCITRAL Model Law on Cross-Border Insolvency. http://www.uncitral.org/uncitral/en/uncitraltexts/insolvency/ 1997Model.html. ——— 2005. “Legislative Guide on Insolvency Law.” https://www.uncitral.org/pdf/english/ texts/insolven/05-80722Ebook.pdf. World Bank. 2015. Principles for Effective Insolvency and Creditor-Debtor Rights Systems, Revised 2015. World Bank, Washington, DC. https:/​/​openknowledge​​.worldbank​​.org/​handle/​ 10986/​23356.

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V CENTRAL BANK FUNCTIONS AND THE GROWING IMPORTANCE OF MACROPRUDENTIAL POLICY

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CHAPTER 9

New Tasks for the European Central Bank: Between Separation, Synergies, and the Preservation of Independence Chiara Zilioli

The global financial crisis, which started in 2007, revealed a clear need for more macroeconomic analysis and macro- and microeconomic monitoring. In response to this lacuna, central banks across the world have performed a key role in providing the necessary expertise and data analysis to policymakers; in parallel, fundamental institutional reforms have been introduced and new functions identified to improve financial stability for the future. The quality of the advice that central banks provided during the crisis, and the competence and efficiency they have demonstrated since the onset of the crisis, earned them the respect of governments and citizens alike. High levels of independence and expertise were the key ingredients for the authoritativeness of their advice in difficult times. At least in Europe, the general public’s appreciation of the contribution made by central banks to tackling the consequences of the financial crisis is evidenced by the assignment to them by their legislators of new public tasks. This expression of trust was an acknowledgment of the success of central banks in pursuing their objectives and of the synergies between their classic monetary policy functions and certain other functions, relative to the control of the banking system. Inevitably, the assignment of new tasks entails challenges for the traditional central banking model and, in particular, for central bank independence. This chapter explores these and other related issues. The first section addresses the interplay between the core objective1 of the European Central Bank (ECB)— maintaining price stability—with financial stability. The second section examines

Chiara Zilioli is Director General of Legal Services at the European Central Bank (ECB) and Professor of Law at Goethe University, Frankfurt. The views expressed here are purely personal and do not necessarily reflect the position of the ECB. The author acknowledges the help of Andra Florian in reviewing an earlier draft of this chapter. 1

Article 127.1 Treaty on the Functioning of the European Union (TFEU).



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the potential synergies and tensions between the ECB’s tasks.2 Finally, the third section addresses the impact of the ECB’s newly conferred powers3 on its independence.

THE ECB AND ITS PRICE AND FINANCIAL STABILITY TASKS: PRICE STABILITY MUST PREVAIL (EVEN IN CRISIS TIMES) Since the establishment of monetary unions, the Treaty of Maastricht and today the Treaty on the Functioning of the European Union (TFEU), lay down a clear hierarchy for the objectives and tasks conferred on the ECB and the Eurosystem.4 On the one hand, Article 127(1) TFEU provides: “The primary objective of the European System of Central Banks (ESCB) . . . shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources.”5 Primary law, which in the EU legal system corresponds to the constitutional level, assigns to the ECB and the Eurosystem, as a clear priority in the performance of their basic tasks, the responsibility for the maintenance of price stability. Secondary objectives are also assigned, but these may be pursued only as long as they do not jeopardize the achievement of the objective of price stability. Financial stability is not explicitly mentioned among the objectives in this article. On the other hand, since the very beginning,6 the treaty has mentioned the role of the ECB and the Eurosystem in relation to financial stability. Article 127(5) TFEU provides that “the ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system.”7 Despite the fact that primary law does not define the concept of financial stability, and that financial stability does not fall under the umbrella of the “basic tasks to be carried

Article 127.2 TFEU. Council Regulation (EU) No. 1024/2013 conferring specific tasks on the ECB concerning policies relating to the prudential supervision of credit institutions (OJ L 287, 29.10.2013), p. 63 (SSM Regulation). 4 The Eurosystem is composed of the ECB and the national central banks of the EU member-states that have adopted the euro. 5 Article 2 of the Statute of the ESCB uses identical wording when stating the ESCB’s objectives. 6 In the Maastricht Treaty this article was numbered 105(5); the numbering has changed but its contents have not been revised. 7 Article 3.3 of the Statute of the ESCB uses identical wording when enumerating the ESCB tasks. 2 3

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out through the ESCB,”8 it is undisputed that the treaty assigns a (contributory) financial stability role to the ESCB, requesting it to cooperate with the national or European competent authorities whose primary mandate is to preserve financial stability.9 Given the wording and the systematic nature of the treaty, it is undisputed that the ESCB’s financial stability mandate is only ancillary (and, in that sense, subordinate and instrumental) to its core objective of maintaining price stability.10 Another aspect of the ECB’s contributory role in the field of financial stability lies in its advisory tasks. Article 127(4) TFEU provides that the ECB is to be consulted on draft national and EU legislative provisions, inter alia, on matters of financial stability.11 Through the opinions that it issues on legislation in the area of financial stability, the ECB contributes to the convergence of legislation and thereby to financial stability. The origin and the position in the treaty of these legal bases show that, even precrisis, the importance of financial stability as a factor favoring the pursuit, by central banks, of their price stability mandate was universally acknowledged, albeit there was no intention to accord preeminence to this task. As is true of any central bank, the ECB has a legitimate interest in ensuring that financial stability is preserved, because financial stability is instrumental to, and can foster, price stability.12 In particular, whereas the pursuit of price stability does not automatically lead to the achievement of financial stability (in the sense that while prudent implementation of monetary policy through the management of interest rates may alleviate tensions in the financial system, it cannot guarantee financial stability), there is a consensus that financial stability can be achieved more readily under conditions of price stability. Furthermore, it is arguable that financial stability is a necessary, if insufficient, condition for the achievement of some of the ESCB’s other secondary tasks, as well as of an efficient allocation of resources. It follows that financial stability is valuable in helping a central bank foster price stability, as the orderly functioning of the monetary policy transmission mechanism can be better ensured in a financially stable environment. Moreover, even if there is no automatic two-way relationship between them, price stability and financial stability tend, in the long term, to mutually reinforce each other (Issing 2003).

Article 3.1 of the Statute of the ESCB. Financial stability still falls primarily within the responsibility of other competent authorities in the European Union and in the member-states. 10 Article 127(1) TFEU. 11 Article 2 of Council Decision 98/415/EC of June 29, 1998, on the consultation of the European Central Bank by national authorities regarding draft legislative provisions (OJ L 189, 3.7.1998, p. 42) provides: “The authorities of the Member States shall consult the ECB on any draft legislative provision within its field of competence pursuant to the Treaty and in particular on . . . rules applicable to financial institutions insofar as they materially influence the stability of financial institutions and markets.” 12 Indeed, some scholars have expressed the view that the preservation of financial stability is more important for social welfare than the preservation of price stability (Blanchard and others 2012, 35). 8 9

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At the same time, there is also a consensus that, in a crisis situation, conflicting measures might be needed to achieve, respectively, price stability and financial stability. To address this potential conflict of interest, the treaty clearly establishes price stability as the ECB’s primary objective, whereas the bank’s role in fostering financial stability is a contributory and ancillary objective that must take second place in the event of conflict with the objective of price stability. The tools that the ECB uses to contribute to the preservation of financial stability can be summarized as follows. First, the ECB monitors financial system developments and publishes periodically in this field. In particular, it publishes its Financial Stability Review, the aim of which is to inform not only experts but also the wider public of potential risks in the financial system (ECB 2019). The ECB’s advisory tasks in relation to draft laws concerning the financial system can also contribute to preserving financial stability. As already mentioned, national and EU legislators are under a primary law obligation to consult the ECB on draft legislation falling within its fields of competence, including draft financial sector legislation touching on financial stability.13 Through its opinions, the ECB can steer the legislative process in order to foster financial stability.14 Another avenue is the operation of TARGET215 and T2S16 and the exercise of oversight over financial market infrastructures. Whereas the Eurosystem’s main objective in operating these infrastructures is the exercise of monetary policy tasks, this also contributes to the preservation of financial stability. Unless they are legally and financially sound, these infrastructures could serve as channels for the propagation of systemic risks throughout the financial system.17 Furthermore, the Eurosystem also contributes to financial stability by participating in, and providing its expertise to, international fora, such as the IMF, the Financial Stability Board, the Bank for International Settlements, the European Systemic Risk Board (ESRB), and the European Banking Authority. Finally, the ECB is involved in the provision by the national central banks of emergency liquidity assistance to domestic banks, in support of national financial stability.18 It is for the bank’s Governing Council to determine, on the basis of The ECB may also issue “own initiative opinions” on topics in its fields of competence. This is the case even though ECB opinions are not legally binding, because national legislators have generally agreed to amend their legislative proposals rather than adopting legislation that conflicts with the ECB’s views. 15 https://​www​.ecb​.europa​.eu/​explainers/​tell​-me/​html/​target2​.en​.html. 16 https://​www​.ecb​.europa​.eu/​paym/​t2s/​html/​index​.en​.html. 17 Eurosystem oversight covers different types of financial market infrastructures, instruments, and entities: (1) payment systems (systemically important payment systems and non-systemically important payment systems); (2) securities settlement systems and central counterparties; (3) payment instruments; and (4) other infrastructures and service providers. More information is on the ECB’s website at http://​ www​.ecb​.europa​.eu. 18 Emergency liquidity assistance is, in essence, exceptional liquidity support (of a lender of last resort type) extended by a national central bank to temporarily illiquid but solvent credit institutions. The provision of such assistance is not regulated either in the treaties or in the statute of the ESCB. 13 14

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Article 14.4 of the statute of the ESCB, whether such assistance interferes with the monetary policy or other tasks of the Eurosystem (for instance, because its provision is not subject to limits and/or where its recipients appear unlikely to regain market access in the short to medium term).

Enhanced Focus in the European Union on Financial Stability Awareness of the importance of financial stability has greatly increased since the start of the financial crisis in 2007, an event that demonstrated that even long periods of price stability, achieved in pursuit of a prudent and consistent monetary policy, are not sufficient to prevent financial instability. In response to the financial crisis, the European Commission mandated a group chaired by Jacques de Larosière, a former IMF managing director, to make proposals to strengthen supervision within the European Union and to improve the European Union’s financial architecture. The resulting de Larosière Report identified several causes of the financial crisis, namely the lack of adequate macroprudential supervision, the lack of consistency in the application of supervisory powers across member-states, and the absence of adequate means for supervisors to take common decisions on shortcomings of common interest (The High-Level Group on Financial Supervision in the EU 2009). To address these problems, the de Larosière Report recommended an important role in macroprudential supervision for the ECB, which, in the chairman’s view, was uniquely placed to perform macroprudential tasks, the geographical scope of which would cover the whole of the European Union.19 At the same time, the de Larosière Report opposed the idea of the ECB being empowered to carry out microprudential supervision tasks. The report gave two reasons. On the one hand, the ECB’s competences were limited by the treaties (as they excluded the supervision of insurance undertakings). On the other hand, implementing an ECB-centric model of microprudential supervision might prove too complex and prone to potential conflicts of interest with monetary policy. At the same time, the de Larosière Report did not exclude the possibility of granting the ECB a leading oversight and coordination function in the microprudential supervision of cross-border banks, with a binding mediation role for the national competent authorities (NCAs) of member-states. This would comprise, first, the definition of supervisory practices; second, the promotion of supervisory convergence; and third, the assumption of regulatory responsibility for issues relevant to procyclicality, leverage, risk concentration, and liquidity mismatches. For microprudential supervision, the de Larosière Report proposed the establishment of the European System of Financial Supervision, included the European Banking Authority, the European Insurance and Occupational Pensions Authority, and the European Securities Markets Authority.

Lying at the heart of the ESCB, the ECB is uniquely placed to collect the necessary information and data from member-states. 19

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The ESRB is discussed in more detail in the second section of this chapter. Not long after its establishment, in 2012 the European Commission and the European Council pushed for the establishment of a Single Supervisory Mechanism (SSM), with the ECB at its center despite the recommendations of the de Larosière group,20 and of a Single Resolution Mechanism (SRM).

Synergies and Tensions between the ECB’s Functions There is a clear link between macro- and microprudential policy, both of which seek to achieve financial stability. In this regard, paragraph 148 of the de Larosière Report states that “[m]acroprudential supervision cannot be meaningful unless it can somehow impact on supervision at the micro-level; whilst microprudential supervision cannot effectively safeguard financial stability without adequately taking account of macro-level developments.” Precrisis, the prevailing wisdom had been that if microprudential supervision could succeed in averting the failure of individual institutions, the cumulative effect would be a stable financial system. Indeed, supervisors had focused mostly on the health of individual financial institutions and paid much less attention to the stability of the financial system as a whole. The weak point of their reasoning was the failure to recognize that the system as a whole could be vulnerable to shocks liable to negatively affect financial stability, and that there could be vulnerabilities which, while negligible for some individual institutions, could have a substantial negative impact when viewed from a systemwide perspective (Athanassiou 2014). The close link between macro- and microprudential policies became also visible in the public discussion on the “macroprudential toolkit.” Whereas the “capital requirements directive,” or CRD IV,21 and the “capital requirements regulation,” or CRR,22 provide for a limited number of dedicated macroprudential tools (such as the countercyclical capital buffer, the systemic risk buffer, and national competence to take stricter measures aimed at addressing macroprudential or systemic risks), most of the tools envisaged for macroprudential supervision derive from the microprudential toolkit. It could therefore be argued that macroprudential supervision is largely dependent on the enforcement action taken by microprudential supervisors. For this reason, where the mandate of a central bank encompasses microprudential supervisory competences, its overall role in

See the report by the president of the European Council, Herman van Rompuy, “Towards a Genuine Economic and Monetary Union,” Brussels (2012); and the Communication from the Commission, “A Blueprint for a Deep and Genuine Economic and Monetary Union,” COM/2012/0777 final. 21 Directive 2013/36/EU on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (OJ L 176, 27.6.2013, p. 338). 22 Regulation (EU) 575/2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (OJ L 176, 27.6.2013, p. 1). 20

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ensuring financial stability increases quite markedly, while it becomes more difficult to mark a sharp borderline between tools and competences.23

The ECB and Its Macroprudential Supervisory Role The years since the crisis have seen greater emphasis being placed on the involvement of central banks in macroprudential supervision as a precondition for the achievement of financial stability. The establishment of the ESRB may be regarded as one of the main indicators of this new emphasis on central bank involvement in macroprudential supervision postcrisis. The general mandate of the ESRB is to monitor financial sector developments throughout the European Union24 and to detect potential risks capable of affecting the financial system as a whole.25 Whenever such risks are detected, the ESRB may issue recommendations and warnings. However, the ESRB has no enforcement powers, and neither the member-states nor the EU bodies are under an obligation to act in accordance with its recommendations and warnings. The ECB plays a central role in the ESRB: first, the task of providing the analytical, statistical, logistical, and administrative support necessary for the fulfilment of the ESRB’s tasks was conferred on the ECB; and second, the ESRB is chaired by the president of the ECB.26 The ESRB is governed by a general board, in which the president and the vice president of the ECB have voting rights. Concrete but limited macroprudential powers were granted to the ECB only later on, with the adoption of the SSM Regulation in 2013.27 Article 5 of the SSM Regulation (discussed in greater detail later) deserves particular mention here as it is of direct relevance to the assessment of the ECB’s competences in macroprudential supervision. It provides that the authority to apply macroprudential tools remains vested with the national supervisory authorities, rather than the ECB. However, where necessary, the ECB is granted the authority to apply higher requirements for capital buffers to credit institutions and to impose more This also explains why many member-states have involved their national central banks in banking supervision. 24 As explained in the following, the ECB’s mandate in respect of microprudential supervision has a more limited geographical scope, being restricted to member-states participating in the SSM. 25 Article 3 of Regulation 1092/2010 on European Union macroprudential oversight of the financial system and establishing an ESRB (OJ L 331, 15.12.2010, p. 1): “The ESRB shall be responsible for the macroprudential oversight of the financial system within the Union in order to contribute to the prevention or mitigation of systemic risks to financial stability in the Union that arise from developments within the financial system and taking into account macroeconomic developments, so as to avoid periods of widespread financial distress.” 26 An amendment to the ESRB regulation was agreed in April 2019 (Letter from the Chair of COREPER II to the Chair of the ECON Committee, 1 April 2019, confirming agreement on the text of the ESFS review http://www.europarl.europa.eu/RegData/commissions/econ/lcag/2019/0401/ECON_LA(2019)003029_EN.pdf ). Formal adoption and publication is expected in October or November 2019. Under the amendment, the ECB president will become the permanent chair of the ESRB, while originally this was envisaged for a period of five years. 27 SSM Regulation, see footnote 3. 23

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stringent measures upon them, subject to close coordination with national authorities. The ECB’s macroprudential supervisory competences under Article 5 appear to go beyond those that the ESRB has assumed (as mentioned previously, the ESRB lacks the authority to make decisions that are binding on their addressees). Whereas the Article 5 competences are anchored in secondary law, it remains the case that their attribution to the ECB considerably reinforces the ECB’s mandate in the field of macroprudential supervision (and its role in financial stability). At the same time, because it is only a competence to “reinforce” a national measure, Article 5 confirms the “contributory nature” of the ECB’s tasks in the macroprudential field.

The ECB and Its Microprudential Supervisory Powers The financial crisis served as the catalyst for the activation of Article 127(6) of the EU treaty and for the adoption of the SSM Regulation, through which extensive microprudential supervisory powers were conferred on the ECB. By clearly demonstrating that fragmented microprudential supervision was liable to pose risks for the common currency and the internal market, the financial crisis paved the way for a transfer of prudential supervisory powers over credit institutions from national supervisors to the ECB, notwithstanding the de Larosière group’s recommendations to the contrary.28 The four essential aspects of the ECB’s involvement in microprudential supervision are summarized in the following. First, whereas financial stability is not limited to the banking sector, the ECB’s supervision only covers credit institutions, as defined in Article 4(1)(1) of the CRR, and excludes insurance companies (pursuant to Article 127(6) TFEU), investment services firms (which are regulated by the Markets in Financial Instruments Directive),29, 30 and the various other institutions listed in Article 2(5) of the CRD IV on a country-by-country basis. Significantly, the SSM Regulation

Even prior to the entry into force of the SSM Regulation, which directly conferred on the ECB the powers to perform prudential supervision, the ECB was already equipped with legal tools to ensure the proper implementation of the newly attributed tasks. These tools included the competence to issue a regulation pertaining to prudential supervision and the competence to take the decisions necessary for carrying out the tasks entrusted to the ESCB under the treaties and under the statute of the ESCB, both of which are provided for under Article 132(1) TFEU. 29 Directive 2014/65/EU on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (OJ L 173, 12.6.2014), p. 349. 30 However, the draft “Regulation (EU) 2019/… of the European Parliament and of the Council on the prudential requirements of investment firms and amending Regulations (EU) No 575/2013, (EU) No 600/2014 and (EU) No 1093/2010,” adopted on a preliminary basis by the EU Parliament (see http://www.europarl.europa.eu/RegData/commissions/econ/lcag/2019/03-20/ECON_ LA(2019)002699_EN.pdf ) to be formally adopted and published in October or November 2019, amends (at its article Article 63.3) the definition of “credit institution” under Article 4 of Regulation (EU) No 575/2013 (the CRR), bringing certain investment firms within the supervision of the ECB. 28

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and the accompanying SSM Framework Regulation31 cover, as “supervised entities,” individual credit institutions established in the participating member-states and their prudentially consolidated parent undertakings, including financial holding companies and mixed financial holding companies (as part of a “supervised group”). Under Article 41 of the SSM Framework Regulation, branches established in participating member-states by credit institutions established in nonparticipating member-states also qualify as supervised entities, with all such branches opened in the same jurisdiction being treated as a single supervised entity. Second, the ECB’s supervisory mandate covers the euro area member-states only, subject to the possibility for member-states whose currency is not the euro to enter into a “close cooperation agreement” with the SSM to be established by a decision adopted by the ECB.32 Close cooperation is a voluntary (opt-in) regime for non–euro area member-states. It allows all banks in the relevant non–euro area member-state to become part of the SSM, subject to the obligation to fully cooperate in the sharing of information with the SSM and to them being bound by all ECB regulations and decisions in supervisory matters.33 As of August 2019, two member-states have requested the ECB to enter into a close cooperation agreement.34 Third, whereas the ECB oversees all significant and less-significant banks in the participating member-states, direct supervision only covers significant credit institutions (typically, systemically relevant institutions at the national level). The significance of credit institutions is determined on the basis of certain criteria relating, inter alia, to the total value of their assets, the ratio of their assets to national GDP, and their relevance for the domestic economy.35 The responsibility for the supervision of less-significant credit institutions is assigned by the SSM

Regulation (EU) No. 468/2014 of the ECB establishing the framework for cooperation within the SSM between the ECB and national competent authorities and with national designated authorities (SSM Framework Regulation) (ECB/2014/17) (OJ L 141, 14.5.2014), p. 1. 32 See Article 7 of the SSM Regulation and Decision 2014/434/EU of the ECB on the close cooperation with the national competent authorities of participating member-states whose currency is not the euro (ECB/2014/5) (OJ L 198, 5.7.2014), p. 7. 33 One significant difference between supervision in a euro area and a non–euro area member-state is that the ECB is not allowed to adopt legally binding legal acts that are directly applicable to (significant) banks in the relevant non–euro area member-state. In this situation, the Supervisory Board of the ECB is to address its instructions to the national competent authority, which will then need to ensure that the supervised bank applies those decisions by virtue of binding legal acts they adopt (see the second subparagraph of Article 7(1) of the SSM Regulation). 34 They are Bulgaria (https://seenews.com/news/bulgaria-sends-request-for-close-cooperation-onbanking-supervision-with-ecb-628829) and Croatia (https://seenews.com/news/croatia-asks-toenter-close-cooperation-with-ecb-on-road-to-euro-area-655626). 35 See the second subparagraph of Article 6(4) of the SSM Regulation. 31

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Regulation to the national competent authorities,36,37 whereas the ECB is in charge of ensuring the effective and consistent functioning of the SSM.38 At the same time, the ECB is exclusively competent to authorize and to withdraw authorization in respect of all credit institutions within the euro area, as well as to assess all qualifying holdings. Fourth, the ECB exercises in the euro area (and in the member-states that have entered close cooperation) the supervisory powers set out in the CRD IV and the CRR for national authorities and applies national implementing law.39 The application of national law by the ECB in the exercise of its microprudential supervisory powers and in the performance of its tasks (also on account of the existence, in the CRD IV, of options and discretions for the national authorities) is unprecedented in the institutional history of the European Union (Di Bucci 2018; Kornezov 2016).

Could the ECB’s New Functions Jeopardize Its Independence? One of the fundamental reasons why micro- and macroprudential supervisory tasks were assigned to the ECB by the EU legislation was its expertise in macroeconomic and financial stability issues. Because the ECB is the central bank of the euro area, it has at its disposal much of the information necessary to assess matters that are relevant to financial stability and its preservation. At the same time, the involvement in financial sector supervision of a central bank, which also has monetary policy and price stability mandates, clearly offers certain synergies. For instance, subject to professional secrecy and confidentiality safeguards, the flow of necessary information within a single institution avoids double reporting and is generally more straightforward compared with

National authorities have a mandate that is restricted to their jurisdiction and may have different mandates and powers regarding banks, investment firms, and insurance undertakings, as well as with regard to macroprudential oversight and supervision. 37 It is interesting that even if an institution or group fulfills the criteria for classification as significant, Article 6(4) of the SSM Regulation provides that it may, owing to “particular circumstances,” be considered as less significant. Under Article 70 of the SSM Framework Regulation, “particular circumstances” exist “where there are specific and factual circumstances that make the classification of a supervised entity as significant inappropriate, taking into account the SSM’s objectives and, in particular, the need to ensure the consistent application of high supervisory standards.” Under Article 71 of the SSM Framework Regulation, the existence of such circumstances is to be assessed on a case-by-case basis. Finally, under Article 72 of the Framework Regulation, the ECB shall review, at least once a year, whether those “particular circumstances” continue to apply, and, if they do not, adopt and notify its decision to the relevant institution. 38 See Article 6 of the SSM Regulation; see footnote 4. See also the ECJ judgment in the L-Bank case, stating that the ECB has the exclusive competence on the supervision of the banks, while the national competent authorities cooperate with it (http://curia.europa.eu/juris/document/document.jsf?text= &docid=213858&pageIndex=0&doclang=en&mode=lst&dir=&occ=first&part=1&cid=8666721), paragraphs 38 and 41. 39 Article 4.3 of the SSM Regulation; see footnote 4. 36

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its exchange across different institutions. Furthermore, the macroprudential function is bound to benefit from the central bank’s involvement in banking supervision, as the central bank can draw on its macroeconomic expertise when supervising credit institutions and make optimal use of its understanding of the particularities of individual institutions in defining the parameters of its monetary policy. On the other hand, banking supervision and monetary policy can be perceived as pursuing conflicting objectives. Therefore, it is essential that there is clarity as to whether and when supervisory decisions may be influenced by monetary policy concerns and vice versa, even if it is not entirely clear that full separation between them is truly desirable.40 The exercise by the same central bank of monetary policy and supervisory policy functions entails two main sources of tension: conflict between the objectives of preserving price stability and of ensuring the soundness of credit institutions (and, through them, financial stability); and tension between the different intensities of democratic accountability specific to each of these functions. Linked to the latter is the question of whether, taking a holistic view, entrusting a central bank with these two different tasks has the potential to affect negatively the very high level of independence that the central bank enjoys. It is precisely to guard against the risks arising from these tensions that the ECB is required to uphold a principle of strict separation between its supervisory and its monetary policy tasks (see the following). One of the challenges for the ECB is how to maintain the synergies and advantages of combining monetary policy with banking supervision under the same roof, while at the same time fully respecting the principle of separation. Another challenge is to ensure that the full measure of independence needed in order to conduct monetary policy is not diluted on account of the perception that a “lighter” version of independence is acceptable in the context of the exercise of supervisory functions (Zilioli and Riso 2018). The principle of separation and its practical implementation in the context of the SSM is examined in the following.

The Separation Principle41 In its recitals, the SSM Regulation explicitly refers to the potential conflict of interest between maintaining price stability and the objectives of supervision

Indeed, one of the main weaknesses of the ECB’s monetary policy during the financial crisis was the lack of detailed information on the financial health of the banking system. It is also interesting to note the trend resulting from the financial crisis of restoring microprudential supervisory tasks to central banks: see, for example, the developments that took place in the United Kingdom following the financial crisis. 41 Article 25 of the SSM Regulation. 40

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(which are to protect the safety and soundness of credit institutions and the stability of the financial system as a whole).42 The obligation for the ECB to keep its supervisory tasks separate from its monetary policy tasks and to prevent them from interfering with each other is clearly stated in Article 25 of the SSM Regulation. To ensure sufficient separation between the ECB’s monetary and supervisory roles and lessen the role of the Governing Council in the adoption of supervisory decisions, the SSM Regulation provides for the establishment of a separate preparatory body, the Supervisory Board, and for a nonobjection (or positive silence) procedure: the draft decisions prepared by the Supervisory Board are deemed to have been approved unless the Governing Council explicitly rejects them within a defined (short) period, subject to the provision of reasons.43 To further ensure functional separation in respect of decision-making, the Governing Council is to hold separate meetings (with separate agendas) for monetary and supervisory decisions.44 Furthermore, this functional separation extends to, and is reinforced by, the separation of staff involved in the different tasks and their reporting lines. The establishment of the Mediation Panel under Article 25(5) of the SSM Regulation is yet another means to ensure the separation of monetary policy from banking supervision, thereby guaranteeing the ECB’s independence. The Mediation Panel is to consider appeals by member-state national competent authorities against rejections by the Governing Council of decisions drafted by the Supervisory Board.45 The Mediation Panel will be called upon to adopt an opinion when the NCA of a participating member-state expresses a difference of views regarding the objections of the Governing Council of the ECB to a draft decision of the Supervisory Board. Opinions adopted by the Mediation Panel are not, however, binding on the Governing Council, which remains the supreme decision-making body under the SSM. Moreover, the SSM Regulation emphasizes the principle of independence, not only for the ECB itself but also for the NCAs, and even more for the members of the Supervisory Board and of the Steering Committee.46

Recital 65 of the SSM Regulation states: “The ECB is responsible for carrying out monetary policy functions with a view to maintaining price stability in accordance with Article 127(1) TFEU. The exercise of supervisory tasks has the objective to protect the safety and soundness of credit institutions and the stability of the financial system. They should therefore be carried out in full separation, in order to avoid conflicts of interests and to ensure that each function is exercised in accordance with the applicable objectives.” 43 The positive silence procedure also seeks to address non–euro area member-states’ concerns about their lack of representation on the Governing Council. 44 The ECB has also adopted Decision 2014/723/EU on the implementation of separation between the monetary policy and supervision functions of the ECB (ECB/2014/39) (OJ L 300, 18.10.2014), p. 57. 45 The Mediation Panel comprises one member per participating member-state, chosen from among the members of the Governing Council of the ECB and the Supervisory Board. The vice-chair of the Supervisory Board will initially chair the meetings of the Mediation Panel, but without having voting rights. 46 Article 19 of the SSM Regulation. 42

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Concerning the higher level of the democratic accountability required for the exercise of supervisory tasks, Recital 55 of the SSM Regulation states: “The conferral of supervisory tasks implies a significant responsibility for the ECB to safeguard financial stability in the Union, and to use its supervisory powers in the most effective and proportionate way. Any shift of supervisory powers from the Member State to the Union level should be balanced by appropriate transparency and accountability requirements.” In this regard, as an expression of proportionality (Zilioli 2019), the SSM Regulation provides that the ECB is accountable for its supervisory tasks to the European Parliament and to the European Council as democratically legitimized institutions, including regular reporting, and responding to questions by the European Parliament in accordance with its Rules of Procedure, and by the Eurogroup in accordance with its procedures. Furthermore, the ECB is required to forward the same reports to the national parliaments of the participating member-states, which may also invite the chair or a representative of the Supervisory Board to participate in an exchange of views. This level of accountability is higher than that required for the exercise of the ECB’s monetary policy competences. Nevertheless, because the two competences are exercised under the separation principle, the aforementioned accountability requirements do not affect the ECB’s independence in the exercise of its supervisory tasks.47 Accountability does not mean to take instructions, it’s rather to “rendre compte,” explain and justify, decisions independently taken.

CONCLUSION This chapter describes the new roles and functions conferred upon the ECB since the onset of the global financial crisis. It highlights the fact that these new functions have placed the ECB in a delicate position, with the pursuit of potentially conflicting objectives, raising the concern that its efficient operation could be impeded and its independence jeopardized. Despite the inevitable tensions among these roles and functions, and in particular between the monetary policy and the supervisory functions, the ECB has proven able to reconcile them. This success is in large part due to three factors: a clear hierarchy of objectives provided by the treaty drafters—despite the enlargement of the ECB’s mandate, price stability continues to be its primary objective, with the achievement of financial stability remaining an ancillary or instrumental task; the introduction of the principle of separation between the monetary policy and supervisory functions; and the constitutional protection of the ECB’s independence as an institution, as enshrined in the treaty and the statute of the ESCB. It is possible to conclude, therefore, that through these safeguards, the ECB has been able to fulfill the new functions assigned to it and to combine its monetary policy with its supervisory and financial stability tasks. In doing so, it has For an extensive analysis of the independence and accountability of the ECB when performing its monetary policy and its supervisory tasks, see Zilioli 2016. 47

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reaped the benefit of the synergies between these competences without compromising its independence, which is an essential component of monetary policy decision-making.

REFERENCES Athanassiou, Phoebus. 2014. “The Evolving Role of Central Banks in Banking Supervision.” Finanzmarktregulierung in der Krise, 71–81. Blanchard, Olivier J., David Romer, A. Michael Spence, and Joseph E. Stiglitz (eds.). 2012. In the Wake of the Crisis: Leading Economists Reassess Economic Policy. Cambridge, MA: MIT Press. Cassola, Nuno, Christoffer Kok, and Francesco Paolo Mongelli. 2019. “After the Crisis: Synergies between the Three ECB’s Responsibilities.” ECB Occasional Paper. Di Bucci, Vittorio. 2018. “Quelques questions concernant le contrôle juridictionnel sur le mécanisme de surveillance unique, in Liber amicorum Antonio Tizzano - De la Cour CECA à la Cour de l’Union: le long parcours de la justice européenne, Torino (Giappichelli).” http:// europa.eu/pub/pdf/other/escblegalconference2016_201702.en.pdf. European Central Bank (ECB). 2019. Financial Stability Review. https://www.ecb.europa.eu/ pub/pdf/fsr/ecb.fsr201905~266e856634.en.pdf?613f7cd049b8715ed75ba22c21fab16f. High-Level Group on Financial Supervision in the EU. 2009. https://ec.europa.eu/economy_ finance/publications/pages/publication14527_en.pdf. Issing, Otmar. 2003. “Monetary and Financial Stability: Is There a Trade-off?” Paper presented at the ECB Conference on Monetary Stability, Financial Stability and the Business Cycle at the Bank for International Settlements, Basel, March 29. http://www.ecb.europa.eu/press/ key/date/2003/html/sp030329.en.html. Kornezov, Alexander. 2016. “The Application of National Law by the ECB—A Maze of (Un) answered Questions.” ESCB Legal Conference 2016. https://www.ecb.europa.eu/pub/pdf/ other/escblegalconference2016_201702.en.pdf. Van Rompuy Report. 2012. “Towards a Genuine Economic and Monetary Union.” Brussels. Zilioli, Chiara. 2016. “The Independence of the European Central Bank and its New Banking Supervisory Competences.” In Independence and Legitimacy in the Institutional System of the European Union, edited by Dominique Ritleng, 125–79. New York: Oxford University Press. ———. 2019. “Proportionality as the Organizing Principle of European Banking Regulation.” https://ssrn.com/abstract=3415468. ———, and Antonio Riso. 2018. “New Tasks and Challenges to Central Bank Independence: The ECB and the Eurosystem Experience.” In Research Handbook on Central Banking, edited by Conti-Brown Lastra. Cheltenham: Edward Elgar.

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CHAPTER 10

Central Bank Legal Mandates and the Growing Importance of Macroprudential Arrangements: The Latin American Experience Manuel Monteagudo

INTRODUCTION The IMF is not only an economic institution but also a legal phenomenon that, as well-recognized by legal doctrine, plays a significant role in the evolution and construction of international law.1 We find it pertinent to celebrate the seventieth anniversary of the Legal Department of the IMF by organizing a seminar devoted to the promotion of financial stability “through the rule of law.” Attribution of powers and individual and collective rights must be recognized and submitted to law as preeminent source of authority. Everybody, including the state and public bodies, are submitted to law. That is the classical understanding of the rule of law (Corten 2009). In the end, financial stability needs to be achieved by enforcing rules and guaranteeing the rights of individuals and participants of financial markets in the context of a constitutional order, where powers are clearly attributed to authorities and regulators. According to the German tradition of ordoliberalism in the Economic Constitution (group of specific constitutional provisions related to economic stability), the rule of law must guarantee individuals the free exercise of their economic rights (Monteagudo 2010b).

Manuel Monteagudo is General Counsel of the Central Bank of Perú and Professor of International Law at the Pontificia Universidad Católica del Perú. The author expresses special recognition to Alonzo Jiménez Aleman, lawyer from the Central Bank of Peru, for support in researching legal sources for this work. The views expressed in this article are the sole responsibility of the author. 1 Among the abundant sources about the IMF and the evolution of monetary law, we recommend as classical reference the article of Professor Steve Zamora: “Sir Joseph Gold and the Development of International Monetary Law,” The International Lawyer 23 (1989): 1009–26, reprinted in Festschift for Sir Joseph Gold 439 (Verlag Recht und Wirtschaft, 1990). Professor Zamora used to mention that the IMF virtually “created” international monetary law. Zamora, S. 1995. “Economic Relations and Development.” In The United Nations Legal Order, edited by Oscar Schachter and Christopher C. Joyner, Volume 1, 520. New York: Cambridge University Press, 1995.



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Macroprudential policy, a central measure proposed by the IMF for achieving financial stability in response to the recent global financial crisis, may imply a reattribution of constitutional goals and functions to central banks. Using their increased experience in macroeconomic matters, central banks should assume or share some level of policy and regulatory responsibilities with governments and financial regulators to guarantee financial stability in the era of globalization. At this point, the decisive question is whether, after more than two decades of worldwide reforms in central banks to assure their independence from political influence (particularly in countries that experienced high inflation), it is possible to rethink a new constitutional arrangement for independent central banks. Montesquieu, in De l’esprit des lois, warned that separation of powers does not mean that public entities play their roles and use their powers in a insulated way. He emphasized that the powers of public bodies are always incomplete and none of them can act in isolation (Ardant 1999). In fact, this basic proposition of the eighteenth-century theory of state fits well with what governments and monetary and financial regulators are facing in today’s world: acting together in the face of a common challenge and keeping their exclusive competences. The question needs to be approached with a dose of realpolitik and considering the fact that a new worldwide macroprudential reform is already in place. In the United States and the United Kingdom, specific legislation has created financial stability committees that gather together central banks with financial regulators and government for conducting macroprudential policy, combining powers to make recommendations to, and regulate, banking and financial participants. In the United States, the Dodd-Frank legislation created the Financial Stability Oversight Council, where the Federal Reserve participates with the government (as chair) and other members.2 In the United Kingdom, the Financial Services Act created the independent Financial Policy Committee at the Bank of England, with the participation of representatives from the Treasury.3 In the European Union, the European Central Bank (ECB) is also engaged in macroprudential policy. Under the Single Supervisory Mechanism Regulation,4 the governing council of the ECB is responsible for taking macroprudential decisions with the collaboration of the Macro Prudential Forum and the Financial Stability Committee (which includes the ECB, national central banks, and supervisory national authorities), leaving a space of action to national macroprudential authorities. This chapter seeks to call attention to Latin America’s experience in setting central banks’ involvement within the new macroprudential institutional arrangements and the challenges that these reforms imply at the constitutional level. After presenting a summary of the most representative institutional reforms

2 Dodd-Frank Wall Street Reform and Consumer Protection Act. 2010. Pub. L. No. 111–203, 124 Stat.1376 (Title I). 3 UK Financial Services Act 2012 (Part 1A). 4 Council Regulation (EU) No. 1024/2013 of October 15, 2013.

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establishing financial stability committees with the participation of central banks, we will focus on three basic reflections: • The possibility that macroprudential frameworks might impair central bank independence, based on the experiences of Peru and Chile. • Whether the free trade agreements that some Latin American countries have established during the last years under the US model are enough to consider macroprudential measures as part of prudential exemptions. • Peru’s experience in implementing macroprudential measures without a financial stability committee. Even though in Latin America some structural social and economic problems and challenges remain to be resolved, it is well recognized that, in general terms, the region has moved away from the disruptive debt episodes of the 1980s. Financial systems are more resilient to global financial crises after a period of implementation of dramatic monetary, financial, and fiscal reforms.5 One of those reforms was the consolidation, in many countries, of independent central banks. Therefore, the attribution of a new mandate or function to the central bank related to macroprudential policy should be a new and successful evolution for guaranteeing monetary and financial stability, and not an experiment with the potential to damage the achievements gained in institutional economics.

LATIN AMERICA FOLLOWS THE GENERAL TREND OF CREATING FINANCIAL STABILITY COUNCILS Considering a representative group of Latin American countries, including Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Uruguay, it is evident that the region has basically followed—with some exceptions and peculiarities—the general pattern of establishing financial stability councils for macroprudential supervision or regulation with the participation of central banks, finance ministries, and financial and banking regulators.

5 See the “Latin America‘s Fiscal and External Strength: How Dependent Is It on External Conditions?” section in the May 2013 issue of Regional Economic Outlook: Western Hemisphere—Time to Rebuild Policy Space (pp. 37–45). http://www.imf.org/external/pubs/ft/reo/2013/whd/eng/wreo0513.htm. See also most recently what IMF surveys consider in the April 2016 Regional Economic Outlook: Western Hemisphere— Managing Transition and Risk. “Although external conditions weigh on the regional outlook, growth outcomes have varied widely across countries, depending on domestic factors. In certain countries, the slowdown in growth can largely be accounted for by the terms-of-trade shock. In these cases, a relatively smooth adjustment reflects improvements to policy frameworks that were implemented over the past 20 years, which solidified domestic price stability while permitting increased exchange rate flexibility and sustainable fiscal policy with the space to respond to external shocks. These credible monetary and fiscal frameworks have allowed Chile, Colombia, Mexico, and Peru to implement countercyclical policies anchored by medium-term consolidation strategies, smoothing the impact of external shocks on growth” (pp. 18–19). http://www.imf.org/external/pubs/ft/reo/2016/whd/eng/pdf/wreo0416.pdf.

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Table 10.1 summarizes the composition of financial stability councils in these countries. TABLE 10.1

Macroprudential Authorities in Latin America Mexico

Colombia

Peru

Chile

Brazil

Argentina

Uruguay

The Financial System Stability Council (2010): Minister of Finance, Deposit Insurance, Central Bank and three supervision agencies (Banking, Insurance, and Pensions).1 Coordination Committee for Monitoring of the Financial System (2003–14): Central Bank, Minister of Finance, Deposit Insurance Corporation, and Financial Superintendence.2 Informal coordination (2008): Central Bank, Minister of Finance, and supervision agencies (Superintendence of Banking, Insurance, and Pension Funds; and Superintendence of the Securities Market).3 The Financial Stability Council (2011–14): Minister of Finance and three supervision agencies (financial institutions, securities and insurance, and pension funds). The Central Bank acts as advisor.4 The Subcommittee of Financial Stability5 was created by the Committee on the Regulation and Supervision of Financial Insurance, and Complementary Pension Markets (COREMEC) in 2010. COREMEC was created in 20066: Central Bank, Minister of Finance, Minister of Social Security, Securities Commission, National Council of Complementary Pensions and National Council of Private Insurance Companies. The Central Bank has as a goal to promote monetary stability and financial stability among others.7 Coordination Council on Monetary, Financial and Exchange Policies: Minister of Finance and Central Bank (2010).8 The Financial Stability Committee: Minister of Finance, Central Bank, Superintendence of Financial Services, and the Corporation for the Protection of Bank Savings.9

Created by Federal Accord of 29 July 2010 and incorporated into Financial Law of 10 January 2014. The current composition of the committee was established by Decree No. 1954 of 7 October 2014, but the committee was created by Law 795 of 14 January 2003. 3 See Jácome, Nier, and Iman 2012, 20. 4 Article 1 of Law 20.789. The Council was created in 2011 by Decree Supreme No. 953 and consecrated at the law level in 2014 by the Law 20.789. 5 Deliberation No. 12 of COREMEC of 30 August 2010. 6 Created by a Presidential Decree No. 5685 of 25 January 2006. 7 Article 3 of the Organic Law modified by the Law No. 26739 of 28 March 2012. 8 Decree 272/2010 of 18 February 2010. 9 Decree 224 of 23 June 2011. 1 2

One common element of the majority of countries (not including Argentina and Uruguay)6 is that central banks have an implicit mandate related to the preservation of financial stability. In Argentina, Brazil, and Uruguay, the central bank also assumes banking supervision functions. As mentioned by Cristiano de Oliveira, the Central Bank of Brazil “construed its macroprudential mandate on the language employed by the 1964 financial system law, even if, as was to be

6 Argentina and Uruguay are also banks’ supervisors. See Jácome, Niev, and Iman 2012, supra note 11, p. 20.

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expected, it contains no references to ‘financial stability,’ ‘systemic risk,’ or any similar concepts” (de Oliveira Lopes Cozer 2015). In general, financial stability councils and macroprudential policies serve as an operational or institutional mechanism to engage monetary authorities with financial stability. The interesting question is how subsequent legislation in some Latin American countries has extended the scope of functions of monetary authorities to a new domain after a previous period of reforms of central bank legislation aimed at reinforcing their independence by narrowing, or focusing, their goals and functions on monetary affairs. Another relatively common element is precisely the predominance of independent central banks involved in financial stability councils. That is the case of the group of countries forming the Pacific Alliance (Chile, Colombia, Mexico, and Peru) as well as Uruguay.7 Today the monetary authorities of these countries are ranked among independent central banks.8 In the case of Colombia, even though the Ministry of Finance is the president of the board of the Banco de la Republica,9 the Colombian constitution (Article 371) and the central bank charter consecrate central bank independence (which has been recognized by the Constitutional Tribunal).10 Brazil and Argentina’s central banks may not be considered as independent as those of the countries in the Pacific Alliance group.11 Finally, Peru is the only country in the group that has not formally established (by law and regulations) a financial stability council. However, since 2008 there is a mechanism for informal coordination between the Minister of Finance, the Central Bank, the Superintendence of Banks and Insurance Companies, and the Superintendence of Securities Markets (Jácome, Nier, and Iman 2012, at 25).

7 The Pacific Alliance is an integration bloc (for services resources, investment, and movement of people) created by a treaty (Acuerdo Marco de la Alianza del Pacífico) signed by Chile, Colombia, México, and Peru on June 6, 2012. 8 See indexes of central bank independence in Nergiz Dincer and Eichengreen 2014. 9 Article 28 of the Law No. 31, Law of the Banco de la República. 10 The Constitutional Court of Colombia has had many decisions confirming central bank independence in different aspects of central bank’s governance vis-à-vis government and other public bodies. One of the most significant decisions was rendered on November 11, 1993, when the court stated that the Banco de la República is a body created for the service of the functional imperative of guarantying a “healthy” currency and therefore taken away from political influence and not being part of government (paragraph 12). 11 See Jácome, Nier, and Iman 2012, 18, 20.

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CHALLENGES AND PERSPECTIVES OF MACROPRUDENTIAL INSTITUTIONAL ARRANGEMENTS IN LATIN AMERICA The Risk of Impairing Central Bank Independence: The Cases of Peru and Chile Central bank independence implies a constitutional operation for two major reasons: separation of powers and the guarantee of economic rights. There is a separation of powers because of the reattribution of monetary sovereign powers in favor of a sole specific body—the central bank—not being part of the government. There is an actual separation of functions in the sense that most constitutions and treaties that recognize independent central banks split the state’s fiscal activities (taxation as the major source of public revenues) from the state’s ability to create money. In fact, a constitution necessarily implies a division of powers, as was proposed in France in 1789: “Any society in which the guarantee of the rights is not secured, or the separation of powers not determined, has no constitution at all.”12 Thus, to assure the effective separation, many constitutions and central bank laws prohibit central banks from financing governments.13 In this constitutional order, central banks’ actions to preserve monetary stability will never be confused with the search for resources to finance fiscal policies (Monteagudo 2010a, 496–498). The second reason for the constitutionality of central bank independence is even more classical, as the reattribution of competences has as a primary goal to preserve or guarantee individuals’ right to monetary stability. Monetary stability allows all individuals to exercise fully their economic rights by the use of a monetary instrument as a stable vehicle for trading and saving. That is why for German ordoliberals, monetary stability should be listed among fundamental rights and, therefore, part of the economic constitution (Tietmeyer 1999). As mentioned, many independent central banks have unique or primary objectives to preserve monetary stability, without interference from other public goals that remain in the hands of the representative government or its agencies. In that context, how is it possible to attribute to an independent central bank a new goal or functional responsibility related to financial stability without impairing such status of independence? Even more, macroprudential policy in the hands of financial stability councils—constituted by the government, the central bank, and financial regulators—might imply the approval or recommendation of regulations that interfere with the management of monetary instruments. An example is the introduction of rules pertaining to liquidity requirements as a means to curb systemwide credit growth (IMF 2013). In fact, ab initio, there is not an Article 16 of the 1789 “Declaration of the Rights of Man and of the Citizen.” As examples, this interdiction is found in Article 123 (ex Article 101 of TEC) of the Treaty on the Functioning of the European Union, Article 45 of the Bank of Israel Law, Article 164 of the Constitution of Brazil, Article 109 of the Constitution of Chile, and Article 84 of the Constitution of Peru.

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evident conflict between monetary goals and macroprudential goals, but at some critical point the conflict could arise between assuring price stability and adjusting credit to secure adequate liquidity for financial institutions (financial stability). One key question is whether creating institutional arrangements that might produce some interference of functions between the central bank and government or financial regulators is consistent with a constitutional order supposedly ensuring the independence of central banks from government. The proposed problem seems not to have the same intensity in countries where central banks are also in charge of banking or financial regulation or supervision (Argentina, Brazil, and Uruguay), as long as macroprudential policy is not far from the central bank’s explicit goals and functions. However, even in these cases the presence of the government in financial stability councils could produce a constitutional inconsistency with central bank independence. In any case, the classical debate about whether the central bank should also assume banking and financial regulation responsibilities could provide some interesting elements to address the more complex problem of central bank independence and financial stability councils. Those who oppose the concentration of powers have claimed that a banking regulation bias could make central banks more relaxed regarding monetary policy and the use of liquidity instruments, to the detriment of the monetary stability goal. Defenders respond that for an effective monetary policy and payment system to function, central banks should not only have hard information on bank solvency (as banks are the primary intermediaries of money creation), but also the powers to impose prudential rules.14 What happens in legal reality is that, even before the period of multiplication of financial stability councils, legislation in different countries and integrated zones provided central banks with different levels of power and functions in the area of banking prudential regulations. For example, the original version of Article 127.6 of the Treaty of the European Union Function already established that the European Council could assign prudential supervision functions to the ECB.15 This provision has also given legal support to ECB’s engagement on macroprudential policy responsibilities.16 There are no doubts about the direct connection between monetary policy and financial stability and the need to establish some level of regulatory consistency or communication between both bodies of law and regulations. It could even be proposed that if money multiplication is an action of the banking and financial industry, the monetary stability goal naturally includes financial stability. However, economic reasoning is not always translated automatically into law. Constitutions and treaties are usually interpreted under the principle of attribution to determine the scope of jurisdiction and powers of public bodies; that is, it is necessary to find in law the basis of regulatory powers and the capacity to impose See a summary of this debate in Monteagudo 2010a. Article 127.6 (ex Article 105.6 of the TEC) of the Treaty on the Functioning of the European Union. 16 Council Regulation (EU) No. 1024/2013 of 15 October 2013. 14 15

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obligations to individuals and moral persons. One example of this is the power of central banks to impose the constitution of legal reserves.17 Let us see the consistency problem that may arise in Peru’s constitutional system and how Chile resolved a similar experience. According to Peru’s Constitution, the central bank is an autonomous public entity within the framework of its organic law. Its goal is to preserve monetary stability, and its functions are regulating money and credit in the financial system, managing international reserves, and other functions provided by the Central Bank Charter.18 Peru’s constitution also establishes that the central bank is governed by its board of directors, thereby creating—at the constitutional level—a self-government regime.19 Additionally, the Constitution entitles the Superintendence of Banks, Insurance Companies, and Private Pension Funds to supervise (“control”) those financial participants, leaving to legislation the determination of its functional autonomy and organization.20 As mentioned, the level of constitutional independence of the Superintendence of Banks, Insurance Companies, and Private Pension Funds is not the same as the central bank’s, as the Constitution only refers to functional independence to be determined by the Congress. In that constitutional order, how is it possible to create, by law, a financial stability council where an independent central bank shares macroprudential regulatory responsibilities with government and the Superintendence of Banks, Insurance Companies, and Private Pension Funds, to the point that those common responsibilities could generate the imposition of monetary regulations? Chile, which has “one of the most independent central banks in the emerging market world,”21 offers a very innovative solution. The Financial Stability Council of Chile was created by the Supreme Decree No. 953 of 2011 but consecrated at the law level by Law No. 20.789 of 201422 and is chaired by the Minister of Finance. The Financial Stability Council is also composed of the three financial supervision agencies (for banks, securities and insurance, and pensions). The two key institutional arrangements of the council are the following: (1) the central bank participates in the council only as an advisor to the chairman (who is not a member with voting power), and (2) the council’s powers “are not above the legal mandate of their members.”23 In fact, the council only has the capacity to make regulatory recommendations24 and, when considering recommendations that may have any effect over central bank powers, Article 2 of Law 20.789 provides

See Monteagudo 2010a, supra note 31; and Triantyfillou 1992. Article 84 of the Peruvian Constitution. 19 Article 84 of the Peruvian Constitution. 20 Article 87 of the Peruvian Constitution. 21 Jácome, Nier, and Iman 2012, footnote 36. 22 The approval of Law No. 20.789 was subjected to a constitutional review by the Constitutional Tribunal that declared its conformity. See Biblioteca del Congreso Nacional de Chile n.d. 23 Presentation of Raddatz 2015. 24 Article 2.3 of Law 20.789. 17 18

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a suspension procedure at the request of the Minister of Finance, established in Article 19 the Central Bank Law.25 The Chilean solution has left central bank independence almost unharmed and reinforced its protection in case regulatory recommendations from the Financial Stability Council may interfere with monetary policy. In addition, it must be taken into account that advisory powers or the authoritative production of nonbinding measures has become a centerpiece of the evolution of international economic law. Soft law has become an efficient “regulatory” instrument for implementation purposes.

Classical Carve-Out and Macroprudential Exemptions Since the beginning of the 1990s, many Latin American countries have liberalized international trade, foreign investment, and financial services through bilateral investment treaties and free trade agreements.26 Many aspects of the free trade agreement model formerly promoted by the United States have prevailed in negotiations with Latin American countries; for example, the prudential exemption provided in the Chapter of Financial Services, which basically mirrors the prudential carve-out (or prudential exemption) provided in the Annex on Financial Services of the General Agreement on Trade and Services (GATS) of 1994. Paragraph 2 (a) of the Annex establishes: Notwithstanding any other provisions of the Agreement, a Member shall not be prevented from taking measures for prudential reasons, including for the protection of investors, depositors, policy holders or persons to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity and stability of the financial system. Where such measures do not conform with provisions of the Agreement, they shall not be used as a means of avoiding the Member’s commitments or obligations under the Agreement. . . .

As remarked by Matsushita and others, “the prudential carve-out ensures that other economic and societal objectives, such as consumer protection and financial stability, can be protected. If the Global Financial Crisis (GFC) has shown that this has not happened sufficiently in the past, it was certainly not the World Trade Organization (WTO) parameters which limited the right sensibly to regulate the financial services industry.”27 These authors also remark that the current prudential carve-out In this cases, Article 2 of Law 20.789 refers to the procedure provided in Article 19 of the Constitutional Law of the Central Bank of Chile, “At any meeting attended, the Minister shall have the right to suspend the applicability of any decision or resolution passed by the Board for a period not to exceed 15 days, counting from the date of such meeting, provided that, if all Board Members insist upon the application thereof, such suspension shall have no effect.” 26 The International Centre for Settlement of Investment Disputes database reports the proliferation of bilateral investment treaties of some representative Latin American countries: Argentina (58), Brazil (14), Chile (55), Colombia (17), Costa Rica (20), Equator (27), Mexico (32), Peru (35) and Uruguay (34). https://​icsid​.worldbank​.org/​apps/​ICSIDWEB/​resources/​Pages/​Bilateral​-Investment​ -Treaties​-Database​.aspx​?tab​=​AtoE​&​rdo​=​TCN. See also Rodríguez Mendoza 2012. 27 Matsushita and others 2015, 630. 25

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exemption “would accommodate the new focus of central banks and regulators in addressing systemic risk.”28 However, it is difficult to imagine that GATS writers had in mind macroprudential measures in the actual sense of the concept when they designed the carve-out exemption. Even though the examples of prudential measures proposed by Paragraph 2 (a) are not precisely typical macroprudential measures (“measures for the protection of investors, depositors, policy holders”), the reference to “ensure the integrity and stability of the financial system” amplifies the scope of the exemption with a visionary perspective. In addition to that, the annex provision employs the term “prudential reasons” and does not refer to specific types of measures.29 In the Peru–United States Free Trade Agreement, signed on April 12, 2006, and entered into force in February 2009, the prudential carve-out transposes GATS’ text in Article 12.10 (1).30 However, it adds an explanation of what prudential reasons may mean, stating that “it is understood that the term ‘prudential reasons’ includes the maintenance of the safety, soundness, integrity, or financial responsibility of individual financial institutions or cross-border financial service suppliers” (footnote 4). It is clear that in this example of “prudential reasons” there is a more classical micro approach than a macro one, referring to “individual financial institutions” and regulatory objectives (“safety, soundness, integrity, or financial responsibility”) associated with Basel Committee and Anti–Money Laundering/Combating the Financing of Terrorism standards, as well as social responsibility principles. The language of the footnote of Article 12.10 (1) does not use examples more related to the era of macroprudential policy. However, there is no doubt that these “examples” are not part of numerous clausus or a closed list of prudential reasons. The text starts by saying that the term “prudential reasons” includes the referred examples and also Article 12.10 (1), as used in the text of the GATS, including to exemplify the measure for prudential reasons, ending with a general expression that expressly refers to measures “to ensure the integrity and stability of the financial system.” Therefore, it is clear enough that,

Ibid. “[it] does not restrict the freedom of regulatory authorities with respect to the type of measures that can be applied. . . . Rather its focus is on the objectives or the underlying reasons, rather than on the instruments used in pursuance of those objectives . . . the carve-out is designed to cover any type of measures that a country might see fit as long as it is in pursuance of the prudential reasons identified in the carve-out.” See Marcheti 2011, 279. 30 Article 12.10 Exemptions (1): Notwithstanding any other provision of this Chapter or Chapter Ten (Investment), Fourteen (Telecommunications), or Fifteen (Electronic Commerce), including specifically Articles 14.16 (Relationship to Other Chapters) and 11.1 (Scope and Coverage) with respect to the supply of financial services in the territory of a Party by a covered investment, a Party shall not be prevented from adopting or maintaining measures for prudential reasons, including for the protection of investors, depositors, policy holders, or persons to whom a fiduciary duty is owed by a financial institution or cross-border financial service supplier, or to ensure the integrity and stability of the financial system. 28 29

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according to the text of the treaties, macroprudential measures are among the carve-out exemptions. Considering the conceptual basis of the carve-out exemption, it should be taken into account that its basic idea is that—in the context of liberalizing trade, investment, and financial services—the states and regulators keep the regulatory capacity in some specific areas such as the banking sector.31 The carve-out exemption is not provided in the GATS or free trade agreement as a domestic policy exemption that should be “necessary” in special circumstances; in fact, as a principle, all prudential measures are exempted.32 Future free trade and investment agreements may amplify the list of examples to avoid unnecessary discussion on this issue. However, it is interesting to observe the evolution of financial regulation and liberalization treaties that might need to be revisited occasionally with a view to ensuring their consistency.

The Implementation of Macroprudential Policy without an Institutional Arrangement: Peru’s Experience Peru is an example of a country that, though not having set a formal financial stability council and explicit macroprudential legislation, has been able to implement some macroprudential measures. As already explained, the Central Reserve Bank of Peru has as a unique goal the preservation of monetary stability, whereas the Superintendence of Banks, Insurance Companies, and Private Pension Funds is the actual banking regulator. However, this separation of functions between monetary policy and banking regulation admits, in the field of legislation, some sort of joint regulatory coordination. This is because the central bank has a consulting role for approving some banking regulations and licenses (such as for organizing and managing banks and financial institutions),33 establishing autonomous banking equities,34 providing previous opinion for the liquidation of banks,35 providing previous opinion for bank rehabilitation plans,36 providing previous favorable opinion on the Superintendence’s definition of “exceptional circumstances” for justifying an increase in bank equity,37 providing previous

“GATS strongly adheres to the starting point that the host country has the right to regulate and supervise banking activity in its market, even if this involves banking activity by foreign banks. At present, The GATS only prohibits WTO members from taking a series of specific market access restrictions, prohibits WTO members from discriminating when adopting measures and requires them to adhere to due process requirements. The GATS encourages mutual recognition, but contains no obligation for WTO members to recognize the equivalence of each other’s banking regulation or supervision.” See De Meester 2014, 59. 32 See Marcheti 2011, 292. 33 Article 19 of Law No. 26702 (Peruvian Banking Law). 34 Article 38 of the Peruvian Banking Law. 35 Article 95 of the Peruvian Banking Law. 36 Article 125 of the Peruvian Banking Law. 37 Article 144 of the Peruvian Banking Law. 31

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favorable opinion for the constitution of bridge banks,38 and providing previous opinion for the authorization of operations not explicitly considered in the banking law.39 This common experience between the central bank and the banking regulator40 has permitted an important level of coordination between both entities. One primary action of the central bank (also implemented by some African central banks)41 is the publication of periodical financial stability reports since 2007. The Central Bank of Peru publishes the report “with the objective of identifying the risks that affect the functioning of financial markets, financial stability, and payment systems.”42 The report is justified because “financial shocks can diminish the efficiency of monetary policy.”43 It covers an assessment of risks for banking, financial, and payment systems. Peru’s Constitution also establishes that the central bank has the function of informing the country, “accurately and periodically” about the state of national finances.44 This general provision, which does not distinguish between the public sector and banking finances, serves also as a foundation for the central bank’s financial stability reports. The Peruvian economy still confronts financial dollarization as one of the long-term effects of the 1980s hyperinflation episode. In March 2016 the ratio of dollarization of banks loans was 35 percent, from above 60 percent at the beginning of the century.45 In that scenario, dollarization in a context of exchange rate volatility becomes a macrorisk, especially for the banking system. This special circumstance has led the Central Bank of Peru to adopt measures—mostly in the area of reserve requirements—to create incentives for gradual dedollarization. Mercedes García-Escribano concludes that “the findings confirm that Peru bank de-dollarization has been the result of a three-prong approach. Macroeconomic stability, proxied by inflation, different measures of exchange rate changes, and sovereign credit risk (EMBI), had a significant impact on dedollarization. Prudential measures, such as the introduction of asymmetric reserve requirements and provisions for currency-induced credit risk, had an impact on banks’ incentives to borrow and lend in soles” (García-Escribano 2010, 5). The main measures adopted include the following: • A legal reserve regime of differentiated reserve requirements by currency;45

Article 151.2 of the Peruvian Banking Law. Article 221.44 of the Peruvian Banking Law. 40 The central bank has also the power to fix limits to the interest of banking operations in exceptional circumstances. Article 9 of Peruvian Banking Law. 41 Caruana 2014. 42 Preface of the Reporte de estabilidad Financiera of June 6, 2016. http://​www​.bcrp​.gob​.pe/​docs/​ Publicaciones/​Reporte​-Estabilidad​-Financiera/​ref​-mayo​-2016​.pdf. 43 Ibid. 44 Article 84 of the Peruvian Constitution. 45 See the evolution of the ratio of de-dollarization of credits in Banco Central de Reserve del Peru 2016. 46 Central Bank Circulares No. 041–2015-BCRP and 005–2016-BCRP. 38 39

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• The imposition of additional reserve requirements for housing mortgages and car loans in US dollars, aimed at reducing the risk of excessive indebtedness in foreign currency;47 • The imposition of additional reserve requirements to banks that do not reduce their credits in foreign currency, aimed at reducing the risk of excessive indebtedness in foreign currency;48 and • The offer of substituting repos to enhance the substitution of foreign currency loans for local currency loans.49 The Superintendence of Banks, Insurance Companies, and Private Pension Funds has also approved prudential regulations for limiting banks’ foreign exchange positions.50 Whereas all these measures have been approved under exclusive competences with some level of informal coordination, international experience shows the positive effects of interagency councils, with the eventual participation of government taking into account the specific legal and political realities of each country. However, Peru’s experience shows that, even in the absence of explicit mandates and formal arrangements, central banks and banking regulators are able to respond to some of the challenges of financial stability.

CONCLUSION Latin America is following the general trend of establishing a macroprudential institutional framework. However, this process must preserve the achievements gained through central bank independence, which has proved to be an efficient mechanism for economic and financial stability, especially in countries that have experienced high inflation. It is also quite important to ensure that international treaties for the liberalization of foreign investment, trade, and financial services clearly include macroprudential measures within the carve-out prudential exemption. Even in the suboptimal scenario of an absence of formal macroprudential institutional arrangements, central banks and banking regulators can still generate macroprudential measures.

REFERENCES Ardant, Philipe. 1999. Institutions politiques et droit constitutionnel, 47. Paris: LGDJ. Banco Central de Reserve del Peru. 2016. “Reporte de Inflacion.” http://www.bcrp.gob.pe/docs /Publicaciones/Reporte-Inflacion/2016/marzo/reporte-de-inflacion-marzo-2016.pdf. Biblioteca del Congreso Nacional de Chile. n.d. “Historia de la Ley Nº 20.789 Crea el Consejo de Estabilidad Financiera.” http://www.bcn.cl/catalogo/detallelibro?bib=254151&n=1.

Article 10.b of Circular No. 041–2015-BCRP. Article 10.a of Circular No. 041–2015-BCRP. 49 Article 3.c of Circular No. 002–2015-BCRP. 50 Article 6 and 6-A of SBS Resolution No. 1455 –2003, modified by Resolutions Nos. 1593–2010, 1536–2010, 923–2011, 10454–2011, 9076–2012, 1890–2015, and 4861–2015. 47 48

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Caruana, Jaime. 2014. “The Role of Central Banks in Macroeconomic and Financial Stability.” BIS Papers 76. Corten, Olivier. 2009. “L’Etat de Droit en Droit International Général: Quelle Valeur Juridique Ajoutée?” In L’Etat de Droit International, Rapport Général, Actes du Colloque de Bruxelles de la S.F.D.I., Paris, Pedone, 11. De Meester, Bart. 2014. Liberalization of Trade in Banking Services: An International and European Perspective. New York: Cambridge University Press. de Oliveira Lopes Cozer, Cristiano. 2015. “Macroprudential Policy in Brazil: Institutional Framework and Recent Experience.” Revista da Procuradoria-Geral do Banco Central 9 (1): 2777. García-Escribano, Mercedes. 2010. “Peru: Drivers of De-Dollarization.” IMF Working Paper 10/169, International Monetary Fund, Washington, DC. International Monetary Fund (IMF). 2013. “Implementing Macroprudential Policy: Selected Legal Issues.” IMF Policy Paper, Washington, DC. ———. 2013. Regional Economic Outlook: Western Hemisphere—Latin America’s Fiscal and External Strength: How Dependent is it on External Conditions? Washington, DC, May. Jácome, Luis I., Erland W. Nier, and Patrick Iman. 2012. “Building Blocks for Effective Macroprudential Policies in Latin America: Institutional Considerations.” IMF Working Paper 12/183, International Monetary Fund, Washington, DC. Marcheti, Juan. 2011. “The GATS Prudential Carve-Out.” In Financial Regulation at the Crossroads: Implications for Supervision, Institutional Design and Trade, edited by Panagiotis Delimatsis and Nils Herger. Frederick: Wolters Kluwer Law & Business. Matsushita, Mitsuo, Thomas J. Schoenbaum, Petros. C. Mavroidis, and Michael Hahn. 2015. The World Trade Organization: Law, Practice and Policy, third edition. Oxford International Law Library. Monteagudo, Manuel. 2010a. “La Independencia del Banco Central.” Banco Central de Reserva del Perú, Instituto de Estudios Peruanos y Universidad del Pacífico, 32–34. ———. 2010b. “Neutrality of Money and Central Bank Independence.” In International Monetary and Financial Law: The Global Crisis, edited by Mario Giovanoli and Diego Devos. New York: Oxford University Press. Nergiz Dincer, N., and Barry Eichengreen. 2014. “Central Bank Transparency and Independence: Updates and New Measures.” International Journal of Central Banking 10: 221–22. Raddatz, Claudio. 2015. “The Chilean Experience with the Financial Stability Council (CEF)” in Peru. Rodríguez Mendoza, Miguel. 2012. “Tratados de Libre Comercio en América del Sur. Tendencias, Perspectivas y Desafíos.” Serie Políticas Públicas y Transformación Productiva 7, Corporación Andina de Fomento, Caracas, Venezuela. Tietmeyer, Hans. 1999. Economie sociale de marché et stabilité monétaire, 8–9. Paris: Economica. Triantyfillou, Dimitris. 1992. L’activité administrative de la banque centrale. Paris: Litec.

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CHAPTER 11

The Central Bank as Macroprudential Supervisor François Gianviti

Central banks have gradually recognized that, even though their main function was the conduct of monetary policy, they had to be concerned about the financial stability of the banking sector or, more broadly, the whole financial sector. In a number of countries, the central bank has traditionally been vested with supervisory and sometimes regulatory powers over commercial banks. In other countries, where central banks had no supervisory or regulatory powers, they could still contribute to financial stability, albeit to a limited extent, as lenders of last resort. The prudential supervision of individual banks (or microprudential supervision), however, while effective to monitor the solvency and liquidity of individual banks, is not always sufficient for the central bank to detect and avert systemic risks for the financial stability of the banking sector. Macroprudential supervision was undertaken, therefore, initially almost as an academic exercise and without any formal basis, to detect these systemic risks. Financial stability reports on economic and financial developments affecting the banking sector were published (see Čihák 2008), followed by stress tests conducted in cooperation with commercial banks, but many central banks had no authority to require changes in the banks’ financial structure. In more and more countries, however, macroprudential supervision is now formally recognized as a component in the mandate of a central bank, with specified duties and powers that may vary with the nature of the tasks assigned to the central bank.

Scope of Macroprudential Supervision Depending upon the applicable law, the scope of macroprudential supervision by the central bank may include one or more of the following functions: • Identification and assessment of systemic risks to the financial stability of the banking sector or, more broadly, the financial sector (including

At the time this chapter was written, François Gianviti was General Counsel and Director of the Legal Department of the IMF.



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insurance companies, pension funds, and the securities market),1 and making recommendations as needed for improvements in the legal framework and business practices for the prevention of financial crises;2 • Regulation: exercise of regulatory powers through enactment of subordinate rules3 for prudential purposes (that is, for financial stability, but not for monetary policy objectives, although there is inevitably some overlap). In some cases, the agency’s mandate will include the authority to enact regulations also for market conduct integrity and consumer protection (“integrated approach”),4 whereas, in other cases, two separate agencies will be established (“twin peaks approach”); • Supervision stricto sensu5: exercise of supervisory powers, that is, prudential supervision of systemically important6 banks or, more broadly, systemically important financial institutions to enforce applicable laws and regulations7 through (1) inspection and monitoring, including the conduct of stress tests for a micro- and macroassessment of risks,8 (2) issuance of instructions or recommendations for compliance with laws and regulations and for improvements in risk avoidance controls and procedures (for example, monitoring of traders’ operations), and (3) imposition of disciplinary sanctions for failure to comply with laws, regulations, or instructions. In some cases, the mandate may also cover supervision for market conduct integrity and consumer protection; and • Bank resolution for systemically important banks or, more broadly, for systemically important financial institutions.

1 Macroprudential supervision of the different components of the financial sector may also be entrusted to separate agencies, in which case some form of cooperation among them has to be organized. 2 For an example of the various tasks involved in this function, see Article 3 of Regulation (EU) No. 1092/2010 of the European Parliament and of the Council of 24 November 2010 on European union macroprudential oversight of the financial system and establishing a European Systemic Risk Board. 3 These rules are “subordinate” in the sense that they have to be consistent with the relevant legislation authorizing their adoption. 4 The European Banking Authority is an example of an integrated approach; see Regulation (EU) No. 1093/2010 of the European Parliament and of the Council of 24 November 2010, Article 1.5. 5 There is a considerable degree of confusion in the use of the terms “regulation” and “supervision.” A “supervisor” may or may not have regulatory powers. Conversely, a “regulator” may or may not have supervisory powers. Some countries make a clear distinction between supervision and regulation. Others do not. 6 The definition of “systemically important” may vary over time and from country to country. The supervisor may also be allowed to determine, on a case-by-case basis, whether a particular financial institution is “systemically important.” 7 These laws and regulations include, but are not always limited to, those enacted for prudential purposes. 8 In addition to a microprudential assessment of internal risks within each institution, these tests take into account systemic risks, such as a real estate bubble leveraged by unsustainable credit growth, and their possible impact on the financial system, including spillover and feedback effects.

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Expansion of the Central Bank’s Mandate: Internal Changes and Questions Making the central bank a macroprudential supervisor will require the hiring by the central bank of personnel with special expertise, particularly for the regulation, inspection, and resolution functions. These officials will have to be subject to specific rules, including a prohibition, for those who have access to confidential information related to the supervision or resolution of financial institutions, of sharing that information with any other person, including officials in other departments of the central bank. There may also have to be some changes within the structure of the central bank, with different collegial bodies or senior officials (such as deputy governors) accountable for the performance of different functions.9 In addition, this expansion of the central bank’s mandate raises at least three questions: • Having to conduct monetary policy while acting as macroprudential supervisor, is the central bank now faced with conflicting objectives? • What is the potential liability and reputational risk for a central bank acting as macroprudential supervisor? • Should the central bank be granted the same operational independence for macroprudential supervision it has been given for the conduct of monetary policy, and, if not, could this affect its independence in the conduct of monetary policy?

CENTRAL BANK’S OBJECTIVES Monetary Stability and Financial Stability Are Complementary Objectives . . . It is often said that, as monetary stability contributes to financial stability and vice versa, the objectives of monetary policy and those of financial supervision are not only complementary but also mutually supportive (Gianviti 2010). This is generally true. In a stable macroeconomic environment, with reasonable price stability (that is, annual domestic consumer price increases around 2 percent10), interest 9 For instance, in the European Central Bank, a Supervisory Board has been established for the supervision of credit institutions. Within the Bank of England, its functions as Prudential Regulation Authority are carried out by a separate structure under the authority of the Prudential Regulation Committee. 10 This monetary policy objective of slow and regular increases in consumer prices is based on the assumption that these prices are not artificially manipulated. If they are regulated or subsidized by the government, monetary policy has no impact on them. Moreover, a stable consumer price index does not necessarily mean that the standard of living remains the same. For example, higher income or real estate taxes, which reduce the amount of disposable income, are not counted as price increases in the consumer price index; they may even result in a lower price index if they are used to subsidize consumer prices.

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rates are also fairly stable, which allows banks and other financial institutions to make more reliable risk assessments than in situations of price and interest rate volatility.

. . . Unless There Is a Major Financial Crisis . . . When faced with a major financial crisis in which a substantial part of the banking system, while not insolvent, has become illiquid and is unable to meet the demand for cash withdrawals, the central bank acting as lender of last resort will have to increase the amount of central bank money in the country’s economy. A large addition to the volume of money in circulation could have an inflationary effect, unless it takes place in a recessionary context. This effect should be temporary, however, assuming that the banking system recovers and the excess liquidity is sopped up by the central bank.

. . . Or an Antideflationary Monetary Policy . . . When price increases fall below 2 percent, central banks often engage in inflationary policies, with low interest rates, coupled sometimes with massive purchases of securities, including the purchase of long-term government and corporate bonds (“quantitative easing”). They may even impose negative interest rates on bank deposits with the central bank to prompt commercial banks to lend more to public and private entities.11 If there are not enough creditworthy private sector borrowers to absorb this additional liquidity, banks will have no choice but either to invest abroad or lend to the government, which may then be able to borrow at low or even negative interest rates.

. . . Undermines Financial Stability . . . Theoretically, this easy money policy, unless it results mostly in large capital outflows toward countries offering higher interest rates, should rekindle inflation by increasing both credit to the private sector and public spending. As lower interest rates will usually result in a depreciated exchange rate, the cost of imports will rise, and higher import prices will help achieve the inflation objective. Moreover, a depreciated exchange rate will make the country’s exports more competitive, and an increase in exports will contribute to domestic growth. An easy money policy should also allow governments to make structural reforms that would improve productivity. It often has the opposite effect, however, as it allows governments not to engage in unpopular structural reforms as long

11 It has also been suggested that the central bank should distribute a uniform amount of money as grants to every resident in order to stimulate demand (“helicopter money”). A distribution of central bank loans was also recently proposed, but for a different purpose, namely, the financing of one-off allowances for individual projects (see Grass 2016). Sooner or later, an economist will argue that central banks should extend “nonrefundable loans” to governments, at zero or negative interest rates, under the condition that the proceeds be disbursed within a short period of time to boost inflation.

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as they can finance their deficits and subsidize unproductive activities by borrowing at low or negative interest rates. An easy money policy, however, may have a negative impact on the financial sector. Faced with lower returns on their investments and a higher cost of their deposits with the central bank, commercial banks turn to riskier loans to make a profit, or lend to stock market speculators who inflate the value of securities way beyond their realistic levels, thus creating a minefield of nonrepayable loans and asset bubbles. There may be a similar bubble in the real estate market, which, when it bursts, can jeopardize the stability of the whole banking system, as exemplified by the subprime debacle. Insurance companies and pension funds that become unable to generate enough income from their safer investments, such as government bonds, to cover their payments may be tempted, or even encouraged by the authorities, to diversify their portfolios and engage in riskier but more profitable investments. This diversification is also a precautionary measure for the future. When interest rates return to a normal level, there will be an immediate depreciation of insurance companies’ and pension funds’ portfolios that were invested in low interest rate bonds, which will create a risk of insolvency.12 A temporary suspension of disbursements may be required to avoid bankruptcy.

. . . and Generates a Conflict of Objectives Faced with the immediate and potential risks resulting from an antideflationary monetary policy, the agency vested with regulatory powers over the banking (or financial) sector will strengthen the prudential ratios to ensure the continued liquidity and solvency of banks (or, more broadly, financial institutions). For example, a higher capital-to-loans ratio will be imposed, which will reduce the profitability of banks. Similar measures may have to be taken for other financial institutions. Strengthening the prudential ratios, however, reduces the volume of credit that banks may inject into the economy, which is in direct opposition to what the central bank is trying to do.13 If the supervisor is the central bank, it is faced with a dilemma: should it go even further in its easy money policy while strengthening prudential ratios in a way that offsets the effect of its monetary policy on the banking sector? Or should it tone down this easy money policy because it undermines the stability of the financial sector and can be pursued only at the risk of having, at some point, to bail out banks and other financial institutions that have become illiquid and may soon become insolvent? It is a typical example of conflicting objectives, which can 12 Another risk for holders of government bonds is that higher interest rates may also affect a highly indebted government’s ability to service its debt, which could result in a restructuring or consolidation of outstanding debt. 13 The negative impact of stringent prudential ratios on economic growth is more pronounced in countries, such as those of the European Monetary Union, that rely heavily on the banking sector for credits to the private sector than in countries, such as the United States, where the funds come to a much larger extent from the issuance of stocks and bonds.

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lead to a compromise giving a limited effect to each objective or be resolved by prioritizing one objective over the other.

Hierarchy of Objectives When monetary stability is prescribed by law, not just as the primary objective of monetary policy but also as the primary objective of the central bank itself, this goal governs all the bank’s activities. Monetary stability trumps all the objectives that may be assigned to the central bank, either explicitly or implicitly, including the objective of financial stability. Under this scenario, the central bank must conduct monetary policy and, more generally, carry out its functions to achieve its monetary policy objective regardless of the impact it may have on financial stability. This would mean that it should be prepared to sacrifice the stability of the financial sector on the altar of monetary stability. In practice, however, unless the legislation imposes a rigid, quantified inflation target, the central bank will generally have enough leeway in the implementation of its monetary policy objective (for example, by postponing the return to a 2 percent annual price increase) to preserve the integrity of the financial sector.

CENTRAL BANK’S LIABILITY Several types of liability risks can be envisaged. For instance: • The central bank abuses or misuses its power (with or without malice). • The central bank fails to exercise adequate supervision, resulting in a bank’s failure. • The central bank discloses confidential information obtained in the course of its supervisory activities. • A report published by the central bank contains substantially inaccurate information, which misleads depositors or investors and results in financial losses for them. In all these cases, as the central bank’s wrongful conduct is actually a consequence of an action or failure to act by its governor, directors, or other officials, the question of these officials’ own liability may be raised.

Increased Risk with a Formal Mandate The issue of liability could arise even if macroprudential supervision were carried out informally and without an explicit mandate in the legislation. If, for instance, inaccurate information were published without a disclaimer, the agency could be held liable to those who relied on that information in the conduct of their business. The issue is more likely to arise, however, if an explicit mandate is given to the central bank.

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Liability may be incurred in the performance of any prudential task assigned to the central bank, but the task that will most likely give rise to liability issues is the enforcement of laws and regulations (prudential supervision). If, for example, a commercial bank becomes insolvent, the central bank will be the primary target of civil suits on the grounds that, had it acted in a timely and responsible fashion, these losses would have been averted. The risk of civil actions against a central bank acting as supervisor cannot be taken lightly. The cases brought against the Bank of England in English courts and against the French Banking Commission in French administrative courts after the failure of the Bank of Credit and Commerce International show that these civil suits may result in substantial costs to the supervisor, in terms of damages when the plaintiffs succeed and, even if the plaintiffs’ action is eventually dismissed or dropped, in expensive legal fees.14

Different Rules on Bank Supervisors’ Liability There are no uniform rules on the liability of bank supervisors, and there are substantial differences in national laws (see Andenas and Fairgrieve 2002; Athanassiou 2011; Dijkstra 2012; Nolan 2013). Even within the European Union, uniform rules have not been adopted. In the Peter Paul decision of 2004, the European Court of Justice, in response to a request by the Bundesgerichtshof (Germany) for a preliminary ruling, held that member-states of the European Union that have deposit-guarantee schemes may exonerate the banking supervisor of any liability to individuals for wrongful action or omission in the performance of its supervisory duties.15 The following are a few examples of the diversity of rules in the European Union.

German Law In the Peter Paul case, the issue before the German courts was whether the German credit institutions’ supervisor could be liable in tort to a bank’s depositors for not properly supervising a bank, the failure of which had resulted in a financial loss for the plaintiffs. Under German law, the credit institutions’ supervisor was required to exercise its functions “only in the public interest,”16 which the courts interpreted as meaning that it could not incur any liability to depositors or other creditors.17 The question put to the European Court of Justice was

On these cases, see Andenas and Fairgrieve 2002, 757. Peter Paul, ECJ Decision of 12 October 2004, Case C-222/02. 16 Belgium and Luxembourg have enacted similar laws. See Athanassiou 2011. 17 Statutory immunity would be unconstitutional in Germany, but limiting the scope of an agency’s functions (for example, by imposing a duty of care only to the public) is not. The supervisor would still be liable, however, to the bank itself for its wrongful actions against the bank. See Andenas and Fairgrieve 2002, 771–72. 14 15

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whether this rule of German law was consistent with the European Directive on banking supervision. In its ruling, the European Court of Justice held: If the compensation of depositors prescribed by Directive 94/19/EC of the European Parliament and the Council of 30 May 1994 on deposit-guarantee schemes is ensured, Article 3(2) to (5) of that directive cannot be interpreted as precluding a national rule to the effect that the functions of the national authority responsible for supervising credit institutions are to be fulfilled only in the public interest, which under national law precludes individuals from claiming compensation for damage resulting from defective supervision on the part of that authority.

In the same ruling, the court also held that other European directives on credit institutions did not preclude the adoption of a rule under national law exonerating the supervisor of any liability to individuals.

French Law In contrast to German law, French law has no similar provision exonerating the supervisor of any liability to a bank’s depositors. French administrative courts, therefore, applying general principles of French administrative law, have concluded in a number of cases that the French banking supervisor could be liable to depositors for failing to exercise proper supervision of a bank.18 To claim damages, plaintiffs have to prove gross negligence by the supervisor (faute lourde).19 The courts will also determine the extent to which the responsibility of the plaintiffs’ losses can be attributed to the banking commission, for its lack of adequate supervision, and to the bank’s directors, for their mismanagement of the bank. In the Kechichian case, where fraud was found to have been the main cause of United Banking Corporation’s bankruptcy, the state was held liable for only 10 percent of the depositors’ losses.20

Italian Law Italian courts have recognized the liability, for lack of adequate supervision, of bank and other financial institutions’ supervisors to depositors and other investors.21

18 Until 2003, the banking supervisor (separate from the regulator) was the Commission bancaire; it was a government body, not a legal entity. Since 2003, the Autorité des marchés financiers has been the regulator and supervisor of all financial sector activities; it is a legal entity. 19 Although some lower courts had concluded that simple negligence was sufficient, the Conseil d’Etat held that gross negligence had to be established. See the cases cited by Andenas and Fairgrieve 2002, 768–71. 20 Conseil d’Etat, 30 November 2001, No. 219562. 21 See the cases cited by Andenas and Fairgrieve 2002, 772–73.

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English Law After the collapse of the Bank of Commerce and Credit International, the Bank of England, which was then the supervisor of banks, became entangled in lengthy and costly litigation with depositors who (unsuccessfully) claimed that the bank was responsible for their losses.22 The Three Rivers case, as it is known, gave rise to two decisions of the House of Lords, in 2000 and 2001.23 The plaintiffs had to prove more than negligence or gross negligence. By statute, the Bank of England could only be liable if the act or omission resulting in a financial loss “was in bad faith.” Bad faith is interpreted in English law as malice. In the case of public agencies or officials, it is often described as “misfeasance in public office.” Misfeasance may take two forms. It may be targeted at one or several persons or it may just be knowledge that the action or omission is wrongful and will injure someone. The House of Lords agreed, however, that indifference as to the risk of loss (recklessness) was sufficient to meet the condition of misfeasance. Bad faith, even broadly defined to include indifference to the harmful consequences of one’s action or inaction, is still a very high standard. Clearly, the objective of this requirement of bad faith is to give the utmost protection, short of complete immunity, to the supervisor. Under such a test, the depositors really had no serious chance of succeeding in their claims against the Bank of England. One consequence of this case may have been the 1998 change in UK legislation transferring the supervision of banks from the Bank of England to the Financial Services Authority. This responsibility was later transferred to the Prudential Regulation Authority, which was a corporate entity, until, in 2016, the Bank of England became the Prudential Regulation Authority. Under the UK Financial Services Act 2012, the principle is that the Prudential Regulation Authority and its officials do not incur any liability “for anything done or omitted in the discharge, or purported discharge” of the authority’s functions. The traditional exception, which requires proof of bad faith, has been retained.24

22 The plaintiffs abandoned their claims after 12 years of proceedings and with a £73 million bill in legal fees; see Nolan 2013, 205. 23 Three Rivers District Council and others v Governor of the Bank of England and Company of the Bank of England [2000] 2 WLR 1220 and [2001] UKHL 16. 24 See UK Financial Services Act 2012, Schedule 1ZB, Part 4, paragraph 33. For an identical provision on the liability of litigators, see section 88 of the Act. In the same provisions, however, there is now a second exception, albeit a very limited one, to the principle of nonliability. The Prudential Regulation Authority’s and its officials’ exoneration of liability in damages does not apply either if “(a) the act or omission is shown to have been in bad faith, or (b) so as to prevent an award of damages made in respect of an act or omission on the ground that the act or omission was unlawful as a result of section 6(1) of the Human Rights Act 1998.”

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International Standard The Basel Committee on Banking Supervision, in its Core Principles for Effective Banking Supervision of September 2012, has adopted the following recommendation (Principle 2, Essential criteria, paragraph 9). Laws provide protection to the supervisor and its staff against lawsuits for actions taken and / or omissions made while discharging their duties in good faith. The supervisor and its staff are adequately protected against the costs of defending their actions or omissions while discharging their duties in good faith.25 Short of complete immunity, which would in any case be inconsistent with constitutional provisions in a number of countries and the European Convention on Human Rights, the adoption of this standard in national laws or international conventions would provide supervisors with the most effective protection. The underlying assumption that led to the adoption of this standard may have been that the protection of depositors should be ensured instead by an adequate deposit-guarantee scheme. This is not always the case, however. There are substantial differences in the level of protection afforded by these schemes, even among developed countries. For example, while deposits are guaranteed up to $250,000 in the United States, they are only guaranteed up to €100,000 (about $110,000) in the European Union. Moreover, the guarantee in the United States applies to each depositor’s account ownership category (checking accounts, savings accounts, money market deposit accounts, and certificates of deposit) in each bank insured by the Federal Deposit Insurance Corporation. By contrast, the guarantee in the European Union applies only to a depositor’s aggregated accounts in the same bank. This means that the total coverage per depositor in each bank is $1 million dollars in the United States compared to €100,000 in the European Union. A low level of protection for depositors is not very attractive and may compound the liquidity problem already faced by banks in some countries.

Single versus Dual Liability Standard Single Standard The liability standard used, for example, by the United Kingdom and advocated by the Basel Committee on Banking Supervision is a single standard: bad faith of the supervisor in the performance of official duties. It applies both to the

25 As good faith should be presumed, the burden of proving bad faith has to be on the plaintiffs. The UK legislation, in this regard, is better than the Basel Committee’s recommendation as it explicitly requires proof of bad faith.

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supervisory agency, which is a government body or a public entity, and to its officials, who are individuals.26 The reason usually advanced for this very high standard is that liability for mere or even gross negligence would have a chilling effect on the performance of official duties by the supervisor. This is not a fully convincing reason. Whereas the chilling effect of litigation risk may affect the conduct of individuals managing or employed by the agency, the agency, which by its nature is not subject to human feelings, cannot be subject to that effect. What is being protected, therefore, by requiring bad faith on the part of the agency, is taxpayer money.27 Probably, the same concern would not be relevant if the supervision of banks were entrusted to a private company. As mentioned earlier, there may have been a tradeoff between a very high liability standard, which protects taxpayer money, and the adoption of deposit-guarantee schemes to protect depositors. These guarantee schemes offer no protection, however, to other creditors. Nor do they cover the losses incurred by shareholders as a result of a supervisor’s wrongful actions if they are not taken in bad faith.

Dual Standard In contrast to this single liability standard, some legal systems have a dual liability standard. In French administrative law, for example, bad faith (faute personnelle) is a liability standard for civil servants, but not for the state or its agencies. The state or a state agency can be liable for negligence and, depending on the nature of the activity, the test may be simple or gross negligence.28 As noted previously, the French Conseil d’Etat has concluded that the relevant test for the banking supervisor’s liability was gross negligence. This dual standard affords a substantially stronger protection to all those who have incurred losses due to a wrongful act or omission of the supervisory agency, while also protecting the agency’s officials who have acted in good faith in the discharge of their duties.

26 The Financial Stability Board, in its 2014 Key Attributes for Effective Resolution Regimes (paragraph 2.6), has adopted a similar standard for resolution authorities: “The resolution authority and its staff should be protected against liability for actions taken and omissions made while discharging their duties in the exercise of resolution powers in good faith, including actions in support of foreign resolution proceedings.” 27 As the agency has no mind of its own, its “bad faith” can only be the bad faith of individuals acting on its behalf. Deeming the agency to have acted in bad faith because of these individuals’ actions allows the plaintiffs to sue the agency as a solvent principal for the wrongful actions of its agents. 28 Proof of simple negligence is normally sufficient for administrative as well as civil liability (In lege Aquilia et levisssima culpa venit). Proof of gross negligence is required in administrative law only in special cases, such as hazardous activities (for example, riot control) or functions where a complete knowledge of all relevant data is particularly difficult to obtain (for example, supervision of municipalities’ activities). Administrative courts have gradually restricted the number of cases in which gross negligence is required.

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In the European Union, the dual liability standard for a supervisory/regulatory agency and its officials has been adopted for the European Banking Authority.29

Reputational Risk A central bank that fails to prevent a bank’s failure may well be protected from liability suits, but the law will not protect it from public reproach. This is especially true in cases where many—and, particularly, small—depositors have lost their savings, if it appears that a more effective supervision of the bank could have prevented its failure. If this sentiment is shared by the legislature, a parliamentary committee will be appointed to investigate the central bank’s conduct, providing an opportunity to reopen the eternal question of the central bank’s accountability in a democratic society. Inevitably, at stake will be not only the role of the central bank in macroprudential supervision but also its role in the conduct of monetary policy, including its independence in the conduct of that policy.

CENTRAL BANK’S INDEPENDENCE The independence of central banks, which is now generally regarded as “best practice,” is part of a broader trend. In more and more countries, and for different reasons, legislation has been enacted to establish agencies that operate independently of the government.30 These entities are given the authority to perform tasks that would normally be the responsibility of the government, including the execution of specified laws.31 Some may be allowed by the legislature to enact 29 See Regulation (EU) No. 1093/2010 of the European Parliament and of the Council of 24 November 2010, Article 69: Liability of the Authority 1. In the case of non-contractual liability, the Authority shall, in accordance with the general principles common to the laws of the Member States, make good any damage caused by it or by its staff in the performance of their duties. The Court of Justice of the European Union shall have jurisdiction in any dispute over the remedying of such damage. 2. The personal financial liability and disciplinary liability of Authority staff towards the Authority shall be governed by the relevant provisions applying to the staff of the Authority. 30 The term “government” is used here to designate the organ of the state that exercises the executive power, that is, is in charge of executing the laws. In some countries, it is called the cabinet. In the United States, where the term “government” includes the executive, legislative, and judicial branches, the equivalent of the cabinet is the executive branch, sometimes referred to as the [president’s name] administration. 31 The establishment of such agencies may raise constitutional issues. Does the legislature have the authority to divest the government of powers (enforcement of laws) conferred upon it by the constitution? Conversely, if the government refuses to enforce laws that it disagrees with, should not the legislature have the authority to establish agencies that will enforce these laws? Moreover, the proliferation of independent agencies may be seen, in a democratic society, as a sign of distrust in the people’s representatives as more and more powers originally vested in elected officials are being gradually transferred to unelected technocrats who are expected to be guided in their decisions by other than political considerations.

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regulations that will have the force of law. They may even be vested with judicial powers. What the term “independence” covers, however, is not uniform and does not always apply to all the functions performed by the agency.32

Formal versus Operational Independence An agency may be described as independent simply because it is outside the framework of the government. But this independence from the government may be largely formal. Being outside the government’s framework does not necessarily mean that the government has no control over the agency. The government may have some control over the agency if it has the power, for example, to give instructions to the agency on some key aspects of its work, or to veto its major decisions, or to appoint and remove its chief executive officer and other senior officials, or to approve or make major cuts in its budget. Formal independence, therefore, does not by itself give an agency the capacity to discharge its mandate if it may be subject to external interference in its decision-making process. An agency cannot be fully accountable for the performance of its functions unless it is able to operate at arm’s length from the government. Only an agency vested with operational independence can be regarded as truly independent and, therefore, fully accountable for its actions.

The Three Pillars of Operational Independence An agency can be deemed to be truly independent when three conditions are met. First, it should be allowed to perform its mandate without any external interference (in other words, it has full operational independence). In particular, it should not be subject to instructions or veto over its decisions. Second, the status of its chief executive officer and other decision-making officials (board of directors, for example) should guarantee their independence. They should be appointed for a substantial period of time (for example, five years or more) and should have security of tenure.33 They should not serve at the pleasure, or in any way be subject to the authority, of any external individual, organ, or entity; only for incapacity or serious breach of duty or criminal offence can their appointment be terminated. As long as they are in office, their remuneration should not be reduced. Also, procedures designed to avoid any real or perceived conflict of interest (such as participation in entities within their jurisdiction) should be established. Third, the agency should have its own sources of financing, or earmarked budget resources, allowing it to discharge its mandate properly. Clearly, this third condition is the most difficult to meet. When an agency is funded by annual budget appropriations, it is always at the mercy of targeted or across-the-board budget cuts and it may even become hostage to a political conflict between the On the legal and policy issues raised by the various types of independent agencies in the United States, see Davis 1993 and Breger and Edles 2015. 33 Preferably, their terms of office should not coincide with the tenure of the person or body making the appointment. 32

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executive and legislative branches. As central banks generate their own resources, they do not run that risk (unless they have to be recapitalized), but supervisory and regulatory agencies do run that risk, unless they are given the authority to determine the level of their fees in order to cover their costs, which does not seem to be a common feature of their charters.

Degrees of Operational Independence When deciding whether the proper performance of a particular function requires full operational independence, consideration has to be given to the particular nature of that function and the need to prevent political interference in its performance. It is also possible to envisage different degrees of operational independence, depending on the type of function being performed. For example, if a fully independent central bank receives a mandate to perform an additional function for which some but not full operational independence seems warranted, the government could be allowed to appoint and remove from office the decision-making officials (chief executive officer and board of directors) who are in charge of that particular function in the central bank, but without the authority to give instructions to them for the performance of that function. The government should not be allowed, however, to exercise that power against officials (for example, the governor of the central bank) who are also in charge of functions for which the central bank’s independence cannot be infringed. Otherwise, the government could use its disciplinary power as a threat to dictate their conduct of monetary policy. Another possibility would be to require the government’s consent or give it a power of veto, but only for specified types of decisions (for example, a change in the banks’ capital ratio or a major bank’s liquidation involving a bailout by the government).34

Scope of Central Banks’ Operational Independence In the European Union and many other parts of the world, central banks are established as formally and operationally independent agencies, but their operational independence does not necessarily extend to all the tasks within their mandates. For example, the European Central Bank and the national banks that are members of the European System of Central Banks are independent for the performance of the tasks listed in the treaty provisions governing the monetary union, including the definition and implementation of monetary policy.35 National central banks in the European System of Central Banks, therefore, are 34 For an example of government approval being required for certain decisions, see the UK Bank of England and Financial Services Act 2016, Section 13, Part 3A, section 30C, on the operational independence of the Bank of England as Prudential Regulatory Authority. 35 See Article 127 of the Treaty on the Functioning of the European Union.

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not subject to instructions from their national authorities for the performance of these tasks, but their independence does not extend to additional tasks that could be conferred upon them by their national laws.36 In the United Kingdom, the Bank of England’s independence is limited to the conduct of monetary policy: it is subject to instructions from the Treasury “except in relation to monetary policy.”37

Independence in the Conduct Of Monetary Policy The main reason for making central banks operationally independent of any other authority is related to the core function of their mandate, which is the conduct of monetary policy.38 The UK experience, in this respect, illustrates the policy considerations that lead a country to shift the conduct of monetary policy from the government to an independent central bank. In 1997, when the British Parliament was considering a bill giving effect to the promise by the Chancellor of the Exchequer (Gordon Brown) to transfer responsibility for monetary policy from the Treasury to the Bank of England, a research paper was prepared for the information of the House of Commons (Blair and Edmonds 1997). According to the paper, the former Chancellor, Nigel Lawson, although from the opposite party, had reached the same conclusion ten years earlier. After saying, in 1987, “I make the decisions and the Bank carries them out,” he had suggested, in 1988, giving “statutory independence to the Bank, charging it with the statutory duty to preserve the value of the currency, along the lines already in place and of proven effectiveness for the US Federal Reserve, the National Bank of Switzerland, and the Bundesbank” (Blair and Edmonds 1997, 9). The research paper went on to explain that the case for an independent central bank rested both on empirical data and a theoretical argument. Empirical data provided by academic research showed that countries with the most independent central banks had the lowest inflation figures. If, therefore, low inflation was the objective, the conduct of monetary policy should be entrusted to an independent central bank. The theoretical argument was that a government, even if it has an objective of low inflation over the long term, has an incentive, in the short term, to “spring an inflation shock,” which “will reduce the value of its existing public debt and can temporarily increase output if workers’ wages respond only slowly See Article 130 of the Treaty on the Functioning of the European Union. This exception was introduced by the Bank of England Act 1998. In the conduct of monetary policy, the Bank of England has unlimited operational independence, but not goal independence. An annual inflation target is determined by the Chancellor of the Exchequer; if the target is missed by one percentage point above or below the target, the Governor of the Bank will send an open letter to the Chancellor explaining why the target was missed and what actions the bank intends to take to get back to the target. 38 Emergency lending (also called emergency assistance) provided by the central bank as lender of last resort is generally not regarded as a monetary policy measure. It may be subject to instructions from, or prior approval of, the Treasury. 36 37

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to inflation” (Blair and Edmonds 1997, 24). If the government, therefore, is in charge of monetary policy, the immediate political gain to be obtained from an expansionary monetary policy will tend to prevail over the long-term objective of low inflation. An independent central bank that is not subject to the same pressure will be better able to achieve that objective. Behind these economic considerations lies a political and ethical issue. On the one hand, it can be argued that the value of the currency issued by a state or on its behalf (by the central bank) and held by other persons is a claim on that state (or its central bank), which the state (or the central bank) should not be free to alter at will. An alternative argument is that the state (or the central bank) should be free to change the value of the currency as it pleases in order to achieve fiscal, economic, and/or political objectives. A debasement of the currency, either by law or through monetary policy, will benefit debtors to the detriment of creditors,39 but the main beneficiary will be the state itself. Inflation increases the nominal value of the tax base (incomes, transactions, and property), which generates more fiscal revenue in nominal terms, while the nominal value of the state’s outstanding debt remains unchanged.40 The state may even be able to increase its fiscal revenue in real terms, as a percentage of the country’s gross domestic product, simply by not adjusting the tax brackets for inflation. As Milton Friedman aptly put it in a nutshell: “Inflation is taxation without legislation.” Making the central bank independent with a mandate of price stability should be seen as an assurance that the purchasing power of the currency within the country will be preserved. This assumes, of course, that the central bank does not betray its mandate in order to serve the government’s agenda.

Independence in Macroprudential Supervision As noted previously, macroprudential supervision may be understood to cover at least four different functions (systemic risk assessment, regulation, supervision stricto sensu, and bank resolution). These functions may be performed by the same 39 According to Plutarch, there is some evidence, albeit not fully documented, of one of the first examples of a devaluation designed to alleviate debtors’ indebtedness, namely, Solon’s decision as archon of Athens, in 594 BC, to depreciate the Athenian drachma by reducing its silver content. Some of his Athenian friends, who knew of this impending measure, borrowed large sums of drachmas to buy property and made a fortune. Perhaps inspired by Solon’s example, Dionysius, ruler of Syracuse from 407 until his death in 367 BC, having emptied the public coffers and borrowed heavily to finance wars, constructions, public spectacles, and his own lavish lifestyle, ordered all the coins in the city to be brought to him, under penalty of death, then had each one-drachma coin stamped with a two-drachma mark, and finally used the new coins to repay his debt at a 50 percent discount in real value (Bullock 1930). 40 There is one exception: the nominal value of the debt will be adjusted if it is subject to a maintenance of value clause. Also, as a result of inflation, some foreign currencies may have appreciated against the national currency, in which case the cost of servicing the state’s debt denominated in these currencies will increase.

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agency, which could be the central bank, or by separate (and preferably not overlapping) agencies. In any case, whether they are performed by one or several agencies, the reasons for granting or denying operational independence to the agency in charge should be the same. The fact that a central bank is independent in the conduct of monetary policy does not necessarily lead to the conclusion that it should have the same independence when performing other tasks or functions. It is conceivable, therefore, that the central bank, while retaining its independence for the conduct of monetary policy, should be subject to instructions from the government when acting, for instance, as banking regulator. This could lead, however, to a conflict of objectives, in which the central bank could no longer achieve its monetary policy objectives because the government’s financial stability objectives would take precedence.

Systemic Risk Assessment Regardless of whether the central bank, or any other agency performing that function, is given full operational independence, it would not make much sense for the government to dictate the contents of its publications. When a country’s financial and economic data are readily available to the public, not only the central bank but also other private and public (domestic or international) entities may become engaged in the same or similar exercises. The incentive for them to closely scrutinize these data and assess their credibility will be even greater if there is a perception that the government is interfering in the performance of that function by the central bank and is dictating the contents of the published reports. When these data are not readily available to the public but only to the government or some of its agencies, such as the central bank, there may be greater temptation for the government to interfere in the drafting of these reports. One possible incentive is to increase confidence in the banking system when there are persistent rumors about the liquidity or solvency of some banks. If this were to happen, however, these reports would soon lose all credibility. The result may well be that the public, once it becomes aware that it is being misinformed, will overreact and lose any confidence in the banking system.

Regulation Regulations are often described as subordinate legislation because they are an exercise of a delegated but limited power to enact rules. Full operational independence in the exercise of that power is conceivable only if its limits are clearly circumscribed and cannot be expanded by the regulating agency. Even with those limitations, there is no clear consensus that a prudential regulator should be given full operational independence. In the European Union, for example, the European Banking Authority has been given full independence in its decision-making process, but the status of most

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decision-making officials does not guarantee their independence.41 The members of the Board of Supervisors are not appointed to the Board in a personal capacity: they are members either in an official capacity, as heads of national supervisory agencies, or as representatives of another organ or entity of the European Union. The same is true of the Management Board, with the exception of the chairperson, who has no vote.42

Supervision Stricto Sensu: International Standard According to Principle 2 of the 2012 Core Principles for Effective Banking Supervision, adopted by the Basel Committee on Banking Supervision, the supervisor should have full operational independence: The supervisor possesses operational independence, transparent processes, sound governance, budgetary processes that do not undermine autonomy and adequate resources, and is accountable for the discharge of its duties and use of its resources. The legal framework for banking supervision includes legal protection for the supervisor.

The formulation of this standard seems to be based on the assumption that the banking supervisor has no supervisor. In the European Union, however, the national authorities in charge of banking supervision and, apparently, the European Central Bank itself when acting as supervisor of credit institutions,43 may receive instructions from the European Banking Authority for the performance of their functions in emergency situations.44

Bank Resolution: International Standard According to paragraph 2.5 of the 2014 Financial Stability Board’s Key Attributes for Effective Resolution Regimes, a resolution authority for financial institutions should have full operational independence: The resolution authority should have operational independence consistent with its statutory responsibilities, transparent processes, sound governance, and adequate resources and be subject to rigorous evaluation and accountability mechanisms to assess the effectiveness of any resolution measures. It should have the expertise,

41 See Regulation (EU) No. 1093/2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Banking Authority), Article 42. 42 See Regulation (EU) No. 1093/2010, Articles 45 and 48; on the status of the Executive Director, see Article 48. 43 On the role of the European Central Bank as supervisor of credit institutions, see Council Regulation (EU) No. 1024/2013 of 15 October 2013, conferring specific tasks on the bank concerning policies relating to the prudential supervision of credit institutions. Also see Regulation (EU) No. 468/2014 of the European Central Bank of 16 April 2014 establishing the framework for cooperation within the Single Supervisory Mechanism between the European Central Bank and national competent authorities and with national designated authorities (SSM Framework Regulation). 44 See Regulation (EU) No. 1093/2010, Article 18.

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resources, and the operational capacity to implement resolution measures with respect to large and complex firms.

The European Single Resolution Mechanism provides an example of operational independence given to authorities or agencies in charge of recovery and resolution procedures for credit institutions and investment firms. At the national level, the authority in charge of resolution, which may be the central bank,45 must have operational independence,46 which means that it “shall act independently and in the general interest.”47 At the European Union level, the Single Resolution Board also has operational independence, but this independence is more precisely defined and subject to some limitations resulting from some of its members’ status as officials of the member-states. In its decision-making process, the Board must “act independently and in the general interest” and “neither the Member States, the Union’s institutions or bodies, nor any public or private body shall seek to influence the Chair, the Vice-Chair or the members of the Board.”48 The status of some board members, however, does not guarantee their full independence. While the chair, the vice chair (who has no vote except when representing the chair), and the four full-time members have tenure,49 the other members of the board are “appointed by each participating Member State, representing their national authorities.”50 This difference in status may explain a difference in the obligations imposed on board members. The chair, the vice chair, and the four full-time members “shall perform their tasks in conformity with the decisions of the Board, the Council, and the Commission. They shall act independently and objectively in the interest of the Union as a whole and shall neither seek nor take instructions from the Union’s institutions or bodies, from any government of a Member State, or from any other public or private body.”51 These obligations do not apply to board members appointed by each member-state, probably because they could conflict with their obligations as officials of their respective countries.

The national authority is not necessarily the central bank. See Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms, Article 3.3. 47 See Regulation (EU) No. 806/2014 of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment in the framework of a Single Resolution Mechanism and a Single Resolution Fund, Article 47.1. 48 See Regulation (EU) No. 806/2014, Article 47.1 and 3. 49 See Regulation (EU) No. 806/2014, Articles 43.1 (a) and (b) and 56. They are appointed for five years and their removal from office is subject to substantive and procedural conditions. 50 See Regulation (EU) No. 806/2014, Article 43.1 (c). 51 See Regulation (EU) No. 806/2014, Article 47.2. 45 46

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CONCLUSION A few conclusions can be drawn from this survey. First, as macroprudential supervision encompasses several functions, different agencies may be in charge of each function, in which case some form of coordination must be organized. Second, if the central bank is one of these agencies, there is no reason why it should discharge its macroprudential mandate differently than any other agency that would be charged with the same tasks. Third, the central bank, in the discharge of its macroprudential mandate, may have to pursue objectives inconsistent with those of monetary policy, in which case the latter should take precedence over the former, albeit with some flexibility in their implementation. Fourth, when acting as macroprudential supervisor, the central bank may incur liability and reputational damage, which may trigger challenges to its independence in the conduct of monetary policy. Fifth, if, in the exercise of macroprudential supervision, the central bank does not have the same degree of operational independence it has in the conduct of monetary policy, whoever has authority over the central bank (for example, the finance minister or the government) for the performance of macroprudential supervision may give instructions to the central bank that conflict with the achievement of the central bank’s monetary policy objectives.

REFERENCES Andenas, Mads, and Duncan Fairgrieve. 2002. “Misfeasance in Public Office, Governmental Liability, and European Influences.” International Comparative Law Quarterly 51: 757. Athanassiou, Phoebus. 2011. “Financial Sector Supervisors’ Accountability: A European Perspective.” European Central Bank Legal Working Paper 12, European Central Bank, Frankfurt. Blair, Christopher, and Timothy Edmonds. 1997. “Bank of England Bill.” House of Commons Library Research Paper 97/115, House of Commons, London. Breger, Marshall J., and Gary J. Edles. 2015. Independent Agencies in the United States: Law, Structure, and Politics. New York: Oxford University Press. Bullock, Charles J. 1930. “Dionysius of Syracuse—Financier.” The Classical Journal 25 (4): 260. Čihák, Martin. 2008. “Central Banks and Financial Stability: A Survey of Financial Stability Reports.” In Current Developments in Monetary and Financial Law, 5. Washington, DC: International Monetary Fund. Davis, Neal. 1993. “Political Will and the Unitary Executive: What Makes an Independent Agency Independent?” Cardozo Law Review 15: 273. Dijkstra, Robert J. 2012. “Liability of Financial Supervisory Authorities in the European Union.” Journal of European Tort Law 3: 346. Gianviti, Francois. 2010. “The Objectives of Central Banks.” In International Monetary and Financial Law, The Global Crisis, edited by Mario Giovanoli and Diego Devos, 449. New York: Oxford University Press. Grass, Etienne. 2016. Génération réenchantée: chroniques du progrès. Paris: Calmann-Lévy. Nolan, Donal. 2013. “The Liability of Financial Supervisory Authorities.” Journal of European Tort Law 4: 190.

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VI LEGAL FRAMEWORK FOR ISLAMIC BANKING

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CHAPTER 12

Promoting Financial Stability: Issues and Challenges in Islamic Finance Jaseem Ahmed

The task of standard setters such as the Islamic Financial Services Board (IFSB) is to provide the guiding principles that enable regulators to require, or force, “firms to talk” in the public interest.1 This applies in particular to financial sector regulators who must oversee institutions whose failure could have cascading or system-wide impacts. Moreover, because financial institutions often have cross-border operations and are highly interconnected, there is value to an international language, or benchmark, for the standards and guiding principles used by regulators. In contributing to the development of internationally consistent, robust supervisory regimes, the IFSB’s standards are benchmarked against those of our international comparators, with whom we work closely: the Basel Committee for Banking Supervision, the International Association of Insurance Supervisors, and the International Organization of Securities Commissions. This function has become more prominent in recent years with the rapid growth and internationalization of Islamic finance, which has resulted in the emergence of Islamic banking sectors that are of domestic systemic importance—in that they exceed 15 percent of total banking sector assets—in a number of key jurisdictions (IFSB 2016a). Standards must be embedded in the legal and regulatory framework that underpins supervisory and regulatory functions, and which plays a critical role in supporting the stability and resilience of financial systems. However, the key challenges to Islamic finance, from the perspective of stability and resilience, are not all located within the legal and regulatory frameworks per se, but rather fall within the broad span of the financial infrastructure that supports markets and

Jaseem Ahmed was the Secretary-General of the Islamic Financial Services Board (IFSB) from 2011 to 2017. He thanks Dr. Volker Nienhaus and Mr. Peter Casey. He also thanks Mr. Zahid ur Rehman Khokher and Mr. Esam Osama Al-Aghbari, Assistant Secretary-General and Member of the Secretariat, respectively, of the IFSB, for their very helpful suggestions and comments. Any remaining errors and omissions are those of the author. 1

The phrase is adapted from Admati and Pfleiderer 2000.



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intermediaries, and of which the legal and regulatory framework are constituent parts. Thus, while the legal and regulatory frameworks are rightly viewed as central to financial infrastructure, two observations will point toward an interconnected set of issues that have made policy more complex in Islamic finance. First, Islamic banks will need to be able to manage their liquidity through access to a regular supply of high-quality liquid assets. For a conventional bank, this is provided by government bonds that carry a rate of interest and are hence not permitted in Islamic finance. It has been a challenge for many countries to develop Sharī’ah-compliant government securities, primarily in the form of Sukūk, that provide this key liquidity management function.2 The issue is that it has proved challenging to find the Islamic law basis for a tradable security that is based on general government revenues, in which a specific rate of return, linked to a concrete project, is not easily identified (Sundararajan, Marston, and Shabsigh 2011). Second, central banks will want to be able to provide emergency liquidity support to an Islamic bank in crisis times. Again there are technical and Sharī’ah issues that have resulted in a relatively slow progress in this area, at least in some if not in all jurisdictions. These key aspects of the liquidity management infrastructure will need to be addressed at the very outset of decision-making and planning for the introduction of Islamic finance, in parallel with other measures that directly focus on building the legal and regulatory framework. In view of this, the IFSB has stressed over the years the importance of the liquidity management infrastructure and the way it interconnects with the development of government securities, the development of a Sharī’ah-compliant interbank market, and the further development of risk-management capabilities within financial institutions and at the macroprudential level (IFSB 2008). Since the global financial crisis, the IFSB has if anything raised the importance it has accorded to this issue. This is especially relevant, in the postcrisis environment, in the light of the recognition that this issue is related to a more general one: that of the absence of a sufficient supply of safe assets, which is characteristic of a crisis environment. Islamic finance is not in crisis, but neither is it necessarily immune to it. For this reason, it will be imperative to take up as the highest priority the development of safe assets—assets that have high liquidity and tradability. Two other medium-term issues that the IFSB raised shortly after its establishment, and which now feature as key elements of the postcrisis integrated approach to financial stability, were Sharī’ah-compliant deposit insurance schemes and insolvency and resolution regimes to facilitate rapid and timely restructuring and/or recapitalization of failing or insolvent institutions. These

2 Sukūk are certificates that represent a proportional undivided ownership right in tangible assets, or a pool of tangible assets and other types of assets. These assets could be in a specific project or specific investment activity that is  Sharī’ah-compliant. See the IFSB “Glossary” at http://​www​.ifsb​ .org/​terminologies​.php.

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Chapter 12  Promoting Financial Stability: Issues and Challenges in Islamic Finance

latter issues are getting important attention in the IFSB’s research program, which is often a leading indicator of standards and guiding principles to come.3 The rest of this chapter will address the following issues. First, in what sense is Islamic finance distinctive, thereby requiring a different approach to regulation and supervision? Second, what are the key legal and regulatory challenges it faces? Third, how have IFSB standards been shaped to respond to these challenges? Fourth, what further progress in the implementation of IFSB standards has been made? Finally, what further work on the standards do we expect to develop in the near future?

WHAT IS DISTINCTIVE ABOUT ISLAMIC FINANCE? Islamic finance derives its legitimacy from principles embedded in Islamic law. These principles require that Islamic financial transactions must serve a higher purpose, that is they must serve the goals of social justice, to be achieved through economic transactions that achieve shared prosperity. Financial transactions must be geared toward promoting the real sector. They should be based upon risk-sharing and partnership to the extent possible. The earning of returns in the absence of risk—in a word, “interest”—is forbidden. There are prohibitions against gambling. There are restrictions on excessive leverage, excessive speculation, and excessive complexity. Together, these constitute a distinct system of ethics that can be described as the “embedded governance” of Islamic finance in which the emphasis is on the real sector, ethical conduct, and social impact.4 These are essential aspects of Islamic finance that contributed to its resilience during the crisis. Thus, Islamic financial institutions were largely unexposed to the toxic financial assets that were at the heart of the global crisis. The toxic assets did not, in general, pass the Sharī’ah test (at least in relation to complexity). That they did not pass the Sharī’ah test was aided by an innovation introduced by modern Islamic finance: the Sharī’ah Advisory Board, which is unique to Islamic finance and provides Islamic financial institutions with additional audit and governance mechanisms.

Addressing Differences Islamic finance has some distinctive features that mean the standards developed for conventional finance often do not fit it in an adequate or satisfactory manner. To give three key examples: • The profit-sharing investment accounts offered by Islamic banks are (or should be) risk-bearing rather than equivalent to deposits;

For example, IFSB 2014 and 2016b. Islamic Financial Services Board, Islamic Development Bank, and Islamic Research and Training Institute 2010. See also Ahmed 2016. 3 4

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• Islamic mortgages are often based on a leasing structure that involves the bank holding title to the assets; and • Islamic insurance—Takaful—involves principles of risk-sharing rather than conventional risk transfer. These represent real differences with conventional finance. Yet it is also true that finance, whether Islamic or conventional, serves a broad set of common or overlapping functions and needs. It is not surprising, therefore, that some of the solutions look somewhat similar. However, in view of the differences there is a risk that the distinctiveness will be lost if Islamic finance is required to be regulated within a framework of conventional standards and guiding principles. That would be a great loss, not least for the wider inclusion in the financial system of people who are currently self-excluded for religious reasons but who look for confirmation that Islamic finance really is different and meets their requirements and aspirations.

THE KEY LEGAL AND REGULATORY CHALLENGES Three key considerations in law, among others, provide an overview of issues faced in jurisdictions seeking to introduce and appropriately regulate Islamic financial institutions. First, a fundamental issue in law, which applies to all Islamic finance, is under what conditions a firm, or an instrument, can claim to be “Islamic.” If a bank says, “This is an Islamic mortgage,” what concern does the regulator, or the law, have in that claim? If a customer believes that claim has been made falsely, can they sue? This issue of Sharī’ah governance is approached in different ways in different places. Some regulators have their own boards of scholars to decide ultimately what can and cannot be claimed. In other places, the emphasis is on the firm having its own arrangements and a proper basis for making the claim. Others rely mainly on disclosure. But there needs to be clarity about the approach. At the same time, it should be stressed that there is a rich body of Islamic law on which scholars have drawn in providing solutions that have expanded the range of Islamic finance transactions in recent times. And while the principle of precedent, or stare decisis, which is a key feature of common law, does not have a parallel in Islamic law, we can nevertheless observe movement toward greater consistency in recent times. Modern approaches to information dissemination, and dialogue between different jurisdictions, are leading to greater transparency and understanding of the basis for differences in approach, as well as to convergence on many issues. The second key consideration is the ability of the legal system to provide transparency and predictability to the enforcement of Islamic finance contracts. Here, it is relevant that Islamic finance transactions involve both Islamic and secular law. We can distinguish between Sharī’ah-incorporated jurisdictions and purely secular jurisdictions. In a Sharī’ah-incorporated jurisdiction, Islamic finance contracts will be enforced in accordance with Sharī’ah, because the

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Chapter 12  Promoting Financial Stability: Issues and Challenges in Islamic Finance

governing law has already incorporated Sharī’ah. However, in a secular jurisdiction that does not give cognizance to Sharī’ah, enforcement will take place as a matter of contract enforcement in accordance with the governing law of the land without reference to Islamic law. The contract will be enforced in relation to its provisions, in the light of national law, and not the Sharī’ah. From this perspective, the contract is simply a form of private law, which different kinds of legal systems are able to enforce (DeLorenzo and McMillen 2011). The courts in such secular jurisdictions as the United Kingdom and the United States have been willing and able to enforce Islamic finance contracts despite being secular jurisdictions. We have also seen a number of recent cases in which the US Bankruptcy Court has supported complex bankruptcy restructurings in a chapter 11 filing on a Sharī’ah-compliant basis (McMillen 2016). And third, it is important to bear in mind that countries that promote Islamic finance are at markedly different stages of economic, market, and institutional development. Reflecting these differences, these countries are also at different phases of legal and regulatory development for Islamic finance. Their source of law varies, with common law prevalent in some jurisdictions whereas others rely predominantly on civil and commercial codes. Some common law jurisdictions in Asia give formal cognizance to Sharī’ah, whereas others do so through secular provisions inherited from colonial times, but these may be restricted to personal law and have no applicability to financial transactions. A different context is provided by Arab-speaking countries that have inherited commercial codes from Ottoman times—codes that have subsequently been refined and modernized. These jurisdictions have constitutional frameworks that typically also recognize Sharī’ah as a source of law. There are differences in the hierarchy of laws in these jurisdictions, where customary law, the commercial codes, and Islamic law are all sources of law. Despite these differences, however, each jurisdiction faces a common set of issues, and there is an international dialogue on good practices. Broadly speaking, unity in principle and diversity in practice would be a good characterization of the approaches to the regulation and supervision of Islamic finance. Against this background of institutional and historical diversity, the common goal for the establishment of Islamic finance on a sound legal and regulatory basis has been pursued in diverse ways. While some countries have opted to have separate laws for Islamic finance, others have chosen to amend existing laws, sometimes through a minimal set of changes to the laws in place for conventional finance; this is the route taken in the United Kingdom (Ainley and others 2007). Clarity and transparency in the legal framework are vital to ensure a level playing field among financial institutions and to foster consumer confidence, but this can be achieved in different ways depending on the national institutional setting. The IMF’s important cross-country survey on the legal and regulatory framework identifies and sheds light on many such differences (Song and Oosthuizen 2014). Additional perspective can be provided through the recognition of the policy alternatives and the factors that shape the choices made in different national

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settings. Thus, whether a jurisdiction opts for exemptions from existing laws, seeks amendments to them, or decides to draft altogether new laws for Islamic finance represents a set of forward-looking decisions in which the scope of the central bank’s powers can be a key determinant. Where the central bank has wide powers, the authorities may well decide to anchor the introduction of Islamic finance on its current powers, while setting in motion the needed longer-term adjustments to the legal framework. Many countries address this challenge by developing a road map that targets minimum, necessary changes needed to provide an initial legal framework, while more comprehensive legislation is being drafted and discussed with appropriate stakeholders, such as national legislative bodies. Other issues bear upon the underlying legal framework. One, for example, involves regulation and supervision for an environment where conventional and Islamic finance coexist, with Iran and Sudan being the two exceptions in which only Islamic financial transactions are recognized. Another issue is the appropriate choice of distribution channel for Islamic financial products to reach consumers, and whether this is to be done through stand-alone Islamic banks, or some combination of subsidiaries and window operations. These are live issues today across jurisdictions and continents.

LEGAL AND REGULATORY ASPECTS OF THE IFSB’S STANDARD SETTING Turning to the supervisory and regulatory framework, as Figures 12.1 and 12.2 indicate, a key question, and the first focus of the IFSB when it was established, was on how capital adequacy and liquidity standards were to be applied to Islamic banks. In particular, how should the distinctive character of profit-sharing investment accounts be recognized? The IFSB initially issued several Standards and Guidance Notes on the effective measurement and disclosure of these accounts, and on making transparent their effective rates of return. Among other issues addressed through the “first generation” of IFSB standards prior to the global financial crisis, the following featured prominently: • Guiding principles on the design of effective credit registries, recognition of external credit-rating agencies, and the measurement of nonperforming financing; • The principles on which conduct of business and transparency and market discipline in Islamic banks should be based; and • Sharī’ah governance principles and corporate governance issues. To date the IFSB has issued 26 standards, guiding notes, and technical notes covering the banking, capital markets, and Takaful, or Islamic insurance sector. The focus of the initial standards was principally on the banking sector, as this represented about 80  percent of assets under management globally, but since 2007 the scope has expanded to include both Takaful and Islamic Capital

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Chapter 12  Promoting Financial Stability: Issues and Challenges in Islamic Finance

Figure 12.1. IFSB Standards: Banking, Followed by Other Sectors 19 Standards

IFSB Standards and Guidelines

6 Guidance Notes

Banking IFSB-1: Risk Management

Precrisis

Capital Market

IFSB-2: Capital Adequacy

IFSB-6: Governance of Islamic Collective Investment Schemes

IFSB-3: Corporate Governance for Institutions Offering Islamic Financial Services

IFSB-8: Corporate Governance for Takaful

IFSB-4: Transparency and Market Discipline

IFSB-11: Solvency for Takaful Undertakings

IFSB-5: Supervisory Review Process

IFSB-14: Risk Management for Takaful

IFSB-7: Special Issues in Capital Adequacy

IFSB-18: Guiding Priniciples on Retakaful

Takaful

IFSB-12: Liquidity Risk Management

Postcrisis

1 Technical Note

Cross-Sector

IFSB-13: Stress Testing

IFSB-9: Conduct of Business

IFSB-15: Revised Capital Adequacy Standard

IFSB-10: Shar ’ah Governance System

IFSB-16: Revised Supervisory Review Process IFSB-17: Core Priniciple for Islamic Banks GN-6: Quantitative Measures for Liquidity Risk

Dec-2016 Apr-2017

Expected New Standards Technical Note on Stress Testing for IIFS Disclosure Requirements Islamic Capital Markets Products

Note: The Expected New Standards were approved and issued in December 2016 and April 2017, respectively. Three additional standards were issued in December 2018, bringing the total issuances to 22 Standards and Guidance Notes, and 2 Technical Notes.

Markets. A joint paper with the International Association of Insurance Supervisors led in 2007 to the launch of a series of standards on the Takaful sector, which is ongoing. The IFSB has directed a major work program into these technical areas over the years. It will need to further redefine the work program to keep up with the changes in the Basel standards. A significant effort has been made since 2012 to adapt to the Basel III framework, which has posed some challenges. A considerable effort is underway both to reflect the specific risk factors that apply to Islamic finance and to provide a frame of reference to the global architecture for financial sector stability with a view toward achieving greater consistency. Challenges posed by Basel III Capital and Liquidity Framework. The Basel-mandated increases in banks’ capital quality, consistency, and transparency have raised issues for Islamic finance. In general, the capital structures of the significant majority of Islamic banks are dominated by Tier 1 capital in common equity form. In addition, most have capital adequacy ratios significantly higher than those seen in the conventional banking sector. The reasons for this can be explained by strict Sharī’ah prohibitions on what constitutes the capital for Islamic financial institutions. Thus, the prohibition of Gharar (conditionality and uncertainty) has had an impact in terms of the absence—or presence only in limited forms—of Islamic subordinated debt, preference shares, and hybrid and callable capital structures.

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Figure 12.2. Major Focus on Capital, Investment Accounts, and New Issues Published Guidance Notes March 2008 December 2010 March 2011 April 2015

GN-1: Capital Adequacy (Credit Ratings Assessments) GN-2: Capital Adequacy (Commodity Murabahah Transactions) GN-3: Smoothing the Profits Payout to IAHs GN-4: Capital Adequacy (Determination of Alpha Factor) GN-5: Takaful and Retakaful (Credit Ratings Assessments) GN-6: Quantitative Measures for Liquidity Risk Published Technical Notes

March 2008

TN-1: Issues in Strengthening Liquidity Management of Institutions Offering IFS Published Research

April 2014 November 2014 October 2015 March 2016 Banking

WP-01: Strengthening the Financial Safety Net: Role of SLOLR Facilities WP-02: Evaluation of Core Principles Relevant to IF Regulation WP-03: Financial Consumer Protection in Islamic Finance WP-04: Comparative Study on the Implementation of Selected IFSB Standards WP-05: Shar ’ah Non-Compliance Risk in the Banking Sector WP-06: Strengthening the Financial Safety Net: The Role of SCDIS Takaful

Cross-sector

Note: IAHs = investment account holders; IFS = Islamic financial services; SCDIS = Shar ’ah-compliant deposit insurance schemes; SLOLR = Shar ’ah-compliant lender of last resort.

As a result of these considerations, the capital structures of Islamic financial institutions and their above-average capital ratios put them in a favorable position relative to many of their conventional counterparts. Nevertheless, some areas require attention. In raising Tier 2 capital, for instance, the issue is how institutions offering Islamic financial services will meet Sharī’ah requirements before meeting the regulatory requirements for instruments such as subordinated debt, hybrid capital, convertible contingent capital, and Sukūk that can be considered as capital. These issues are addressed in the IFSB’s Revised Capital Adequacy Standard, which required, among other features, upfront specification of the conditions under which one type of capital converts into another, as a bank goes from being a “going concern” to a “gone concern.” In addition, the IFSB has felt it appropriate to provide a set of requirements comparable to Basel in terms of its capital conservation, countercyclical, and other buffers. Liquidity is an area where Islamic banks are impacted to a significant extent by Basel III, principally due to the lack of liquid Islamic financial instruments. For example, Basel III stresses the need for banks to maintain a stock of assets that can easily be turned into cash at reliable values, either through markets or central banks’ cash from a “discount window.” In fulfilling the liquidity requirement of Basel III via the discount window, much work remains to be done to ensure an adequate supply of Sukūk that can provide assets that qualify for discount window access.

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Chapter 12  Promoting Financial Stability: Issues and Challenges in Islamic Finance

Figure 12.3. IFSB Standards Implementation Surveys IFSB Standards Implementation Survey

2007

2008

2009

2010

2011

2012

2013

2014

2015

The breadth of implementation (for example, the number of countries implementing standards) The survey captures:

Challenges being faced by the member RSAs in the implementation of standards The support expected from the IFSB Secretariat

The information collected from implementation surveys has aided the IFSB’s efforts to fine-tune its standards development as well as IFS initiatives to suit the needs and constraints faced by its member jurisdictions.

Source: IFSB 2015b. Note: IFSB = Islamic Financial Services Board; RSA = regulatory and supervisory authority.

A key issue is limited availability of Sharī’ah-compliant instruments/Sukūk that can meet Basel III’s requirements. In particular, it is difficult for many such instruments to meet the market-related characteristics such as “active and sizeable market,” “presence of committed market makers,” “low market concentration,” and “flight to quality.” Availability of Level 1 assets is not adequate in most jurisdictions. Also, a repo market is not available in most jurisdictions; therefore, the expectation of being “traded in large, deep and active repo or cash markets” is not applicable to many Sharī’ah-compliant assets. Despite the challenges, various options are available for the application of the liquidity framework to Islamic banks, and these are addressed in detail in IFSB’s most recent standard on liquidity management issued in 2015 (IFSB 2015c). Basel III had suggested three alternative treatments in jurisdictions where sufficient liquid assets are not available. The IFSB’s Quantitative Impact Survey provided the feedback that the majority of both supervisory authorities and banks were agreeable to these proposals, which include committed facilities from the central bank and the use of additional Level 2 assets with a higher haircut, when Level 1 assets are not available in sufficient volume.

PROGRESS IN IMPLEMENTATION OF STANDARDS A significant effort is underway to strengthen implementation through workshops and surveys. The IFSB Implementation Surveys were launched in 2011 and were designed not only to assess progress made, but also to identify the requirements, intentions, and plans of our members over the medium term (Figure 12.3). The initial survey focused on 11 standards issued by the IFSB, whereas that of 2015 covered 17 standards. The surveys, which are now annual, indicate a strengthening and widening process of standards implementation (Figure 12.4). Progress, in terms of movement across the four-fold classification used by both the IFSB and the Financial Stability Institute, requires closer examination.

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Figure 12.4. Implementation Has Picked Up Final rule in force

30%

Final rule published

1%

32%

20%

8% 40%

Within 1 year

4%

1–3 years

23%

3–5 years

13%

Complete In progress Planning Not planned [[?]] Draft regulations published

0%

Regulation in drafting stage

8%

Source: IFSB 2015b. Note: Based on a total of 39 respondents.

The first survey in 2011 indicated that the earliest IFSB standards featured more frequently across jurisdictions as having been fully or partially completed. The 2015 survey indicates a new dimension, that the most recent standards touching upon the updated capital and liquidity framework now feature prominently as being planned or under implementation. This is brought out in Figure 12.5. Thus, it can be seen that the first IFSB standard, issued in 2005, is recorded as having been fully implemented by 42 percent of survey respondents, 10 years later in 2015. In contrast, IFSB 15, which refers to the new capital adequacy framework and was issued in 2013, has in a short space of two years been fully implemented by 26 percent of respondents in 2015. (The “take-up rate” in Figure 12.5 is defined as the implementation rate divided by the number of years since issuance). This could be an indication that the pressure of Basel III is spilling over to early implementation of comparable IFSB standards, which of course remain voluntary. On the other hand, IFSB-10—the standard on Sharī’ah governance, which was issued in 2010 and initially had a slow take-up—now is the most frequently cited standard planned for implementation. The take-up of this standard is likely to be linked to a growing policy focus on an expanding Islamic finance sector, as well as stronger capabilities for planning and implementing reforms. The preconditions for successful implementation, identified by the surveys, have remained broadly consistent over the years (Figure 12.6). The top-ranked issues and constraints remain those related to having in place a strong legal and regulatory framework, and staff capabilities. In terms of addressing the key constraints, the surveys indicate consistency in the importance given to technical assistance from the IFSB in translating its standards into more meaningful and practical guidance notes and reports. The scope of the identified needs for technical assistance includes an enhanced program of customized train-the-trainers

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Chapter 12  Promoting Financial Stability: Issues and Challenges in Islamic Finance

Figure 12.5. Standards Completed by Timeline When comparing implementation progress as a function of time, it is observed that the implementation speed is increasing for newer standards.

2005

06

07

09

10

12

13

14

0% IFSB-17

GN-6

IFSB-16

IFSB-15

IFSB-14

IFSB-13

IFSB-12

IFSB-11

IFSB-10

IFSB-9

IFSB-8

IFSB-7

IFSB-6

IFSB-5

IFSB-4

IFSB-3

IFSB-2

IFSB-1

50% 47% 46% 43% 45% 42% 40% 35% 33% 35% 31% 30% 32% 32% 31% 26% 25% 27% 22% 25% 25% 20% 22% 15% 14% 10% 5% 0%

N/A

Average rate of RSA implementation per 1 year

15

2015 Base: All Respondents, N = 39.

Source: IFSB 2015b. Note: Based on a total of 39 respondents. IFSB = Islamic Financial Services Board.

workshops for supervisory agencies, known as Facilitating the Implementation of the IFSB Standards. The key priority, therefore, is to find the resources and organizational modes and partnerships that help committed jurisdictions meet the challenges they face and their desire for assistance in addressing these challenges. These are issues that the IFSB has elaborated on in its Strategic Performance Plan 2016–18, through an expanded capacity to be provided by its Implementation Unit. To paraphrase the chairman of the Basel Committee, standards and principles, if not implemented, are like a lighthouse in which the light is not turned on. In respect of Islamic finance and the standards of the IFSB, while much remains to be done, we can safely conclude that the light in the lighthouse is being turned on across an increasing number of jurisdictions.

The IFSB’s Medium-Term Agenda The following specific sets of issues provide the medium-term framework for the IFSB’s work program. First, to complete by fine-tuning the body of standards related to the new international standards for financial stability. These include a new technical note on stress testing, which was submitted to the IFSB Council in December 2016, and further revision to capital adequacy issues as needed. A new standard is targeted for completion in the area of transparency

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Figure 12.6. Challenges in Implementation Detailed knowledge of Islamic finance has been rated the most significant challenge to implementation, and financial considerations the least. Human Resources and Capacity Building Implementation needs a detailed knowledge of Islamic finance, which few staff of our organization have

Extremely insignificant Very insignificant Very significant Extremely significant 14%

Our supervisory staff face challenges to supervise and assess the compliance with 5% Islamic finance–related regulations and guidelines, once issued

24%

Significant

46%

19%

24%

16%

43%

8%

Other Factors Lack of or poor quality of available industry data to support 5% implementation of the standards

16%

Process of standards implementation is too time intensive or requires an 5% excessive administrative effort for RSA

14%

Existing statutory/legal framework hinders the standards’ implementation as the framework needs to be changed or adapted first before implementation can occur

8%

11%

Number of Islamic finance institutions/size of industry (in terms of market share) is too 3%8% small to make implementation viable Process of standard implementation is financially prohibitive for RSA 5% (budgetary constraints)

38%

32%

54%

27%

19%

5%

22%

35%

32%

8%

35%

51%

19%

22%

24%

Source: IFSB 2015b. Note: RSA = regulatory and supervisory authority.

and market disclosure for the banking sector, to reflect the recent Basel paper on this subject.5 Second, we will be paying increasing attention to Takaful and the development of Islamic capital markets, both in terms of new standards and in terms of research and knowledge products. Because banking is the largest sector in Islamic finance, it was our initial priority in standard-setting, but in our recently published Strategic Performance Plan for 2016–18 we intend to put more effort than hitherto on capital markets, Takaful and also on financial inclusion. A new Standard for Transparency and Disclosure on Islamic Capital 5

This Standard was approved and issued as IFSB-22 in December 2018.

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Chapter 12  Promoting Financial Stability: Issues and Challenges in Islamic Finance

Markets is under preparation and was submitted to the IFSB Council in early 2017 and a standard on the Supervisory Review Process for Takaful was launched in 2016.6 Third, we have launched a program for the preparation of Core Principles for Islamic Finance Regulation, which aims to achieve greater consistency and focus of implementation efforts for both Islamic and conventional parts of the financial system in all jurisdictions. The first set of Core Principles for the banking sector were issued in 2015, and in 2016 we launched the preparation of Core Principles for ICM (IFSB 2015a). Core principles for Takaful are expected to be launched in 2018, once the International Association of Insurance Supervisors has concluded its ongoing review of its own core principles. The development of the core principles by the IFSB is in response to the existence of gaps in the regulatory and supervisory framework in many countries. The Core Principles assist supervisory authorities that are regulating and supervising Islamic finance to identify applicable principles and benchmarks, to fill the gaps in the existing policies and regulations in their jurisdictions. The Core Principles can be used by both advanced and emerging market jurisdictions. Fourth, the heightened importance of legal and regulatory reforms that promote greater resilience has been incorporated into a new program that aims to promote cooperation among our members on stability issues. In this context, a specific set of activities is the Islamic Financial Stability Forum, where we are working to develop greater cross-border understanding of crisis management and resolution issues, as well as those related to the development of the financial safety net. The IFSB Stability Forum focused on anti–money laundering and provided the background for the launch of a working paper on this subject in 2017. Finally, we also have a research program intended to lay the groundwork for possible future standards. Our work in that area will include, among others, macroprudential issues and resolution and recovery frameworks. The resolution of Islamic banks, in particular, raises challenging issues, some of which are addressed in a joint publication by the IFSB and World Bank (2011). One important area is the treatment of profit-sharing investment accounts, which are a key product of Islamic banks. Should investors in these be treated like depositors who are owed a debt or as fully risk-bearing investors? Can an order of priorities be established between creditors, as would normally be done in conventional insolvency law, given that Sharī’ah would normally rank all creditors equally? Where banks do business with each other, for example, in the Islamic money market, can obligations be set off against each other, even if the contractual bases are different? Issues like these are important even in resolution short of insolvency, as the Financial Stability Board has taken the view that resolution arrangements should respect the hierarchy of claims, and that no creditor should be worse off

6 These standards were approved in April 2017 and December 2018, respectively. See http://ifsb.org for a list of all issued standards.

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than if the institution had been allowed to become insolvent (Financial Stability Board 2014). There are other unexplored issues, some of which connect with other safety-net issues, especially lender of last resort and deposit insurance, on which the IFSB has published research papers.

CONCLUSION A modern financial sector, including for Islamic finance, is highly dependent on a legal and regulatory framework that ensures transparency, consistency, and predictability. The diversity noted across countries in the legal and regulatory frameworks for Islamic finance reflects a variety of factors, including differences in source of law and in stages of economic and institutional development. The IFSB aims to accommodate this diversity, while also providing a consistent basis for promoting financial stability through the implementation of its standards. This is challenging, not least because of the rapid pace of growth and internationalization that is transforming the face of Islamic finance. These developments, however, are taking place in the context of sustained scrutiny and dialogue involving regulators and policymakers. The scrutiny underpins a dynamic process of recalibration, revision, and strengthening of the legal and regulatory framework across many jurisdictions. Overall, these developments indicate that the supervisory and regulatory framework for Islamic finance faces challenges not unlike those faced in conventional financial systems at a similar stage of development. But in specific areas the challenges are daunting in terms of what is needed to articulate solutions consistent with Islamic law. In this environment, the stability of the financial system, and the orderly development of Islamic finance, will be aided by the parallel and joint implementation of Basel Core Principles and the standards and guiding principles of the IFSB. The stronger postcrisis emphasis on the key objective of financial stability, and the larger role of Islamic finance in many jurisdictions, pose challenges that are relevant from a wider perspective. The first challenge is how to strengthen the national regulatory and supervisory framework, in a way that is consistent across borders, to enhance the stability and resilience of Islamic finance. A second challenge is how to facilitate the integration of Islamic finance into the surveillance framework that monitors the stability of the global financial system. It will be important for a wider international engagement, including in particular by the IMF in tandem with the IFSB and other institutions, to address these issues.

REFERENCES Admati, Anat R., and Paul Pfleiderer. 2000. “Forcing Firms to Talk: Financial Disclosure Regulation and Externalies.” Review of Financial Studies 13 (3): 479–519. Ahmed, J. 2016. “Ethics in Economics and Finance: An Islamic Finance Perspective.” In The Business of Ethics, edited by Raymond Madden. Kuala Lumpur, Malaysia: IBFIM.

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Chapter 12  Promoting Financial Stability: Issues and Challenges in Islamic Finance

Anat Admati and Paul Pfleiderer. 2000. “Forcing Firms to Talk.” The Review of Financial Studies 131 (3): 479–519. Ainley, Michael, Ali Mashayekhi, Robert Hicks, Arshadur Rahman, and Ali Rvalia. 2007. Islamic Financial Services in the UK: Regulation and Challenges. London: Financial Services Authority. DeLorenzo, Y. T., and Michael J. T. McMillen. 2011. “Law and Islamic Finance: An Interactive Analysis.” In Islamic Finance: The Regulatory Challenge, edited by Rifaat Ahmed Abdel Karim and Simon Archer. Hoboken, NJ: John Wiley & Sons. Financial Stability Board (FSB). 2014. “Key Attributes of Effective Resolution Regimes for Financial Institutions.” http://www.fsb.org/wp-content/uploads/r141015.pdf. Islamic Financial Services Board (IFSB). 2008. “Technical Note on Liquidity Management.” Islamic Financial Services Board, Kuala Lumpur, Malaysia. ———. 2014. “Strengthening the Financial Safety Net: Role of Sharī’ah-Compliant Lender of Last Resort Facilities.” Working Paper 1, Islamic Financial Services Board, Kuala Lumpur, Malaysia. ———. 2015a. “Core Principles for Islamic Banks.” http://ifsb.org. ———. 2015b. Implementation Survey. Kuala Lumpur, Malaysia: Islamic Financial Services Board. ———. 2015c. “Quantitative Measures for Liquidity Risk Management in Institutions Offering Islamic Services.” Guidance Note 6. http://ifsb.org/standard/GN-6%20GN%20 on%20LRM%20(April%202015)-final.pdf. ———. 2016a. Islamic Financial Services Industry Stability Report. http://www.ifsb.org/docs/ IFSI%20Stability%20Report%202016%20(final).pdf. ———. 2016b. “Strengthening the Financial Safety Net: The Role of Sharī’ah-Compliant Deposit Insurance Schemes.” Working Paper 6, Islamic Financial Services Board, Kuala Lumpur, Malaysia. ———, Islamic Development Bank, and Islamic Research and Training Institute. 2010. “Islamic Finance and Global Financial Stability. Report of the High-Level Task Force.” Islamic Financial Services Board, Kuala Lumpur, Malaysia. Islamic Financial Services Board and World Bank. 2011. Effective Insolvency Regimes: Institutional, Regulatory and Legal Issues Relating to Islamic Finance. Kuala Lumpur, Malaysia: Islamic Financial Services Board. Song, Iwon, and Carel Oosthuizen. 2014. “Islamic Banking Regulation and Supervision: Survey Results and Challenges.” IMF Working Paper 14/220. International Monetary Fund, Washington, DC. Sundararajan, V., David Marston, and Giath Shabsigh. 2011. “Monetary Operations and Government Debt Management Under Islamic Banking.” In Islamic Finance Writings of V. Sundrarajan, edited by J. Ahmed and H. Kohli, 21–51. Thousand Oaks, CA: SAGE Publications Pvt. Ltd.

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CHAPTER 13

Prudential and Liquidity Management Frameworks for Islamic Banks in Arab Countries Inutu Lukonga

The rapid growth of Islamic banking in Arab countries presents important economic opportunities, but it also presents financial stability challenges. Islamic modes of banking can increase financial intermediation, enhance economic growth, and facilitate the “bailing-in” of investors in the resolution of distressed Islamic banks.1 However, the scope of Islamic banking activities extends beyond traditional financial intermediation and, as a result, Islamic banking operations give rise to a unique set of risks that cannot be adequately addressed by prudential regulations designed for conventional banks.2 The unique risks include, among others, displaced commercial risk, rate of return risk, Sharī’ah noncompliance, and equity investment risk. This chapter reviews the extent to which Arab countries have adapted their banking frameworks for prudential and liquidity management to cater to the unique risk characteristics of Islamic banks. The analysis draws on the 2016 Survey of Prudential Frameworks in Countries with Islamic Banks in their Financial Systems that was undertaken by staff of the IMF, in collaboration with regulatory and supervisory bodies. The conclusions in this report reflect the experiences in 16 of the 22 members of the Arab Monetary Fund, for which questionnaire responses were completed and submitted. In a few cases, Technical Assistance reports provided adequate information to undertake the assessment. The rest of the chapter is structured in four parts. The first section provides an overview of the scale, growth, and operations of the Islamic banking industry in member countries of the Arab Monetary Fund. The second section discusses the

Inutu Lukonga is a senior economist and financial sector expert on banking, securities, and pensions regulations in the Middle East and Central Asia Department of the IMF. The author acknowledges the input of Abdullah Haron and the guidance of Zeine Zeidane. 1 See IMF 2015 and Barajas, Ben Naceur, and Massara 2015 for a more detailed discussion of the benefits that Islamic banking offers. 2 These include raising funding using profit-sharing investment accounts (PSIAs) and, on the asset side, acting as a partner in property ownership or trade in tangible assets.

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Chapter 13  Prudential and Liquidity Management Frameworks



status of the regulatory and supervisory frameworks in those countries, covering the legal framework, the licensing regimes, prudential regulations, Sharī’ah governance, consumer protection, and supervision. The third section reviews liquidity management tools, the financial markets (money and Sukūk3), resolution frameworks, lender of last resort, and Sharī’ah-compliant deposit insurance schemes. The last section summarizes the findings and discusses policy options for the sound development of the Islamic banking industry.

OVERVIEW AND RECENT DEVELOPMENTS Scale and Growth The Islamic finance industry in Arab countries is dominated by the banking segment. Islamic banking assets account for 80 percent or more of the Islamic finance industry in 21 of the 22 Arab countries. Capital market products— consisting largely of Sukūk and, in some cases, Islamic investment companies and funds—are the other significant segments. The Islamic insurance (Takaful  ) and reinsurance (Retakaful  ) industries, as well as the Islamic microfinance sector, are still very small. The Islamic banking industry has grown rapidly in geographical reach, asset value, and market shares. Islamic banks are now present in all but one Arab country and have in most cases gained significant market shares. Using the threshold of 15 percent market share of domestic banking system assets at the end of September 2015, Islamic banking has become systemically important in 11 Arab countries: Bahrain,4 Djibouti, Iraq, Jordan, Kuwait, Mauritania, Qatar, Saudi Arabia, Sudan, the United Arab Emirates, and Yemen. In several other countries, Islamic banking has significant market shares of between 5 and 15 percent, including in Egypt, Oman, and West Bank and Gaza. The stability of Islamic banks is therefore important for overall financial stability (Figure 13.1). The growth of the Islamic banking industry in Arab countries reflects the interaction of economic, regulatory, political, and other idiosyncratic factors. On the supply side, sustained periods of high oil prices and large savings in oil-exporting Arab countries contributed to a favorable economic backdrop for the growth of Islamic banking. In addition, many countries progressively established an enabling regulatory environment, whereas some governments gave explicit targets for the growth of Islamic banking. On the demand side, favorable demographics played an important role, most notably by large unbanked populations in countries with large Muslim populations (Demirgüç-Kunt, Klapper, and Randall 2013; Imam and Kpodar 2010). In addition to the supply and demand factors, the small starting base for Islamic banks had a statistical effect on the growth rates registered.

3 4

Sukūk is the Islamic equivalent of bonds. Bahrain’s Islamic banking is systemically important in the retail sector.

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Figure 13.1. Size of Islamic Banking Sector in Arab Countries 1. Market Share of Islamic Banking Assets in the Banking System (Percent)

2. Shares of Global Islamic Banking Assets (Percent, end-June 2015)

Using a threshold of 15 percent market share, Islamic banks are systemically important in 11 Arab countries.

Several Arab countries also account for a significant share of the global Islamic banking sector. 20

SDN SAU KWT YEM QAT IRQ BHR MRT ARE JOR DJI EGY OMN TUN

18 16 14 12 10 8 6 4 2 0

15

30

45

60

75

90 105 SAU ARE KWT QAT BHR EGY SDN JOR

0

3. Structure of the Islamic Finance Sector (Percent of total assets)

4. Islamic Banking Assets by Country (Percentage share)

The Islamic banking sector is the dominant segment of the Islamic finance industry. Banking Sukuk Takaful Other

The assets of Islamic banks are concentrated in the Gulf Cooperation Council.

120 BHR 8%

100

SDN JOR 3% 1%

OMN 1% Others 1%

QAT 12%

80

SAU 43%

60 40 KWT 13%

20 0

DZA BHR DJI KWT QAT SAU SDN ARE

ARE 18%

Sources: Islamic Financial Services Board, Financial Stability Report 2016; Ernst and Young 2016; and IMF survey results. Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

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Chapter 13  Prudential and Liquidity Management Frameworks

The Islamic banking industry is highly concentrated in a geographical location and also within the domestic banking systems. Member countries of the Gulf Cooperation Council account for about 90 percent of the total Islamic banking assets of Arab countries and about 40 percent of the global Islamic banking assets. Within the Gulf Cooperation Council, nearly half of the assets of the Islamic banks are in Saudi Arabia, followed by the United Arab Emirates, Kuwait, and Qatar. Bahrain is home to the largest number of Islamic banking institutions, but its share in global Islamic banking assets is small. The Islamic banks range from small banks that focus on niche markets to domestically and regionally systemically important banks with extensive crosssector and cross-border operations. At least 13 Islamic banks have cross-border operations, six of which operate in more than five countries, and two operate in 14 and 17 countries, respectively. The operations of some of the Islamic banks span a broad range of sectors, including nonfinancial corporations such as property development companies, but also aviation, hospitals, and schools. Therefore, group and cross-border risks are material to the region; as a result, consolidated and cross-border supervision, as well as cross-border resolution, must be an integral part of the regulatory and supervisory frameworks.

The Corporate and Balance Sheet Structures The majority of countries allow conventional banks to offer Islamic banking products and services. Commingling of assets is, therefore, a material risk in many of the countries, and segregation of funds should be part of the prudential regulations. In particular, 10 countries (Algeria, Bahrain, Djibouti, Mauritania, Morocco, Oman, Saudi Arabia, Tunisia, United Arab Emirates, West Bank and Gaza) permit full-fledged Islamic banks and conventional banks to offer Islamic finance products and services termed “Islamic windows.”5 Apart from Sudan, which operates an exclusively Sharī’ah-compliant banking system, only four countries (Jordan, Kuwait, Lebanon, Qatar) restrict the provision of Islamic banking products and services by conventional banks through Islamic windows. Like their conventional counterparts, Islamic banks in the Arab countries are mainly funded by domestic deposits, but their deposits include profit-sharing investment accounts (PSIAs). The share of PSIAs on the balance sheets of Islamic Banks is as high as 50 percent in Bahrain and Jordan. Islamic banks in Saudi Arabia, on the other hand, show greater reliance on nonremunerated deposits. The large share of PSIAs in the liability structure has important regulatory implications for consumer protection, and capital and liquidity requirements. • PSIAs raise the need for greater disclosure on investment strategies and computation of payouts. This requires changes in governance structures to ensure representation of investment account holders’ (IAHs’) interests.

5 In four countries (Djibouti, Tunisia, Morocco, West Bank and Gaza), however, conventional banks have not yet established Islamic banking operations, although they are permitted to do so.

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• PSIAs raise issues of computation and comparability of capital adequacy ratios (CARs), because Islamic banks, in some countries, use profit equalization reserves (PERs) to smooth out profits to IAHs, and investment risk reserves (IRRs) to protect capital, in an effort to minimize potential for deposit runs in difficult times. Also, not all countries treat PSIAs and these reserves the same way when setting capital adequacy requirements. • Another question concerns the run-off rates for liquidity requirements under Basel III and loss absorption of PSIAs in resolution of Islamic banks in the event of distress. The assets of the Islamic banks largely consist of debt-like financing, but investment and risk-sharing products have increased to significant levels in some countries. At the end of June 2015, the share of financing instruments in Islamic banking total assets ranged between 40–70 percent in eight countries (Bahrain, Jordan, Kuwait, Oman, Qatar, Saudi Arabia, Sudan, United Arab Emirates). Over 60 percent of this financing are debt-like products based on Murabahah contracts (sales with mark-up) and Ijara (leasing products). Islamic banks in three countries (Djibouti, Sudan, Tunisia), however, have a large share of risk-sharing products based on either Musharakah or Mudarabah (joint partnership) contracts. Investment in Sukūk is significant for Bahrain, Qatar, and Sudan. This asset structure implies that while credit risk is the predominant risk, market and equity risks are significant in some countries. The financing also exhibits significant concentrations in cyclical sensitive real estate, construction, and trade sectors and in households (Figure 13.2), which results in common exposures and may heighten the potential for systemic risks.

Financial Soundness and Outlook Financial fundamentals of the Islamic banks are generally strong, but credit and liquidity risks are relatively elevated. At the end of September 2015, CARs were above statutory limits in 11 countries.6 However, the ratio of nonperforming financing was high in several countries. The banks remain profitable in aggregate, but less than their conventional peers. Profit margins have also been trending down in some countries. Liquidity conditions have been tightening in the oil-exporting economies, and efficiency indicators, denoted by the high cost-toincome ratios, have weakened in some countries (Figure 13.3). Risks to the outlook are tilted to the downside. The changing economic dynamics and geopolitical factors have potential to slow the growth of the Islamic banking industry in Arab countries and also affect the financial performance. In several countries, the strong and sustained double digit growth rates registered by the Islamic banking industry underwent a marked decline in 2015. Although it is too early to draw reliable long-term inferences, headwinds from low oil prices

6 Figure 13.3 charts are based on CARs reported in the survey and other indicators as reported to the IFSB (http://​www​.ifsb​.org/​). For Bahrain, the figures reflect domestic retail banks.

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Chapter 13  Prudential and Liquidity Management Frameworks



Figure 13.2. Balance Sheet Structure of Islamic Banks Percent, June 2015 1. Asset Structure

2. Financing, by Instrument

Financing accounts for the bulk of assets.

Sales and lease contracts (Murabahah and Ijara) account for the bulk of the financing, but equitybased contracts have increased to significant levels in some countries. Murabahah Ijara Mudarabah Musharakah Others

Sukuk Financing Interbank financing

Other securities All other assets

100

100

70

75 50

40

25 BHR ( R) BHR (W) KWT OMN QAT SAU ARE DJI SDN TUN JOR

JOR

SDN

ARE

SAU

QAT

OMN

KWT

–20

BHR

10

0

3. Liability Structure

4. Financing Structure, by Sector

Funding sources vary, but profit-sharing investment accounts are significant in a number of respondent countries.

The sectoral distribution of financing varies, but there is a high concentration in cyclical sensitive sectors.

Capital and reserves Interbank Current accounts PSIA

Other Sukuk Other (Commodity Murabahah, etc)

Others Household Industry

Services Real estate Trade

Financials Construction Public sector

SAU

ARE

SDN

JOR

JOR

OMN

EGY

0

SDN

25 ARE

25 SAU

50

QAT

75

50

KWT

75

OMN

100

BHR

100

0

Sources: Central Bank of Bahrain Statistical Bulletin; Islamic Financial Services Board Database; and Qatar Central Bank Statistical Bulletin. Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. PSIA = profit sharing investment accounts.

have made the macroeconomic environment challenging in jurisdictions in which Islamic finance has a large presence. In some countries (Iraq, Libya, Syria, Yemen), conflicts and other geopolitical developments render the operating environment challenging for banks, including the Islamic banks.

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Figure 13.3. Financial Soundness and Efficiency Indicators (Percent)

1. Capital Adequacy Ratio

2. Nonperforming Financing

Capital adequacy ratios remain high, although the Nonperforming financing is elevated for several countries. ratios are trending down for some countries. 2015 80

2013

September 2015

2013 18 15

60

12

40

9 6

20

3

3. Liquid Asset Ratio (Percent)

4. Return on Assets (Percent)

Liquidity asset ratio levels are lower in oil-exporting economies ...

... and Islamic banks are, on aggregate, profitable.

2015

2013

September 2015

TUN

DJI

JOR

EGY

SDN

ARE

SAU

OMN

BHR

KWT

JOR

TUN

SDN

DJI

EGY

UAE

SAU

QAT

OMN

0 BHR

0 KWT

214

2013

100 80 60 40 20 0

BHR KWT OMN SAU ARE EGY SDN JOR BHR KWT OMN SAU ARE EGY SDN JOR DJI

6 5 4 3 2 1 0 –1 –2 –3

Sources: Islamic Financial Services Board; and IMF Survey of Islamic Banking. Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

REGULATORY AND SUPERVISORY FRAMEWORKS Legal and Regulatory Frameworks Most countries have put in place legislation that recognizes Islamic banking practices, products, and institutions. Banking laws in 13 countries (Bahrain, Djibouti, Iraq, Jordan, Kuwait, Lebanon, Morocco, Oman, Qatar, Sudan, Tunisia, United Arab Emirates, West Bank and Gaza) provide for the establishment of Islamic banks.7 The laws also give central banks powers to regulate and supervise Islamic 7 Indications are that Iraq, Syria, and Yemen also have a legal framework in place that recognizes Islamic banking, but questionnaire responses have not been received yet.

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Chapter 13  Prudential and Liquidity Management Frameworks

banks. However, Algeria, Mauritania, and Saudi Arabia have no explicit legal framework for Islamic banking services, even though two of these countries have systemically important Islamic banking systems. Progress in adapting the licensing requirements to Islamic banking characteristics has been uneven, and the preventative characteristics of the licensing tools are underused. Ten countries (Bahrain, Iraq, Jordan, Kuwait, Lebanon, Morocco, Oman, Sudan, United Arab Emirates, West Bank and Gaza) require banks to obtain an Islamic banking license. However, not all the countries require ex ante evidence of arrangements for an appropriate Sharī’ah corporate governance structure, the right of IAHs to monitor the performance of their investments, the transparency of the financial reporting, internal and external audit functions, and other control measures. In addition, only three countries (Bahrain, Jordan, Oman) require different “fit and proper” requirements for Islamic banks.8 Six jurisdictions (Iraq, Jordan, Kuwait, Oman, Sudan, West Bank and Gaza) have regulations that require Sharī’ah board members to undergo fit and proper tests. Reforms to adapt regulatory frameworks to the specificities of Islamic banking have also progressed at an equally uneven pace, thus risks unique to Islamic banks may not be adequately addressed. Eight countries (Bahrain, Djibouti, Jordan, Kuwait, Oman, Qatar, United Arab Emirates, West Bank and Gaza) have adapted their regulatory frameworks to include explicit provisions for Islamic banks. In five other countries (Algeria, Iraq, Mauritania, Saudi Arabia, Tunisia), the authorities applied a single integrated regulatory framework without specific provisions for Islamic banking. Approaches to capital adequacy requirements have continued to vary, undermining comparability of solvency risks. The differences relate to the capital requirements for PSIA with regard to loss-absorption (alpha factor), which represents the ratio of actual risk transfer to shareholders of Islamic banks, the eligibility of PER and IRR and risk weights for assets, such as for profit-sharing financing like Musharakah and Mudarabah. There is also regulatory uncertainty regarding instruments that qualify for additional Tier 1 (AT1) and Tier 2 (T2) capital instruments. More specifically: • Seven countries (Bahrain, Iraq, Jordan, Kuwait, Oman, Qatar, Sudan) apply the Islamic Financial Services Board (IFSB) formula in the calculation of the CAR.9 • Three countries (Bahrain, Jordan, Oman) apply an alpha of 30 percent, Kuwait and Sudan apply 50 percent, and Qatar applies 100 percent.

8 Fit and proper requirements for the three countries include a requirement for management and shareholders to have knowledge of Islamic banking or training in Islamic banking principles and accounting. 9 The IFSB formula ensures that PSIAs are somehow loss absorbing and therefore do not require Islamic banks to hold capital against full or part of credit and market risk-weighted assets funded by PSIAs (see IFSB 15, Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services).

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• In five countries (Bahrain, Djibouti, Iraq, Qatar, Sudan), PER is permitted in the calculation of the CAR, and Bahrain and Qatar also allow IRR in CAR computation. Contractually, PSIAs should be loss-absorbing, but because many countries treat the accounts as deposits, the loss-absorption capacity of PSIAs is either limited or nonexistent. In several countries (Bahrain, Jordan, Oman, Sudan, United Arab Emirates, West Bank and Gaza), Islamic banks are required to maintain capital against assets funded by PSIAs, implying that the PSIAs are not loss-absorbing. Similarly, Djibouti, Tunisia, and the United Arab Emirates treat restricted investment accounts (RIA) as on-balance-sheet items, in which case the bank may undertake joint investment and the account holders may be covered by the deposit insurance schemes. For the United Arab Emirates, banks are also required to maintain capital against the RIA. Regulations in many countries do not require segregation of Islamic deposits from conventional funds, thus commingling is a material risk. Only five countries (Bahrain, Morocco, Oman, Tunisia, United Arab Emirates) require conventional banks to maintain Islamic deposits separately from the banks’ other funds. Jordan, Kuwait, Lebanon, the United Arab Emirates, and West Bank and Gaza allow Islamic banks to invest in fixed properties such as land and buildings, while restricting or prohibiting conventional banks from such investments. The provision for Islamic banks to invest in properties has resulted in some Islamic banks investing in a broad range of nonfinancial corporations whose risk profiles can be difficult to assess and, therefore, make the corporate structures complex and challenging to supervise.10 Three countries (Jordan, Lebanon, West Bank and Gaza) allow Islamic banks to undertake trading activities in movable assets (vehicles, equipment, trading goods), and for these countries, the inventory risk can be substantial.

Supervisory Frameworks Islamic banks are subject to supervisory oversight in all the Arab countries, but only a few have tailored their examination manuals to identify the risks unique to them. Several countries (Jordan, Oman, Saudi Arabia, Tunisia, United Arab Emirates, West Bank and Gaza) use onsite and offsite examination manuals that apply to all banks with no distinction between Islamic and conventional banks. Consolidated and cross-border supervision for Islamic banks remains a challenge. Six countries (Bahrain, Iraq, Kuwait, Oman, Saudi Arabia, West Bank and Gaza) are required to supervise their Islamic banks on a consolidated basis, and Bahrain and Kuwait report having cross-border supervisory arrangements for the Islamic banks. The United Arab Emirates and Qatar, which do not undertake consolidated or cross-border supervision, are home to Islamic banks with cross-sector subsidiaries and cross-border operations. Cross-border supervision is The nonfinancial corporations mostly include property management and real estate companies, but some Islamic banks are invested in aviation, hospitals, and schools. 10

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Chapter 13  Prudential and Liquidity Management Frameworks

also undertaken against the backdrop of different practices in countries with respect to prudential measures, accounting, and, in some cases, Sharī’ah interpretation. Countries continue to apply different accounting standards, which affects consistency and comparability of Islamic banking financial statements. Five countries (Bahrain, Djibouti, Jordan, Qatar, West Bank and Gaza) have made it mandatory for Islamic banks to adopt Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and IFSB standards. In Kuwait and the United Arab Emirates, Islamic banks are required to adopt International Financial Reporting Standards like their conventional counterparts, and IFSB and AAOIFI standards are neither mandatory nor an option, even though IFSB standards are considered in the formulation of regulations.

Corporate Governance Frameworks Corporate governance frameworks have increasingly been adapted to address the specificities of Islamic banking, but practices vary and Sharī’ah noncompliance remains a material risk. Centralized or national Sharī’ah boards (NSBs) that help standardize industry practices and improve consumer perceptions are required and have been established in seven countries (Bahrain, Djibouti, Iraq, Morocco, Sudan, United Arab Emirates, West Bank and Gaza).11 Five countries (Algeria, Iraq, Mauritania, Morocco, Saudi Arabia) do not require Islamic banks to establish a Sharī’ah board at the bank level. The Sharī’ah boards differ in their mandate, scope, governance, and accountability, making harmonization of rulings a challenge. In particular, of the seven countries that require centralized or NSBs, in Bahrain and Djibouti the Sharī’ah boards only have advisory powers. The NSB in Iraq has powers to evaluate Sharī’ah compliance in addition to advisory powers. In the other four countries (Morocco, Sudan, United Arab Emirates, West Bank and Gaza), the NSBs have rule-making and enforcement powers in relation to Islamic banks. By contrast, most of the Sharī’ah boards at the commercial banks have decision-making powers to rule on the compliance of products and contracts with Sharī’ah, with the exception of those in Bahrain and Lebanon. These disparities open room for arbitrage and introduce uncertainty among consumers regarding the Sharī’ah compliance of some products. Sharī’ah noncompliance remains a material risk because not all countries require Islamic banks to have internal controls for enforcing Sharī’ah compliance. Only five countries (Bahrain, Jordan, Oman, Sudan, United Arab Emirates) require Islamic banks to have specific internal control units for Sharī’ah

Oman is in the process of finalizing the establishment of a Sharī’ah board. In the case of Kuwait, while the central bank law does not provide for a national Sharī’ah board, in case of any conflicts in the opinion by Islamic banks, they can refer the issue to the Fatwa council in the Ministry of Awqaf and Islamic Affairs, which is the final authority on all fiqh (Islamic Jurisprudence) issues in the Islamic financial industry. 11

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compliance, in addition to the (regular) internal audit unit. The role of external auditors in ensuring Sharī’ah compliance is also not well-integrated in the risk management and supervisory process. Seven countries (Djibouti, Iraq, Jordan, Kuwait, Oman, Sudan, Tunisia) require external auditors of an Islamic bank to review the adequacy and the effectiveness of the internal controls systems for Sharī’ah compliance.12 Seven other countries (Algeria, Lebanon, Mauritania, Morocco, Saudi Arabia, United Arab Emirates, West Bank and Gaza) do not specify any role. Thus far, only Bahrain has conducted an external Sharī’ah audit, and Kuwait more recently issued new governance rules that include requirements for Sharī’ah audits.

Consumer Protection Consumer protection frameworks are part of the regulatory frameworks in many countries, but some gaps remain. In countries that have enacted laws to protect consumers, there has been a greater focus on addressing information asymmetries related to Sharī’ah compliance. Less attention has been given to disclosures on the investments of IAHs, on ensuring that their interests are represented on the board, or on providing frameworks for speedy and cost-effective resolution processes. Consumer education is also proceeding at an uneven pace. Disclosure requirements have focused more on Sharī’ah compliance and there has been less progress in ensuring representation of IAHs’ interests. Twelve of the 16 respondents require Islamic banks to disclose the state of Sharī’ah compliance but only five countries (Bahrain, Jordan, Kuwait, Oman, Sudan) require greater disclosures from Islamic banks regarding the operations of the investment accounts, with some adopting IFSB and AAOIFI standards. All but three countries (Iraq, Mauritania, Saudi Arabia) require Islamic banks by law or regulation to inform their RIA and URIA customers of their profit-smoothing practices, but only three countries (Bahrain, Sudan, West Bank and Gaza) require Islamic banks to appoint independent board directors representing (explicitly or implicitly) the interests of IAHs. Less progress has also been made in other aspects of consumer protection, such as ensuring speedy and cost-effective dispute resolution mechanism. Only Saudi Arabia and Sudan have Sharī’ah courts with jurisdiction over Islamic banks. In addition, only Bahrain, Sudan, and Tunisia have arbitral forums or alternative dispute resolution forums that customers may go to for the resolution of Islamic banking disputes.

In the case of Oman, external auditors, in addition to certifying that controls and systems have been maintained, are required to ensure that in the case of the Islamic window there is no commingling of funds with the conventional parent. 12

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Chapter 13  Prudential and Liquidity Management Frameworks

LIQUIDITY MANAGEMENT, RESOLUTION, AND SAFETY NETS Liquidity Management Liquidity management by Islamic banks remains a challenge. Whereas notable progress has been made in developing Sharī’ah-compliant instruments to manage liquidity at the bank level, limited progress has been made for systemic liquidity management by central banks and the development of Islamic interbank markets. Issuance of Sukūk, though increasing, is still limited to a few countries and secondary markets are yet to develop. Many countries do not have sufficient Sharī’ah-compliant, high-quality liquid assets to meet the Basel III liquidity requirements, forcing Islamic banks to maintain a high level of cash. Interbank markets are more developed between Islamic banks and conventional banks than among Islamic banks, possibly reflecting the limited number of players. Interbank markets between Islamic banks and conventional banks are reported to exist in six countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates). Meanwhile, only four countries (Bahrain, Saudi Arabia, Sudan, United Arab Emirates) have developed a domestic currency interbank Mudarabah market among Islamic banks. The Sukūk market is still very limited. In only four countries (Bahrain, Oman, Qatar, Sudan) does the government issue domestic Sukūk, and among these, only Bahrain and Sudan issue Sukūk regularly. The limited development of the Sukūk market reflects a variety of constraints, with several countries (Djibouti, Saudi Arabia, United Arab Emirates) citing lack of interest or need, Kuwait facing legal impediments, and Jordan and Iraq citing uncertainties on how best to issue the Sukūk. In the absence of Sharī’ah-compliant securities and remunerated reserves, Islamic banks are forced to hold a large share of their assets in cash and unremunerated reserves to comply with liquidity requirements at the expense of profitability. The adaptation of central bank operations, on the other hand, is uneven and mostly incomplete. In only five countries (Bahrain, Kuwait, Saudi Arabia, Sudan, United Arab Emirates) do central banks or monetary authorities conduct regular liquidity provision and absorption operations for Islamic banks. Very few countries have Sharī’ah-compliant lender of last resort facilities or emergency liquidity assistance (ELA) for solvent banks facing sustained liquidity pressures. A few countries (Saudi Arabia, Kuwait, Sudan, United Arab Emirates) issue central bank securities.13 Another small group (Bahrain, Oman, Saudi Arabia, Sudan) issue government securities or Sukūk to manage liquidity in Islamic banks. Only three countries (Kuwait, Saudi Arabia, United Arab Emirates) have developed overnight standing

13 The maturity structure of these securities varies, with Saudi Arabia and the United Arab Emirates offering a broad range of maturities from short to long term, and Kuwait offering three and six months. The contracts underlying the central bank securities also vary, with Kuwait basing the instruments on Tawarruq, Saudi Arabia using Murabahah, Sudan using Ijara, and the United Arab Emirates using commodity Murabahah.

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credit facilities for Islamic banks, and only one, Saudi Arabia, offers an overnight standing deposit facility. None have developed foreign exchange swap facilities for Islamic banks. Still to be developed are Sharī’ah-compliant lenders of last resort that have clear governance procedures, work allocations, collateral criteria, oversight, eligibility rules, and operational procedures.

Resolution Framework and Sharī’ah-Compliant Deposit Insurance Scheme The legal and policy frameworks for bank resolution are being strengthened in a number of Arab countries, but generally they are not yet well-developed. Two countries (Kuwait, United Arab Emirates) do not provide explicit powers for taking official control of a failing bank. The distress-resolution process for Islamic banks does not differ from that of conventional banks, except in Jordan and Qatar. There are no arrangements in place to resolve Islamic banks with cross-border operations. With respect to liquidation, only Djibouti, Jordan, and Qatar have liquidation laws for banks that contain features that are exclusive to Islamic banks. In five countries (Algeria, Bahrain, Kuwait, Oman, United Arab Emirates), liquidation of banks is governed by the corporate bankruptcy laws. Sharī’ah boards do not play a role in any of the countries’ resolution process. Sharī’ah-compliant deposit insurance schemes (SDIS) have been slow to develop. Only Bahrain and Sudan have SDIS in place, and Jordan is in the process of establishing one.14 Sudan’s SDIS covers current accounts (Qar) and investment accounts (Mudarabah), whereas that of Bahrain and the planned SDIS for Jordan cover Islamic deposits and unrestricted investment accounts. In all three countries, the SDIS is modeled on the Takaful (Islamic insurance) principle. In four countries (Algeria, Lebanon, Saudi Arabia, West Bank and Gaza) Islamic banks are covered by the same deposit insurance framework as conventional banks, and the deposit insurance premiums collected are managed in a single indivisible pool. In Djibouti, Jordan, and Oman, the deposit insurance system is only for conventional banks and does not cover Islamic banks. Three countries (Kuwait, Tunisia, United Arab Emirates) do not have an explicit deposit insurance framework.15

CONCLUSION AND POLICY RECOMMENDATIONS Arab countries have made significant advances in strengthening the prudential and liquidity management frameworks for Islamic banks, but progress has been uneven. With few exceptions, countries have enacted legal frameworks that provide greater clarity and certainty on permissible activities and on the supervisory In Bahrain, Islamic banks are covered by the same deposit insurance regulatory framework as conventional banks, but the deposit insurance premiums collected from Islamic banks are managed separately, on a Sharī’ah-compliant basis. 15 Tunisia is in the process of developing a deposit insurance scheme. 14

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oversight of Islamic banks. However, progress has been uneven in adapting licensing requirements, prudential regulations, and consumer protection, and in developing comprehensive data for surveillance of the industry and liquidity management instruments. Less progress has been made in adapting resolution frameworks and in developing SDIS. At the country level, only a few countries have systematically reformed the regulatory and supervisory frameworks in line with industry standards, including through detailed rulebooks for Islamic banks, or have adapted supervision tools and strengthened corporate governance frameworks. The agenda, therefore, remains broad. In countries where Islamic banks are operating without a legal foundation, the necessary laws and regulations should be enacted. Policymakers should focus on putting in place an enabling environment that levels the playing field with the conventional banking industry and allows market forces to play their role. Licensing guidelines and the approval process for Islamic banks and Islamic windows needs strengthening. Whereas several elements of an appropriate licensing process are common to Islamic and conventional banking, additional specific requirements related to the licensing of Islamic banks and authorization of Islamic windows are needed. In particular: • Islamic banks should be required to obtain Islamic licenses. Approval of the Islamic license should be conditional upon proof of arrangements for an effective Sharī’ah governance framework and strong control functions that address risks inherent in Islamic banking activities. • Conventional banks planning to conduct Islamic banking (through windows or dedicated branches) should be subject to prior approval by the regulatory authority. They should be required to have the internal systems, procedures, and controls to ensure that transactions and activities of windows are in compliance with Shari’ah rules, that Islamic and conventional business are properly segregated ex ante and ex post, and that adequate disclosures are made on windows operations. • Fit and proper criteria for management and major shareholders should include knowledge of Islamic finance, and Sharī’ah scholars should also be subject to similar fit and proper requirements. Greater adoption of IFSB standards on capital adequacy is needed to ensure loss absorbency of PSIA, as well as consistency in assessing solvency risks. Regulators should adopt IFSB guidelines on capital adequacy ratios, notably the introduction of the alpha factor to allow for some loss-absorbency by PSIAs. On the capital side, regulators should adopt the IFSB standards, including for eligible AT1 and T2, which are in line with the Basel III requirements to enhance banking system resilience. Sharī’ah governance frameworks could be further strengthened, including through the establishment of NSBs and an enhanced audit function. NSBs would provide further clarity and consistency on Sharī’ah issues, support the supervision function, including fit and proper examination of bank-level Sharī’ah advisors, and facilitate the development of Sharī’ah-compliant central bank monetary operations and sovereign. In addition, strengthening the independence of

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Sharī’ah boards at the bank level and enhancing Sharī’ah audit functions, including by external auditors, should remain priorities for countries. Further attention should be devoted to education and training in Islamic financing to ease constraints on the availability of qualified scholars. Rules governing investments in properties and movable assets warrant reconsideration to limit permissible activities to those critical to the functioning of Islamic banks. In countries where Islamic banks are permitted to invest in properties and undertake trading activities, the prevalence of nonfinancial corporations in the groups can create complex corporate structures, which present substantial challenges for consolidated supervision as well as for consumer protection. Therefore, regulators are encouraged to reconsider these rules, grandfathering the existing structures while giving them enough time and incentives to wind down their nonfinancial subsidiaries. Supervisory capacity should continue to be upgraded to ensure adequate skills and expertise in assessing emerging risks in the industry. Supervisory authorities should, in particular, continue to equip themselves with risk analytical tools, including adapted onsite and offsite examination tools. They should also seek to cover the risks comprehensively, including the misselling of Islamic banking products and services, ensuring consumer protection, promoting governance, and maintaining internal controls. In that regard, implementing the IFSB Core Principles for effective supervision of Islamic banks would be a step in the right direction. Supervisors will need to adapt rating methodologies, such as the CAMELS system, to Islamic banking and implement the IFSB standard on stress testing. Comprehensive data on Islamic banking balance sheets and soundness is needed to facilitate risk analysis and monitoring. Consolidated balance sheets for Islamic banks and more granular data on the instruments used for funding and financing are critical for identifying emerging risks and their materiality as well as the potential impact on macroeconomic policy formulation. Consumer protection frameworks that cater to the specifics of Islamic banking products should be an integral part of regulatory frameworks in countries with Islamic banking sectors. Sharī’ah principles, which govern Islamic finance, provide a strong foundation for consumer protection, but the features alone cannot guarantee adequate protection for consumers. Consumer protection frameworks should be anchored in laws, disclosures, financial education, and cost-effective enforcement mechanisms. In addition to disclosure of Sharī’ah compliance, more is needed to improve consumer education, enhance disclosures to IAHs on their investments, including as it relates to payouts and use of PER and IRR, and to ensure representation in the governance structure. Liquidity management frameworks need further strengthening, including the provision of ELA. Further developing Islamic interbank money markets and central bank monetary operations is critical for enhancing Islamic banks’ liquidity management capacities. In particular, central banks should develop Sharī’ah-compliant open market operations (outright transactions or repo), standing facilities, and ELA that have clear governance procedures, work allocations, collateral criteria, oversight, eligibility rules, and operational procedures for providing ELA. Deepening

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Sukūk markets, including by regular sovereign issuance of tradable Sukūk with different maturities, could help provide a benchmark pricing curve and increase the provision of income-generating, high-quality, liquid assets. Islamic banks are not immune to the risk of failure, thus legal frameworks for their resolution are important for preserving overall financial system stability. Some countries (Bahrain, Djibouti, Sudan, West Bank and Gaza) have experienced bankruptcies of some Islamic banks, requiring responses by national authorities. It is therefore important to ensure that countries with Islamic banks have in place legal and regulatory frameworks, including bank resolution and deposit insurance regimes, that facilitate their orderly resolution. Legal clarity on the treatment of investment accounts in resolution is needed, and SDIS should be further developed, and its role better clarified, in the resolution process. The ability to resolve large and complex Islamic financial institutions with crossborder operations should also be ascertained.

REFERENCES Barajas, A., S. Ben Naceur, and A. Massara. 2015. “Is Islamic Banking a Possible Avenue for Increasing Financial Inclusion?” IMF Working Paper 15/31, International Monetary Fund, Washington, DC. Demirgüç-Kunt A., L. Klapper, and D. Randall. 2013. “Islamic Finance and Financial Inclusion.” Policy Research Working Paper 6642, World Bank, Washington, DC. Elsie Addo Awadzi, Carine Chartouni, and Mario Tamez. 2015. “Resolution Frameworks for Islamic Banks.” IMF Working Paper 15/247, International Monetary Fund, Washington, DC. Ernst and Young. 2016. “World Islamic Banking Competitiveness Report 2016: New Realities, New Opportunities.” http://www.ey.com/Publication/vwLUAssets/ey-world-islamic-banking-competitiveness-report-2016/$FILE/ey-world-islamic-banking-competitivenessreport-2016.pdf. Imam, P., and K. Kpodar. 2010. “Islamic Banking: How Has it Diffused?” IMF Working Paper, 10/195, International Monetary Fund, Washington, DC. Imam, Patrick, and Kangni Kpodar. 2015. “Is Islamic Banking Good for Growth?” IMF Working Paper, 15/81, International Monetary Fund, Washington, DC. Islamic Financial Services Board. 2015. “Core Principles for Islamic Finance Regulations (Banking Segment),” Islamic Financial Services Board, Kuala Lumpur, Malaysia. Kammer, Alfred, Mohamed Norat, Marco Piñón, Ananthakrishnan Prasad, Christopher Towe, Zeine Zeidane, and an IMF staff team. 2015. “Islamic Finance: Opportunities, Challenges, and Policy Options.” IMF Staff Discussion Note 15/05, International Monetary Fund, Washington, DC. Kyriakos-Saad, N., C. El Khoury, M. Vasquez, and A. El Murr. 2015. “Islamic Finance and Anti-Money Laundering and Combating the Financing of Terrorism. “IMF Working Paper 16/42, International Monetary Fund, Washington, DC. López-Mejía, A., S. Aljabrin, R. Awad, M. Norat, and I. Song. 2014. “Regulation and Supervision of Islamic Banks.” IMF Working Paper 14/219, International Monetary Fund, Washington, DC. Lukonga, Inutu. 2015. “Islamic Finance, Consumer Protection, and Financial Stability,” IMF Working Paper 15/107, International Monetary Fund, Washington, DC. ———. 2015. “Seven Questions on Islamic Finance.” IMF Research Bulletin 16 (2): 6–9.

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Financial Stability and Legal Frameworks for Islamic Bank Resolution and Anti–money Laundering/Combating the Financing of Terrorism Elsie Addo Awadzi and Chady Adel El Khoury

Islamic banks are institutions that conduct banking operations on the basis of Islamic jurisprudence (Sharī’ah). Islamic banks currently operate in more than 60 countries, including in the Middle East and Southeast Asia, Sub-Saharan Africa, and Central Asia, and play an important role in many jurisdictions and regions (see IMF 2017a; Kammer and others 2015). Islamic banking presents an opportunity for many member countries to enhance financial intermediation and inclusion and mobilize funding for economic development.1 In at least 14 jurisdictions, Islamic banks are considered systemic, meaning that their failure could be systemically significant or critical for the financial systems in which they operate, and possibly beyond.2 It is therefore imperative that while jurisdictions embrace Islamic banking and the benefits they potentially provide, they also adopt the necessary measures to promote financial stability. Robust legal frameworks for the regulation, supervision (including for anti–money laundering/combating the financing of terrorism [AML/CFT]), and resolution of Islamic banks are required in Islamic banking jurisdictions. In many jurisdictions, however, the legal framework governing Islamic banking Elsie Addo Awadzi and Chady Adel El Khoury are Senior Counsels in the Legal Department of the IMF. 1 Islamic banking benefits potentially include increased financial market depth and financial inclusion, and increased funding for economic development. However, the growth of Islamic banking and its complexities pose new challenges and unique risks for regulatory and supervisory authorities. See IMF 2017b. 2 Consistent with the definition in the Islamic Financial Stability Board’s “Financial Stability Report, 2016,” Islamic banking is classified as systemically important if it accounts for 15 percent or more of the domestic banking system assets. Relevant jurisdictions include Bangladesh, Brunei, Iran, Kuwait, Malaysia, Qatar, Saudi Arabia, Sudan, United Arab Emirates, and Yemen.

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transactions is unclear, as the rights and obligations of parties to such transactions are not always explicitly provided for in law. In jurisdictions where the Sharī’ah is a dominant or exclusive source of law, Islamic banking transactions may enjoy recognition and enforceability by the courts and supervisory authorities. In other jurisdictions whose legal systems are not fundamentally based on Sharī’ah, however, Islamic banking transactions may be recognized and enforced only to the extent that they can be “precisely and effectively incorporated” into contracts recognizable under secular contract law (McMillen 2004). Similarly, the accounting principles for Islamic banks are not always clearly spelled out or applied consistently across Islamic banking jurisdictions. Progress has been made, however, toward clarifying the accounting and supervisory principles applicable to Islamic banks. In this regard, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has issued a broad range of accounting, auditing, governance, ethics, and Sharī’ah standards for Islamic banks.3 Also, the Islamic Financial Services Board4 has issued Islamic banking–specific prudential supervisory standards (Core Principles for Islamic Finance Regulation [Banking Segment]), drawing from the Basel Core Principles for bank supervision.5 Islamic banking jurisdictions are at various stages of adoption of these accounting, governance, and supervisory standards (Song and Oosthuizen 2014). A number of key gaps, however, remain in the framework for promoting financial stability in Islamic banking jurisdictions. These include the absence of legal frameworks for resolving failed Islamic banks and Sharī’ah-compliant lender of last resort facilities and deposit insurance schemes. Another key gap is the absence of AML/CFT requirements and supervision customized for Islamic banks. Very little guidance exists at the international level for designing such legal frameworks. This chapter will discuss, in particular, key issues in the design of legal frameworks for resolution and AML/CFT in the Islamic banking context. It argues that although international standards exist for the design of resolution and AML/CFT regimes for banks in general, more guidance is required at the international level for customizing the existing standards for jurisdictions with Islamic banks, given the unique features of those banks.

3 AAOIFI was established in 1991 in Bahrain to supplement international accounting and auditing standards by developing, interpreting, and disseminating accounting and auditing standards for Islamic financial institutions. AAOIFI currently has 200 members from 45 countries, including central banks, financial institutions, and other participants from the international investment bank and finance industry. See http://​www​.aaoifi​.com/​aaoifi/​TheOrganization/​Overview/​tabid/​62/​language/​en​ -US/​Default​.aspx. 4 Established in 2002 and based in Kuala Lumpur, Malaysia, the Islamic Financial Services Board currently has 188 members, including regulatory and supervisory authorities, international organizations, and market players. See Islamic Financial Services Board, “List of Members: By Category,” http://​www​.ifsb​.org/​membership​.php​?id​=​1. 5 Issued by the Basel Committee on Banking Supervision.

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ARE ISLAMIC BANKS DIFFERENT? Underlying the proposition that international guidance is needed for Islamic banking–specific legal frameworks for resolution and AML/CFT is the fundamental question of whether Islamic banks are any different from conventional banks. They are indeed different from conventional banks in a number of ways. In particular: • The role of Islamic jurisprudence: Islamic banks are fundamentally defined by a set of Islamic finance principles, which have evolved over the years from the Sharī’ah. These principles prohibit the making or paying of interest income (Riba) or the taking of excessive risks (Gharar), among others, and require transactions to be underpinned by real economic activities and risk-sharing. Historically, a number of schools have emerged in Islamic jurisprudence reflecting variations in methodology, approach, and local conditions. Modern Islamic jurisprudence pertaining to Islamic finance cuts across the traditional schools in an effort to provide (to the extent possible) a harmonized framework of principles that is relevant for modern banking and finance. The need to comply with these principles results in corporate structures, governance structures, balance sheets, and products and services that tend to be different from those of conventional banks, as will be discussed in the text following. • Corporate structures: Islamic banking services are normally provided separately from conventional banking, through dedicated stand-alone Islamic banks or through subsidiaries or windows of conventional banks. 6 Conventional banks seeking to provide Islamic banking services often set up windows that are not legally separate from the bank but whose operations are ring-fenced from the conventional banking operations in order to comply with the Sharī’ah prohibition against comingling of Islamic financial operations from non-Islamic ones. From a resolution and an AML/CFT standpoint, Islamic banking windows of conventional banks may present certain unique challenges. Among other things, a different approach may be required to assess the operations, assets, liabilities, and risks of Islamic banking windows—including in relation to the products and services they offer—relative to the conventional banking aspects of the entity. • Governance: Islamic banks have governance structures that differ somewhat from those of conventional banks. In addition to boards of directors and other governance structures used by conventional banks, Islamic banks maintain governance arrangements designed to help promote compliance with applicable Sharī’ah principles. In particular, Islamic banks in many jurisdictions establish Sharī’ah supervisory boards either on a mandatory or

6 The choice of stand-alone Islamic banking subsidiaries or windows are often shaped by legal, regulatory, and tax considerations in a given jurisdiction, among others (IMF 2017a).

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voluntary basis.7 These boards consist of Sharī’ah scholars and other professionals (such as economists, accountants, financial sector experts, and lawyers) and have the primary role of advising the institution on the extent of compliance of its activities and operations with relevant Sharī’ah principles. In certain jurisdictions, national or centralized Sharī’ah boards or councils also exist, established as part of the central bank or other supervisory agency or as a stand-alone institution. Sharī’ah supervisory boards and the Sharī’ah compliance role they play for Islamic banks may have implications for the design of institutional arrangements for Islamic bank resolution and AML/ CFT internal controls. • Balance sheets: The balance sheets of Islamic banks tend to be different from those of their conventional peers and are underpinned by transactions structured to comply with Sharī’ah prohibitions against interest and excessive risk-taking. Islamic banking transactions range from interest-free deposits (or loans), sale and purchase agreements on deferred payment terms, leases, fee-based agency agreements, and profit/loss-sharing or loss-bearing agreements.8 While in substance the economic effects of these transactions in many cases may be similar to those of conventional banking products, the legal relationships between the Islamic bank and its counterparties may differ significantly from the conventional banking context. For example, Islamic banks often assume the roles of vendor/purchaser, lessor/lessee/hirer, agent, and equity partner, among others, and sometimes directly or through special purpose vehicles. These have implications for the design of frameworks for resolution of failed Islamic banks (for example, how various transactions are ranked in the creditor hierarchy and are otherwise treated in resolution) and pose challenges for AML/CFT supervision. • Nature of certain Islamic banking products: Some products reflect potential complexities and risks for Islamic banks and for the economy at large. There is no evidence that the money laundering/terrorism financing risks in investment banks are any different from those posed by conventional banks. However, very little work has been done by the international community to develop an understanding of the specific money laundering/terrorism financing risks that may be posed by Islamic products. Money launderers and terrorist financiers often use complex products and transactions to conceal the source of the funds or their intended use. Islamic finance products are designed with an asset-based feature to provide for economic intermediation, as opposed to financial intermediation for conventional finance products. This feature introduces a layer of complexity, which may render it

The Sharī’ah governance framework also includes internal control, external audit, and reporting functions, which form the basis of the Sharī’ah board to stakeholders. See Accounting and Auditing Organization for Islamic Financial Institutions n.d.; and Islamic Financial Services Board 2009. 8 The most commonly used Islamic banking contracts include profit-sharing investment accounts, mudārabah, mushārakah, Ijara (lease), wakala (agency-type), or Sukūk (trust certificates). 7

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more vulnerable to abuse by criminals. Furthermore, Islamic banking products may have substantial effects on macroeconomic stability if not well regulated. Islamic banking contracts tend to be designed with an asset-based feature to provide for economic intermediation, as opposed to financial intermediation for conventional finance products. This feature introduces a layer of complexity given that asset price volatility could impact an Islamic bank’s balance sheets profoundly, whereas distress could lead to fire sales of its holdings in such assets, with implications for the wider economy. Likewise, such asset-based transactions may be more vulnerable to abuse by criminals and can increase the exposure of Islamic banks to risks. Given these important differences, among others, the direct application of international standards for resolution of failing banks and for AML/CFT cannot be assumed. In the interest of promoting financial stability in Islamic banking jurisdictions, the design of frameworks for bank resolution, and for the design of AML/CFT requirements and supervisory frameworks in the Islamic banking context, should adequately address unique features of Islamic banks and the risks they present.

LEGAL FRAMEWORKS FOR RESOLUTION OF ISLAMIC BANKS International financial law reform efforts following the global financial crisis of 2007–08 have focused, among other things, on promoting global financial stability by strengthening financial safety nets. In many key jurisdictions, the crisis showed that court-based corporate insolvency frameworks were inadequate for addressing systemic bank failures. The absence of legal tools to address bank failure in an orderly fashion led to government bail-outs of failing banks, with severe consequences for fiscal stability, as well as fomenting political resistance in many countries. International reforms have since been undertaken to promote robust legal frameworks for addressing nonviable financial institutions. In particular, the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions (“Key Attributes”) represent a nonbinding standard for the design of frameworks for orderly resolution of failing financial institutions (banks and nonbank financial institutions) that could be systemically significant or critical if they fail (Financial Stability Board 2011). It recommends the adoption of legal and institutional frameworks to ensure that banks that are nonviable or likely to be nonviable are resolved by a broad range of administrative powers and tools at an early stage (before balance sheet insolvency) in a manner that promotes financial stability and without exposing taxpayers to losses.9

9 The Key Attributes provide for a broad set of resolution powers and techniques to be made available to resolution authorities to undertake mandatory recapitalization, forced mergers, debt restructuring through bail-in, purchase and assumption, and transfers of assets and liabilities to bridge banks.

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Although there are as yet no designated global systemically important Islamic banks, some Islamic banks may be of systemic importance in specific jurisdictions or regions, or in some way, connected with systemic financial institutions.10 Islamic bank failures in the past have exposed gaps in the financial safety nets of jurisdictions where they operate.11 Furthermore, the interconnectedness between Islamic banks and the conventional banking sector through Islamic banking windows of conventional banks, as well as cross-border operations of Islamic banks, potentially could increase systemic risks from the failure of an Islamic bank. A critical gap in the global financial stability agenda, however, relates to the lack of guidance for the design of robust Sharī’ah-compliant financial safety nets for Islamic banking jurisdictions. Financial safety nets (in particular, bank resolution frameworks) in many such jurisdictions are not well developed. In particular, whether for conventional banks or Islamic banks, very few of these countries have put in place special bank resolution frameworks, and others have relied on their general corporate insolvency frameworks. To the extent that special bank resolution frameworks have been established, they do not yet distinguish between conventional and Islamic banks, with the one exception of Malaysia’s Islamic Financial Services Act (Act 759) of 2013, which has a resolution framework for Islamic banks. The importance of a well-designed legal framework for Islamic banking resolution cannot be overemphasized, especially given different interpretations of the Sharī’ah by various Islamic schools of jurisprudence, which could have implications for legal certainty in resolution. In designing Islamic banking-specific resolution frameworks, several key issues would appear relevant. In particular: • Role of Sharī’ah compliance: A fundamental question in the design of Islamic banking resolution frameworks would be the extent to which Sharī’ah law plays a role in the resolution process. In particular, it is important to clarify whether the legal powers, tools, and techniques by which resolution is effected and implemented should be Sharī’ah-compliant. Given that the sanctity and validity of Islamic banking hinges on relevant Sharī’ah jurisprudence, it would appear that a resolution regime for Islamic banks may have to be Sharī’ah-compliant. For this reason, it is important to consider the possible relevance of applicable Sharī’ah jurisprudence in the areas

The Financial Stability Board’s list of global systemically important banks, as of November 2017, included 30 global banks. While none of these is an Islamic bank, it is possible that at least some of them may have Islamic banking windows or subsidiaries. See Financial Stability Board 2017. 11 The failure of Ihlas Finance in 2001 and the subsequent run on Islamic bank deposits in Turkey during the Turkish financial crisis is a case in point. Other examples include the near-failure of Dubai Islamic Bank and Noor Islamic Bank of Dubai, the Kuwait Finance House, the al-Rajhi Bank of Saudi Arabia, and the Islamic al-Hilal Bank of Abu Dhabi. More recently, the failure of Kenya’s Chase Bank—a conventional bank with an Islamic banking window—exposed the complexities of supervising and resolving conventional banks with such windows. 10

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of banking, bankruptcy, insolvency, and market regulation when designing Islamic bank-specific resolution regimes.12 • Institutional arrangements for resolution: The legal framework should clearly provide for an administrative authority to resolve failed Islamic banks, such as the supervisory authority, the deposit guarantee scheme operator (if any), or an other relevant agency. Another critical issue is the extent, if any, to which Sharī’ah boards may have a role to play in resolution of investment banks, for example, by assessing whether resolution measures are compliant with relevant Sharī’ah principles, whether on an ex ante or ex post basis. Sharī’ah boards generally help to oversee Sharī’ah compliance by investment banks. There are generally two types of Sharī’ah boards, namely centralized Sharī’ah boards (established by supervisory agencies, for example) which provide guidance on Sharī’ah compliance for all investment banks in a given jurisdiction, and internal Sharī’ah boards that are established by individual investment banks to ensure Sharī’ah compliance. The design of institutional arrangements for Islamic bank resolution may need to avoid potential conflicts that could emerge between a Sharī’ah board and the resolution authority in relation to Sharī’ah compliance of resolution measures. Where a jurisdiction’s legal framework provides a mechanism for judicial review of resolution actions undertaken by the resolution authority, it would be important for the Islamic bank resolution regime to clarify the extent to which the courts may consider whether specific resolution measures were compliant with relevant Sharī’ah jurisprudence.13 • Resolution triggers: Triggers for activating resolution powers with respect to Islamic banks should reflect their unique business model. A good legal framework for resolution should provide for clear triggers (such as quantitative and/or qualitative triggers) for initiating resolution of a failing bank. For conventional banks, quantitative triggers largely reflect a “borrowing and lending” business model, with indicators of nonviability that include weak regulatory capital adequacy ratios often impacted by nonperforming loans and other poor-quality assets, and persistent liquidity problems (for example, inability to pay debts as they fall due). In the case of Islamic banks, the application of conventional resolution triggers may be problematic, given

For a discussion on the application of insolvency proceedings in the Islamic finance context, see McMillen 2012. 13 In the context of resolution, judicial review aims to ensure, in general, that the resolution authority has acted within its legal authority and followed due process. The Key Attributes call for resolution regimes that do not constrain the implementation of, or result in a reversal of, measures taken by resolution authorities acting within their legal powers and in good faith. In an Islamic banking resolution context, there could perhaps be a valid question as to whether a resolution authority taking measures that do not respect relevant Shari’ah jurisprudence could be said to have acted within their legal powers. 12

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differences in their business model, which relies heavily on sales, leasing, and profit/loss-sharing arrangements. • Resolution powers and tools: Islamic bank–specific resolution frameworks should provide explicitly for a broad range of powers to facilitate effective resolution. In line with the Key Attributes, these should include the resolution authority’s powers to (1) replace senior management of the institution; (2) place the institution under official control; (3) impose moratoriums and stays, if necessary; (4) restructure the bank through techniques such as purchase-and-assumption14 or bail-in;15 or (5) liquidate the bank. These powers are expected to be exercised in a manner that achieves key resolution objectives of ensuring the stability of the financial system (in which the bank/group operates) through the preservation of critical functions, protection of depositors, and minimization of losses to taxpayers. While some resolution powers (for example, forced mergers or forced recapitalization) appear not to violate relevant Islamic finance principles, others such as purchase-and-assumption and bail-in powers may require more legal clarity from an Islamic banking perspective. In any event, the lack of sufficient legal clarity may have consequences for the choice of resolution strategy in a given case. • With respect to purchase-and-assumption, the legal framework for Islamic bank resolution may need to clarify key issues, such as which transactions (including profit-sharing investment accounts) are classified as assets or liabilities for purposes of transfer to an acquiring institution. More fundamentally, it is unclear whether the Sharī’ah prohibition against the sale of debt in return for interest (ribā) could make purchase-and-assumption transactions for Islamic banks challenging. This is because the sale of certain Islamic bank assets (for example, receivables from leasing or sales agreements) or liabilities below face value would imply a discount, which could be interpreted as “interest” and therefore possibly barred by the Sharī’ah. Furthermore, the purchaser of a troubled bank’s assets and liabilities would likely include certification of its operations as Shari’ah-compliant, which could delay finding a suitable acquirer (especially in jurisdictions with small investment bank sectors). To mitigate this risk, it may be possible in appropriate cases for authorities of a given jurisdiction to establish and license a Shari’ah-compliant bridge bank to acquire assets and liabilities of the failed institution in a timely fashion.

In a purchase-and-assumption transaction, the resolution authority transfers the assets and liabilities of a troubled Islamic bank to a healthy acquirer (or bridge bank) without the consent of existing shareholders or creditors of the troubled bank. 15 Bail-in, as contemplated by Key Attribute 3.5, involves the mandatory write-down or c­ onversion of debt, equity, and other capital instruments of a bank in resolution to help stabilize the bank and to allocate losses among shareholders and unsecured and uninsured creditors. 14

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• The extent to which bail-in powers could be applied in the resolution of Islamic banks will also need to be clarified in legal frameworks. Among other things, the legal treatment of a transaction—in particular, whether it is held as a client asset or as a liability of the bank, and if as a liability, whether secured or unsecured—has implications for its ability to be bailed-in. For example, funds standing to the credit of depositors under profit-sharing investment accounts may be treated as risk-bearing client assets in some jurisdictions. Turkey and other jurisdictions, however, insure such funds under deposit insurance schemes, and as a result, these funds could be deemed not appropriate for bail-in, given that they are guaranteed to an extent. More fundamentally, it would appear that the concept of debt write-down and the “no debt forgiveness” principle may be inconsistent with relevant Sharī’ah prohibitions. The concept of debt write-downs under bail-in assumes mandatory forgiveness of the portion of the debt written-off, which is forbidden under Sharī’ah. Similarly, where bail-in is to be carried out through an equity-to-debt conversion, the “no debt forgiveness” Sharī’ah principle may be relevant. An equity-debt conversion that recognizes debt at par value may in principle not be a problem under Sharī’ah law. In addressing these issues from a statutory standpoint, jurisdictions could also clarify possibilities for Sharī’ah-compliant bail-ins, perhaps through contractual arrangements. These questions and issues need to be addressed explictly by Islamic banking jurisdictions. In the design of resolution regimes, jurisdictions are faced with key choices. Whether or not the general legal framework of a jurisdiction recognizes Sharī’ah law, there may be practical challenges in applying conventional resolution regimes to Islamic banks, given the issues discussed previously. A clear legal framework for resolving Islamic banks that addresses key issues such as those discussed in this chapter, would be useful for promoting financial stability through orderly and speedy resolution with legal certainty.

AML/CFT LEGAL FRAMEWORKS FOR ISLAMIC BANKS There is no evidence that the money laundering and terrorism financing risks in Islamic banks are any different from those posed by conventional banks. Rather, the choice of conventional bank or Islamic bank to launder the proceeds of crimes or finance terrorism would appear to be dictated by convenience and opportunity, rather than by any inherent differences between them. However, very little work has been done by the international community to develop an understanding of the specific money-laundering and terrorism-financing risks that may be posed by Islamic banks or to determine whether modifications need to be made to Financial Action Task Force (FATF) standards to address them (Financial Action Task Force 2012). Banks (both conventional and Islamic) are vulnerable to abuse by money launderers and terrorist financiers. Criminal activities, such as drug trafficking,

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smuggling, human trafficking, and corruption, tend to generate large amounts of proceeds. To mitigate the risk of misuse by money launderers or terrorist financiers, it is essential that banks adopt and implement adequate controls and procedures that enable them to know the person(s) with whom they are dealing. Adequate customer due diligence on new and existing customers is a key part of such controls. The FATF standards on AML/CFT place customer due diligence and other so-called preventive measures at the heart of an effective AML/CFT framework. Effective customer due diligence requires (1) the verified identification of a customer and/or beneficial owner; (2) an understanding and, if appropriate, the collection of information on the purpose and intended nature of the business relationship and the source of the funds; and (3) the ongoing monitoring of the business relationship. These requirements are designed to ensure that financial institutions know on whose behalf they are holding funds or conducting transactions, and to identify any potential suspicious activity. Where appropriate, financial institutions are required to report suspicious transactions to the competent authorities. Financial institutions’ AML/CFT programs consist of internal policies, procedures and controls (including appropriate compliance management arrangements), and adequate screening procedures for hiring employees. The FATF standards were developed mainly with the conventional financial sector in mind. They do not make special provision for Islamic banking. Most countries with an Islamic banking presence have put in place AML/CFT regimes that are based on the FATF standards. Legislators and regulators in those countries have imposed the same requirements to identify and verify the identity of clients and beneficial owners, conduct due diligence to verify the source of funds, and report suspicious transactions. However, some features of the FATF standards would not appear to fully take into account the specific features of Islamic banks. For instance, the definition of a “financial institution,” included in the glossary of the FATF Recommendations, does not encompass comprehensively the reality of Islamic financial institutions. Financial institutions are defined as natural or legal persons conducting one or more financial activities (for example, deposits and lending) listed in the glossary, which does not seem to incorporate the variety of existing Islamic banking products and services. Moreover, the glossary defines a financial institution as acting for or on behalf of a customer, whereas Islamic banks engage for or on behalf of partners. In addition to the divergence of definitions, there has been very little study of the potential money-laundering and terrorism-financing risks arising from Islamic banking. While these risks in conventional financial sector activities have been the subject of numerous studies and publications on methods, trends, and typologies prepared by FATF and FATF-style regional bodies and their members, there are no corresponding studies in the field of Islamic banking. No money laundering and terrorism financing typologies or indicators related to Islamic banking have been published by AML/CFT national concerned agencies or standard setters, and there is no common understanding of the typologies and techniques used for money laundering and terrorism financing in Islamic banks. Identifying the main

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typologies would facilitate raising the private sector’s attention to the techniques most commonly used by criminals in Islamic finance and would enable relevant governmental agencies to identify the areas of greater money-laundering and terrorism-financing risks and take appropriate mitigating measures. In particular, some specific features of Islamic banking could present vulnerabilities that require a different approach in the design of AML/CFT regimes. Areas that merit further study include, for instance, the specific nature of the relationship between a financial institution and its customers, the management of the high volume of Zakat16 by investment banks, and the complexity of certain transactions and products. Islamic products require that the financing provided is asset-based, often resulting in the purchasing, ownership, transfer, and transactions of real goods between counterparties. The result is a complex layering of transactions and the involvement of third parties in order to be Sharī’ahcompliant. This can create opportunity for launderers to use those products to conceal the proceeds of crimes without detection.

CONCLUSION The chapter has argued that Islamic banking jurisdictions need to explore the benefits of adopting Islamic banking–specific resolution and AML/CFT frameworks. At a minimum, jurisdictions must clarify what resolution toolkits they have in place to tackle Islamic banking failure in an orderly manner to preserve financial stability and to protect taxpayers from losses. Similarly, jurisdictions must adopt AML/CFT requirements and supervisory approaches that are specific to the unique features and risks of Islamic banks. Gaps in the international regulatory framework for bank resolution and AML/ CFT as they relate to Islamic banks should be addressed. Further analytical work on the potential complexities and uncertainties identified in this chapter should be undertaken by relevant international bodies, in close consultation with other standards setters. This effort should help to customize conventional standards in these areas for application to Islamic banks.

REFERENCES Addo Awadzi, Elsie, Carine Chartouni, and Mario Tamez. 2015. “Resolution Frameworks for Islamic Banks.” IMF Working Paper 15/247, International Monetary Fund, Washington, DC. Accounting and Auditing Organization for Islamic Financial Institutions. n.d. “Governance Standards on Sharī’ah Supervision and Compliance.” http://aaoifi.com/?lang=en.

Under the Shari’ah, Zakat is intended to be a poverty reduction, income redistribution, and stabilization scheme. It is levied on those individuals whose wealth is beyond a certain exempted allowance. The wealth used for Zakat purposes is broadly defined and includes cash, precious metals (for example, gold and silver), animal stock (for example, camels, sheep, and cows), and agricultural produce (for example, wheat, barley, dates, and grapes). 16

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Financial Action Task Force. 2012. “International Standards on Combating Money Laundering and the Financing of Terrorism & Proliferation: The FATF Recommendations.” http://www. fatf-gafi.org/media/fatf/documents/recommendations/pdfs/FATFRecommendations.pdf. Financial Stability Board. 2011 (updated 2014). “Key Attributes of Effective Resolution Regimes for Financial Institutions.” http://www.fsb.org/wp-content/uploads/r141015.pdf. ———. 2017. “2017 List of Systemically Important Banks (G-SIBs).” http://www.fsb.org/ wp-content/uploads/P211117-1.pdf. Islamic Finance Services Board. 2009. “Guiding Principles on Sharī’ah Governance Systems for Institutions Offering Islamic Financial Services.” http://www.ifsb.org/standard/IFSB-10%20 Shariah%20Governance.pdf. International Monetary Fund (IMF). 2017a. “Ensuring Financial Stability in Countries with Islamic Banking.” IMF Policy Paper, International Monetary Fund, Washington, DC. ———. 2017b. “Ensuring Financial Stability in Countries with Islamic Banking—Case Studies.” IMF Multi-Country Report 17/145, International Monetary Fund, Washington, DC. Kammer, Alfred, Mohamed Norat, Marco Piñón, Ananthakrishnan Prasad, Christopher Towe, Zeine Zeidane, and an IMF staff team. 2015. “Islamic Finance: Opportunities, Challenges, and Policy Options.” IMF Staff Discussion Note 15/05, International Monetary Fund, Washington, DC. Kyriakos-Saad, Nadim, Manuel Vasquez, Chady El Khoury, and Arz El Murr. 2016. “Islamic Finance and Anti-Money Laundering and Combating the Financing of Terrorism.” IMF Working Paper 16/42, International Monetary Fund, Washington, DC. McMillen, Michael J. T. 2004. “Enforceable in Accordance with its Terms: A Proposal Pertaining to Islamic Sharī’ah.” Presentation at the Islamic Financial Services Board meeting in Bali, Indonesia. ———. 2012. “An Introduction to Sharī’ah Considerations in Bankruptcy and Insolvency Contexts and Islamic Finance’s First Bankruptcy (East Cameron).” https://papers.ssrn.com/ sol3/papers.cfm?abstractid=1826246. Song, Inwon, and Carel Oosthuizen. 2014. “Islamic Banking Regulation and Supervision: Survey Results and Challenges.” IMF Working Paper 14/220, International Monetary Fund, Washington, DC.

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International Efforts toward More Resilient Conventional and Islamic Banking Sectors: Implementation Challenges Mehmet Siddik Yurtcicek and Mehmet Sefik Yurtcicek Financial stability and sustainable economic growth rely significantly on an effective and resilient banking system. Banks are at the center of the credit intermediation processes between savers and investors, and they provide critical services to their customers who count on them in conducting their daily business. Weaknesses and failures of a bank can threaten domestic and international financial stability. Large and internationally active banks pose more risks to the sector, and to the economy in general, than do smaller ones. Since the outbreak of the global financial crisis of 2007–08, national and international regulatory and supervisory authorities have been working to create safer financial systems, prevent systemic risks, and protect taxpayers’ interests. These initiatives have given birth to several developments in the regulation, supervision, and resolution of banks as well as deposit insurance systems. This chapter elaborates on some of the potential implementation challenges and presents several suggestions to address them.

RECENT INTERNATIONAL REGULATORY DEVELOPMENTS The Basel Committee’s Initiatives Historical Background1 The central bank governors of the Group of 10 (G10) countries2 established the Basel Committee on Banking Supervision in 1974 in response to the disruptions in the international financial markets after the collapse of the Bretton Woods Mehmet Siddik Yurtcicek is Senior Counsel Manager at the BaFin Consultancy, and Mehmet Sefik Yurtcicek is an Islamic Finance Consultant. 1

For detailed information, see Basel Committee on Banking Supervision 2016.

2

The Committee has 28 member jurisdictions after expansion of its membership in 2009 and 2014.

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system of managed exchange rates in 1973.3 Countries are represented on the committee by their central banks and banking supervision authorities (if there is a separate supervisory authority from the central bank). The committee aims to enhance financial stability by improving supervisory know-how and the quality of banking supervision worldwide. The committee sets minimum standards for the regulation and supervision of banks, provides a platform for countries to share their experience on supervisory issues, and works to improve cross-border cooperation and identify risks for the global financial system.4 The first Basel Capital Accord (“Basel I”) was published in July 1988. Basel I established a minimum 8  percent ratio of capital to risk-weighted assets to strengthen the stability of the international banking system and to remove unfair differences in national capital requirements. In January 1996, the committee issued a Market Risk Amendment to the Capital Accord, allowing banks to use internal models (“value-at-risk” models) to measure their market risk capital requirements.5 The Basel II Revised Capital Framework, comprising three pillars, was published in June 2004. The first pillar is the 8  percent minimum capital requirement, the second pillar is the supervisory review of an institution’s capital adequacy and internal assessment process, and the third pillar is an effective use of disclosure to strengthen market discipline and encourage sound banking practices.

Basel 2.5 Measures The global financial crisis of 2007–08 drew attention to the importance of keeping sufficient regulatory capital during significant market stress. The crisis had shown that the level of capital requirements for trading activities was insufficient to absorb losses. The initial response of the Basel Committee to the crisis was a set of revisions to the market risk framework in July 2009, which have become known as Basel 2.5 (Basel Committee on Banking Supervision 2009). The revisions aimed to address the problem of banks’ undercapitalized trading books.6 To increase the overall level of capital for market risk, Basel 2.5 introduced the incremental risk charge, which is estimated based on a one-year capital horizon and calculation of “stressed value at risk.”

Examples are the failures of Bankhaus Herstatt and the Franklin National Bank of New York in 1974. The Committee’s decisions are just recommendations that are expected to be implemented by national authorities but do not have legal enforceability. 5 “Value at risk” is a measure that quantifies the level of financial risk within a firm or investment portfolio over a specific time frame. See Investopedia 2019. 6 “Trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book.” For this definition and detailed information, see paragraphs 684–89 in Basel Committee on Banking Supervision 2004. 3 4

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Basel III Measures The Basel Committee in 2010 developed a new comprehensive set of reform measures (Basel III) to strengthen the regulation, supervision, and risk management of the banking sector (Basel Committee on Banking Supervision 2010, revised 2011). The committee aimed to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, improve risk management and governance, and strengthen banks’ transparency and disclosures. These measures are among the most stringent responses to the financial crisis: they strengthen microprudential regulation, which will help raise the resilience of individual banking institutions in periods of stress, and they address macroprudential risks that can build up across the banking sector.7 Basel III measures are strengthening the regulatory capital framework and increasing both the quality and quantity of the regulatory capital base, as well as enhancing the risk coverage of the capital framework. Basel III also brings a minimum Tier 1 leverage ratio (non–risk-based 3 percent) that serves as a backstop to constrain excess leverage in the banking system (Basel Committee on Banking Supervision 2010, revised 2011). According to the new capital framework, the predominant form of Tier 1 capital (“going concern” capital8) must consist of common shares and retained earnings (at least 4.5 percent of risk-weighted assets at all times). The remainder of the Tier 1 capital base (core Tier 1 and additional Tier 1 capital should be at least 6 percent of risk-weighted assets at all times) must be comprised of instruments that have certain features (subordinated, fully discretionary dividends or coupons, no maturity date, and no incentive to redeem). Instruments that can be qualified as Tier 2 capital (“gone-concern” capital)9 should also have certain features, and Tier 1 capital plus Tier 2 Capital must be at least 8  percent of risk-weighted assets at all times. Above the minimum capital requirement (8  percent) the committee introduced a capital conservation buffer (2.5 percent), comprised of Common Equity Tier 1, which can be drawn down in periods of stress. The countercyclical buffer (between zero and 2.5 percent of risk-weighted assets) is a macroprudential tool to protect the banking sector in periods of excess credit.10 The committee also introduced a bank-specific countercyclical buffer (between zero and 2.5 percent to total risk-weighted assets) for systemically important banks.

The macroprudential approach focuses on the financial system as a whole. The “going concern” capital is the capital that allows a bank to continue its activities and keeps it solvent. 9 “Gone concern” capital is capital that acts as support for depositors in receivership, bankruptcy, or liquidation but has less of a role in preserving the bank as a “going concern.” See Cohen 2010. 10 Countercyclical capital buffer is intended to protect the banking sector against losses that could be caused by cyclical systemic risks. Banks are required to keep more capital at times of credit growth that can be reduced when the cycle turns. 7 8

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To create a strong liquidity base for banks, the committee introduced the liquidity coverage ratio to promote short-term resilience of a bank’s liquidity (Basel Committee on Banking Supervision 2013). According to this new ratio, banks will need to keep sufficient high-quality liquid resources to survive a severe stress scenario (a 30-day period). The committee also developed the net stable funding ratio to promote liquidity resilience for a longer, one-year time horizon, giving incentives for a bank to fund its activities with more stable sources.11

Core Principles for Effective Banking Supervision The Core Principles for Effective Banking Supervision (“Core Principles”) are the benchmark for assessing the quality of national supervisory systems, and are also used by the IMF and the World Bank in the context of the Financial Sector Assessment Program (FSAP) to gauge the effectiveness of countries’ banking supervisory systems.12 The committee in 1975 issued the original “Concordat,” which aimed to expand the supervisory coverage to include foreign banking establishments and to provide adequate and consistent supervision across member jurisdictions. The Concordat was revised in May 1983 and reissued as principles for the supervision of banks’ foreign establishments. The principles of the Concordat were reformulated and published as the minimum standards for the supervision of international banking groups and their cross-border establishments in July 1992. In September 1997, 25 basic principles for an effective supervisory system were published. The developments in the global financial markets during the financial crisis made it necessary for the Basel Committee to review and revise the Core Principles. After the revision in 2012, the number of Core Principles was increased from 25 to 29 and merged with the assessment methodology. As limited human resources make it necessary for the supervisory authorities to employ their resources effectively, the revised Core Principles bring greater focus on risk-based banking supervision that is proportionate to risk profiles and systemic importance. The Core Principles encourage supervisory authorities to devote more time and resources to larger, more complex or riskier banks. The first part of the Core Principles (numbers 1 to 13) focuses on effective risk-based supervision and the need for early intervention and timely supervisory actions, and it addresses supervisory powers, responsibilities, and functions. The second part (numbers 14 to 29) covers good corporate governance, risk management, and compliance with supervisory standards.

For more details on the committee’s works on strengthening the international regulatory framework for banks, see “Finalising Post-Crisis Reforms: An Update. A Report to G20 Leaders” (Basel Committee on Banking Supervision 2015). 12 FSAP is a comprehensive assessment of a country’s financial sector. FSAPs analyze the resilience of the financial sector, the quality of the regulatory and supervisory framework, and the capacity to manage and resolve financial crises (IMF 2017). 11

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Financial Stability Board General The Financial Stability Board (FSB) has been active since its establishment (2009) in developing and promoting financial sector policies to enhance global financial stability.13 FSB members have agreed to implement a broad range of policy reforms to build more resilient financial institutions and markets. One of the first priorities of the Board was to address the systemic risks and moral hazards associated with firms that are regarded as “too-big-to-fail.”14 In this respect, higher loss-absorbency capacity, resolution planning, and more intensive coordinated supervision are developed for the financial institutions that have global systemic importance (see FSB 2010, n.d.-b). The FSB has taken a number of steps to mitigate risks arising from shadow banking, making the over-the-counter derivatives market safer through increased standardization, central clearing, and reporting of all trades to trade repositories. FSB’s work on the legal entity identifier (a unique identification of parties to financial transactions) aims to advance transparency. Sound Compensation Practices are developed to reduce bankers’ incentives to take excessive risk. The FSB also addresses data inadequacies in the sector, especially those of globally active financial institutions.15

Resolution Regimes The main goal of well-developed micro- and macroprudential supervision is to reduce both the probability and impact of possible failures. Effective crisis management and orderly resolution frameworks are essential requirements to minimize the adverse impacts of failures on the banking sector. The financial crisis demonstrated the urgent need for effective resolution regimes. The FSB has identified “resolution regimes” as a priority area, and in 2011 developed “The Key Attributes of Effective Resolution Regimes for Financial Institutions” (the “Key Attributes”) for an effective resolution regime (FSB 2011a). Additional guidance documents for insurers, financial market infrastructures, and the protection of client assets were adopted and incorporated as annexes into the 2014 version of the Key Attributes document (FSB 2014). The objective of the Key Attributes is to resolve systemically significant financial institutions in an orderly manner without taxpayer exposure to loss, while maintaining continuity of their vital economic functions. The implementation of the Key Attributes is a critical part of policy measures to reduce the moral hazard risks in the banking industry.

The FSB was established in April 2009 as the successor to the Financial Stability Forum, which was founded in 1999 by the G7 finance ministers and central bank governors. 14 “Too big to fail” refers to institutions that are so big, complex, and interconnected with the rest of the financial system that the public cost of allowing them to go out of business is judged to be too high. 15 For more information, see the “First Annual Report” (FSB 2015). 13

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The Committee on Payments and Market Infrastructures Historical Background The G10 governors established the Committee on Payment and Settlement Systems (CPSS) in 1990. The CPSS monitors and analyzes developments in domestic payment, settlement, and clearing systems as well as in cross-border and multicurrency settlement schemes in an attempt to contribute to efficient payment and settlement systems and build strong market infrastructure. In June 2014, the central bank governors of the Global Economy Meeting decided to rename the CPSS as the Committee on Payments and Market Infrastructures (Bank for International Settlements 2015). The committee is a global standard-setter that works to promote the safety and efficiency of payment, clearing, settlement, and related arrangements. The committee also serves as a forum for central bank cooperation in related oversight, policy, and operational matters (Bank for International Settlements 2015).

Principles for Financial Market Infrastructures Financial market infrastructures enable clearing, settlement, and recording of financial transactions, and play a critical role for financial stability. Weak infrastructures can pose significant risks to the financial system and be a potential source of contagion. The Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions (IOSCO) reviewed and updated the standards and developed “Principles for Financial Market Infrastructures” in 2012. The new standards harmonize the existing international standards for payment systems, central securities depositories, securities settlement systems, and central counterparties.

International Association of Deposit Insurers Historical Background The Working Group on Deposit Insurance, established by the Financial Stability Forum in 2000, issued its report on the guidance for establishing a deposit insurance system in September 2001. As a result, the International Association of Deposit Insurers (IADI)16 was founded on May 6, 2002, as a nonprofit organization, constituted under Swiss law.17 Deposit insurance is the indispensable component of the financial system safety net. Deposit protection plays a key role for maintaining depositor confidence. The financial crisis underscored the importance of maintaining that confidence. In June 2009, the IADI, together with the Basel Committee, developed the “Core Principles for Effective Deposit Insurance Systems” as a benchmark for countries to assess the quality of their deposit insurance systems (Basel Committee 16 17

IADI has 80 member organizations, 9 associates, and 13 partners. See details at International Association of Deposit Insurers n.d.

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on Banking Supervision and IADI 2009). The Core Principles are also used by the IMF and the World Bank in the context of the FSAP. In 2014, the IADI revised the Core Principles and merged the compliance assessment methodology into the document (IADI 2014a). The revised Core Principles addressed the need for operational independence of deposit insurers and provided them with additional tools. The revised Core Principles document has 16 principles (the number used to be 18) and 96 assessment criteria. The rapid growth pace of the Islamic financial services industry has increased the need for Islamic deposit insurance systems that work in accordance with Sharī’ah rules. This need is acknowledged by the IADI, but because the Core Principles do not specifically take into account Sharī’ah rules, a decision was made to adopt a separate set of IADI Core Principles for Effective Islamic Deposit Insurance Systems in collaboration with the relevant Islamic standard-setting bodies. The IADI thus published two discussion papers on Islamic deposit insurance in 2014: “Insurability of Islamic Deposit Investment Accounts” (IADI 2014a) and “Sharī’ah Approaches for the Implementation of Islamic Deposit Insurance Systems Discussion Paper” (IADI 2014c).

Islamic Banking General About 75 countries are more or less involved in Islamic finance throughout the world.18 The global Islamic finance industry has grown rapidly over the past decade. The annual growth rate was around 17 percent between 2009 and 2013 (Islamic Financial Services Board [IFSB] 2015b). The industry’s assets are worth around US$2 trillion (World Bank 2015). Legal environments for Islamic banking display great diversity among jurisdictions. The systemic importance of the Islamic banks is relatively higher in some predominantly Muslim countries such as Iran, Malaysia, Saudi Arabia, and Sudan. In most IFSB member countries, Islamic banking is developing alongside the conventional financial sector in dual system environments. The exceptions are Iran and Sudan, which have only Islamic banks. Islamic banking operations are substantially different from conventional banking. First, Islamic banks’ operations must not breach Sharī’ah law that prohibits interest gain, profit-making without real economic activity, and uncertainty. Furthermore, Islamic banking transactions are based mainly on real assets and centered on risk-sharing that is closely related to the real economy. These features expose Islamic banks to some unique risks such as Sharī’ah noncompliance risk,19

See also “List of Members: By Category” (IFSB n.d.-a). Sharī’ah noncompliance risk is the risk that arises from a bank’s failure to comply with the Shari’ah rules and principles determined by the Shari’ah board of the bank or relevant body in the jurisdiction in which the bank operates. 18 19

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displaced commercial risk,20 and equity investment risk.21 The special characteristics of Islamic banking, therefore, require specific regulation, supervision, resolution, monetary policy, liquidity management, and tax policy. Similar to conventional banks, a strong financial safety net, an effective crisis management, and a resolution framework applicable to Islamic banks will consequently contribute to financial stability and economic growth. Therefore, parallel standards, taking into consideration the special characteristics of Islamic finance, are crucial for the integration of Islamic finance into the global financial system and for overall financial stability.

Islamic Financial Services Board The IFSB was established in 2002 as an international standard-setting organization to promote and enhance the soundness and stability of the Islamic financial services industry by issuing global prudential standards on banking, capital markets, and insurance sectors. The IFSB works closely with relevant international, regional, and national organizations such as the IMF, the World Bank, the Basel Committee, and the International Association of Insurance Supervisors (IAIS). The IFSB sets new standards, adopts existing international standards that are consistent with Sharī’ah principles, or makes changes on these standards in line with Sharī’ah rules before their adoption. The IFSB’s work complements that of the Basel Committee, the IOSCO, and the IAIS. As of the end of 2015, the IFSB published 17 standards, 6 guidance notes, and 1 technical note (ISFB n.d.-b). These standards cover, among others, Sharī’ah Governance (IFSB-10 December 2009), Capital Adequacy (IFSB-15 December 2013), the Supervisory Review Process (IFSB-16 March 2014), and Core Principles for Islamic Finance Regulation (IFSB-17- April 2015).

Accounting and Auditing Organization for Islamic Financial Institutions The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is an Islamic international corporate body that prepares accounting, auditing, governance, ethics, and Sharī’ah standards for Islamic financial institutions and the industry (AAOIFI n.d.-a). The AAOIFI was established in accordance with the agreement signed by Islamic financial institutions on February 26, 1990, in Algiers. AAOIFI was registered on March 27, 1991, in Bahrain as an international autonomous nonprofit corporate body (AAOIFI n.d.-b).

An Islamic bank may donate a part of its profits to the investment account holders (to be able to give competitive returns), and the possibility of this donation is considered as “displaced commercial risk.” This is because initially the risk is to be borne by investment account holders, but it has been displaced over to the bank as it volunteers to do so. 21 The risk arises from entering into a partnership for the purpose of undertaking or participating in a particular financing or general business activity as described in the contract, and in which the provider of finance shares in the business risk. 20

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AAOIFI has 200 members from 40 countries, including central banks, Islamic financial institutions, and other participants from the international Islamic banking and finance industry worldwide. It develops new standards and reviews existing standards for Islamic financial institutions. AAOIFI has issued a total of 88 standards: 48 on Sharī’ah, 26 on accounting, 5 on auditing, 7 on governance, and 2 codes of ethics. So far, AAOIFI standards have been adopted by the Kingdom of Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan, and Syria. The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Saudi Arabia, and South Africa have issued guidelines that are based on AAOIFI’s standards and pronouncements (AAOIFI n.d.-a).

Implementation Challenges Implementation Monitoring International institutions and standard-setters have created different mechanisms to assess the implementation of the international financial standards.22 To this end, the Basel Committee established the Regulatory Consistency Assessment Programme in 2012 to monitor the timely adoption of Basel II, 2.5, and III.23 The FSB, on the other hand, was given the mandate of coordinating and promoting the implementation of agreed G20/FSB financial reforms.24 The “peer reviews” are the most intensive monitoring mechanism of the FSB.25 The IMF and World Bank assess the implementation of the international financial standards that they have endorsed, through the FSAP, and the results of these independent assessments are summarized in Reports on the Observance of Standards and Codes. To avoid overlaps between assessments, the FSB determines its topics of assessment in advance in consultation with the IMF and World Bank.26 The IMF, the World Bank, and the standard setters (FSB, Basel Committee on Banking Supervision, IADI, IOSCO, and IFSB) are increasingly devoting substantial time and resources to monitoring the implementation of the growing number of standards across the globe. The assessment process itself, on the other hand, harbors bidirectional challenges concerning both the implementers and assessors.27 In what follows, some of those challenges are analyzed under four

For the list of Key Standards see FSB n.d.-b and IMF 2002. See Basel Committee on Banking Supervision 2012, revised 2013 and 2016. 24 In this regard, see FSB 2011a. 25 There are two types of peer reviews: thematic reviews and country reviews. Thematic reviews focus on the implementation and effectiveness of standards across the FSB members. Country reviews focus on the implementation and effectiveness of regulatory, supervisory or other financial sector policies in achieving the desired outcomes in a specific FSB member jurisdiction. 26 For detailed information see FSB (2015), Standing Committee on Standard Implementation. 27 In this document the term “assessor” is used to define the assessors of international institutions such as the IMF and the World Bank, and the assessors of the standard setters such as the FSB, Basel Committee on Banking Supervision, IADI, IOSCO, IFSB, etc. 22 23

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headings: human resources, timely and consistent implementation, practical application of the standards, and the unique characteristics of Islamic banking.

Human Resources Sufficient and qualified human resources are the key to the full, consistent, and prompt implementation of the standards. Therefore, human resources are the most crucial assets of regulatory and supervisory institutions. The adoption of the prudent international standards requires, from the human resources perspective, a high level of language capability, sound knowledge, and expertise on economy, law, and accounting. The need for implementation of comprehensive regulatory reforms poses significant human resource challenges. One of the most important challenges for assessors and implementers during the adaptation process of the international standards into domestic law is the lack of competent human resources in many national authorities, which may lead to shortfalls and inconsistencies in implementation. Human resource constraints may also prevent supervisory authorities from delivering effective supervision. Thus, it is vital that the domestic team adopting international standards have a sufficient number of competent economists, lawyers, accountants, and information technology specialists. Assessors should check whether domestic institutions of the subject country have sufficient human resources with relevant skills, qualifications, and good grasp of the standards. To address this challenge, national regulatory authorities should invest more in their human resources and allocate adequate budgets to recruit and train a sufficient number of qualified staff. At this juncture, technical assistance provided by the assessors to the regulatory authorities would help improve the human capacity, reduce shortfalls, and achieve consistent application. Institutional structures of the regulatory and supervisory authorities may add another layer to the challenges for implementation. Countries employing the “functional approach” to banking supervision are likely to encounter more human resources– and communications-related problems.28 Division of limited human resources among several institutions may result in inefficient use of the total qualified human capacity at hand, which may also lead to collaboration difficulties among the staff of multiple supervisory authorities with different agendas. Even clear-cut regulations or memoranda of understanding mentioning close cooperation, coordination, and information-sharing may not be able to eliminate divergences in practice. Conflicts may arise particularly from disagreements about the extent of mandates of authorities. To address such conflicts, encouraging the adoption of the “twin peaks” or “integrated” approaches appears to be a viable

The “functional approach” is one in which supervisory oversight is determined by the business that is being transacted by the entity, without regard to its legal status. Each type of business may have its own functional regulator. 28

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option.29 This would also facilitate more effective consolidated supervision by eliminating overlap and duplication risks.

Timely and Consistent Implementation The success of the international financial standards depends primarily on their timely and globally consistent implementation, not least because of ever-growing linkages among economies. The risk of a financial crisis spilling over from one country to others renders timely and consistent implementation of the international standards vital—not only to improve the resilience of the global financial sector but also to level the playing field for all jurisdictions. Jurisdictions should therefore act to adopt international standards on time, and the assessors, for their part, should intensify efforts to maintain consistency of implementation.30 Because the adoption of the standards brings extra costs to the financial sector, and thus creates competitive disadvantages, countries are generally reluctant to be the first to implement them.

Practical Application of the Standards To ensure practical applicability of the adopted standards, the legal framework in each jurisdiction should be reviewed for possible hurdles. Compatibility of the implemented standards with other domestic regulations, such as the commercial law and bankruptcy law as well as the constitution, is crucial to achieving a healthy implementation. Because a substantial part of the tools and powers envisaged by the standards is designed to be used in extraordinary times (that is, when an individual bank or an entire banking system is in a significant stress), it may be difficult to know beforehand whether, or the extent to which, the standards can be applied in practice. Therefore, the practical applicability of the standards should be checked against the relevant regulations. It should be checked, for example, whether the commercial law allows companies to issue contingent bonds that can be qualified as additional Tier 1 and Tier 2 capital. A further solution could involve checking the property law and the constitution to see whether it is possible to override the rights of shareholders/creditors and to what extent the cooperation with foreign authorities is allowed. As a follow-up to this process of scrutiny, necessary amendments must be made to any regulations hindering the applicability of standards to achieve full The “twin peaks approach,” a form of regulation by objective, is one in which there is a separation of regulatory functions between two regulators: one that performs the safety and soundness supervision function, and the other focuses on conduct-of-business regulation. The “integrated approach” is one in which a single universal regulator conducts both safety and soundness oversight and conduct-of-business regulation for all the sectors of a financial services business. For a detailed account on the matter, see Group of Thirty 2008. 30 Even the use of national discretions can impair the comparability of implementation across jurisdictions. Therefore, the Basel Committee decided to eliminate certain discretions. See Basel Committee on Banking Supervision 2014. 29

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compliance and consistent application. Because there are so many jurisdictions, it is particularly challenging for assessors to identify inconsistencies among regulations within a jurisdiction. Therefore, domestic regulators should assess all relevant regulations, communicate with concerned state authorities for prospective amendments to facilitate the practical application, and report to the assessors accordingly.

The Unique Characteristics of Islamic Banking As mentioned previously, apart from Iran and Sudan, Islamic banks operate alongside conventional banks. In countries where Islamic banking is present, domestic regulatory and supervisory authorities as well as assessors should be aware of the special characteristics of Islamic banking operations and take them into account while regulating and supervising the market. The Islamic banking standards are likely to be more difficult to implement because of the lack of capacity in Islamic finance, or a lack of support at the political level for implementation. The biggest challenge for assessors and implementers, in this respect, is again building human capacity, but in this case the need for staff equipped with additional expert knowledge about and experience in Islamic finance comes to the fore (Casey 2015). To increase this capacity, domestic authorities and assessors should establish effective cooperation and collaboration channels with the Islamic standard-setting institutions. To be sure, some cooperation arrangements are already in place. The Bank for International Settlements and the World Bank are associate members of the IFSB (IFSB n.d.-a). The IMF staff, as well, participate in the activities of the IFSB. Furthermore, the Basel Committee, the IADI, and the IOSCO work closely with the IFSB in preparing new standards according to specific features of Islamic finance. The FSB also started to devote more attention to Islamic finance during Turkey’s G20 presidency in 2015 (Group of Twenty 2015). Yet the assessment of the implementation level of the Sharī’ah-compliant prudential standards remains a fundamental challenge. Integrating the assessment of Sharī’ah-compliant standards into the FSAP can be a solution. Collaboration of the IMF and World Bank with the Islamic standard-setters in assessment of Sharī’ah-compliant standards is of critical importance. Such cooperation and collaboration under the FSAP in countries where Islamic banks operate will help better integrate Islamic banking into the global surveillance framework and thereby contribute to the stability of the global financial system. The assessment of application of the Core Principles for Islamic Finance Regulation, for instance, could be conducted under the FSAP (ISFB 2015a). In this case, the IMF and World Bank would effectively collaborate with the IFSB in assessing the implementation of the Core Principles for Islamic Finance.31 On the other hand, because the Islamic standards have not been implemented widely, This collaboration can be similar to the Basel Committee’s collaboration with the IMF/World Bank in their monitoring of the implementation of the Committee’s prudential standards. 31

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and countries do not have the capacity or intention to put in place Sharī’ah-compliant frameworks for Islamic banks, the assessment against the Islamic core principles can be discretionary. Nevertheless, the Islamic Development Bank, the Islamic Research and Training Institute, the IFSB, and the International Islamic Financial Market—in collaboration with the IMF and World Bank—have taken some steps to supplement the FSAP with Islamic financial assessment.32 Within this context, an analysis of the gaps between the FSAP and the needs of Islamic financial sector was conducted. There is also a pilot Islamic FSAP project that is planned to be organized by the Islamic Development Bank in the near future. Last but not least, it is always possible for domestic regulatory and supervisory authorities to adopt the IFSB standards to better address the Islamic banks’ business models and conduct self-assessments.

CONCLUSION A resilient global financial system depends on sound financial regulation and supervision. The recent crisis, just as the previous ones, demonstrated that a financial crisis in one country can quickly cross borders and create global turbulence. The international standards developed on the basis of the lessons learned from the financial crisis should be implemented across the globe in order to fully realize the benefits. Institutional and prudential arrangements should be put in place to improve the resilience of banking sectors in the face of domestic or international financial crises. This primarily requires qualified and adequate human capital; timely, consistent, and practical implementation; and due consideration to the idiosyncratic characteristics of the Islamic banking.

REFERENCES Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). n.d.-a. “About AAOIFI.” http://aaoifi.com/about-aaoifi/?lang=en. ———. n.d.-b. “History.” http://aaoifi.com/our-history/?lang=en. Bank for International Settlements. 2015. “Committee on Payments and Market Infrastructures (CPMI)—Overview.” https://www.bis.org/cpmi. ———. 2014. “CPSS—New Charter and Renamed as Committee on Payments and Market Infrastructures.” http://www.bis.org/press/p140901.htm. Basel Committee on Banking Supervision. 2004. “International Convergence of Capital Measurement and Capital Standards, A Revised Framework.” http://www.bis.org/publ/ bcbs107.pdf. ———. 2009. “Revisions to the Basel II Market Risk Framework.” http://www.bis.org/publ/ bcbs158.pdf.

The Islamic Development Bank–World Bank Working Group on Islamic Finance met in Jeddah during January 2009. The Islamic Research and Training Institute and the Islamic Development Bank prepared a document entitled “Towards Developing a Template to Assess Islamic Financial Services Industry (IFSI) in the Bank-IMF Financial System Assessment Program (FSAP).” 32

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Chapter 15  International Efforts toward More Resilient Conventional

———. 2010 (revised 2011). “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems.” http://www.bis.org/publ/bcbs189.pdf. ———. 2012 (revised 2013 and 2016). “Basel III Regulatory Consistency Assessment Programme.” http://www.bis.org/publ/bcbs264.htm and http://www.bis.org/bcbs/publ/ d361.htm. ———. 2013. “Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools.” http://www.bis.org/publ/bcbs238.pdf. ———. 2014. “Basel Capital Framework National Discretions.” http://www.bis.org/bcbs/publ/ d297.pdf. ———. 2015. “Finalising Post-Crisis Reforms: An Update. A Report to G20 Leaders.” http://www.bis.org/bcbs/publ/d344.pdf. ———. 2016. “History of the Basel Committee.” http://www.bis.org/bcbs/history.pdf. ———, and International Association of Deposit Insurers (IADI). 2009. “Core Principles for Effective Deposit Insurance Systems.” http://www.bis.org/publ/bcbs156.pdf. Casey, Peter. 2015. “Comparative Study on the Implementation of Selected IFSB Standards.” Islamic Financial Services Board Working Paper 04/10/2015, Islamic Financial Services Board, Kuala Lumpur, Malaysia. Cohen, H. Rodgin. 2010. “Basel Committee Proposes Strengthening Bank Capital and Liquidity Regulation.” http://corpgov.law.harvard.edu/2010/01/07/basel-committee-proposesstrengthening-bank-capital-and-liquidity-regulation. Committee on Payment and Settlement Systems, Technical Committee of the International Organization of Securities Commissions. 2012. “Principles for Financial Market Infrastructures.” http://www.bis.org/cpmi/publ/d101a.pdf. Financial Stability Board (FSB). 2010. “Reducing the Moral Hazard Posed by Systemically Important Financial Institutions: FSB Recommendations and Time Lines.” http://www.fsb.org/ wp-content/uploads/r101111a.pdf. ———. 2011a. “A Coordination Framework for Monitoring the Implementation of Agreed G20/FSB Financial Reforms.” http://www.financialstabilityboard.org/wp-content/uploads/ r111017.pdf. ———. 2011b. “Key Attributes of Effective Resolution Regimes for Financial Institutions.” http://www.financialstabilityboard.org/wp-content/uploads/r111104cc.pdf. ———. 2014. “Key Attributes of Effective Resolution Regimes for Financial Institutions.” http://www.financialstabilityboard.org/wp-content/uploads/r141015.pdf. ———. 2015. “First Annual Report 28 January 2013–31 March 2014.” http://www.fsb.org/ wp-content/uploads/First-FSB-Annual-Report.pdf. ———. n.d.-a. “Addressing SIFIs.” https://www.fsb.org/work-of-the-fsb/implementationmonitoring/monitoring-of-priority-areas/addressing-sifis. ———. n.d.-b. “Key Standards for Sound Financial Systems.” http://www.fsb.org/what-we-do/ about-the-compendium-of-standards/key standards. ———, Standing Committee on Standard Implementation. 2015. “Handbook for FSB Peer Reviews.” http://www.financialstabilityboard.org/wp-content/uploads/FSB-Peer-ReviewHandbook-12-March-2015.pdf. Group of Thirty. 2008. “The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace.” http://www.group30.org/images/PDF/The%20Structure%20of%20 Financial%20Supervision.pdf. Group of Twenty. 2015. “Fact Sheet on the Antalya Summit Outcomes.” http://g20.org.tr/ fact-sheet-g20-antalya-summit-outcomes. International Association of Deposit Insurers (IADI). 2014a. “IADI Core Principles for Effective Deposit Insurance Systems.” http://www.iadi.org/docs/cprevised2014nov.pdf. ———. 2014b. “Insurability of Islamic Deposits and Investment Accounts.” https://www.iadi. org/en/assets/File/Papers/Approved%20Research%20-%20Discussion%20Papers/ Insurability_of_Islamic_Deposit_Investment_Accounts_publication-Nov_2014-FINAL.pdf.

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———. 2014c. “Sharī’ah Approaches for the Implementation of Islamic Deposit Insurance Systems: Discussion Paper.” http://www.iadi.org/docs/ShariahApproachesforIDIS-forpublication-Nov2014-FINAL.pdf. ———. n.d. “About IADI.” http://www.iadi.org/en/about-iadi. International Monetary Fund (IMF). 2002. “List of Standards, Codes and Principles Useful for Bank and Fund Operational Work and for Which Reports on the Observance of Standards and Codes Are Produced.” IMF, Washington, DC. http://www.imf.org/external/standards/ scnew.htm. ———. 2017. “Financial Sector Assessment Program (FSAP).” IMF, Washington, DC. http:// www.imf.org/external/np/fsap/fssa.aspx. Investopedia. 2019. “Value at Risk–VaR.” http://www.investopedia.com/terms/v/var.asp. Islamic Financial Services Board. 2015a. “IFSB-17 Core Principles for Islamic Finance Regulation (Banking Segment) (CPIFR).” http://www.ifsb.org/standard/IFSB-17%20 Core%20Principles%20for%20Islamic%20Finance%20Regulation%20(Banking%20 Segment)%20(December%202015)%20(final).pdf. ———. 2015b. |Islamic Financial Services Industry Stability Report.” http://www.ifsb.org/ docs/2015-05-20_IFSB%20Islamic%20Financial%20Services%20Industry%20 Stability%20Report%202015final.pdf. ———. n.d.-a. “List of Members: By Category.” http://www.ifsb.org/membership.php?id=2. ———. n.d.-b. “List of Published Standards.” http://www.ifsb.org/published.php. World Bank. 2015. “Islamic Finance.” World Bank, Washington, DC. http://www.worldbank. org/en/topic/financialsector/brief/islamic-finance.

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Seminar Summary: Discussion on Corporate Debt Sean Hagan, A. Unnikrishnan, Sijmen de Ranitz, Richard Gitlin, and Luis Méjan Panelists

The panel discussed how to design and implement an effective corporate workout framework, underlining that this is not only critical for economic growth but also for financial stability because of its connection with the reduction of nonperforming loans in the financial sector.

INTRODUCTION Mr. Hagan explained how designing and implementing a legal institutional framework for resolving corporate debt problems is not something that is typically associated with financial stability. The IMF gets involved in the context of a crisis, in which the priorities are focused on stabilizing the financial sector; adopting adequate fiscal, monetary, and exchange rate policies; and dealing with the financial sector in distress. Once stabilization is achieved, however, another problem arises: the crisis has left a large part of, or sometimes the entire, corporate sector on its knees for a variety of reasons. This problem is often not addressed ex ante because corporations, unlike commercial banks, are not subject to special regulation and supervision. This is a systemic problem because once stabilization is achieved, the next step is to try to reignite growth. If the entire corporate sector is in distress, and if corporations are not in a position to invest or employ because they are overwhelmed by debt, the problems will manifest in the banks, as levels of nonperforming loans (NPLs) begin to rise. Those NPLs impair banks’ abilities to provide credit to healthy Sean Hagan was General Counsel and Director of the Legal Department of the IMF. A. Unnikrishnan is Legal Advisor for the Reserve Bank of India. Sijmen de Ranitz is a lawyer for RESOR NV (The Netherlands). Richard Gitlin is Chairman of Gitlin & Company, LLC. Luis Méjan is a professor at the Law School of the Instituto Tecnológico Autónomo de México.



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companies—if there are any—precisely when it is most needed. This may even result in the NPLs rising to a level in which a second wave of banking distress brings more financial instability. A lesson from the financial crises is that the design of a framework for addressing systemic corporate debt distress is crucial at an early stage. Another lesson learned is that shortcomings of the corporate debt resolution framework can be a latent problem in an economy not yet in a crisis, but in which indebtedness of the corporate sector increases over time. It may manifest by rising levels of NPLs; in other cases, because the banks are nervous about the capital implications of NPLs, they disguise them by evergreening the loans. A number of emerging market economies are experiencing significant overindebtedness in the corporate sector. The design of frameworks that address this issue, in India, in China, or elsewhere, is becoming a critical priority.

RELATIONSHIPS BETWEEN SYSTEMIC CORPORATE DEBT, FINANCIAL STABILITY, AND ECONOMIC GROWTH Mr. Gitlin used the hypothetical example of a country whose companies have high levels of problem loans. The companies fall into two categories: (1) companies that have a future if they can be restructured (that is, companies that will be able to provide economic growth and create jobs if they are reorganized), and (2) companies that have no future (that is, they will never be able to make a profit, irrespective of any measures taken). These companies absorb huge economic assets but cannot invest or create jobs, so they deteriorate very quickly. The responsible course is to redeploy those assets to productive uses. Large amounts of assets are trapped in such companies, and it is important to get those assets back into productivity. Mr. Gitlin then discussed a systemic situation: Indonesia during the Asian financial crisis. The IMF provided assistance to Indonesian authorities in adjusting the macroeconomic policies. However, because of currency devaluation, the companies were unable to repay their debts, which for the most part were denominated in foreign currency. Almost every major company in Indonesia could not get capital and could not function. Unfortunately, Indonesia did not have a developed formal bankruptcy system with effective courts. Therefore, it was necessary to examine how commercial issues could be resolved in that environment; generally, parties did not use the courts—instead, senior persons, respected by both parties, were brought in to mediate. A government agency, the Jakarta Initiative, was created for effective mediation between the creditors and the corporate debtors. The approach required the creation of incentives and disincentives (carrots and sticks). To get the parties to make use of the agency, a government entity, the Jakarta Initiative Task Force, was created, including a regulatory vehicle to allow participants to get the necessary approvals and measures to resolve tax issues. A further incentive to use the system

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Seminar Summary: Discussion on Corporate Debt

was that if a company did not act in good faith, it could be referred to the attorney general’s office, which could file a bankruptcy petition against the firm. Thus, in this systemic situation a practical solution was found to get the economy back on its feet. Addressing the issue of the problem loans, particularly if they reach systemic levels, is critical. And it cannot be done by the private sector only; this requires the involvement of the central bank, the regulators, the legislature, and full cooperation among all parties to come up with a proper solution. Mr. de Ranitz analyzed the problem in the context of any economy, in which there are four layers, lowest to highest: (1) natural persons, (2) companies, (3) banks, and (4) the government. With regard to natural persons and companies, if there is a serious corporate debt overhang, companies will not be able to obtain new loans and invest. Employees’ spending behavior will be affected, and they may start saving due to fears of unemployment. The local economy deteriorates too. Although the number of NPLs will be increasing, banks will recognize these NPLs only if the regulator puts on pressure. Banks tend to avoid addressing problem loans. At the government layer, employees, companies, and banks will generate less income and profits, resulting in a decrease of taxable income across the board. As soon as the number of NPLs increases, something should be done because the longer the wait, the more serious the problem will be. If something changes in one layer, it will have a direct effect on all the others. For example, if an insolvency law was created to allow natural persons to obtain a fresh start after one or two years, it could have a direct effect on the banks unless legislation includes measures to avoid fraud and abuse. Mr. Méjan discussed the cost of not dealing with these issues proactively. In the 1990s, the insolvency regime in Mexico was not performing well and did not help the corporations deal with their NPLs. The government decided to create new legislation to address the issue that insolvency is not only a problem of the debtor with their creditors but also an issue that involves the debtor, creditors, employees, and the government. The debtors as entrepreneurs invest their money in the business and want to recover their money to be able to reinvest; creditors are in a similar position. Because a bank or several banks are usually among the creditors, financial authorities need to consider the problems of the insolvent company. Suppliers and clients of the company also suffer the impact of insolvency, as does the government, through lost tax revenue. Insolvency is a holistic problem: When there is a crisis, insolvency problems often arise two or three years later when the firms suffer the consequences. Thus it is important to create a regime that deals with this particular outcome. Mr. Unnikrishnan explained that the problem arises when lenders have to lend to unviable companies, the money is tied down, and lenders cannot use their funds for productive uses. Borrowers suffer if they do not receive timely assistance to rehabilitate or improve their businesses. With an absence of certainty in the legal regime leading to an insolvency regime, and in the actions to be taken, there has

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to be legal certainty and clarity regarding the outcome in case the borrower fails to repay. For example, India has a fragmented and antiquated insolvency legislation. A new bankruptcy code is being discussed in Parliament, addressing both personal and corporate insolvency, and there is a bill regulating the insolvency of financial institutions. Mr. Hagan summarized that systemic corporate indebtedness, before, during, or after a crisis—or without a crisis—can have knock-on effects unless it is properly addressed.

CONVERGENCE IN INSOLVENCY LAWS AND DESIGN OF OUT-OF-COURT PROCEDURES Mr. Hagan discussed the convergence of insolvency laws across the world and of the role the government should play in out-of-court procedures in the context of corporate restructuring. Mr. Gitlin explained that with an effective insolvency system, companies can be swiftly liquidated or restructured, as in the United States. The more efficient the insolvency system, the quicker the economic recovery will be. For example, some US oil fracking companies have filed for Chapter 11 proceedings and are restructuring their debt to become more competitive. They will emerge stronger after this crisis. Thus, with an insolvency system that can address troubled companies quickly, some companies will be liquidated and some will be restructured, but those companies that are effectively restructured will be ready to compete. There are four reasons for developing an out-of-court system: (1) it is faster, and speed is essential; (2) it is less costly; (3) there is less publicity, and publicity is harmful to companies in distress; and (4) it may be essential to use out-of-court procedures if the formal system does not work well. There are general principles for out-of-court restructuring, such as the ones adopted by the International Association of Restructuring, Insolvency and Bankruptcy Professionals, which are based on common sense: a stay of proceedings, provision of information, and creditor engagement in negotiations. The problem with an out-of-court approach is that without special legislation, creditors must achieve 100 percent consensus, which makes it very difficult to reach an agreement. Therefore, in some cases, special statutes have been passed to avoid this requirement. These hybrid systems allow most of the restructuring work to be completed out of court, with minimal court intervention. Every out-of-court restructuring law is different and must address the characteristics of each country. Mr. Gitlin cited examples in Australia, France, the United Kingdom, and the United States. There is no one-size-fits-all formula, but the marrying of an out-of-court negotiation with a court procedure to keep it efficient is a valuable option. Mr. de Ranitz stated that there is not much convergence in formal insolvency laws because insolvency systems reflect political choices. Certain countries want to protect employees at any price, whereas other countries want to protect the

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financial sector by granting security rights and quick ways of foreclosure. Thus harmonization focuses more on procedural aspects than on the substantive insolvency law. Insolvency laws are necessary, but an institutional framework is also required, that is, courts that understand insolvency, and efficient and reliable insolvency practitioners. Out-of-court restructuring is an attractive option not only when the insolvency law is deficient, but also when the courts are deficient. If the outcome under insolvency law is clear, there is no point in spending resources on legal advisors and court fees to arrive at the predicted result. A predictable insolvency system may take the burden away from the overburdened courts. Mr. Hagan explained that the predictability of the insolvency system is critical to an out-of-court framework because it defines parties’ leverage. If the outcomes are not clear, parties will be less willing to negotiate. Mr. Méjan discussed critical features of insolvency law in Mexico. There have been very few insolvency cases under the new Mexican regime, only about 700 cases, which is low considering the high number of companies in the nation. Out of those cases, 35 percent were solved through reorganization, including some large, cross-border cases, which are cited as precedent in international insolvency law. Key features of the new Mexican insolvency law focus on maximizing the value of the enterprise, either through reorganization or liquidation. This shift in focus is important for financial and judicial authorities. Other key features are the reduction in time of the proceedings, transparency, and predictability. The law incorporated the prepackaged reorganization plan at a later date, and it has been a success. Since the introduction of these amendments, almost all insolvency cases have used the prepack system: the debtor and most of the creditors decide on the reorganization plan and bring it through the insolvency system. It is a hybrid system, rather than an out-of-court procedure, which reduces litigation and procedural complexities. Mr. Unnikrishnan discussed regulation of the financial sector during general corporate distress. In a systemic corporate distress situation, there may be a market failure affecting restructuring. Debtors do not necessarily want to restructure their debt because they hope that there will be future concessions. Creditors adopt a similar attitude: banks avoid restructuring in the hope of an economic turnaround and because it may imply writing down their claims, with the corresponding impact on their capital. The primary role of the state is to provide a legal framework that enables a settlement and mediation and incentives for out-of-court settlements. However, Mr. Unnikrishnan indicated that out-of-court arbitration can be more expensive than judicial processes. Another problem of out-of-court restructuring is that bankers’ concessions can lead to liability, which is a serious concern. Mr. Hagan pointed out that one basic principle for both bank resolution and corporate insolvency is the “no creditor worse off than in liquidation” principle: in a reorganization, no creditor should be in a worse position than in a liquidation. Even with that principle in mind, there are jurisdictions in which certain creditors, especially

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state-owned banks, prefer to liquidate rather than reach a settlement, because of the concerns about potential liability. Mr. Gitlin mentioned the problem of officials who provide favorable treatment to politically connected borrowers. The issue of liability, however, was a powerful deterrent to efficient debt restructuring agreements, particularly in India, and may require a special legislative intervention. Another strategy is to move the bad loans to an asset management company, subject to a special legal regime. In Mr. Gitlin’s view, this is a good vehicle to involve professionals to deal with debt restructuring, under the protection provided by the special law. Mr. de Ranitz discussed how to involve banks in the negotiation process. Financial creditors are generally in a strong position and are willing to negotiate, whereas suppliers do not play a significant role. Suppliers are more interested in keeping the borrower as a client than in the full recovery of their past claims—but banks need to recover their loans. It is important to protect secured creditors in insolvency and their rights to enforce on their collateral after a specified stay period in insolvency. The protection of secured credit is fundamental to promote access to finance and economic growth. Mr. Hagan pointed out the need to ensure an efficient credit enforcement mechanism, because this increases the availability of credit for the benefit of society. There is a strong correlation between efficient credit enforcement mechanisms and the price of credit. Mr. Méjan discussed the correlation between the cost of credit, efficiency, and debt enforcement, and the issue of regulatory forbearance. The banking sector supports the development of a strong insolvency regime because it makes it possible to lend money with the confidence that it may be recovered if problems arise. From the regulatory perspective, Mr. Méjan cited postpetition financing of companies under reorganization in Mexico, in which the regulatory framework was modified to promote these transactions. Mr. Unnikrishnan explained the motivation and the key features of the new Indian law in connection with the position of financial regulators. India did not have a comprehensive bankruptcy law; individual and partnership bankruptcies were covered by antiquated legislation. Companies are regulated by the Company Act of 2013, which does not include insolvency provisions. Special legislation exists for industrial companies, but this law is not general. Legal procedures are complemented by Reserve Bank guidelines on corporate debt restructuring (Corporate Debt Restructuring Guidelines and Strategic Debt Restructuring). The situation is far from satisfactory, because there is no certainty, clarity, or single applicable law. The new bankruptcy law will provide a comprehensive regime for corporate insolvency, with important influence from US bankruptcy law. Insolvency professionals’ participation in all processes, and the key role of financial creditors in taking a decision on companies’ viability, are defining the new law’s characteristics. The new law also introduces specialized courts to deal with corporate and household insolvency. Mr. Gitlin discussed two ways in which the government could intervene. First, it can develop a secondary market in distressed debt. This would allow banks to

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Seminar Summary: Discussion on Corporate Debt

receive a payment for their loans right away—without having to go through a long restructuring process—so they can use the funds for new lending. The entities buying distressed debt at a discount have more flexibility in finding restructuring solutions. In Japan, a public fund was created to acquire distressed debt. The second example refers to companies that are extremely important for the national economy, such as Chrysler and General Motors. If there is a lack of private funding, the state may have to provide funding to support the restructuring of critical industries. The playbook needs to be adapted to changing circumstances to find creative solutions to address new problems. Mr. de Ranitz stated that in exceptional circumstances, governments sometimes have to act, even if these acts are not basically in line with the laws. For example, the government of the Netherlands bought ABN Amro overnight— without a shareholders’ meeting and without involvement of the supervisory board. Governments should consider their tax laws when they discuss corporate restructuring, because in some countries debt forgiveness will be taxed as profit by the company and will result in a disincentive for the restructuring process.

QUESTIONS FROM AUDIENCE Questions were taken from the audience, covering the following: (1) determination of viability of a company; (2) influence of corporate insolvency over financial resolution frameworks; (3) role of professional creditors in enabling successful restructuring, including the use of a code of conduct for debt restructuring; (4) regime for the liability of directors and managers; (5) tax implications of debt restructuring; and (6) dividing line between restructuring and liquidation. Panelists answered in no particular order. Mr. Gitlin indicated that the use of explicit financial ratios to determine the viability of companies is not recommended, since these ratios fail to capture the circumstances of each company. He favored the use of detailed professional reports to analyze viability. Regarding the liability of managers, he noted a traditional approach, exemplified by the traditional English system, which seeks to punish managers and displace them in the event of the insolvency of the company, and a second approach, which is less destructive of value, based on taking advantage of the potential for rehabilitation provided by the skills of the incumbent managers, which in turn fosters entrepreneurship. This is the approach in the United States, and it is influencing other countries, including the United Kingdom. This approach does imply that fraudulent managers are not punished, and managers who were simply unsuccessful in business should not be punished for that reason in insolvency proceedings. Mr. de Ranitz also commented on corruption and fraud. In his view, insolvency law is not the best instrument to fight fraud. This should be done through criminal law, maybe punishing directors for stealing assets or engaging in wrongful trading, but this should not become a dominant feature of insolvency law. Regarding the participation of tax authorities in restructuring, the law should

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define conditions under which the tax authority will accept a debt restructuring proposal. On the position of managers, he agreed that bringing in outside professionals to manage the business has disadvantages, and the professionals may be reluctant to accept these engagements for fear of liability, despite the availability of insurance coverage. On the question of whether to restructure or liquidate, he recommended looking carefully at the company and deciding whether it is better to preserve the existing organization or to sell the business as a going concern, as in English prepackaged administrations. Mr. Méjan supported the idea that insolvency law is not criminal law. Although criminal law elements are in the origins of insolvency law, it has proven to be a strong deterrent in using the insolvency system. He addressed the question of the dividing line between restructuring and insolvency: insolvency is defined by the debtor’s inability to pay its debts, and the question about whether to reorganize or liquidate the enterprise is subsequent to the determination of insolvency. The decision about the viability of the business is a key question in the insolvency proceeding, and the assistance of insolvency professionals helps the creditors, debtor, and court in taking that decision. An additional question is the treatment of shareholders in the reorganization of companies; country systems adopt different approaches in this area. The US approach of treating shareholders as residual claimants under the absolute priority rule is an interesting approach to determine the value of shareholders’ rights. Regarding the criteria for defining insolvency, Mr. Unnikrishnan considered that they must be easy to assess. On the question about whether to restructure or liquidate, financial creditors should have the final decision. Regarding the liability of managers, almost all legal systems have provisions to tackle fraudulent behavior, but he warned against the risk of applying these provisions to actions taken in good faith, because they may deter managers from taking decisions. In his closing remarks, Mr. Hagan mentioned the importance of tackling corporate debt issues early for the adjustment process to be less severe. One of the consequences of strict liability is that company directors and managers will wait because of the concern that if they file, they will be liable. Thus, one of the consequences is delayed filings. The decision on viability must be taken in the context of a creditor-driven process. If liabilities exceed the value of the assets, shareholders are effectively wiped out, and creditors are left to determine whether to liquidate or to rehabilitate, according to their assessment of the returns of the liquidation versus the reorganization of the company. After that, he thanked the panel and the audience for the discussion.

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VII RECENT TRENDS IN FINANCIAL SECTOR REGULATION: THE PROBLEM OF DE-RISKING

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CHAPTER 16

Pressures on Correspondent Banking: Impact, Drivers, and Responses Yan Liu and Francisca Fernando

INTRODUCTION Correspondent banking is a cornerstone of global trade and economic activity. In today’s highly connected economic world, correspondent banking helps to facilitate cross-border flow of goods and services, and it supports economic growth through international trade and cross-border financial activity. In many emerging markets and low-income countries, correspondent banking services help promote financial inclusion by assisting cross-border remittances and aid flows. According to the Society for Worldwide Interbank Financial Telecommunications (SWIFT), about 7,000 banks use the SWIFT network for correspondent banking and have more than 1  million individual correspondent banking relationships (CBRs).1 Without these relationships, businesses may be cut off from international trade and financing, families may be unable to collect remittances from relatives working abroad, and foreign investors may be unwilling to invest if there is a risk that they will be unable to repatriate their profits. So, what is a correspondent banking relationship? By way of example, a company in Barbados wants to send $100,000 to another company in Jamaica to pay for the import of goods. Given that they transact in US dollars, the banks of the companies in each country will have to use intermediaries: other banks connected to the US Federal Reserve System. These intermediaries, which tend to be global banks, are called correspondent banks. The banks of the companies in Barbados and in Jamaica are called respondent banks. In a correspondent banking arrangement, a correspondent bank provides a deposit account or other liability account and a range of services to a respondent bank and its customers. The arrangement requires an exchange of messages between banks to settle transactions by crediting

Yan Liu is Assistant General Counsel and Francisca Fernando is Counsel, both in the Legal Department of the IMF. The views expressed in this chapter are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 1

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or debiting accounts. These messages could be associated with payments, trade finance, foreign exchange, or securities transactions. Correspondent banking services can be provided in three main forms: (1) correspondent accounts in which a respondent bank enters into an agreement with a correspondent bank to execute payment on its behalf and on behalf of its direct customers; (2) nested accounts involving the use of a CBR by a respondent bank’s immediate customers for their clients; and (3) payable through accounts in which a respondent bank allows its customers to access its correspondent bank directly to conduct business. Correspondent banking services can also support the channeling of small payments that have been aggregated by money transfer operators. In recent years, CBRs have been under pressure in some countries and regions. Surveys and analysis conducted by multilateral and regional bodies point to countries in the Caribbean, Middle East and North Africa (MENA), Sub-Saharan Africa regions, and the Pacific region, and especially small and fragile states, as particularly affected by this phenomenon. These regions have experienced a decline in CBRs, raising concerns about potential implications on the financial systems, remittances, and financial inclusion if these trends continue. These surveys also reveal the multitude of interrelated factors behind this phenomenon, although they vary case by case. To address these concerns, there have been intensified efforts at the international, regional, and country levels to deepen the understanding of issues related to CBRs, develop policy responses, and identify actionable industry solutions. This chapter focuses on the effect of CBR pressures, its main drivers, and coordinated efforts to tackle CBR pressures.

TRENDS AND IMPACT The decline in correspondent banking varies among several regions, reflecting a complex set of economic, financial, and geopolitical concerns. In early 2015, some countries reported large-scale terminations of CBRs, but at the time quantitative data were not available on payment flows associated with correspondent banking. Several perception-based surveys, conducted by multilateral and regional bodies, reflect on the extent of this phenomena, including to try to ascertain the possible impact and the factors driving these terminations and restrictions on CBRs. These surveys suggest that the impact was felt more acutely in certain regions and had affected certain types of business lines, financial services, and categories of customers more than others.2

2 This chapter refers to a number of global and regional perception-based surveys. Since the time of writing this article, many more such surveys have been conducted by various institutions. This article refers to a few of these only.

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Chapter 16  Pressures on Correspondent Banking Impact, Drivers, and Responses

Global Perception-Based Surveys The World Bank conducted one of the first global perception-based surveys in 2015. It surveyed 110 banking authorities, 20 global banks, and 170 local and regional banks across all regions. The survey notes that CBRs were declining in some regions, with the Caribbean as the most affected region. In particular, small jurisdictions with low business volumes and transactions in Europe, Central Asia, the Caribbean, and Africa; countries perceived as high-risk jurisdictions for money laundering and terrorist financing; and countries with significant offshore banking activities and jurisdictions subject to international and bilateral sanctions faced a decline in CBRs. Banking products and financial services were affected, notably for check clearing, clearing and settlement, cash management services, international wire transfers, and trade finance. The survey also notes that certain categories of customers were more affected than others, particularly money transfer operators and other remittance companies, small and medium domestic banks, and small and medium exporters (World Bank 2015).

Regional Perception-Based Surveys Since then, a number of regional surveys have also been carried out that focus on regional trends, including in the Caribbean, MENA, Asia and Pacific, and Sub-Saharan Africa regions. Three major surveys took place in the Caribbean in 2016. The Caribbean Association of Banks survey, which covered 38 banks from 18 jurisdictions, notes that more than half the banks (58  percent) had lost at least one CBR, with Suriname, Guyana, and Jamaica as the most affected jurisdictions (CAB 2016). A report by the Caribbean Community, which compiled country surveyed information, highlights that the impact varied between different businesses depending on the country context. For example, in Jamaica, money service businesses, or cambios, were the most affected; in The Bahamas, Cayman Islands, and Turks and Caicos Islands, money transfer businesses were more affected. The survey notes that international business companies were most impacted within the Eastern Caribbean Currency Union (CARICOM 2016). The Association of Supervisors of Banks of the Americas survey received responses from 25 of its associate members in Latin America and the Caribbean. In line with findings of other surveys, the report notes that the Caribbean region was more affected than Latin America and notes the possible impact of these trends on emerging markets (ASBA 2016). IMF staff also conducted a survey in September 2016 with central banking authorities and commercial banks in the Caribbean. The survey findings reiterate that international wire transfer services and high-risk sectors, such as offshore financial services and gaming, were the most affected. When replacements were found or relationships maintained, they came with additional restrictions and higher fees (Alleyne and others 2017). In the MENA region, the Union of Arab Banks carried out a survey with the IMF in 2015. The survey finds 40 percent of the banks reporting that their CBRs

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had become more demanding, time-consuming, complex, and more expensive to maintain. The report examines Anti–Money Laundering/Combating the Financing of Terrorism Controls—a key driver of pressures on these relationships. It also looks at the impact of the Basel III prudential regulations, and the US Foreign Account Tax Compliance Act requirements on banking relationships, in particular with the increasing cost of compliance (IMF and UAB 2015). In 2016, the Arab Monetary Fund, IMF, and World Bank conducted a survey to assess to what extent Arab banks had seen terminations and restrictions of CBRs between 2012 and 2015. Roughly 39  percent of survey respondents from 17 Arab countries indicated a significant decline in the scale and breadth of CBRs. Banks noted that their ability to conduct foreign currency–denominated transactions, especially in US dollars and euros, were affected (Arab Monetary Fund, International Monetary Fund, and World Bank 2016). The IMF carried out a survey of small states in the Asian and Pacific region in 2016. Survey responses suggest that countries were increasingly under pressure to maintain CBRs and experienced issues with the repatriation of remittances. This led to the account closure of money transfer operators in smaller states such as Fiji, Samoa, and Tonga and closure of money transfer operators in Australia and New Zealand (Alwazir and others 2017). In August 2015, the Australian government’s financial intelligence agency, the Australian Transaction Reports and Analysis Center, carried out a more in-depth analysis of the impact on the remittances sector. This survey focused on the largest remittance network providers and their more than 5,000 affiliates. Analysis of reporting on remittance flows to the Center showed no significant change in the overall remittances sector in terms of volume of transactions or the actual dollar value of funds flow, despite providers and affiliates facing terminations and increased pressures (AUSTRAC 2015). In September 2017, the Eastern and Southern African Anti-Money Laundering Group conducted a survey in Sub-Saharan Africa. It was circulated to all 18 of its member countries and targeted a broad range of public and private sector stakeholders, including from the banking, insurance, securities, co-operative societies, money or value transfer services, and foreign bureau sectors (ESAAMLG 2017). Forty percent of respondent banks surveyed noted that they had faced terminations of their CBRs. Kenya, Mauritius, and South Africa were among the countries most affected. Notably, pressures on CBRs had affected money or value transfer services and in some countries, the casino sector, foreign exchange bureaus, and nonprofit organizations (NPOs).3 An International Finance Cooperation survey in 2017 of more than 300 of its banking clients in 92 countries suggests that more than a quarter of the survey participants saw reductions in CBRs. Survey results show that Sub-Saharan Africa, Latin America and the Caribbean, Europe, and Central Asia reported declining correspondent banking networks with the greatest frequency. Those 3 In addition to regional-specific surveys, some sector-specific reports have focused more specifically on the lack of access to financial services by NPOs in general. A report by Eckert, Guinane, and Hall (2017) indicates that two-thirds of US-based NPOs faced problems in accessing financial services.

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most affected by CBR terminations were non–oil-exporting countries, import-dependent countries, countries with lower total imports, countries with smaller GDP, unrated countries, smaller banks by total assets and equity, and higher risk banks (IFC 2017). Recognizing that these surveys are mostly perception based, the Financial Stability Board (FSB) stepped up its efforts to monitor trends in data with respect to correspondent banking. The FSB reached an agreement with the SWIFT to use data on SWIFT payment messages to analyze trends in correspondent banking. Given that SWIFT is the most commonly used standard for cross-border payments, it is presumed that SWIFT data cover a significant part of global correspondent banking activity and would therefore provide the most comprehensive dataset to assess trends in CBRs. The Committee on Payments and Market Infrastructure (CPMI) published a report in 2016 using aggregated country-level SWIFT data from 2011 to 2015. The data show that the overall volume of payments (that is, the total number of payment messages sent) increased between 2011 and 2015, but the overall value of the payments sent and the number of active correspondents (that is, the number of banks that sent or received messages in each corridor) declined from 2011, suggesting possible increased concentration of correspondent banking activities (CPMI 2016). FSB (2017) updated the country-level data. In addition to using the SWIFT data, the FSB carried out a survey of 345 banks in 48 jurisdictions, focusing on CBRs between January 2011 and June 2016. The data and survey suggest that the decline in CBRs continued in 2016, with higher rates of decline observed in the Caribbean and among small states in the Pacific (FSB 2017). In March 2018, the FSB released updated data on CBRs, taking into account midyear data for 2017. The updated data show that the decline in the total number of active correspondents continued into the first half of 2017 with regional variations. There was an increase in the number of active corridors for Oceania, Eastern Europe, and North America, while the rest of the Americas and Europe as well as Africa and Asia continued to experience declines. Since then, the FSB published additional updated datasets in March 2018 (FSB 2018a) and November 2018 (FSB 2018b). Most recently, the CPMI released the most up to date quantitative review of correspondent banking data in May 2019, reflecting SWIFT data from 2012 to 2018. The CPMI reports that globally the number of CBRs have shrunk by 20 percent over the past seven years. As before it was recognized that the decline was more pronounced in certain regions—for example, the Americas (excluding North America) where there has been a 30 percent decline of active CBRs since 2012. Going forward, the CPMI will continue to publish an annual quantitative review of SWIFT data for the next five years. (CPMI 2019) The IMF has been monitoring trends, risks, and drivers in the context of its work on surveillance, financial sector assessment programs, and capacity building. These issues are discussed in the context of IMF’s Article IV consultations with its member countries, especially when these issues could have a macro-critical impact on a country’s economy, or when authorities request to discuss them. Where

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available, IMF country teams have been trying to collect data on trends and assess impact. For example, in Belize, at some point, only two of the 10 domestic banks had CBRs with full banking services. In Angola, by 2015, all commercial banks had lost their direct CBRs with US correspondent banks. In Liberia, all commercial banks had lost at least one CBR, with the most affected losing about 78 percent of their CBR accounts. In the Bahamas, a survey by the Central Bank in 2016 notes that 26  percent of respondents faced restrictions or terminations of at least one CBR.4 Despite these trends in CBR withdrawal or reduction in some countries, macroeconomic consequences of this phenomenon at a global level have not materialized. This is particularly due to banks’ ability to find replacements or alternative arrangements for the payment flows. The IMF Policy Paper on Recent Trends in Correspondent Banking Relationships—Further Consideration (IMF 2017b) indicates that cross-border payments have generally remained stable, and economic activity has been largely unaffected. However, it stresses that in a limited number of countries, particularly small and fragile states, there has been a concentration of cross-border flows through fewer CBRs or alternative arrangements. Such concentration could attenuate financial fragilities in these countries, pose financial stability risks, and undermine growth and financial inclusion prospects by increasing costs of financial services. In addition, the search for alternative arrangements, particularly for remittances, could push the transactions to informal channels, reducing the ability of the authorities and banks to monitor and mitigate risks.

DRIVERS BEHIND CBR PRESSURES The phenomenon of CBR withdrawal or reduction has many dimensions, and its drivers vary. Pressures on CBRs typically reflects banks’ individual business decisions based on an assessment of the profitability and risks of the relationships, and often concerns correspondent banks’ lack of confidence in respondent banks’ capacity to effectively manage risks. In general, high volume, low return, and balance sheet intensive business lines such as correspondent banking have become less attractive since the global financial crisis. Global regulatory reforms have entailed a significant increase in banks’ capital requirements, raising the cost of capital. Worldwide, authorities have enhanced regulation to address concerns about tax evasion and combat money laundering and the financing of terrorism, and to expand international and bilateral economic and trade sanction regimes. These changes have resulted in increased compliance costs for banks, which in turn may have unintended consequences of making CBRs costlier and less attractive to global banks. More

4 See IMF staff reports for Belize (IMF 2017a), Angola (IMF 2016a), Liberia (IMF 2016b), and the Bahamas (IMF 2017c).

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recently, there has been a focus on drivers like corruption. Compliance costs could further increase because of measures aimed at safeguarding against cyber risks. Changes in the regulatory environment, including the Financial Action Task Force’s (FATF’s) international standards on anti–money laundering/combating the financing of terrorism in 2012, have focused on a risk-based approach. Banks are required to adopt a risk-based approach toward their customers, including to implement due diligence measures commensurate with customers’ money-laundering and terrorist-financing risk profile. In determining whether to maintain or terminate a CBR, global banks consider the regulatory environment in which the respondent bank is operating, the country’s or region’s risk, and the respondent bank’s size, customer base, business model, and risk management framework. When smaller respondent banks have a business model that services higher risk customers, such as the offshore sector or online gaming, the global bank will need to first satisfy itself that the bank has the sufficient capacity to manage those risks. A global bank’s decision to withdraw CBRs is subject to its risk tolerance policies. In recent years, several global banks have been subjected to enforcement actions and hefty fines, in particular by US regulatory authorities. According to data from Boston Consulting Group, banks globally have paid $321  billion in fines since 2008 for regulatory and trade and economic violations.5 These are mainly enforcement actions for misconduct or criminal behavior by global banks, in particular for violations of economic and trade sanctions, banking secrecy laws, and anti–money laundering/combating the financing of terrorism regulations. Some of these banks have signed nonprosecution and deferred-prosecution agreements, which are voluntary agreements between the bank and the regulatory authorities to undertake certain remedial actions in exchange for not being subjected to full enforcement procedures or to delay such procedures. Accordingly, these banks have taken steps to curtail and monitor financial services in line with these agreements, some of which may go beyond the regulatory requirements. This changing regulatory and enforcement landscape has affected other banks’ risk tolerance policies as well. Although the agreements are not normative instruments, other banks have studied them to better understand regulatory expectations. In some cases, this has led to a risk-averse attitude on the part of banks in conducting financial services. As the surveys and the IMF’s work on these issues have indicated, there are common drivers within regions. For example, in the Caribbean, one of the most affected regions, global correspondent banks are concerned with respondent banks’ capacities to manage risks, especially regarding high-risk business lines such as offshore and gaming sectors. In addition, many of these are in small 5 For example, BNP Paribas was fined $8.97 billion by US authorities in 2015 for violating US economic sanctions against Cuba; the Islamic Republic of Iran; and South Sudan. HSBC was fined $1.92  billion in 2012 for violating US economic sanctions against Cuba; the, Islamic Republic of Iran; Libya; Myanmar; and South Sudan. HSBC also violated US anti-money laundering regulations. Commerzbank AG was fined $1.45 billion in 2015 for violating US economic sanctions against the Islamic Republic of Iran and South Sudan.

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jurisdictions and whose low volume transactions do not make it profitable or justifiable to maintain the increased compliance costs. In the Pacific, remittance flows have been affected, driven by correspondent banks’ concerns about risks associated the capacity of money transfer operators to carry out proper due diligence on their customers. In the MENA region, countries under economic and trade sanctions, such as the Islamic Republic of Iran and South Sudan, have been affected because correspondent banks’ concerns over enforcement actions have led to more risk-averse policies.

POLICY RESPONSES AND INDUSTRY SOLUTIONS Given the multitude of drivers, there is no silver bullet to address CBR pressures, and solutions need to be tailored to the circumstances of an affected country or region. Efforts at the multilateral, regional, and national levels have deepened the understanding of the phenomenon to develop responses. The IMF, World Bank, and FSB, in collaboration with other international and regional organizations, have facilitated international dialogue among stakeholders on policy responses and industry solutions. For example, the IMF held regional roundtables in the Caribbean (2017, 2018, 2019), the MENA region (2016, 2017), the Pacific region (2018, 2019), and Central Asia (2018), and Africa (2018, 2019). These events gathered global and respondent banks and other stakeholders to identify solutions. The FSB adopted a four-point action plan in 2015 to tackle the decline in correspondent banking through (1) examining the dimensions and implications of the issue, (2) clarifying regulatory expectations, (3) strengthening domestic capacity building in jurisdictions with affected respondent banks, and (4) enhancing tools for due diligence by correspondent banks (FSB 2015). The FATF, the international standard setter on anti–money laundering/combating the financing of terrorism, has made efforts to ensure that the application of a robust framework on that issue does not lead to an indiscriminate withdrawal of CBRs. National authorities have clarified regulatory expectations and strengthened their regulatory and supervisory frameworks on issues including anti–money laundering/combating the financing of terrorism. The private sector has developed and implemented market-based solutions to reduce compliance costs and increase the efficiency of CBRs. Policy responses and industry initiatives have been proposed, and some have been implemented. Some measures address underlying drivers, including the following: • Enhance communication among banks to build trust. • Strengthen respondent banks’ capacity to manage risks. • Improve legal and regulatory frameworks and implementation in affected jurisdictions. • Clarify international standards by FATF and regulatory expectations by home regulators of global banks.

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• Harmonize regional regulatory frameworks. • Remove impediments to information sharing. • Use Know Your Customer utilities and Legal Entity Identifier. • Improve payment messages and Fintech solutions to improve the quality of information and facilitate due diligence processes. • Bundle banking products and set volume or risk-based pricing to reduce compliance costs and increase profit margins. • Consolidate transactional traffic by channeling the transactions of several banks through an intermediary bank. Other measures help contain and mitigate the impact of CBR withdrawal and reduction. They provide alternative arrangements to facilitate cross-border payments and transfers, including remittances these include establishing or enhancing the use of existing regional payment and clearing systems.6 These measures vary in the utility, feasibility, and implementation timeframe. Stakeholders— especially certain correspondent and respondent banks—consider some of the preceding measures as having an impact on tackling the CBR phenomenon across regions, and good progress has been made on their implementation. Enhancing communication between global and respondent banks is key to building trust, fostering a common understanding of risks, and helping to identify solutions. Communication needs to be a two-way stream. Correspondent banks should clearly communicate their risk-tolerance policies and expectations. For example, some global banks have issued policy statements on transactions considered high-risk. Respondent banks should explain their risk-management frameworks and practices, and communicate their efforts to enhance their compliance programs. Greater communication would allow global banks to provide opportunities for remediation to the extent that deficiencies in respondent banks’ compliance system are identified, thereby avoiding immediate termination of CBRs. With this in mind, global banks have stepped up training and technicalassistance efforts for their respondent banks, including as a way to further convey expectations and enhance communication.7 Strengthening respondent banks’ capacity to effectively assess and manage risks is a prerequisite for maintaining CBRs. Decisions to terminate or restrict CBRs often relate to correspondent banks’ lack of confidence in respondent banks’ adequacy of controls to manage anti–money laundering/combating the financing of terrorism, tax evasion, or other risks that they could bear through liability and fines in their home jurisdictions. Technical assistance and training by public sector

6 Such regional arrangements would create a central mechanism to allow for the processing and settlement of cross-border payments, without the need to go through a correspondent bank. It has potential efficiency gains, notably from the consolidation of payment flows and greater standardization. 7 An example of this is Standard Chartered Bank’s Regional Correspondent Banking Academies: https://​www​.sc​.com/​en/​explore​-our​-world/​correspondent​-banking/​

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capacity development providers and global banks have helped to improve the capacity of local banks. There may be situations when, despite technical assistance and training, some respondent banks would still not have the capacity to effectively manage risks. For example, some small local banks have very limited resources and capacity to conduct proper due diligence but engage in high-risk businesses such as online gaming and offshore. Low capacity and very risky businesses, when combined, can be a toxic cocktail that causes global banks to withdraw CBRs. In such cases, these local banks need to apply a risk-based approach and terminate such business lines to maintain their CBRs. Improving regulatory and supervisory frameworks of affected jurisdictions is crucial to correspondent banks’ decisions on maintaining or terminating a CBR, because they are viewed as proxies for local banks’ risk management systems. If the decline in CBRs is driven by the perception that a jurisdiction has a weak anti–money laundering/combating the financing of terrorism framework, national authorities should take swift and determined actions to ensure compliance with international standards, including effective implementation of regulation and supervision. Standardizing such regulations and consolidating supervision at a regional level could provide a level playing field for correspondent banks, helping build trust and reduce risks. For example, the Eastern Caribbean Central Bank has consolidated anti–money laundering/combating the financing of terrorism supervision into a regional operation under its responsibility. For this solution to work, regional supervisors need to take actions to ensure effective implementation of the harmonized or standard anti–money laundering/combating the financing of terrorism regulations. Removing legal and practical impediments to information sharing helps to ensure provision of timely, accurate, and adequate information by respondent banks on transactions, their originators, and beneficiaries to correspondent banks. This helps correspondent banks to meet their customer due diligence requirements. If a jurisdiction’s legal framework prevents the transmission of such information by a local bank to its correspondent bank, such barriers should be removed by amending legislation. To the extent that there are no legal barriers, respondent banks need to closely examine the contracts with their customers to eliminate any practical impediments. Clarifying, clearly communicating, and consistently enforcing regulatory expectations by home regulators of correspondent banks remains important. Home regulators have clarified regulatory expectations, including on the “know your customer’s customer” requirement. For example, US regulators clarified in 2016 that they are not following a zero-tolerance policy, as some banks have suggested. Instead, they expect banks to follow a risk-based approach and have robust compliance programs that enable a clear understanding of their customers’ risk profiles and expected account activity. Regulators note that the largest and most prominent monetary penalties in recent years have generally involved a sustained pattern of serious violations on the part of banks (US Treasury 2016). Nevertheless, some banks continue to be unclear about regulatory expectations, affecting their decision to maintain or terminate CBRs, home regulators should

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continue to clarify, clearly communicate, and consistently enforce their regulatory expectations. Moreover, national authorities in both home countries of correspondent banks and affected countries should implement the FATF Guidance on Correspondent Banking (2016).8 Consolidating transactional traffic banks can help address concerns over economies of scale. When economies of scale drive global banks’ decision on CBRs, transactional traffic should be consolidated through the use of other banks, including more regional banks or Tier 2 or Tier 3 banks as intermediaries. Payment flows of small local banks are consolidated to ensure a sufficient level of transaction flows, and the intermediary bank processes these consolidated international payments and transfers them through its CBRs. To make this option viable, the intermediary bank must have a robust control and risk management system and make efforts to ensure full transparency throughout the relationship chain to give correspondent banks confidence in the CBRs. This solution is gaining traction in the Caribbean, Pacific islands, and Africa. However, it sometimes entails higher costs and leads to concentration risks, as well as raises issues of market competitiveness. The IMF is supporting its membership to develop and implement solutions in line with the strategy endorsed by its Executive Board in April 2017. The strategy focuses on three main areas: surveillance, capacity development, and facilitating dialogue. The IMF is using its Article IV consultations with member countries to monitor trends in CBRs, drivers, and possible impacts; to gather data to assess the macroeconomic impact of the phenomenon; and to provide policy advice. The IMF has increased efforts to tailor capacity development to help authorities identify CBR-related risks, including through the development of a CBR data monitoring tool to help country authorities identify CBR risks (Grolleman and Jutrsa 2017), and to address the underlying drivers of these pressures through technical assistance and training. The IMF has been using its convening power to bring together public and private sector stakeholders such as by launching a series of regional initiatives to have open dialogue on these issues and to identify policy responses and industry-led solutions. These roundtable workshops—which have brought together global correspondent banks, regional banks, respondent banks, money transfer operators, and on occasion, regulatory and supervisory authorities—have provided a forum in which to engage and identify concrete and actionable solutions to address CBR pressures for countries in a specific region.

8 FATF (2016) clarifies, among other things, that banks are not required to conduct customer due diligence on the customers of their customers, also known as “know your customer’s customer,” and that due diligence measures against banks has to be commensurate with their level of money laundering and terrorism-fiinancing risks. In addition, there should be ongoing monitoring and communicating between banks.

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CONCLUSION CBRs help to enable the provision of domestic and cross-border payments and transfers. While trends in CBR withdrawal seem to be stabilizing in some regions, there are significant concerns over pullback by global banks, and ongoing pressures on CBRs remain. In some countries, cross-border flows have been concentrating through fewer channels, and some groups—such as remittance service providers—continue to be affected, which has implications for financial inclusion goals. The factors behind this phenomenon are multiple, interrelated, and vary among cases. However, these trends are the result of banks’ individual business decisions that account for profitability and risk considerations, in line with the banks’ risk tolerance policies. The multifaceted nature of CBR pressures requires collective and coordinated action by public and private sector stakeholders. There is no “one size fits all” solution; therefore, measures should be tailored to the circumstances and appropriately sequenced based on their utility, feasibility, and implementation timeframe. These measures can include not only policy responses, including to strengthen the regulatory and supervisory frameworks and clarify regulatory expectations, but also industry-led solutions targeted at reducing compliance costs, increasing profit margins, enhancing due diligence measures by banks, and strengthening the capacity of banks. It is imperative that the IMF—with other stakeholders—continues to support its membership on these issues.

REFERENCES Alleyne, Trevor, Jacques Bouhga-Hagbe, Thomas Dowling, Dmitriy Kovtun, Alla Myrvoda, Joel Okwuokei, and Jarkko Turunen. 2017. “Loss of Correspondent Banking Relationships in the Caribbean: Trends, Impact, and Policy Options.” IMF Working Paper WP/17/209, International Monetary Fund, Washington, DC. https:/​/​www​​.imf​​.org/​~/​media/​Files/​ Publications/​WP/​2017/​wp17209​​.ashx. Alwazir, Jihad, Fazurin Jamaludin, Dongyeol Lee, Niamh Sheridan, and Patrizia Tumbarello. 2017. “Challenges in Correspondent Banking in Small States of the Pacific.” IMF Working Paper WP/17/90, International Monetary Fund, Washington, DC. http:/​/​www​​.imf​​.org/​en/​ Publications/​WP/​Issues/​2017/​04/​07/​Challenges​​-in​​-Correspondent​​-Banking​​-in​​-the​​-Small​​ -States​​-of​​-the​​-Pacific​​-44809. Arab Monetary Fund (AMF), International Monetary Fund (IMF), and World Bank. 2016. “Withdrawal of Correspondent Banking Relationships (CBRs) in the Arab Region: Recent Trends and Thoughts for Policy Debate.” Washington, DC. https:/​/​www​​.imf​​.org/​en/​News/​ Articles/​2 016/​0 9/​0 2/​P R16392​​- AMF​​- IMF​​-WB​​- launch​​- Report​​- withdrawal​​- of​​ -Correspondent​​-Banking​​-Relationships​​-in​​-Arab​​-region. Association of Supervisors of Banks of the Americas (ASBA). 2016. Impact of Compliance/ Regulatory Risk in Financial Activity (“De-Risking”) in the Americas. Mexico City, Mexico. http:/​/​www​​.asbaweb​​.org/​E​​-News/​enews​​-44/​Docs/​banksup/​02banksup​​.pdf. Australian Transaction Reports and Analysis Centre (AUSTRAC). 2015. “Bank De-risking of Remittance Businesses.” Strategic Analysis Brief, Sydney, Australia. https:/​/​www​​.austrac​​.gov​​ .au/​sites/​default/​files/​2019​​-07/​sa​​-brief​​-bank​​-derisking​​-remittance​​-businesses​​_WEB​​.pdf. Caribbean Association of Banks (CAB). 2016. Correspondent Banking Survey Summary Report. Castries, St. Lucia. http:/​/​cab​​-inc​​.com/​files/​documents/​Correspondent​​_banking​​_survey ​​ _Report​​_Revised​​_Latest​​.compressed​​.pdf.

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Chapter 16  Pressures on Correspondent Banking Impact, Drivers, and Responses

Caribbean Community (CARICOM). 2016. “De-risking and Its Impact: The Caribbean Perspective.” CCMF Working Paper 01/2016, Caribbean Centre for Money and Finance, St. Augustine, Trinidad and Tobago. http:/​ /​ www​​.ccmf​​-uwi​​.org/​files/​publications/​working​​ _papers/​2016TWGDR​​.pdf. Committee on Payments and Market Infrastructures (CPMI). 2016. “Correspondent Banking,” Bank for International Settlements, Basel, Switzerland. http:/​/​www​​.bis​​.org/​ cpmi/​publ/​d147​​.pdf. ———. 2019. “CPMI Correspondent Banking Chartpack,” Bank for International Settlements, Basel, Switzerland. https:/ ​ / ​ w ww​​ . bis​​ . org/ ​ c pmi/​ p aysysinfo/​ c orr​​ _ bank​​ _ data/​ chartpack​​_1905​​.pdf. Eastern Southern African Anti-Money Laundering Group (ESAAMLG). 2017. Survey Report on De-risking in the ESAAMLG Region. Dar es Salaam, Tanzania. http:/​/​www​​.esaamlg​​.org/​ userfiles/​ESAAMLG​​%20Report​​%20on​​%20De​​-risking​​%20​​-%20September​​%202017​​.pdf. Eckert, Sue E., Kay Guinane, and Andrea Hall. 2017. Financial Access for U.S. Nonprofits. Washington, DC: Charity & Security Network. https:/​/​www​​.charityandsecurity​​.org/​system/​ files/​FinancialAccessFullReport​​_2​​.21​​%20(2)​​.pdf. Erbenová, Michaela, Yan Liu, Nadim Kyriakos-Saad, Alejandro López-Mejía, Giancarlo Gasha, Emmanuel Mathias, Mohamed Norat, Francisca Fernando, and Yasmin Almeida. 2016. “The Withdrawal of Correspondent Banking Relationships: A Case for Policy Action.” IMF Staff Discussion Note 16/06, International Monetary Fund, Washington, DC. https:/​/​www​​.imf​​ .org/​e n/​Publications/​Staff​​- Discussion​​- Notes/​Issues/​2 016/​1 2/​3 1/​T he​​-Withdrawal​​- of​​ -Correspondent​​-Banking​​-Relationships​​-A​​-Case​​-for​​-Policy​​-Action​​-43680. Financial Action Task Force (FATF). 2016. Guidance on Correspondent Banking. Paris, France. http:/​/​www​​.fatf​​-gafi​​.org/​publications/​fatfrecommendations/​documents/​correspondent​​ -banking​​-services​​.html. Financial Stability Board (FSB). 2015. Report to the G20 on Actions Taken to Assess and Address the Decline in Correspondent Banking. Basel, Switzerland. http:/​/​www​​.fsb​​.org/​2015/​11/​report​​ -to​​-the​​-g20​​-on​​-actions​​-taken​​-to​​-assess​​-and​​-address​​-the​​-decline​​-in​​-correspondent​​-banking. ———. 2017. FSB Correspondent Banking Data Report. Basel, Switzerland. http:/​/​www​​.fsb​​.org/​ 2017/​07/​fsb​​-correspondent​​-banking​​-data​​-report/​. ———. 2018a. Correspondent Banking Data Report—Update. Basel, Switzerland. http:/​/​www​​ .fsb​​.org/​2018/​03/​fsb​​-correspondent​​-banking​​-data​​-report​​-update/​. –––—. 2018b. Correspondent Banking Data Report—Update. Basel, Switzerland. https:/​/​www​​ .fsb​​.org/​2018/​11/​fsb​​-correspondent​​-banking​​-data​​-report​​-update​​-2/​. Grolleman, Dirk Jan, and David Jutrsa. 2017. “Understanding Correspondent Banking Trends: A Monitoring Framework.” IMF Working Paper 17/216, International Monetary Fund, Washington, DC. https:/​/​www​​.imf​​.org/​en/​Publications/​WP/​Issues/​2017/​10/​04/​ Understanding​​-Correspondent​​-Banking​​-Trends​​-A​​-Monitoring​​-Framework​​-45318. International Finance Cooperation (IFC). 2017. De-risking and Other Challenges in the Emerging Market Financial Sector. IFC, Washington, DC. https:/​/​www​​.ifc​​.org/​wps/​wcm/​ connect/​3 d215edb​​- 55da​​- 4097​​- 982c​​- e90409d6621a/​I FC+2017+Sur vey+on+ Correspondent+Banking+in+EMs+final​​.pdf​​?MOD​​=​​AJPERES. International Monetary Fund (IMF). 2016a. “Angola: 2016 Article IV Consultation Staff Report.” IMF Country Report 17/39, Washington, DC. https:/​/​www​​.imf​​.org/​en/​ Publications/​CR/​Issues/​2017/​02/​06/​Angola​​-2016​​-Article​​-IV​​-Consultation​​-Press​​-Release​​ -Staff​​-Report​​-and​​-Statement​​-by​​-the​​-44628. ———. 2016b. “Liberia: 2016 Article IV Consultation Staff Report.” IMF Country Report 16/238, Washington, DC. https:/​/​www​​.imf​​.org/​en/​Publications/​CR/​Issues/​2016/​12/​31/​ Liberia​​- 2016​​- Article​​- IV​​- Consultation​​- Press​​- Release​​- Staff​​- Report​​- and​​- Statement​​ -by​​-the​​-44100. ———. 2017a. “Belize: 2017 Article IV Consultation Staff Report.” IMF Country Report 17/286, Washington, DC. https:/​/​www​​.imf​​.org/​en/​Publications/​CR/​Issues/​2017/​09/​19/​

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Belize​​-2017​​-Article​​-IV​​-Consultation​​-Press​​-Release​​-Staff​​-Report​​-Informational​​-Annex​​ -Statement​​-45264. ———. 2017b. “Recent Trends in Correspondent Banking Relationships: Further Consideration.” IMF Policy Paper, Washington, DC. https:/​/​www​​.imf​​.org/​en/​Publications/​ Policy​​-Papers/​Issues/​2017/​04/​21/​recent​​-trends​​-in​​-correspondent​​-banking​​-relationships​​ -further​​-considerations. ———. 2017c. “The Bahamas: 2017 Article IV Consultation Staff Report.” IMF Country Report 17/314, Washington, DC. https:/​/​www​​.imf​​.org/​en/​Publications/​CR/​Issues/​2017/​10/​ 06/​The​​-Bahamas​​-2017​​-Article​​-IV​​-Consultation​​-Press​​-Release​​-and​​-Staff​​-Report​​-45310. International Monetary Fund (IMF) and Union of Arab Banks (UAB). 2015. The Impact of De-Risking on MENA Banks: Joint Survey. Washington, DC. http:/​/​www​​.nmta​​.us/​assets/​docs/​ DOBS/​the​​%20impact​​%20of​​%20derisking​​%20on​​%20the​​%20mena​​%20region​​.pdf. US Department of the Treasury. 2016. “U.S. Department of the Treasury and Federal Banking Agencies Joint Fact Sheet on Foreign Correspondent Banking: Approach to BSA/AML and OFAC Sanctions Supervision and Enforcement.” Press Release, Washington, DC. https:/​/​ www​​. treasury​​. gov/​p ress​​- center/​p ress​​- releases/​Documents/​Foreign​​% 20Correspondent​​ %20Banking​​%20Fact​​%20Sheet​​.pdf. World Bank. 2015. “Withdrawal from Correspondent Banking: Where, Why, and What to Do About It.” Working Paper 101098, World Bank, Washington, DC. http:/​/​documents​​ .worldbank​​.org/​curated/​en/​113021467990964789/​Withdraw​​-from​​-correspondent​​-banking​​ -where​​-why​​-and​​-what​​-to​​-do​​-about​​-it.

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Seminar Summary: Discussion on De-Risking Adel Al Qulish, Michaela Erbenova, Grovetta Gardineer, Sally Scutt, and Jose Luis Stein Panelists

This panel discussion was chaired by Ms. Yan Liu, Assistant General Counsel of the Legal Department of the IMF. The panelists discussed the drivers, consequences, and potential solutions to the withdrawal of correspondent banking relationships (CBRs) in several regions, also referred to as “de-risking.”

INTRODUCTION Ms. Liu introduced the phenomenon of the withdrawal of CBRs, commonly referred to as “de-risking,”1 including by citing reports of how this trend affected a number of regions, such as Latin America and the Caribbean, Africa, and Asia, and noted in particular how it affected small jurisdictions, as well as fragile and conflict-affected states (for example, its impact on remittance flows to Somalia). Although this trend can affect financial intermediation and financial inclusion, ultimately the termination or withdrawal of CBRs is the result of banks’ business decisions that reflect a cost-benefit analysis. In addition, although there have been trends in the reduction of CBRs, most institutions have been able to find replacements or put in place alternative arrangements.

Adel Al Qulish is Executive Secretary of the Middle East and North Africa Financial Action Task Force. Michaela Erbenova is Division Chief of the Monetary and Capital Markets Department at the IMF. Grovetta Gardineer is Senior Deputy Comptroller for Compliance and Community Affairs in the Office of the Comptroller of the Currency. Sally Scutt is Strategic Advisor at the International Compliance Association. Jose Luis Stein is Vice President of Supervision of Preventive Measures at the Mexican National Banking and Securities Commission. 1 Although the term de-risking is common, it confuses the dialogue on the trends and drivers of the withdrawal or termination of CBRs, so it is used here in quotation marks. A more accurate term to refer to this phenomenon is “the termination or withdrawal of CBRs.”



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WHAT IS “DE-RISKING”? Ms. Gardineer noted the negative connotation associated with the term de-risking, defining the phenomenon as the “whole-scale exiting of either geographies or customers without regard to understanding on a case-by-case basis what level of risk is posed to the correspondent bank.” Accordingly it is important for banks to focus on risk evaluation, case by case, in line with a risk management approach, whereby banks are required to periodically assess the risks posed by certain customers and whether they have the appropriate levels of control to manage that risk. Ms. Scutt agreed with the negative connotation of the term de-risking, stating that the decision by banks to withdraw from certain relationships is in response to banks’ risk management decisions. These decisions are based on which types of risks the banks find to be no longer manageable, including to avoid being the “last man standing” when engaging with a potentially risky bank. Mr. Al Qulish explained the Financial Action Task Force’s (FATF’s) definition of de-risking as “the situation where banks or financial institutions terminate or restrict business relationship with clients or categories of clients to avoid rather than manage the risk in line with the FATF risk-based approach.” The FATF is trying to help financial institutions understand that the risk-based approach does not mean wholesale termination of relationships but rather that FATF recommendations require case-by-case analysis of risks. The FATF is concerned with the effect of “de-risking” on the global financial system. Mr. Stein defined de-risking as “a series of arbitrary actions through which financial institutions determine to terminate, deny, or limit their relationships with certain clients” without the necessary knowledge, due diligence, and understanding of these clients and their transactions. Ms. Erbenova noted that the IMF’s concern with “de-risking” stems from many banks reacting to the new postcrisis environment, which may cause negative externalities for cross-border financial flows and has potential effects on financial stability and macroeconomic consequences. These issues are relevant to the IMF’s surveillance mandate and may necessitate the provision of policy advice to affected member countries. The IMF promotes the implementation of international standards by assisting countries in developing their national regulatory and supervisory frameworks and by facilitating a dialogue on this phenomenon.

WHAT IS THE EVIDENCE OF “DE-RISKING,” AND HOW DOES IT MATERIALIZE? Mr. Stein explained the effect Mexico has experienced from “de-risking,” including on correspondent accounts and remittances, and the difficulty for Mexican banks to repatriate US dollars. From the supervisory authority perspective, the focus should be to ensure that Mexican banks follow proper due diligence

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Seminar Summary: Discussion on “De-Risking”

processes. On the positive side, this has given financial institutions in Mexico a greater understanding of the importance of compliance with anti–money laundering/combating the financing of terrorism (AML/CFT) obligations to fight financial crime and maintain the credibility of the financial system. Mr. Al Qulish noted that the FATF had conducted a study in the Middle East and North Africa in 2015. He mentioned that some financial institutions have not taken on certain customers, such as charities or politically exposed persons. Ms. Scutt explained that evidence of “de-risking” from certain banks’ perspective revealed concerns as to their ability to manage financial crime risk. This has an effect on certain countries and customers, including money service businesses and pawn brokers, which involve a heavy movement of cash. In addition, there are issues of trade finance, which is also cash-flow driven. Ms. Gardineer elaborated that larger banks have seen account closures of well-established banking relations, which could result in transactions being driven underground, making them especially vulnerable to money-laundering risks. These banking decisions have not been arbitrary, however, but rather based on weaknesses, as identified in consent orders issued against banks, which led to risk re-evaluation by banks. Ms. Erbenova noted that global evidence is to date largely survey-based, such as the surveys by the World Bank on remittances and CBRs, the Union of Arab Banks focusing on the Middle East and North Africa, the Association of Banking Supervisors of the Americas, and the British Bankers Association. The Caribbean has been particularly affected, with at least 15 banks in five countries losing their CBRs, including two central banks. Affected customers included small and medium exporters and small and medium banks, for whom the cost of due diligence is higher. Ms. Erbenova emphasized that “de-risking” is not limited to emerging markets or low-income countries, and that the United States and Europe are not immune. As to the possible effect on financial stability, financial inclusion, and macroeconomic consequences, Ms. Erbenova indicated that there is no conclusive evidence in terms of a reduction of cross-border flows. There could be, however, a more significant effect felt in smaller countries. For example, the reduction of correspondent banking relations in the Bahamas has affected remittances to Haiti (in Haiti, remittances are 23 percent of GDP, and 75 percent of these remittances come from the Bahamas). Samoa serves as a hub for money service businesses, through which intermediate remittances flow. The effect on remittance flows could potentially affect vulnerable groups and their livelihoods. Issues with the fragmentation of the regional banking system could have negative economic implications if they affect trade downstream.

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WHAT ARE THE DRIVERS AND CONSEQUENCES OF “DE-RISKING”? Mr. Stein mentioned that the reduction of financial services has affected Mexico’s financial inclusion and the interconnection of the financial system. This has been reflected in decisions by global banks and through the knock-on effect on local banks’ relationships with less-regulated financial institutions and certain client relationships. Although there are limited hard data on “de-risking,” several cases confirm this trend. There is a need for sharing client information to build confidence in relationships with global banks. Mexico has taken steps to address this issue, including by making necessary amendments to the Mexican legislation to enhance the sharing of information. Ms. Gardineer noted that US regulators do not require banks to apply the know your customer’s customer principle as a general rule. However, in a risk-averse environment, banks should have some understanding on the client relationship, type and volume of transactions, and client’s activities to know if a suspicious transaction has occurred. Banks should also conduct regular customer due diligence. The situation could improve if supervisory expectations were effectively communicated, and the realities of how foreign correspondent accounts, remittances, and clearance of US dollars are effectuated in the financial system were better understood. One of the drivers is the increasing costs of compliance, particularly with regard to the Banking Secrecy Act and AML/CFT requirements, which must be balanced against the cost-benefit analysis of maintaining relationships with high-risk customers. Other drivers include concerns related to financial crimes, incongruent risk appetites, and adjustments of business strategies for certain geographic regions. Ms. Scutt noted that the geopolitical landscape has changed significantly, posing challenges for banks on the frontline in terms of ensuring that legitimate payments can flow into and out of conflict and postconflict areas. The sanctions regime has led banks to have a zero tolerance for risk. In addition, there are issues with data protection and data privacy that inhibit global banks from sharing suspicious transaction reports and are barriers to information-sharing on risky clients. Another driver is global banks’ concerns with the scale of the fines imposed through enforcement actions. Ms. Gardineer noted that the zero-tolerance risk policy has stemmed from the posteconomic downturn, when banks were “truly hanging on for their financial lives” and were more focused on compliance and being risk-averse.

WHAT ARE THE POTENTIAL RESPONSES TO “DE-RISKING”? Ms. Scutt noted that a collective solution with the private sector, public sector, and law enforcement is needed to mitigate the risk of financial exclusion and financial intermediation. Potential responses could include focusing on beneficial

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Seminar Summary: Discussion on “De-Risking”

ownership, documentation for individuals who are disadvantaged, looking at safer corridors, and increasing capacity building for certain countries. There are potential ways to increase customer information through technological initiatives for individuals who are financially excluded. Mr. Stein outlined two main actions to address “de-risking.” Countries must build stronger AML/CFT regimes to regain credibility. In addition, countries, including the United States, must provide further guidance to banks on procedures to maintain or terminate a business relationship. For example, Mexico has strengthened its AML/CFT regime and has revised its legal framework to better comply with the new FATF standards. The National Banking and Securities Commission has been working on transitioning to a risk-based approach to supervision, which allows for a more targeted supervision of banks. Mr. Al Qulish spoke of the measures taken by the FATF to address the misinterpretation of one of the drivers of “de-risking.” He recommended that FATF develop guidance on how to manage the risk in the context of correspondent banking and to assist money remitters to identify the risk and apply a risk-based approach. Ms. Gardineer noted initiatives planned by the Office of the Comptroller of the Currency, including engagement with prudential regulators and with the public and private sectors. Guidance—in terms of expanding knowledge of the drivers and consequences of “de-risking”—would be part of the solution. Ms. Erbenova noted the role of the public sector, especially in enabling a legal and regulatory environment that would allow for adequate risk management. The public sector can help with contingency planning when a country is cut off from all correspondent flows, including considering creating safe corridors for payments to continue flowing to it. In addition, when “de-risking” is a regional trend, the public sector could help set up regional arrangements to process transactions and consider providing industries with utilities to facilitate customer due diligence.

QUESTIONS FROM THE AUDIENCE Question: Are there circumstances where it would be justified for a government to interfere in a bank’s decision to close an account—for example, when the government perceives the consequence of closing a big client account to be disastrous? Ms. Gardineer: The United States has a policy that recognizes that financial institutions are private entities and can make business decisions without government interference. The Office of the Comptroller of the Currency, however, is trying to engage further with financial institutions so that they understand better the drivers and consequences of “de-risking” and to ensure there is good governance behind those decisions. Question: What can be done in cases where the private sector would reasonably consider a relationship too risky, but there is a need for continued international

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transfers, for example, to Somalia. Would you establish different kinds of channels for payments in those instances? Ms. Gardineer: There is a need for a collective response and to develop better guidance and understanding of supervisory expectations—which may include ways for financial institutions to understand the weak points that give them concern—but maintain some aspects of foreign correspondent banking or remittance activity. Collaboration will help institutions understand whether there is an opportunity to take that type of an approach and still maintain strong, safe sound controls without having dire consequences on certain countries. Question: Do we need to find measures that are more binding, and not just directives or guidelines that go toward financial inclusion, but rather strike a good balance between risk assessment and banks’ business decisions? Mr. Stein: This is to be determined through case-by-case analysis. Mexico has issued directives requiring banks to have clear procedures in determining whether they should keep a client and to ensure that banks follow these procedures. Ms. Scutt: One way of striking the balance is by looking at categories of customers subject to risk reassesment, such as charities and money service businesses, that may not have the same stringent standards as applied to banks, and ensuring the same quality of supervision for these institutions.

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Index

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), 217, 225 establishment of, 243 Ad hoc obligations, 95n37 AML/CFT requirements. See Antimoney laundering and combating the financing of terrorism requirements Antideflationary monetary policy, 174 Antimoney laundering and combating the financing of terrorism (AML/CFT) requirements, 225, 264, 277 FATF on, 233, 267 for Islamic banking, 232–34 Arab Monetary Fund, 208 Asian financial crisis of 1990s, 133–34 IMF in, 252 Assessment, rights of, 110 Asset management industry, regulatory reform and, 6 Asset separation, 19–20 Asset structure, in Islamic banking, 213f Attribution, principle of, 163 Australian Transaction Reports, 264 Bail-in bonds, 89 Bail-in strategies, 19 advantages of, 37 bail-outs compared with, 85–86 for bank failure, 72 bridge, 92 closed-bank, 20 defining, 85–86 execution of, 94–95 FSB on, 85–86 indirect, 92 Islamic banking and, 232 loss absorption and, 20–21 MREL and, 20 open-bank, 20, 92 in regulatory reform, 33–50 SIFIs and, 38–48 statutory, 115

total loss absorbing capacity and, 38–48 Bail-outs bail-in strategy compared with, 85–86 defining, 85–86 Balance sheet structure, in Islamic banking, 211–12, 227 Banco de la Republica, 161 Banco Spirito Santo, 66 Bank failure, bail in strategy for, 72 Bank financing, for corporate debt restructuring, 126 Bank for International Settlements, 146 IFSB and, 247 Banking credit, formal companies using, 136t Banking Reform Act 2013, 33 Banking Secrecy Act, 278 Banking Union, 64 establishment of, 12 pillars of, 12–13 Single Rulebook and, 13 Bank of England (BoE), 32, 158, 179 on exit strategies, 38 independence of, 185 Resolution Paper of, 36–37 resolution strategies of, 33 on valuations, 38 Bank of England Act 1998, 185n37 Bank of Portugal, 66 Bank Recovery and Resolution Directive (BRRD), 11, 13, 32 amendments to, 89 Article 45, 46 Article 45(12), 63 Article 55, 67 Article 66(3), 65 Article 66(4), 66 Article 66(5), 66 on cross-border resolution, 75 EBA and, 58 in EU resolution framework, 14 European Commission on, 47



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Key Attributes for Effective Resolution and, 58–59 MREL and, 46, 62–63 safeguards, 22 SRM and, 14n18 TLAC and, 46 Bankruptcy, 175 corporate debt restructuring and, 126 in Mexico, 131n3 nonperforming loans and, 125 Bankruptcy Code, Chapter 11, 36 Bankruptcy Court, US, 197 Bank supervisor liability in France, 178 in Germany, 177–78 international standards on, 180 in Italy, 178–79 United Kingdom, 179 Barbados, 261 Basel 2.5 framework, publication of, 237 Basel Committee, 188 on Banking Supervision, 31, 73 Cross-Border Resolution Group, 74 historical background of, 236–37 international regulation and, 236–39 on Islamic Finance, 203 Market Risk Amendment to Capital Accord, 237 Pillar 3 framework, 94 Basel Core Principles, 225, 239 Basel I framework, 8, 237 Basel II framework, 8 Islamic finance and, 199–201 publication of, 237 Basel III framework, 8, 8n1, 91, 264 on discount window, 200 goals of, 238 IFSB and, 202 on liquidity, 200 publication of, 238 Sharī’ah governance and, 201 BoE. See Bank of England Bonds, bail-in, 89 Boston Consulting Group, 267 Brazil, 160–61 Brexit, 28, 33 Bridge bail-in strategy, 92 Bridge bank, 19–20 Brown, Gordon, 185

BRRD. See Bank Recovery and Resolution Directive Capital adequacy ratio (CAR), 212 in Islamic banking, 214f Capital instruments ranking, 21–22 Capital requirements directive (CRD), 11, 13, 152 Article 2(5), 150 of ECB, 148 Capital requirements regulation (CRR), 11, 13, 152 Article 4(1)(1), 148 of ECB, 148 Capital structure liabilities, in crossborder resolution, 86 CAR. See Capital adequacy ratio CBRG. See Cross Border Resolution Group CBRs. See Correspondent banking relationships Central banks of Chile, 164–65 classical debates on, 163 during financial crisis of 2008, 143 financial stability task of, 160, 173–74 formal independence of, 183 formal mandate, 176–77 independence of, 162–65, 182–83 in Latin America, 158–59 liability of, 176–82 major financial crises and, 174 mandate, 173 monetary policy of, 185–86 monetary stability and, 162–65, 173–74 objectives of, 173–76 operational independence of, 183–85 of Peru, 164 reputational risk and, 182 systemic risk and, 166 Central clearing counterparties (CCPs) clearing services, 117 cross-border resolution and, 119–20 default management processes and, 118 equity write-down and, 115–16 FMIs and, 114 FSB on, 113–14 governing of, 119

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Index 283

home jurisdiction, 120 ISDA on, 118n34 under Key Attributes for Effective Resolution, 112, 114 legal frameworks for resolution of, 115 limited recourse provisions and, 117 loss allocation rules, 111–14 mutuality principle among, 115 netting sets and, 117–18 nondefault losses, 114–15 participants, 109n8 PFMI on, 119 recovery and resolution arrangements, 109n7, 111–16 Resolution Guidance, 113n18 resolution regime development, 114– 15, 118 role of, 107 rulebook, 108, 115n24, 116, 119 shareholders, 114 silo structures and, 117 special resolution regimes for, 108, 108n6 structural elements of, 116–18 systemic importance of, 107–8 transparency and, 114–15 waterfall, 109–11 Central Reserve Bank of Peru, 167 Charities, 280 Chile central bank of, 164–65 financial stability councils of, 164 macroprudential powers in, 162–65 China, shadow banks in, 5 Chrysler, 257 Claim priority, in corporate debt restructuring, 130 Classical carve-out, in Latin America, 165–67 Clean holding company requirements, of TLAC, 40 Closed-bank bail-in, 20 CMGs. See Crisis management groups COAGs. See Cooperation agreements Comity, 96n41 Commercial codes, from Ottoman empire, 197 Commission Delegated Regulation (EU) 2016/1075, 59

Commission Delegated Regulation (EU) 2016/1450, 62–63 Committee on Payment and Settlement Systems (CPSS), historical background of, 241 Committee on Payments and Market Infrastructure, 265 Common Equity Tier 1, 238 Concordat, 239 Conflict resolution, 245–46 Constitutional Court of Colombia, 161n10 Consumer prices, monetary policy and, 173n10 Consumer protection, in Islamic banking, 218, 222 Continuity of services, 118n35 Contractual cross-border recognition, 96–97 Contractual recognition clauses cross-border resolution and, 66–67 International Swaps and Derivatives Association on, 67 Cooperation agreements (COAGs), 71 Cooperation architecture, EU resolution framework and, 58–59 Cooperation mandate, cross-border resolution and, 70–71 Core Principles for Effective Banking Supervision, Basel Committee, 225 issuing of, 239 revision of, 239 Core Principles for Islamic Finance Regulation application of, 247–48 launching of, 205 Corporate debt economic growth and, 252–54 financial stability and, 252–54 insolvency laws and, 254–57 out-of-court procedures and, 254–57 Corporate governance frameworks, in Islamic banking, 217–18 Corporate sector, financial sector and, 130–31 Correspondent banking communication in, 269 defining, 261 impact of, 262–66 regulatory frameworks in, 270

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supervisory frameworks in, 270 trends in, 262–66 Correspondent banking relationships (CBRs), 261 drives of pressures, 266–68 FATF on, 271 FSB on, 265, 268 IMF on, 267–68 industry solutions for, 268–71 policy responses to, 268–71 withdrawal from, 266, 267 Corruption, 257–58 Council Decision 98/415/EC, 145n11 Council of the European Union, 10 in decision-making, 18–19 CPPs. See Central clearing counterparties CPSS. See Committee on Payment and Settlement Systems CRD. See Capital requirements directive Creditor hierarchies cross-border resolution and, 79–80 under insolvency laws, 89 Criminal law, insolvency law and, 258 Crisis management groups (CMGs) COAG support of, 71 in cross-border recognition, 98 cross-border resolution and, 81 in European Union, 23 G-SIBs and, 56 non-binding memoranda of, 59 Critical functions, FSB on, 84n4 Cross-border effectiveness, 96–98 Cross-border insolvency, 77n16 Cross-border recognition CMGs in, 98 contractual, 96–97 cost allocation, 98–99 home-host cooperation in, 98–99 statutory, 96–97 Cross-border resolution bankrupt, 84–86 BRRD on, 75 capital structure liabilities in, 86 CCPs and, 119–20 challenges in, 77–81 CMGs and, 81 conditions for, 95 contractual recognition clauses and, 66–67

cooperation mandate and, 70–71, 80 creditor hierarchies and, 79–80 early termination rights and, 97–98 effectiveness of, 79–80 enforcement of, 71–72 EU and, 57 evolution of, 101 features of enforcement mechanisms, 76–77 firms impacted by, 100 FSB on, 83–84 funding in, 95 in global dimension, 64–65 implementation of, 65–66, 77–81 international approach to, 55–58 interpretation of, 80 Key Attributes for Effective Resolution and, 69–77, 87–88 legal mechanisms for enforcement of, 74 middle ground approach to, 73–74 MPOE and, 61 operating liabilities in, 86 operational continuity in, 95 operational structures and, 100 paradigm shifts in, 84–86 planning, 101 preferred strategies for, 60–62 recognition of, 74–75, 80–81 ring fencing and, 62–64 SPOE and, 61 support for, 75–76 territorial approach to, 73 in TLAC, 87–95 too-big-to-fail syndrome and, 55–56 toolkit, 86–99 universal approach to, 73 Cross Border Resolution Group (CBRG), 31 CRR. See Capital requirements regulation Culture, 7–8 Debasement of currency, 186 Debt restructuring, 255 achievement of, 126 bank financing for, 126 bankruptcy and, 126 claim priority in, 130 company viability and, 126

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Index 285

consequences of failure to, 131 debt instruments for, 126 global strategy for, 126–29 hybrid systems for, 129 informal, 128–29 international contributions to, 133–35 key features of robust systems for, 129 in Latin America, 137 legal framework for, 131–32 mechanism design for, 130–32 in Mexico, 127n1, 135–40 miscellaneous incentives in, 132 out-of-court, 128–29 problems with, 125 state role in, 132–33 systemic crisis and, 127–28 World Bank on, 129 See also Corporate debt Decision-making, 183, 189 Council of the European Union in, 18–19 European Commission in, 18–19 NRAs and, 17 Dedollarization, 168 Default losses, nondefault losses and, 115 Default management processes, CCPs and, 118 Deposit Guarantee Schemes Directive (DGSD), 11, 13 De-risking consequences of, 278 defining, 275–76 drivers of, 278 evidence of, 276–77 FATF on, 276 IMF on, 276 responses to, 278–79 Derivatives, OTC, 107 DGSD. See Deposit Guarantee Schemes Directive DIP financing development, 147 in Mexico, 137–40 Directive 2001/24/EC, 59, 65 Directive 2014/59/EU, Article 45, 88n13 Discount window, Basel III framework on, 200 Discriminatory actions, 73n8 Dodd-Frank Act, 30, 34, 91n26, 158

costs under, 50 FDIC and, 71n3 Duel liability standard, 181–82 Early termination rights, cross-border resolution and, 97–98 Eastern Caribbean Currency Union, 263 EBA. See European Banking Authority ECB. See European Central Bank Economic Constitution, 157 Economic growth, corporate debt and, 252–54 EEA. See European Union/European Economic Area ELA. See Emergency liquidity assistance EMDEs. See Emerging markets and developing economies Emergency liquidity assistance (ELA), 146n18, 219 Emerging markets and developing economies (EMDEs), 3 IMF on, 4–5 regulatory reform and, 4 Equity write-down, CCPs and, 115–16 ESAs. See European Supervisory Agencies ESCB. See European System of Central Banks ESRB. See European System Risk Board EU. See European Union EU resolution framework BRRD in, 14 components of, 14 cooperation architecture and, 58–59 SRM in, 14 European Banking Authority (EBA), 11, 146, 147, 188 BRRD and, 58 Framework Cooperation Arrangement of, 57n5 European Central Bank (ECB), 10, 188 advisory tasks of, 146 authority of, 149–50 CRD of, 148–49 CRR of, 148–49 ESRB and, 150 in euro area, 152 financial stability task of, 144–55 Governing Council, 146–47 independence of, 152–53

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Law & Financial Stability

macroprudential powers of, 148–49, 158 microprudential powers of, 150–52 new functions of, 152–53 objectives of, 143–44 oversight of, 147 price stability task of, 144–55 separation principle of, 153–55 SSM and, 151, 158 supervisory mandate of, 151 synergies and tensions in functions of, 148–49 weaknesses of monetary policy of, 153n40 European Commission, 10 on BRRD, 47 in decision-making, 18–19 in financial crisis of 2008, 147 Proposal of Directive, 63–64 European Convention of Human Rights, 37, 180 European Court of Justice, 178 European Deposit Insurance Fund, 13 European Deposit Insurance Scheme, 13 European Insurance and Occupational Pensions Authority, 147 European Monetary Union, 175n13 European resolution colleges, establishment of, 23–24 European Securities Markets Authority, 147 European Supervisory Agencies (ESAs), 11 European System of Central Banks (ESCB) Article 14.4 of statute of, 147 enforcement powers of, 149 objective of, 144 secondary tasks of, 145 TFEU on, 144–45 European System of Financial Supervision, 147 establishment of, 11 European System Risk Board (ESRB), 146, 148 amendments to, 149n26 ECB and, 150 enforcement powers of, 149 European Treaty, 57

European Union (EU) crisis management groups in, 23 cross-border resolution and, 57 financial crisis of 2008 response of, 32, 57 harmonization within, 79–80 on MREL, 39 European Union/European Economic Area (EEA), 73 Eurosystem on financial stability, 146 objectives of, 144, 146 oversight of, 146n17 Ex ante cooperation agreements, for G-SIFIs, 71 Exchange rate volatility, 168 Executive Session, SRB, 17–18 Exit strategies BoE on, 38 FDIC on, 38 SPOE in, 35 Failure resolution, 85 FATF. See Financial Action Task Force Federal Deposit Insurance Corporation (FDIC), 29, 43, 180 Dodd-Frank Act and, 71n3 on exit strategies, 38 under OLA, 31 on resolution strategies, 36 Federal Deposit Insurance Fund, 13 Federal Reserve, 96n44 SIFIs and, 47 on TLAC, 40 Federal Reserve Rule, 40, 43 restrictiveness of, 41 Financial Action Task Force (FATF), 232 on AML/CFT requirements, 233, 267 on CBRs, 271 on de-risking, 276 on financial institutions, 233 on money laundering, 233 Recommendations of, 233 Financial Conduct Authority, 38 Financial crisis of 2008 central banks during, 143 EU response to, 32, 57 European Commission in, 147 international responses to, 30

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Index 287

origins of, 28–29 reforms after, 3, 28 regulation during, 28 SIFIs in, 28 UK response to, 32–33 US response to, 30–32 Financial market infrastructure (FMI), 117n33 access to, 118n35 CCPs and, 114 implementation guidance of, 108n2 PFMI on, 119n36 Financial Market Supervisory Authority, 71n3 Financial Policy Committee, 158 Financial sector, corporate sector and, 130–31 Financial Sector Assessment Programs, 4, 239, 265–66 Financial Services Act 2012, 32 Financial Services Authority, 179 Financial stability of central banks, 160, 173–74 of ECB, 144–55 enhanced focus on, 147–48 of Eurosystem, 146 monetary policy and, 163 preservation of, 145n12 value of, 145 Financial stability, corporate debt and, 252–54 Financial Stability Board (FSB), 3–4, 6, 23, 30, 55–56, 181n26 on bail-in strategy, 85–86 on CBRs, 265, 268 on CCPs, 113–14 on critical functions, 84n4 on cross-border resolution, 83–84 goals of, 240 history of, 240 in international regulation, 240 on Islamic banking, 247 on Key Attributes for Effective Resolution, 78, 83–84 objectives of, 39 on shadow banks, 240 on SIFIs, 39–40 Supervisory Intensity and Effectiveness work stream of, 7

term sheets, 92n27 on TLAC, 39–40 on TLAC Standard, 56 trend monitoring by, 265 See also Key Attributes for Effective Resolution, FSB Financial Stability Committee, 158 Financial stability councils of Chile, 164 in Latin America, 159–61 in Peru, 161 Financial Stability Oversight Council, 158 FMI. See Financial market infrastructure Foreign Bank Organization, 64–65 Foreign resolutions, 75–76 Formal independence, of central bank, 183 Framework Cooperation Arrangement, of EBA, 57n5 France, 47 bank supervisor liability in, 178 Fraud, 257–58 Friedman, Milton, on inflation, 186 FSB. See Financial Stability Board Functional approach, 245 G10. See Group of 10 G20. See Group of 20 García-Escribano, Mercedes, 168 General Agreement on Trade and Services (GATS), 165, 166, 167n31 General Motors, 257 Germany, 89 bank supervisor liability in, 177–78 Gharar, 199, 226 Global Economy Meeting, 241 Global systemically important banks (G-SIBs), 23, 39–40 CMGs and, 56 entities within, 91 failure of, 56 MPOE for, 90 public disclosures, 94n32 securities, 94 TLAC and, 88n14 Global systemically important financial institutions (G-SIFIs), 69 ex ante cooperation agreements for, 71

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288

Law & Financial Stability

Going-concern capital, 238 Goldman Sachs v. Novo Banco, 66, 80n21 Government bonds, 175n12 defining, 182n30 See also the State Group of 10 (G10), 236, 241 Group of 20 (G20), 6–7, 107 G-SIBs. See Global systemically important banks G-SIFIs. See Global systemically important financial institutions Haircutting initial margin, 110 variation margin gains, 110 Harmonization, 65 within EU, 79–80 between resolution regimes, 78 Helicopter money, 174n11 Holding companies, 91n26 Home-host cooperation, in cross-border recognition, 98–99 Hong Kong Special Administration Region, 75 Huertas, Thomas, 55 Human resources, in international regulation, 245–46 Hyperinflation, in Peru, 168 IADI. See International Association of Deposit Insurers IFSB. See Islamic Financial Services Board Ijara, 212 IMF. See International Monetary Fund India, insolvency law in, 256 Indirect bail-in strategy, 92 Inflation, Friedman on, 186 Inflation shocks, 185 Informal restructuring, 128–29 Information sharing, 270 Initial margin defining, 109n9 haircutting, 110 Insolvency law criminal law and, 258 defining, 258 in India, 256 Insolvency laws, 48

corporate debt and, 254–57 creditor hierarchy under, 89 cross-border, 77n16 formal, 254–55 NCWOL and, 255–56 out-of-court procedures and, 254–57 SIFIs and, 29 See also Mexican Insolvency Law Insolvency regime, key features of, 129–30 Instituto Federal de Especialistas de Concursos Mercantiles, 136n8 Integrated approach, 245–46, 246n29 International Association of Deposit Insurers (IADI), historical background of, 241–42 International Association of Insurance Providers, 199 International Association of Restructuring Insolvency & Bankruptcy Professionals, 135, 254 International cooperation, SRB and, 23–24 International Monetary Fund (IMF), 73, 263–66 Article IV consultations of, 271 in Asian financial crisis of 1990s, 252 on CBRs, 267–68 on de-risking, 276 on EMDEs, 4–5 Financial Sector Assessment Programs, 4 on Islamic finance, 197 as legal phenomenon, 156 on middle ground approach, 74 monitoring conducted by, 244–45 Policy Paper, 266 on rule of law, 157 on shadow banks, 5 International Organization of Securities Commissions (IOSCO), 193, 241 International regulation Basel Committee and, 236–39 consistent implementation of, 246 FSB in, 240 functional approach to supervision of, 245 human resources in, 245–46 IFSB in, 243

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Index 289

implementation challenges in, 244–48 integrated approach to supervision of, 245–46, 246n29 Islamic banking and, 242–44, 247–48 monitoring, 244–45 practical application of standards in, 246–47 resolution regimes in, 240 timely implementation of, 246 twin peaks approach to supervision of, 245–46, 246n29 International standards, of bank resolution, 188–89 International Swap Dealers Association, 78 on safeguards, 79 International Swaps and Derivatives Association (ISDA), 36, 97 on CCPs, 118n34 on contractual recognition clauses, 67 Investment risk reserve (IRR), 212 IOSCO. See International Organization of Securities Commissions Iran, 198 IRR. See Investment risk reserve ISDA. See International Swaps and Derivatives Association Islamic banking AML/CFT requirements for, 232–34 assets by country, 210f asset structure, 213f bail-in strategies and, 232 balance sheet structure in, 211–12, 227 banking products in, 227–28 benefits of, 224n1 capital adequacy ratio in, 214f concentration of, 211 consumer protection in, 218, 222 conventional banking and, 221, 226–28 corporate governance frameworks in, 217–18 corporate structure in, 211–12, 226 defining, 224 financial soundness of, 212–13 financing in, by instrument, 213f financing structure in, by sector, 213f FSB on, 247 growth of, 208

institutional arrangements in, 230 international regulation and, 242–44, 247–48 Islamic jurisprudence in, 226 Key Attributes for Effective Resolution on, 228 legal frameworks for, 224–25, 228–32 liability structure in, 213f licenses for, 221 liquid asset ratio in, 214f liquidity management in, 219–20 market share of, 210f maturities in, 219n13 nonperforming financing in, 214f outlook of, 212–13 purchase-and-assumption in, 231–32 recent developments in, 209–14 regulatory frameworks, 214–16 resolution framework in, 220 resolution powers and tools, 231 resolution triggers in, 230–31 return on assets in, 214f safety nets in, 229 scale of, 209–11 shares of global assets in, 210f Sharī’ah governance in, 201 supervisory frameworks in, 216–17, 222 systemic importance of, 209 Islamic capital markets, 204–5 Islamic finance Basel Committee on, 203 Basel II framework and, 199–201 Core Principles for Islamic Finance Regulation, 205 distinctive qualities of, 195–96 IMF on, 197 liquidity in, 200 regulatory challenges in, 196–97 structure of, 210f transparency in, 196–97 World Bank on, 205 Islamic Financial Services Act, 229 Islamic Financial Services Board (IFSB), 193, 225 adoption of standards of, 221 Bank for International Settlements and, 247 Basel III framework and, 202

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290

Law & Financial Stability

establishment of, 243 expected new standards, 199f implementation challenges, 204f implementation progress, 201–6 implementation surveys, 201f, 202 in international regulation, 243 major focuses of, 200f medium-term agenda of, 203–6 Quantitative Impact Survey, 201 Revised Capital Adequacy Standard, 200 role of, 243 on Sharī’ah, 194–95 Stability Forum, 205 standards by timeline, 203f standard-setting by, 198–201 Strategic Performance Plan, 203–5 World Bank and, 247 Islamic Financial Stability Forum, 205 Islamic jurisprudence, in Islamic banking, 226 Italy, bank supervisor liability in, 178–79 Jakarta Initiative, 253 Kechichian case, 178 Key Attributes for Effective Resolution, FSB, 7, 30, 31, 83n1, 107–8 on bank resolution, 188–89 BRRD and, 58–59 CCPs under, 112, 114 cross-border resolution and, 69–77, 87–88 FSB on, 78, 83–84 implementation of, 78, 83–84 on Islamic banking, 228 objectives of, 240 on safeguards, 79 stabilization powers in, 87–88 on transparency, 119n36 wind-down powers in, 88 King, Mervyn, 55 Kotnik case, 66 Larosière, Jacques de, 147 Larosière Report, 147, 150 Latin America central banks in, 158–59 classical carve-out in, 165–67

corporate debt restructuring in, 137 financial stability councils in, 159–61 macroprudential exemptions in, 165–67 macroprudential powers in, 160t, 162–69 Lawson, Nigel, 185 Legal-entity-driven processes, 117 Legislative Guide on Insolvency Law, UNCITRAL, 134 Ley de Concursos Mercantiles, 125, 135 Liability structure, in Islamic banking, 213f Limited recourse provisions, CCPs and, 117 Liquidity asset ratio in Islamic banking, 214f Basel III framework on, 200 emergency liquidity assistance, 146n18 in Islamic finance, 200 management in Islamic banking, 219–20 of SIFIs, 48 Long-term debt, of SIFIs, 38–39 Loss absorption, bail-in and, 20–21 Loss allocation rules, CCP, 111–14 waterfall and, 110 Luxembourg, 22 Macroprudential exemptions, in Latin America, 165–67 Macro Prudential Forum, 158 Macroprudential powers in Chile, 162–65 of ECB, 148, 158 implementation of, 167–69 in Latin America, 160t, 162–69 in Peru, 162–65, 167–69 Macroprudential supervision defining, 172 independence in, 186–87 regulation of, 172, 187–88 scope of, 171–72 stricto sensu, 188 systemic risk and, 187 Major financial crises, central banks and, 174 Market Risk Amendment to Capital Accord, Basel Committee, 237

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Index 291

Matsushita, Mitsuo, 165–66 Mediation Panel, 154 Mexicana case, 135 Mexican Insolvency Law Article 37, 138 Article 43, 138 Article 75, 138–39 Article 224, 139 key features of, 255 Probability of Default in, 139 Severity of Loss in, 139 Mexico, 125, 280 bankruptcy in, 131n3 companies and credit in, 136–37 corporate debt restructuring in, 127n1, 135–40 DIP financing in, 137–40 financial crisis in, 131n4 NPLs in, 253 Microprudential powers, of ECB, 150–52 Middle ground approach to cross-border resolution, 73–74 IMF on, 74 Minimum requirements for own funds and eligible liabilities (MREL), 88 bail-in and, 20 BRRD and, 46, 62–63 establishment of, 15 EU on, 39 setting of, 59 TLAC and, 46 Misfeasance, 179 Model Law on Cross-Border Insolvency, UNCITRAL, 134 Monetary policy antideflationary, 174 of central banks, 185–86 consumer prices and, 173n10 debasement of currency through, 186 of ECB, 153n40 financial stability and, 163 independence in conduct of, 185–86 systemic risk and, 187 Monetary stability central banks and, 162–65, 173–74 ordoliberalism on, 162 Money laundering, 205 FATF on, 233

See also Antimoney laundering and combating the financing of terrorism requirements MPOE. See Multiple point of entry MREL. See Minimum requirements for own funds and eligible liabilities Mudarabah, 212, 215, 219 Multiple point of entry (MPOE) cross-border resolution and, 61 for G-SIBs, 90 SIFIs and, 34 Murabahah, 212, 219n13 Musharakah, 212, 215 National Banking and Securities Commission, 279 National Bank of Greece v. Metliss, 96, 96n39 National competent authorities (NCAs), 147 National resolution authorities (NRAs), 10 decision-making and, 17 resolution tools of, 19 safeguards, 21 SRB and, 15–19 National Sharī’ah board (NSB), 217 NCAs. See National competent authorities NCWOL. See No creditor worse off than in liquidation Netting sets, CCPs and, 117–18 No creditor worse off than in liquidation (NCWOL), 88, 113n18 determination of, 117 insolvency laws and, 255–56 violation of, 94 Nondefault losses CCPs and, 114–15 default losses and, 115 Nonperforming financing, in Islamic banking, 214f Nonperforming loans (NPL) bankruptcy and, 125 in Mexico, 253 recognition of, 253 Nonprofit organizations (NPOs), 264 NPL. See Nonperforming loans NPOs. See Nonprofit organizations

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292

Law & Financial Stability

NRAs. See National resolution authorities NSB. See National Sharī’ah board Occupy movement, 28 OLA. See Orderly Liquidation Authority De Oliveira, Cristiano de, 160–61 Open-bank bail-in, 20, 92 Operating liabilities in cross-border resolution, 86 subordination to, 88–89 TLAC and, 88–89 Operational continuity, in cross-border resolution, 95 Operational independence of central bank, 183–85 degrees of, 184 scope of, 184–85 Operational structures cross-border resolution and, 100 rationalization of, 100 Orderly Liquidation Authority (OLA), 30, 34, 35 FDIC under, 31 Ordoliberalism, 157 on monetary stability, 162 OTC derivatives. See Over-the-counter derivatives Ottoman empire, commercial codes from, 197 Out-of-court procedures consensus in, 254 corporate debt and, 254–57 insolvency laws and, 254–57 the state in, 255 Out-of-court restructuring, 128–29 Over-the-counter (OTC) derivatives, 107 Pacific Alliance, 161 Par condicio creditoris, 130 Pari passu treatment, 22, 89 Peer reviews, 244 PER. See profit equalization reserves Perception-based surveys, 262 global, 263 regional, 263–66 Peru central bank of, 164 economy of, 168 financial stability councils in, 161

hyperinflation in, 168 macroprudential powers in, 162–65, 167–69 Peru-United States Free Trade Agreement, 166 Peter Paul case, 177 PFMI. See Principles for Financial Market Infrastructures Plenary Session, SRB, 17–18 Presidential election of 2016, 28 Price stability task, of ECB, 144–55 Principle of attribution, 163 Principles and Guidelines for Effective Insolvency and Creditor Rights Systems, 134 Principles for Cross-Border Effectiveness of Resolution Actions, 57 Principles for Financial Market Infrastructures (PFMI), 109n9, 110–11 CCPs and, 119 development of, 241 on FMIs, 119n36 Principle 1, 119n36 Principle 4, 110n14 Profit equalization reserves (PER), 212 Profit-sharing investment accounts (PSIAs), 211 Prudential Regulation Authority, 179 PSIAs. See Profit-sharing investment accounts Public officials, the state and, 133 Public policy, 77, 77n16 Qar, 220 Quantitative easing, 174 Realpolitik, 158 Reattribution, 162 Recapitalization, 40–41 Regulatory Consistency Assessment Program, 8 establishment of, 244 Regulatory reform, 3 asset management industry and, 6 bail-in in, 33–50 compression of, 8 EMDEs and, 4 financial deepening and, 4–5

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Index 293

financial inclusion and, 4–5 gaps in, 9 monitoring, 9 process of, 28–30 shadow banks in, 5 systemic risk and, 6 too-big-to-fail syndrome and, 6–7 Reorganisation measures, 65 Reports on the Observance of Standards and Codes, 244 Reputational risk, central banks and, 182 Resolution colleges establishment of, 23 European, 23–24 Resolution entities defining, 90 TLAC and, 90–91 Resolution groups, TLAC and, 90–91 Resolution regimes, harmonization between, 78 Resolution strategies of BoE, 33 FDIC on, 36 in UK, 33 Resolution tools of NRAs, 19 of SRB, 19 Resolvability conditions, 95 Respondent banks capacity of, 269–70 communication with, 269 defining, 261 Restricted investment accounts (RIA), 216 Restructuring actions, 20 Retakāful, 209 Return on assets, in Islamic banking, 214f Revised Capital Adequacy Standard, IFSB, 200 RIA. See Restricted investment accounts Riba, 226, 231 Ring fencing, 42 adverse consequences of, 55 cross-border resolution and, 62–64 Risk reassessment, 280 Risk sharing, 212 Risk-weighted assets framework, 8–9 Rule of law defining, 157 IMF on, 157

Safeguards, BRRD, 22 Sainz, Alejandro, 137 Sale of business tools, 19–20 Sapin 2 law, 47 Satmex case, 135 SDIS. See Sharī’ah-compliant deposit insurance schemes Securities and Exchange Commission (SEC), 36 Separation principle, of ECB, 153–55 Shadow banks in China, 5 drivers of, 5 financial development and, 5 FSB on, 240 IMF on, 5 in regulatory reform, 5 Shareholders CCP, 114 rights of, 94n35 Sharī’ah advisory board, 195 Sharī’ah-compliant deposit insurance schemes (SDIS), 220 Sharī’ah governance, 200 Basel III framework and, 201 compliance with, 229–30, 247 IFSB on, 194–95 in Islamic banking, 201 noncompliance with, 217 strengthening, 221–22 Sharī’ah test, toxic assets and, 195 SIFIs. See Systemically important financial institutions Silo structures, CCPs and, 117 Single liability standard, 180–81 Single point of entry (SPOE), 34 BoE and, 36–38 corporate structure and, 61 cross-border resolution and, 61 exit strategy in, 35 summary of, 35–36 support for, 76 United Kingdom and, 36–38 Single Resolution Board (SRB), 10, 60 appeal panel, 22 establishment of, 14–15 Executive Session in, 17–18 functioning of, 14–15 international cooperation and, 23–24

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294

Law & Financial Stability

NRAs and, 15–19 Plenary Session in, 17–18 resolution tools of, 19 SRM and, 17 Single Resolution Mechanism (SRM), 10, 60 Article 21, 21 BRRD and, 14n18 establishment of, 12–13, 148 in EU resolution framework, 14 functioning of, 14–15, 17 safeguards, 21 SRB and, 17 Single Rulebook applications of, 13 Banking Union and, 13 establishment of, 11–12 main texts of, 13 Single Supervisory Mechanism (SSM) Article 5 of, 149 Article 6(4) of, 152n37 Article 6 of, 152n38 Article 25, 154 Article 25(5), 154 Article 41 of, 151 Article 71, 152n37 Article 72, 152n37 ECB and, 151, 158 establishment of, 12–13, 148 Recital 55 of, 155 Recital 65 of, 154n42 Society for Worldwide Interbank Financial Telecommunications (SWIFT), 261, 265 Special resolution regimes, for CCPs, 108, 108n6 SPOE. See Single point of entry SRB. See Single Resolution Board SRM. See Single Resolution Mechanism SSM. See Single Supervisory Mechanism Stabilization powers, in Key Attributes for Effective Resolution, 87–88 Stare decisis, 196 the State in corporate debt restructuring, 132–33 as creditor, 133 as debtor, 133 as entrepreneur, 133

in out-of-court procedures, 255 public officials and, 133 as regulator, 132–33 as supervisor, 132–33 Statutory bail-in, 115 Statutory cross-border recognition, 96–97 Steering Committee, 154 Strategic Performance Plan, IFSB, 203–5 Sub-Saharan Africa, 262 Subsidiaries, 80 TLAC Standard on, 92 Substituting repos, 169 Sudan, 198 Sukûk, 194, 209, 212, 219 Surplus TLAC, 93 SWIFT. See Society for Worldwide Interbank Financial Telecommunications Switzerland, 89 Systemically important financial institutions (SIFIs), 27 bail-ins and, 38–48 corporate reorganizations of, 49 Federal Reserve and, 47 in financial crisis of 2008, 28 FSB on, 39–40 global, 43 insolvency of, 29 liquid assets of, 48 long-term debt of, 38–39 MPOE approach, 34 powers of, 31–32 recovery plans, 48–49 total loss absorbing capacity and, 38–48 See also Global systemically important banks Systemic crisis, corporate debt restructuring and, 127–28 Systemic risk assessment of, 187 central banks and, 166 macroprudential supervision and, 187 monetary policy and, 187 regulatory reform and, 6 T2S, 146 Takāful, 196, 198, 204, 209, 220 Take-up rate, 202

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Index 295

TARGET2, 146 Tawarruq, 219n13 Tea Party movement, 28 Tear-up, 110 Territorial approach, to cross-border resolution, 73 Terrorism, 227 See also Antimoney laundering and combating the financing of terrorism requirements TFEU. See Treaty on the Functioning of the European Union TLAC. See Total loss absorbing capacity TLAC Standard, 41 FSB on, 56, 88n15 on subsidiaries, 92 Too-big-to-fail syndrome, 27, 128 addressing, 30 cross-border resolution and, 55–56 elimination of, 50 further implementation steps for addressing, 48–50 regulatory reform and, 6–7 Total loss absorbing capacity (TLAC), 7, 64, 80 accumulation of, 100 bail-in strategy and, 38–48 BRRD and, 46 clean holding company requirements of, 40 in cross-border resolution, 87–95 disclosure of, 93–94 external, 40, 91 Federal Reserve Board on, 40 FSB on, 39–40 G-SIBs and, 88n14 internal, 40, 43, 91–92 location of, 90–91 MREL and, 46 operational liabilities and, 88–89 requirements for, 87–88 resolution entities and, 90–91 resolution groups and, 90–91 restrictions on, 93 SIFIs and, 38–48 standards, 42 surplus, 93 term sheets, 92n27 Toxic assets, Sharī’ah test and, 195

Transactional traffic banks, 271 Transparency CCPs and, 114–15 in Islamic finance, 196–97 Key Attributes for Effective Resolution on, 119n36 Treaty of Maastricht, 144 Treaty on the Functioning of the European Union (TFEU) Article 3, 144 Article 123, 162n13 Article 127(1), 144 Article 127(4), 145 Article 127(5), 144 Article 127(6), 150 on ESCB, 144–45 Twin peaks approach, 245–46, 246n29 UK. See United Kingdom UNCITRAL. See United Nations Commission on International Trade Law Union of Arab Banks, 263–64, 277 United Banking Corporation, 178 United Kingdom (UK) bank supervisor liability, 179 financial crisis of 2008 response of, 32–33 resolution strategies in, 33 SPOE and, 36–38 United Nations Commission on International Trade Law (UNCITRAL), 96 Legislative Guide on Insolvency Law, 134 Model Law on Cross-Border Insolvency, 134 Working Group V, 135 United States financial crisis of 2008 response of, 30–32 secular jurisdiction in, 197 Universal approach, to cross-border resolution, 73 Uruguay, 161 Valuations, BoE on, 38 Value-at-risk models, 237 Variation margin gains haircutting, 110

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Law & Financial Stability

Veto, power of, 184 Vitro case, 135 Volcker Rule, 42 Waterfall CCP, 109–11 defining, 108 loss allocation tools, 110 Wind-down powers, in Key Attributes for Effective Resolution, 88 Working Group on Deposit Insurance, 241

World Bank, 277 on corporate debt restructuring, 129 IFSB and, 247 on Islamic finance, 205 monitoring conducted by, 244–45 Principles and Guidelines for Effective Insolvency and Creditor Rights Systems, 134 Zakat, 234

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