Resolution is much more than just a capital issue – a material capital shortfall will almost certainly lead to a liquidity shortfall and so a successful resolution will require more than bail-in or partial transfer, but also sufficient funding to allow the bank to meet its liabilities throughout the stabilisation period and beyond. Simply put, bail-in alone may not be the complete solution – without additional liquidity support, banks can still fail.
The Bank of England’s Statement of Policy on Funding in Resolution (FiR), published in July 2019 as part of its Resolvability Assessment Framework (RAF), helps address this issue. In-scope banks and building societies now have until January 2022 to complete their preparations and demonstrate that they have sufficient analytical, financial and operational capabilities to manage liquidity during resolution.
In this blog we look at some of the themes we see as key to a successful implementation of the regulatory requirements.
Don’t re-invent the wheel
The BoE has encouraged firms to leverage their existing capabilities in developing all parts of the RAF. While funding in resolution is itself a new requirement, elements of the existing prudential framework can be leveraged to support the analysis. As far as possible, the capabilities for measuring and monitoring FiR should be consistent with those already in use and can be used to monitor liquidity through a period of stress and into resolution. Stress parameters and other factors would need to change as a firm moves along the continuum to resolution, but using a consistent approach, where possible. Firms should also consider potential mitigating actions.
The existing PRA110 liquidity return already requires detailed daily movements out for 92 days, covering the 90-day FiR requirements, and so could provide a useful starting template. But it alone is not the answer. and would need to be enhanced to take into account the additional factors likely to be encountered during a resolution. Also, stress testing is an embedded part of liquidity management that also features in the recovery planning process. Leveraging this, along with supporting in-house systems helps firms align the RAF to existing liquidity regulations. This can complement the liquidity elements of the scenario analysis undertaken as part of compliance with recovery planning requirements (SS9/17).
Some firms will have participated in the PRA’s trading book solvent wind-down exercises, which will provide a number of useful pointers as to expectations around counterparty behaviour under stress. From an operational perspective, the Bank of England is likely to expect firms to have an approach that is consistent with the relevant calculations performed for the funding element of Operational Continuity in Resolution (OCIR)
Firms are expected to be able to run the scenario assuming that resolution has commenced following a prolonged liquidity stress, so resources will be depleted and a number of recovery options would already have been used. In addition, retail and wholesale customer behaviour in a resolution may be very different than a normal stress and will require careful consideration. For most firms, this will be a new way to perform liquidity analysis, but is essential for the BoE in understanding potential liquidity requirements in resolution.
Additional complexities are added by the requirements to consider intra-group flows between material subsidiaries and the impact of any material currencies. Firms also need to consider local jurisdictional funding and currency requirements, as well as the risk that local regulators ring-fence liquidity.
Understanding the BoE’s Resolution Liquidity Framework
The BoE understands that stress on liquidity in resolution is hard to model and will depend on the reaction of short-term liability holders and the broader market to the bail-in and also that their willingness to lend to a bank in resolution will send a strong signal as to the continued solvency and post-restructuring viability of the firm.
The BoE’s Resolution Liquidity Framework (RLF) has been developed to provide the means without stigma to lend to a firm in resolution potentially in size and for an extended period against a broader range of collateral. But the BoE is also concerned that any lending exposure that firms might take on is only temporary – hence the accent on funding in resolution in the RAF to allow the BoE to understand from firms the various factors driving their potential funding needs and available collateral, and to carry out sensitivity analysis on liquidity projections. This will facilitate tracing a path for funding back to viability and the repayment of any RLF or other central bank support.
It is likely that if the BoE confirms that the firm will have access to the RLF in a resolution, it would assuage many wholesale and retail customers’ concerns. This in turn could reduce the need for that funding. This might make the entire exercise seem redundant – after all, the UK authorities are highly unlikely to allow a systemically important firm to enter into a disorderly liquidation. Whilst there is obviously some truth in this, the analysis of the funding position is fundamentally tied into the creditworthiness of the resolved bank – access to funding is achieved by being able to post assets to the BoE and it is the quality of these assets that determines the level of haircuts and whether the assets could be monetised.
Forecasting unencumbered assets and having the data available on a T+1 basis is a challenge, especially for firms operating across multiple business lines, legal entities and jurisdictions. Any challenges experienced in achieving this prior to a stress will only be amplified during one. It is therefore essential that firms focus on understanding what collateral is available, what would be acceptable at the BoE and at what haircut. Some may need to enhance their capabilities in this area.
Firms also need to consider what additional collateral will be required with external counterparties, particularly for operational and intra-day purposes. Financial Market Infrastructure firms (FMIs) require significant amounts of high quality liquid assets (HQLA) from firms in the normal course of business and it is likely that these demands will increase in the run up to, and following, a resolution. This will mean less HQLA available for repo funding in the market or from the RLF. Given that the circumstances are highly unusual, firms should make a careful analysis of likely available collateral in resolution and make appropriately conservative haircuts.
The BoE will remain the lender of last resort in a resolution – but, in the first instance, liquidity should come from the firm’s own resources and the BoE expects firms to seek any funding from third-party facilities where they can. This may be in limited supply, but firms should provide analysis and do any ex ante work that they can to identify third parties that will accept collateral and could be used to provide funding in a resolution. The RLF should be utilised to the minimum extent possible and firms will be expected to have explored as many alternative opportunities as they can.
Rigorous testing is a fundamental part of a strong governance framework and will need to become embedded as part of overall preparedness for resolution. The BoE will expect firms to develop scenarios to test the flexibility of their approach to dealing with varying factors and to adapting at short notice. An effective test is likely to contain a live ‘fire drill’ element to demonstrate the firm’s responsiveness, decision-making capabilities and governance, as well as the ability to operationalise key elements. It will also be important to show that firms have good MI available to monitor funding during a resolution. This can also be linked to the recovery planning scenario testing and fire drills that some firms already undertake.
While testing must be performed ‘on a regular basis’, the RAF is not prescriptive as to the exact form it should take and there is no requirement that a test of the liquidity requirements should take place simultaneously with all the other elements of the RAF. However, the Bank may supply firms with specific areas to test and may wish to observe capabilities.
A robust testing approach, supported by independent specialists, lends credibility to a statement that the firm is compliant with the FiR requirements and has a good picture of its funding sources and uses during resolution.