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Resolution of Financial Firms

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Resolution of a financial firm has been defined as a particular kind of instant bankruptcy, destroying the interests of some creditors quickly and unmercifully, while giving others, especially the bank’s depositors, a fresh and happy start.Resolution is meant to be implemented before contagion sets in and the institutions’ counterparties, including customers, traders, and even competitors, also fail, either through panic or poor risk management [1]. In India the resolution regime for financial firms is proposed to be specified through the Financial Resolution and Deposit Insurance Bill, 2016.This Code will provide a specialised resolution mechanism to deal with bankruptcy situations in banks, insurance companies and other financial sector entities.

 

Background

The global financial crisis of 2008-09 highlighted the deficiencies of the most adversely affected jurisdictions in the sense that these did not have the requisite powers to protect the stability and effective working of the financial system in cases of systemically important financial institutions (SIFIs) or “too-big-to-fail” (TBTF), with substantial global presence and linkages, leading to rescue (or bail-out) of failing financial institutions (FIs) with unparalleled amounts of public funds. Therefore, development of an effective resolution framework has been a priority for the international community. The Financial Stability Board (FSB) was tasked by G20 leaders with developing robust alternatives to publicly-funded rescues, such that critical or systemic FIs might be allowed to fail safely. FSB published the new standards in the form of “Key Attributes of Effective Resolution Regimes for Financial Institutions” (or “Key Attributes”) in October, 2011. On October 15, 2014, FSB published additional guidance that expands on specific Key Attributes  (KAs) relating to information sharing for resolution purposes and sector-specific guidance that sets out how the KAs should be applied to insurers, financial market infrastructures (FMIs) and the protection of client assets in resolution. According to FSB, the objective of an effective resolution regime is to ensure resolution of financial institutions without severe systemic disruption and without exposing taxpayers to loss, while protecting critical economic functions through mechanisms which make it possible for shareholders and unsecured and uninsured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation.There are twelve essential features of KAs that should be part of the resolution regimes of all jurisdictions.

The KAs specify the resolution framework at both the national and international levels, with the key objective of making resolution feasible without severe systemic disruption and without exposing taxpayers to loss. The KAs include a comprehensive “toolkit” of resolution powers for national authorities, including powers to: (i) take control of a financial institution from existing management and shareholders; (ii) effect a resolution of the troubled institution through the sale or merger of theentity, the transfer of assets and liabilities of the institution to third parties, or throughforced debt restructuring or “bail-in” [2]; and (iii) support the resolution through a temporarystay on the execution of early termination rights under financial contracts.FSB conducted a thematic review of the status of implementation of KAs in its 24 Members countries. The review which was published in March,2016 showed that many jurisdictions did not comply with all the KAs.

The Insolvency and Bankruptcy Code, 2016 enacted by the Parliament provides for resolution and liquidation of non-financial firms, although some financial service providers could be notified to be covered under the said Code by the Central Government in consultation with the appropriate financial sector regulator. Recent experience and research have shown that resolution of financial institutions requires a special regime that is faster than any traditional insolvency procedure, where rights of the creditors and other stakeholders can be overridden in the interest of the financial system (including the consumers) and the economy. In the Budget 2016-17, it was announced that the Code for resolution of financial firms, together with the Insolvency and Bankruptcy Code will provide a comprehensive resolution mechanism for our economy. Accordingly, a Committee of the Government [3] has proposed the Financial Resolution and Deposit Insurance Bill, 2016 suggestingestablishment of a special resolution regime for financial firms in line with international best practices (KAs).

 

Economic Case for a specialised resolution Regime
Sometimes it is argued that weak or unsuitable resolution regimes are associated with acute incentive distortions and agency problems, allowing excessive risk-taking and making regulators unable or unwilling to step in. It has been suggested in a theoretical model that regulators have incentives to prefer bailout if they do not have proper resolution technologies [4]. Therefore, if other options for resolution of a financial sector entity are not available and public infusion of capital becomes the only alternative, this is certain to create enormous moral hazard [5] and reduce the force of market discipline. If only bail outs are preferred mode of resolving a financial sector entity, it amounts to policymakers trading market discipline in exchange for market liquidity. It has been documented in the empirical research [6] that institutions which expect to obtain public support hold smaller amounts of tangible common equity relative to total assets, on average.

In view of the above, there appears to be a solid case for financial sector institutions to be subject to a special resolution regime [7]. Such regimes may facilitate overall financial stability by improving the trade-off between the need to stabilise the financial system and to minimise fiscal costs and longer run-costs of moral hazard. These can reinstate incentives which are otherwise compromised by expectations of public support, “too important / complex to fail”. However, financial stability can not only be guaranteed through creation of special resolution regimes. Additional measures increasing the ex-post resolvability or reducing the ex-ante risk-taking of financial sector entity might also be required [8].

It may be recognised that failures of financial sector entities, like insolvency of inefficient non-financial sector entities, are necessary for efficient reallocation of economic resources in the long run. Therefore, there is a need for a regulatory regime for resolution which not only expects and allows such financial sector entities to fail, but also improve our capacity for resolving those failed, in an orderly fashion.Therefore, themain objective of the proposed Financial Resolution and Deposit Insurance Bill(“the Bill”) is to establish an independent Resolution Corporation, which will contribute to the stability and resilience of the financial system by efficiently resolving financial firms in distress, provide deposit insurance to banks, monitor the Systemically Important Financial Institutions and protect the consumers of financial sector entities and public funds to the extent possible.

 

Recommendations of the Committee to draft a code on resolution of financial firms

The Committee has proposed the Financial Resolution and Deposit Insurance Bill, 2016 to provide for an enabling legal framework for creation of an independent Resolution Corporation. The Financial Resolution and Deposit Insurance Bill, 2016consolidates the existing laws relating to resolution of certain categories of financial institutions (“covered service providers”), including banks, insurance companies, financial market infrastructures, payment systems, and other financial service providers (excluding individuals and partnership firms), which are presently scattered in a number of legislations, into a single legislation, and provides for additional tools of resolution to enable the new authority (“Resolution Corporation”) to maintain the systemic stability in the country. The Financial Resolution and Deposit Insurance Bill, 2016 also provides for certain special provisions in relation to resolution of central counterparties because of their unique status in the financial system.

The major recommendations contained in the Report are as follows:



1. David T Zaring (2010). ‘A lack of resolution’. Emory Law Journal. Vol. 60, p. 99.

2. It is mentioned in the KA that powers to carry out bail-in within resolution should enable resolution authorities to:
(i) write down in a manner that respects the hierarchy of claims in liquidation equity or other instruments of ownership of the firm, unsecured and uninsured creditor claims to the extent necessary to absorb the losses; and to
(ii)convert into equity or other instruments of ownership of the firm under resolution (or any successor in resolution or the parent company within the same jurisdiction), all or parts of unsecured and uninsured creditor claims in a manner that respects the hierarchy of claims in liquidation;
(iii) upon entry into resolution, convert or write-down any contingent convertible or contractual bail-in instruments whose terms had not been triggered prior to entry into resolution and treat the resulting instruments in line with (i) or (ii).
In contrast, bail out happens when the sovereign authority steps in to save the institution using tax- payers’ money.

3. Pursuant to the Budget announcement, a Committee was set-up under the Chairmanship of Shri Ajay Tyagi, Additional Secretary, Department of Economic Affairs, Ministry of Finance on 15 March 2016 with representatives from the Ministry of Finance, the financial sector regulatory authorities and the Deposit Insurance and Credit Guarantee Corporation with instructions to submit a Report and a draft Code.  The Committee submitted its Report on 21 September 2016alongwith a Draft Bill known as ‘The Financial Resolution and Deposit Insurance Bill, 2016’.

4. DeYoung, R., M. Kowalik, and J. Reidhill. (2013), “A Theory of Failed Bank Resolution: Technological Change and Political Economics”, Journal of Financial Stability 9(4), pp. 612-627.

5. The principle of Moral Hazard refers to a situation where a person or an economic entity is encouraged to undertake more risk than warranted due to the guarantee /protection he is assured of.

6. Nier, Erlend and Ursel Baumann (2006), “Market Discipline, Disclosure and Moral Hazard in Banking,” Journal of Financial Intermediation, Vol. 15, pp. 333–62.

7. Čihák, Martin and ErlendNier (2009), “The Need for Special Resolution Regimes for Financial Institutions—The Case of the EU,” IMF Working Paper No. 09/200.

8. Ignatowski, M. and J. Korte. (2014), “Wishful Thinking or Effective Threat? Tightening Bank Resolution Regimes and Bank Risk-Taking”, ECB Working Paper Series No. 1659.

9. Covered Service Providers (CSPs)are entities covered for the purposes of resolution under the Financial Resolution and Deposit Insurance Bill, 2016. These are so called because, otherwise these can be covered under The Insolvency and Bankruptcy Code, 2016through a Government notification.



References


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Contributed by

Dr. Shashank Saksena (IES 1987)

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