20 December 2012
ECB contribution to the European commission’s public consultation on a possible recovery and resolution framework for financial institutions other than banks
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1. Introduction
The ECB supports the work of the European Commission towards developing an effective recovery and resolution framework for financial institutions other than banks, including in particular FMIs in view of the increasingly important role that such infrastructures play with regard to preserving financial stability. It is vital that very robust arrangements exist for the recovery of Financial Market Infrastructures (FMIs) and, if that fails, for their resolution. The ECB welcomes the opportunity to provide input into the public consultation that the Commission has launched to this end. Owing to its role and responsibilities for monetary policy and the stability of the financial system at large, the ECB has a particular interest in FMIs including payments systems, central counterparties (CCPs), central securities depositories (CSDs), and trade repositories.
This contribution focuses on the recovery and resolution of such FMIs. It consists of two parts. First, it provides a few general observations on aspects that the Eurosystem considers to be particularly important from a central bank perspective. Second, it provides short answers to the individual questions raised in section 3 of the consultation document focusing on FMIs.
2. Main observations
2.1. Scope of the recovery and resolution regime
The Commission’s consultation mainly focuses on CCPs and CSDs, whereas payment systems are excluded from further consideration “given their special relationship with and oversight by central banks”. Central banks have a special relationship with FMIs from a number of perspectives: as users, service providers, and overseers. This relationship as such, however, cannot guarantee that service continuity will be preserved under all circumstances.
Rather, the ECB considers that all systemically relevant FMIs including payment systems should be subject to a recovery and resolution regime unless they are owned and operated by a central bank. Large-value payment systems and many retail payment systems are systemically relevant. They may provide settlement guarantees, can be exposed to credit risk themselves or entail credit and liquidity risk among their participants, and are essential for the functioning of financial markets and the economy at large. It is vital that service continuity of such systems is preserved. Moreover, the existence of a sound recovery and resolution framework is a precondition for a globally acting payment system to be located in the EU. The ECB therefore considers that all systematically relevant payments systems should be subject to a recovery and resolution regime. Only those payment systems that are owned and operated by central banks should be exempted as in this case the continuity of services can be guaranteed under all circumstances.
Similarly, while trade repositories are less systemically relevant as they do not take on credit risk and do not pose an immediate threat to the functioning of financial markets should they fail, they are still important infrastructures that support relevant authorities in identifying risks in OTC derivatives markets. Moreover, in view of their fragmentation and given that their business models have not been tested over a sufficient period of time, trade repositories may well be exposed to business risks and losses that could cause them fail. It needs to be ensured that in such an event data can be transferred smoothly to another trade repository. Trade repositories should therefore also be covered by the EU recovery and resolution framework to be developed.
2.2. Need for effective recovery and resolution regimes specifically designed for FMIs
The ECB believes that effective risk management in line with the CPSS-IOSCO Principles for Financial Market Infrastructures (Principles) is key in preventing any need for recovery and resolution of FMIs. However, FMIs and relevant authorities nevertheless need to be prepared for the failure of an FMI which can lead to severe systemic disruption if it causes markets to cease to operate effectively.
FMIs are different from other types of financial institutions in a number of ways. First, there is a higher significance of service continuation for financial stability. In providing critical operations and services, an FMI develops direct relationships with participants, other FMIs, and other service providers, which increase its interconnectedness and the potential for disruptions to spread quickly across the financial system. Second, FMIs often have few, if any, substitutes or alternative providers. These differences are relevant to the choices facing authorities to achieve resolution including the possibility and necessity to consider creating a bridge institution. Third, this functional difference also affects the size and composition of the balance sheet of an FMI. For example, FMIs rarely issue subordinated debt instruments commonly seen in financial institutions. These differences can extend to the equity part of a balance sheet, where FMIs may be owned by their members or public authorities. This may have the effect of requiring some adaptation of bail-in as a resolution tool. Finally and importantly, the Principles require FMIs to have rules and plans in place for the allocation of uncovered losses and liquidity shortfalls. Such requirements constitute an important step towards ensuring the FMI’s recovery and do not exist for banks.
Against this background and in view of the specific nature of FMIs that makes them different from banks, the ECB believes there is a need for establishing a European recovery and resolution regime which is specifically designed for the purposes of FMIs and distinct from the resolution framework for banks.
2.3. Need for consistency at international level
Drawing on experience in the field of regulations for OTC derivatives and central clearing, the ECB believes it is highly desirable to achieve international consistency of recovery and resolution regimes for FMIs. Divergences in national rules create a potential for regulatory arbitrage and may confront infrastructures and their participants with contradicting and/or overlapping rules. To this end, the ECB urges the Commission to align any possible EU regulation in this field with the recovery and resolution framework that is currently being developed at global level by CPSS and IOSCO. At this stage, the international standards setters have developed two sets of provisions to guide the development of recovery and resolution regimes:
(i) The CPSS-IOSCO Principles: While the main focus of the Principles is to prevent the need for recovery and resolution measures on the basis of effective risk management, they go beyond prevention and contain a number of relevant references to the recovery of FMIs, including most importantly rules for the allocation of uncovered losses and liquidity shortfalls as well as capital requirements for FMIs to cover business losses and to ensure an orderly wind-down or reorganisation of its critical operations and services (see Principles, 4,7 and 15).
(ii) The Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes): In the event of recovery failing, a statutory resolution regime is needed. In their consultative report on recovery and resolution regimes for FMIs, the CPSS and IOSCO have adapted the Key Attributes to take into account the specific characteristic of FMIs.
Importantly, the CPSS and IOSCO are currently in a process of elaborating further on an effective recovery regime for FMIs along three main lines: (i) the relations between FMI risk management, recovery, and resolution; (ii) tools for recovery; and (iii) cooperation among authorities. The ECB is confident that the forthcoming EU recovery and resolution regime for FMIs will be aligned with the international standards as being developed by CPSS and IOSCO.
2.4. Need for a centralised and effective resolution mechanism
The EU is currently in a process of moving towards a banking union including an integrated resolution framework as one of three pillars constituting a banking union. The establishment of a European Resolution Authority represents a critical next step to this end. While the EU regulatory framework for CCPs under EMIR is based on the concept of supervisory colleges and the creation of a single European supervisor for FMIs has not yet been taken forward, there is nevertheless a strong case for a centralised EU resolution mechanism for FMIs for a number of reasons.
First, the resolution of FMIs requires swift decision taking that cannot afford lengthy coordination processes among a multitude of authorities. For example, supervisory authorities may assess a given situation differently. Such differences in the assessment of available information in an event of urgency may complicate the finalization of the resolution process. A common resolution structure, with a unified resolution regime and a single resolution authority would avoid such problems and facilitate swift decision making. Second, many FMIs are so large in size and scope that their failure would, on the one hand, endanger the financial system of several countries at the same time, but on the other hand, be too large for the national government of the home country to be supported in case of stress and thereby causing or exacerbate funding problems of the sovereign, which might further destabilize the financial sector. For these reasons, a centralised resolution authority in particular for CCPs, ICSDs, and large-value payment systems would be very beneficial especially as financial stability and the implementation of monetary policy critically depend on the smooth functioning of payment and settlement systems.
Against this background, the ECB would propose designating a single centralised European Resolution Authority for FMIs, in particular for CCPs, ICSDs, and large-value payment systems, even before the current framework for the regulation and oversight of FMIs has been moved further ahead towards greater centralisation. The ECB believes that ESMA could act as the single resolution authority for such FMIs, in cooperation with the ECB in view of its roles both as future European banking supervisor and as central bank of issue.
2.5. Need to distinguish between different types of FMIs
Effective recovery and resolution regimes are important for all types of FMIs. However, FMIs are different in nature, are exposed to different types of risks, and their failure may have different systemic implications. Careful distinction therefore needs to be made between the different risk profiles that FMIs may have.
For example, in the event of the default of a CCP, the most serious problem that needs to be addressed is the allocation of any uncovered losses and liquidity shortfalls first by means of recovery on the basis of the CCP’s own rules and subsequently if recovery fails by statutory loss allocation for resolution. Similarly, the recovery of a CCP needs to focus on tools that can be used to re-establish a matched book including tear up in the event regular auctions do not work. In contrast, for the recovery of CSDs, the focus needs to be on managing business risk and maintaining adequate capital resources to this end and to ensure the smooth transfer of services either to third parties or a bridge institution that might need to be created just for that purpose.
Such differences in emphasis and focus do not necessarily call for separate recovery and resolution regimes per type of FMI, but suggest that relevant provisions and requirements might need to be adjusted and complemented to fit the specific risks and systemic implications that a particular type of FMI may be exposed to and/or create.
2.6. Need to clarify the relationship with regular insolvency law
The distinction between the resolution regime for FMIs and regular insolvency rules needs to be clearly drawn in that a resolution regime for FMIs may either replace ordinary insolvency law or complement it as an intermediate step needed to prevent insolvency. For example, to the extent that resolution focuses on steps and measures to be taken by authorities after recovery efforts have failed and before regular insolvency proceedings start, e.g. measures to ensure the orderly wind down of CCPs or transfer of services, a statutory resolution regime may complement regular insolvency law by serving as a tool to prevent regular insolvency proceedings from coming into force.
Alternatively, a resolution regime for FMIs may replace existing insolvency rules to the extent that specific loss allocation rules could be required that are different from those that would result from ordinary insolvency law. Similarly, the need to preserve service continuation may require specific rules that may deviate from and thus replace ordinary insolvency law.
3. Answers to specific questions
- Do you think that a framework of measures and powers for authorities to resolve CCPs and CSDs is needed at EU level or do you consider that ordinary insolvency law is sufficient?
In general, loss sharing rules under a resolution regime for FMIs should be designed in a way that the default of an FMI has the least systemic impact and avoids recourse to taxpayer money. It is by no means certain that ordinary insolvency law can achieve this result. The development of a recovery and resolution framework for FMIs offers the unique opportunity to make sure that losses are assigned to a sufficiently large group of entities and in particular to those that are most capable of coping with them, thus likely achieving a better outcome than if regular insolvency rules were applied.
Moreover, continuation of services is more critical for FMIs than it is for other financial institutions. Ordinary insolvency law may not cater sufficiently for this overarching concern.
- In your view, which scenarios/events might lead to the need to resolve respectively a CCP and a CSD? Which types of scenarios CCPs/CSDs and authorities need to be prepared for which may imply the need for recovery actions if not yet resolution?
There are different triggers for recovery and resolution respectively. If an FMI fails to maintain a generally sound financial condition, it may need to implement its recovery plan (or be forced to do so by the appropriate authority). In particular, if an FMI fails to maintain sufficient capital against its general business risk or if it emerges that the financial resources (including margin and default fund contributions) are not sufficient to cover the losses from one or more participant defaults, the recovery plan should be implemented in order to put the FMI on a sustainable path to financial health.
The triggers for an FMI entering into resolution include (1) the recovery plan has failed or has not otherwise been implemented in a timely manner, (2) resolution of the FMI under regular insolvency law could be disruptive to the financial system, or (3) the relevant authority determines that the circumstances warrant bypassing execution of the recovery plan and placing the FMI into resolution immediately. In general, it is important to note that authorities and market participants will never be able to predict and prepare for all possible scenarios that might trigger resolution. Therefore, resolution regimes should be sufficiently flexible to allow authorities to optimally respond to various scenarios and circumstances.
- Do you think that existing rules which may impact CCPs/CSDs resolution (such as provisions on collateral or settlement finality) should be amended to facilitate the implementation of a resolution regime for CCPs/CSDs?
If resolution arrangements should also include the bailing in of some or all of the surviving participants’ initial and variation margin, this could be in contradiction with EMIR. For instance, EMIR stipulates that “a CCP shall not use the margins posted by non-defaulting clearing members to cover the losses resulting from the default of another clearing member” and a CCP shall not “expose the non-defaulting clearing members to losses that they cannot anticipate or control”.
Furthermore, the ECB would not exclude at this stage that existing rules and regulations might have to be adapted and amended once the recovery and resolution regime for FMIs has been more fully developed in order to ensure that the various rules are consistent with each other.
- Do you consider that a common resolution framework applicable to CCPs and CSDs is desirable or do you favour specific regimes by type of FMIs?
As outlined above, different types of FMIs are exposed to different risks and their failure may cause different types of disruption. Key differences are whether or not an FMI takes on credit risk, and to what extent the functioning of financial markets would be disrupted if the FMI ceases operation, which affects the need for transferring services to another provider (if available) or establishing a bridge institution. Such differences in emphasis and focus do not necessarily call for separate recovery and resolution regimes per type of FMI, but suggest that relevant provisions and requirements might need to be adjusted and complemented to fit the specific risks and systemic implications that a particular type of FMI may be exposed to and/or create.