Bank resolution

BANKS PERFORM A CRITICAL ROLE in the domestic and global economy by receiving deposits, making payments and providing other financial services. Although many financial services are increasingly being provided by non-bank entities, particularly in response to fintech developments (for a discussion about fintech, see China Business Law Journal volume 7, issue 8: Fintech and smart contracts), banks still occupy a unique position because of the comprehensive services that their licences permit them to provide. Consequently, legal systems around the world have always recognized special procedures for dealing with banks and financial institutions that experience financial difficulties. Banks and financial institutions are often subject to special provisions and exemptions in the domestic laws governing corporate insolvency (for a discussion about insolvency, see China Business Law Journal volume 4, issue 10: Bankrupt or insolvent?).

This article discusses the concept of bank resolution and why it has become a key focus of attention since the global financial crisis. It discusses developments that are designed to strengthen the powers of regulators around the world and encourage them to co-ordinate their responses to the resolution of banks that operate on a cross-border basis. Finally, the article outlines developments in the Asia-Pacific region.

WHAT IS BANK RESOLUTION?

In banking regulation, the term “resolution” refers to the action that a regulator (known as the “resolution authority” in this context) takes to resolve financial difficulties experienced by a bank. A primary objective of resolution is to protect public interests by continuing the critical functions of a bank, maintaining financial stability and trust in the financial system and imposing minimal costs on taxpayers. The term “resolution” is often used alongside “recovery”, which is the term used to describe the process by which banks and other financial institutions can recover their financial health.

Effective resolution action is of critical importance in the case of global systemically important banks and financial institutions, as reflected in the problems caused by such institutions during the global financial crisis. A major concern was the extent to which governments had to use taxpayers’ funds to bail out financial institutions that were facing collapse, particularly those financial institutions considered “too big to fail”. Bail-out is generally considered to be sub-optimal because of the risks to taxpayers and the moral hazard that this creates.

Another major concern during the global financial crisis was the inability of regulators to co-ordinate their actions in respect of banks that operated on a cross-border basis. The lack of effective cross-border co-ordination arguably contributed to disorderly collapses, the inability to preserve asset values and contagion of financial instability across borders.

In response to the lessons of the global financial crisis, most governments around the world have agreed to strengthen the resolution tools and powers of regulators, and to work towards achieving closer co-ordination of cross-border resolution actions.

REGULATORY CO-ORDINATION

The Financial Stability Board (FSB) is a global standard-setting body that monitors and assesses the global financial system and proposes actions needed to address financial stability concerns. In 2011, following the global financial crisis, the FSB published a document entitled Key Attributes of Effective Resolution Regimes for Financial Institutions, which sets out the core elements that the FSB considers to be necessary for an effective resolution regime. Updated in 2014, the key attributes are aimed at facilitating the orderly resolution of a bank and maintaining the continuity of its vital economic functions without exposing taxpayers to loss flowing from bank failure.

The key attributes call for banks to maintain their own recovery plan and for resolution authorities to maintain a resolution plan, particularly in respect of global or domestic systemically important banks or financial institutions. They set out a range of resolution tools that resolution authorities should have. These include the power to:

• take control of distressed banks and appoint administrators;
• replace management;
• transfer assets to a bridge institution to take over and continue the critical functions of a bank;
• delay (or stay) the operation of contractual early termination clauses to facilitate the transfer of contracts to another entity and the continuity of critical functions;
• require a bank to be recapitalized or restructured; and
• wind up the bank.

One critical tool, which has proven to be controversial, is the power to order bail-in; namely, the power of a regulator to order that certain debts of a bank be converted into equity. The purpose of such a power is to shift the responsibility for bank failure to a bank’s shareholders and creditors, and away from the public.

A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at law.asia.