Bank Regulation Quo Vadis? A Review of Current Regulatory Trends
René Bösch
The leading European banking lawyer according to our research shares his insight on recent regulatory initiatives and the outlook for financial institutions and the lawyers who advise them.
René Bösch
The financial crisis has not only hit financial institutions very hard, but has also put regulators around the world on the spot. The unprecedented nature, depth and geographical reach of the market turmoil throughout 2007 and 2008 and into 2009, has forced regulators and lawmakers around the world to respond. It is not an exaggeration to state that the collapse of the US investment bank Lehman Brothers in autumn 2008 rocked the international financial system and it was clear such a system shock required regulatory action in response.
In the 2008 edition of The International Who’s Who of Banking Lawyers, I called for restraint on the part of regulators and supervisors when crafting regulatory initiatives in response to the crisis. However, in the interim, regulators and lawmakers around the world have not infrequently rushed to action and called for a “regulatory tsunami” in response to the crisis. A significant number of reform projects at both the national and international level have been initiated in the area of financial market regulation, and the G20 has been taking on the political leadership in this area. The G20 has repeatedly called for better and more comprehensive regulation and supervision of the financial system and has put tackling the systemically important institutions (the so-called “SIFIs”) at the top of its agenda.
Regulatory Initiatives From Basel II to TBTF Regulation
The focus of most of the aforementioned reform projects has predominantly been on the stabilisation of financial institutions and the implementation of preventive measures. It is therefore not surprising that the G20 mandated the Financial Stability Board (FSB) to procure recommendations on the reduction of risks in connection with SIFIs and that the Basel Committee has initiated work on improving the quality of regulatory capital. On 12 September 2010, the Group of Governors and Heads of Supervision approved a new reform package proposed by the Basel Committee on Banking Supervision, which is referred to as the “Basel III” reforms. By focusing on improving the quality of regulatory capital (eg, Basel III will require banks to maintain a larger part of their regulatory capital in the form of common equity rather than in the form of hybrid instruments) and increasing the current minimum capital requirements, the Basel Committee seeks to reduce banks’ exposure to market disruptions, such as those encountered during the recent crisis. Basel III also includes two new liquidity rules designed to make banks less vulnerable to distortions in the interbank funding market and customer pressure by requiring banks to hold enough cash and other easily marketable assets to survive a 30-day crisis. The Basel III rules will be phased in gradually through the end of 2018.
The EU decided to establish a European Systemic Risk Board for macro-supervision and systemic risk. Several other initiatives have been considered in the EU, including the establishment of rescue funds for distressed financial institutions, which would be set up or financed by financial institutions as an act of solidarity. In addition, studies have been commissioned as to the feasibility and advisability of levying taxes on banks based on their levels of borrowing and risk.
In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law by President Obama on 21 July 2010. One of the primary goals of the Dodd-Frank Act is to prevent situations from arising in which the US federal government would need to rescue SIFIs. Aside from establishing the Financial Stability Oversight Council, the Dodd-Frank Act also sets forth specific rules regarding the behaviour and restricted and prohibited activities of banks. The Dodd-Frank Act is a good example of the more recent trend in banking regulation, which is to not only increase regulatory capital requirements, but also to require banks (or at least large banks that qualify as SIFIs) to organise themselves in such a way so that they can continue to carry out their systemically important functions and services during a financial crisis without the need for government intervention.
The Swiss economy is particularly exposed to the Too Big To Fail phenomenon (“TBTF”) because the two largest Swiss banks play a leading role in both the national and international financial sector. In November 2009, acknowledging that the failure of either of these two banks would not only endanger the stability of the Swiss financial system, but also directly affect all sectors of the real economy in Switzerland, the Swiss Federal Council established a commission of experts to address the economic risks posed by large companies and make proposals on how to limit these risks. The commission of experts, which was composed of representatives from the government, the financial industry and the real economy, as well as of academics, presented its proposal in early October 2010. In order to reduce the Swiss economy’s exposure to the two largest Swiss banks, the commission proposed a package of measures (so-called “policy mix”) rather than limiting its focus to increased regulatory capital requirements. Some of the proposed measures have a preventive effect and are designed to prevent insolvency. The other measures have a curative effect and are designed to minimise the negative repercussions on the Swiss economy caused by the insolvency of a systemically important financial institution, while at the same time ensuring the maintenance of such financial institution’s systemically important functions.
While acknowledging that banks benefit from the constitutionally protected freedom to autonomously organise themselves, the expert commission found that the banks should nevertheless be required to take or plan certain organisational measures in order to ensure that they are able to maintain their systemically important functions in case of insolvency. There will be new laws or regulations setting forth the standards that Swiss SIFIs must meet in order to satisfy this new requirement. In particular, Swiss SIFIs will be required to demonstrate that they will be able to maintain their systemically important functions in the event of their insolvency. In order to be able to do so, a Swiss SIFI will have to establish emergency plans (which may eventually be equivalent to a living will) that specify in great detail the specific measures (including the timing thereof) that such SIFI will take or implement in order to ensure that goal, and such emergency plans will need to be approved by the Swiss regulator.
Bridge Bank Concepts Versus Bail-In Framework
The Swiss approach to address the TBTF phenomenon, as well as other nation’s regulatory initiatives, put quite some emphasis on the possibility that a bank could transfer its systemically relevant functions or other assets to a separate legal entity (ie, a “bridge bank” or a “lifeboat”). In the bridge bank scenario, the transfer of assets to a bridge bank would ensure that, should the continuation of the bank no longer be viable, its systemically relevant functions could be maintained by the bridge bank while the now insolvent bank is liquidated without the need for governmental support or intervention.
In the context of the TBTF discussions in Switzerland, a common understanding has been reached as to the different stages of a bank crisis. During the bank’s so-called “recovery phase”, the focus is on the risk management measures (eg, issuance of new equity, asset divestitures, issuance or trigger of contingent convertible capital instruments) that the bank takes on its own initiative. Only after the measures that the bank has taken in its discretion have failed, will the bank enter the so-called “resolution phase” during which the competent regulator may impose restructuring measures.
To date, discussions regarding the measures to be taken before or during the resolution phase have focused on the transfer of the distressed bank’s assets to a lifeboat, with the bridge bank being adequately funded by the “old” bank before times of financial distress or benefiting from funding provided by specially established rescue funds. For instance, Germany just adopted a law that contemplates the transfer of assets in the “eleventh-hour”, ie, in the context of a work-out as an ultima ratio in order to avoid liquidation and permit the maintenance of the bank’s systematically relevant functions. However, the focus has just recently shifted to the possibility of applying debt-to-equity swaps to recapitalise distressed banks. This technique serves the same purpose as a voluntary or forced transfer of assets to a lifeboat, but also may allow for the stabilisation of the whole bank as a going concern as opposed to securing “only” the continuance of its systemically relevant functions in a new carrier. In that vein, leading representatives of the financial industry have been promoting the idea of a bail-in, an idea that has received great interest. Conceptually, a bail-in should be understood as a fast-track recapitalisation procedure whereby the competent regulator exercises a (yet to be granted) statutory power just prior to (and in lieu of) the opening of a bankruptcy or liquidation proceeding with respect to a troubled bank. The goal of a bail-in is to create a better option for policy-makers, so that they do not have to face the same dilemma they were presented with during the recent crisis – namely, either bail out a bank with taxpayer funds or risk systemic contagion and possible financial collapse. A bail-in is not a “bail-out” since no taxpayer funds, governmental capital or guarantees are used. In a successful bail-in, the troubled bank can be pulled back from the brink of becoming a “gone concern” (liquidation) and continue as a “going concern”.
Different versions of the bail-in concept are currently being evaluated in many jurisdictions around the globe. One of the most delicate issues to be addressed when evaluating any such version of the bail-in concept is whether the relevant bail-in measure (in particular a forced debt-to-equity swap) imposed by the competent regulator would trigger an event of default under any of the financial contracts to which the troubled financial institution is a party, which could jeopardise the ability of the financial institution to continue as a going concern. In addition, it is very unclear whether a forced measure taken by a regulator in one country would be accepted by the regulator in, or the laws of, another country. Ultimately, such issues can probably only be solved in an international context through an internationally coordinated effort. However, in the meantime, a “building-block approach” may help to overcome some of the most troublesome issues. The building-block approach means that certain of these issues are avoided through contractual means, ie, by embedding contractual arrangements in financial instruments that would facilitate a debt-to-equity swap in certain situations, which would consequently not be considered an event of default under the terms of the relevant instrument.
Outlook - Quo Vadis?
A significant number of regulatory and legislative initiatives have been undertaken in the last two years to address the problems and risks of a financial crisis and to assure that financial institutions and the economy as a whole will be safer, more robust and able to withstand market disruptions in the future. In many countries the main focus has been put on SIFIs and ensuring that during the next financial crisis state intervention can be avoided and no taxpayer funds, governmental capital or guarantees will need to be used (at least not to a significant extent). A very broad range of measures have been identified, evaluated, proposed or implemented. Those that take the form of increased regulatory capital requirements, such as higher quality and greater minimum levels of regulatory capital, new or increased liquidity maintenance rules and diversification rules, shall primarily serve preventive goals. In addition, in many countries organisational requirements have been or will be imposed on banks (or at least banks that are SIFIs) in order to ensure that the maintenance of at least the systemically important functions of a troubled bank (or SIFI) is guaranteed during future crises. On the other side of the spectrum, new rules on bank resolvability or reorganisation shall ensure that bank regulators may order the transfer of systemically relevant functions or other assets of troubled banks to new carriers to protect such functions and other assets should the bank cease to be a going concern. In addition, the idea of bailing-in a bank by way of a mandatory debt-to-equity conversion has emerged as a potentially powerful and interesting alternative available to national regulators.
All these regulatory initiatives involve complex processes and pose complex legal, economic and business issues that require careful analysis and evaluation. While it is understandable that the public calls for swift solutions in order to prevent national governments or taxpayers from having to step in during the next crisis, the complexity of these issues and new legal and business concepts warrants an in-depth analysis and requires time. Quick-fix solutions may not achieve their intended purpose and may just be spraying sand in the eyes of the public and the regulators. Therefore, I repeat my call for some restraint on the part of regulators, supervisors and lawmakers in their approach to solving the issues. Only new regulations that ultimately work in times of a new financial crisis will be helpful, and irrespective of any such regulations work, they must also be acceptable to the financial industry in order to be successful, which means that they must not distort the financial industry as a whole or impose onerous burdens on financial institutions in the operation of their business.