Supplementary Submission to the Financial System Inquiry 3. Crisis Management and Resolution

The Interim Report observes perceptions in a number of countries, including Australia, that some institutions are ‘too big to fail’. This is the perception that the institution would receive government solvency support, because its failure would damage the financial system and broader economy. Such perceptions can reduce market discipline and alter management incentives, which in turn may result in an imprudent allocation of risk and resources from society's point of view.^[10]

The Interim Report puts forward a number of measures to minimise the extent of perceptions that institutions are ‘too big to fail’ in Australia. The measures aim to reduce the probability that such institutions will fail and/or strengthen the likelihood or credibility of orderly resolution with minimal taxpayer support. In considering the merits of the various options, it is important to assess both the stability implications as well as the effects on competition, and to take account of the substantial work underway, globally and domestically, seeking to improve the resilience of the financial system. The Bank's initial submission discussed these at length, though a brief recap of some key areas is provided below (RBA 2014, pp 43–72).

3.1 Recovery and Resolution Preparedness

As detailed in the Bank's initial submission, a number of steps have been taken in the area of crisis management and resolution arrangements in recent years (RBA 2014, p 58). The Financial Stability Board's (FSB's) peer review of resolution regimes in 2013 suggested that Australia's resolution arrangements for ADIs and insurers were generally consistent with international best practice and compared well to many other jurisdictions. That said, it is an inherently challenging area that requires continuing attention, and the Bank endorses the Inquiry's support for ongoing work in this area.

Work on recovery and resolution preparedness in Australia across the main financial agencies is coordinated through the CFR, which has a longstanding working group dedicated to crisis management. This work seeks to improve CFR agencies' preparedness to manage a financial stress situation in an orderly fashion. It maintains a crisis management training framework, which incorporates regular training exercises and testing of the CFR agencies' ability to respond to and coordinate actions in a crisis situation. Under the auspices of the Trans-Tasman Council on Banking Supervision, work is also continuing on response arrangements for the Australian and New Zealand authorities in the event of financial stress with a trans-Tasman dimension.

3.2 Imposing Losses on Creditors

The Interim Report seeks views on options to increase the ability to impose losses on creditors in the event of a systemically important ADI's failure. The appropriate resolution strategy for a failed institution depends on the circumstances. Accordingly, it is helpful to have a range of potential resolution tools available, a point often emphasised in current international deliberations on this issue. Imposing losses on creditors could potentially be achieved via statutory bail-in powers or by business transfer.^[11] In some instances, the best outcome could be achieved using a mix of strategies.

As outlined in the Bank's initial submission, ‘bailing in’ unsecured senior creditors could potentially reduce the fiscal cost of a systemically important bank's resolution, but it also carries the risks of deepening the institution's financial distress and spurring contagion to the broader financial system (RBA 2014, p 49). To date there are few, if any, examples of banks that have successfully been resolved as going concerns through the use of bail-in powers. These risks mean that the design and use of bail-in policy options need to be approached cautiously.

The FSB is coordinating international efforts to assess and develop proposals for ‘gone concern loss absorbing capacity’ for global systemically important banks (G-SIBs), to be presented to the G20 Summit in Brisbane in November 2014. These proposals aim to ensure that G-SIBs' funding structures are compatible with orderly resolution if a G-SIB fails, while minimising the need for taxpayer-funded support. Although the proposals would not apply to Australian-owned banks (as they are not currently globally systemic), the CFR agencies, including the Bank, are closely following this work, with a number of agencies represented in the international forums that are helping to shape the proposals.

3.3 Resolution Powers and Financial Market Infrastructure Oversight and Resolution

The Interim Report notes two areas where work is underway to address gaps related to resolution.

• Some areas where current resolution powers and tools could be enhanced, as outlined in the 2012 consultation paper Strengthening APRA's Crisis Management Powers (Treasury 2012).
• The CFR's 2012 recommendations, including a specialised resolution regime, to address gaps identified around regulation of financial market infrastructures.

The Bank strongly endorses the Inquiry's support of the ongoing process to strengthen regulators' resolution powers in these areas.

3.4 Ring-fencing

As the Interim Report observes, policymakers in Europe and the United States have mandated the separation of certain aspects of banks' commercial banking and investment banking businesses. The appeal of structural separation in these jurisdictions is that it would quarantine risks posed by the large and potentially complex trading and investment banking business of many of the large banks; some of this trading and investment banking activity has been considered more risky than the traditional commercial banking operations serving the needs of these banks' customers in the non-financial sectors. These ring-fencing efforts are relatively new and so their effects remain unclear.^[12]

The Inquiry seeks opinions on whether ring-fencing would be appropriate in Australia. Relevant for assessing the cost-benefit relationship in Australia is the fact that trading books comprise a small portion of Australia's large banks' balance sheets so there is less scope for large trading losses to ‘spill over’ and affect the provision of credit to the economy (Graph 1). Given this, a less costly approach (such as APRA's approach of proactive supervision) could address the objectives that ring-fencing is designed to achieve.

Non-operating holding company structures are available in Australia, and a small number of APRA-regulated entities currently use this corporate structure. However, such structures are more relevant to business models that combine commercial banking with substantial non-banking business or activities in capital markets; these are not applicable to the vast majority of ADIs in Australia.

Footnotes

For example, if reduced market discipline were to allow firms to access funds at a lower cost than would otherwise be the case, management may then be encouraged to take on projects that would otherwise have been considered non-viable. [10]

A recent example of bail-in (of junior creditors) by business transfer is the resolution of Banco Espírito Santo in Portugal, in which most assets and the depositors and senior creditors' claims were moved to a new ‘good bank’, Novo Banco. [11]

For example, Keppo and Korte (2014) suggest that the limits on commercial banks trading asset holdings, as part of the Volcker rules, have not resulted in a decline in risk-taking. [12]