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Living wills to be the gauge for risk

Legal Matters

The message to the financial services industry is clear – the days of lighttouch regulation are over. As legislators move to ensure that market disturbance on the global scale of the recent crisis can never happen again, financial institutions are braced for a new, tougher regulatory regime.

In the UK (although discussions on this theme are also taking place at both EU and international level), the big new idea is a requirement on financial institutions to establish and operate recovery and resolution plans (RRPs). For UK firms, these so-called living wills will be subject to a new regime established by the Financial Services Bill.

The FSA will set the procedure and establish rules designed to ensure firms have processes in place to facilitate recovery in the event of market stress. If this recovery plan becomes unviable, the authorities will implement the resolution plan – a contingency planning exercise designed to ensure the company can be efficiently wound down or, in the new language of this burgeoning area of regulation, resolved as a gone concern in a manner that protects consumers and avoids wider market upset.

The FSA is hinting that legislation on living wills is set to impact drastically on the financial sector, and Lord Myners’ recent speech to the Smith Institute referred to living wills as “one of the most radical proposals in global financial reform in a century”.

All politicking aside, the question remains, what does the new world of living wills really mean for the industry? Already we know that deposit-takers, including banks and building societies, are likely to have to draft RRPs. The global pilot was launched last year and includes six of the major insurance groups, as well as major banking groups such as HSBC and Barclays.

In non-bank sectors, the more onerous living wills process is likely to be extended further, possibly under the guise of a firm’s systemic importance. For example, bigger life offices and general insurers are in the regulator’s sights.

Lord Myners’ recent speech to the Smith Institute referred to living wills as ’one of the most radical proposals in global financial reform in a century’

Non-bank investment firms will also be caught but the precise scope of each of the new requirements – and the rules themselves -will be subject to consultation.

Living wills have two potentially costly roles. The first is a vast exercise in contingency planning. Although recovery plans will be scrutinised by
regulators and subject to their approval, firms will have considerable control over them and be responsible for tackling the legal and compliance issues that arise.

Due diligence will be required on all the potential difficulties, such as legal barriers from the group structure or negative pledges in contracts,
that might impede rapid execution of the plan.

In contrast, the resolution plan will belong to the authorities – who will be responsible for deciding how to effect resolution if failure occurs. The role of the firm here is to examine how resolution options might play out and to be ready to deliver the data and other resources those involved in the resolution will require.

Firms will be expected to maintain up-to-date financial information and data sets – possibly in permanent data rooms – in a form that meets FSA
requirements. This will include information on the group’s legal, operational and business structure and much more besides. RRPs are therefore likely to transform the way in which client and other data is stored.

The so-called singlecustomer view was announced by the FSA last year. From the end of 2010, banks must be able to deliver data sets giving the Financial Services Compensation Scheme insured balance for each individual customer across all the different brands of that bank entity.

Removing impediments to resolution may include a requirement to insolvency proof their contracts with key staff and service suppliers, so that an administrator will not lose these resources as soon as he is appointed.

A special reserve may be needed to fund the costs of these contracts during the administration.

There will be a greater emphasis on internal policemen within financial institutions. A new boardlevel role is planned for the purpose of establishing and implementing living wills. The business resolution officer, a sort of in-house funeral director, will be responsible for ongoing
compliance. This includes the need for management to consider how changes, such as acquisitions, will impact their RRPs. Not only will plans have to be updated but, in some cases, the potential impact on resolution may prevent a deal taking place.

On one level, living wills are a contingency planning exercise on a grand scale. However, this new regulatory tool has another, potentially even more revolutionary, role. RRPs are the logical extension of stress-testing in that they plan for the contingencies not covered by stress-testing assumptions. This switch to disaster-mode thinking links to the broader re-appraisal of capital and liquidity standards and the increased impact of contingent capital.

The authorities are only just starting to get to grips with lessons from the crisis that fall within the new mantras of macroprudential regulation and systemic risk. To help them, they will have access to a mass of new data derived from firm-and industry-level stress-testing and the new requirements for reverse stress-testing back from failure.

What good will this do and how will the data be used? Living wills offer regulators an ideal opportunity to address many of these macroprudential mechanism brainteasers – the belief that institutions have become too big, complex or interconnected to fail.

The RRP process gives the regulator a tool to probe these issues without having to devise hard-edged and highly controversial Volckerstyle rules. This may be the instrument of choice in that it puts the onus back on each financial institution to prove it can fail without taxpayers’ money or broader contagion being at risk.

The Bank of England has stated that in assessing RRPs, regulators must consider whether “with this structure and business model, can the resolution authority achieve a resolution at an acceptable cost” – essentially, would the consequences of an institution failing be so uncertain or dangerous that the authorities might have to mount a rescue with taxpayers’ money?

Armed with this mass of new information, authorities can challenge each firm according to this criteria,looking at issues such as at its business models, structure, scale and risk.

From its draft living will, an institution may be judged by the new bad cop FSA to pose too great a risk, on account of its size, complexity or its role within the financial system. In retail sectors, an institution may be challenged if its failure threatens potentially large uninsured consumer losses.

As the authorities learnt in the recent crisis, financial stability concerns – and political pressure – can dictate that the Government rescues a failing firm rather than enforcing the principle of moral hazard against the consumer.

RRPs provide a regulatorfriendly tool to address that most fundamental issue which politicians have debated in simplistic terms – should the banks be broken up? This is the potentially radical endpoint of the living will process.

Paul Edmondson is a partner at CMS Cameron McKenna


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