In this blog post, Komal Shah, Company Secretary, explains aspects of Recovery and Resolution planning done in large sized financial institutions.
What are recovery and resolution plans?
Simply put, recovery and resolution plans, also called living wills, are a plan of what a financial institution needs to do in the event it is about to collapse.
Though the terms recovery plans and resolution plans are often used together in one breath, there is a fine line of difference. Recovery planning would be used when restoring the viability of the financial institution (recovery) still seems possible, while resolution planning would be used when the collapse seems inevitable.
Why were these plans born?
One would think as to why a financial institution would predict itself to collapse? Why not function in such a way so that there would never be a situation of failing? However, the shattering of the belief that it was possible for a financial institution to function in such a manner so that it never fails, is precisely what led to the birth of recovery and resolution planning.
When a financial institution which is sizeable enough to impact the economy of a country fails, it is very likely to have implications on other institutions (or for that matter, even other countries), which would be unpredicted, just like aftershocks to an earthquake. What seemed like a sound and profitable business judgment a few years ago, would then seem like an insane decision, in the economical earthquake scenario.
This very realization of the fact that an economic earthquake is possible, as it started with the collapse of Lehmann Brothers in 2008, is what led to the setting up of the Financial Stability Board (FSB) by the G20 countries, and ultimately, recovery and resolution planning.
It’s not like we haven’t had our share of failure of market-affecting financial institutions before 2008 – the US 64 of the Unit Trust of India being a point in case. And there have been legislative responses to such instances, such as the repeal of the UTI Act.
Then, there is something called the ‘Prompt Corrective Action’ which can be initiated by the Reserve Bank of India (RBI) once the set trigger points of a regulated financial entity show a serious threat to solvency.
But the requirement for preparing systematic recovery plans by the entity itself did not exist before being filtered down from ‘key attributes’ agreed upon by the G20 countries after the 2008 economic crisis.
Who needs to prepare these plans?
These plans were initially required to be prepared by global systemically important financial institutions (G-SIFIs) and other institutions which, in the belief of the national authorities had impact on financial stability, if they failed.
Per the Dodd Frank Wall Street Reform and Consumer Protection Act, bank holding companies with total consolidated assets of $50 billion or more and other financial companies designated for supervision by the Federal Reserve need to submit the resolution plans to the Federal Reserve and the Federal Deposit Insurance Corporation.
In India, ‘specified banks’ (meaning specified by the RBI as such) need to prepare recovery plans and these should be integrated within their overall risk management systems (like fire extinguishers in a building) so that if need arises, they can be acted upon immediately. The plans have to be submitted to the RBI.
Interesting to note that plans to be submitted to the Fed are ‘resolution’ plans while those to be submitted to the RBI are ‘recovery’ plans.
How do these plans need to be prepared?
Per the guidance issued from the FSB, some of the important factors for developing resolution strategies are:
- Sufficient Loss absorbing capacity (LAC): This basically means that the financial institution should have enough LAC to be able to stand up back again with additional capital or to properly wind down. This can be maintained through equity or debt, but needs to come from entities who can themselves absorb losses without adverse effects. The guidance also specifies considering the creditor hierarchy vis a vis the LAC.
- Legal and operational structure & continuity: The structure of the financial institution should enable critical functions to continue while it is being orderly wound up.
- Enforceability of ‘bail in’: The institution needs to be legally able to ask the creditors / depositors to take a loss rather than the government and taxpayers (bail – out).
- Funding arrangements: The institution needs to plan how and from where it will bring in the funding to meet temporary liquidity requirements.
- Approvals or authorizations needed to implement the strategy: The institution must consider how the approvals or authorizations necessary to implement the resolution plans will be obtained.
Other important factors to be considered include treatment of business contracts during the resolution, cross border cooperation agreements, managing the data and information systems, fall back options in case the preferred resolution plan does not work, and the post resolution strategies.
The RBI has clearly specified the structure of the recovery plans with the main ingredients being as under:
- Integration: Since the RBI believes in prevention rather than cure, the first element is to explain how the plan has been integrated within the bank’s risk management framework;
- Stress Scenarios: This basically involves checking the bank’s capacity to withstand extreme economic movements and their effects on the bank’s capital adequacy;
- Trigger framework and identification of triggers, early warning indicators: What will be the triggers which will start the implementation of the bank’s recovery plan, how to decide triggers which would have both qualitative and quantitative factors, what are the early warning indicators even before the triggers are reached;
- Recovery plan options: Summary, details and impact of each recovery plan option and the credibility of each option;
- Issues: Possible issues in the execution of the recovery plan and ways to overcome these issues;
- Accessing Central Bank’s facilities: Plans in the event the bank is going to require to access the Reserve Bank of India’s or overseas banks’ liquidity facilities;
- Radical options: Detailing radical options such as selling off part or whole of banking business in extreme stress events;
- List of executives: List of key executives / officials who will be involved in initiating / implementing recovery actions and their roles and responsibilities.
Need to know about recovery and resolution planning
For anyone working with a large bank, particularly in finance, legal or compliance departments, recovery and resolution planning will affect their everyday work since these will be ingrained within the risk management framework of the bank, and hence, the need to know what it means and entails. For large sized private clients of a bank, it helps to know that the bank does have the appropriate planning in place.