Too big to fail
CSj highlights the key elements of the government’s proposed ‘resolution regime’ designed to ensure that regulatory authorities in Hong Kong have the tools necessary to intervene if a major, systemically important financial institution gets into financial difficulties.
As was demonstrated by the collapse of Lehman Brothers in 2008, the consequences of a major, systemically important financial institution going into bankruptcy can be catastrophic on a global scale, but what can or should regulators in Hong Kong do to manage such a scenario? During the global financial crisis that followed the collapse of Lehman, we were given an object lesson in what not to do – governments around the world used vast sums of public money to rescue financial institutions.
‘The rescue of these financial institutions resulted in taxpayers being called upon to subsidise their shareholders and creditors; something which is undesirable, including because it weakens market discipline making future failures and crises more likely,’ the Financial Services and the Treasury Bureau (FSTB) has pointed out (www.fstb.gov.hk/fsb/ppr/consult/resolution_faq_e.pdf).
One good thing to come from this debacle, however, has been a renewed political will to establish the regulatory infrastructure needed to avoid financial instability while protecting taxpayers should a systemically important financial institution fail in the future. This led to the Financial Stability Board (FSB) publishing its Key Attributes of Effective Resolution Regimes for Financial Institutions in 2011.
Currently, as Dr Martin Sprenger, Head of Policy Research and Development at the HKMA, pointed out at the Institute’s ACRU seminar earlier this year, financial regulators in Hong Kong have very few of the powers identified by the FSB as being a necessary part of an effective resolution regime. As an FSB member jurisdiction, Hong Kong is expected to take the steps necessary to meet the standards set out in the Key Attributes, and the government has been working to make the necessary legislative changes to establish an effective resolution regime for financial institutions in Hong Kong before the end-2015 deadline set by the FSB.
The key elements of that resolution regime, which has been under consultation since 2014, are now fairly clear. In October this year, the FSTB, in conjunction with the Hong Kong Monetary Authority (HKMA), the Securities and Futures Commission (SFC) and the Insurance Authority (IA) (together – the resolution authorities), published their conclusions to their second consultation on this issue. In this article, CSj highlights some of the key elements of the proposed regime.
What is the purpose of the proposed resolution regime?
Insolvency is a critically important market discipline, but, in the case of a large-scale, systemically important financial institution, this discipline is effectively unavailable. The major banks operating in Hong Kong, for example, provide critical financial services for large numbers of people, businesses and other financial institutions. The sudden termination of those services under an ordinary liquidation procedure would be likely to cause general financial instability. Moreover, it could set in motion a ‘domino effect’, as the liquidity and capital positions of other financial institutions come under pressure.
The proposed resolution regime is therefore designed to provide the resolution authorities with additional supervisory intervention powers, as an alternative to ordinary liquidation procedures, should any systemically important financial institution become non-viable. The resolution would have three main objectives, namely:
- to secure continuity of critical financial services, and payment, clearing and settlement functions, as well as the stability and effective functioning of the financial system
- afford an appropriate degree of protection to depositors, investors with client assets and insurance policyholders, and
- subject to pursuing these first two objectives, to contain the costs of resolution and, in so doing, protect public funds.
With regard to the second objective above, the proposed regime includes a series of safeguards relevant to all creditors. The resolution authorities would be obliged to impose losses in a manner that broadly respects the creditor hierarchy that would apply in liquidation. Moreover, they would be obliged to seek to provide outcomes for depositors, investors and insurance policyholders that are at least equal to those that would have been afforded to them if the financial institution had entered ordinary liquidation proceedings.
With regard to the third objective, the proposed resolution regime does include the possibility of taking the failing institution into temporary public ownership, but this is included as a last resort where the threat to financial stability is severe and where it is assessed that the other resolution options cannot be used to safely resolve matters.
Which institutions will it apply to?
The proposed regime will apply to a wide range of financial institutions including those authorised by the HKMA, the SFC and the IA, licensed corporations, insurers and companies that operate systemically important stock markets or future markets. Moreover, the Financial Secretary will have the power to bring further entities, including unregulated entities, within the scope of regime.
The proposed regime also gives the resolution authorities the ability to cooperate internationally. Some 29 out of the 30 global systemically important banks, and eight out of the nine global systemically important insurers are present in Hong Kong. If one of these institutions went down, Hong Kong would need to work with other jurisdictions to deal with the fallout. The Key Attributes issued by the FSB seeks to foster coordination and cooperation of resolution efforts where a cross-border institution becomes non-viable. This might involve a group-wide resolution carried out by the home jurisdiction and supported by key host jurisdictions.
How would a resolution work in practice?
If a systemically important financial institution gets into difficulties and all potential recovery options have been exhausted, the regime gives the resolution authorities the power to intervene ahead of the triggers normally set for insolvency. Where the failing institution is regulated by one of the three resolution authorities included in the proposed scheme, that authority would be responsible for intervening. Where the institution operates across multiple sectors, a lead resolution authority will be designated to co-ordinate the resolution.
The resolution authorities will be able to make use of five options:
- transfer to a commercial purchaser
- transfer to a bridge institution
- transfer to an asset management vehicle
- bail-in (an officially-mandated creditor-financed recapitalisation), and
- temporary public ownership.
The ‘bridge institution’ referred to in option two, would most likely be a company limited by shares under the Companies Ordinance, with the Hong Kong government as the initial shareholder and staff of the resolution authority as directors. The bridge institution could then be transferred to a third-party commercial purchaser or, if appropriate, to bailed-in creditors at a later date.
The exact mechanism for a statutory bail-in have not yet been finalised. ‘Respondents made a number of constructive comments on various issues (including valuation) with respect to the bail-in mechanism’, the consultation conclusions state, adding that the authorities will take note of these in developing processes and procedures for the practical execution of bail-in. The authorities expect to issue guidance or a code of practice setting out their approach to carrying out a bail-in once the legislation establishing the resolution regime comes into effect.
What powers would the resolution authorities have?
Under the proposed regime, the resolution authorities will be given powers to ensure an orderly resolution, including powers to gather information from financial institutions, issue directives to institutions, and remove directors and senior managers. The authorities would also have powers to claw‐back remuneration from individuals whose acts or omissions have materially contributed to the institution becoming non‐viable.
What are the next steps?
As mentioned above, Hong Kong is expected to take the steps necessary to meet the standards set out in the FSB’s Key Attributes by the end of this year. While this deadline is no longer achievable, the government is hoping at least to introduce its Bill establishing a resolution regime into LegCo by the end of the year. Meanwhile, the resolution authorities are working on preparing codes of practice and guidance for stakeholders on the implementation of the proposed resolution regime.
More information is available on the websites of the Financial Services and the Treasury
Bureau (www.fstb.gov.hk), the Hong Kong Monetary Authority
(www.hkma.gov.hk), the Securities and Futures Commission
(www.sfc.hk) and the Insurance Authority (www.oci.gov.hk).