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Icons are made by Freepik, Chanut-is-Industries, redempticon, Iconjam, and Uniconlabs from Flaticon at www.flaticon.com Cover design: Kora Reichardt Strengthening Financial Stability, Resilience and Safety Nets in the Pacific Islands: Сompilation of In-Depth Papers August 2022 1 Contents CONTENTS ABSTRACT  4 ACKNOWLEDGEMENTS  4 SUMMARY  5 Importance of financial stability, resilience and efficiency  7 EXECUTIVE SUMMARY  7 Summary of the policy papers  9 COVID-19 AND FINANCIAL STABILITY: GUIDANCE ON FINANCIAL SYSTEM SURVEILLANCE IN THE PANDEMIC  14 Purpose of this paper  15 Impact of the pandemic on financial system stability in the PICs  15 Responding to the COVID-19 pandemic – strengthening financial system surveillance  16 Loan classification and provisioning  18 Withdrawing temporary loan support arrangements  19 Capital and solvency analysis  20 Intensification of ‘virtual’ on-site assessments of asset quality and risk management  21 Engagement with parent banks  21 Engagement with external auditors  22 Conclusions and recommendations  22 Appendix 1. Indicative table of surveillance data for the Covid and post-Covid periods  24 Appendix 2. COVID-19 loan restructuring responses by APRA and RBNZ  26 COVID-19 AND FINANCIAL STABILITY: MICROPRUDENTIAL AND MACROPRUDENTIAL POLICY: SEEKING THE RIGHT BALANCE  29 Introduction  30 A recap of definitions of microprudential and macroprudential policies  30 Complementarity and conflict between microprudential and macroprudential policies  32 Potential tensions between microprudential and macroprudential supervision  33 Use of macroprudential policies in response to the pandemic  33 Macroprudential policy governance, transparency and accountability  35 Conclusions  37 Appendix 1. Macroprudential and other prudential policy initiatives taken by national authorities in response to the coronavirus pandemic  38 Appendix 2. Macroprudential frameworks in Australia and New Zealand  43 COVID-19 AND STRESS TESTING  47 Introduction  48 Overview  48 The foundations of stress testing  49 COVID-19 and the financial sector  51 Stress testing in the pandemic  53 Introducing top-down stress testing in the PICs  56 Bottom-up stress testing—basic principles  58 Stress testing by the largest central banks during COVID-19  59 Appendix 1. References  61 COVID-19 AND FINANCIAL STABILITY: EARLY INTERVENTION IN BANKING SUPERVISION  63 Introduction  64 Context  64 International principles and practice on early intervention  65 Indicative example of early warning system  69 Indicative example of an early intervention framework  73 Concluding thoughts  78 Appendix 1. Country examples of early intervention frameworks  79 COVID-19 AND FINANCIAL STABILITY: RECOVERY PLANNING FOR BANKS  92 Introduction  93 Overview  93 Executive summary of the recovery plan  94 Contents 2 3 Contents Governance of recovery plans  95 Integration of recovery plan with risk management arrangements  97 Overview of the bank – and critical functions and services  98 Triggers for activation of the recovery plan  101 Restoration points for recovery  103 Recovery options  104 Scenarios for recovery plans  109 Communications  111 Preparatory measures  111 Testing of recovery plans by banks  112 Review and update of the recovery plan  113 COVID-19 AND FINANCIAL STABILITY: BANK RESOLUTION  115 Introduction  116 Key Attributes  116 Resolution objectives  120 Resolution toolkit  121 Resolution options  122 Assessing systemic impact  134 Resolvability assessments and resolution planning  135 Cross-border cooperation and coordination  136 Resolution funding  138 Findings and recommendations for PICs  139 Appendix 1. Selection of particular resolution options  140 FINANCIAL STABILITY IN THE PACIFIC ISLANDS: FINANCIAL SAFETY NETS  147 Introduction  148 Part A: Emergency Liquidity Assistance  148 Part B: Deposit insurance  154 Appendix 1. IADI Core Principles for Effective Deposit Insurance Systems  164 ABSTRACT Over the past two years, the World Bank has been  Early intervention in banking supervision working with Pacific Island Countries (PICs) to assess  Recovery planning for banks the impact of the COVID 19 pandemic on their financial systems and provide guidance to the PIC  Bank resolution prudential authorities on policy issues relating to  Financial safety nets strengthening the resilience of financial systems in the region. As part of this work program, the World This volume pulls together these deep dive papers Bank produced a series of seven ‘deep dive’ papers while being mindful that each paper stands on its own. on a range of issues relating to financial stability in Yet, an integrated approach is needed in all of these the PICs. Each paper was presented during an online policy areas and it is vital to tailor reforms to country workshop with the prudential authorities of the PICs specific circumstances This recognizes that, even in a and followed by a Questions & Answers session. stable financial system there will inevitably be periods of financial stress and that there is a need to ensure The papers in the series are: that frameworks are in place to address these events  COVID-19 and financial stability: Guidance on cost-effectively and in ways that preserve market financial system surveillance in the pandemic discipline, avoid moral hazard and minimize fiscal  COVID-19 and stress testing risks.  Micro prudential and macro prudential policy: Seeking the right balance ACKNOWLEDGEMENTS This note has been prepared by Katia D’Hulster (Lead thoughts and opinions expressed in the text belong Abstract / Acknowledgements Financial Sector Specialist), Geof Mortlock (Consultant) solely to the authors, and not necessarily to the and Peter Lohmus (Consultant). The authors wish to authors’ employer, organization, committee or other thank Ergys Islamaj (Senior Economist), Ezio Caruso group or individual. (Senior Financial Sector Specialist), Pamela Lintner (Senior Financial Sector Specialist), Stuart Yikona This report was supported by the Korean government (Program Manager) and Chris Wilson (Consultant) for through the Seoul Center for Finance and Innovation. their useful comments and suggestions. The views, 4 5 Summary SUMMARY 1. The COVID-19 pandemic has had significant  Recovery planning for banks economic impacts on the Pacific Island Countries  Bank resolution (PICs), as is the case with many countries globally. In recognition of this, the World Bank has been  Financial safety nets working with selected PICs to assess the impact of 1 the pandemic on the countries’ financial systems 3. The topics selected for the papers reflect the and provide guidance to the PIC authorities on policy importance of these areas for financial stability issues relating to strengthening the resilience of and resilience. The topics covered in this work financial systems in the region. This work commenced have come under renewed attention after the global in mid-2020 and has continued through to June 2022. financial crisis of 2008/09 due to their relevance to seeking to prevent financial instability from arising 2. As part of this work program, the World Bank and dealing with threats to stability at an early stage produced a series of seven ‘deep dive’ papers on in their emergence. The papers also address the a range of issues relating to financial stability in handling of financial distress and failure in a manner the PICs. These papers were designed to provide consistent with financial stability outcomes. These analysis and guidance for the PIC authorities on papers do not intend to cover policy responses to the several elements of financial system regulation and full suite of emerging risks and threats to the financial supervision. Although they were prepared in the system stability of the PICs.2 context of the financial stability issues that could arise in the COVID-19 pandemic and its aftermath, 4. An important cross-cutting theme in all of they also address financial stability matters in a wider the papers is the dominance of foreign banks in context, with a forward-looking focus. Each paper the PICs. This factor needs to be considered in the was presented during an online workshop with the design and implementation of policies, regulations prudential authorities of the PICs and followed by a and supervisory practices in all of the topics covered Q&A session. The papers in the series are: in the papers. It will be especially important for the PIC authorities to have close regard to the inter-  COVID-19 and financial stability: Guidance on country contagion risks that can arise with a strong financial system surveillance in the pandemic presence of cross-border banking and insurance in the  COVID-19 and stress testing region. Cross-border cooperation and coordination  Micro prudential and macro prudential policy: is therefore an essential aspect of the design Seeking the right balance and implementation of policies, regulations and supervisory practices in the region.  Early intervention in banking supervision  1  The countries covered by the World Bank’s capacity building in this study are: Federated States of Micronesia, Fiji, Palau, Papua New Guinea, Samoa, Timor-Leste, Tonga and Vanuatu.  2  The World Bank report “Financial Stability and Resilience in the Pacific Islands in Turbulent Times” gives a more comprehensive analysis of risks and vulnerabilities to the financial systems of the PICs. It also provides policy recommendations for the PICs. This collection of deep dive papers describes international standards and good practices in designing and implementing these above- mentioned policy recommendations in in the PICs financial sectors. 5. The topics provided in this paper are relevant Once the foundations for financial stability have for small Island jurisdictions, yet an integrated been established, or at least are well advanced, approach is needed in all of these policy areas then progress on recovery planning, resolution, and it is vital to tailor them to country specific and financial safety needs to receive high priority circumstances. This recognizes that the various attention. This recognizes that, even in a stable themes discussed in this paper are interconnected. financial system there will inevitably be periods of It is therefore advisable that the PICs, supported financial stress and that there is a need to ensure that by the World Bank and/or other agencies, adopt frameworks are in place to address these events cost- a comprehensive approach to the financial sector effectively and in ways that preserve market discipline, reform process that promotes an integrated approach avoid moral hazard and minimize fiscal risks. to reform initiatives and to ensure an appropriate degree of consistency across the policy areas where 6. This publication pulls together all of these there are closed interconnections. There is also a papers into a single volume while being mindful need for an appropriate sequencing of reforms. The that each paper stands on its own. The purpose of reforms to strengthen micro prudential supervision this publication is to make the papers available to a and macroprudential supervision, together with early wider audience. intervention, need to be accorded a high priority, given that they form the foundations for building financial stability in the region. Strengthening cross- border cooperation and coordination at all stages of supervision will be an important element in this. Summary 6 7 Executive Summary EXECUTIVE SUMMARY examples of how harmful financial instability can be „ IMPORTANCE OF for economies and wider society. Equally, there are FINANCIAL STABILITY, many examples of countries whose financial systems, although stable, are not efficient in meeting the RESILIENCE AND EFFICIENCY needs of their economies and societies, as evidenced by sub-optimal allocation of credit to the economy, 7. Clarity of the terms ‘financial stability,’ inadequate pricing of risk, asset price distortions, and ‘resilience,’ and ‘financial system efficiency’ are lack of financial inclusion. important. For the purpose of this publication, ‘financial stability’ is defined as a condition in which 9. Financial systems perform a number of the financial system (including all of the entities functions that are essential to economic activity within it) are capable of identifying, measuring, and the functioning of society. The core functions monitoring and managing financial risks to a level include: (a) intermediation of funds between needed to enable the financial system to perform its borrowers and lenders; (b) ‘maturity transformation’ of core functions in the economy effectively and with funds (i.e., banks using short-term deposits to facilitate sustained institutional viability. An important element long-term loans); (c) provision of payment services for of financial stability is ‘financial resilience’, which is households, businesses and government agencies; (d) the ability of the financial system to maintain critical provision of a repository for savings and investment; functions and services in the face of severe economic and (e) provision of risk management services through and financial shocks. ‘Financial system efficiency’ insurance and risk hedging instruments (such as is the ability of a financial system to perform its interest rate and currency swaps). core functions cost-effectively, to channel financial resources to their most productive use, to meet the 10. Unless a financial system is stable and resilient needs of consumers of financial services, and to in the face of economic and financial shocks, it will respond quickly, safely and effectively to changing not be effective in performing its core functions. consumer needs and economic circumstances. Financial stability requires financial institutions to have capital and liquidity buffers to maintain their 8. A stable, resilient and efficient financial system core functions in acute stress. It requires prudent has long been recognised as a critical foundation risk management, including credit risk, liquidity for a country’s economic, financial and social risk, interest rate risk, foreign exchange risk, and welfare. Many financial crises, such as the Asian operational risks. It also requires financial institutions financial crisis of 1997/1998 and the global financial to have strong governance arrangements along with crisis a decade later, have highlighted the importance contingency plans to enable them to recover from of financial stability and resilience by providing adverse financial impacts. 11. Although there are marked-based incentives the region. However, as with any policy area, the for financial institutions to pursue sound risk proposals covered in the papers will require careful management practises, regulation is warranted cost/benefit assessment by the authorities to ensure to correct for market failures. Regulation and that policies, regulations and supervisory practices supervision of financial institutions help to promote are proportionately applied and ‘fit for purpose’. They financial stability, resilience and efficiency by requiring need to be tailored to the particular characteristics institutions to adhere to minimum standards and needs of each country, taking into account the designed to achieve a low probability of failure in the small size of the financial systems and the limited face of adverse events. These requirements include resources of financial institutions and financial minimum capital and liquidity buffers, governance sector authorities in each country. In this regard, it is requirements, risk management requirements, important that the policies, regulations and practices public disclosure of financial data, and requirements are kept relatively simple to the extent practicable for recovery from severe shocks. Regulatory so that they are feasible, cost-effective and strike the arrangements are also needed to deal with situations appropriate balance between promoting financial in which a financial institution becomes non-viable. In stability and financial efficiency. It also needs to be these circumstances, regulatory authorities need to recognized that the policy reforms referred to in have legal powers, policies and capacity to resolve a these papers are generally of a medium to longer financial institution in ways that maintain continuity term nature, and (with few exceptions) could not of critical financial services, protect depositors and be implemented in the short-term. Rather, what policyholders, and minimize the risk of government- is needed, for each PIC, is a program of reforms, funded bailouts. Financial safety nets, which include targeted to the needs of each country, that sets out, in emergency liquidity support arrangements by central an appropriately prioritized and sequenced manner, banks and deposit insurance schemes to protect small the reforms to be implemented over a 5 to 10 year depositors in bank failures, shield financial systems, period. depositors and policyholders during financial distress and failures. 14. An important cross-cutting theme in all of the papers is the dominance of foreign banks in the 12. Significant efforts have been made in recent PICs. This factor needs to be taken into account in the years to ensure financial stability, resilience and design and implementation of policies, regulations efficiency. The global financial crisis of 2008/09 and supervisory practices in all of the topics covered increased the impetus in these efforts. More recently, in the papers. It will be especially important for the PIC the COVID-19 pandemic and its aftermath have caused authorities to have close regard to the inter-country a renewed focus on the means by which financial contagion risks that can arise with a strong presence stability can be strengthened. These issues are of cross-border banking and insurance in the region. relevant for every country. They are equally relevant For example, there is a need to manage contagion for the PICs, and in some respects even more so, risk by establishing appropriate liquidity buffers in given the vulnerability that small, under-developed the case of foreign branch operations and capital and countries, some of which are highly dependent liquidity buffers in the case of foreign subsidiaries. on tourism, already face in a turbulent economic It also raises the complex issue of cross-border environment. It is for these reasons that the World functional dependencies, especially in the case of Bank has worked closely with the financial sector branches and subsidiaries of banks which rely heavily authorities in the PICs to promote greater capacity for on parent bank or holding company functionality. strengthening financial stability in the region. The management of these risks needs to be carefully balanced with the need to strike an appropriate 13. The issues addressed in these papers are balance between financial stability and efficiency. all important elements in the promotion of Also, weighing of benefits and costs of different policy financial stability in the PICs. Implementation of options is crucial. There are limits as to how far host appropriately-designed policies and supervisory country protections can be taken without risking the practices in these areas will make a substantial efficiency of the financial system and, potentially, Executive Summary contribution to further strengthening the stability, reducing the incentives for foreign banks and insurers resilience and efficiency of the financial systems of to maintain core services in host countries. 8 9 Executive Summary 15. Cross-border cooperation and coordination with potential negative implications for the stability is therefore an essential aspect of the design of financial systems. The aftermath of the pandemic and implementation of policies, regulations and is also affecting the region through supply chain supervisory practices in the region. Building on disruption, inflationary pressures, rising interest rates existing cross-border relationships between the home and volatility in asset prices. In this context, enhanced and host countries, it will be important to further surveillance of banks and other entities in the financial increase the arrangements needed to facilitate system in the PICs becomes particularly important. regular information exchange, and cooperation and coordination in policy development, regulatory 18. The supervisory authorities in the region need implementation, and supervisory arrangements. This to enhance their surveillance of banks and other needs to involve not just the supervisory authorities/ intermediaries to monitor developments in asset central banks in the PICs, but also the finance quality in the wake of the pandemic. In particular, ministries in areas where their responsibilities are there is a need to ensure that banks are accurately relevant, such as in the design and implementation of identifying the loans that are unlikely to return to bank resolution frameworks and financial safety nets. performing status once temporary support measures put in place during the pandemic have been phased 16. Some of this cross-border cooperation and out. The paper emphasizes the importance for the coordination is best achieved bilaterally between supervisory authorities to assess the adequacy of home and host countries. However, multilateral banks’ recognition of loan impairment and loan loss arrangements involving a home country and all provisioning, and to monitor the remediation policies relevant host countries, may be more efficient in banks are applying to transition loans that are under some cases, such as where banks domiciled in a home temporary support arrangements back to normal country operate in multiple jurisdictions in the region. status, or into a formally recognised category of loan Supervisory colleges play an important role in this impairment. regard, as do associated crisis management groups. However, in the case of large foreign banks operating 19. The paper notes that financial surveillance has in the PICs, where the local operations are systemically to be supported by strengthened off-site monitoring important in the host countries but are unimportant and on-site assessment processes. Off-site monitoring in the context of global banking group, supervisory will need to be based on granular information on banks’ colleges and crisis management groups are unlikely and non-bank lenders’ loan portfolios, with identification to be sufficient. In such cases, the PIC authorities of loans that are under support measures, such as may need to seek to strengthen their relationships loan restructuring, interest payment suspension, with the relevant home authorities to try to enhance loan repayment deferral, and elongated loan information exchange and engagement on specific maturity. There is also a need for information on cross-border policy issues. banks’ and non-bank lenders’ assessment of the ability of borrowers to resume normal loan servicing capacity. On-site assessment capacity may need to be strengthened to enable supervisors to conduct selected reviews of loans under stress in order to „ SUMMARY OF THE POLICY assess the level of impairment and the adequacy of PAPERS specific provisions against loan impairment. 20. Finally, supervisory authorities should Enhanced financial system consider providing additional guidance to banks and non-bank lenders on asset classification and surveillance provisioning. The easing of the regulatory definition of non-performing loans, even on a temporary basis, 17. A key theme of the capacity building with the should be avoided, so as to reduce moral hazard PICs has been the need for strengthened surveillance risk and maintain accuracy and transparency of loan of financial systems in response to the pandemic. quality. It is therefore important for supervisors This recognises that the pandemic has had a very to ensure appropriate public disclosure of: (i) the significant impact on economic activity in the region, materiality of loan restructuring; (ii) the performance development, modelling, and integration of the results of the loan portfolio; (iii) any adjustments made to of stress tests into the calibration of microprudential policies to assess borrowers’ creditworthiness; and and macroprudential policies. There is also a need to (iv) the impact of these adjustments. When needed, deepen the capacity of banks to undertake ‘bottom supervisors should provide additional guidance to up’ stress testing in accordance with scenarios ensure that the policies applied to deal with the crisis provided by the supervisory authorities and banks’ and their impact are disclosed. own scenarios. As part of this, it will be important for the banks in the region to continue to strengthen their stress testing governance arrangements, data quality, modelling capacity and the integration of Stress testing stress test results into their risk appetite statements, capital frameworks and risk management. Given the 21. Financial system stress testing will be an strong presence of foreign banks in the region, there important tool going forward for the PICs. For will also be a need to further enhance cross-border the PIC authorities that already have stress testing coordination of bank stress testing between the home frameworks in place, it will be important to review and host supervisory authorities in order to enable these frameworks to consider the most appropriate stress testing to be undertaken on a cohesive whole- scenarios to assess the potential vulnerability of the of-group basis. banking system in the transition to the post-COVID-19 environment. Scenarios should seek to evaluate the implications for banks’ loan quality, lending growth prospects, net interest margins, profitability Macroprudential policy and liquidity in a forward-looking scenario that incorporates plausible features of the post-COVID-19 24. Macroprudential policy has been an important economic environment. It will be especially important element in the response to the pandemic in many for stress testing to evaluate the impact of higher countries globally. Some macroprudential elements inflation, rising interest rates and increased volatility have been also used in in responding to the pandemic in exchange rates on the PIC economies and financial and its aftermath in the region, although macroprudential systems. policy generally remains under-developed in the region. 22. For the authorities that have not yet undertaken stress testing, it will be important 25. Macroprudential policy is used in combination to start building capacity in this area. The initial with microprudential policy tools for financial focus should be on evaluating the risks to the stability purposes. In order to maintain financial banking system in the post-COVID-19 economic stability, macroprudential policy can be used in environment. Stress testing will be especially useful in tandem with monetary policy, fiscal policy and the assessment of vulnerability for scenarios in which industry policy tools, depending on specific policy the return to pre-COVID-19 levels of economic activity objectives. This has been the case in many countries takes longer than currently expected, such as in an in response to the COVID-19 pandemic, including in environment of rising interest rates and emerging some PICs, where various macroprudential policy global recessionary pressures. Stress testing will also initiatives were deployed in combination with a be an important tool in evaluating the economic and substantial easing in monetary policy, fiscal expansion, financial implications of climate change and increased and various targeted assistance programs to reduce risks associated with more frequent and severe the adverse impacts of the pandemic on the economy tropical cyclone activity. and financial system. An example of macroprudential policy deployed in response to the pandemic was 23. The strengthening of stress testing the release of countercyclical capital buffers in those arrangements in the PICs will require further countries which had such buffers in place. The easing development in various areas. These include the of bank liquidity requirements, including reserve need to strengthen ‘top down’ stress testing capacity Executive Summary requirements, was also undertaken in some countries at the central banks/supervisory authorities in the in response to the pandemic, including, for example, region, including the frameworks needed for scenario in Papua New Guinea. 10 11 Executive Summary 26. Although macroprudential policy can be a and addressed, the greater is the prospect of the useful tool to reduce procyclicality of regulatory institution being able to rectify the situation and requirements, it may conflict with microprudential restore itself to financial soundness. policy. For example, easing capital and liquidity requirements can increase the potential vulnerability 29. A well-developed early intervention framework of individual banks to stress and potentially increase provides a structured framework for a proactive moral hazard risk. The potential conflicts between response by the supervisory authority to emerging macro- and microprudential policies need to be stress or breaches of prudential requirements by carefully identified and managed. Equally, it is banks. For it to be effective, it is essential for an early important to ensure that macroprudential policy is intervention framework to have triggers informed by designed and implemented in ways that are best early warning indicators and risk-based supervision, aligned to desired financial stability outcomes and where the actions for intervention are activated at with minimal risk of unintended adverse side effects. a relatively early stage of an emergence of financial stress. An early intervention framework should include 27. In order to manage these risks, the World a structured set of supervisory responses, particularly, Bank’s paper notes the importance of establishing but not limited to capital and liquidity ratios, asset a robust framework for macroprudential policy. quality, and profitability, based on escalating range of The key elements of this framework include the need triggers. for: (a) clarity of policy objectives; (b) a clearly specified rationale for the deployment of a policy initiative; (c) 30. Supervisory authorities need to have a comprehensive ex ante assessment of costs and contingency plans for dealing with bank stress. benefits of policy initiatives; (d) an assessment of These plans should be scenario-based and identify, potential complementarities and conflicts between for any given scenario, the types of preventative macro- and microprudential policy objectives; (e) an and corrective actions that supervisors would ex post assessment of the efficacy of policy initiatives; appropriately take to respond to the situation. The (f) a robust governance framework; (g) a framework contingency plans should be subject to regular for effective consultation between relevant agencies; testing through simulation exercises. Lessons learned and (h) robust arrangements for transparency from the exercises can then be used to refine the and accountability of the agency responsible for contingency plans and, where appropriate, to modify macroprudential policy. elements of the preventive and corrective action plans. 31. Most PICs have at least some of the elements Early supervisory intervention needed for effective early intervention. However, further progress is needed to strengthen these 28. An important element in promoting financial frameworks, including in respect of early warning stability is early intervention in periods of systems, more structured triggers for intervention, a emerging stress. Although the PICs have endured structured set of escalating supervisory responses, the pandemic without severe impairment to financial and contingency planning. stability, the risks remain that the aftermath of the pandemic may lead to future stress in some financial systems. More generally, financial systems remain vulnerable to a range of causal stress-factors, Bank recovery planning including severe climatic events, global financial 32. The PIC supervisory authorities should seek to shocks, localized structural imbalances in the economy ensure that banks have recovery plans in place to and asset markets, and inadequacies in financial deal with emerging financial stress. Recovery plans institution risk management. An effective framework are an important element in the ability of banks and for early intervention is therefore necessary in other financial institutions to restore themselves to order to enable supervisory authorities to respond financial soundness following a financial shock, such quickly and decisively to emerging pressures before as loan impairment, operational risk loss or adverse a financial institution deteriorates to the point of liquidity conditions. becoming non-viable. The earlier stress is identified 33. Recovery plans should become a standard Resolution Regimes for Financial Institutions (Key requirement for all banks in the PICs, as is the case Attributes). Although the authorities have some of the increasingly in most countries globally. The plans legal powers needed for bank resolution, there are should be integrated into banks’ risk management significant shortcomings relative to the Key Attributes frameworks and designed to enable the financial in most of the countries in the region. institution to restore capital, liquidity and operational capacity back to pre-defined restoration levels, and to 37. The gaps in Key Attributes vary from country to maintain continuity of all essential banking functions country. The main ones include: (a) insufficient clarity and support systems. Recovery plans should be of resolution objectives; (b) inadequate allocation of subject to robust governance arrangements, with responsibilities for bank resolution; (c) inadequate ultimate responsibility for the recovery plan resting specification of triggers for entry into resolution; with a bank’s board of directors or local branch (d) inadequate powers to enable resolvability management. There should be a requirement for assessments and resolution planning to be banks to undertake regular testing of their recovery undertaken; (e) inadequate powers to require banks to plans, and for the supervisory authorities to oversee make structural changes needed to be pre-positioned this testing process. Recovery plans should be for resolution; (f) lack of sufficient powers to enable designed to address relatively severe scenarios of a range of resolution options to be implemented; (g) financial impact to capital and liquidity and should excessive reliance on court-based processes; and (h) incorporate a comprehensive set of triggers and inadequate safeguards in the resolution process. recovery actions. 38. It is recommended that the PIC authorities 34. Most of the PIC supervisory authorities have strengthen their bank resolution frameworks. not yet introduced bank recovery planning Although the financial systems in the region are requirements. It is therefore suggested that this be currently stable and there appears to be no imminent progressed, with a view to strengthening the ability of threat of acute bank distress or failure, it is important banks in the region to restore themselves to financial for the authorities to develop the tools needed to and operational soundness in the face of economic respond cost-effectively and promptly to such events and financial shocks. if they arise. This should be done through resolution arrangements that enable the authorities to resolve failing banks and other financial institutions in ways that maintain the continuity of essential financial Bank resolution services, protect small depositors, and maintain confidence in the financial system, while minimizing 35. An essential accompaniment to the supervisory the risk of government-funded bailouts. arrangements for banks is a framework for resolving a non-viable bank. An effective resolution regime is necessary if non-viable financial institutions are to be resolved in a manner that maintains the Financial safety nets stability of the financial system, protects small depositors, avoids moral hazard and minimizes fiscal 39. A financial safety net is a critical element in risks. maintaining financial system stability. It is designed to provide funding structures to deal with bank 36. Most PICs have relatively under-developed distress and failure. A financial safety net generally frameworks for bank resolution, with legislation comprises two elements – each very different in for bank crisis management falling short purpose and structure: emergency liquidity assistance of international best practices. The relevant (ELA) for banks experiencing short-term liquidity stress benchmarks include the principles set out in the and deposit insurance to protect ‘small’ depositors in a Executive Summary Financial Stability Board (FSB) Key Attributes of Effective bank failure. 12 13 Executive Summary 40. Emergency liquidity assistance is a key part 43. Although deposit insurance helps to promote of the financial stability toolkit. It involves the financial stability and facilitate cost-effective provision by a country’s central bank (the lender of resolution of failed banks, it has some potential last resort) of liquidity to a bank in periods of liquidity risks. Deposit insurance can potentially create moral stress and helps to reduce the likelihood of a bank hazard by weakening depositor-related market failing due solely to illiquidity. ELA facilitates continuity discipline on banks and reducing the incentives for of critical banking functions in periods of market banks to manage their risks prudently. These risk illiquidity. Best practice suggests that a central bank factors can be reduced to a substantial degree by the should only provide ELA if certain preconditions design of the deposit insurance framework, including have been met, including that the bank in question by limiting the level of protection to small, retail has exhausted all market-based and shareholder- deposits and by charging banks a risk-based levy sourced liquidity support, is adequately capitalized to fund the deposit insurance scheme. In addition, (or is in the process of being recapitalized) and has the potential for reduced incentives for the prudent sufficient collateral to cover all credit and market risks management of risks by banks can be substantially associated with ELA. mitigated by maintaining robust regulatory and supervisory requirements, including in relation 41. The central banks in the PICs with their own to banks’ capital, liquidity, governance, and risk currency generally have statutory powers that management frameworks. enable them to provide ELA to banks in periods of liquidity stress. Various IMF and World Bank missions 44. None of the PICs have established deposit have concluded that the statutory framework for ELA insurance schemes as yet. This is a major gap in in central bank law is adequate in most respects in the framework for effective bank resolution and the region. However, some areas for improvement should be addressed within PICs when time and have been identified, including the need for a more resources permit. In doing so, the PIC authorities precise specification of the purposes and precondition should have regard to the international guidance that for providing ELA. The paper endorses the need is available on deposit insurance, especially the IADI for strengthening in those areas and notes that Core Principles for Effective Deposit Insurance Systems. central banks in the region should ensure that they Deposit insurance schemes should be designed and have policies and procedures in place that cover implemented in ways that are best suited to the small the following elements; bank viability assessment, nature of financial systems in the PICs. This suggests collateral requirements, terms and conditions for ELA, keeping the deposit insurance scheme relatively and the ways to manage the moral hazard risks with simple in design, anchored to the so-called ‘paybox ELA. plus’ type of deposit insurance (i.e., where the scheme can make payouts to insured depositors and also 42. Deposit insurance is a key part of the financial contribute funding to other forms of bank resolution). safety net for dealing with bank failures. A deposit insurance scheme helps to reduce the risk of depositor runs and inter-bank contagion in periods of financial system stress. It helps to facilitate effective bank resolution by providing a funding source for depositor reimbursement and a mechanism for prompt payout of deposits or transfer of deposit accounts to another bank or a bridge bank without reliance on public funding. COVID-19 AND FINANCIAL STABILITY: GUIDANCE ON FINANCIAL SYSTEM SURVEILLANCE IN THE PANDEMIC September 2021 15 COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic This is especially the case for banks with significant „ PURPOSE OF THIS PAPER exposures to the tourist sector, regional airlines and retail sector, given that these sectors have been 1. The paper provides guidance on financial system severely impacted by prolonged border closures surveillance, with particular focus on the impact and the substantial collapse of foreign tourism. In of the pandemic, but also with a view to enhancing the PICs affected by tropical cyclones, such as Fiji, the capacity of the PIC authorities to assess the Solomon Islands, Tonga and Vanuatu, banks and other stability of their financial systems and identify lenders have also been impacted by the damage the emerging risks in sufficient time to facilitate an cyclones have inflicted on the agriculture sector and effective response to them. This paper covers the the communities dependent on the export of crops. following issues: The eventual impact on bank asset quality, profit and  Recap of the financial stability issues in the PICs. capital has yet to work itself out; much will depend on the extent and duration of the pandemic’s economic  Review of international guidance on financial impact, and the effectiveness and sustainability of system surveillance in the context of the COVID-19 government and central bank policy responses. The pandemic. impact on banks’ asset quality and loan provisioning  Identification of the data needed to assess financial will become apparent once the temporary government institutions’ risks in the context of the COVID-19 support and debt servicing concessions have fully pandemic, especially relating to asset quality, expired and bank customers are placed back on to impairment recognition, provisioning, profits, normal commercial debt servicing arrangements. exposure concentration, capital and liquidity. 4. A weakening in bank and non-bank lender  Guidance on the assessment of asset quality and profits and capital appears unavoidable as a result differentiation between temporary and enduring of narrowing interest margins, reduced appetite loan impairment. for lending, increased holdings of (very low return) liquid assets, and the likelihood of increasing 2. This paper should be read in conjunction with loan losses. Against these risks, the starting point the paper published by the World Bank in April for banks’ capital positions in the PICs is generally 2021: Financial Sector Monitoring in PIC Countries and strong, with most banks in the region having relatively Potential COVID-19 impact on Financial Stability,3 which high capital ratios. Liquidity positions are also strong, provided an overview of the economies and financial with most banks holding large balances of high- systems in the Pacific Islands in the context of the quality liquid assets relative to deposits and other COVID-19 pandemic. liabilities. Moreover, the risks to financial stability and depositors will be mitigated to a substantial degree by the dominant presence of strong parent banks from jurisdictions with sound governance, risk management „ IMPACT OF THE PANDEMIC and supervisory frameworks, especially in the case of parent banks domiciled in Australia and, in the case of ON FINANCIAL SYSTEM some of the smaller PICs, US and French banks. There STABILITY IN THE PICS is a risk, though, that these banks will seek to reduce operating costs as part of their remediation strategies in ways that could, in the medium term, see growing 3. The economic impact of the pandemic in the pressure on some banks, such as ANZ and Westpac, PICs has potentially major implications for the to further cut back or sell of their PIC operations. countries’ financial stability. Banks are likely to Westpac is already on this path, having sold off some sustain a deterioration in asset quality as a result of its business in the region and with plans to further of credit exposures to small and medium-sized exit the region. This creates a medium to longer term enterprises (SMEs) and households affected by the risk for financial stability and efficiency for the PICs. economic contraction associated with the pandemic.  3  The paper can be accessed at: https://documents1.worldbank.org/curated/en/959561620281668616/pdf/Financial-Sector- Monitoring-in-PIC-Countries-and-Potential-COVID-19-impact-on-Financial-Stability.pdf 5. A greater risk for the banking systems in the 8. The extent of cross-border banking in PICs PICs arises from the potential impact of the creates a risk of contagion between home and pandemic on domestically-owned banks and host countries. This risk is low in the case of banks non-bank lending institutions, including some whose parent entities have strong governance and development banks with commercial operations. risk management arrangements and are domiciled in This is especially a risk for PNG, Fiji, Samoa, Solomon countries with robust supervisory frameworks, such as Islands and Tonga, given the extent to which domestic Australia and the United States. However, the risk of banks have a major share of total banking system cross-border contagion is considerably greater where assets. Fiji, Samoa and Tonga, among others, are also the parent banks are domiciled in countries with at some risk to the extent that foreign parent banks of relatively under-developed supervision and corporate subsidiaries and branches in their jurisdictions come governance and where the host operations in PICs under capital pressure. Cross-border contagion risk represent a substantial proportion of the parent is therefore an important issue to be factored into bank group global balance sheet. These risks place a financial system impact. premium on the need for effective cooperation and coordination between home and host authorities, 6. The financial stability impact is also influenced including for the detection of risk, early intervention, by the quality of supervisory arrangements and supervision, recovery planning and resolution. This financial safety nets in the PICs. In most countries is an area where considerable strengthening of in the region, prudential supervision is at a relatively arrangements would be beneficial, particularly in the early stage of maturity and is under-resourced, case of parent banks that are domiciled in PICs and with significant areas of non-compliance with the other countries with limited supervisory capacity and BCBS Core Principles.4 Prudential supervision tends where the banks in question have operations that are to be mainly compliance-based rather than risk- systemically important in home and host countries in based, with relatively limited off-site monitoring. the region. On-site examinations have often been suspended because of the pandemic and, more generally, tend to be hampered by too few staff with the depth of knowledge required, particularly as regards asset quality reviews and risk management assessments. „ RESPONDING TO THE However, in recent years, progress has been made in COVID-19 PANDEMIC – COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic several PICs as regulatory and supervisory frameworks have been overhauled. STRENGTHENING FINANCIAL 7. There is relatively little development of early SYSTEM SURVEILLANCE warning indicators and stress testing in most of the PICs, which reduces the ability of supervisory 9. The pandemic creates a need for further authorities to detect emerging stress at an early intensifying financial system surveillance. stage. This reflects an insufficiency of staff with the This is especially the case in respect of banks necessary skills, knowledge and experience needed and systemically significant non-bank financial for the effective development and implementation of intermediaries whose asset quality and profitability early warnings systems and stress testing. However, are being significantly impacted by the economic in some of the PICs considerable progress has been effects of the pandemic and lockdown initiatives. made in building capacity in surveillance, stress testing 10. Considerable international guidance has been and on-site supervision. This is encouraging and will issued in the last year or so to assist supervisory help to strengthen the supervisory authorities in those authorities in response to the pandemic. This PICs to respond effectively to the Covid impact on the has involved particular focus on enhanced financial financial system.  4  See, for example, various IMF/World Bank FSAP and FSSR reports for PICs, together with a range of TA reports provided to the PIC authorities. In many of these reports, the findings reached included that the banking supervision arrangements were generally not sufficient to meet financial stability objectives and materially not compliant with the Basel Core Principles. 16 17 COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic system surveillance, the regulatory treatment of bank 13. To mitigate risks to financial stability, the IMF, loans subject to temporary restructuring, and the World Bank and other international agencies note initiatives needed to ensure that impaired loans are that supervisors should implement enhanced appropriately identified and provisioned against. monitoring of the performance of bank exposures. Detailed information about the composition and 11. In particular, useful guidance has been performance of the banking book is needed to identify provided by the following papers. The PIC potential deterioration in asset quality. Additional authorities are encouraged to review the papers (if information collected and analysed should consider they have not already done so) and incorporate the both mandated government measures and other key points of guidance into the strengthening of their measures taken at the initiative of commercial banks, financial system surveillance frameworks. The papers such as restructuring of loans (unrelated or in addition in question include: to government measures).  COVID-19: The Regulatory and Supervisory 14. International guidance notes that banks have Implications for the Banking Sector, A Joint IMF- made a wide range of specific arrangements World Bank Staff Position Note, May 20205 with individual borrowers to assist them during  Strengthening Regulatory Reporting and Supervisory the pandemic. The timing of removal of these Analysis in Response to COVID-19, International arrangements may vary across a bank’s loan book Monetary Fund, December 20206 and potentially impact the formal recognition of  Supervisory Actions and Priorities in Response to the non-performing loans (NPLs). Supervisors need COVID-19 Pandemic Crisis, International Monetary information on the status of loans, with clear Fund, October 20207 differentiation between categories of loans by reference to the nature of temporary support to  Guidelines - Prudential treatment of problem which they are subject – e.g., suspension of interest assets – definitions of non-performing exposures payments, suspension of principal repayments, and forbearance, Basel Committee on Banking elongation of loan maturity, and so forth. Supervision, April 20178 15. Increased surveillance will likely need to 12. International guidance notes that enhanced involve the collection and analysis of more supervisory monitoring of asset quality will be granular data on asset quality, including NPLs key both during the pandemic and during the and loans that have been subject to restructuring recovery phase. This recognises that credit risk might (by category of restructuring). Surveillance will also not become apparent for many months following require an analysis of the basis on which banks are the unwinding of the support measures given the differentiating between loans that are temporarily phased nature of the termination of temporary affected by the pandemic but expected to recover, support measures and the time it is likely to take and loans which are likely to be permanently for banks to assess the viability of borrower debt impaired. Surveillance will also need to include an servicing capacity as economic activity recovers. In this assessment of the transition of loans from temporary context, international guidance notes that tracking loan servicing suspension/restructuring back to the quality of banks’ loan portfolios will be important fully performing, and the remediation processes for supervisors to ensure banks are provisioning for loans that are identified as being permanently accurately and prudently and that banks’ capital ratios impaired. Particular attention will need to be given reflect their actual solvency conditions. to the banks’ provisioning for loan losses, with a view to ensuring that provisioning adequately reflects the  5  Accessible at: https://www.imf.org/en/Publications/Miscellaneous-Publication-Other/Issues/2020/05/20/COVID-19-The- Regulatory-and-Supervisory-Implications-for-the-Banking-Sector-49452  6  Accessible at: https://www.imf.org/-/media/Files/Publications/covid19-special-notes/enspecial-series-on-covid19strengthening- regulatory-reporting-and-offsite-analysis-in-response-to-co.ashx  7  Accessible at: https://www.imf.org/-/media/Files/Publications/covid19-special-notes/enspecial-series-on-covid19supervisory- actions-and-priorities-in-response-to-the-covid19-pandemic-cr.ashx  8  Accessible at: https://www.bis.org/bcbs/publ/d403.htm expected level of losses and that capital is therefore 18. International standards-setters have being measured on an accurate basis. Appendix 1 of stated that loan classification definitions and this paper sets out an indicative set of data that PIC provisioning rules should not be relaxed. They have authorities could consider obtaining from banks to argued that it is critical to measure non-performing enhance their understanding of asset quality and loan loans and potential losses as accurately as possible – loss provisioning. i.e., to ensure that there is an appropriate distinction between loans that are restructured but are likely to return to normal performing status following the end of the restructuring period and loans that, although „ LOAN CLASSIFICATION subject to temporary restructuring, are unlikely to return to performing status. In this regard, banks AND PROVISIONING9 should not be permitted or encouraged by supervisory authorities to hide losses. The status of the exposures 16. One of the main supervisory responses to (performing versus non-performing) and the level of the pandemic has been the use of flexibility in provisioning should be reassessed on a regular basis the rules relating to loan restructuring. Many to account for the evolution of the situation. supervision authorities have permitted banks to 19. International guidance indicates that it is treat restructured loans as performing provided important for supervisors to understand how the that the loans were fully performing before the relaxation of loan classification and provisioning pandemic took effect. Examples from the region rules can impact transparency and data reliability. include the temporary relaxation of NPL recognition If such a relaxation occurs, financial statements and for restructured loans announced last year and again prudential ratios may no longer adequately reflect in July this year by APRA, and last year by the RBNZ. the financial situation of banks. Without reliable Appendix 2 summarises the approach adopted information, the market, the public and the authorities by these supervisory agencies. They are similar in cannot distinguish weak banks from sound banks, many respects to the policies applied by some of the which could lead to a wider loss of confidence in the supervisory authorities in the PICs. banking system, with adverse implications for financial 17. A temporary suspension of NPL classification stability. for restructured loans facing temporary 20. Supervisors in jurisdictions that have difficulties is appropriate during the pandemic. COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic implemented a temporary relaxation of loan However, there is significant risk that it could lead classification requirements should ensure to a misclassification of asset quality, and an under- that banks continue to regularly assess the statement of NPLs. This risk arises if banks do not creditworthiness of borrowers. It is essential for adequately distinguish between restructured loans supervisors to collect detailed information that that are likely to return to a fully performing status enables assessment of the solvency conditions following the restoration of normal loan servicing of banks, irrespective of these temporary relief requirements, on the one hand, and restructured measures. As such, it is important for supervisors to loans which are unlikely to return to a satisfactory understand in detail banks’ credit position, taking into level of loan servicing performance, on the other account the difference between loans under payment hand. In the former case, the loans can legitimately be moratoria that remain viable and those loans that regarded as temporarily restructured and performing. are unlikely to remain viable (i.e., are unlikely to be In the latter case, the loans should be treated as performing once moratoria ceases). non-performing and should be subject to loan loss provisioning in accordance with applicable accounting standards and regulatory requirements.  9  The interactions between International Financial Reporting Standards (IFRS) and prudential definitions are outside of the scope of this paper. 18 19 COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic 21. In this context, the PIC authorities should consider providing additional guidance to banks „ WITHDRAWING on asset quality classification and provisioning, TEMPORARY LOAN SUPPORT building on the guidance from international standards, particularly those issued by the BCBS.10 ARRANGEMENTS It is suggested that the authorities should refrain from relaxing the regulatory definition of non-performing 23. An important theme that has emerged in exposures, with a view to ensuring that banks the international dialogue on financial policy undertake accurate and complete assessments of responses to the pandemic is the need for loan classification and that provisioning for loan losses a transparent and coherent framework for is realistic. The easing of the regulatory definition of the unwinding of temporary loan support non-performing loans, even on a temporary basis, arrangements. Similarly, governments and their should be avoided, to reduce moral hazard risks and agencies need to establish clear processes and maintain accuracy and transparency of loan quality. timeframes for the unwinding of macroeconomic It is therefore important for the authorities to ensure support arrangements, such as the progressive appropriate reporting to supervisors and public easing of fiscal stimulus and the normalization of disclosure by banks of: (i) the materiality and nature monetary policy. In all these areas, there is a need for of loan restructuring; (ii) the performance of the loan clearly specified and transparent indicators for when portfolio; (iii) any adjustments made to banks’ policies temporary support measures – economic and financial to assess borrowers’ creditworthiness; and (iv) the – are to be unwound, and the procedures and phasing impact of these adjustments. Supervisory authorities to be followed in the unwinding process. should regularly disclose aggregate banking industry data on loans that are subject to Covid-related 24. For regulatory dispensation for banks in restructuring arrangements and NPLs to promote respect of restructured loans, supervision greater transparency. authorities need to establish a transparent set of thresholds for when the regulatory dispensation 22. Surveillance and the assessment of asset will be terminated and the processes that banks quality will entail drawing a clear distinction should follow for transitioning restructured loans between taking a flexible approach to the back to normal performance terms. The thresholds recognition of NPLs and associated provisioning, for terminating temporary regulatory dispensation on the one hand, from regulatory forbearance might appropriately relate to the easing of COVID-19 (i.e., the delaying of appropriate regulatory and restrictions, such that the reversion to normal loan supervisory actions without satisfactory reasons), classifications would apply once COVID-19 restrictions on the other. Flexibility is necessary and desirable, have been substantially lifted and economic stress as it makes allowance for the inherent uncertainty in associated with such restrictions has substantially assessing asset quality and the difficulty in drawing eased. Having a clear and transparent set of indicators the distinction between borrowers’ temporary liquidity for the termination of these arrangements is problems and permanent difficulties in the current important, given the danger that, in the absence of circumstances. However, a flexible approach still this, temporary regulatory dispensation could endure seeks to ensure that, ultimately, there is a genuine for an excessive period, leading to moral hazard and attempt to recognise and value NPLs assets and a heightened risk of inaccurate recognition of loan to make appropriate provisioning for expected impairment. Equally, it is important for regulators to losses. In contrast, regulatory forbearance – such provide guidance to banks on the timeframe following as the supervisors allowing banks to suspend NPL the termination of regulatory dispensation within recognition and provisioning for an indefinite period which they must transition loans back to normal loan - is not desirable and carries a risk of NPLs not being performance terms and to undertake updated reviews appropriately identified and addressed, hence of their loan portfolios and provide revisions to their resulting in an over-statement of a bank’s true capital loan impairment and provisioning data. position.  10  See especially Measures to reflect the impact of COVID-19, Basel Committee on Banking Supervision, April 2020, accessible at: https://www.bis.org/bcbs/publ/d498.htm 27. Asset quality reviews and associated solvency „ CAPITAL AND SOLVENCY assessments may be needed in situations where ANALYSIS there is significant doubt over the adequacy of a bank’s or non-bank lender’s loan classification and loan loss provisioning, especially if this is 25. The economic impact of the pandemic has the sufficiently significant as to pose a risk to the potential to cause material losses on banks’ loan entity’s financial soundness. For most situations, books and a reduction in income, with attendant the supervisory authorities should be able to rely impacts on banks’ capital positions. In recognition on a combination of ‘virtual’ on-site and off-site of this, guidance from the IMF and other international assessments of asset quality and provisioning bodies suggests the need for supervisory authorities to evaluate bank capital adequacy and solvency. to take a proactive approach to the assessment of However, in some situations, such as where there is banks’ capital positions, including through asset significant concern over the level of a bank’s NPLs quality reviews or solvency assessments, reviews or where there is concern that a large proportion of of banks’ Internal Capital Adequacy Assessment a bank’s restructured loans might be irrecoverable, Process (ICAAP)s, and forward-looking stress testing. it may be necessary for the authorities to consider Undertaking detailed analysis to assess the potential requiring banks to undergo a special purpose capital impact of the pandemic will assist supervisors external audit or dedicated asset quality review by to determine whether specific supervisory actions are appointed independent parties, such as the bank’s needed to mitigate financial stability risks. It is also external auditor or another major audit firm. The important for supervisors to assess changes in the authorities may also need to consider strengthening ability of banks to raise new capital, and the quality their technical capacity for undertaking solvency and cost of capital potentially raised, which may be assessments in situations where material uncertainty negatively impacted in the current environment. arises over a bank’s financial soundness. In this 26. The PICs have the advantage that most regard, the PIC supervisory authorities are able banks entered the pandemic with relatively to draw on international guidance on solvency strong capital ratios – generally well above assessments and asset quality reviews, such as those regulatory requirements and high by the average issued by the IMF.11 The World Bank is also able to capital ratios of banks in many jurisdictions provide guidance to the PIC authorities on solvency internationally. Nonetheless, it will be important assessment frameworks. for the supervisory authorities to assess the impact COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic 28. Stress testing is also an important tool for the pandemic is having – and might continue to have assessing the potential capital impact of the - on banks’ and non-bank lenders’ capital positions. pandemic and its aftermath on banks. Stress tests This is especially the case given the extent to which provide a mechanism for assessing capital, liquidity new variants of COVID-19 are now impacting some and earnings for individual financial institutions and of the countries in the region and the risk that the the financial system as a whole on a forward-looking pandemic might take much longer than previously basis. This will be especially useful in assessing expected. Accordingly, the supervisory authorities in the impact of the pandemic on banks and other the region are encouraged to consider the frameworks financial institutions over the next 2 to 3 years, as they might usefully apply to assess banks’ and non- PICs’ temporary support measures are unwound, bank lenders’ capital positions. Two techniques are fiscal policy is gradually brought back to a sustainable relevant in this context: asset quality reviews/solvency position, and monetary policy is progressively assessments using current assessments of banks’ and normalized. It will be important to review stress non-bank lenders’ loan portfolios and investment testing scenarios to consider the most appropriate assets, and forward-looking stress tests.  11  See for example The Role of Bank Diagnostics in IMF-Supported Programs, International Monetary Fund, December 2019, accessible at: https://www.imf.org/~/media/Files/Publications/TNM/2019/TNMEA2019004.ashx See for example 2021 Financial Sector Assessment Program Review—Background Paper On Quantitative Analysis, International Monetary Fund, May 2021, accessible at: https://www.imf.org/en/Publications/Policy-Papers/Issues/2021/05/28/2021-Financial- Sector-Assessment-Program-Review-Background-Paper-On-Quantitative-Analysis-460523 20 21 COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic scenarios to assess the potential vulnerability of financial institutions, and with risk management staff, banks as they transition from the current COVID-19 frontline credit management staff, and internal audit. situation to the post-COVID-19 environment. Scenarios Discussions by remote means would also usefully should seek to evaluate the implications for banks’ be held with the boards of banks and other financial loan quality, lending growth prospects, net interest institutions, with particular focus on the directors margins, profitability and liquidity in a forward-looking responsible for risk management and overseeing the scenario that incorporates plausible features of the response to the pandemic. post-COVID-19 economic environment. Stress testing will be especially useful in the assessment of bank and non-bank lender vulnerability for scenarios in which the return to pre-COVID-19 levels of economic activity „ ENGAGEMENT WITH takes longer than is currently expected. PARENT BANKS 31. Engagement with foreign parent banks (where „ INTENSIFICATION applicable) will also be an important element in financial surveillance given the extent of cross- OF ‘VIRTUAL’ ON-SITE border banking linkages in the region. In particular, ASSESSMENTS OF ASSET it is suggested that the authorities engage with the parent banks of subsidiaries and branches in the QUALITY AND RISK PICs on the guidance they are providing to their MANAGEMENT subsidiaries/branches as to the approach taken to loan restructuring and debt servicing relief for customers adversely impacted by the pandemic. 29. On-site assessment capacity will need to be The authorities could also usefully engage with strengthened to enable supervisors to conduct parent banks in respect of the banks’ guidance and selected reviews of loans under stress in order support to their subsidiaries and branches as regards to assess asset quality and the adequacy of assessing the likely level of NPLs emerging from the provisions against loan impairment. However, pandemic and the provisioning needed in respect of on-site assessment is unlikely to be feasible in the such loans. It would also be important to engage with ‘normal’ way in the PICs (as in many countries globally) parent banks on the extent to which they are assisting until the pandemic no longer poses a significant risk their PIC operations with respect to NPL resolution to health. Until then, most of the analysis undertaken processes. by the authorities will likely be in the form of off-site assessment through enhanced collection and analysis 32. A further matter for discussion with the parent of prudential information provided by banks and other banks is the extent of their internal audit review financial institutions. of their foreign subsidiaries’ operations as regards asset quality, NPL recognition, provisioning and 30. To the extent feasible, the authorities NPL processes. To the extent that foreign bank should consider remote means of conducting operations in the PICs are dependent to a substantial quasi-on-site assessments of banks and other extent on parent bank functionality (e.g., as regards financial institutions, focusing in particular on IT functions, legal services, payments and clearing of the institutions’ asset quality, classification of foreign currency transactions, HR functions, etc), it loans between performing and non-performing, will also be important for the authorities to engage provisioning for potential loan losses, and NPL with the parent banks on the adequacy of ongoing resolution processes. This could likely be done functionality support and the contingency plans in through video-conferencing, including discussions place in the event that the banks’ operations in the with the senior management of banks and other PICs sustain operational difficulties. iii. identify loans that are assessed by banks as „ ENGAGEMENT WITH being unlikely to return to viability; EXTERNAL AUDITORS iv. assess the level of NPLs by category (e.g., those which are assessed as being unable to return 33. It is also important for the authorities to to normal commercial terms, those which are engage with the external auditors of the regulated in arrears by x number of days relative to their financial institutions. In particular, matters for current servicing obligations, etc); discussion would include the extent to which external v. assess the level of NPLs based on estimated auditors have been engaged by their bank clients to recoverable value (and therefore estimated undertake specific assessment of loan impairment loss) by category of loan; and recognition and provisioning policies, and whether they have been involved in reviewing the adequacy of vi. assess the level of provisioning relative to loan loss provisioning in the context of loans impacted expected losses. by the pandemic. See the attached table in Appendix 1 for an indicative set of types of data that could be requested from 34. Consideration may need to be given to banks on a regular basis. requesting special purpose audits of financial institutions’ loan impairment recognition policies b. Seek regular (e.g., quarterly) updates from banks and practices, and to undertake dedicated on the specific remediation measures being taken assessments of loan loss provisioning. The in respect of restructured and non-performing timing for such reviews will much depend on the loans. circumstances. Currently, with some PICs still in c. Establish transparent thresholds for the lockdown mode and with border closures in place, termination of regulatory dispensation for loans there would be practical difficulties in implementing subject to temporary restructuring and loan special purpose audits or reviews, given the need for repayment deferral, and provide guidance to these to involve some element of on-site assessment. banks on the process and timeframe for banks However, once PICs move back to more normal to transition loans back to normal servicing levels of operation, and on-site assessments can requirements and to report updated NPLs and be undertaken by audit firms or other specialists provisioning data. appointed or approved by supervisory authorities, COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic then consideration should be given to this option. d. Engage (virtually if necessary) with bank boards, senior management and CROs (or equivalent) to obtain updates on the status of loans under restructuring/support and in different categories NPLs, and discuss the remediation strategies they „ CONCLUSIONS AND are pursuing. RECOMMENDATIONS e. Assess the adequacy of banks’ processes for identifying NPLs, determining expected loan losses, 35. It is suggested that the PIC authorities consider and provisioning for loan losses, including by undertaking the following initiatives, to the extent discussion with the banks’ internal auditors and that they have not already done so: external auditors. If the supervisory authorities have concerns as to the adequacy of a bank’s a. Develop a template to collect enhanced and capacity and processes in these areas, they should more granular data from banks on a regular (e.g., consider requiring the banks to engage their quarterly) basis in order to: external auditors or other independent parties i. monitor and assess the status of loans under approved by the supervisors to undertake special temporary support arrangements; purpose reviews and to report the findings back to ii. assess progress in transitioning such loans back the supervisory authorities. to performing status on commercial terms; 22 23 COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic f. In the case of PICs which are host authorities areas of vulnerability. This information will help for subsidiaries or branches of foreign banks, the authorities to determine future supervisory the authorities should engage with the home actions, especially in the case of banks that authorities to obtain an update on the parent bank are identified as having relatively weak capital position with respect to NPLs and capital, and to positions (see the paper on Stress testing). seek to ensure that the parent bank is providing j. If the authorities have material doubt over the necessary support to the subsidiary/branch in the accuracy of a bank’s stated asset quality, respect of its NPL recognition, provisioning policies provisioning and capital positions, and have and NPL resolution processes. concerns as to the possible viability of the bank g. In the case of PICs which are home authorities in question, they should consider requiring the for banks with subsidiaries or branches in other bank to undergo an asset quality review/solvency countries, the authorities should engage with assessment by an independent and competent the host authorities to obtain an update on the party approved by the authorities and at the subsidiary/branch position with respect to NPLs expense of the bank. and capital/net assets, and to obtain regular k. The authorities should consider strengthening the updates on NPL recognition, provisioning policies, public disclosure requirements for banks in respect and NPL resolution processes. Home authorities of asset quality, NPLs, loan loss provisioning, should seek to ensure that the parent bank is profitability and capital position, and require bank applying a whole-of-group consistency to its NPL boards to be responsible for the accuracy and policies and processes, and that the parent bank completeness of these disclosures. is providing support as necessary to its foreign subsidiaries and branches. l. The authorities should review and strengthen their contingency plans for dealing with weak banks. h. Where a PIC supervisory authority has specific This should include ensuring that early intervention concerns in relation to a bank’s capital position, arrangements and response strategies are and the possible need for recovery actions, sufficiently comprehensive and adequately cater it should engage with the bank and parent to the possible scenario that some banks may face bank (where applicable) to seek to ensure that if a significant proportion of their loans currently appropriate recovery strategies are being put classified as restructured become non-performing. in place. In this regard, supervisory authorities should review banks’ recovery plans and capital contingency plans to ensure that they adequately set out plausible capital maintenance and restoration actions. i. PIC authorities should consider developing a framework to require banks to undertake a stress testing exercise based on parameters determined by the authorities, involving a forward-looking scenario that seeks to assess the range of possible bank asset quality, profit and capital outcomes for the period from end 2021 through to end 2023 with a range of assumptions as to the possible future paths of Covid infection levels, lockdown arrangements, and resumption of ‘normal’ economic activity (ranging from a ‘best case’ to a ‘worst case’ scenario). These stress tests will help to inform an assessment of the adequacy of banks’ capital positions and identify potential „ APPENDIX 1. INDICATIVE TABLE OF SURVEILLANCE DATA FOR THE COVID AND POST-COVID PERIODS Category of Types of data information Loan classification Granular breakdown of loans by category of counterparty and nature of collateral (if any), such as:  Loans to natural persons disaggregated by type of collateral Loans by  Loans to natural persons of an unsecured nature counterparty  Loans to SMEs disaggregated by type of collateral and collateral  Loans to SMEs of an unsecured nature  Loans to larger businesses disaggregated by type of collateral  Loans to larger business of an unsecured nature Granular breakdown of loans by category of temporary support (if any), differentiating between loans that are covered by government-mandated or facilitated support and loans that have been given concessional terms by the bank in isolation to government support programs, including loans by reference to:  Loans with a suspension of interest payments  Loans with a suspension of principal repayments  Loans with a combination of suspension of both interest and principal payments/ repayments Loans under  Loans subject to an elongation of loan maturity period temporary  Loans subject to government guarantees support or  Loans whose terms have been restructured by the bank outside of any government- restructuring mandated program  Loans where a proportion of the loan has been or might be converted to equity COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic  Loans classified as restructured loans under which additional lending has been made With information that identifies the amount of loans in each category on a monthly basis, and which identifies the proportion of loans in each category that have been restored to normal business terms Banks should be required to identify those restructured loans that are not expected to resume normal performing status and to assess the expected loss in relation to such loans Granular breakdown of loans by:  Industry category of the borrower  Geographic region of borrower With special identification of loans to entities in industries or economic sectors which have Loans by been adversely impacted by border closures and other pandemic-related matters, such as: industry and  Hotels and other forms of foreign visitor accommodation geographic region  Airports  Airlines  Land transport providers associated with tourism  Travel agents and tourist package operators  Retail sector, particularly those businesses which cater mainly to foreign visitors 24 25 COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic Category of Types of data information Asset quality Granular data on:  Loans that are subject to temporary support measures that are in arrears in respect of the payment obligations under the support measures (i.e. failing to meet loan servicing obligations under the terms of the loan restructuring), by age of arrears NPLs  Loans that have been otherwise restructured by the bank and are assessed as non- performing  Loans in arrears by days of arrears (e.g. 30 days, 60 days, 90 days, etc) The data should preferably indicate the industry/sector of the borrower This might include categorisation of loans by:  Bank assistance to the borrower to facilitate restoration to viability – e.g., through further NPLs by loan restructuring or extended repayment holidays nature of  Loans which are subject to some form of receivership or administration resolution  Loans under which the bank has required the borrower to agree to the appointment of an action adviser/manager to seek to restore the loan to viability  Loans which are under court-based insolvency proceedings  Loans under which foreclosure actions have been taken Recoverable value of loans and provisioning Estimated Estimated recoverable value of each of the categories of loans under temporary support and recoverable restructuring value of loans by category Estimated recoverable value of loans by category of NPLs General provision Specific provisions by category of loans: Provisioning  loans under temporary support and restructuring  loans by category of impaired loans Other types of information Data might include:  HQLA by category of asset  HQLA ratio to total liabilities  LCR (if applicable) Liquidity  Maturity mismatch of assets and liabilities  Rate of deposit withdrawal  Trends in inter-bank funding (where applicable)  Net cashflows from the loan portfolio (identifying cashflow impairment) Data might include:  Interest rate risk (e.g., VAR, interest rate maturity mismatches on assets and liabilities, or Market risks other measures currently used by the supervisory authority)  Currency risk (e.g., net open currency positions or other metrics used by the supervisory authority) Category of Types of data information Data might include:  Revenue by category  Net interest income  Operating expenses Profitability  Provisioning expenses  NPAT  ROA  ROE „ APPENDIX 2. COVID-19 LOAN RESTRUCTURING RESPONSES BY APRA AND RBNZ The measures apply regardless of whether or not the Australia borrower has previously been granted a repayment deferral due to the impact of the pandemic. For The Australian Prudential Regulation Authority (APRA) transparency, APRA will require ADIs to publicly announced on July 18, 2021 regulatory support disclose and report the nature and terms of any for banks offering temporary financial assistance repayment deferrals and the volume of loans to which to borrowers impacted by COVID-19. The APRA they are applied. ADIs must also still continue to statement is reproduced below: provision for these loans under relevant accounting “A number of authorised deposit-taking institutions COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic standards. (ADIs) have announced COVID-19 support packages Today’s announcement largely mirrors the temporary that will provide affected borrowers with an option support measures APRA announced in March 2020.12 to defer their loan repayments. These packages This temporary treatment ended on March 31, 2021. have been offered to small business and home loan APRA will release an updated prudential standard in customers. July 2021 formalising this new treatment, in line with In response, APRA is providing regulatory relief to the approach taken in 2020.”13 assist ADIs in supporting their customers through this period. For eligible borrowers, ADIs will not need to On March 20, 2020, APRA issued the following treat the period of deferral as a period of arrears or statement announcing the initial loan restructuring a loan restructuring. This will apply to loans that are regulatory relief measures for banks and other ADIs. granted a repayment deferral of up to three months before the end of August 2021. This will provide banks “The Australian Prudential Regulation Authority and borrowers with additional flexibility to manage (APRA) today confirmed its regulatory approach to the the period ahead. COVID-19 support packages being offered by banks and other lenders to their borrowers in the current environment.  12  https://www.apra.gov.au/news-and-publications/apra-advises-regulatory-approach-to-covid-19-support  13  Source: https://www.apra.gov.au/news-and-publications/apra-announces-further-regulatory-support-for-loans-impacted-by- covid-19 26 27 COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic Many banks have recently announced COVID-19 New Zealand support packages that provide affected borrowers with an option to defer their repayments for a period On 27 March 2020, the Reserve Bank of New Zealand of up to six months. These packages have mainly been (RBNZ) issued regulatory guidance to facilitate banks offered to small business and home loan customers. offering loan repayment deferrals to their customers. Where a borrower who has been meeting their This guidance enabled banks to temporarily treat repayment obligations until recently chooses to take deferred loans as performing (non-defaulted) for up the offer not to make repayments as part of a a period of up to six months. Loan deferrals were COVID-19 support package, the bank need not treat initially made available to residential mortgages, the period of the repayment holiday as a period of including business lending secured against residential arrears. Similarly, loans that have been granted a property. repayment deferral as part of a COVID-19 support package need not be regarded as restructured. In April 2020 the scheme was extended to cover other lending, including lending to small and medium APRA will be writing to all authorised deposit-taking enterprises (SMEs) and agriculture. The RBNZ also institutions (ADIs) to advise them of the specific clarified that there were no barriers in the regulatory reporting treatment for loans subject to these support capital framework to non-bank deposit takers (NBDTs) arrangements. APRA will require ADIs to report to also offering loan deferrals to their customers. APRA, and publicly disclose, the nature and terms of any repayment deferrals and the volume of loans to In the absence of further intervention, the RBNZ’s which they are applied. ADIs must also still continue regulatory guidance would have expired on 27 to provision for these loans under relevant accounting September 2020 and the standard regulatory standards. treatment of deferred bank loans would apply APRA also confirmed that the Coronavirus SME from that point forward. The RBNZ extended its Guarantee Scheme announced by the Commonwealth concessionary treatment of deferred loans until Government yesterday is to be regarded as an eligible 31 March 2021. As with the previous guidance, the guarantee by the government for risk-weighting extended guidance allowed banks to treat loans purposes.” 14 deferred under the programme as performing (non- defaulted), provided they were not otherwise recorded as in arrears, on a watch-list or impaired in any way as APRA published regular monthly data on ADIs’ at 29 February 29 2020. The RBNZ stated that deferred COVID-19 restructured loans through much of 2020 loans should not be treated as being in arrears, or as a and through to February 2021. This provided helpful distressed restructuring. transparency on the extent of loan restructuring attributable to COVID-19 and associated data on loan The RBNZ stated a clear expectation that repayment impairment, and was based on detailed reporting that deferrals should not be the ‘default option’ offered APRA obtained from all ADIs.15 to customers. In particular, the RBNZ noted an expectation that lenders only approve an extension It is not yet clear whether APRA will resume this or new loan deferral where there is a need for it and a COVID-19 public reporting following the reimposition benefit to the borrower, and when the lender assesses from July 2021 of various lockdown arrangements that there is a reasonable prospect of that customer to combat COVID-19 in various Australian cities and resuming payments when the deferral period ends. states.  14  Source: https://www.apra.gov.au/news-and-publications/apra-advises-regulatory-approach-to-covid-19-support The letter APRA sent to ADIs in March 2020 can be accessed here: https://www.apra.gov.au/sites/default/files/2020-03/ Changes%20to%20reporting%20obligations%20in%20response%20to%20COVID-19.pdf  15  An example of this monthly reporting can be accessed on this link to the APRA website: https://www.apra.gov.au/temporary-loan-repayment-deferrals-due-to-covid-19-february-2021 It noted that, for many borrowers, resuming, or New Zealand entered into a major lockdown in August continuing payments in some form would be the 2021 as a result of an outbreak of community-based most suitable approach, rather than extending a COVID-19 in Auckland. The lockdown is likely to extend repayment deferral. This may include returning to well into September 2021 for Auckland, with a lesser payments on the original schedule, or on a revised level of restriction for other areas in New Zealand. It schedule following a loan restructure. There may remains to be seen what the RBNZ might announce in also be borrowers where the lender considers that respect of loan restructuring arrangements for banks there is little reasonable prospect that the borrower and NBDTs in relation to these recent developments. will be able to resume payments once a deferral ends. In all cases the RBNZ stated an expectation that lenders engage with each borrower with a deferred loan, or seeking a new deferral, to identify the most appropriate solution for that borrower. Banks and customers had flexibility over the term of any deferral, but the concessionary loan treatment expired on March 31, 2021. COVID-19 and Financial Stability: Guidance on financial system surveillance in the pandemic 28 29 COVID-19 AND FINANCIAL STABILITY: MICROPRUDENTIAL AND MACROPRUDENTIAL POLICY: SEEKING THE RIGHT BALANCE November 2021 meet its financial obligations as they become payable. „ INTRODUCTION Microprudential policies are therefore focused mainly on the financial soundness of an individual 1. The theme of this paper is microprudential financial institution, such as banks, non-bank deposit- policy and macroprudential policy in the context takers, general insurers, and long-term insurers. of responding to the pandemic. It looks at the In doing so, however, microprudential policies also objectives of the respective policies, including points of help to promote the stability and resilience of the complementarity and conflict between the two types financial system as a whole and, through that, help of prudential policy, summarises global experience to contribute to the overall objective of promoting in the use of macroprudential policy in the response sustainable economic growth and societal welfare. to the pandemic, and sets out guidance on the use of such policies, drawing on international principles. 4. Microprudential policies generally involve the The paper is intended to assist the PIC financial sector use of prudential regulations and initiatives in authorities to review their respective microprudential relation to a number of matters. These typically and macroprudential policy frameworks, with a include regulatory requirements in respect of: view to seeking to ensure clarity of objectives,  the ownership and governance of a financial complementarity of application, assessment of policy institution; efficacy, and effective governance.  the fitness and properness of directors and senior officers;  the systems and controls for the identification, „ A RECAP OF DEFINITIONS measurement and management of risks, and the frameworks for risk appetite and risk oversight; OF MICROPRUDENTIAL  limits on exposure concentration and connected AND MACROPRUDENTIAL lending; POLICIES  limits on net open positions for market risks (e.g., foreign currency risk); COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala 2. For the purpose of this paper, it is useful  capital requirements (generally based on a variant to recap what is meant by the terms of Basel II or III); ‘microprudential’ and ‘macroprudential’. This  liquidity requirements (often anchored in some recognizes that these terms are often used in different way to Basel III); contexts and with varying interpretations as to their meaning. Therefore, clarity of definition is helpful to  asset quality reporting and loan loss provisioning; the remainder of the discussion in the paper.  contingency plans for capital, liquidity and business continuity, and recovery plans; and 3. Microprudential policy refers to prudential regulation and supervision applied to financial  off-site monitoring and on-site assessments. institutions for the primary purpose of promoting the soundness and safety of each individual 5. Macroprudential policy refers to policies that financial institution. The objective of such regulation involve the use of prudential regulation for the and supervision is to achieve a very low (but not zero) purpose of limiting systemic risks and promoting probability of institutional failure by seeking to ensure financial stability. As noted in the paper Elements that a financial institution manages its risks prudently, of Effective Macroprudential Policies: Lessons from has plans in place to restore itself to financial and International Experience, published jointly by the IMF, operational soundness in the face of a financial shock, FSB and BIS in August 2016,16 macroprudential policy has sufficient capital buffers to absorb losses while still typically operates through three main intermediate remaining viable, and has sufficient liquidity in place to objectives:  16  This document is accessible via the following web link: https://www.bis.org/publ/othp26.htm 30 31 COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala a. Increase the resilience of the financial system to e. the use of ‘speed limits’ on lending to particular aggregate shocks by building and releasing buffers sectors or on higher-risk loans to slow the growth that help maintain the ability of the financial in new lending in periods of perceived risk to system to function effectively, even under adverse financial system stability; conditions. f. liquidity tools, such as increasing the LCR b. Contain the build-up of systemic vulnerabilities requirement applicable to banks in periods in over time by reducing procyclical feedback which there are perceived to be higher liquidity between asset prices and credit, and containing risks or lowering the LCR or other liquidity unsustainable increases in leverage, debt, and requirements in situations where the banking volatile funding. system is flush with excess liquidity and the authorities wish to encourage banks to apportion c. Control structural vulnerabilities within the more of their balance sheets to lending. financial system that arise through interlinkages, common exposures, and the critical role of individual intermediaries in key markets that can 7. Macroprudential policy is generally used in render individual institutions ‘too-big-to-fail’. combination with other policies to achieve desired outcomes. In particular, macroprudential policy is used in combination with microprudential policy 6. Macroprudential policy can be implemented to promote desired financial stability outcomes, through a range of policy instruments. These vary while also ensuring that the objective of promoting from country to country and are evolving in response the soundness and safety of individual financial to different financial stability threats, but often institutions is maintained. In addition, and depending include: on the policy objectives and economic situation, a. the use of capital buffers (such as the counter- macroprudential policy can be used in tandem with cyclical buffer) as a mechanism for lowering capital complementary monetary policy, fiscal policy and requirements in periods of economic downturn industry policy to achieve the desired economic and when greater bank lending might be desirable, and financial stability policy objectives. This has very much increasing capital requirements in periods of rapid been the case in many countries in response to the economic growth and increases in asset prices COVID-19 pandemic, where various macroprudential which could pose a threat to financial stability; policy initiatives were deployed in combination with a b. the use of risk-based lending restrictions, such as substantial easing in monetary policy, fiscal expansion, loan-to-valuation and debt-to-income limits on and various targeted assistance programs to reduce residential property-related loans to constrain the adverse impacts of the pandemic on the economy banks’ lending in periods of high property price and financial system. In this context, macroprudential inflation and high household or SME leverage; policy can be used to reinforce monetary policy outcomes – e.g., to lower inflationary pressures – by c. the use of variable risk weights in the bank capital reducing the reliance on the standard monetary policy framework, such that the risk weight applicable to instruments, such as an official short-term interest higher-risk loans or loans to higher-risk sectors of rate. In doing so, it can enable a more targeted set the economy may be used to reduce the appetite of macroprudential policy initiatives to be taken to for and the extent of lending in these areas, and address pressure points, such as asset price inflation, to increase the capital buffer needed to cover while reducing the need for use of the much blunter potential losses on such loans; mechanism of raising interest rates. d. the use of sectoral exposure lending limits to slow lending (or increase lending, as the case may be) to particular sectors of the economy; macroprudential policy is targeted at promoting the „ COMPLEMENTARITY stability of the financial system (and in particular the AND CONFLICT BETWEEN stability of the banking system), it tends to be more complementary with microprudential policy than MICROPRUDENTIAL AND if macroprudential policy is assigned a wider set of MACROPRUDENTIAL objectives (e.g., to ease pressure on monetary policy in the pursuit of reducing inflationary pressures or to POLICIES encourage or discourage lending to particular sectors of the economy for economic development purposes). 8. In most respects, microprudential policy and This is one of the reasons why it is important that macroprudential policy work in tandem towards there are clearly defined and well-understood policy a common goal of financial stability. However, objectives for macroprudential policy, with a view to there are circumstances when conflicts or tensions focusing policy on financial stability objectives rather arise between microprudential and macroprudential than widening its ambit into policy objectives that policies. This has been noted in various papers create greater potential conflict with microprudential globally. For example, in the European Central policy. Bank Financial Stability Review published in May 2014,17 the ECB made a number of observations 10. Macroprudential policy can help to reinforce on the complementarities and tensions between microprudential policy objectives in a number microprudential and macroprudential policy. Likewise, of ways. For example, it can be used to facilitate the complementarities and tensions between lending in periods of economic adversity through macroprudential policies and microprudential policies such mechanisms as the countercyclical capital buffer. were discussed in the IMF Staff Discussion Note: To the extent that such an initiative helps banks ‘Macroprudential and Microprudential Policies: Toward to maintain lending at higher volumes than would Cohabitation’, published in June 2013. Some of the 18 otherwise be the case, the policy can assist in reducing main issues raised in these and other papers are the risk of loan losses that might otherwise be more COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala summarised briefly below. likely if banks collectively cut lending and thereby exacerbated the effects of an economic downturn. Another example of potential complementarity between macroprudential and microprudential Complementarities between policies is the use of loan-to-valuation ratios and microprudential and borrower debt-servicing ratios to reduce pressures on residential property prices. Such policies offer the macroprudential supervision potential benefit of reducing wider financial system instability and economic growth risks associated 9. The ECB, IMF and other bodies have noted that with property price bubbles. They can also assist in substantial complementarities exist between promoting the financial soundness of individual banks microprudential and macroprudential policies, by reducing the risk profile of their loan portfolios and that the two policy areas can play an equally relative to what they might otherwise have been and important role in promoting financial stability. by lowering the risk of loan losses associated with a The extent of complementarity much depends on fall in property prices. the respective objectives of the two policy areas. If  17  European Central Bank Financial Stability Review, May 2014 https://www.ecb.europa.eu/pub/pdf/fsr/art/ecb.fsrart201405_03.en.pdf  18  IMF Staff Discussion Note: ‘Macroprudential and Microprudential Policies: Toward Cohabitation’, June 2013 https://www.imf.org/external/pubs/ft/sdn/2013/sdn1305.pdf 32 33 COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala to encourage or discourage lending to particular „ POTENTIAL sectors of the economy, as might be the case if TENSIONS BETWEEN macroprudential policy is used to reduce the risk of household sector stress due to residential property MICROPRUDENTIAL AND price bubbles or to encourage lending to sectors MACROPRUDENTIAL perceived by the government to be under-funded by banks. Such policies might have little connection to SUPERVISION financial stability outcomes and might even lead to worse financial stability outcomes than in the absence 11. However, macroprudential policies can create of such policies. For example, macroprudential tensions or even conflicts with microprudential policies applied for these purposes could actually policy in certain circumstances. For example, during worsen the risk profile of individual banks by diverting economic downturns, diverging microprudential their lending into exposure categories that carry and macroprudential policy approaches have the higher risks than would have occurred in the absence potential to generate frictions. This could arise if of macroprudential policies. macroprudential policy is used countercyclically to stimulate economic growth by facilitating a greater 13. It is therefore essential that there are volume of bank lending – e.g., by lowering bank capital appropriate mechanisms in place to manage this buffers, relaxing limits on bank lending to particular risk. Examples of these mechanisms include: (i) setting economic sectors, or by reducing limits on LVR and clear policy objectives for macroprudential policy borrower debt servicing constraints. Although such and limiting the use of such policy for objectives that macroprudential policies might well have the benefit diverge from financial stability outcomes; (ii) the use of of stimulating economic growth and reducing the cost/benefit assessments to evaluate policy options ex extent or duration of a recession, the policies can ante and ex post; and (iii) a framework for evaluating exacerbate the risk profile and increase potential the trade-offs between different policy objectives probability of bank failure for individual banks by and policy options. This will be discussed later in the encouraging banks to lend to a greater degree than paper. Before doing so, it is useful to summarise how they would otherwise have done. Reflecting this, macroprudential policies were applied in response in economic downturns, microprudential policies to the pandemic and to assess the extent to which would generally be applied to strengthen bank these policies may or may not necessarily complement capital ratios, rather than to ease them, and to microprudential policy objectives. This is discussed in tighten restrictions on higher risk lending, than to the next section of the paper. loosen them. Accordingly, in periods of economic stress, macroprudential and microprudential policies have the potential to move in opposite directions. This suggests the need for a careful assessment of „ USE OF the trade-offs between the two policy areas and the importance of coordinating the deployment of MACROPRUDENTIAL macroprudential and microprudential policies so POLICIES IN RESPONSE TO as to be mutually reinforcing rather than mutually undermining. THE PANDEMIC 12. Another example of the potential for 14. In response to the COVID shock, many conflict between microprudential policy and countries have used macroprudential policy macroprudential policy is when macroprudential tools to enable banks to absorb expected losses policies are applied for objectives that are not and support the continued provision of credit to closely linked to financial stability. This can arise, the real economy.19 The main motivation for using for example, if macroprudential policies are used macroprudential policy has been to enable banks  19  In countries that adopted Basel III, the COVID-19 crisis showed that some banks were reluctant to dip into their capital buffers to avoid market stigma. The functioning of capital and liquidity buffers is therefore being further studied by international standard setters such as the FSB. to continue to provide credit through the period effect on the real economy. However, it was noted that of subdued economic activity of the pandemic, to such a relaxation is possible only if macroprudential ease stress on borrowers, and to reduce the risk of buffers are in place, and useful only if the relaxation NPL remediation initiatives by banks from causing of the available buffers is expected to relieve stress or further stress to economic activity and asset prices. remove binding constraints on the provision of credit Responses have included: to the real economy. Relaxation of other types of tools can relieve a range of stresses if conditions allow.  release of countercyclical capital buffers; Examples include:  delaying the implementation of scheduled  Where a countercyclical capital buffer (CCyB) has increases in bank capital ratio requirements; already been activated, it can be relaxed to support  an easing of liquidity requirements (e.g., reductions the flow of credit to the economy, by providing in LCR or HQLA/liability ratio requirements); additional capacity to lend through a period of  relaxation of bank reserve requirements; increased credit risks. Where the CCyB is not available, banks could be encouraged to use the  relaxation of constraints on lending to particular capital conservation buffer (CCB). Consideration sectors of the economy; and can also be given to a relaxation of systemic  relaxed borrower-based tools (e.g., loan-to- risk buffers that are designed to protect against value ratios, debt servicing ratios, and sectoral macroeconomic risks. lending limits) to support access to credit for  Banks should be able to make use of their high- small business owners and households that are quality liquidity assets under the liquidity coverage experiencing temporary financial distress. ratio (LCR) when needed to counter liquidity stress in local currency. A relaxation of reserve 15. In addition to these macroprudential policy requirements (in domestic currency) can also help initiatives, many supervisory authorities granted alleviate such liquidity pressures for banks. temporary relief to banks in the regulatory  Foreign currency reserve requirements can be classification of loans subject to restructuring during relaxed to mitigate foreign exchange funding the pandemic period, such that the restructured loans pressures. Where countries have introduced COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala need not be treated as non-performing. In some additional LCR requirements in foreign currency, cases, depending on the application of accounting they can allow banks to use the buffer or relax the standards, banks were not required to hold specific requirement. provisions against loans subject to temporary restructuring.  A relaxation of sectoral tools (such as caps on loan-to-value ratios) can also be considered, where 16. A summary of macroprudential policy and related prevailing settings of such tools is tight and a initiatives taken by selected jurisdictions in response relaxation would be useful to support the provision to the pandemic is set out in Appendix 1 of this paper. of credit to households and firms. 17. The IMF, among others, have provided guidance 18. As noted by national authorities and on the use of macroprudential policies in response international agencies, the relaxation of to the pandemic. In its paper Special Series on macroprudential and other regulatory policies in COVID-19 ‘Monetary and Financial Policy Responses for response to the pandemic carries risks. Although Emerging Market and Developing Economies’,20 the IMF macroprudential and other regulatory policy initiatives noted that a relaxation of macroprudential tools can taken in response to the COVID-19 pandemic have help the financial system absorb the impact of the assisted in reducing adverse economic impacts economic shocks associated with the pandemic and and financial stability risks, the initiatives have the ease a credit crunch that might otherwise amplify the  20  See https://www.imf.org/-/media/Files/Publications/covid19-special-notes/enspecial-series-on-covid19monetary-and- financial-policy-responses-for-emerging-market-and-developin.ashx 34 35 COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala potential to sow the seeds of future financial stability risk. The easing of capital ratios carries the risk „ MACROPRUDENTIAL of inducing moral hazard on the part of banks by POLICY GOVERNANCE, encouraging them to lend more aggressively and with less discernment than might otherwise have been TRANSPARENCY AND the case if they believe that loan losses resulting from ACCOUNTABILITY such lending will be partly offset by further possible relaxations in capital ratio requirements. Likewise, 20. The potential conflicts between the relaxation of liquidity requirements carries the macroprudential policy and microprudential policy risk of banks taking a less prudent approach to the need to be carefully identified and managed. management of liquidity risks. The widening of central Equally, it is important to ensure that macroprudential bank liquidity facilities for banks, as was done in many policy is designed and implemented in ways that countries in response to the pandemic, carries a risk are best aligned to desired financial stability of inducing moral hazard by creating a presumption outcomes and with minimal risk of unintended by banks that central bank liquidity will be easier to adverse side effects. The need to have appropriate obtain in future periods of stress than was previously structures in place to manage the risks associated thought likely. This could cause some banks to with macroprudential policy and to maximize the become less cautious in the management of liquidity prospect of achieving desired policy outcomes is well risk in future periods of stress. recognized and has been the subject of analysis by various agencies, including central banks, supervision 19. The relaxation of loan impairment recognition authorities, the IMF,21 World Bank,22 and Toronto also creates risks. In particular, it creates a risk Centre.23 that banks do not adequately distinguish between restructured loans that remain viable and will resume 21. The international guidance points to a number normal performance requirements following the of factors which, taken together, can assist in pandemic, from those loans that, although subject promoting an effective macroprudential policy to temporary restructuring, are unlikely to resume framework and reduce the risks of conflicts normal performance status. There is a danger that between macroprudential and microprudential banks may take advantage of the temporary loan policy. The key elements include the following: restructuring arrangements to delay the recognition of loan impairment and associated provisioning for a. Clarity of policy objectives. As with any area of loan losses. As a consequence, bank capital ratios policy, macroprudential policy should be anchored may appear to be stronger in some cases than would to well-defined and well-reasoned objectives. be the case upon closer scrutiny. Accordingly, it The fundamental objective of macroprudential is important that supervisory authorities exercise policy should be the promotion of financial system particular vigilance now, and in the months ahead, stability. As a general principle, macroprudential as the world (hopefully) emerges from the worst of policy should only be applied to achieve financial the pandemic, in ensuring that banks’ asset quality is stability outcomes. If it is used for wider purposes, reported accurately and that provisioning is based on such as to promote price stability or reduce asset a realistic assessment of expected loan losses. price inflation, the ultimate purpose should still be anchored to financial stability. Any use of macroprudential policy for reasons that do not anchor to, or that conflict with, financial stability should be viewed with considerable caution.  21  See for example: IMF Staff Discussion Note: ‘Macroprudential and Microprudential Policies: Toward Cohabitation’, June 2013 https://www.imf.org/external/pubs/ft/sdn/2013/sdn1305.pdf  22  See for example: World Bank Study: Macroprudential Policy Framework: A Practice Guide https://documents1.worldbank.org/curated/en/664661468331743319/pdf/Macroprudential-policy-framework-a-practice-guide.pdf  23  See Integrating Microprudential Supervision with Macroprudential Policy, TC Notes, Toronto Centre, March 2021 https://res.torontocentre.org/guidedocs/Integrating%20Microprudential_Supervision%20with%20Macroprudential%20Policy%20 FINAL.pdf b. Clearly specified rationale for the deployment behaviour of financial institutions, the ability of of a policy initiative. The use of a particular financial institutions to manage risks, and the macroprudential policy initiative should be ability of financial institutions to absorb losses based on a well-specified policy rationale. This arising from risks. If the macroprudential policy should include specification of the problem to be initiative is expected to have an adverse effect in addressed by the policy initiative – i.e., the market any of these respects (e.g., by inducing greater risk- failure or other factors that justify the use of the taking by financial institutions or causing them to policy. It should also include an assessment of the hold lower buffers against risks than they would in channels by which the policy initiative will address the absence of the policy initiative), then it should the problem and will promote financial stability only proceed if the net contribution to overall outcomes – e.g., the means by which the initiative financial stability objectives significantly outweighs will reduce destabilising influences on the financial the negative impact on microprudential policy system and/or promote resilience of financial objectives. institutions, systems and markets to the causes of e. Ex post assessment of the efficacy of the instability. policy initiative. Any macroprudential policy c. Ex ante assessment of costs and benefits. The initiative should be assessed on a regular basis proposed deployment of a macroprudential policy (e.g., annually) to assess its efficacy in meeting the initiative should be subject to comprehensive cost/ defined policy objectives and to evaluate, on an ex benefit assessment. Unless the expected benefits post basis, the costs associated with the policy. If exceed the expected costs, the policy initiative the analysis calls into question the efficacy of the should not be implemented. The costs to be taken policy, then a prima facie case exists for the policy into account should include: (i) compliance costs; to be modified or withdrawn. (ii) administrative costs; (iii) efficiency costs (e.g., f. Governance of macroprudential policy. adverse impacts on allocative efficiency, productive Macroprudential policy should be subject to efficiency and dynamic efficiency); and (iv) robust governance. This includes ensuring that economic costs (e.g., adverse impacts on economic there is an agency (or occasionally a co-agency activity). It should also include an assessment of arrangement) with explicit statutory responsibility COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala the risks associated with the policy initiative, such for macroprudential policy formulation and as the possible effects on financial institution implementation. The agency should be sufficiently risk management behaviour, moral hazard risks, resourced to perform the functions required for and financial institution probability of default. effective policy formulation and implementation. The assessment of benefits should include an Structures should be established to ensure that assessment of the potential effect on the targeted any internal conflicts are properly identified and problem on which the policy rationale is based and managed – this being especially the case where the the contribution this will make to strengthening macroprudential policy agency is also responsible the resilience of financial institutions, systems and for microprudential policy and/or monetary markets, and reducing destabilising influences on policy. If the central bank is the macroprudential financial stability. agency, there needs to be a framework in place d. Assessment of potential complementarity to ensure that macroprudential policy is not used and conflicts between macroprudential as a substitute for, or supplement to, monetary and microprudential policy objectives. The policy for price stability purposes if this creates consideration of a macroprudential policy initiative a material risk of undermining financial stability should involve an assessment of the extent to outcomes. If the macroprudential policy agency is which the initiative will complement or conflict also responsible for microprudential policy, there with microprudential policy objectives. In this needs to be a framework for ensuring that conflicts regard, the initiative should be assessed in terms between macroprudential and microprudential of its potential impact on the risk appetite and policy are avoided or managed. 36 37 COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala g. Consultation between relevant agencies. It is important to ensure that macroprudential policy „ CONCLUSIONS is formulated and implemented in consultation with other relevant agencies – e.g., other financial 22. This paper has discussed the role of regulators and the finance ministry. This is best macroprudential policy in the promotion achieved through an inter-agency committee or of financial stability and the potential working group, such as a Financial Stability Council. complementarities and conflicts between Proposed policy initiatives, together with cost/ macroprudential policy and microprudential benefit/risk assessments, should be submitted to policy. It has noted that, in most respects, the inter-agency body and assessed by members macroprudential policy and microprudential policy of the body before any policy decision is made. are complementary policy areas and each contributes Reviews of policy and ex post efficacy assessments to the promotion of financial system stability. should also be subject to inter-agency consultation. However, it has also argued that potential conflicts can arise between the two policy areas. The paper h. Transparency. Macroprudential policy should be has observed that a well-designed policy framework, subject to robust transparency at every stage of with well-defined objectives, governance, cost/ policy formulation and implementation, as well as benefit assessments, transparency, and accountability in ex post assessments. Policy proposals should arrangements, can go a long way towards reducing be subject to consultation with all interested or at least clearly identifying and managing parties through a formal consultation process. potential conflicts between macroprudential and Proposals should be accompanied by transparent microprudential policies. cost/benefit/risk assessments, and be open to challenge. Feedback by interested parties to 23. The World Bank suggests that it would consultation papers should be published and the be useful for the authorities in the PICs to macroprudential policy agency should publish undertake an assessment of their frameworks its response to any such feedback. Ex post for macroprudential policy to seek to ensure assessments of efficacy of macroprudential policy that the arrangements in place accord with should be published and open to a transparent sound principles and practice. The key elements consultation/feedback process. for an effective macroprudential policy framework, i. Accountability. The macroprudential policy as discussed in this paper, provide a useful set of agency should be accountable for its actions (or reference points for such an assessment. lack of actions) in respect of macroprudential policy. It should be required by statute to report publicly at least annually on its macroprudential policy performance, including ex post efficacy reports. The agency should be subject to scrutiny by a suitable committee of Parliament. The agency should be subject to periodic performance audits by an independent body appointed by the Minister of Finance or other appropriate minister to assess the adequacy of the performance of the agency by reference to pre-identified assessment criteria. Any findings of the audit should be publicly disclosed. „ APPENDIX 1. MACROPRUDENTIAL AND OTHER PRUDENTIAL POLICY INITIATIVES TAKEN BY NATIONAL AUTHORITIES IN RESPONSE TO THE CORONAVIRUS PANDEMIC This appendix summarises macroprudential and other billion of Common Equity Tier 1 capital held by euro prudential policy responses to the COVID-19 pandemic area banks, facilitate the absorption of credit losses for selected jurisdictions. The information is sourced and support lending to the economy. principally from the IMF Policy Responses to COVID-19 policy tracker document.24 These macroprudential actions complement and reinforce the measures announced by ECB Banking Supervision since 12 March 2020. The initiatives taken include the following: Australia  Countercyclical capital buffer (CCyB) – Among the seven Euro area countries with positive The Australian Prudential Regulation Authority rates, France, Ireland and Lithuania reduced (APRA) provided temporary relief from its capital the CCyB to 0%, while Belgium, Germany and requirement, allowing banks to utilize some of their Slovakia revoked the previously announced CCyB large buffers to facilitate ongoing lending to the activations. Slovakia subsequently further reduced economy provided minimum capital requirements its CCyB to 1%. Of the countries with which the are met. The scheduled implementation of the Basel ECB has established close cooperation, Bulgaria III reforms in Australia was postponed by one year also revoked the previously announced CCyB to January 2023. In March 2020, APRA granted a increase. Reciprocity arrangements require banks regulatory concession for six months, allowing banks to apply the CCyB rate of the country in which the to not treat deferred loan payment due to COVID as exposures are located, irrespective of the bank’s impaired and hence avoiding higher capital charges. location. As a result, euro area bank requirements COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala The concession was later extended to 31 March 2021. have not only been lowered due to CCyB APRA also suspended the issuing of new licenses in reductions in euro area countries, but also due to response to the large economic uncertainty. Dividend those in the Czech Republic, Denmark, Hong Kong, payment restrictions were put in place for banks and Iceland, Norway, Sweden, and the United Kingdom. insurers in April 2020 to build capital buffers, then relaxed in July and fully lifted from January 2021.  Systemic risk buffer (SyRB) – Estonia and Finland fully released the SyRB to 0% while the Netherlands reduced the existing 3% SyRB for three institutions. Europe25  Other systemically important institutions (O-SII) buffer – In addition to the reductions in the European and national authorities have taken various SyRB, Finland and the Netherlands also decided to measures to address the impact of the coronavirus lower the O-SII buffer for one bank each. For the (COVID-19) pandemic on the financial sector. Several institutions in Finland this results in an effective euro area macroprudential authorities (including reduction of the combined structural buffers (SyRB central banks and banking supervisors) have reduced and O-SII buffers) by 1% of risk weighted assets. capital requirements, including the countercyclical Cyprus, Greece, Lithuania and Portugal announced capital buffer (CCyB) and other macroprudential that they will delay the phase-in of O-SII buffers by buffers. These measures amount to more than €20 one year for all or for some O-SIIs.  24  This can be accessed at: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#A  25  Source: https://www.ecb.europa.eu/pub/financial-stability/macroprudential-measures/html/index.en.html 38 39 COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala  Postponing the introduction of announced To further support the stability of the financial system, measures and non-renewal of existing the start date for a regulatory change requiring measures – The Netherlands postponed the higher capital for banks was initially postponed for 12 introduction of capital surcharges on domestic months to July 2021, and subsequently for a further mortgage loan exposures under Article 458 of the 12 months to July 2022. Other regulatory initiatives Capital Requirements Regulation (CRR). Finland in the pipeline were also put on hold for at least six decided not to renew the risk weight floor on months. The RNBZ also agreed with the banks in April internal ratings based (IRB) mortgage exposures 2020 that there would be no dividend payments on under the same article beyond 1 January 2021. ordinary shares and redemption of non-CET1 capital instruments. On 31 March 2021, the RBNZ eased the  Other adjustments related to the entry into restrictions, allowing banks to pay up to 50 percent of force of the amended Capital Regulations their earnings as dividends to shareholders until July 1, Directive (CRD IV) – Buffers for systemically 2022, at which point the RBNZ intends to remove the important institutions (global and other) and restrictions entirely. institution-specific SyRB buffers will now become cumulative as a result of amendments linked to the The RBNZ removed temporarily the mortgage loan- CRD V. O-SII buffers can also be increased beyond to-value ratio (LVR) restrictions effective from 1 2.0%. These regulatory changes have resulted in May 2020. The RBNZ re-imposed these restrictions buffer rate adjustments in some countries to avoid from March 2021 at pre-pandemic levels, with a changes in the combined buffer requirement (CBR) further tightening of investors residential loan LVR for systemically important institutions that would restrictions from May 2021. A further tightening in LVR not be commensurate to risks. The Netherlands requirements took effect from 1 October 2021 in an fully released the SyRB and raised the O SII buffer attempt to combat rising residential property prices. for one institution above 2.0%, resulting in a stable CBR for all systemically important institutions. The New Zealand government, the RBNZ, and the Croatia replaced the existing two SyRB rates of New Zealand Bankers Association also announced a 3.0% and 1.5% with a single SyRB rate of 1.5%, number of financial measures to support SMEs and resulting in an unchanged CBR. Austria lowered the homeowners. These included six-month principal and SyRB and O-SII buffers, resulting in a stable CBR interest repayment deferrals to mortgage holders for all systemically important institutions. Slovakia and SMEs affected by COVID-19 and the BFGS. has announced that, with effect from 1 January The concessional regulatory treatment of loans on 2022, it will abolish the SyRB and change the O-SII repayment deferrals ended on 31 March 2021. buffers, resulting in a stable CBR for all systemically important institutions. Papua New Guinea New Zealand The central bank and bank supervision authority, BPNG, reduced the Cash Reserve Requirement to 7 In April 2020, the Reserve Bank of New Zealand (RBNZ) percent from 10 percent to provide additional liquidity reduced the banks’ core funding ratio requirement to the commercial banks. To encourage interbank from 75 to 50 percent to help banks make credit activity, BPNG increased the margin on central bank available. With the improvement in financial market borrowing by 25 basis point to 100 basis points of conditions, the Term Auction Facility and Corporate both sides of KFR. All financial institutions agreed to Open Market Operation, for which usage had been provide relief of 3 months on loan repayments and very low, were removed after 16 March 2021. The interest payments to customers who have lost their minimum requirement on banks’ core funding ratio jobs, on a case-by-case basis. To cover for the 3-month will be raised back to 75 percent from 1 January 2022. loan repayment holiday for borrowers severely affected by the COVID crisis, BPNG suspended loan- loss provisioning for affected loans during this period. Philippines Singapore The central bank and banking supervision authority, On 14 February 2020, the Monetary Authority of the BSP, announced a series of regulatory relief Singapore (MAS) welcomed the announcements measures for the banking sector, including: (i) a from banks and insurers in Singapore to support temporary relaxation of requirements on compliance their customers facing financial difficulties due to the reporting, maximum penalties on required reserves impact of the COVID-19 outbreak, while adhering to deficiencies, and single borrower’s limits; (ii) easier prudent risk assessments. On 31 March 2020, the access to the BSP’s rediscounting facility; (iii) a MAS and the financial industry announced a detailed temporary relaxation of asset classification and package of measures to help individuals and SMEs provisioning requirements (subject to BSP approval); facing temporary cashflow difficulties. The package and (iv) a temporary relaxation of prudential has three components: (i) help individuals meet regulations regarding mark-to-market valuation of their loan and insurance commitments; (ii) support debt securities. These relief measures were intended SMEs with continued access to bank credit and to encourage banks to provide temporary financial insurance cover; and (iii) ensure interbank funding relief to their borrowers. markets remain liquid and well-functioning. A second package announced on 30 April 2020 extends the To encourage lending to micro, small, and medium- scope of relief for individuals to a broader set of loan sized enterprises (MSMEs), the BSP allowed loans to commitments. MSMEs to be counted as part of banks’ compliance with reserve requirements, temporarily reduced On 19 March 2020, the MAS announced the their credit risk weights to 50 percent, and assigned establishment of a US $ 60 billion swap facility with zero risk weight to loan exposures guaranteed by the US Federal Reserve. The MAS drew on this facility the Philippine Guarantee Corporation. Also, loans to to provide USD liquidity to Singapore banks through certain large enterprises that were critically impacted weekly auctions held every Monday since late March by the pandemic (but not part of a conglomerate) 2020. On 17 December 2020, MAS announced that could be recognized as in compliance with reserve the swap facility had been further extended to end- requirements. The BSP increased the limit on banks’ September 2021. real estate loan share to 25 percent from 20 percent COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala of their total loan portfolio (net of interbank loans). On 7 April 2020, the MAS announced that it would Further, the Financial Institutions Strategic Transfer adjust selected regulatory requirements and (FIST) Act was passed in February 2021 to facilitate the supervisory programs to enable financial institutions sale of nonperforming assets by financial institutions, to better deal with issues related to the pandemic. to help improve their balance sheets and restore On 8 April 2020, the MAS announced a $125 million lending capacity. support package to sustain and strengthen financial services and FinTech capabilities. The package, funded by the Financial Sector Development Fund, has three Samoa main pillars: (i) supporting workforce training and manpower costs; (ii) strengthening digitalization and The Central Bank of Samoa (CBS) encouraged operational resilience; and (iii) enhancing FinTech commercial banks to reduce interest rates and firms’ access to digital tools. associated bank fees and charges. The CBS has sought to maintain ample liquidity in the banking system to On 29 July 2020, the MAS called on locally- support businesses and stands ready to activate its incorporated banks headquartered in Singapore to lending facilities for financial institutions. The fiscal cap their total dividends per share to 60 percent of and economic response package included provision the FY2019 level and offer shareholders the option of a three-month grace period to be applied for all to receive dividends in scrip (as shares) instead of loan payments. To compensate part of the losses in cash. On 7 August 2020, the MAS urged Finance interest income, local commercial banks received companies incorporated in Singapore to also cap their payments from the government. total dividends per share for FY2020 at 60 percent of FY2019’s level. 40 41 COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala On 3 September 2020, the MAS announced measures cash reserve requirements from 7.5% to 5% to ensure to enhance the banking system’s access to Singapore additional liquidity support. The government also dollar (SGD) and US dollar (USD) funding effective encouraged commercial banks to grant a three to from 28 September 2020. A new MAS SGD term six-month grace period for all loan repayments. On facility provides SGD funds in the 1-month and 21 December 2020, CBSI purchased its first covid-19 3-month tenors, complementing the existing overnight domestic development government bond valued at MAS Standing Facility. A wider range of collateral SI$60 million in the secondary market. comprising cash and marketable securities in SGD and major currencies are accepted. Domestic systemically important banks that are incorporated in Singapore are able to also pledge eligible residential property Timor-Leste loans as collateral at the term facility. The authorities introduced a credit moratorium for On 5 October 2020, the MAS and the financial 3 months in August 2020 which led to 23 percent of industry announced extended support for individuals total bank loans being restructured. This scheme was and (SMEs) that need more time to resume loan 26 reintroduced for 2021, with an extended duration of 9 repayments. Individuals with residential, commercial months. Moreover, the credit guarantee scheme was and industrial property loans who are unable to extended to cover micro-enterprises in addition to resume making full loan repayments can apply to small and medium enterprises. make reduced instalment payments pegged at 60 percent of their monthly instalment, and eligible SMEs may opt to defer 80 percent of principal payments on secured loans. These measures expired progressively Tonga in 2021. On 19 March 2020, the National Reserve Bank of On 23 November 2020, the MAS announced that it Tonga (NRBT) Board approved the provision of would provide up to Renminbi (RMB) 25 billion ($5.1 liquidity support to the banking system. It also billion)27 of funding to banks in Singapore, in an effort committed to easing exchange control requirements if to deepen renminbi liquidity and further strengthen needed. The NRBT started meeting weekly with banks banks' ability to meet the growing RMB business to ensure there is clear communication, enhanced needs of their customers in Singapore and the region. preparedness and best practices. It supported banks in their effort to mitigate the negative impact of the In January 2021, the authorities announced that micro COVID-19 virus on the economy as well as provide and small firms severely impacted by COVID-19 could essential financial services to households and (i) apply for a Simplified Insolvency Programme to help businesses. Commercial banks are assisting their restructure their debts or facilitate orderly winding up; customers affected by the COVID-19 virus on a case (ii) enter into renegotiation of certain contracts such as by case basis and depending on individual customers' leases or licenses for commercial property, under the circumstances by: (i) reducing or suspending the Re-Align Framework. principal loan repayments to interest only loan repayments; (ii) restructuring loans to businesses that have reduced business hours, in affected sectors such as tourism and related industries like transportation Solomon Islands and to individuals who have been laid off; (iii) extending the terms of loans to reduce repayments; The Central Bank of Solomon Islands (CBSI) relaxed (iv) reducing loan interest rates on a case by case some commercial banks’ prudential guidelines. basis; and (v) providing access to short-term funding, Effective from 15 June 2020, the CBSI reduced the if required.  26  https://www.mas.gov.sg/news/media-releases/2020/mas-and-financial-industry-extend-support-for-individuals-and-smes  27  https://www.mas.gov.sg/news/media-releases/2020/mas-enhances-rmb-liquidity-through-a-new-rmb-25-billion-initiative-for- banks reflecting some reduction in the uncertainty related to Vanuatu Covid, and the ability of banks to withstand significant losses, according to results of the two stress tests The Reserve Bank of Vanuatu (RBV) initiatives carried by the Prudential Regulation Committee and included: a reduction of commercial banks’ Capital the Financial Policy Committee. Adequacy Ratio (CAR) from 12.0 per cent to 10.0 per cent; and the reactivation of the Bank’s Imports The Financial Conduct Authority (FCA) introduced a Substitution and Export Finance Facility (ISEFF) and the package of targeted temporary measures to support Disaster Reconstruction Credit Facility (DRCF). customers affected by coronavirus, including by setting the expectation for firms to offer a payment freeze on loans and credit cards for up to three United Kingdom months. In November, the mortgage moratorium was extended until end-April and the FCA also extended The Bank of England announced that the UK for 6 months the period to request a payment deferral countercyclical capital buffer (CCyB) would be reduced for consumer credit. to rate to 0 percent from a pre-existing path toward 2 percent by December 2020, with guidance that it will remain at 0 for at least 12 months. In December United States 2020, the Financial Policy Committee (FPC) updated its guidance on the path for the CCyB rate, expecting US federal banking supervisors encouraged this rate to remain at 0 percent until at least 2021 Q4. depository institutions to use their capital and Due to the usual 12-month implementation lag, any liquidity buffers to lend, to work constructively with subsequent increase of the rate is not expected to borrowers affected by COVID-19, and indicated take effect until 2022 Q4 at the earliest.28 COVID-19 related loan modifications would not be classified as troubled debt restructurings. Holdings of On 3 February 2021, the Bank of England finalized a U.S. Treasury Securities and deposits at the Federal technical review of the potential impact of a negative Reserve Banks could be temporarily excluded from policy rate, concluding that this could be of use COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala the calculation of the supplementary leverage ratio with further preparations. On 3 March 2021, the for holding companies. Other actions include offering government announced the introduction of a new regulatory reporting relief and adjusting supervisory mortgage guarantee scheme from April 2021 for approach to temporarily reduce scope and frequency borrowers with a deposit of just 5 percent on homes of examinations and give additional time to resolve with a value of up to £600,000, together with the non-critical, existing supervisory findings. extension of the stamp duty land tax (SDLT) exemption until June 2021. On 23 April 2021, the central banks Regulatory actions included lowering the community have decided to discontinue offering dollar liquidity at bank leverage ratio to 8 percent, and providing the 84-day maturity, given improvements in U.S. dollar extension transition for the Current Expected Credit funding conditions (operational change effective as of Loss accounting standard. Paycheck Protection 1 July 2021). They will however continue to hold weekly Program-covered loans were accorded a zero percent operations with a 7-day maturity. risk weight, and assets acquired and subsequently pledged as collateral to the Money Market Liquidity The Prudential Regulatory Authority (PRA) set out Facility and Paycheck Protection Program Liquidity supervisory expectation in March 2020 that large Facility would not lead to additional regulatory banks should suspend dividends and buybacks until capital requirements. The authorities allowed early end-2020, cancel outstanding 2019 dividends and pay adoption of "the standardized approach for measuring no cash bonuses to senior staff. In December 2020, counterparty credit risk". A gradual phase-in of the PRA however announced its intention to return restrictions on distributions to shareholders would toward the standard framework for bank distributions, apply when a bank's capital buffer declines.  28  See also: https://www.bankofengland.co.uk/coronavirus 42 43 COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala „ APPENDIX 2. MACROPRUDENTIAL FRAMEWORKS IN AUSTRALIA AND NEW ZEALAND clear mechanisms for identifying and monitoring Australia systemic risk; and a number of policy tools available to contain systemic risk, including supervisory tools. The Australian financial sector authorities apply In particular, the Australian authorities have taken a macroprudential policy in a less formal and structured holistic approach, seeing macroprudential policy as manner than many countries. To date, the authorities being subsumed within a broad and comprehensive have not formalised a macroprudential policy financial stability policy framework that is backed framework as such, but the Australian Prudential by inter-agency cooperation and coordination. Regulation Authority (APRA) routinely takes into Furthermore, the Australian Prudential Regulation account financial stability considerations in the Authority (APRA) modifies the intensity of its calibration of prudential regulatory requirements, prudential and supervisory tools in line with variations such as capital ratio requirements and risk weights. in the level of institution-specific risks as well as overall The Reserve Bank of Australia (RBA) undertakes systemic risks. This framework is viewed as having financial stability assessments on a regular basis been effective to date in helping to mitigate systemic through its six-monthly financial stability reports. risk; the policy actions taken in late 2014 to shore up The Council of Financial Regulators (CFR), the prudent residential housing lending standards is a coordination body comprising APRA, Australian recent example as outlined below. Securities and Investments Commission (ASIC), RBA and Commonwealth Treasury, meets quarterly and Four main agencies play a role in managing financial regularly assesses the state of the financial system in stability. APRA is the primary regulator of financial assessing the appropriateness of regulatory responses institutions and has an explicit statutory financial to threats to financial stability. stability mandate. It supervises a range of institutions including banks and other deposit-taking institutions, In 2016, the RBA published an article in its sets prudential standards and holds a wide range Bulletin on macroprudential policy issues.29 The of directive and resolution powers. It is also the article summarised the Australian approach to only agency with the power to directly change the macroprudential policy as it applied in 2016 (which has behaviour of financial entities, and hence the majority not significantly changed since then). The following of the tools for macroprudential policy in Australia extract from the RBA Bulletin article provides a cogent can only be exercised by APRA. The Reserve Bank summary of their approach to macroprudential policy of Australia [RBA] provides liquidity to the financial issues: system, has regulatory powers over clearing and “The relevant agencies [APRA, ASIC, RBA and settlement facilities and the payments system, and Commonwealth Treasury] consider the Australian incorporates financial stability assessments in its regulatory framework to be consistent in broad terms monetary policy decision process and publications. with the guidance provided by the international The Australian Securities and Investments Commission work, though in some respects Australia has a less (ASIC) is the corporate regulator, promotes market formal framework than many other economies. integrity and helps to ensure sound consumer The Australian framework includes: a shared protection laws, including within the financial sector. responsibility for financial stability across regulatory The Australian Treasury provides advice to the agencies with effective coordination arrangements; government on public legislation and enacting the Treasurer's powers.  29  The article can be accessed here: https://www.rba.gov.au/publications/bulletin/2016/dec/8.html The actions of these four agencies in promoting explicit macroprudential focus in line with the Basel the stability of the Australian financial system are framework, and other measures such as the LCR and coordinated by the Council of Financial Regulators the capital buffers for domestic systemically important (CFR), which is chaired by the [RBA] Governor. The CFR banks. APRA also has the ability to alter the behaviour serves as a discussion and information-sharing forum of regulated entities through its advisory capacity, for its four members and as a means of coordinating communication with individual entities and industry, macroprudential and other regulatory actions, though public commentary and its directive powers. The it has no regulatory functions or powers apart from complementary instruments available to the [RBA] those of its individual members. in pursuing its financial stability objective include the use of its role as liquidity provider to the financial APRA and the [RBA] undertake a variety of analyses to system. The [RBA] also recognises that the setting assess systemic risk. Both agencies use a broad range of macroeconomic policies needs to be informed by of information to detect emerging vulnerabilities financial stability developments, and financial stability and risks to the financial system, including individual assessments are therefore regularly incorporated institution credit, balance sheet and other data, into its decision-making processes. Public discussion macroeconomic and asset price indicators and of these assessments in the semi-annual Financial behavioural indicators (e.g., measures of risk appetite). Stability Review also aims to help shape the risk Lending standards and the capacity of borrowers assessments and decisions of households and firms.” to service their debts receive particular attention. In carrying out its duties, APRA takes an industry-wide On October 6, 2021, APRA announced30 or systemic perspective, consistent with its financial macroprudential policy decisions with respect to stability mandate. For example, APRA's risk-based highly leveraged residential mortgage loans, reflecting approach subjects institutions that pose greater concerns over high residential property prices and systemic risks to more intensive supervision and increased household leverage. On the same day, APRA can apply higher capital or other prudential APRA stated that it is also taking steps to ensure that requirements on a financial institution of concern. macroprudential policy more broadly is placed on a APRA also undertakes ‘bottom-up’ system-wide sound longer-term footing. It noted that, later this stress testing and the [RBA] is currently developing year, APRA plans to publish an information paper COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala a ‘top-down’ system-wide stress testing framework. outlining its framework for macroprudential policy, This approach to detecting financial stability risks which will cover all capital and credit options. helps to ensure that a broad range of indicators and developments is taken into account in order to This information paper will set out: determine where the most significant risks lie.  APRA’s approach to macroprudential policy, including objectives, the full toolkit of options, and In terms of policy actions to mitigate the identified implementation; risks, both agencies see macroprudential policy as inseparable from microprudential policy. In  how APRA would apply macroprudential policy to essence, effective policy measures to mitigate non-ADI lenders, should circumstances warrant it; financial stability risks are seen as ensuring ongoing and good microprudential supervision as much as  a process of consultation on proposals to embed macroprudential policy. The framework is therefore macroprudential policy tools more clearly in APRA’s not just about regulation, but also ongoing supervision formal prudential requirements. at an institutional level that takes into account a macro perspective (including the supervision of lending Together with other members of the Council of standards and practices). Against this background, Financial Regulators, APRA stated that it will continue APRA can use a variety of tools to address systemic to monitor and assess the risks in residential risk, including its supervision and its prudential mortgage lending as they evolve. tools. APRA's toolkit includes the CCyB, which has an  30  APRA’s statement on October 6, 2021 is accessible here: https://www.apra.gov.au/strengthening-residential-mortgage-lending-assessments 44 45 COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala ƒ Debt-servicing-to-income ratio restrictions New Zealand – a cap on the percentage of a borrower’s income that can be allocated to servicing debt The Reserve Bank of New Zealand (RBNZ) is the agency payments; in New Zealand responsible for macroprudential policy. It performs this function in accordance with ƒ Interest rate floors – a floor on test interest its statutory powers (as set out in the Reserve Bank rates used by banks in their serviceability of New Zealand Act 1989) and is accountable to the assessments. Minister of Finance in respect of this function. Capital and liquidity tools transmit directly to financial The RBNZ states that macroprudential policy aims to stability via bank balance sheets. Capital tools (the limit the serious and lasting consequences of boom- CCyB and SCR) do this by increasing the amount of bust cycles for the financial system, the economy and capital that banks have available to absorb losses. society. An unsustainable boom in credit and asset Liquidity tools (the CFR) do this by reducing the prices can result in a bust that creates losses for vulnerability of banks to disruptions in funding banks, businesses and households, and hampers the markets. LVRs and debt serviceability restrictions ability of banks to continue lending to the economy. enhance the resilience of banks via household balance sheets, reducing the potential for large mortgage Macroprudential policy is one part of the RBNZ’s defaults and losses in the event of a significant toolkit for maintaining financial stability – the correction in the housing market. consistent supply of financial services that the economy relies on. It can reduce the impact of a stress Macroprudential tools are intended to be used when scenario on the financial system by: the RBNZ identifies heightened risks to the financial  building additional resilience in the financial system. system, so that banks can support the economy even when it is under stress; and If the RBNZ’s monitoring of the financial system identifies:  reducing risky mortgage lending, so that banks have fewer losses to absorb.  a lack of resilience in the financial system there could be a case for using a capital or liquidity tool, depending on the nature of the risk identified. The RBNZ has a number of macroprudential tools Capital tools (the CCyB and SCR) can be used to available, including: increase the ability of banks to absorb losses.  the countercyclical capital buffer (CCyB) Liquidity tools (the CFR) can be used to reduce  sectoral capital requirements (SCR) banks’ vulnerability to a disruption in funding markets. Requiring banks to build their capital  adjustments to the minimum core funding ratio and liquidity buffers during the upturn means the (CFR) tools can be eased in the downturn to improve  restrictions on high loan-to-value ratio (LVR) the ability of banks to continue lending, and not residential mortgage lending. worsen the scale of the downturn.  debt serviceability restrictions including but not  risks related to excessive household credit and limited to: house price growth, LVRs can be used to increase the resilience of the financial system to an eventual ƒ debt-to-income (DTI) ratio restrictions – a cap downturn via household balance sheets. Also, on mortgage debt (or total debt of a borrower tightening LVR restrictions is more effective than including mortgage debt) as a multiple of capital or liquidity tools at moderating the scale income; of a boom because it directly constrains the availability of credit. Once the RBNZ has identified that a macroprudential The RBNZ’s macroprudential policy framework policy response appears to be necessary, and the is described in material published on the RBNZ macroprudential tool it intends to use, it will consult website.31 on its policy proposal – present evidence from its monitoring of the financial system, explain how the proposal would contribute to financial stability, and gather feedback from the public, regulated entities and other stakeholders. The RBNZ states that it consults with the Minister of Finance and the Treasury when it is actively considering a macroprudential intervention.  31  These can be accessed here: https://www.rbnz.govt.nz/regulation-and-supervision/banks/macro-prudential-policy https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Background%20papers/Macroprudential-policy-framework. pdf?revision=94e409bf-367c-425c-be6e-651f8b013a42 COVID-19 and Financial Stability: Microprudential and macroprudential policy: Seeking the right bala 46 47 COVID-19 AND STRESS TESTING March 2022 as financial intermediaries under various economic „ INTRODUCTION scenarios. Although stress tests broaden the understanding in predicting evolving conditions in the 1. The purpose of the paper is to assist the PIC banking sector, or of individual banks, the results are authorities to develop stress testing frameworks affected by several factors, such as data availability while factoring in the particularities of the and quality, models’ capacity to capture contagion COVID-19 pandemic. The paper is based on effects and interlinkages (both within the financial observation that a majority of PIC authorities have system and beyond). Hence, stress tests provide an not yet introduced stress testing as a surveillance indication, rather than a definitive answer, on the instrument, although a number of foreign bank impact of adverse conditions on banks’ resilience; branches and subsidiaries are using stress-tests and the results of stress tests embody the inherent as part of their risk management tool. The paper uncertainty that exists within forward looking also gives a snapshot on stress testing in advanced scenarios, models, and analyses. economies during the pandemic. Some examples based on the RBF collaboration with the IMF Technical 5. Most stress testing models focus primarily Assistance (TA) mission are also reflected in this paper. on solvency risk, but the recent global financial crisis highlighted the need to explicitly take 2. This paper covers the following issues: into account liquidity and market risks in stress  Recap the underlying principles of stress testing. testing. Liquidity can significantly tighten from the combination of funding risk (the risk that some banks  A high-level review of banking sector performance are unable to roll over existing funding or to obtain during COVID-19. new funding) and market liquidity conditions (the  Running stress-tests during a crisis, including conditions under which banks can sell, or sell and during COVID-19. repurchase, assets in financial markets to meet their immediate or near-term funding needs). Market  An introduction to setting up stress testing risk mostly occurs from a bank’s activities in capital frameworks in PIC. markets. It is due to the swings of equity markets, commodity prices, interest rates, and credit spreads. 3. This paper should be read in conjunction with Banks are more exposed to the market risks if they are the paper published by the World Bank in April involved in investing in capital markets or sales and 2021: Financial Sector Monitoring in PIC Countries and trading, which is, in general, not the case in PICs. Potential COVID-19 impact on Financial Stability,32 which provided an overview of the economies and financial 6. Stress test outcomes are useful tools for systems in the Pacific Islands in the context of the planning supervisory activities. The results of COVID-19 pandemic. stress tests can help focus supervisory attention on the more vulnerable financial institutions and add an additional layer in overseeing banks’ risk and capital management (such as for reviewing and „ OVERVIEW validating by the regulators banks’ Internal Capital Adequacy Assessment Process (ICAAP) of banks, and their liquidity adequacy assessments (ILAAP)). Stress 4. Stress testing is a useful tool to help to tests can help to focus attention on institutional risk assess banking sector health under different appetite and management of risks; as well as on macroeconomic and financial conditions. It more specific fields, such as credit risk or market risk. provides a systematic, disciplined framework Also, stress tests can motivate on-site investigations for assessing whether banks (or other financial in areas such as data and IT infrastructure. On a institutions) have adequate capital to absorb losses regulatory level, stress test results can inform the COVID-19 and Stress-testing and to maintain sufficient liquidity to meet obligations regulators in calibration of prudential regulatory as they become payable in order to maintain viability requirements (especially capital ratios, liquidity  32  The paper can be accessed at: https://documents1.worldbank.org/curated/en/959561620281668616/pdf/Financial-Sector- Monitoring-in-PIC-Countries-and-Potential-COVID-19-impact-on-Financial-Stability.pdf 48 49 COVID-19 and Stress-testing buffers, and sectoral exposure limits). Since the global financial crisis, an increasing number of countries „ THE FOUNDATIONS OF assess capital ratio levels under adverse scenarios and STRESS TESTING use the resulting assessment for evaluating capital adequacy or required capital. Along with early warning 10. Stress testing is a multifaceted process exercises, stress tests are also increasingly used to involving several steps. Stress testing can be thought calibrate macroprudential measures and supervisory of as a process that includes (i) identification of specific policy changes (BIS, 2017). vulnerabilities or areas of concern; (ii) construction of a scenario; (iii) mapping the outputs of the scenario 7. Similarly, stress testing should be also seen into a form that is usable for an analysis of financial as an integral to banks’ risk management. As a institutions’ balance sheets and income statements; forward-looking risk management tool, it guides bank (iv) performing the numerical analysis, (v) considering management in risk identification, monitoring, and any second-round effects; and (vi) summarizing assessment in avoiding potential adverse outcomes. It and interpreting the results. Such a framework provides an indication of the financial resources that would typically include a macroeconomic model might be needed to absorb losses should large shocks characterizing linkages among key macroeconomic occur. Hence, stress testing helps improve banks’ variables, such as Gross Domestic Product (GDP), readiness to withstand adversity by improving the interest rates, the exchange rate, and other variables, understanding of risk, enhancing capital management, and linking macroeconomic indicators to risk drivers, informing recovery planning and reducing the overall to detailed market and credit risk portfolio models likelihood of failures. As such, stress testing should from which, for example, provisions and losses can be also contribute to formulating and pursuing banks’ derived (IMF, 2007). strategic and policy objectives. 11. In general, stress tests can have a micro- or 8. Many stress tests conducted by banks pre-Global macroprudential policy objective. Microprudential Financial Crises (GFC) were not designed to capture stress tests, the primary focus of this note, assess the the extreme market events that were experienced. resilience of an individual bank to macroeconomic Most banks later realized that one or several aspects and financial shocks, encompassing an examination of their stress tests did not even broadly match actual of banks’ balance sheets with a focus on capital and developments under stress. In particular, pre-GFC prudential ratios, but increasingly also on assessments scenarios tended to reflect mild shocks, assume of risk management practices. In a nutshell, they shorter durations and underestimate the correlations provide the regulators with information on whether between different positions, risk types and markets financial institutions should take remedial actions, due to system-wide interactions and feedback effects. such as increasing regulatory capital, reducing risk Prior to the crisis, ‘severe’ stress scenarios typically exposures, or improving capital planning processes. resulted in estimates of losses that were no more than a quarter’s worth of earnings, and typically much less 12. Macroprudential stress tests, on the other (BIS, 2009). This has changes in recent years, including hand, assess the impact of an adverse scenario by introducing reverse stress testing. on the financial system’s capital, profitability, and ability to support activity in the economy as a 9. However, stress tests are still limited in their whole. They are designed to assess the system-wide usefulness as a remedy and should be used in resilience to financial and economic vulnerabilities, combination with other tools. Stress test results are which may include effects emerging from linkages susceptible to many factors, including limitations in with the broader financial system or the real economy. data quality and granularity, severity or scope of the These tests aim at capturing the behavioural scenarios, and model risk—especially in relation to responses of banks as well as the interactions of these complex methodologies and related assumptions in institutions with each other and with other economic times of crisis. They should not be viewed as a forecast agents. Macroprudential stress-tests may also be used of banks’ future performance under any stress; as an input to calibrate macroprudential measures. rather, they aim to identify the impact on banks of a specific stress scenario, based on a number of given assumptions (BIS, 2018). 13. Conducting a macroprudential stress test is a from historical events, but can also hypothetically challenging task and can at least partly explain created, such as during uncharted developments like why macroprudential stress tests have developed the current pandemic. only recently. Therefore, alternatively, the system- wide perspective may be implemented as extensions 16. Countries differ significantly in the extent they to bank-level approaches (i.e., by aggregating use stress testing as a financial policy toolkit. results for individual banks and explicitly adding The level of resources available and dedicated for interactions), or as completely separate approaches stress testing strongly affects the approach taken. (using more bank-level, aggregate or market-based Complex exercises, covering many banks and data) (Anderson et al. 2018). A major hindrance for requiring sophisticated modelling approaches, require macroprudential stress testing is the availability of significant resources, regardless of whether they appropriate data. Since macroprudential stress tests are run bottom-up or top-down. Besides resources, aim to capture direct and indirect sources of systemic building up stress testing requires focusing on risk amplification, and how such amplification clearly defining goals and processes of stress testing, mechanisms change their structure, as well as expertise for extracting and preparing data, deriving the speed of risk propagation under shocks, data shock assumptions, setting up tests, running test constraints are more restrictive. iterations, and reporting results. 14. There are two main approaches to conducting 17. Stress testing usually starts with undertaking stress tests. In bottom-up stress tests, individual single risk, single-period stress testing. At a banks use their internal models. In top-down later stage, the authorities should consider multi- stress tests, regulatory authorities apply their own period testing, interconnectedness analysis, more models. The chief advantage of a bottom-up stress accurate liquidity testing, central bank/supervisory test is that, since banks’ internal models capture each administered bottom-up tests, assessment of bank institution’s idiosyncrasies, it is possible to better stress testing models and results, review of banks’ understand the specific drivers of the results for capital planning in terms of economic and regulatory individual banks. In contrast, the main advantage of capital, and support for resolution planning. Without a top-down stress test is that, by using a common proper preparations, however, introducing more model for different banks, authorities can compare advanced levels of stress testing—such as multi- the results across banks to obtain better insights period stress testing—will likely lead to problems in regarding their respective vulnerabilities to the same operationalizing the entire exercise. shocks. However, weaknesses are also evident in both 18. The introduction of such enhancements approaches. It can be more difficult, for example, to would not replace the single-period testing. The take into account the interactions between banks in latter would continue to provide uncomplicated a bottom-up stress test, while top-down tests tend to sensitivity tests and offer a challenger model to capture the characteristics of banks in less detail (Bank other testing approaches. It is important to note that of Canada, 2014). the preparation phase for the start-date analysis, 15. In terms of degree of severity, a scenario can including the required data sets, is very similar to that be described as either ‘baseline’ or ‘adverse’. A required for more advanced testing. Building a sound baseline scenario consists of a set of economic and foundation therefore greatly simplifies and supports financial conditions that is generally consistent with the successful deployment of more advanced testing. the projection of a likely path for future economic and 19. Stress testing quality is underpinned by financial conditions. The baseline scenario usually the quality of data available. There is a need does not lead to a stressed result, except when to collect stress test-specific data in order to applied during a crisis. An adverse scenario is a set of achieve the relevant risk coverage, in particular for COVID-19 and Stress-testing economic and financial conditions which is designed microprudential exercises. Specific data collections to stress the performance of the banking sector or increase the quality of modelling and related analytical an individual bank. The level of stress is significantly work, as well as enhances the understanding of stronger than in a baseline scenario, even if the latter banks’ behavior and support granular supervisory is already stressed. Stress factors are usually drawn 50 51 COVID-19 and Stress-testing work and action. Regular (non-stress-test specific) COVID-19 in most jurisdictions. Hence, banks generally data collections may not be comprehensive enough did not need to use their capital and liquidity buffers to cover stress testing needs, but concerns about to meet loan demand, enabling them to weather reporting burden and proportionality considerations the initial pandemic shock and, to a various extent, may limit the possibility of introducing additional, continue to support economic activity more than the stress test or even risks-specific data collections. It is initial shock (pandemic) would have suggested. Also, important for banks to have IT systems that deliver Basel Committee of Banking Supervision analysis adequately accurate data, at the level of breakdown indicates that more strongly capitalized banks and frequency that would be required by the showed higher increases in lending to businesses and authorities leading the stress test (BIS, 2018). households than other banks (Abboud et al, 2021). 20. In more established financials systems, the 22. As to some specific regulatory measures, focus of stress testing varies from bank-specific to the release of countercyclical capital buffers systemic impact. For example, in the United States (CCyB) was relatively quick in most jurisdictions, and the Euro-area, authorities have used stress tests but these were not always available or of to evaluate the resilience of individual banks and to sufficient scale to provide substantial additional assess their recapitalization needs under stressed macroprudential space. In response to the COVID-19 conditions. In some other jurisdictions, e.g., in some shock, thirteen out of fifteen jurisdictions with an Scandinavian countries, the central banks focus on active CCyB either reduced the buffer requirement better understanding how the banking sector would to zero or revoked plans to increase the buffer. In be affected by adverse macroeconomic developments. other cases, where a positive CCyB was not in place, In some jurisdictions, the interconnection with other authorities lowered other regulatory requirements. countries/regions requires national central banks While it is difficult to assess the quantitative effect of or supervisory authorities to design stress test these capital releases, some studies have provided scenarios that explicitly incorporate regional or global evidence that they had a positive effect on lending dimensions in an internally coherent manner. during the pandemic, although banks generally have not yet had to use their capital buffers to meet loan demand thus far (Abboud et al, 2021). There are alternative views that these measures had little „ COVID-19 AND THE effect as banks were reluctant to lower their capital ratios, possibly due to concerns about an adverse FINANCIAL SECTOR market reaction (FSB, 2021). Also, there were no clear timetables and/or other indications regarding the 21. Large and internationally active banks entered pace the banks would need to be rebuild the buffers, the pandemic with robust capital positions, contributing to slow release of the buffers. In some unlike at the dawn of the global financial crisis jurisdictions, using the capital conservation buffers (GFC) when the banking sector had relatively low restricted dividends and bonuses payments. levels of capital and liquidity. To a certain extent, 23. The banking systems in most jurisdictions the banking sector’s resilience can be attributed to did not experience notable liquidity pressures, the relatively recent adoption of Basel III reforms in although the banks took extra steps to maintain many jurisdictions. For example, the core equity of their liquidity levels well above regulatory the largest European banks went from an average of requirements. A large majority of larger banks 9.1 percent of risk-weighted assets (RWA) at the end entered the crisis with solid liquidity positions—both of 2008 to 16.5 percent at the end of the third quarter in terms of their high-quality liquid asset (HQLA) of 2020, while the core equity of ‘global systemically holdings and their liquidity coverage ratios (LCR). important banks’ (G-SIBs) in North America rose from Some liquidity pressures were experienced by banks 12.5 percent of RWA to 14.3 percent over the same who were reliant on unsecured wholesale money period (Emerson et al, 2021). The pandemic shock markets. Most banks experienced sizeable inflows of was also bolstered by effective monetary, fiscal and deposits as consumption and investments declined regulatory policy responses during the initial phase of and government support measures provided cash buffers. These deposits provided a source of low- The sudden stop of tourism inflows in March 2020 cost funding. Notably, the increase in already strong immediately impacted such economic activities as liquidity positions suggests that banks prefer larger restaurants and hotel services, transportation, and liquid asset buffers, instead of lending, in the face of other business activities. As a group, the unweighted economic and market uncertainty. average real GDP of Pacific Islands with a reliance on tourism (Fiji, Palau, Samoa, Tonga, and Vanuatu) 24. One of the legacies of the ongoing pandemic contracted by 6.6 percent in 2020 and is expected to may be a build-up of leverage and debt overhang decline by a further 6.5 percent in 2021. Countries in the non-financial sector. High corporate (but with a heavy reliance on commodity exports (PNG and also household) indebtedness was already a concern Solomon Islands) also experienced large contractions before the outbreak of COVID-19. The pandemic has in GDP during 2020, due in part to the decline in focused the attention of policymakers on the risks external demand for their products. However, these to the balance sheets of the non-financial private countries are expected to benefit from the global sector and on the necessity of monetary, fiscal and recovery and increase in commodity prices in 2021. regulatory policy responses to avoid deep recessions, credit crunch and bankruptcies as well as potential 27. Banking sectors in PICs have remained lasting scarring effects on economic structures (IMF, generally stable, partly due to the strong 2021). Rapid and large official credit support has starting point reflected in relatively high bank further increased debt levels, especially in the hardest- capital ratios. Bank lending and deposit rates have hit sectors, and the current low level of corporate decreased, and private sector credit contracted, insolvencies seems predicated on continued policy although financial conditions have remained loose and support. Addressing debt overhang, including by liquidity in the banking system has increased. Non- facilitating the market exit of unviable companies, and performing loans have risen in some countries (e.g., by promoting the efficient reallocation of resources to where banks have also made significant provisions viable firms, may be a key task for policymakers going to withstand credit risk shocks).33 Nevertheless, the forward (FSB, 2021). This should be also taken into reported capital adequacy of the banking sector consideration in conducting bank stress-tests. has strengthened or remained relatively stable, partly reflecting extensive policy support, debt 25. The economic impact of the pandemic on most service moratoria and deferrals, and interest-only PICs, however, has been severe. As pointed out by payments. Moreover, the risks to financial stability and the IMF (2021a), the COVID-19 pandemic continues depositors were mitigated to a substantial degree by to weigh heavily on the PICs, but not uniformly. For the dominant presence of strong parent banks from example, in Fiji, real GDP contracted by an estimated jurisdictions with sound governance, risk management 15.7 percent in 2020 and is projected to contract by and supervisory frameworks, especially Australia and, a further 4 percent in 2021. In Palau, the real GDP in the case of some of the smaller PICs, US and French contracted by 9.7 percent (year-on-year) in FY2020 banks. The situation may change, however, as the and is estimated to have contracted further by 17.1 repayment holidays are set to phase out. percent (year-on-year) in FY2021. Some PICs remained to a large extent COVID-19 free, but the effects of 28. While the outlook for the banking sector is the pandemic and local containment measures have generally positive, the balance of risks is tilted strained their economies. to the downside in most PIC jurisdictions. The PIC economies remain, in general, in precarious positions 26. Output losses in economic sectors have varied given pandemic-related uncertainty. Vulnerabilities in the region, largely as a function of dependence have been exacerbated by diminished fiscal space. on tourism and commodity exports, the stringency The economies remain at high risk from natural of local lockdowns, and the size and efficacy of disasters, particularly from the effects of tropical policy support. Economic contractions have been cyclones. The recovery and medium-term outlook in COVID-19 and Stress-testing most pronounced in tourism-dependent economies. the baseline scenario also hinge on a full recovery  33  The latest stress tests in Fiji indicate all banks are capable of withstanding moderate credit risk shocks while still complying with minimum capital requirements. Under a ‘severe’ shock scenario where the entire COVID relief portfolio (almost 19 percent of banks’ total loans) is added to existing NPLs, four banks would need to strengthen their capital adequacy. 52 53 COVID-19 and Stress-testing of tourism, but it is unclear whether pre-pandemic branches is not as effective in isolation from the tourism and spending patterns will fully re-establish health of the parent banks (or banking groups), but themselves. Contingent liabilities have surged during the underlying analysis and risk assessment will be the pandemic as the government extended loan still important to understand the potential collective guarantees, particularly to state enterprises—some of impacts on the financial system. It is also important which could potentially end up on the government's to note that while the banking systems in PICs are not books, depending on the pace and depth of recovery strongly integrated within the host jurisdiction, there and/or emergence of new shocks. In addition, the may be strong interlinkages with various banks within sustainability of the economic outlook will rest their home jurisdictions, particularly in Australia. critically on the governments’ ability to embark on the policy reforms necessary for macro-fiscal stabilization 31. These external risks highlight the need for and, in some jurisdictions, to begin reducing public cooperation and coordination between host debt. and home authorities, including in supervision and stress testing. In the case of PICs, which are 29. Given the dependence of the banking sector host authorities for branches of foreign banks, the on the foreign banking groups in most PIC authorities should make every effort to engage with jurisdictions, supervisors will need to project the home authorities to obtain an update on the bank-by-bank analysis to macro-prudential parent bank position with respect to capital, credit implications and policies. As discussed in the World quality, and liquidity. This also applies to a large Bank note ‘COVID-19 and Financial Stability: Guidance extent to subsidiaries with stand-alone balance on financial system surveillance in the pandemic’, the sheets (as opposed to branches). This is an area extent of cross-border banking in PICs creates a risk where considerable strengthening of arrangements of contagion between home and host countries (i.e., should be a priority, particularly in the case of parent in PICs). This risk is relatively low in the case of banks banks that are domiciled in countries with limited whose parent entities have strong governance and supervisory capacity and where the banks in question risk management arrangements and are domiciled have operations that are systemically important in in countries with robust supervisory frameworks, host countries in the region. such as in Australia. However, the risk of cross- border contagion is considerably greater where the 32. There is considerable uncertainty about the parent banks are domiciled in countries with weaker path of the economy and the resulting losses supervision and corporate governance and where in the banking sector due to COVID-19. As banks the host operations in PICs represent a substantial were expected to fall closer to their minimum capital proportion of the parent bank group global balance requirements, there was a concern they may not be sheet. able or willing to support lending in the economy, which could amplify the downturn. While these 30. Similarly, the stability of the banking system uncertainties have subsided to a large degree, and in many PIC jurisdictions is underpinned by the banks have, in general, remained well-capitalized, the dominance of large foreign banks that are often pandemic in not yet over. present in the market directly and operate as branches, having access to parent institutions for capital and liquidity. The practical difference from a stress testing perspective is that branches „ STRESS TESTING IN THE typically do not have their own capital—in a direct legal sense—against which the impact of shocks could PANDEMIC be shown. The main practical implication is that the stress testing impacts have to be expressed in terms 33. Stress testing has been considered particularly of a different variable than capital or capital adequacy important after long periods of benign economic (e.g., in terms of profits), or notional capital (e.g., and financial conditions, which has often led to domestic assets minus domestic liabilities), although complacency and the under-pricing of risk. Most some jurisdictions have introduced capital metrices risk management models, including stress tests, use for branches. In any case, the traditional reliance historical statistical relationships to assess risk which on capital adequacy assessments and liquidity for is assumed to be driven by historical relationships. The recent crises, however, have revealed some could incorporate some new parameters, e.g., related flaws with relying solely on such an approach, as to infection/mortality rates and indicators of economic backward-looking historical information did not pick activity in the sectors most impacted by social up the possibility of severe shocks nor the build-up distancing requirements. of vulnerabilities within the system. Moreover, the relevance of past data to extraordinary events such as 36. Looking forward, the post COVID-19 recovery the disruption of global supply chains could be even may happen at different speeds. The significant more limited. impact of the pandemic on economic developments and its exceptional characteristics may entail a 34. Conducting stress testing during extreme longer-term structural change. Various industries events, such as the COVID-19 pandemic, has and customer groups are recovering at diverse added further challenges due to the different speeds, which may in turn impact customer behavior nature of the shock compared with standard – both on the asset side (credits), as well as on the macroeconomic shocks in regular stress testing liability side (deposits). This may significantly change in “normal” times. The stress testing exercise in the the stress testing methodology for many banks as pandemic is complicated by the fact that the latter customer behavior has only played a minor role presents new types of transmission channels and in stress testing and simulation to date (Rehker et risks, so the models used in ordinary times may not al, 2020). Considering these factors, the scenarios work. Containing the virus and the drastic steps, from should be calibrated by combining statistical analysis social distancing to lockdowns, that governments supplemented by qualitative expert judgement. For had to undertake are unprecedented and had an instance, a traditional adverse scenario could be immediate impact on the real economy through the tweaked to increase the level of stress in the most simultaneous occurrence of both demand and supply affected economic sectors by COVID-19. shocks, with related financial sector spill-overs and side-effects such as supply bottlenecks. For instance, 37. Since the baseline forecasts are already the shock may have prolonged the non-reversible significantly below the long-term average growth effects on the viability of some sectors, such as path, consideration should be given applying a tourism and some other services sectors. Hence, both smaller-than-usual shock (for example, one or one- the scenarios design and models may need to be and-half standard deviations) below the baseline revised for an initial shock such as a pandemic in order over the first two-years. Consistent with this to map the shock’s propagation across the economy trajectory, a set of complementary macro and financial and on the profitability and solvency parameters of variables can be simulated using time series models. banks (BIS, 2020). It has been also suggested to design a new baseline scenario that incorporates the deep economic 35. Moreover, the shock originated outside the contraction which were already visible at the onset of economy and the financial system, and two years the pandemic, and then to create a stress scenario on into the pandemic, there are still many unknowns this basis. More importantly, the scenario design will involved. There is still no clear and unanimous view have to incorporate an assumption as to how deep as how the pandemic may evolve in the near future and prolonged the economic impact of the COVID-19 and what are the exact transmission channels from shock will be. the shock to the financial sector. Hence, the calibration of the scenarios has been difficult as past data have 38. From the macroeconomic perspective, stress been of limited value to simulate economic dynamics tests could help to evaluate under what conditions in the projections. Furthermore, since the COVID-19 banks could continue providing credit, and what crisis is quickly evolving in real time, partly because of risks this would entail for them. In this context, mutations and government responses, the relevance stress tests can be used as a tool to analyze and of the constructed scenarios in the near term is communicate how the pandemic can affect the COVID-19 and Stress-testing subject to considerable uncertainty. Therefore, the banking sector as a whole in order to get a better assumed correlations within the models and between view of the possible implications of a collective action risk types may continue to remain inadequate in a problem leading to aggregate lending being too low, crisis like this. Also, the scenarios that reflects the compared with the social optimum. Combined with micro- and macroeconomic impact of the pandemic the exceptional measures taken in response to the 54 55 COVID-19 and Stress-testing pandemic, these tests can help authorities balance assessing the impact of the pandemic on banks and the risk of a deep economic contraction with that of other financial institutions over the near future, as putting the banking sector’s viability under threat. (BIS, temporary support measures are unwound, fiscal 2020). policy is brought back to a more sustainable position, and monetary policy is normalized. A sluggish 39. To adequately reflect the overall risks for recovery would also call for assessing intertemporal the financial industry, the interdependencies trade-offs between regulatory support and the related between government support, industries, and potential negative impact on banks’ balance sheets as customer behavior need to be taken into account. the consistency of policy measures across different It is important to keep in mind that government phases of the crisis to balance different goals is interventions and the regulatory flexibility have played important. a crucial role in reducing the economic impact of the pandemic. A wide range of exceptional support 42. From the banks’ perspective, the impact of the measures were introduced by the authorities across pandemic on economic growth, consumption and the globe. These include loan and guarantee programs investments could be permanent, expected to be to small and medium-sized businesses, monetary reflected in banks' risk profile, profitability and policy easing, as well as regulatory and supervisory eventually in their income statements and balance relief measures, reducing debtors’ financial burden sheets. In this context, the stress testing could be a and creating additional financial leeway for those who helpful tool also for the banks as understanding the have suffered in the crisis and reducing banks’ credit potential paradigm shift is important. It is plausible risk. In ordinary circumstances, stress tests would that the banks would need to rethink their business exclude such policy steps, taken in response to the models and, depending on how the pandemic shock, as the focus is expected to be on the impact of develops, they may need to adjust their lending the shock before any policy measure is taken. portfolios, risk appetite, and pricing. Such current or anticipated changes in business strategy may also be 40. In these extraordinary circumstances, needed to be reflected in the stress testing approach. however, it could make sense to internalize Whereas traditional stress testing assumes, as a the policy measures in the scenarios. The rule, an unchanged business strategy over the time interdependencies of the measures with the financial horizon of the stress test exercise, the mentioned system will significantly impact banks’ profitability, interdependencies need to be taken into account and credit risk as well as operational and liquidity risks. modeled for stress tests going forward (Rehker et al, However, the inclusion of government measures is not 2020). always straightforward and raises practical issues as it requires making assumptions about the effectiveness 43. The significant uncertainties associated of the measures, their possible extensions, and the with COVID-19 (such as emerging new virus path forward once these measures are withdrawn. variants) and related stress tests call for Moreover, some of the more intrusive regulatory careful interpretation of results and following interventions, including the loan forbearance communication to the broader public. As discussed measures, which have allowed to halt reclassification in Baudino (2020), the credibility of the results could or provisioning, may have in fact weakened the banks’ be questioned by market participants if they were to balance sheet allowing the losses to be “concealed” be used as triggers for remedial actions by banks or behind forbearance measures. Hence, banks and non- supervisors before the tests have been refined and bank lenders could still face additional losses as these tailored to the new type of shock. Stress test results measures are unwound. in a COVID-19 situation may therefore be considered indicative only in the first round of exercises. This 41. Stress testing will be especially useful in could change once authorities have time to develop the assessment of banks’ vulnerabilities for sufficiently reliable approaches to deal with the scenarios in which the return to pre-COVID-19 specificities emerging during the COVID-19, and banks levels of economic activity takes longer than can contribute to the exercise via the bottom-up is currently expected. Stress testing in these component. uncertain circumstances will remain a useful tool in 47. Designing internally consistent macro „ INTRODUCING TOP-DOWN scenarios with other macro-financial variables, STRESS TESTING IN THE PICS that would be consistent with the initial shocked values of risk factors (e.g., unemployment or commodity prices), would preferably require 44. A number of jurisdictions across the world macro models. Those forecasting models are not have started stress testing with using single factor available in many countries, however. To a large sensitivity analysis. The single factor sensitivity extent, this is due to a lack of reliable and sufficiently analyses focus on key risks areas for the banking long time series of macro and financial data, as well as systems and is adequate for its intended purposes, econometric skills. Expert judgment may the suffice including for concentration risk related to the largest for sensitivity analysis but may not produce consistent individual large exposures, across the board increase variable paths. Also, as systemic financial crises in NPLs and defaults that could result from common have been rare in the region, stress testers may face macro-economic shocks, shocks to specific sectoral challenges in using historic data to calibrate shocks to exposures in particular the construction and real anchoring variables. estate sectors, as well as natural disaster shocks affecting households, hotels and restaurants and 48. Given that macro-models do not generally other retail and wholesale trade sectors. include financial sector variables, the stress testing framework can include a ‘satellite model’ 45. More complex stress tests rely on scenarios that maps a subset of macroeconomic variables embedding sets of exogenous macro-financial into financial sector variables. Satellite models shocks. These scenarios focus on what would be a link macro-financial variables with selected risk relevant macroeconomic adverse scenario for each indicators (for example, NPLs or probability of default, country, and what would be a set of trajectories provisioning) as well as profit-and-loss items (for for macro-financial variables, consistent with the example, interest income and expenses, fees and realization of extreme but plausible shocks affecting commissions, administrative costs). The transmission financial sector performance. In a simpler scenario- of macroeconomic shocks causing is assessed by based stress testing, it is usually recommended to use estimating satellite models based on historic data real GDP growth as an anchor to calibrate the severity (Table 1). Satellite models can estimate credit risk of the stress tests adverse scenario. In addition to (e.g., Probability of Default (PD) or Loss-Given-Default real GDP, however, the authorities could also rely on (LGD) models), interest rate risks, net interest margins other indicators of economic activity for an anchor. and fees and commission income. For PICs, indicators of activity in the tourism industry (tourist arrivals, length of tourist stays) or imports of 49. Satellite models can be constructed based on goods and services can be tried to calibrate shocks to (usually quarterly) data for individual banks over financial variables using satellite models (see below). a period of time. Credit risk models can be estimated for the total loan portfolio, and data availability 46. The severity of adverse scenarios based permitting, for loan segments using historical data on on real GDP (or some other indicators) can be loan performance by bank and types of lending (for benchmarked in different ways. First, it can be instance, loans to individuals and loans to business), done on the basis of the historical distribution of GDP along with a set of macro-variables that are expected growth relying on the two-standard deviation rule to affect default probabilities. For each model, requiring that GDP growth in the adverse scenario different combinations of explanatory variables can falls (relative to the start year) by at least two standard be considered. The set of explanatory variables should deviations of the two-year cumulative GDP growth rate be customized to the economy taking into account the which can be estimated over a longer period of time. judgment on relevant variables. Models can be then Secondly, the severity and path for real GDP growth COVID-19 and Stress-testing chosen considering their overall fit, the significance can be also estimated over a (usually) three-year of individual variables, the alignment of coefficients’ horizon benchmarked on the basis of past recessions. sign with economic intuition, and the out of sample In each historical scenario, the paths of GDP growth performance (Table 2). can be built based on the observed paths of real GDP growth deviations from the base year in each episode of recession. 56 57 TABLE 1. List of variables tested in the satellite models during Fiji IMF TA work34 COVID-19 and Stress-testing Category Variable Economic Performance GDP growth Tourism Earnings, Visitor Arrivals, Tourism Length of Stay, Electricity Production, Sectoral Performance Gold Production, Cane Production, Pinewood Intake, Sugar Production, Woodchip, Indicators Mahogany, Cement Production Consumption Net VAT Collections, New Consumption Lending, Electricity Consumption, New Indicators Vehicle Registrations, Second Hand Vehicle Registrations Investment Indicators Domestic Cement Sales, New Investment Lending Labour Market Unemployment Consumer Prices All Items, Food and Non-Alcoholic Beverage, Alcoholic Beverages, Tobacco & Narcotics Exсhange rates Nominal Effective Exchange Rate, Real Effective Exchange Rate Trade Imports Growth, Exports Growth Reserves Import Coverage Ratio Lending Rate, Savings Deposit Rate, Time Deposit Rate, T-bill Rate, Government Bond Interest Rates Yield 10Y Indicator variables, Length, Category, Wind Speed, Pressure, Damage (Million FJD), Cyclon variables Number of deaths Note: YoY growth, QoQ growth, YoY change, QoQ change and levels of the variables were considered in the estimation of the satellite models. Different lags were taken into account. TABLE 2. List of selected variables in satellite models used in Fiji IMF TA35 Model Type Dependent Variable Independent Variables NPLs Total Loan Logit transformation of NPLs:  GDP Growth YoY Portfolio ln(npl/(1-npl)  Lending Rate (level) Tourism  Earnings Growth YoY  Visitor Arrivals Growth YoY  Tourism Length of Stay Growth YoY NPLs Household Loans Logit transformation of NPLs:  GDP Growth YoY ln(npl/(1-npl)  Lending Rate (level) NPLs Business Loans Logit transformation of NPLs:  Lending, Rate (level) ln(npl/(1-npl)  Tourism Length of Stay Growth YoY Implied Lending Rate Interest Income over Loans Growth  T-bill rate Growth YoY  Imports Growth YoY Implied Deposits Rate Interest Expense over Deposits Growth  GDP Growth YoY  Goverment Bond Yiels 10Y Growth Implied Rate on Non- Non-Interest Income over Assets  Imports Growth YoY Interest Earning Assets Growth  Tourism Length of Stay Growth YoY  34  Source: RBF  35  Source: RBF 50. Profit and loss (P&L) models aim at explaining macroeconomic indicators, such as the changes in the dynamics of effective interest rates on assets real GDP growth, tourist arrivals, the unemployment and liabilities implied by income and interest rate, or in real effective exchange rates, using a expenses. These models can be constructed using panel vector autoregression model; (ii) using the information on banks’ income statements and a set elasticities to calculate the implied change in NPLs/ of macroeconomic variables that are expected to ROAs consistent with the macroeconomic scenario; affect implicit interest rates and non-interest income and finally (iii) estimating the amount of loan loss of the banks. The P&L models allow to project shocks provisions resulting from the change in NPLs. to effective lending and deposit rates, and to non- interest income under the adverse scenario, and are 53. This approach may involve significant used in the stress test exercise to project the profit simplifications. For example: (i) the increase in and losses for the scenario horizon. For example, the NPL, as a result of the macroeconomic shock, is these dependent variables can be calculated based assumed to equal additional loan loss provisions, on the financial statements: (i) interest income over which are deducted from CET1 capital; (ii) changes total loans, (ii) interest expense over deposits and: in collateral values are not considered; (iii) market (iii) non-interest income over assets. Once again, risks such as liquidity and contagion risks, or macro- the models should be selected based on their feedback effects that might amplify the impact of overall fit, the statistic and economic significance of initial shocks, are not considered; (iv) and banks and individual variables, the alignment of coefficients’ the authorities take no mitigating actions to counter sign with economic intuition and the out of sample the effects of the shock on bank balance sheets. performance. For example, factors like short-term 54. The use of ROA could be justified as the effect and long-term interest rates on public debt, imports of NPLs could in some jurisdictions underestimate growth and GPD growth may explain the dynamics on the deterioration of banks’ net income and implied interest rates. Interest income over total loans capital. This is partly because other factors, such growth is usually positively associated with increases as exchange rates, interest rates, and asset prices, in the T-bill rate and total imports. Similarly, interest could also affect banks’ internal capital generation expenses over deposits growth are often positively capacities. In addition, since some banks may write associated with increases in government bond yields off NPLs faster than others, analysing the NPL stock and GDP growth. Non-interest income over total may underestimate the severity of the deterioration assets is usually positively associated with an increase in credit quality in periods of extreme stress. Hence, in total imports or an increase on the tourism length the NPL model can be complemented by estimating of stay. an ROA model that directly links banks’ ROA with 51. The last step in stress testing is designing a macroeconomic indicators (the same as the NPL balance sheet tool that calculates income, losses, model), and estimate the change in ROA, which is changes in balance sheet positions, risk weights assumed to directly affect CET1 capital. and, ultimately, capital adequacy. This tool would use as inputs bank level data at the starting date of the scenario, the regression coefficients of the satellite models and a set of assumptions. „ BOTTOM-UP STRESS 52. In order to provide a relatively fast estimate of TESTING—BASIC PRINCIPLES the potential impact of the pandemic on banking system solvency, countries can consider using 55. In addition to conducting top-down stress empirical models quantifying the effect of the tests, the authorities should encourage banks to macro-shocks on banks’ capital by modelling NPLs run their own bottom-up stress tests, using their and return on assets (ROA). In this exercise, credit COVID-19 and Stress-testing own internal models. As a forward-looking risk risk can be estimated by modelling NPLs and ROAs management tool for banks, stress testing constitutes with key macroeconomic indicators:36 (i) estimating a key input into risk identification, monitoring the elasticities between NPLs/ROA and some key and assessment. As such, stress testing should  36  The following example draws on IMF, 2020. 58 59 COVID-19 and Stress-testing contribute to formulating and pursuing strategic and policy objectives. In order to strengthen banks „ STRESS TESTING BY THE risk management practices and to better integrate LARGEST CENTRAL BANKS top-own and bottom-up stress tests, the authorities should over-time develop supervisory guidance for DURING COVID-19 banks on how they should conduct stress tests as part of their risk management framework. 58. According to Bank of England (BoE), the 2020 stress test exercise was replaced by a desktop 56. A sound governance framework in the banks analysis of the resilience of the UK banking sector is essential to the effectiveness of stress testing. to the pandemic (Table 3).37 In this context, the Banks’ stress testing frameworks should describe Financial Policy Committee carried out a ‘reverse governance structures in a comprehensive way and stress test’ to analyze how much worse than the are well-documented. This structure should identify central projection the economic outcome would need all key stakeholders, the roles and responsibilities to be in order to deplete banks’ regulatory capital of senior management, bank oversight bodies and buffers by around 5 percentage points (5 percent was those responsible for the ongoing operation of the based on the 2019 stress test results which indicated stress testing framework with clear line of oversight, the buffers had to continue to lend). The scenarios objectives and requirements; structured roles generated by authorities were very severe, resulting and responsibilities; and policies and procedures in a cumulative loss of economic output that were to support the end-to-end stress testing process. around twice as big as that in the BoE Monetary Policy Banks are expected to have a structured, repeatable Committee’s central projection in August 2020, and scenario development process with effective accompanied by a significant rise in unemployment, to consultation, review, and challenge mechanisms. around 15 percent. Because banks had larger capital Inputs and challenges should be sought from across buffers than such a depletion of capital would have, the organization, including from various lines of they used up, in aggregate, only around 60 percent of businesses. Stress testing assumptions and limitations the buffers above their minimum requirements in this should be appropriately justified and documented stress test. (see APRA, 2020 for more details). 59. The Federal Reserve (Fed) did two stress tests 57. The authorities should regularly review banks’ of the banking system in 2020, trying to simulate internal stress testing frameworks. Supervisors the impact a long-lasting economic downturn and should examine the stress testing results as part of pandemic would have on the banking system.38 their review of the ICAAP process and the liquidity The Fed’s worst-case scenario in 2020, a double-dip risk management of banks. In order to conduct an recession, would have caused roughly a quarter of oversight of stress testing as part of the supervisory all the biggest banks to breach their minimum capital process, the authorities should be ready to set clear requirements. The harshest test (‘severely adverse specific of stress testing objectives for banks. The scenario’) involved a hypothetical global recession supervisors should be regularly engaged with banks lasting from late 2020 to September 2022, causing the to understand the extent to which stress testing is U.S. economy to contract 4 percent. Unemployment integrated into a bank's risk management framework would jump to 10.75 percent, and stock prices would by discussing scenario selections; have an overview fall 55 percent. The average CET1 capital ratio of about data quality as well as about the model these banks would have dropped to 10.6 percent development processes. This framework should from an average level of 13 percent, still more than ensure a full and consistent oversight and monitoring double what is required under the Dodd-Frank Act. of the actions taken at the different stages of the The Fed analysis of the de facto credit growth, which bottom-up stress testing process. includes both loans and undrawn credit commitments, showed that it grew at a broadly average pace in 2020. Although credit growth was strongly correlated with bank size and business models, the analyses found  37  https://www.bankofengland.co.uk/stress-testing/2021/key-elements-of-the-2021-stress-test  38  https://www.federalreserve.gov/econres/feds/files/2021024pap.pdf TABLE 3. Key features of three ad hoc stress testing exercises under COVID-1939 ECB Board of Governors of the Features Bank of England Banking Supervision Federal Reserve System Date of exercise May 2020 July 2020 June 2020 New Covid-specific YES YES NO; use scenario of Dodd- scenario(s)? ("illustrative" scenario) (central and severe) Frank stress test, but adjust three key variables and make targeted adjustments Top-down / bottom- Top-down only Top-down only Top-down only up Number of downside One ("illustrative" Two (central and severe Three (U/V/W-shaped) Covid scenarios scenario) scenarios) Stress horizon 3 years (to Q1 2023) 2½ years (to Q4 2022) 3 years (to Q1 2023) Include COVID-19 YES (fiscal, regulatory YES (monetary, regulatory ONLY regulatory and bank policy response? and monetary policy and fiscal relief measures, tax relief measures support) to a large extent) Any publication? YES, instead of regular YES, instead of regular YES, in addition to regular stress test stress test stress test Publication of NO NO bank-level, but NO bank-level, but bank-level results or publication of distribution publication of distributions distributions? of CET1 ratios, across of CET1 ratios across the the sample and business sample models Aggregate CET1 drop 380 bp 190 bp (central scenario) 210 bp (V-shaped), 380 in the scenario and 570 bp (severe bp (U-shaped) and 430 bp scenario) (W-shaped) What happens with Authorities encourage Use the stress test to Use the stress test the ad hoc stress test banks to support assess the impact of to understand the results? lending, otherwise COVID-19 on banks, implications of downside there is a risk of an and identify potential scenarios for bank capital even bigger economic vulnerabilities at an early contraction stage little association between credit growth and either the 60. The ECB published its first pandemic-era stress tightness of regulatory capital constraints or measures testing in July 2020.40 The vulnerability analysis of bank health, suggesting that extraordinary focused on two scenarios set out in the June 2020 macroeconomic conditions affecting credit demand macroeconomic projections. The central (baseline) COVID-19 and Stress-testing were the primary explanation for significant scenario, the most likely to materialize according to fluctuations in aggregate credit. ECB staff, foresaw real GDP in the euro area decline by 8.7 percent in 2020, and GDP growth at 5.2 percent  39  Source: “Stress-testing banks during the COVID-19 pandemic.” Baudino, Patrizia. Financial Stability Institute Brief No 11. BIS  40  https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr200728~7df9502348.en.html 60 61 COVID-19 and Stress-testing and 3.3 percent in 2021 and 2022, respectively. The 61. The Australian Prudential Regulation Authority severe scenario, which represents a more adverse, (APRA) has undertaken several stress tests based but still plausible development of the crisis, foresaw on a range of scenarios designed to assess the real GDP decline by 12.6 percent in 2020, and GDP resilience of the banking system, with an emphasis growth at 3.3 percent and 3.8 percent in 2021 and on severe downside risks.41 This included an iterative 2022, respectively. The analysis also reports the cycle of APRA-led common scenario bottom-up stress results under the baseline scenario published by tests undertaken by the largest banks. These stress the European Banking Authority for the EU-wide tests were streamlined in design and focused on 2020 stress test. As this scenario was defined before assessing capital resilience of the banking system the coronavirus outbreak, it provided a benchmark to the potential drivers of economic stress arising to assess the impact of the pandemic on banks. from severe but plausible COVID-19 led downturns. The central scenario depleted banks’ CET1 ratio by The results of the stress test indicated that despite approximately 1.9 percentage points to 12.6 percent, the emergence of significantly reduced earnings and and severe scenario by 5.7 percentage points to loss of capital in the banking system under a severe 8.8 percent by end 2022, driven by impaired credit economic downturn, the banking system would exposures and market risk losses. In the latter have been able to absorb the impacts of economic scenario, several banks would have needed to take stress. This fall in capital was reflected in the banking action to maintain compliance with their minimum system’s aggregate CET1 ratio, which was estimated capital requirements, but the overall shortfall to decrease by 5 percentage points from 11.6 percent remained contained. Considering the extraordinary prior to the stress to a low point of 6.6 percent in current circumstances and in order to avoid subjecting 2022. After withstanding the impact of the stress, at its banks to additional operational burden, the ECB used lowest point, the banking system would have had the already available data for this exercise, including capacity to absorb further losses before reaching its regular supervisory reporting. minimum capital requirement. „ APPENDIX 1. REFERENCES Abboud, Alice, Duncan Elizabeth, Horvath Akos, Iercosan Diana, Loudis Bert, Martinez Francis, Mooney Timothy, Ranish Ben, Wang Ke, Warusawitharana Missaka, Wix Carlo. “COVID-19 as a Stress Test: Assessing the Bank Regulatory Framework.” 2021. Board of Governors of the Federal Reserve System, Washington, DC, March. https://www.federalreserve.gov/econres/feds/files/2021024pap.pdf Anderson, Ron, Baba Chikako, Danielsson John, S. Das Udaibir, Kang Heedon, and Segoviano Miguel. 2018. “Macroprudential Stress Test and Policies: Searching for Robust and Implementable Frameworks.” London School of Economics, London, February. Australian Prudential Regulatory Authority (APRA). 2020. Stress Testing Assessment: Findings and Feedback, Sydney, February. https://prod.apra.shared.skpr.live/sites/default/files/2020-02/Stress%20testing%20assessment%20 findings%20and%20feedback.pdf Bank for International Settlements (BIS),. 2018. “Stress-testing banks – a comparative analysis.” Financial Stability Institute (FIS), Basel, July. https://www.bis.org/fsi/publ/insights12.pdf BIS. 2020. “Stress-testing banks during the COVID-19 pandemic.” Baudino, Patrizia. Financial Stability Institute Brief No 11. Basel, October. https://www.bis.org/fsi/fsibriefs11.pdf BIS. 2017. “Supervisory and bank stress testing: range of practices.” Basel Committee on Banking Supervision (BCBS). Basel, February. https://www.bis.org/bcbs/publ/d427.pdf  41  https://www.apra.gov.au/sites/default/files/2020-12/Information%20Paper%20-%20Stress%20testing%20banks%20 during%20COVID-19.pdf BIS. 2009. “Principles for sound stress testing practices and supervision.” Basel, May. https://www.bis.org/publ/bcbs155.pdf Bank of Canada. 2014. “Stress Testing the Canadian Banking System: A System-Wide Approach.” Bank of Canada, Ottawa. https://www.bankofcanada.ca/wp-content/uploads/2014/06/fsr-june2014-anand.pdf Emerson, Rebecca, Schuermann Til. 2021.“COVID-19: a stress test of bank regulatory reforms.” Chatham House Briefing. London, March. https://www.chathamhouse.org/2021/03/covid-19-stress-test-bank-regulatory-reforms/key-questions-fsb-review Financial Stability Board (FSB). 2021. “Lessons Learnt from the COVID-19 Pandemic from a Financial Stability Perspective.” FSB, Basel, July. https://www.fsb.org/wp-content/uploads/P130721.pdf IMF (International Monetary Fund). 2021. “Global Corporate Stress Tests—Impact of the COVID-19 Pandemic and Policy Responses.” Tressel, Thierry Tressel and Ding Xiaodan. IMF Working Paper WP/21/212, August, Washington, DC. IMF. 2021a. “Asia & Pacific Department. Pacific Islands Monitor; Issue 15.” Washington, DC, October. IMF. 2020. “Assessing the Impact of the COVID-19 Pandemic on the Corporate and Banking Sectors in Latin America.” Washington, DC. October. IMF. 2007. “Introduction to Applied Stress Testing.” Cihak, Martin. IMF Working Paper WP/07/59. Washington, DC, March. Ranadi, Kalolaini, Hesaie Jacinta, Vosamacala Susana, Kabir Md Nurul, Miah Md Dulal, Sharma Parmendra. 2021. “Determinants of bank lending in PICs.” Griffith University, Queensland. https://www.griffith.edu.au/__data/assets/pdf_file/0036/1378926/JPRWP19-web.pdf Rehker, Martin, Feig Marcus, Fleischer Anna. 2020. “Comprehensive Stress Testing Under COVID-19.” https://www.capco.com/intelligence/capco-intelligence/comprehensive-stress-testing-under-covid-19 COVID-19 and Stress-testing 62 63 COVID-19 AND FINANCIAL STABILITY: EARLY INTERVENTION IN BANKING SUPERVISION March 2022 triggers are designed to deepen the understanding of „ INTRODUCTION the bank’s/group’s financial condition and to limit any further deterioration by addressing the underlying 1. This paper provides information and insights cause(s) of the problem and by promoting remedial on early intervention in a risk-based supervision action to restore the bank/group to desired risk framework for banks. It includes discussion settings. of international principles and practice on early intervention, including preventative action and 4. The second stage is corrective action, involving corrective action taken by banking supervisors in supervisory actions to require remediation of a response to emerging stress in a bank/financial bank’s/group’s financial or risk position in more group and the escalation of responses in relation to advanced situations of stress. Corrective actions a worsening financial condition. The paper highlights are generally based on quantitative triggers, such as some areas where the PIC supervision authorities levels of capital ratio, liquidity ratio and NPLs, but also might usefully review their early intervention usually include triggers of a qualitative nature, such arrangements, with a view to strengthening them as serious supervisory concerns over operational where necessary. risk events, breaches of regulatory requirements, or deterioration in governance or management. Corrective actions are designed to ensure that a bank/ financial group rectifies the cause(s) of the problem „ CONTEXT and restores the bank/group to defined levels of financial health and compliance with regulatory requirements, such as prescribed levels of capital 2. A well-developed early intervention framework ratio. is an essential component of banking supervision. It provides a structured framework for a proactive 5. In countries with significant cross-border response by the supervisory authority to emerging banking arrangements, home/host supervisory stress or breaches of prudential requirements by authority cooperation and coordination in early banks. For it to be effective, it is essential for an early intervention are important. In the case of foreign intervention framework to have triggers informed banks operating in a host country as branches or by Early Warning Indicators (EWIs) and a risk- subsidiaries, it is important that the triggers for early based supervision approach, where the triggers for intervention in the host country include, in addition to intervention apply at a relatively early stage in the triggers relating to the subsidiary or branch, applicable deterioration in a bank’s financial condition – well triggers relating to parent bank financial soundness before any breaches of regulatory requirements indicators, given that early intervention might be occur. needed to limit contagion to the local operations COVID-19 and Financial Stability: Early Intervention in Banking Supervision arising from parent bank stress. Equally, it is 3. Early intervention typically involves a two-stage important that, for a home supervisory authority, early process. The first stage is preventative action, involving intervention encompasses a whole-of-group approach, supervisory actions to seek to prevent further such that the triggers and responses are based on deterioration of a bank’s risk position and financial the parent entity’s financial and risk condition as well condition. Under preventative action, the triggers as the global group’s financial and risk conditions. are based on early-stage stress in a bank/financial In situations involving banks/groups with significant group, and include a deterioration in EWIs, and a cross-border operations, it is important to ensure that deterioration in risk relative to a bank’s risk appetite there is a strong level of cross-border cooperation and tolerances - e.g. a rise in non-performing loans (NPLs) coordination in the early intervention framework, such or substandard loans, special mention loans or IFRS9 that the home and host supervisory authorities keep Stage 2), a weakening in profitability, a weakening in each other informed of relevant early intervention capital and liquidity buffers above regulatory minima, indicators and responses, and that there is a and the occurrence of operational risk events, such coordinated approach where required to achieve a as money laundering, fraud or cyber-based losses. cohesive whole-of-group response to the situation. Supervisory actions in response to these early-stage 64 65 COVID-19 and Financial Stability: Early Intervention in Banking Supervision 6. As part of the early intervention arrangements, supervisory authorities need to ensure that „ INTERNATIONAL banks have contingency plans in place to deal PRINCIPLES AND PRACTICE with emerging stress. Contingency plans should be a standard requirement for all banks, including ON EARLY INTERVENTION for capital and liquidity, business continuity, and recovery plans.42 The plans should be integrated into 9. International guidance can be used to banks’ risk management frameworks and designed to inform the design and implementation of early enable the bank to restore capital and liquidity back intervention frameworks. This section of the paper to pre-defined levels, and to maintain continuity of summarises relevant international guidance. all essential banking functions and support systems. There should be a requirement for banks to undertake regular testing of these contingency plans, and for the supervisory authorities to review this testing process. BCBS Core Principles for Effective Banking Supervision 7. Supervisors’ early intervention frameworks need to include triggers for requiring a bank to activate 10. An important starting point is the BCBS Core its contingency plans and recovery plan. The Principles for Effective Banking Supervision. triggers in the early intervention framework should In particular, two of the Core Principles are worth align to the types of triggers that banks incorporate reproducing in this paper as foundations for the into their contingency plans and recovery plans, such development of an early intervention framework: as those relating to capital, liquidity, asset quality and Principle 8 – Supervisory approach; and Principle 11 profitability. – Corrective and sanctioning powers of supervisors. These are set out below: 8. Supervisory authorities need to have their own contingency plans for dealing with bank Principle 8 – Supervisory approach: An effective stress situations. These plans should be scenario- system of banking supervision requires the based and identify, for any given scenario, the supervisor to develop and maintain a forward- types of preventative and corrective actions that looking assessment of the risk profile of individual supervisors would take to respond to the situation. banks and banking groups, proportionate to their The contingency plans essentially involve drawing on systemic importance; identify, assess and address the preventative and corrective actions framework to risks emanating from banks and the banking system identify which of the actions the supervisor would take as a whole; have a framework in place for early in response to particular scenarios of bank stress. The intervention; and have plans in place, in partnership contingency plans should be subject to regular testing with other relevant authorities, to take action to through simulation exercises involving the supervisory resolve banks in an orderly manner if they become authority’s senior management and other relevant non-viable. staff, generally based on a fictitious bank which is Principle 11 – Corrective and sanctioning powers role-played by the supervisors for the purpose of the of supervisors: The supervisor acts at an early stage exercise. Lessons learned from the exercise can then to address unsafe and unsound practices or activities be used to refine the contingency plans and, where that could pose risks to banks or to the banking appropriate, to modify particular elements of the system. The supervisor has at its disposal an adequate preventative and corrective action plans. range of supervisory tools to bring about timely corrective actions. This includes the ability to revoke the banking licence or to recommend its revocation.  42  In some cases, banks will have contingency plans for capital and liquidity that are separate from a recovery plan. In such cases, the capital and liquidity contingency plans deal with relatively mild forms of financial shocks, whereas the recovery plan deals with more severe financial shocks and therefore includes a wider range of recovery initiatives. In other cases, the capital contingency plan, liquidity contingency plan and recovery plan are integrated into one overall financial contingency plan, in which the plan contains an escalating set of responses to an increasingly severe set of financial shocks. 11. These Core Principles are fundamental to purposes of an early intervention framework, the the purpose and design of an early intervention types of legal powers on which it typically relies, the framework. In particular, Principles 8 and 11 stress nature of triggers often used in such frameworks, and a number of key elements that bear repeating, and the types of responses to triggers that can be applied these are: by supervisory authorities.  Supervision should involve a forward-looking 14. The FSI paper, and other international assessment of a bank’s risk profile. guidance, note that there are two broad categories  Supervision requires the capacity for early of early intervention frameworks: intervention to deal with emerging stress/risks  those which are expressed as prompt corrective before they become critical. action frameworks and are based mainly on a  Supervisory authorities need to maintain plans for limited number of specific triggers (mainly capital- dealing with weak banks and for resolving non- related) with mandated response actions by the viable banks. supervisor; and  Supervisory authorities need the legal powers and  those which are more discretionary in nature and tools to require banks to take corrective actions. involve a wider range of triggers (qualitative and quantitative) and which involve a wider range of discretionary supervisory responses. BCBS Frameworks for early 15. Examples of the prompt corrective action supervisory intervention frameworks are the PCA frameworks in the United States and Japan, which have triggers set 12. In addition to the BCBS Core Principles, the in statute, are limited essentially to capital-related BCBS and other international bodies have issued triggers and which specify mandatory supervisory papers that provide specific guidance on early actions. Examples of the more flexible form of intervention. Of particular note in this regard is early intervention, involving a wider range of the BCBS paper Frameworks for early supervisory triggers (qualitative and quantitative) and a wider intervention, issued in March 2018.43 This provides set of discretionary response actions are the early helpful guidance on the key elements of early intervention frameworks in the European Union, intervention frameworks and incorporates references United Kingdom and Australia. Examples of a hybrid to some country examples. A summary of relevant form of early intervention, involving a combination points from the BCBS Frameworks for early supervisory of ‘hard triggers’ (being capital based) and qualitative intervention is set out later in this section of the paper. triggers, and with some flexibility in supervisory response actions, are the intervention frameworks in India and the Philippines. COVID-19 and Financial Stability: Early Intervention in Banking Supervision FSI Insights on policy 16. Each form of early intervention has its benefits implementation No 6 - Early and risks: intervention regimes for weak  The prompt corrective action approach, with its banks more rigid formulation of quantitative triggers and mandatory supervisory actions, has the 13. Further guidance on early intervention merit of simplicity of administration, consistency arrangements is available from the Financial in application across banks and reduced risk of Stability Institute. In particular, its paper FSI Insights regulatory forbearance. However, it tends to be on policy implementation No 6 - Early intervention narrow in the use of triggers (mainly being capital- regimes for weak banks, published in April 201844 is based) and is generally based on actual breaches especially relevant. This provides a discussion of the of regulatory requirements and is therefore  43  Frameworks for early supervisory intervention, BCBS, March 2018, which can be accessed at: https://www.bis.org/bcbs/publ/d439.pdf  44  FSI Insights on policy implementation No 6 - Early intervention regimes for weak banks, April 2018, which can be accessed at: https://www.bis.org/fsi/publ/insights6.pdf 66 67 COVID-19 and Financial Stability: Early Intervention in Banking Supervision later-stage intervention than some of the more techniques and policies that supervisory authorities discretionary early intervention frameworks. Such can apply in dealing with weak banks or banks forms of intervention are also rigid in nature and under stress, providing examples of different types do not enable the supervisory authority to exercise of stress situations. The paper also discusses the judgement-based discretion. importance of bank recovery plans and how these should be deployed by banks, overseen by supervisory  Early intervention frameworks that are authorities, to address particular bank stress discretionary in nature, involving a wider situations, such as deficiencies in capital or liquidity, range of quantitative and qualitative triggers, or weaknesses in asset quality or risk management and considerable discretion as to supervisory systems. The paper also discusses the transition of a responses, offer the benefit of flexibility and weak bank into resolution once it becomes non-viable facilitate early-stage supervisory actions before and assesses a range of resolution options. breaches of regulatory requirements have occurred. However, they also create the risk of regulatory forbearance and can lead to inconsistent approaches to early intervention Typical weaknesses that warrant across different banks in similar circumstances. They also rely to a greater extent on supervisory early intervention judgement, which in turn requires supervisors to have the depth of knowledge, experience and 18. As set out in the BCBS Guidelines for identifying confidence to make the appropriate decisions. and dealing with weak banks, early supervisory Such frameworks tend to work best with intervention is warranted when the following supervisory authorities that have well-established types of weaknesses are observed: risk-based supervision and where the supervision  Poor lending practices. These may include poor authority has considerable autonomy and underwriting skills or an overly aggressive loan operational independence. expansion programme, coupled with an absence  The hybrid approach, involving a combination of incentives to identify problem loans at an early of qualitative triggers and discretionary actions stage and to take corrective action. for early-stage risk deterioration, coupled with  Excessive risk concentrations. These may include quantitative triggers and more structured excessive concentrations in funding, lending, supervisory responses for breaches of regulatory sources of income and risk. Concentrations requirements, arguably offers the best of both can accumulate across products, business worlds. This enables a supervisory authority lines, countries and legal entities, and can be to take discretionary action at the first signs of destabilising. Large exposure regimes aim to limit emerging stress to intensify supervision and excessive concentrations. consider requiring remedial actions by banks, while  Structural imbalances in a bank’s liquidity also having a structured set of specific supervisory position. This may arise from a number of factors, response actions once breaches of key regulatory including an unsustainable maturity structure, a requirements occur. high loan-to-deposit ratio, or a low share of stable sources of funding on total liabilities. An excessive concentration of funding is typical of business BCBS Guidelines for identifying models that are overly reliant on ample market and dealing with weak banks liquidity and that ignore the liquidity funding risk.  Excessive risk-taking. This may come about when 17. A further paper that is useful reference a bank’s compensation scheme ties compensation material for the consideration of early or bonuses to short-term performance (e,g. short- intervention frameworks is the BCBS Guidelines for term increases in the bank’s profits, earnings or identifying and dealing with weak banks, published share price) or performance targets that do not in July 2015.45 This provides useful discussion on the take the related risks into consideration.  45  BCBS Guidelines for identifying and dealing with weak banks, July 2015, which can be accessed at: https://www.bis.org/bcbs/publ/d330.pdf  Weaknesses in risk culture and governance.  Early warning systems. Many supervisors have These could take the form of a lack of risk established early warning systems to identify experience and skills among senior executive and the institutions and issues that require closer non-executive management, a lack of influence of attention. An early warning system typically the risk function, and weaknesses in the way risk is provides alerts on significant changes in financial measured and reported. and prudential indicators and identifies outliers within peer groups. Common indicators across  Breaches or overrides of existing policies and peer banks are monitored and analysed to pick procedures. These could include breaches of limits up anomalies. Through the review of these on concentration, connected lending, value-at-risk indicators and their trends, potential problems are exposure of the trading book and liquidity risk highlighted for supervisory attention and follow- tolerance. Individuals within the bank may override up. As set out in the BCBS Guidelines for identifying policies and procedures by force of personality, and dealing with weak banks, early warning dominant ownership or executive position. systems will not normally provide firm evidence  Fraud or criminal activities. These could include of weaknesses, but they can give indications that money laundering, fraud perpetrated by bank suggest the need for a deeper investigation by the officers, self-dealing by one or more individuals, bank and its supervisor. Early warning systems are and collusive activities. particularly important for helping supervisors to  External factors such as negative direct limited resources towards banks or activities macroeconomic shocks. These could include a where weaknesses are most likely to be found. currency crisis, a weak real economy, inadequate  Stress testing. Supervisors use a range of stress preparation for financial sector liberalisation, a tests in the supervisory process, including system- massive market liquidity squeeze, which may also wide, firm-specific and reverse stress testing. lead to problems for individual banks. External Even although stress testing is built around factors may not overwhelm a well-managed and hypothetical scenarios, the outcome of such financially sound bank, but will expose deficiencies exercises provides supervisors with additional in management and control in weaker banks. qualitative and quantitative information on risks and vulnerabilities to which a bank might be exposed. The results of stress tests can be used to Forward-looking assessments as inform the nature of the triggers applied in an early intervention framework, including in respect of part of early intervention capital, asset quality, net interest margins, market risks and liquidity risks. 19. Early supervisory intervention needs to be supported by forward-looking assessments and  Horizontal, thematic and targeted reviews. COVID-19 and Financial Stability: Early Intervention in Banking Supervision supervisory programs. Good international practice The BCBS notes that some supervisors have in risk-based supervision involves qualitative risk introduced the practice of undertaking horizontal assessments being included in the early intervention analysis as part of ongoing supervision. Horizontal frameworks. assessments can take numerous forms, but typically involve peer benchmarking across banks 20. Forward-looking supervisory tools are used in similar categories and thematic analysis and/ as part of the supervisory review process to give or sectoral data analysis. Horizontal assessments supervisors a range of information on a bank and provide supervisors with additional information the wider market. A number of these tools have on the financial situation of an individual bank been adopted to facilitate the early identification and support an identification of potential outliers of risk areas that may require supervisory action operating in similar business lines. They also help and intervention. The following tools are commonly supervisors to better understand industry trends applied to cover a range of methods that provide and risks to financial stability. In addition to regular supervisors with forward-looking information, both for ongoing monitoring activities and horizontal ongoing supervision and for early intervention: assessments, some supervisors also use targeted 68 69 COVID-19 and Financial Stability: Early Intervention in Banking Supervision reviews for a ‘deep dive’ evaluation of particular tool for early detection of risks and vulnerabilities, areas of supervisory concern. This approach not thus assisting supervisors in early intervention. only complements the day-to-day supervision Business model analysis forms an important of individual banks but can support early part of the supervisory process and enables the identification of emerging risks in the financial supervisor to foresee risks developing. system and in individual banks. The information  Risk culture analysis. Understanding the derived from such analysis can be integrated governance and culture of a bank is critical into early intervention frameworks through the for understanding whether early supervisory identification of possible triggers for enhanced intervention may be needed. The BCBS notes that supervision. some authorities have increased their focus on The effectiveness of horizontal assessments of understanding the extent to which the risk culture banks as a means of establishing benchmarks of individual financial institutions supports their for risk parameters is dependent on the size of formal governance structures and management of the population of banks assessed. The larger the risk. This includes assessing incentive structures, population of banks, the more useful horizontal remuneration and misconduct risk. A supervisor’s analysis will be in establishing benchmark understanding of a bank’s culture can be enhanced indicators and in enabling supervisors to assess by comparing culture across banks. On-site visits each bank against its peers. In financial systems and meetings with senior managers allow the with very small numbers of banks, as in the PICs, supervisor to gain an understanding of how the this kind of analysis, while still useful, is more tone from the top influences staff attitudes and limited in its efficacy. This recognizes that each management of risk. The supervisory assessment bank has its own particular characteristics which of risk culture is often integrated into the early need to be taken into account when comparing intervention framework to provide qualitative one bank against another. In such small sample triggers for enhanced supervisory attention or sizes, peer group analysis can still be valuable specific actions intended to require a bank to as a means of comparing one bank with others address weaknesses in risk culture. across a range of risk parameters, but provides considerably less predictive capacity than does peer group analysis using a larger sample size. Any differences in risk parameters between banks „ INDICATIVE EXAMPLE OF need to be assessed having regard to the particular characteristics of each bank, rather than being EARLY WARNING SYSTEM taken at face value. 21. As noted above, early warning systems are  Governance and risk management. The BCBS an important element of an early intervention notes that an important element of the supervisory framework. Supervisory authorities are advised to review process is to evaluate a bank’s corporate establish and maintain relatively comprehensive early governance practices, including the quality of warning systems as part of the process for detecting board and senior management oversight and the emerging bank stress at an early stage. effectiveness of risk management and control functions. Typical assessments include the strength 22. The nature of early warning systems varies and independence of a bank’s risk management, considerably across supervisory authorities. In compliance and internal audit functions, the quality countries with complex financial systems and high- of its information systems, and the interaction quality data on bank risks, early warning systems between different ‘lines of defence’ (i.e. the ‘first can involve predictive models, especially if there is line of defence’ being front-line management of sufficient long-term data to enable modelling of the business units; the ‘second line’ being the risk relationship between risk variables and bank distress management function, and the ‘third line’ being or failure events. However, for countries with less internal audit). complex financial systems and less comprehensive  Business model analysis. Business model data, early warning systems can involve relatively assessment supports supervisory understanding simple, but still effective, indicators that can provide of a bank’s business model and can be an effective an alert to emerging stress in a bank. These simpler frameworks typically involve a ‘dashboard’ of EWIs level or ‘steady state’ for the indicator for each bank that cover a range of risk-related metrics, usually or for the banking system as a whole, such that EWIs relating to capital, asset quality, profitability, exposure within a defined range of this benchmark would be concentration and liquidity. The systems used often assigned ‘green’. EWIs at higher risk levels relative to involve a ‘traffic light’ form of risk gradation, with the benchmark would be assigned ‘yellow’ to denote green, amber and red levels of EWIs. Depending on emerging stress, and those at a higher-still level would the level of alert (green, amber or red), the EWIs would be assigned ‘red’ to denote a level of high alert. provide a basis for possible further enquiry by the supervisory authority.  NORMAL  EWI is in the normal range and gives 23. Table 4 sets out indicative examples of bank- no basis for concern specific EWIs. These EWIs would be obtained regularly  EMERGING  EWI is materially above normal range from banks and other regulated entities to enable the  STRESS  and provides a possible reason to supervisory authority to monitor the risk condition intensify monitoring and potentially of each entity and the banking system as a whole. consider adjustments to bank risk EWIs should be selected on the basis of their capacity appetite to predict future stress affecting key prudential and financial indicators, such as capital, liquidity, asset  HIGH  EWI is well above the normal range quality profitability and operational risk. The indicators  ALERT  and provides a reason to take would be assigned to a colour coding (such as ‘green’ immediate action to deepen the for normal levels of EWI, ‘yellow’ for higher-than- understanding of the situation, reduce normal levels of risk, and ‘red’ for concerning levels of risk appetite and possibly require risk). This can be done by referencing each EWI to a other remedial actions benchmark indicator which is regarded as a ‘normal’ TABLE 4. Indicative examples of bank-specific EWIs Frequency of Category Early Warning Indicators Monitoring Profitability-  Decline in interest and fee revenue relative to benchmark (e.g., Quarterly, but related EWIs where the benchmark is ‘normal’ level) increased if  Increase in funding cost risk premium relative to normal levels indicators warrant higher frequency Increase in operating expenses relative to benchmark (e.g., where COVID-19 and Financial Stability: Early Intervention in Banking Supervision  of monitoring the benchmark is ‘normal’ level) Capital-  Increase in NPLs relative to total loans (and relative to a benchmark Quarterly, but related EWIs level) increased if  EWIs that relate to asset quality stress (see below) indicators warrant higher frequency  Deterioration in credit quality of investment assets (including HQLA) of monitoring  Increase in growth of new lending relative to benchmark  Increase in proportion of lending in high loan-to-valuation ratio category  Increase in proportion of lending in high debt servicing ratio to disposable income category  Increase in lending to higher-risk sectors of the economy  Increase in connected lending  Increase in credit exposure concentration 70 71 COVID-19 and Financial Stability: Early Intervention in Banking Supervision Frequency of Category Early Warning Indicators Monitoring Liquidity-  Decline in HQLA/total liabilities ratio relative to benchmark Initially quarterly related EWIs  Decline in daily net cash inflows or increase in net cash outflows but moving to relative to benchmark monthly or even weekly monitoring  Increase in deposit outflows relative to benchmark in situations of  Shortening of average maturity of deposits relative to benchmark higher stress  Lengthening of average maturity of loans and other assets relative to benchmark  Reduced proportion of deposits being rolled over at maturity  Persistent increase in liabilities at a rate of growth that exceeds the growth in HQLA  Weakening in credit quality of HQLA Asset  Rise in borrower debt servicing ratio relative to benchmark Quarterly initially, quality-  Rise in household leverage (e.g., debt to total assets and debt to moving to monthly related EWIs household disposable income) (but increased if indicators warrant  Rise in business sector leverage (e.g., debt to total assets and debt higher frequency to business disposable income) of monitoring)  Change in residential property prices  Change in commercial property prices  Change in rural property prices  Proportion of loans in arrears relative to benchmark, by extent of arrears  Requests from borrowers for loan restructuring due to debt servicing stress Operational  Significant increases in call centre enquiries as to problems or risk-related concerns with the ADI relative to benchmark indicator EWIs  Increases in fraud events relative to benchmark indicator  Increase in cyber-attacks on ADI’s IT systems relative to benchmark indicator  Number of reported incidents of market conduct breaches 24. Another forward-looking input into early corrective measures, such as selling assets and intervention arrangements is the information curbing lending, with ramifications for profitability and assessments arising from macroprudential and capital; analysis. This analysis can provide important insights  the risk of direct and indirect credit exposure into emerging risks, including: concentrations, which can pose a threat to bank  the risk of excessive credit growth and leverage, capital positions and amplify losses through which can be an early warning indicator of asset cross-correlation between associated exposure price inflation and asset quality deterioration; categories;  the risk of excessive maturity mismatch and  the risk of skewed incentives (including market illiquidity, which can trigger or exacerbate remuneration incentives that are poorly aligned bank liquidity stress and cause banks to take with desired risk outcomes) and moral hazard, which can lead to inadequate management of risk reinforced by the collective monitoring efforts and potentially lead to bank stress and failure; and of on-site, off-site and specialist supervisory risk teams. In many authorities, organisational changes  risks linked to the resilience of individual financial have been made to reinforce early detection and institutions, which provide important insights into early supervisory actions. The use of horizontal potential stress in financial institutions. risk assessments also ensures checks and balances across supervisory teams of different institutions. Forward-looking information, including Early intervention in the peer group data, is fundamental to providing supervisory process supervisors with a rich source of information that will allow them to identify early warning 25. The BCBS paper on early intervention notes signals and intervene earlier and more effectively. that, based on the approaches observed in a Collective supervisory monitoring also increases number of jurisdictions, programs and processes the surveillance and detection of emerging risks, aimed at intervening in an early and effective at both an institutional and an industry level. While manner have several important characteristics. responsible supervisors are tasked with carrying The BCBS observations are reproduced below: out supervisory decisions directly with the bank, supervisors can be supported by the analysis  Observation 1. Early supervisory intervention and early detection of risks from specialist units. is very closely linked to the supervisory review This ensures that early intervention is not solely process and a forward-looking risk-based dependent on the actions of one supervisor, supervisory framework. The practices observed but is the collective responsibility of teams of show that early supervisory intervention is firmly supervisors. entrenched within a risk-based approach to supervision, where the intensity of supervisory  Observation 3. Communication with banks attention escalates as the risks and impact that forms a large part of how supervisors intervene an institution poses to financial stability increase. early, primarily as the first stage in an Early supervisory intervention therefore involves escalation process. These actions are undertaken supervisors taking actions to require institutions early and primarily through less intrusive means, to correct an identified weakness or potential such as letters and other written communication. issue before minimum regulatory requirements At the same time, supervisors have a range of or buffers are breached. Early intervention general and specific powers and will use escalation actions taken therefore are not exclusively due processes as a means of communicating to banks to a formal framework that prescribes action, the required actions that need to be undertaken. but are also taken as part of ongoing supervisory The use of general supervisory powers therefore COVID-19 and Financial Stability: Early Intervention in Banking Supervision monitoring. As noted above, early intervention is places the onus on institutions to rectify the also influenced by a deterioration in risk indicators identified weakness, rather than on the supervisor in the EWS, which may serve as prompts for to make more difficult decisions to apply a the supervisory authority to undertake a closer corrective or restrictive measure to the activities of assessment of a bank’s risk profile and risk the institution. management in the areas to which the indicators  Observation 4. The will and ability of the relate. supervisor to act early are to a large extent  Observation 2. Early supervisory intervention reinforced and supported by the structure, operates based on the collective monitoring process and powers of a risk-based supervisory efforts of a number of different supervisory framework. For many authorities, well defined teams that are both on- and off-site. Supervisory policies and escalation processes help to guide the authorities have increasingly adopted detailed actions that need to be taken by supervisors under supervisory intervention frameworks that are given circumstances, such as time periods given 72 73 COVID-19 and Financial Stability: Early Intervention in Banking Supervision to institutions to rectify identified weaknesses or between supervisors and individual banks, but changes in ratings stances. Supervisory actions are also with external stakeholders more generally. therefore taken that are commensurate with the Communication enhances the predictability of seriousness of the breach as well as the stage in the supervisors, which in turn can persuade the escalation process, which again appear to give banks to adapt their behaviour at an early stage supervisors a good understanding of what actions and dissuade banks from engaging in unsound need to be taken at any given stage. Structurally, practices. Supervisory communication is also the increasing use of horizontal and vertical teams important for enhancing the accountability also helps to provide different perspectives and and transparency of supervisors and plays an effective challenges to avoid groupthink. important role in educating stakeholders on supervisory expectations and activities, so that  Observation 5. Supervisory development supervisory actions do not come as a surprise and capacity-building are critical for early when undertaken. Successful communication with supervisory intervention. Early and effective external stakeholders is also pre-emptive, and intervention is not only based on the supervisory factored in from the outset. tools or methods in place, but also the training and development that enable and support supervisors to take action. Supervisors with diverse backgrounds can help the authority to have broad and deep technical and behavioural „ INDICATIVE EXAMPLE OF skills in the organisation. Training can ensure these AN EARLY INTERVENTION skills are maintained and further developed, and let experienced supervisors feel valued for their FRAMEWORK knowledge. 26. A discretionary form of early intervention  Observation 6. Incentives for undertaking early framework would typically involve a two-stage supervisory intervention can be strengthened process involving preventative actions for early- through appropriate support structures, stage stress and corrective actions for more clear delegation of responsibilities, effective serious stress situations or where a regulated appraisal systems and sufficient legal backing. entity has breached regulatory requirements. This Ensuring that supervisors are willing to act requires section of the paper sets out an indicative example of authorities to focus on creating a culture for early a two-stage early intervention framework, comprising supervisory intervention within their organisation. preventative actions and corrective actions. Supervisors are incentivised and supported by robust internal governance processes and a clear 27. As noted earlier, preventative actions are and strong message that the organisation supports designed to enable supervisors to deepen their supervisors taking early and timely interventions. understanding of the risk situation in a bank Authorities can also consider reviewing their and to take early actions to seek to prevent internal processes to minimise unnecessary the risk situation from deteriorating further. hierarchy, which can empower supervisors to Corrective actions are intended to involve a structured take action on an identified issue and enable supervisory response to an actual or imminent intervention to be undertaken earlier. breach of prudential regulatory requirement or  Observation 7. Supervisory actions and serious deterioration in risk position, such that the intervention are supported in an environment supervisors would implement the response associated where key stakeholders and the public with a particular trigger unless there were compelling understand that actions taken by the reasons not to do so. supervisory authority are to safeguard and promote the safety and soundness of the 28. By way of illustration, an indicative framework is banking system. Early supervisory intervention set out in Figures 1 and 2. is enabled not only by proper communication FIGURE 1. Preventative actions framework THRESHOLD 1 TRIGGERS EWIs moving from green (normal) to yellow (early alert) SUPERVISORY RESPONSES  Checking the accuracy and completeness of reported data in relation to the relevant risks.  Obtaining more data and qualitative information from a bank in relation to the relevant risks.  Informal discussions with relevant bank staff to better understand the risks in question.  Intensify monitoring of relevant risks where the EWI has moved to amber to better understand whether there is cause for concern – e.g. increase the level of detail required to be reported in the relevant risk areas and increase the frequency of reporting.  Engage at more senior levels with the bank to deepen supervisory understanding of the relevant risks and the actions being taken by the bank to respond to the risks. THRESHOLD 2 TRIGGERS EWIs moving from yellow (early alert) to red (warning) OR Supervisory risk rating moving in a particular risk category from a low-risk rating to higher-risk rating SUPERVISORY RESPONSES  Further intensify monitoring of the relevant risk areas and require reporting from the bank on risk management COVID-19 and Financial Stability: Early Intervention in Banking Supervision policies and practices in relevant risk areas. The degree of escalation in intensity of monitoring (including the detail of data required and the frequency of monitoring) will depend on the extent of the deterioration in risk indicators.  Escalate engagement with more senior levels in the bank (depending on the extent of risk deterioration) to assess the causes of the risk situation and to convey expectations of actions the bank should be taking to address the matter, particularly as regards initiatives to strengthen risk management arrangements.  Undertake targeted on-site examinations of relevant risk areas.  Consider the appointment of an external party with requisite expertise to undertake a review of the risk area and identify appropriate response options.  Require the bank to take remedial measures as appropriate to strengthen deficiencies in risk management, governance, capital and liquidity, as relevant 74 75 COVID-19 and Financial Stability: Early Intervention in Banking Supervision THRESHOLD 3 - CAPITAL TRIGGERS Bank’s capital ratio falls below a given margin (e.g. 200 bps) above the minimum regulatory capital requirement applicable to the bank. For example, if the minimum regulatory capital ratio is 10%, the threshold for early intervention might be set at 12%. SUPERVISORY RESPONSES Require the bank to prepare an action plan, approved by the supervisor, to take steps needed to restore the capital ratio back to a given margin (e.g. 200 bps) above the minimum regulatory requirement and to address the underlying causes of the problem. This might require the supervisory authority to engage with the controlling shareholders of the bank as to their willingness and ability to strengthen the bank’s capital position. Remedial actions might include:  Activate the bank’s capital contingency plan or recovery plan.  Raise additional capital (either equity or an additional tier 1 or tier 2 qualifying capital instrument).  De-risk the balance sheet to increase the capital ratio.  Sell some of the bank’s loan portfolio.  Dispose of non-critical business lines.  Reduce non-essential operating expenses. Require the bank to lower its rate of new lending pending the restoration of capital back to the target level. Require increased bank reporting in relation to key risk areas, including capital, asset quality, loan concentration, risk performance relative to risk appetite, and other risk areas that have contributed to the fall in the capital ratio. THRESHOLD 3 - LIQUIDITY TRIGGERS Bank’s liquidity ratio falls below a defined level above minimum regulatory requirements (e.g. LCR declining below 110% if the minimum regulatory LCR is 100%) SUPERVISORY RESPONSES Require the bank to prepare an action a plan, approved by the supervisory authority, to take steps needed to restore the liquidity ratios back to the required margins above the minimum regulatory requirements and to address the underlying causes of the problem. Require the bank to implement its liquidity contingency plan or recovery plan to assist in reducing liquidity pressure. Possible actions might include:  Reducing non-essential operating expenses.  Reducing the rate of new lending.  Lengthening the maturity of funding where practicable.  Accessing liquidity through a repo or outright sale of assets.  Obtain liquidity support, if necessary, from controlling shareholders, where feasible. FIGURE 2. Corrective actions framework CAPITAL THRESHOLD 1 TRIGGERS Bank’s capital ratio falls below the minimum regulatory capital ratio by a given margin (e.g. up to 100 bps. For example, if the minimum capital ratio is 10%, this trigger would be where the bank’s capital ratio falls between 9% and 10%. SUPERVISORY RESPONSES  Require the bank to prepare a remediation plan to restore bank to compliance with the capital ratio (if the remediation plan has not already been prepared).  Where necessary, the supervisory authority would engage with controlling shareholders to determine an action plan for an injection of capital – either capital provided by the shareholders or shareholder agreement to the issuance of new capital to other potential investors.  Require the bank to invoke its capital contingency plan or recovery plan (if not already activated) to take the actions needed to restore capital back to compliance with the capital ratio. Actions might include: ƒ Issuance of new equity to existing shareholders or to new investors. ƒ Issuance of Additional Tier 1 or Tier 2 qualifying capital instruments. ƒ Selling higher-risk assets. ƒ Selling or securitizing parts of the loan portfolio. ƒ Slowing the rate of new lending. ƒ Reducing non-essential operating expenses. ƒ Selling non-critical business lines. ƒ Suspending dividends. COVID-19 and Financial Stability: Early Intervention in Banking Supervision  Require the bank to cease distributions to shareholders, including dividends, as well as new lending to shareholders  Require the bank to cease bonus payments or remuneration increases to senior management until capital is restored  Require the bank to cease new lending other than under previous committed lending facilities  Require the bank to convert subordinated debt if contractual terms permit  Require the bank to present a capital-raising strategy  Removal of senior management and directors to the extent they are seen as responsible for the bank’s difficulties, and facilitate appointment of new management and directors as necessary  Consideration of merger options if capital cannot be restored to target level within a specified timeframe 76 77 COVID-19 and Financial Stability: Early Intervention in Banking Supervision THRESHOLD 2 TRIGGERS Bank’s capital ratio falls below the minimum regulatory capital ratio by a greater margin (e.g. between 100 bps and 300 bps below the minimum requirement. For example, if the minimum capital ratio is 10%, this trigger would be where the bank’s capital ratio falls to a ratio of between 7% and 9%. SUPERVISORY RESPONSES In addition to the actions above, other responses might include:  Require the bank to dispose of non-critical assets and other non-critical business lines and take other initiatives to de-risk the balance sheet  Requirement to appoint designated persons to assist in the remediation of the bank  Consideration of appointment of an administrator to assume temporary control of the bank if there is insufficient confidence in the bank’s board or management  Consideration of merger options if capital cannot be restored to target level within a specified timeframe THRESHOLD 3 TRIGGERS Bank’s capital ratio falls below the minimum regulatory capital ratio by more severe margin (e.g. between 300 bps and 500 bps below the minimum requirement. For example, if the minimum capital ratio is 10%, this trigger would be where the bank’s capital ratio falls to a ratio of between 5% and 7%. SUPERVISORY RESPONSES The above measures, but also potentially:  Issue directions to the bank to take further specified actions to restore capital to the required level, to facilitate merger or other actions deemed necessary to rectify the situation  Remove and replace key management and directors (if not already done)  Appoint an administrator to assume temporary control of the bank to implement remediation measures or facilitate merger or to begin pre-positioning for resolution if capital cannot be restored and if the supervisor does not have confidence in the ability of the management/board to implement recovery actions THRESHOLD 4 TRIGGERS Bank’s capital falls below a level from which recovery is not possible – e.g. a total capital ratio of below 5% or a CET1 ratio of below 3% SUPERVISORY RESPONSES Initiate entry into resolution unless the administrator presents a bank merger or recovery strategy that will enable the bank to be restored to capital soundness in a defined period of time LIQUIDITY THRESHOLD 1 TRIGGERS Bank’s liquidity ratios fall below minimum regulatory requirements SUPERVISORY RESPONSES  Require the bank to prepare a remediation plan to restore liquidity to above regulatory requirements  Require the bank to invoke liquidity recovery options in its liquidity contingency plan or recovery plan, potentially including: ƒ selling or repo-ing assets for cash, accessing funding under a borrowing facility, obtaining liquidity support from shareholders or increasing the average maturity on liabilities; ƒ suspending new lending (other than under existing committed credit facilities) pending completion of remediation; ƒ reducing non-essential expenditures; ƒ consideration of appointment of an administrator to assume temporary control of the bank if there is no confidence in the bank’s board or management b. In some PICs, there was an inadequate level „ CONCLUDING THOUGHTS of development of early intervention policy frameworks and associated procedures, including 29. It is useful to consider the findings of FSAP triggers for taking preventative or corrective and TA missions to assess the adequacy of early actions and a structured escalation in supervisory intervention arrangements in PICs. In previous responses to such triggers. FSAP and TA missions conducted in some of the PICs, c. In some PICs, there was an inadequate the findings have included assessments of the state of development of early warning systems and the supervisory authorities’ early intervention frameworks. absence of an effective linkage between EWIs and Although the findings and recommendations associated preventative actions. COVID-19 and Financial Stability: Early Intervention in Banking Supervision obviously vary considerably from country to country, some broad themes are apparent. These include: d. As a general observation, PIC supervisory authorities were found to lack adequately a. Some PIC supervisory authorities have developed contingency plans for dealing with bank relatively comprehensive statutory powers for stress and weakness, including a lack of indicative early intervention, including powers to collect strategies for responding to defined scenarios information from supervised entities and to issue involving a deterioration in bank risk. binding directions to such entities. However, in some cases, there were inadequacies or e. Cross-border cooperation and coordination ambiguities in the triggers for the invoking of arrangements were generally found to be some powers, the limited ability to apply direction inadequate in respect of EWIs and early powers before serious financial distress or breach intervention frameworks, with inadequate of regulatory requirements have occurred, and the information exchange of EWIs and other risk inability in some cases to apply corrective action indicators between home and host authorities, and powers on a group-level basis. a lack of agreed coordination of home and host response strategies for dealing with bank stress and weakness. 78 79 COVID-19 and Financial Stability: Early Intervention in Banking Supervision f. To the extent that supervisory colleges exist, c. Does the supervisory authority have a well- they have generally not been strongly engaged in structured framework for early intervention the cross-border cooperation and coordination (including preventative and corrective actions), requirements needed for early intervention. with escalating triggers and response actions? g. Most of the PICs which have undergone FSAPs or d. Does the supervisory authority have contingency TA missions have been found to have inadequate plans in place that set out indicative response arrangements for testing their early intervention actions for a range of scenarios involving the stress arrangements, including inadequate simulation of a bank? testing on a domestic level and no or very limited e. Does the supervisory authority undertake regular cross-border testing. simulation exercises to test its ability to respond to stress in banks? 30. In view of the above observations, it is f. Have robust cross-border arrangements been suggested that the PIC supervisory authorities established to enable effective coordination of the could usefully consider the following questions: early detection of emerging risks and to respond in a. Does the supervisory authority have sufficiently a cohesive manner at home and host supervisory comprehensive early warning indicators and other levels to a deterioration in bank risk and financial processes for the early detection of risks in banks condition on a whole-of-group basis? and other regulated entities? b. Does the supervisory authority have sufficient legal powers to enable it to take preventative and corrective actions, including triggers, response powers and (where applicable) powers able to be applied at a group level? „ APPENDIX 1. COUNTRY EXAMPLES OF EARLY INTERVENTION FRAMEWORKS This appendix provides a summary of some country preparation, early intervention and resolution. The examples of early intervention frameworks. second component which includes Early Intervention Measures (EIM) and their triggers and conditions constitutes the European Union’s formal early intervention regime. A trigger event requires the European Union competent authority to assess whether the early intervention conditions are met. These conditions Information on the European Union early intervention require a breach or a likely breach of prudential framework is sourced from the Financial Stability requirements in the near future. Therefore, the Institute’s FSI Insights on policy implementation No 6 - occurrence of a trigger event by itself does not Early intervention regimes for weak banks, April 2018. necessarily lead to early intervention. It only requires the competent authority to assess whether the The European Union’s Bank Recovery and conditions of a breach or likely breach are fulfilled. Resolution Directive (BRRD) put in place a formal Once it has been determined that the conditions are early intervention regime. In May 2014, the BRRD met, the competent authority may then apply early established a common European recovery and intervention, if appropriate. resolution framework with three components: TABLE 5. Early Intervention Triggers Supervisory review and Material changes, anomalies Significant events (as defined by evaluation process (SREP) in SREP indicators (as defined supervisory authority) scores by supervisory authority) Composite score of 4 Example of thresholds set for Examples: capital adequacy indicators  Major operational risk event Combinations of composite equal to: score of 3 and score of 4 for  Significant deterioration in capital levels  minimum capital specific components: requirements +1.5% or  Signals of need to review asset quality  business model and and/or portfolio valuations  additional capital strategy requirements (Pillar 2) +1.5%  Significant outflow of funds  governance and  Unexpected loss of senior/key staff institution-wide controls  Significant rating downgrade  capital adequacy  Resolution authority consults to  liquidity adequacy determine if FI is “failing or likely to fail” Early Intervention Triggers The second set of triggers includes material changes/ anomalies identified in the monitoring of financial/ The EIM are designed to “supplement rather than non-financial SREP indicators. While the choice of replace the existing SREP and the supervisory changes and/or breaches are mostly left to the measures based on its outcomes”, according to discretion of supervisory authorities, the BRRD (in Art the EBA’s Guideline. The intention is to provide a 27.1) and the EBA’s Guidelines include a breach of backstop for regular supervision and therefore limit the institution’s capital requirements plus a margin the consequences of supervisory forbearance. The of 1.5% as one of the possible triggers. The objective triggers link discretionary and formal interventions, is to show that the bank “is likely in the near future with the EBA’s guidelines identifying three sets of to infringe the requirements”. It also demonstrates triggers. that the purpose is to encourage using triggers as “tripwires” that can lead to an early intervention The first set of triggers (Table 5) is specifically before the minimum requirements are breached. COVID-19 and Financial Stability: Early Intervention in Banking Supervision derived from the SREP and include both the overall assessment and specific combinations of the overall The third category includes “significant events” that assessment and of SREP components. The first trigger need investigating and may trigger the EIM. These are is an overall SREP score of 4. The pre-defined score defined broadly. Illustrative examples are provided. combinations are internal governance and institution- “Significant events” include major operational risk wide controls, and the bank’s business model and events such as rogue trading, severe IT problems, strategy, as well as its capital adequacy and liquidity significant fines imposed by public authorities, and adequacy. The supervisory authority needs to consider signals of the need to review asset quality, including early intervention measures in these four cases when frequent and material adjustments to the bank’s the SREP component is assigned a score of 4 even financial statements due to errors in valuation and when an overall SREP score of 3 indicates that “there frequent changes in accounting, or unexpected losses is no high risk to the viability of the institution”. This is of senior management or key staff who have not been because each of these four elements is a sign that the replaced. bank’s performance will deteriorate in the near future if the identified vulnerabilities are not addressed. 80 81 COVID-19 and Financial Stability: Early Intervention in Banking Supervision TABLE 6. European Union’s EIM Regime – powers and supervisory measures EIM Measures Require management body to: Supervisory procedure for activating EIM:  Implement recovery plan measures within specific  Investigate the situation if causes of breach timeframe unknown  Examine situation, identify corrective measures, draw  Decide whether to apply early intervention up action programme and timetable measures  Convene (or convene directly) a shareholder meeting  Document breaches, outcomes of  Remove/replace board members/senior managers if investigations, decisions to act (or not) found unfit to perform their duties  Notify resolution authorities upon determining  Draw up a debt restructuring plan that conditions for EIM are met Changes to the business strategy Conditions for removal of management/board:  Significant financial deterioration  Infringements of law, regulations, statutes  Serious administrative irregularities  Measures of Art. 27 insufficient to reverse deterioration Changes to the legal/operational structure of the bank Appointment of temporary administrator (one year): If removal of senior management/board is insufficient Acquire all necessary information to update the resolution plan, prepare for resolution, for valuation of assets and liabilities Provide all information above to resolution authority Cases where a resolution authority decides to and MiFID II) or Regulation (MiFIR) or that it is likely consult with a supervisory authority regarding to breach any of them in the near future, it may then whether an institution is “failing or likely to fail” are decide on early intervention measures. also significant events. In this case, Articles 102.2 and 102.3 of the BRRD Directive determine the The EIM are provided as a menu of measures from conditions for resolution. While the determination which the supervisory authority can choose (Table 6). that a bank is “failing or likely to fail” usually belongs Rather than requiring the application of specific to the supervisory authority, Article 102.2 allows the powers and measures to specific trigger breaches, resolution authority to reach such a determination the BRRD obliges supervisory authorities to take subject to having the necessary tools, adequate a formal and documented decision on whether to access to the relevant information and to adequate intervene or not and what measures to use should an consultation with the supervisory authority. intervention take place. As part of this decision, they must identify the causes of breaches and notify the If a trigger event has occurred, the competent resolution authority when it has determined that the authority assesses whether the early intervention intervention conditions are met. Breaches, outcomes conditions are satisfied. If it determines that the credit of investigations into their causes and decisions to act institution has breached the prudential requirements (or not to do so, as the case may be) must be explicitly of the Capital Requirements Directive (CRDIV), the documented. Accordingly, and contrary to other Capital Requirements Regulation (CRR) and the formal intervention frameworks, there is no bank Markets in Financial Instruments Directives (MiFID classification according to intervention triggers. The BRRD allows for the removal of senior to improve their condition. Its aim is to help banks management and/or of the bank’s board in three take corrective measures, including those prescribed specific cases where EIM measures are insufficient by RBI, in a timely manner, in order to restore their to reverse the deterioration. These are a significant financial health. deterioration in the bank’s financial condition, serious infringements of laws, regulations or bylaws, or In addition to capital ratios, triggers include leverage, serious administrative irregularities. The nomination asset quality and profitability indicators. Capital of a temporary administrator for one year (or triggers include the total risk-based capital ratio, the exceptionally longer if the conditions for nomination CET1 ratio, but not the Tier 1 ratio, with the RBI setting remain valid) can take place when the removal of the minimum capital requirements that are higher than bank’s management and board are insufficient to the Basel III minimum levels. The asset quality and address its problems. profitability indicators are a non-performing asset ratio (net non-performing advances ratio or NNPA) and a return-on-assets ratio. The Tier 1 leverage ratio is also monitored as part of the framework. India The 2017 revisions reset the indicators, making them Information on the Indian early intervention more stringent and/or more granular (Table 7). The framework is sourced from the Financial Stability risk-based capital triggers now include the CET1 Institute’s FSI Insights on policy implementation No 6 - ratio in addition to the total capital adequacy ratio. Early intervention regimes for weak banks, April 2018. The number of NNPA ratio thresholds has increased from two (10% and 15%) to three (6%, 9% and 12%) Revised in April 2017, the Reserve Bank of India’s and their levels have been reduced. Negative return (RBI) PCA framework is used to induce stressed banks on assets (RoA) ratios have been introduced for TABLE 7. PCA triggers in India Tier 1 leverage NNPA Triggers Total capital ratio or CET1 ratio ROA ratio ratio ratio Risk TCR: up to 250 basis points (bps) below Less than 4% At least Negative threshold 1 minimum requirement (10.25% as of 31 More than 3.5% 6% to RoA for two March 2017) less than consecutive 9% years At least 7.75% – less than 10.25% and/ or CET1: up to 162.5 bps below minimum COVID-19 and Financial Stability: Early Intervention in Banking Supervision requirement (6.75% as of 31 March 2017) At least 5.125% but less than 6.75% Risk TCR: more than 250 bps below but not Less than 3.5% At least Negative RoA threshold 2 exceeding 400 bps below minimum 9% to for three requirement (10.25% as of 31 March 2017) less than consecutive 12% years At least 6.25% – less than 7.75% and/or CET1: more than 162.50 bps below but not exceeding 312.50 bps below minimum requirement (6.75% as of 31 March 2017). At least 3.625% but less than 5.125% Risk CET1: in excess of 312.50 bps below N/A 12% and Negative threshold 3 minimum requirement (6.75% as of 31 more RoA for four March 2017) consecutive years Less than 3.625% 82 83 COVID-19 and Financial Stability: Early Intervention in Banking Supervision all thresholds. The PCA framework is applicable to measure or combination of measures that it deems to all banks operating in India including small banks be the most appropriate. and foreign banks operating through branches or subsidiaries based on breach of risk thresholds of Regarding the removal of management and/or identified indicators. A bank is placed under the PCA board members, the common menu of discretionary framework based on financial results and the RBI’s measures (Table 9) include those whereby the RBI supervisory assessment. may recommend to owners (e.g., the government, private owners, or parent company of a foreign bank The introduction of a “common menu” allows for branch) to bring in a new management team and/ more flexible interventions. India’s framework initially or a new board of directors. Under the PCA and in included a limited list of discretionary measures that conjunction with the powers vested with the RBI under could be taken in addition to “mandatory actions” the Banking Regulation Act (BR Act), 1949, the RBI may as each risk threshold was breached. The revised remove managerial persons (under Section 36AA) framework includes a “common menu” of measures and supersede the board of directors for a maximum that can be taken in addition to specified “mandatory period of 12 months (under Section 36ACA). Under the actions.” Each heading of the “common menu” same section of the BR Act, 1949, the RBI may also, includes a wider range of possible measures, with when the board of directors is superseded, appoint in an “any other” category added in for good measure consultation with the government, an administrator to (Table 8). This essentially allows the RBI to select any which it may issue directions. TABLE 8. PCA powers – Mandatory and discretionary actions Threshold Mandatory actions Discretionary actions Risk threshold 1 Restriction on dividend distribution/ Special supervisory interactions remittance of profits Strategy-related Promoters/owners/parent of foreign banks to bring in capital Risk threshold 2 (in Restriction on branch expansion, Governance-related addition to mandatory domestic and/or overseas Capital-related actions of Threshold 1) Higher provisions as part of the Credit risk-related coverage regime Risk Threshold 3 (in Restriction on branch expansion, Market risk-related addition to mandatory domestic and/or overseas HR-related actions of Threshold 1) Restriction on management Profitability-related Operations-related compensation and directors’ fees Any other TABLE 9. Examples of discretionary actions Types of Examples of actions discretionary action Special supervisory More intensive supervision: quarterly (or more frequent) interactions Special supervisory monitoring meetings, special inspections and targeted scrutiny, special audit Strategy related Activation of recovery plan, review of business model and/or business lines. Undertake business process reengineering/restructuration of operations Types of Examples of actions discretionary action Governance related Recommend to owners to bring in new management and/or board, removal of managerial persons, supersede board, restrictions on directors’ and managers’ compensation etc Capital related Review of capital planning, require submission of capital plan, increase reserves through retained earnings, restrictions on investments/expansion, restrictions/ reductions of high-risk activities/exposures Credit risk related Require plan to reduce stock of NPAs, strengthening of credit risk management, reduce risk concentrations, risk assets, unsecured exposures etc Market risk related Reduce interbank borrowings, restrictions on wholesale/costly deposits, derivative activities etc HR related Restriction on staff expansion, review of specialised training needs of existing staff Profitability related Restrictions on capital expenditure other than technological upgrades Operations related Restrictions on branch expansion plans/reduce branches, restrictions on entering new lines of business, reduction in non-fund-based business etc to “internationally active banks” incorporated in Japan Japan. These are banks that have branches and/or subsidiaries outside Japan. Purely domestic Japanese Information on the Japanese early intervention banks are exempt from international capital adequacy framework is sourced from the Financial Stability requirements but must maintain specific, but lower, Institute’s FSI Insights on policy implementation No 6 - minimum capital requirements. Early intervention regimes for weak banks, April 2018. Following the introduction of Basel III, Japan’s PCA Japan’s PCA regime was introduced in April 1998 framework for internationally active banks uses three through the “Law to Ensure the Soundness of Financial capital ratios (CET1 Ratio, Tier 1 ratio and Total CAR) Institutions”. The framework was introduced when as triggers to determine that a bank has become Japan was coping with a system-wide banking crisis undercapitalised (Table 10). Undercapitalised banks during which it became apparent that all major banks are classified into four categories according to their and regional banks had significantly understated level of undercapitalisation, with corrective measures COVID-19 and Financial Stability: Early Intervention in Banking Supervision their non-performing loans and based their asset stipulated for each category. The table below presents valuations on overly optimistic assumptions. the four categories, their associated trigger levels and Since the introduction of the Basel I framework, the respective measures that the FSA may order the international minimum capital requirements apply bank to take. TABLE 10. Japan’s PCA framework for internationally active banks Categories of Total Tier 1 undercapitalised capital CET1 ratio FSA powers ratio banks ratio No action 8% or 6% or 4.5% or No PCA action more more more Category 1 From 4% to From 3% From 2.25% Submission of business improvement plan less than to less to less than including measures for recapitalisation 8% than 6% 4.5% and order its implementation 84 85 COVID-19 and Financial Stability: Early Intervention in Banking Supervision Categories of Total Tier 1 undercapitalised capital CET1 ratio FSA powers ratio banks ratio Category 2 From 2% to From 1.5% From 1.13% Submission and execution of less than to less to less than recapitalisation plan 4% than 3% 2.25% Prohibit or limit dividend distribution/ bonus payments Restrict asset growth or order asset reduction Prohibit/limit acceptance of costly deposits Downsizing of specific operations Closure of operations (except head office) Other measures Category 2.2 From zero From zero From zero Order measures for: strengthening of to under to under to under bank’s capital, downsizing of operations, 2% 1.5% 1.13% bank merger or withdrawal of license Category 3 Under 0% Under 0% Under 0% Suspension of all or part of bank’s business operations Moreover, the supervisory authority has the power to must necessarily maintain stability of the financial remove bank management and boards of directors system through preservation of confidence therein. through Prime Minister’s orders. Additionally, under While preservation of confidence in the financial the resolution framework based on the Deposit system may call for closure of mismanaged banks Insurance Act, the Prime Minister has the power to and/or financial entities under its jurisdiction, such appoint a financial reorganisation administrator. The closure is not the only option available to the Bangko former takes place in application of the Banking Act Sentral. When a bank’s closure, for instance, is (Article 27) when a bank has violated laws, regulations, adjudged by the Monetary Board to have adverse its own bylaws or any Prime Minister’s order. In systemic consequences, the State may act in addition to its powers to remove senior management accordance with law to avert potential financial system and Board, the supervisory authority may suspend instability or economic disruption. part or all of the activities and rescind the license. The administrator has all necessary powers to represent It is recognized that the closure of a bank or its and operate the bank and manage its assets and intervention can be a costly and painful exercise. For is expected to end its duties within one year by this reason, the Bangko Sentral, as supervisor, can transferring the bank’s business to – or merging it with enforce PCA as soon as a bank’s condition indicates – another bank. higher-than normal risk of failure. PCA essentially involves the Bangko Sentral directing the board of directors of a bank, prior to an open Philippines 46 outbreak of crisis, to institute strong measures to restore the entity to normal operating condition within In carrying out its primary objective of maintaining a reasonable period, ideally within one year. These price stability conducive to a balanced and sustainable measures may include any or all of the following growth of the economy, the Bangko Sentral Pilipinas components:  46  The material of this section is sourced from the Bangko Sentral Pilipinas website: https://morb.bsp.gov.ph/appendix-68/  implementation of a capital restoration plan;  a change in the composition of the board of directors or any of the mandatory committees  implementation of a business improvement plan; (under the MORB); and  an enhancement to the frequency and/or depth of  implementation of corporate governance reforms. reporting to the board of directors; Capital restoration plan – this component contains  a reduction in exposures to and/or a termination the schedule for building up a bank’s capital base or reduction of business relationships with (primarily through an increase in Tier 1 capital) to a affiliates that pose excessive risk or are inherently level commensurate to the underlying risk exposure disadvantageous to the supervised financial and in full compliance with minimum capital adequacy institution; and requirement. In conjunction with this plan, the Bangko  a change of external auditor. Sentral may also require any one or a combination of the following: A bank may be subject to PCA whenever any or all of  limit or curtail dividend payments to common the following conditions obtain: stockholders;  When either of the Total Risk-Based Ratio, Tier 1  limit or curtail dividend payments to preferred Risk-Based Ratio, or Leverage Ratio falls below stockholders; and 10%, 6% and 5%, respectively, or such other minimum levels that may be prescribed for the  limit or curtail fees and/or other payments to said ratios under relevant regulations, and/or the related parties. combined capital account falls below the minimum capital requirement prescribed. Business improvement plan – this component contains the set of actions to be taken immediately to  The CAMELS composite rating is less than “3” or a bring about an improvement in the entity’s operating Management component rating of less than “3”. condition, including but not limited to any one or a  A serious supervisory concern has been identified combination of the following: that places a bank at more-than-normal risk  reduce risk exposures to manageable levels; of failure in the opinion of the director of the Examination Department concerned, which  strengthen risk management; opinion is confirmed by the Monetary Board. Such  curtail or limit the bank’s scope of operations concerns could include, but are not limited to any including those of its subsidiaries or affiliates one or a combination of the following: where it exercises control; ƒ Finding of unsafe and unsound activities that  change or replace management officials; could adversely affect the interest of depositors and/or creditors; COVID-19 and Financial Stability: Early Intervention in Banking Supervision  reduce expenses; and ƒ A finding of repeat violations of law or the  other measures to improve the quality of earnings. continuing failure to comply with Monetary Board Directives; and Corporate governance reforms – this component contains the actions to be immediately taken to ƒ Significant reporting errors that materially improve the composition and/or independence of misrepresent the bank’s financial condition. the board of directors and to enhance the quality of its oversight over the management and operation of The initiation of PCA shall be recommended by the the entity. This also includes measures to minimize Deputy Governor, SES to the Monetary Board for potential shareholder conflicts of interest detrimental approval. Any initiation of PCA shall be reported to its creditors, particularly, depositors in a bank. This to the PDIC for notation. Upon PCA initiation, the likewise lays down measures to provide an acceptable Bangko Sentral shall require the bank to enter into a level of financial transparency to all stakeholders. Such MOU committing to the PCA plan. The MOU shall be actions could include, but are not limited to any one or subject to approval by the Deputy Governor, SES and a combination of the following: confirmation by the Monetary Board. 86 87 COVID-19 and Financial Stability: Early Intervention in Banking Supervision In order to monitor compliance with the PCA, quarterly United Kingdom progress reports shall be made. The Bangko Sentral reserves the right to conduct periodic on-site visits The UK Prudential Regulation Authority (PRA) outside of regular examination to validate compliance maintains an early intervention framework known as with the PCA plan. the ‘Proactive Intervention Framework’ (PIF) (Table 11). Subject to Monetary Board approval, sanctions may be Under the PRA framework, supervisors consider imposed on any bank subject to PCA whenever there a firm’s proximity to failure when drawing up its is unreasonable delay in entering into a PCA plan supervisory plan. The PRA’s judgement about or when PCA is not being complied with. These may proximity to failure is captured in a firm’s position include any or all of the following: within the PIF.  monetary penalty on or curtailment or suspension of privileges enjoyed by the board of directors or Judgements about a firm’s proximity to failure are responsible officers; derived from those elements of the supervisory assessment framework that reflect the risks faced by  restriction on existing activities that the supervised a firm and its ability to manage them, namely, external financial institution may undertake; context, business risk, management and governance,  denial of application for branching and other risk management and controls, capital, and liquidity. special authorities; The PIF is not sensitive to a firm’s potential impact or resolvability.  denial or restriction of access to Bangko Sentral credit facilities; and The PIF is designed to ensure that the PRA puts into  restriction on declaration of dividends. effect its aim to identify and respond to emerging risks at an early stage. There are five PIF stages, On the other hand, if the bank subject to PCA promptly each denoting a different proximity to failure, and implements a PCA plan and substantially complies every firm sits in a particular stage at each point with its conditions, it may continue to have access to in time. When a firm moves to a higher PIF stage Bangko Sentral credit facilities notwithstanding non- (i.e. the PRA determines that the firm’s viability has compliance with standard conditions of access to such deteriorated), supervisors will review their supervisory facilities. The Deputy Governor, SES shall recommend actions accordingly. Senior management of firms will such exemption to the Monetary Board for approval. be expected to ensure that they take appropriate remedial action to reduce the likelihood of failure and In cases where a bank’s problems are deemed to the authorities will ensure appropriate preparedness be exceptionally serious from the outset, or when a for resolution. bank is unwilling to submit to the PCA or unable to substantially comply with an agreed PCA plan, the A firm’s PIF stage is reviewed at least annually and in Deputy Governor, SES may immediately recommend response to relevant, material developments. to the Monetary Board more drastic actions as The PRA considers it important for markets and prescribed under Section 29 (conservatorship) and counterparties to make their own judgements on Section 30 (receivership) of R.A. No. 7653. the viability of a firm. The PRA states that it will not Subject to Monetary Board approval, the PCA status therefore routinely disclose to the market its own of a bank may be lifted: Provided, That the bank fully judgement on a firm’s proximity to failure, not least complies with the terms and conditions of its MOU given the possible risk that such disclosures could act and: Provided, further, That the Deputy Governor, to destabilise in times of stress. As a result, the PRA SES has determined that the financial and operating does not routinely disclose PIF scores to firms. condition of the bank no longer presents a risk to itself or the financial system. Such improved assessment shall be immediately reported to the PDIC. TABLE 11. Proactive Intervention Framework Stage Possible supervisory actions Stage 1 – Low risk to Firm subject to the normal supervisory risk assessment process and actions, including viability of firm recovery and resolution planning. Stage 2 – Moderate Recovery risk to viability of  The intensity of supervision will increase. The PRA may set additional reporting firm requirements, and make use of information gathering and investigatory powers. Supervisors  PRA will require the firm to act to address deficiencies identified over a set period. have identified  The firm will be required to update its recovery plan and may need to activate it. vulnerabilities in a firm’s financial Resolution position of  With the support of the RD, the PRA will assess the firm’s resolvability against the deficiencies in its risk authorities’ preferred resolution strategy and identify changes necessary to ensure management and/or the resolution plan can be feasibly implemented in the event of firm failure. governance practices  The FSCS may be asked to evaluate the quality of data provided to support an SCV, and any obstacles to pay out or deposit transfer. Stage 3 – Risk to Recovery viability absent PRA may require any of the following actions: action by the firm  changes to management and/or the composition of the board; Significant threats to  limits on capital distribution (including dividends and variable remuneration); a firm’s safety and soundness have been  restrictions on existing or planned activities; identified.  a limit on balance sheet growth and/or stricter leverage limits;  setting tighter liquidity guidelines and/or capital requirements. The firm will be required to draw on the menu of options set out in its recovery plan as appropriate. Resolution With the support of the RD, PRA will intensify engagement on contingency planning COVID-19 and Financial Stability: Early Intervention in Banking Supervision for resolution and will have all means necessary to obtain the information the PRA considers it may need to carry out the task. Stage 4 – Imminent Recovery risk to viability of PRA will most likely increase the scale of the recovery actions needed (including in firm relation to liquidity and capital). It will set out a timetable for implementation of recovery actions. The position of a firm has deteriorated such  Firm-led recovery actions will need to be affected in short order and the firm will that the PRA assess need to demonstrate that these were credible and will produce material results. that there is a real  Actions initiated following activation of the recovery plan, including on asset risk that the firm disposal (or sale of firm), will need to be completed. will fail to meet the Threshold Conditions, Resolution but some possibility Where relevant, the RD and FSCS will confirm that all necessary actions to prepare for of corrective action the resolution of the firm have been taken, including that relevant data were readily remains. available. 88 89 COVID-19 and Financial Stability: Early Intervention in Banking Supervision Stage Possible supervisory actions Stage 5 – Firm in Resolution resolution or being PRA will determine the firm no longer meets Threshold Conditions and this is not actively wound up reasonably likely to be rectified. Where appropriate the RD will take the firm into the Special Resolution Regime overseeing the resolution or winding-up the firm. The FSCS may be required to effect depositor pay out and/or to fund deposit transfer, or resolution. For each bank, the classification takes place United States according to five capital metrics. The five categories are well capitalised, adequately capitalised, Information on the United States early intervention undercapitalised, significantly undercapitalised and framework is sourced from the Financial Stability critically undercapitalised. Inclusion into one of the Institute’s FSI Insights on policy implementation No 6 - first four categories is subject to the bank failing to Early intervention regimes for weak banks, April 2018. meet, meeting or exceeding four (or, for the largest Following the savings and loans crisis, in the late institutions, five) pre-determined capital ratio levels. 1980s to early 1990s, federal supervisory agencies The metrics are the total risk-based capital ratio (Total were criticised for failing to take sufficient and timely ratio), the Tier 1 risk-based capital ratio (Tier 1 ratio), action to address the causes of bank failures and the Common Equity Tier 1 capital ratio (CET1 ratio), prevent losses to the deposit insurance fund (DIF) the Tier 1 leverage ratio (Tier 1 leverage ratio) and, for and taxpayers. In response, Congress passed the the largest institutions, the SLR or the eSLR. A bank Federal Deposit Insurance Corporation Improvement is critically undercapitalised when its tangible equity Act (FDICIA) in 1991. The Act contains a number of ratio is 2% or less. The risk-based capital ratios and provisions to improve the supervision of federally the SLR are calculated according to Basel standards, insured deposit-taking institutions such as mandating while the tangible equity ratio and the Tier 1 leverage annual bank examinations and audits and the ratio, which have been required in the United States adoption of a risk-based insurance assessment since the early 1990s, do not have a corresponding system. However, the most widely known provisions Basel standard. The ratios and their respective levels are those that introduced a PCA framework for bank are those incorporated in the Basel III capital rule as supervision. implemented in 2013. The overall objective was to resolve problems arising Restrictions start to apply once an institution becomes at insured deposit-taking institutions with the least “adequately capitalised”. At this stage, it can only possible long-term loss for the DIF. This implies timely accept brokered deposits with an FDIC waiver. It (or prompt) and forceful (or corrective) supervisory cannot pay interest that significantly exceeds the intervention to prevent banks’ problems from market rate in the relevant market area and its becoming deposit insurer or taxpayer liabilities. This risk-based deposit premium may be higher than leads to addressing problems early enough, when that applicable to a “well-capitalised” institution. troubled institutions still have capital to absorb their Harsher restrictions start to apply to a bank when losses. To limit supervisory forbearance, many PCA it becomes “undercapitalised”. The restrictions provisions are mandatory. Specifically, Section 38 of become increasingly stringent as the bank’s condition the FDICIA obliges all regulators to classify supervised deteriorates. They are also cumulative. banks into one of five capital categories according to A major component of PCA is the obligation for the capital-based triggers and to take specific action when undercapitalised bank to adopt a capital restoration these are breached. plan (CRP) that is subject to supervisory approval TABLE 12. Summary of restrictions for “undercapitalised” institutions Undercapitalised47 Significantly undercapitalised48 Critically undercapitalised49 Regulator must: Prohibition of executive bonuses The bank must be placed in or raises without regulatory conservatorship or receivership within 90  Closely monitor the approval days of such a determination unless FDIC bank’s condition and appropriate regulators determine Prohibition of payments on  Require and approve a that other action would better protect subordinated debt capital restoration plan the deposit fund. Redetermination is Regulator must require the bank required every 90 days.  Limit growth to undertake one or more of the If the bank is on average critically  Limit access to the following: undercapitalised for 270 days, a receiver Federal Reserve’s  Sales of voting stock securities must be appointed unless the bank: discount window  Eliminate sister bank  Has positive net worth  Approve acquisitions, exemption to Section 23A and  Is in substantial compliance with the new branches or further restrict transactions approved capital restoration plan entering into new lines with affiliates of business  Is profitable  Limit interest rates paid  Is reducing its ratio of nonperforming  Require the bank to limit/ loans to total loans and terminate excessively risky activities The FDIC and the appropriate regulator certify that the bank is viable and not  Obtain improvements to expected to fail. management by (a) requiring a new board to be elected, The FDIC must prohibit the institution, (b) dismissing any director without approval, from: or executive officer in place  Entering into any material transaction at least 180 days before the not part of its ordinary course of bank became significantly business (e.g., acquisitions, new undercapitalised or (c) require business) the bank to hire executive  Extending credit for any highly officers leveraged transaction  Prohibit deposits from  Amending its articles or bylaws correspondent banks COVID-19 and Financial Stability: Early Intervention in Banking Supervision  Materially changing its accounting  Require divestitures (by the methods bank) of any subsidiary, of any non-depositary affiliate (by the  Engaging in a “covered transaction” as bank’s parent) or of the bank defined in Section 23A itself (by the bank’s parent)  Paying “excessive compensation”  Require any other actions  Paying interest on deposits in excess of prevailing rates  47  ‘Undercapitalised’ is defined as a bank with less than 8% total capital ratio, or less than 6% tier 1 capital ratio, or less than 4.5% CET1 ratio, or less than 4% tier leverage ratio, or less than 3% SLR.  48  ‘Significantly undercapitalised’ is defined as a bank with less than 6% total capital ratio, or less than 4% tier 1 capital ratio, or less than 3% CET1 ratio, or less than 3% tier 1 leverage.  49  ‘Critically undercapitalised’ is defined as a bank with tangible equity ratio of 2% or less, regardless of its other capital ratios. 90 91 COVID-19 and Financial Stability: Early Intervention in Banking Supervision and contains specific provisions. Mandatory CRP a conservator or a receiver. Once a failed bank has provisions include deadlines for submitting the been placed in FDIC receivership, the FDIC is subject to plan (45 days after becoming undercapitalised), the “least-cost resolution” principle, whereby it must requirements related to contents and criteria that choose the resolution alternative in which the total the regulatory agency must comply with when expected expenditure is the least costly to the deposit accepting such a plan. These criteria include the need insurance fund. to assess and determine whether the plan is based on realistic assumptions and whether it is likely to PCA includes safeguards to ensure that forbearance or succeed in restoring the institution’s capital. Failure conservatorships remain temporary and conditional. for an undercapitalised bank to present a plan within The first set of safeguards for banks critically the prescribed delay or to comply with an approved undercapitalised for 270 days is that a receiver must plan leads to reclassifying the bank as “significantly ultimately be appointed unless a number of statutorily undercapitalised”, and therefore subject to additional prescribed conditions are fulfilled. In particular, the and harsher restrictions. bank must have positive net worth, be profitable (or have an upward, sustainable, trend in earnings), have Banks that become critically undercapitalised must be substantially complied with its capital restoration plan, placed in conservatorship or receivership within 90 and be reducing its ratio of nonperforming loans to days of such a determination unless the FDIC and the total loans, and the head of both the FDIC and the appropriate regulator grant a 90-day extension that appropriate (federal or state) regulator must certify can be renewed once. The level set by the appropriate that the bank is viable. The second set of limits is that federal banking agency for tangible equity must be all transactions which may significantly increase the no less than 2%, regardless of other capital ratios, bank’s risk profile are subject to the FDIC’s approval, below which the bank would be deemed critically with these including acquisitions, entering into highly undercapitalised. The Federal Deposit Insurance Act leveraged transactions and amending the bank’s provides that, subject to the aforementioned time bylaws (or paying excessive compensation). limits, the appropriate federal regulator must appoint COVID-19 AND FINANCIAL STABILITY: RECOVERY PLANNING FOR BANKS April 2022 93 COVID-19 and Financial Stability: Recovery planning for banks unions. However, in some countries, recovery plans „ INTRODUCTION have been limited to systemic banks, but with a view to eventual extension to smaller banks in simplified 1. The paper discusses bank recovery planning form. in the context of the supervisory framework for responding to bank stress. It should be read in the 3. The nature of recovery planning requirements context of an earlier paper produced in this series varies from country to country. However, in most – on early supervisory intervention – given that the cases, the supervisory authority specifies expectations activation of a bank recovery plan and implementation for recovery plans and provides general guidance to of one or more recovery options should be seen in the assist banks in the preparation, review and periodic wider context of supervisory initiatives to deal with testing of their recovery plans. Supervisory guidance is bank stress situations. The paper covers the following generally provided on the need for recovery plans to issues: contain:  The objectives and scope of bank recovery plans.  well-specified objectives;  Structure and content of recovery plans.  governance arrangements (with the bank’s board of directors having ultimate responsibility for the  Integration of recovery plans into supervisory early recovery plan); intervention arrangements.  a description of critical functions and services (i.e.  Cross-border cooperation and coordination in the those functions and services that are needed in application of recovery planning to home and host order to maintain core banking activities that are financial institutions. critical to the financial system and the welfare of  Guidance for supervisors on the review and depositors); assessment of recovery plans.  triggers for activation of the recovery plan, linked  Guidance on the testing of recovery plans. to early warning indicators;  restoration points for key financial variables (especially capital and liquidity) that are consistent „ OVERVIEW with the bank being restored to a sound financial condition and in compliance with all applicable regulatory requirements; 2. Recovery planning is important to facilitate the restoration of banks to financial soundness in  a menu of recovery options to enable the bank response to stress events. As noted in the FSB Key to restore itself to the desired level of financial Attributes of Effective Resolution Regimes for Financial soundness; Institutions (Key Attributes), banks (and other 50  scenario analysis that sets out deep financial financial institutions) should have recovery plans impacts affecting capital and liquidity, and the that set out the means by which they would restore recovery options deployable for each scenario, themselves to financial soundness and compliance where the scenarios generally include idiosyncratic with prudential requirements in the event of a financial shocks (in which only the bank in question significant financial shock. Given that recovery plans is impacted) and system-wide financial shocks (in are a key element in any bank’s risk management which the banking system as a whole and the bank framework, many supervisory authorities require in question are impacted); all banks to have recovery plans, including small  pre-positioning requirements to enable recovery banks and credit unions. The requirements for options to be capable of implementation; recovery plans are generally standardized across all supervised financial institutions, but are applied  testing arrangements, under which a recovery plan in a proportionate manner, with large banks being is subject to regular testing and evaluation; and expected to have considerably comprehensive  arrangements for the regular (generally annual) recovery plans than those of small banks and credit review and revision of the recovery plan.  50  The Key Attributes can be accessed via the FSB website here: https://www.fsb.org/work-of-the-fsb/market-and-institutional- resilience/post-2008-financial-crisis-reforms/effective-resolution-regimes-and-policies/key-attributes-of-effective-resolution- regimes-for-financial-institutions/ 4. There is an expectation that recovery plans should a whole-of-group recovery strategy. Coordination is be closely integrated into a bank’s risk management often achieved through supervisory colleges (where framework, including its Risk Appetite Statement they exist) or through bilateral arrangements between (RAS), ICAAP, ILAAP, capital and liquidity contingency the home and host authorities. plans, business continuity plan and stress testing. 9. The remainder of this paper provides guidance 5. Supervisory authorities generally issue on expectations for recovery plans and indicative regulations to set out minimum requirements for questions for supervisors on the following recovery plans. The regulations typically specify the elements of recovery plans: matters that the recovery plan should address, the  Executive summary of the recovery plan governance requirements for the recovery plan, the expected nature of integration of the recovery plan  Governance of recovery plans with a bank’s risk management framework, and the  Integration of recovery plans with the bank’s risk requirements for testing and review. It is common for management framework supervisory authorities to also issue guidance to banks  Overview of the bank and group, and critical that provide more detailed expectations of what the functions and services recovery plans should cover.  Triggers for activation of the recovery plan 6. Recovery plans should be subject to regular  Restoration points to achieve financial soundness supervisory oversight. This generally involves annual off-site review of recovery plans to assess  Recovery options their compliance with regulatory requirements  Scenarios and their fitness for purpose. It also includes an assessment of the extent to which the recovery plan is  Communications integrated effectively with a bank’s risk management  Preparatory measures framework, especially the RAS (to assess the alignment  Testing of the recovery plan of triggers and restoration points in the recovery plan with tolerances in the RAS), ICAAP (to assess  Review of the recovery plan the alignment of the capital recovery options with those in the ICAAP), ILAAP (to assess the alignment of liquidity recovery options with those in the liquidity contingency plan), and stress testing (to assess the „ EXECUTIVE SUMMARY OF extent to which stress tests have been used to inform scenarios in the recovery plan). THE RECOVERY PLAN 7. Supervisors need to ensure that the activation of a bank’s recovery plan is incorporated into the General guidance supervisory preventative and corrective actions 10. A recovery plan should generally include an framework. In that regard, the preventative and executive summary encompassing information on corrective action frameworks should identify the risk COVID-19 and Financial Stability: Recovery planning for banks key features of the recovery plan. It should serve settings at which the supervisory authority would as a roadmap to the recovery plan which allows the generally require a bank to activate some or all of its senior management and Board of a bank to quickly recovery plan, and the supervisory oversight to be understand and assess the recovery options in a applied to ensure that appropriate recovery actions severe stress. are implemented. 11. The Executive Summary should be relatively 8. Cross-border cooperation and coordination brief and should provide a succinct summary of all are important for any bank which has significant of the elements of the plan, including: foreign operations or is a subsidiary or branch of a foreign bank. The home and host authorities should a. the objectives and scope of the plan; seek to cooperate in establishing broadly consistent b. governance of the plan – both in terms of approval recovery planning requirements for the parent bank process and governance in a recovery plan and its subsidiaries and branches, and to promote activation process; 94 95 COVID-19 and Financial Stability: Recovery planning for banks c. its integration with the risk management framework, ICAAP, BCP and related matters; „ GOVERNANCE OF d. the triggers for recovery plan activation, and RECOVERY PLANS escalation and implementation arrangements; e. the ‘restoration points’ for key variables – i.e. General guidance especially capital and liquidity; 14. The recovery plan should contain a description f. the recovery options; of the specific governance arrangements relating g. a brief description of the scenarios; to the plan. This would typically include clearly h. communications; articulating the respective roles and responsibilities of the Board and senior management during the i. process for regular review and testing. different stages of recovery planning, namely:  development, review, approval, and ongoing 12. The Executive Summary should either contain maintenance of the recovery plan during a or include reference to a short checklist of ‘business-as-usual’ environment; and decisions and actions that the senior management team and Board can use to:  monitoring and internal escalation processes for triggering the recovery plan, and the execution of a. determine whether to invoke the recovery plan; recovery actions during a crisis. b. ascertain the nature of the problem affecting the bank, its cause, and its impact; 15. The recovery plan should contain a section c. determine the recovery strategy, including on governance that explains how the recovery recovery actions and communications; and plan was developed, the processes for obtaining senior management approval, and the processes d. ensuring that all actions are subject to effective for obtaining Board Risk Committee and Board oversight and coordination. approval. There should be a senior-level ‘owner’ of the recovery plan, with responsibility for overseeing its development and review, and submission Indicative questions for for approval. The owner is often a bank’s Chief supervisors Risk Officer. The plan should clearly identify the responsibilities of the Board, the relevant Board 13. Supervisors should assess the following committees and senior management in relation to the matters: recovery plan. a. Does the recovery plan contain an executive 16. The recovery plan should describe how the plan summary that is succinct and practical in its focus? would be activated, based on the triggers for the b. Does the executive summary cover the items listed plan. The plan should also identify the management above? structure during the recovery phase, including who has responsibility for particular recovery actions c. Would the executive summary be a useful guide and the authorisations and delegated authorities for senior management and directors for use of required for recovery actions. It is common for the the recovery plan in a situation where the plan CEO or the CEO and Chairperson of the Board to have needs to be applied? Is the executive summary responsibility for the activation of the recovery plan. A easy for a user to access and apply? Crisis Management Team (CMT) is often established by d. Does the executive summary contain a checklist of the CEO to coordinate the recovery process, overseen key decisions and actions that senior management by the CEO and EXCO, and with ultimate oversight by and the Board need to make in deciding to invoke the Board. It is usual for the recovery plan to specify, the recovery plan, in determining the nature and for each recovery option, the level of authority needed impact of the problem being addressed, and in to obtain approval to undertake that particular applying recovery actions? If not, does a separate recovery option. document exist which contains such a checklist? 17. Senior management and the Board need to f. the stakeholders (internal and external) have been ensure that the recovery plan covers all of the identified and their information needs assessed, regulatory requirements and is comprehensive. and the means by which they will be provided with As importantly, they need to ensure that the recovery information (and when) is identified in the recovery plan is ‘fit for purpose’ – i.e. that the recovery plan; plan enables the bank to restore itself to financial g. all staff are aware of the recovery plan and know soundness within a reasonably short timeframe their responsibilities in relation to it; (generally within 3 months of the trigger points in the plan being breached, and no more than 6 months), h. the recovery plan is closely integrated into the sufficient to ensure that the bank is in compliance bank’s risk management framework, including with all prudential requirements, is prudentially sound early warning indicators, stress testing, risk and resilient to future shocks, can resume normal monitoring, risk limits and controls, ICAAP, liquidity operations (at least in respect of its critical functions contingency planning and business continuity and services) and has the confidence of all relevant planning; and stakeholders, including the financial markets. This i. the recovery plan is kept under regular (generally means that the senior management team and Board annual) review, is updated to reflect changes to the must ensure that: bank’s operations and structure, and is subject to a. the recovery plan has clearly defined triggers that regular testing (e.g. an annual ‘desk top’ form of apply before there is any breach of prudential testing and a live simulation exercise every three requirements – i.e. the triggers should occur years). sufficiently early as to enable the bank to take corrective actions soon enough to avoid breaches 18. The Board needs to maintain a close overview of prudential requirements and to avoid, where of senior management’s performance of its possible, a significant deterioration in market responsibilities in relation to the recovery plan. confidence in the bank; The Board also need to clearly understand its own responsibilities in relation to the recovery plan, b. the recovery plan is based on well-defined including the recovery actions entrusted to the Board. scenarios that are realistic and sufficiently severe The Board needs to maintain a comprehensive as to result in the bank sustaining a major fall in understanding of the recovery plan and to be satisfied capital and liquidity (see later in this note), with all that it complies with all regulatory requirements, relevant assumptions pertinent to the scenarios is comprehensive and is practical and realistic. being clearly identified, and where scenarios They also need to ensure that the plan is subject to include both idiosyncratic and system-wide regular testing and to assess the results of the tests. scenarios (and a hybrid of the two); Occasionally, it would be appropriate for the Board to c. the recovery plan contains specific and detailed participate in the tests of the recovery plan, both as recovery actions that are realistic and practicable, active participants and as observers. with the priorities for each recovery action being clearly identified; COVID-19 and Financial Stability: Recovery planning for banks d. the recovery plan quantifies the expected contribution of each recovery action to the Issues to be assessed by purpose for which it is intended – e.g. that recovery supervisors actions designed to increase capital include quantification of the amount of capital expected to 19. Indicative questions that supervisors be raised by the particular recovery action; should consider in reviewing the governance arrangements for recovery plans include: e. the recovery actions are supported by details relating to how each recovery action would Governance over the preparation and sign-off of the be implemented, including step-by-step recovery plan implementation guidance and associated a. Does the recovery plan have an ultimate ‘owner’ documentation required for implementation; in the bank, with suitable skills, experience and seniority, such as the Chief Risk Officer? 96 97 COVID-19 and Financial Stability: Recovery planning for banks b. Was the recovery plan prepared by a senior-level e. Is there a crisis committee with responsibility for team of staff with dedicated responsibility for coordinating recovery actions? developing the recovery plan? f. Is there a Board-level crisis committee that c. Did the team responsible for preparing and oversees and approves the recovery strategy and maintaining the recovery plan comprise key recovery actions? representatives of the key areas of the bank g. Do members of the Board understand their relevant for the plan, including the CRO (or deputy), responsibilities in the recovery plan, including for CFO, Head of Treasury, Head of Operations, Head particular recovery actions? of IT, Head of Legal, Head of Compliance, and Head of Communications? d. Was the recovery plan subject to comprehensive oversight by the Board Risk Committee and „ INTEGRATION OF ultimately by the Board? RECOVERY PLAN WITH e. How thorough was the Board Risk Committee and Board review and sign-off of the plan? How much RISK MANAGEMENT time did the Board Risk Committee and Board ARRANGEMENTS dedicate to reviewing the recovery plan? f. How thorough was the controlling shareholders’ review and sign-off of the plan, particularly as General guidance regards responsibilities applicable to them, such as 20. Recovery plans need to be closely integrated in relation to capital issuance? with banks’ risk management policies and g. What arrangements have been made to ensure processes. To ensure effectiveness, recovery planning that all relevant staff are aware of the recovery should be treated as a critical component of a bank’s plan? risk management framework, rather than an isolated h. Do the members of the Board demonstrate a process that is merely prepared for regulatory thorough understanding of the recovery plan compliance reasons. Several linkages are particularly and the Board’s responsibilities in relation to all noteworthy: relevant elements of the plan? a. the role that a bank’s stress testing processes (and especially reverse stress tests) play in assessing the Governance in the activation of the recovery plan potential impacts on capital and liquidity arising a. Is there a clearly defined governance process for from financial and economic shocks, and for the activation of the recovery plan? Who has the informing scenarios used in the plan; power to activate the recovery plan? b. the importance of early warning indicators, b. If the Board is not involved in activating the supported by robust management information recovery plan, when would the Board be convened systems, in informing a bank’s management and to consider the situation and determine or agree to Board on the triggering of the recovery plan, and the recovery strategy, and to ensure that the Board the linkage between the early warning indicators has effective oversight of the recovery process? and relevant risk settings in the Risk Appetite Statement (RAS); c. Does the recovery plan clearly set out responsibilities for decision-making in respect of c. the close linkages between the recovery plan and particular recovery actions? For example, does it a bank’s ICAAP and ILAAP, particularly as regards set out those recovery actions which are subject the setting of the restoration point for capital and to Board approval, those which are subject to CEO liquidity; approval, and those which can be made by others d. the importance of the triggers in the recovery plan under delegated authority? being informed by and linked to the minimum risk d. Is there a clear allocation of authorities for tolerances in the RAS; exercising recovery actions? e. the importance of the restoration points in the points? Are the triggers for the recovery plan recovery plan being informed by and linked to the aligned to minimum tolerance levels in the RAS in desired risk settings in the RAS; respect of capital and liquidity? f. the linkages between the recovery plan (especially d. Are Early Warning Indicators (EWIs) used in the triggers and recovery actions) as regards capital- recovery plan informed by the bank’s stress testing related matters in the recovery plan and the bank’s and RAS? capital contingency plan, and as regards liquidity- e. Is the recovery plan integrated with the bank’s related matters in the recovery plan and the bank’s ICAAP and capital contingency plan? liquidity contingency plan; f. Is the recovery plan integrated with the bank’s g. the linkages between recovery planning and liquidity contingency plan? business continuity planning, particularly in relation to key operational requirements for g. Is the recovery plan integrated with the bank’s recovery actions; and business continuity plan? h. the feedback from the recovery plan to the bank’s risk appetite settings and risk limits (e.g. adjustments of risk limits and capital and liquidity „ OVERVIEW OF THE BANK buffers following the materialization of shocks that necessitated the activation of the recovery plan, or – AND CRITICAL FUNCTIONS in situations where the supervisors conclude that recovery plan lacks credibility). AND SERVICES 21. It is therefore important that a bank ensures General guidance that its recovery planning processes are fully integrated into the wider risk management 23. The recovery plan should include framework. The recovery plan should include comprehensive information on a bank’s structure information that sets out the nature of the linkages and operations. This should include information on: between the recovery plan and the above matters, a. the ownership structure of the bank, including and the means by which the bank seeks to ensure an identification of all parties with a significant that there is a strong degree of integration of recovery ownership stake; planning into the risk management framework. b. the group structure if the bank has subsidiaries or is owned by a holding company, including an organization chart for the group and an Issues to be assessed by identification of each entity in the group; supervisors c. if the bank is part of a wider financial conglomerate, the nature of its functional 22. Indicative questions that supervisors should interdependencies with the various entities in the consider in reviewing the integration of the COVID-19 and Financial Stability: Recovery planning for banks conglomerate; recovery plan with the bank’s risk management d. the functions performed by the bank and each of framework and related matters include: the other entities in the group – domestically and a. Is the recovery plan adequately integrated with the in other countries; bank’s stress testing arrangements? e. the financial products and services provided by the b. Have the scenarios, restoration points and bank and each entity in the group; recovery actions been informed by stress test f. key risks of the bank and each entity in the group, results? In particular, have reverse stress tests and a description of (or reference to) the risk been used by the bank to identify the magnitude management framework applied to identify, of economic and financial shocks required to cause measure, monitor and manage all material risks; the bank to breach recovery plan triggers? g. the nature of the inter-connections between c. Is the recovery plan integrated with the bank’s entities in the group, including financial and risk management framework and RAS, especially operational inter-connections; as regards the setting of triggers and restoration 98 99 COVID-19 and Financial Stability: Recovery planning for banks h. location of all branches of the bank and offices BOX 1. FSB definition of bank critical functions of other entities in the group, domestically and in and services other countries; i. identification of correspondent banks and other Critical functions are activities performed for third banks or financial service providers with which the parties where failure would lead to the disruption of bank or group has significant business dealings; services that are vital for the functioning of the real economy and for financial stability due to the banking j. nature and extent of participation of the bank and group’s size or market share, external and internal group in financial markets, by category of financial interconnectedness, complexity and cross-border market; activities. Examples include payments, custody, certain k. nature and extent of participation of the bank and lending and deposit-taking activities in the commercial group in payment and settlement systems; or retail sector, clearing and settling, limited segments l. entities that provide critical functions or services to of wholesale markets, market-making in certain the bank and group (see below for a definition of securities and highly concentrated specialist lending critical functions and critical services); and sectors. m. extent and nature of any outsourcing of critical A critical function has the following two elements: functions and services to parties outside the group.  it is provided by a bank to third parties not affiliated to the bank; and 24. An important aspect of recovery planning is the identification of a bank’s critical functionality.  the sudden failure to provide that function would Banks need to identify the critical functions and be likely to have a material impact on the third services they perform, the legal entities and parties, give rise to contagion or undermine the jurisdiction in which the functions and services are general confidence of market participants due to: located, and the inter-dependencies between these ƒ the systemic relevance of the function for the entities. Recovery actions should be designed to third parties; and ensure that, at a minimum, these functions and ƒ the systemic relevance of the bank in providing services can be maintained without interruption. The the function. definitions of critical functions and critical services applied by the Financial Stability Board (FSB) – the international body that provides guidance on bank Critical shared services are activities performed recovery plans - are set out in Box 1. within the firm or outsourced to third parties where failure would lead to the inability to perform critical 25. Recovery plans should identify all critical functions and, therefore, to the disruption of functions functions and services. They should also include vital for the functioning of the real economy or for information on the legal entities (including outsourced financial stability. Examples include the provision of providers) that perform these functions and services, information technology given the dependency of core the jurisdiction in which they are located, and the banking processes on IT and other services such as inter-dependencies between them. facility management and administrative services. 26. At a minimum, the critical functions should include: c. lending and loan servicing, particularly the capacity a. deposit-taking, particularly the capacity to receive to provide credit under committed credit facilities deposits into transaction-facilitated deposit (such as overdrafts and standby facilities), accounts and short-term deposits; participation in existing syndicated lending facilities, trade finance, leasing and factoring; b. wholesale funding, including the capacity to receive deposits from other banks, correspondent banks d. credit card services; and corporate entities, capacity to transact with e. payments, clearing and settlement, and custodial the central bank for money market operations, services, including retail and wholesale payments issuance and servicing of bonds and paper, services, capacity to meet obligations to payment capacity to meet obligations under securities and settlement service providers and other lending, repos and risk transformation services; Financial Market Infrastructures (FMIs), treasury nature of the interlinkages and interdependencies and cash management services; between the bank and other entities in the conglomerate? f. capacity to meet obligations (paying and receiving) in relation to financial derivatives, such as swaps, b. Is there sufficient information on the ownership options, forward contracts and other financial structure of the bank, including an identification of instruments used by the bank or its clients for risk all parties with a significant ownership stake? hedging purposes; and c. Does the recovery plan identify adequately all g. capacity to meet obligations in relation to capital critical functions and services, including critical market transactions and services. shared services within the bank and group (see later in this paper)? 27. At a minimum, the critical services should d. Does it identify the legal entities that provide include the IT and other systems and controls critical functions and services? required to: e. Does it identify the inter-dependencies (functional a. perform all critical functions (as identified above); and financial) between legal entities providing b. maintain all customer and client records; critical functions and services? c. maintain all financial and management accounting f. Does it identify all material outsourcing records and reporting obligations; arrangements for critical functions and services, including the legal entities with responsibility d. identify, measure, monitor and control all for performing these functions and services, the material risks (including credit risk, exposure jurisdictions in which they are based, and reference concentration risk, liquidity risk, interest rate risk, to the legal contracts under which they operate? basis risk, currency risk, equity risk, asset price risk, operational risks and reputation risk); g. Does it identify back-up and business continuity arrangements for all critical functions and services, e. meet all regulatory obligations to BSP and other or refer to these matters being identifiable in the legally binding regulatory requirements. bank Business Continuity Plan? h. Are cross-border operations adequately identified? 28. A recovery plan should set out the recovery actions – financial and operational – to ensure i. Does it identify the financial products and services that all critical functions and services can be provided by the bank and each entity in the group? maintained without interruption. It should also set j. Does it identify the sources of funding for the bank out the recovery actions needed to manage contagion and other entities in the group? risk that could arise from interlinkages with entities in a financial conglomerate or exposures to wider k. Does it identify the key risks of the bank and corporate connectedness. each entity in the group, and a description of (or reference to) the risk management framework applied to identify, measure, monitor and manage COVID-19 and Financial Stability: Recovery planning for banks all material risks? Issues to be assessed by l. Does it identify correspondent banks and other supervisors banks or financial service providers with which the bank or group has significant business dealings? 29. Indicative questions that supervisors m. Does it identify the nature and extent of should consider in reviewing the recovery plan participation of the bank and group in financial information relating to the overview of the bank markets, by category of financial market? include: n. Does it identify the nature and extent of a. Does the recovery plan provide sufficient detail participation of the bank and group in payment of the bank’s organisational structure and and settlement systems? group structure? If the bank is part of a financial conglomerate, does the recovery plan set out the 100 101 COVID-19 and Financial Stability: Recovery planning for banks Similarly, triggers for asset quality are generally set at „ TRIGGERS FOR or below the maximum tolerance in the case of NPLs/ ACTIVATION OF THE total loans and, for profitability, at or slightly above the minimum tolerance for ROE or ROA. If a credit RECOVERY PLAN rating is used as a trigger, then this would usually be set at or slightly above minimum tolerance for the General guidance rating level in the RAS – e.g. one or two notches above the minimum rating for investment grade (BBB- or equivalent). 30. A recovery plan needs to have clearly defined triggers for invoking the recovery plan. The triggers 32. It is often desirable for a bank’s recovery plan should relate to the key risk metrics relevant to the to include a trigger relating to the disruption in financial soundness of a bank and banking group. the performance of critical functions and services. Typically, the triggers will comprise: For example, some banks include a trigger relating to  Capital ratio (e.g., CET1, tier 1 and total capital a sustained interruption to the performance of any ratios) material critical functions and services for more than x hours (e.g. more than 8 hours) or where the disruption  Liquidity ratio (e.g., HQLA to total liabilities, LCR) to critical functions and services has the potential to  Asset quality (e.g., NPLs over 90 days past due as a cause material damage to the bank’s reputation and/ percentage of total loans) or ability to meet payment and settlement obligations.  Profitability (e.g., NPAT as a percentage of total 33. Not all triggers need to be quantitative. assets or equity) Recovery plans can also be designed to include  Credit rating triggers of a qualitative nature. Qualitative triggers could include elements such as: requests from 31. The triggers should be set at a level that counterparties for early redemption of liabilities; enables the recovery plan to be invoked well difficulties in issuing liabilities at current market rates; before the bank breaches prudential requirements an unexpected loss of senior management; adverse and before it gets into any significant difficulties. court rulings; negative market commentary; fraud or The triggers should enable a recovery plan to be malfeasance events; and significant events that could invoked proactively ahead of emerging stress so that a cause significant reputational damage. bank is well placed to respond quickly and effectively to avoid breaches of prudential requirements or 34. In addition to the triggers, banks should adverse market confidence impacts. Triggers for include in their recovery plan or in supplementary capital and liquidity ratios are often set at or slightly material the nature of the early warning indicators above the minimum tolerance levels in the bank’s RAS. (EWIs) they have in place in respect of each trigger. TABLE 13. Indicative examples of EWIs Risk category EWIs Capital  Early-stage deterioration in capital ratios  Capital ratios falling below target levels in the RAS or in ICAAP  Rapid growth in lending  Increase in the proportion of higher-risk lending  Increase in risk appetite  Adverse movement in risk environment  Deterioration in risk management quality  Increase in risk-preferent activity  Deterioration in asset quality  Declining profitability Risk category EWIs Liquidity  Early-stage deterioration in liquidity ratios  Reduced reinvestment of maturing deposits  Shortening of average maturity of funding  Acceleration in withdrawal of deposits  Increase in risk premium on funding costs  Adverse movements in asset/liability maturity mismatch  Reduced cashflows (actual or forecast) from loan portfolio  Reduced ability to obtain funding in the inter-bank market Asset quality  Early-stage deterioration in asset quality indicators  Increase in unemployment and underemployment  Lengthening in loans past due  Increase in requests from borrowers for loan restructuring due to stress  Increase in interest rates  Increase in household and corporate leverage  Decline in asset prices relevant to collateral values Profitability  Increase in operating expenses  Reduced net interest margins  High wage inflation  Weakening in asset quality  Increased competitiveness and contestability in key financial markets  Higher forecast expenses associated with IT/cyber security risk factors  Higher forecast expenditures on bank restructuring and technology updates Banks should maintain comprehensive early warning b. Do the triggers enable the recovery plan to be indicators that enable them to identify, as early as activated well before any breach of prudential possible, emerging stress that could potentially lead requirements has occurred? to a breach in one or more triggers for the recovery c. Are the triggers set in relation to the risk tolerances plan. The early warning indicators would appropriately in a bank’s Risk Appetite Statement (e.g. the bank’s relate to each category of trigger, including capital, lower tolerance levels for capital ratios and liquidity liquidity, asset quality and profitability, as well as early ratios, and its upper tolerance for impaired loans warning indicators relating to qualitative triggers. and for exposure concentration ratios)? COVID-19 and Financial Stability: Recovery planning for banks Indicative examples of EWIs are set out in Table 13. d. What monitoring arrangements are in place to enable the senior management and the Board to regularly monitor data in relation to the triggers? Issues to be assessed by e. What systems apply for alerting the senior supervisors management and Board to a breach or risk of future breach of the triggers? 35. Indicative questions that supervisors should f. Are the triggers supported by comprehensive consider in reviewing the triggers for recovery EWIs? Are there EWIs that provide reliable plans include: predictors of possible future breaches of recovery a. Does the recovery plan differentiate between the plan triggers, including in relation to capital, triggers for activation of the recovery plan as a liquidity, asset quality and profitability? whole, and the triggers for the activation of specific recovery actions? 102 103 COVID-19 and Financial Stability: Recovery planning for banks g. What monitoring arrangements are in place to  Tier 1 capital ratio; enable the senior management and Board to  total capital ratio; regularly monitor data in relation to the EWIs?  HQLA ratio; h. Are the EWIs structured so that they identify escalating levels of potential risks of future trigger  LCR ratio; breaches, such as a ‘traffic light’ structure for EWIs?  profitability, expressed both in ROA and ROE i. Does the plan clearly set out the process by which terms; and a bank would activate its recovery plan and to  asset quality, expressed in terms of relevant activate particular recovery actions? indicators of impaired and restructured assets as a j. Does it identify the persons responsible for the percentage of total assets or total loans. different elements of the activation process? k. Is there a clear documentation of delegated authorities for particular actions? Issues to be assessed by l. Is there an appropriate process for escalation of supervisors decision-making? 38. Supervisors should assess whether the recovery plan sets out appropriate restoration points for the above factors. Supervisors need to „ RESTORATION POINTS FOR satisfy themselves whether the restoration points are realistic and achievable. They also need to assess RECOVERY whether the restoration points are consistent with the bank resuming normal operations, especially for critical functions and services, and maintaining market General guidance confidence. 36. The ‘restoration point’ for recovery needs to 39. Indicative questions that supervisors should be clearly specified in a bank’s recovery plan. consider in reviewing the restoration points for At a minimum, a bank must restore capital and recovery plans are: liquidity to levels that meet the regulator’s regulatory a. Does the recovery plan establish restoration points requirements, with a sufficient cushion to achieve a for key variables, such as capital, liquidity, asset very low probability of any future breaches of these quality and profitability? requirements. However, in many situations, higher restoration points should be specified in order to b. How has the bank set these restoration points? ensure that the bank in question can restore and Were the levels of restoration points for capital maintain market confidence - and as such, retain and liquidity set in relation to the bank’s minimum access to inter-bank funding - and to reduce the tolerances in the Risk Appetite Statement? Were probability of subsequent near-failures. In many cases, they set taking into account the bank’s stress tests? banks tend to set their restoration points towards the c. Do the restoration points provide reasonable higher end of the target range for key risk metrics in assurance that future breaches of prudential their RAS – e.g. as for capital and liquidity. requirements will not occur? In particular, has the bank set post-recovery capital and liquidity levels 37. Bank recovery plans should set out clearly at a sufficiently high level? the restoration points being applied by the bank and the rationale for the restoration points. The d. Would the restoration points enable the bank to restoration points should include restoration levels in retain an acceptable credit rating (sufficient to relation to: maintain access to financial markets and inter- bank funding)?  CET1 ratio; 43. Recovery actions also need to address the „ RECOVERY OPTIONS underlying causes of the problem in order for the recovery action to have credibility. For example, General guidance if poor lending decisions led to a deterioration in asset quality and associated loan losses, and a 40. It is essential that recovery options are set decline in capital, the recovery actions need to go out in a comprehensive manner. Each recovery beyond restoring capital adequacy and asset quality. action should be accompanied by step-by-step The recovery package also needs to address the implementation guidance. The person(s) authorised to underlying cause of the problem – in this example, take each action in the implementation process should the poor lending decisions. Accordingly, recovery be identified clearly, with all delegated authorities actions should provide at least generic guidance made clear. The maximum plausible amount that the as to the steps that a bank would take to identify recovery action would contribute to capital or liquidity and resolve the underlying cause of the problems, should be identified. and to do so in a manner that has credibility to all stakeholders, including rating agencies, depositors, 41. Emphasis needs to be on recovery actions market participants and the news media. This would which are practicable and can be implemented often suggest the need for some form of independent within a relatively short timeframe. A risk expert party to be engaged to assist in the resolution associated with bank recovery plans is that they process – and hence the need for guidance in the evolve into long lists of potential actions, without recovery plan on how this would be facilitated. adequate specification of how practical they are, their contribution to recovery and the timeframe for implementation. This risk can be lessened by banks prioritizing the recovery actions, giving prominence to Recovery actions in relation to recovery actions with the greatest near-term benefit capital in terms of restoring capital, liquidity, profitability and improving asset quality, and which will have credibility 44. The recovery plan should set out with key stakeholders (such as depositors, other comprehensive and detailed recovery actions creditors, the news media and rating agencies). to restore capital (CET1, Tier 1 and total capital) to the target level. The recovery actions need to 42. For each recovery action, the recovery plan be realistic, practicable and credible. Priority should should specify: be given to recovery actions that have the greatest a. the quantitative amount that the recovery action probability of successful implementation in the would contribute to the restoration of capital, shortest period of time, and which make the greatest liquidity, profitability or asset quality; contribution to capital restoration. Recovery actions should generally be capable of completion within 3 b. the period of time required to complete the months desirably, and not more than 6 months. recovery action; c. the processes and procedures required to 45. Recovery actions should be classified into COVID-19 and Financial Stability: Recovery planning for banks implement the recovery action to the point of specific categories, including initiatives to: completion; a. raise equity from existing shareholders via a rights d. the documentation that has been prepared or issue (desirably underwritten by an investment that will need to be prepared to ensure prompt bank) or through private placement of equity to implementation of the recovery action; existing controlling shareholders, consistent with what is permitted under the bank’s constitution; e. the potential legal and regulatory requirements which must be met to implement the recovery b. raise equity from new investors, such as action and the means by which these requirements the issuance of shares to selected potential will be met; shareholders; f. the persons in the bank (including directors) with c. convert debt into equity where the bank has the authority to approve implementation steps for a tranche of debt with contractual provisions the recovery action. to enable it to be converted into equity upon specified triggers being met; 104 105 COVID-19 and Financial Stability: Recovery planning for banks d. write down debt where the bank has a tranche of successful implementation and contribution to the debt with contractual provisions to enable the debt estimated need for additional liquidity. Speed of to be written down upon specified triggers being implementation is critical for any liquidity actions, met; where success and credibility of recovery actions are measured in hours and days, rather than weeks or e. suspension of distributions (including dividends) to months. shareholders; f. reduction or suspension in new lending, so as to 48. Recovery actions should be set out under reduce the amount of additional capital required; specific categories, such as initiatives to: g. initiatives to reduce operational expenses, so as to a. sell marketable securities; reduce the amount of additional capital required; b. obtain liquid assets from controlling shareholders h. sale of assets or change in the mix of assets so as where feasible; to reduce the amount of additional capital required c. raise liquidity via borrowing from other banks and to increase the risk-weighted capital ratio under committed standby facilities; by reducing the amount of risk-weighted credit exposures; d. borrow from the central bank under business-as- usual liquidity facilities provided routinely to banks i. sale of subsidiaries; by the central bank; j. issuance of new debt that meets the eligibility e. sell illiquid assets in exchange for liquid assets, criteria for inclusion in tier 2 capital. including via sale and repurchase agreements or securitisation; 46. With each recovery action, the bank should f. lengthen the maturity profile of liabilities; specify the amount estimated to be raised or capital savings induced by the recovery action g. shorten the maturity profile of assets (where and the timeframe for completion. In each case, feasible); the recovery plan should set out the step-by-step h. reduce the need for liquidity by reducing new implementation arrangements, together with the lending and reducing operating expenses, where draft documentation required for the recovery feasible; action to be implemented. In the case of issuing new capital instruments or raising capital from i. renegotiating the terms of scheduled debt existing shareholders, the recovery plan should repayments and debt servicing where this is include as attachments the draft capital issuance considered feasible and prudent. documentation and underwriting documentation, or at least detailed terms sheets for the documentation. 49. All recovery actions should be quantified As noted in the discussion on scenarios, later in this in terms of the estimated impact on liquidity. document, the feasibility, amount, sequencing and The implementation steps and timeframe for timeframe for implementation of recovery options implementation should be set out in relation to will be different in an idiosyncratic scenario than in each recovery action. Any documentation needed a market-wide scenario. In general, recovery actions for liquidity actions should be set out in draft form will be more feasible, faster to implement and capable attached to the recovery plan or at least detailed of contributing a greater amount to recovery in an terms sheets for documentation provided as part of idiosyncratic scenario than in a market-wide scenario. the recovery plan. This is as true for capital-related recovery actions as it is for other recovery actions. Recovery options for profitability Recovery options for liquidity 50. All recovery actions should meet the standard test of being realistic, practicable and credible, 47. Recovery actions for liquidity, like all recovery and capable of delivering the intended outcomes actions, should be specific, realistic, practicable in a realistic timeframe. Given that the restoration and credible. The recovery actions should be set of profitability is likely to be less urgent and critical to out in order of priority, based on the probability of a bank’s survival (in the short-term), and likely to take longer to achieve than capital and liquidity recovery 54. Recovery actions should be classified into actions, the recovery plan could be expected to attach categories, such as initiatives relating to: lower priority to profitability restoration initiatives a. the restructuring of loans to enhance recoverability in the short-term. However, the restoration of – e.g. by elongating the term of the loan, profitability will be critical for the longer-term survival suspending interest payments, etc; of the bank, both in terms of capital maintenance and market confidence. b. transferring impaired loans into an asset management company owned by the bank; 51. Recovery actions should be set out c. selling impaired loans to other parties; comprehensively with detailed implementation steps. The following categories of recovery actions are d. write-off loans considered to be irrecoverable; likely to be helpful: e. strengthening the quality of lending policies a. Initiatives to reduce operating expenses, consistent and procedures, and associated credit risk with maintaining acceptable risk management management arrangements, in order to enhance practices and critical functions and services. asset quality for new loans. b. Initiatives to increase revenue from under- 55. In the case of each recovery action, the plan should performing business lines where feasible and identify expected impacts on asset quality and the where this is consistent with the bank’s risk timeframe required to achieve the desired outcomes. appetite and risk management frameworks. Implementation steps should be specified in detail. c. Initiatives to reduce or eliminate business activities that do not meet defined ROA and ROE hurdles. d. Initiatives to reduce average funding costs where feasible, consistent with the bank’s risk appetite Other types of recovery actions and risk management frameworks. 56. The recovery plan would generally also include other recovery actions, depending on the bank and 52. Where feasible, each category of recovery action group, and the situation. Examples include: should include estimates of the contribution that the a. Possible removal of staff, including senior initiatives in question are likely to make to increased management, to the extent that they have been profitability, the timeframe expected to achieve this responsible for the cause of the bank’s stress and the steps required to achieve it. situation or are impediments to the recovery process. b. Actions to minimize or manage potential contagion Recovery options for asset risk between entities in the banking group or quality financial conglomerate. c. Actions to address the underlying causes of 53. Recovery actions in respect of improving the bank’s/group’s financial stress, potentially COVID-19 and Financial Stability: Recovery planning for banks asset quality need to meet the standard tests of including: being realistic, practicable and credible. By their nature, recovery actions relating to asset quality i. Establishment of an internal review process improvements will tend to be somewhat longer to evaluate the causes of the situation and the term than the more immediate needs of restoring remedies to address those causes. the bank to sound capital and liquidity positions. ii. Possible appointment of an external, Nonetheless, recovery actions should be achievable independent party to undertake an assessment within timeframes that are likely to be seen as credible of the causes and remedies. and realistic by financial markets, rating agencies, iii. Board oversight of these processes. depositors and other stakeholders – they need to assist in restoring market confidence in the bank. iv. Reporting to the regulator. v. Transparency, including public reporting on causes and remedies. 106 107 COVID-19 and Financial Stability: Recovery planning for banks v. the timeframe for implementation of recovery Issues to be assessed by actions? supervisors k. Do the recovery actions take into account the impact that one type of recovery action will 57. Indicative questions that supervisors should have on another type of recovery action? Are consider in reviewing the recovery actions (in mutual dependencies between recovery actions general terms) include: adequately identified and taken into account in the a. Does the recovery plan contain a comprehensive recovery strategy? suite of recovery actions in respect of capital, liquidity, asset quality, profitability, maintenance of critical functions and services, and communications Capital recovery actions with stakeholders? b. Are the recovery actions credible and realistic? 58. Indicative questions that supervisors should consider in reviewing the capital-related recovery c. Have the recovery actions been set out by priority actions include: of action (i.e., sequence of implementation) and in the relevant categories? a. Do the recovery actions include sufficient capital- raising options? d. Have the impacts of the recovery actions been quantified (e.g., in terms of contribution of the b. Have the capital-raising options been prioritised in bank’s capital, liquidity, etc)? terms of the sequence in which they would occur? e. Can the recovery actions be implemented in a c. Have the capital-raising options been quantified, timely manner (e.g., within 1 week for near-term indicating a maximum plausible amount of capital liquidity recovery, within 1 month for longer-term that could be raised (or capital savings that could liquidity recovery, and within 3 to 6 months for be made)? capital recovery)? d. How long would it take to raise capital? Does f. For each recovery action, is there comprehensive the recovery plan provide sufficient detailed and detailed guidance on step-by-step information to determine whether capital can be implementation procedures? raised within (at most) a 3 to 6 month period from the time that the recovery plan activation has been g. Have the responsible persons and delegated triggered? authorities been identified for each recovery action? e. Does the recovery plan identify in detail the implementation steps required to implement h. Have any legal or regulatory obstacles to recovery particular capital-raising recovery actions? actions been identified and the solutions to those obstacles set out in the recovery plan? f. Does the recovery plan identify all regulatory approvals needed for capital-raising recovery i. Is there supportive documentation for recovery actions? actions – e.g., capital issuance term sheets, indicative capital offer documents, liquidity g. Has the bank prepared the necessary legal standby facility documentation, etc? documentation, or at least terms sheets, for capital-raising recovery options? j. Does the recovery plan adequately differentiate between idiosyncratic and system-wide scenarios h. For bail-in debt (if any), is the process for in terms of the impact these would have on: contractual bail-in documented? i. the selection of recovery actions; i. Does the recovery plan adequately differentiate between idiosyncratic and system-wide scenarios ii. the implementation process for recovery in terms of the types of capital recovery actions actions; that could be used, the amounts likely to be raised, iii. the likely success or failure of recovery actions; the probability of successful implementation and iv. the amount of funds obtained (or saved) by the timeframe required for implementation? particular recovery actions; and j. Have other recovery actions for capital restoration i. Has draft documentation been developed and conservation been identified in sufficient to facilitate liquidity recovery actions, such detail, such as: as draft liquidity injection documentation, standby documentation, terms sheets for such i. selling assets; documentation, etc? ii. selling subsidiaries; j. Do the recovery options identify potential sources iii. reducing the average risk weight of assets by of borrowing – e.g. particular banks, securitisation changing the composition of assets to lower- vehicles, or a borrowing facility with shareholders? risk assets; iv. reducing new lending; v. suspending distributions to shareholders; Profitability recovery actions vi. reducing expenditures, etc? 60. Indicative questions that supervisors should k. Have these options been prioritised and consider in reviewing the profitability-related quantified? recovery actions include: l. Have the implementation procedures for each a. Do the recovery actions include adequate option been documented adequately? initiatives to restore the bank to an acceptable level of profitability, and within a reasonable period of time? Liquidity recovery actions b. Are cost reduction actions adequately identified and quantified? Would cost reduction options 59. Indicative questions that supervisors should weaken the ability of the bank to continue to consider in reviewing the liquidity-related perform critical functions and services? recovery actions include: c. Are actions to increase revenue and margins a. Have the liquidity-raising/saving recovery options adequately identified and quantified? been prioritised? d. Would revenue-enhancing recovery actions b. Are the recovery options practicable? Can they be be consistent with maintaining prudent risk implemented in sufficient time to meet liquidity management or create excessive risks? needs? e. Have the recovery actions been prioritised and c. Are they quantified? quantified? d. Do they contain detailed implementation f. Have the procedures required to implement them guidance? been adequately documented? e. Do the recovery actions include sufficient options for reducing cash outflows – e.g. via reduced new Asset quality recovery actions COVID-19 and Financial Stability: Recovery planning for banks lending, reduced expenditures, suspension of dividends, etc? 61. Indicative questions that supervisors should f. Do the recovery actions include sufficient options consider in reviewing the asset quality-related for increasing cash inflows – e.g. via access to recovery actions include: standby facilities, liquid asset injections from shareholders, acceleration of loan repayments? a. Do the recovery actions include adequate initiatives to identify impaired assets? g. Does the plan contain sufficient initiatives to increase High Quality Liquid Assets? b. Do the recovery actions include undertaking an asset quality review (if needed)? If so, have h. Does it contain sufficient measures to attract the procedures been adequately identified and new deposits and retain existing deposits, and to documented? lengthen the maturity of funding where feasible? 108 109 COVID-19 and Financial Stability: Recovery planning for banks c. Does the recovery plan identify how impaired b. Does the recovery plan identify actions to address assets would be managed in ways that maximise possible intra-group contagion risk, particularly recovery value? in the bank is part of a large group or financial conglomerate? d. Does it contain measures to address the problems that created asset impairment – e.g. measures to c. Does the recovery plan identify generic processes strengthen the credit risk management process? for reviewing and assessing the causes of the problem in question and the remedies to seek to e. Does it contain initiatives to prevent further avoid a repeat of the problem? deterioration in asset quality – e.g. ceasing to extend credit to poor quality borrowers, etc? „ SCENARIOS FOR Critical functions/services recovery actions RECOVERY PLANS 62. Indicative questions that supervisors should General guidance consider in reviewing the critical function/service- related recovery actions include: 64. Supervisory authorities generally require bank a. Does the recovery plan identify all material critical recovery plans to include three types of scenarios functions and services, including the legal entities in their recovery plans: that perform each category of function and service a. an idiosyncratic scenario – i.e., a scenario in which and the legal jurisdiction in which it operates? the bank has been impacted by financial shocks, b. Does the recovery plan identify how the bank will such as major loan losses, liquidity events or maintain critical functions and services with no or operational risk losses, but where the financial minimal interruption? system remains stable; c. How realistic are these recovery actions? b. a market-wide scenario – i.e., where the financial system is in stress, such as in a severe recession, d. Have the recovery actions been prioritised? with many banks sustaining capital and liquidity e. Are the recovery actions supported by detailed pressures, and with the bank in question being implementation processes and IT arrangements? similarly affected; and f. Are they consistent with the bank’s business c. a combined scenario, combining elements of the continuity plan, where consistency would be idiosyncratic and market-wide scenarios which expected? occur simultaneously – e.g., where the financial system is under stress and the bank in question sustains major losses. Other recovery actions 65. The recovery plans should provide reasonably 63. Indicative questions that supervisors should comprehensive descriptions of the scenarios. consider in reviewing other possible recovery This would generally include detailed information actions include: on the magnitude of impact on capital, profitability, asset quality and liquidity, together with all material a. Does the recovery plan include actions that are assumptions made. It is particularly important that the designed to identify and potentially remove scenarios used include severe impacts on both capital persons from the bank/group to the extent that and liquidity, where the bank’s minimum regulatory they are thought to have been part of the cause requirements for capital and liquidity are breached. of the problem or are obstructing the recovery process? 66. It is important that banks do not design Issues to be assessed by recovery plans on the basis of particular causes of an adverse impact on their capital and liquidity supervisors position. The cause of the impact on capital and liquidity is much less important than the magnitude 69. Indicative questions that supervisors should of the impact. The recovery planning process risks consider in reviewing the scenarios for recovery becoming overly complicated if plans are developed plans are:51 on the basis of detailed macroeconomic analysis and a. Does the recovery plan contain credible and severe with overly specific narratives. Moreover, recovery scenarios, with clearly specified and quantified plans tend to be less useful if they are overly scenario- impacts on capital, liquidity, asset quality and specific. Therefore, it is generally preferable for profitability? a recovery plan to have broad-based, high-level b. Do the scenarios include impacts on capital and scenarios that do not involve detailed storylines, but liquidity that are severe enough to cause the that provide relevant details for impacts on: bank to breach its minimum capital and liquidity a. loan losses; regulatory requirements? b. operation risk losses (if the scenario involves these c. Are the scenarios based on the bank’s stress – e.g., a fraud or money laundering event); testing (especially reverse stress tests)? If so, are c. profits; the assumptions and model parameters for the stress tests identified (either in the recovery plan d. capital; or by reference to another document)? e. cash inflows and outflows; d. Do the scenarios include financial projections for f. liquidity position; the bank and banking group extending out two years? g. losses (or gains) arising from market risks as a result of assumed changes in asset prices, interest e. Are the financial projections supported by clearly rates and exchange rates. identified assumptions? f. Do the scenarios clearly differentiate between 67. Scenario analysis should include an an idiosyncratic scenario (in which the financial identification of all material assumptions made for system is operating normally and only the bank the scenario. Financial projections for each scenario in question has sustained major losses) and a should generally extend for two years from the point market-wide scenario (in which many banks are of initial impact. The projections should incorporate experiencing very adverse economic and financial the financial impacts of recovery actions taken in the shocks)? scenario. The selection of recovery actions should take g. Does the recovery plan identify the assumptions into account the nature of the scenario. For example, made as to the different impacts that idiosyncratic initiatives to raise capital and to access liquidity from and market-wide scenarios have on the nature, other banks are likely to be much more challenging feasibility, timeframe and success of recovery in a market-wide or combined scenario than in an actions? COVID-19 and Financial Stability: Recovery planning for banks idiosyncratic scenario. The recovery strategy should reflect these types of considerations. h. Does the recovery plan adequately identify the recovery actions taken for each scenario and the 68. Scenarios should be informed by stress tests, incorporate the financial impacts of these actions particularly reverse stress tests that involve into the financial projections? breaching a bank’s minimum regulatory capital i. Does the recovery plan differentiate between and liquidity ratios. In the market-wide scenario, recovery actions needed for fast-moving events consideration should be given to including climate and slow-moving events, especially as regards change impacts to the extent that the bank in question impacts on liquidity and the likely recovery considers them to be relevant to their risk profile. strategies needed to respond to these?  51  See also the guidance provided by other supervisory authorities on recovery plans. The Bank of England’s guidance Supervisory Statement SS9/17 Recovery Planning, December 2020 is a good example. This can be accessed at: https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/supervisory-statement/2020/ss917update- december-2020.pdf?la=en&hash=7EE218D863A63481884C23BD12C17AA72C147F81 110 111 COVID-19 and Financial Stability: Recovery planning for banks „ COMMUNICATIONS Issues to be assessed by supervisors General guidance 73. Indicative questions that supervisors should consider in reviewing the governance 70. Communications aspects of recovery plans arrangements for recovery plans include: are important. In particular, recovery plans need to identify all stakeholders (internal and external), a. Does the recovery plan identify all internal and the information needs of each stakeholder category external stakeholders? and the means by which those needs can best be b. Does the recovery plan set out stakeholder addressed. Communications actions should include information needs in sufficient detail? proactive and reactive communication initiatives, including: c. Does it set out how and when the information will be provided to each category of stakeholder? a. call centre communications arrangements and upscaling for high volumes of calls; d. Does the recovery plan cover communications via different processes and are these adequate, b. web-based communications; including communications via: c. question and answer material; i. news media statements; d. communications with correspondent banks ii. news media conferences; and other counterparties on matters relating to scheduled payments and settlements; iii. social media; e. communications with credit rating agencies and iv. call centres; the financial news media; v. web-based information; f. information and processes to facilitate news media vi. automated emails; and briefings; and vii. telephone banking messaging? g. guidance for communications via social media. e. Does the recovery plan contain communication process steps in sufficient detail? 71. Recovery plans should also address the need for synchronized communications. This f. Does the recovery plan identify who would be the should include the ability of a bank to announce the lead communicators within the bank (including at recovery actions it plans to take at the same time as Board and senior management levels)? it announces the adverse impact that prompted such g. Does it include draft material for news media actions. This is especially important for banks with releases, call centre scripts, etc? regulatory arrangements that require the banks to announce material developments that could impact h. Does the bank have a strategy to escalate call on investor decisions as soon as the information centre capacity for high-volume calls? becomes available. In that situation, it is critical that a bank has a well-developed strategy to enable it to announce the ‘good news’ (i.e., the recovery actions) at the same time as the ‘bad news’. „ PREPARATORY MEASURES 72. The recovery plan should identify the responsibilities of the Board, CEO, CFO and other General guidance key officers in the communications strategy. 74. To improve the feasibility of recovery actions, The plan should set out the means by which a bank needs to identify the preparatory communications will be coordinated within the bank, measures that should be taken in advance within the group and with the relevant regulatory facilitate implementation of recovery actions. agencies. Such preparatory measures might, for example, Issues to be assessed by include possible changes to organisational or legal structures in the bank and group, the separation supervisors of critical functions and services so that they can be self-supporting, and the preparation of 76. Indicative questions that supervisors should documentation and procedures to facilitate recovery consider in reviewing preparatory measures for actions (especially those involving capital issuance, recovery plans include: securitization, asset sales and accessing liquidity via a. Has the bank identified potential impediments to standby facilities). The recovery plan should describe recovery actions that could be addressed through the preparatory measures to be taken to improve the preparatory measures? effectiveness of recovery options, with work program b. Has the bank identified the preparatory measures to implement the measures. it intends to put in place? 75. Examples of common preparatory measures c. Is the list of preparatory measures complete and include: comprehensive? a. Share issuance terms sheets, documentation d. Does the bank have a work program to implement and issuance procedures – for ordinary shares, preparatory measures? Is the work program preference shares and hybrid instruments (e.g. adequately structured and resourced? subordinated debt capable of conversion to e. What progress has been made in implementing equity). preparatory measures? b. Parent bank capital support arrangements. f. Have the preparatory measures been approved by c. Subordinated debt terms sheets, documentation the Board? and issuance procedures, including tier 1 g. Has internal audit assessed the progress made in subordinated debt and tier 2 subordinated debt. implementing preparatory measures? d. Terms sheets and documentation for equity and h. Has there been any testing of the preparatory debt underwriting agreements. measures? e. Identification of potential underwriters. f. Identification of potential institutional investors. g. Identification of potential merger partners and indicative procedures for merger. „ TESTING OF RECOVERY h. Documentation and operational pre-positioning PLANS BY BANKS for securitization of loans. i. Documentation and operational pre-positioning General guidance for asset sale and repurchase arrangements. 77. It is important that recovery plans are subject COVID-19 and Financial Stability: Recovery planning for banks j. Procedures and arrangements needed to sell to regular testing. Testing can be done in a number subsidiaries if required. of ways, depending on objectives and scope. For k. Indicative shareholder resolutions and Board example, tests can be structured to evaluate: resolutions for particular recovery actions. a. the ability of the bank to detect emerging stress, l. Terms sheets and documentation for liquidity such that the triggers for the recovery plan are able standby facilities. to be invoked as and when required; m. Draft indicative news media statements and Q and b. the ability of the bank to implement recovery A material. actions relating to particular categories of recovery – capital, liquidity, asset quality, profitability, etc; n. Documentation of service-level agreements for all outsourced services and critical shared services. c. the ability to communicate effectively with stakeholders (role-played); 112 113 COVID-19 and Financial Stability: Recovery planning for banks d. the performance of senior management in terms Issues to be assessed by of its responsibilities in a recovery process; e. the performance of the Board in terms of its supervisors responsibilities in a recovery process – especially 80. Indicative questions that supervisors should high-level approvals and communication with consider in reviewing the testing arrangements for external stakeholders and the financial news recovery plans include: media; a. Has the bank identified the proposed f. the data systems required for recovery; arrangements for testing the recovery plan on g. the legal documentation required for certain a regular basis? Has the bank specified clear recovery actions; objectives for testing? h. the ability to implement recovery actions within the b. Is the scope of testing sufficient? Does it cover all specified timeframes, especially for time-critical elements of the recovery plan? actions; c. Does testing include members of senior i. the degree of integration of the recovery plan management team (including CEO) and Board? with the bank’s risk management framework, d. Is Internal Audit involved in the testing process? ICAAP, business continuity plan and governance arrangements. e. Is the frequency of testing sufficient? f. Has an ‘owner’ for the testing process been 78. There are several different forms of testing for identified? recovery planning purposes. The options can include g. Is the testing process adequately resourced? ‘walk-through’ tests of processes and procedures for particular scenarios, live simulation exercises h. Are external parties be involved in the testing for particular elements of the recovery plan (e.g., process? capital, liquidity or communications), and full-scale i. Are the results of tests reported to the Board and live simulations to test the entirety of the recovery integrated into future revisions of the recovery plan. For any substantive testing, it is imperative that plan? the members of senior management are involved in the tests, especially for live simulation exercises, with each member of senior management playing his/her own role. For some tests, it will also be appropriate „ REVIEW AND UPDATE OF for members of the Board to be included in the exercise – e.g., to test the Board Chairperson’s ability THE RECOVERY PLAN to communicate effectively with external parties (role-played). Of particular importance is the testing of senior management and Board members’ capacity General guidance to communicate with role-played news media and 81. A bank’s recovery plan needs to be subject to financial markets, including under realistic time comprehensive and regular review – generally pressure. annually. The recovery plan should identify the 79. The recovery plan should set out the internal review processes that will be applied by framework for the regular testing of the plan. This the bank, including in respect of reviews by the risk should include the objectives and scope of testing, the management unit and internal audit. Reviews should parties responsible for organizing and conducting the be undertaken in respect of all aspects of the recovery tests, the processes and procedures for conducting plan, including the scenarios, triggers, recovery actions the tests, and the means by which the test results will and governance arrangements. The reviews should be be documented and reviewed by the Board, and by informed by the testing of the recovery plan. internal audit. 82. Although reviews of recovery plans can Issues to be assessed by generally be undertaken by a bank’s own staff, occasional external reviews by independent supervisors experts can also be helpful. This is especially helpful if external, independent experts are present at 83. Indicative questions that supervisors should regular tests of the recovery plan, given that they will consider in assessing the processes for reviewing be able to use their insights into the testing process and updating recovery plans include: and results of the tests to assess the adequacy of the a. Has the bank set out the proposed arrangements recovery plan. External reviews are also important for the regular review of recovery plans? Are the in relation to reviewing the adequacy of the bank’s arrangements adequate? management and Board in relation to their respective b. Has an ‘owner’ for the review process been responsibilities in the recovery plan, given that internal identified? staff reviews might be less well placed to conduct such reviews freely and impartially. c. How frequently is the recovery plan reviewed? d. How will the review be integrated with the bank’s review of its risk management framework, risk appetite, ICAAP, BCP, etc? e. What is the involvement of the CEO, EXCO, Board Risk Committee and Board in the review process? COVID-19 and Financial Stability: Recovery planning for banks 114 115 COVID-19 AND FINANCIAL STABILITY: BANK RESOLUTION May 2022 developed, leading to late-stage entry into resolution, „ INTRODUCTION protracted interruptions to critical banking functions, and costly government-funded bail-outs. 1. The paper provides an overview of the issues relating to bank resolution, including resolution 3. The adverse impacts of bank failures have led objectives, legal powers and safeguards, resolution to a renewed approach to the way bank failure policies, and resolvability assessments and is managed. International principles have been resolution planning. The paper includes a review of developed to provide guidance to national authorities the international principles governing bank resolution. on the means by which bank failures can be managed It draws on key resolution-related findings from in ways to minimize the adverse impacts of bank earlier IMF and World Bank FSAP, FSSR and technical failures, while seeking to minimize the use of public assistance missions in the PIC region and highlights funds to facilitate bank resolution. The next section key areas where further work would be desirable of this paper provides an overview of the core in the PICs to strengthen their bank resolution international principles relating to the resolution of frameworks. banks (and of other financial institutions, such as insurers and financial market infrastructures): the Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes), issued by the Financial Importance of effective bank Stability Board (FSB). resolution 2. Although banking regulation and supervision are designed to promote a safe and sound banking „ KEY ATTRIBUTES system and to achieve a low probability of bank failure, bank distress and failure events occur 4. The FSB first issued the Key Attributes52 in 2011 in most countries from time to time. When they and revised them in 2014. The Key Attributes are the do occur, they can prove to be very costly. The costs international standard for resolution regimes for any can include disruption to core financial services and type of financial institution. The standard consists of associated adverse impacts on the economy, inter- 12 key attributes (KAs). bank contagion, losses by depositors and other bank creditors, and fiscal costs (depending on how 5. The 12 KAs cover a number of issues relevant the resolution of the failed bank is funded). Bank to resolution. These include the powers and failures can have enduring impacts on the economy associated legal safeguards, funding arrangements, by impeding banks’ ability and willingness to lend and requirements for planning and cross-border due to constrained capital positions, heightened cooperation that are necessary to facilitate effective risk caution and adverse impacts on investor and resolution. The KAs comprise: consumer confidence. If the resolution of a failed bank is not handled in ways that minimize dislocation to the  KA1 - Scope financial system and economy, losses for depositors,  KA2 - Resolution authority and fiscal costs, the damage resulting from bank  KA3 - Resolution powers failures are even greater. There are many examples COVID-19 and Financial Stability: Bank Resolution of bank failures having severe and lasting impacts on  KA4 - Set-off, netting, collateralization, segregation financial systems and economic activity – as with the of client assets Asian financial crisis in 1997/98, the global financial  KA5 – Safeguards crisis of 2008/09, and domestic bank failure episodes in many countries globally. The economic and  KA6 - Funding of firms in resolution fiscal costs have tended to be greatest in countries  KA7 - Legal framework conditions for cross-border where the bank resolution regime was inadequately cooperation  52  See https://www.fsb.org/2014/10/key-attributes-of-effective-resolution-regimes-for-financial-institutions-2/ 116 117 COVID-19 and Financial Stability: Bank Resolution  KA8 - Crisis Management Groups (CMGs) iii. avoid unnecessary destruction of value and seek to minimize the overall costs of resolution in home  KA9 - Institution-specific cross-border cooperation and host jurisdictions, and losses to creditors, agreements where that is consistent with the other statutory  KA10 - Resolvability assessments objectives; and  KA11 - Recovery and resolution planning iv. consider the potential impact of its resolution  KA12 - Access to information and information actions on financial stability in other jurisdictions. sharing. 10. The resolution authority should have 6. The main aspects of these are summarized below. operational independence consistent with its statutory responsibilities. It should have transparent processes, sound governance and sufficient resources, and be subject to appropriate transparency and KA1 - Scope of resolution regime accountability mechanisms. It should have the expertise, resources and the operational capacity to 7. KA1 notes that any financial institution that implement resolution measures with respect to large could be systemically significant or critical if it and complex firms. The resolution authority and its fails should be subject to a resolution regime staff should be protected against liability for actions that aligns broadly with the principles set out taken and omissions made while discharging their in the Key Attributes. The regime should be clear duties in the exercise of resolution powers in good and transparent as to the financial institutions faith. within its scope. Although the Key Attributes were designed mainly for application to banks, they are also applicable (with appropriate modification) to insurers and financial market infrastructures (such as payment KA3 – Resolution powers and settlement systems). In this regard, the resolution regime should apply to: (i) holding companies 11. Comprehensive legal powers are essential for of a financial firm; (ii) non-regulated operational an effective resolution regime. Resolution should entities within a financial group or conglomerate be initiated when a firm is likely to be no longer viable. that are significant to the business of the group or The resolution regime should provide for entry into conglomerate; and (iii) branches of foreign firms. resolution before a firm is balance sheet insolvent. There should be clear standards or suitable indicators of non-viability to help guide decisions on whether firms meet the conditions for entry into resolution. KA2 - Resolution authority 12. The resolution powers should, at the least, 8. KA2 notes that there should be a designated include the powers to: resolution authority responsible for exercising  remove and replace the senior management and resolution powers over financial firms. Where there directors, and recover monies from responsible are multiple resolution authorities within a jurisdiction, persons, including claw-back of variable their respective mandates, roles and responsibilities remuneration; should be clearly defined and coordinated.  appoint an administrator to take control of and 9. As part of its statutory objectives and functions, manage the financial institution with the objective the resolution authority should: of restoring it, or parts of its business, to ongoing and sustainable viability; i. pursue financial stability and ensure continuity of systemically important financial services;  operate and resolve the institution, including powers to terminate contracts, continue or assign ii. protect depositors, insurance policyholders and contracts, purchase or sell assets, write down debt investors covered by protection schemes (such as and take any other action necessary to restructure with deposit insurance); or wind down the institution’s operations;  ensure continuity of essential services and of resolution measures. Subject to adequate functions by requiring other companies in the safeguards, entry into resolution and the exercise of same group to continue to provide essential any resolution powers should not trigger statutory or services to the entity in resolution, any successor contractual set-off rights, or constitute an event that or an acquiring entity; entitles any counterparty of the financial institution in resolution to exercise contractual acceleration or early  override rights of shareholders, including termination rights. requirements for approval by shareholders of particular transactions, in order to permit a merger, acquisition, sale of substantial business operations, recapitalization or other measures KA5 - Safeguards to restructure and dispose of the institution’s business; 14. An effective resolution framework requires  transfer or sell assets and liabilities, legal rights strong legal powers, but equally needs to have and obligations, including deposit liabilities and robust safeguards to prevent the abuse of those ownership in shares, to a solvent third party; powers. Resolution powers should be exercised in a way that respects the hierarchy of claims while  establish a temporary bridge institution to take providing flexibility to depart from the general over and continue operating certain critical principle of equal treatment of creditors of the functions and viable operations of a failed financial same class, with transparency about the reasons institution; for such departures. In particular, equity should  establish a separate asset management vehicle absorb losses first, and no loss should be imposed where necessary; on senior debt holders until subordinated debt (including all regulatory capital instruments) has  carry out bail-in within resolution as a means to been written-off entirely. Creditors should have a achieve or help achieve continuity of essential right to compensation where they do not receive functions; at a minimum what they would have received in a  temporarily stay the exercise of early termination liquidation of the firm under the applicable insolvency rights that may otherwise be triggered upon regime (i.e. a ‘no creditor worse off than in liquidation’ entry of a financial institution into resolution or in safeguard). connection with the use of resolution powers; 15. Resolution actions should not depend on court  impose a moratorium with a suspension of approval and should not be subject to the risk payments to unsecured creditors and customers of court interference. Resolution law should not and a stay on creditor actions; and provide for judicial actions that could constrain the  effect the closure and orderly liquidation of the implementation or result in a reversal of measures whole or part of a failing financial institution with taken by resolution authorities acting within their timely payout or transfer of insured deposits. legal powers and in good faith. Instead, the law should provide for redress by awarding compensation, if justified. KA4 - Set-off, netting, collateralization, segregation of COVID-19 and Financial Stability: Bank Resolution client assets KA6 – Funding of firms in resolution 13. There needs to be a clear and robust legal framework for set-off, netting and related 16. Jurisdictions should have statutory or other matters. The legal framework governing set-off rights, policies in place so that authorities are not contractual netting and collateralization agreements constrained to rely on public ownership or bail- and the segregation of client assets should be clear, out funds as a means of resolving firms. Where transparent and enforceable in the resolution of firms, temporary sources of funding to maintain essential and should not hamper the effective implementation functions are needed to accomplish orderly resolution, 118 119 COVID-19 and Financial Stability: Bank Resolution the resolution authority or the authority extending the management and resolution of, a cross-border the temporary funding should make provision to financial crisis affecting the institution. CMGs should recover any losses incurred (i) from shareholders and include the supervisory authorities, central banks, unsecured creditors (subject to the ‘no creditor worse resolution authorities, finance ministries and the off than in liquidation’ safeguard); or (ii) if necessary, public authorities responsible for deposit insurance from the financial system more widely. Deposit schemes of jurisdictions that are home or host to insurance should be able to be applied for resolution entities of the group that are material to its resolution funding purposes, subject to a ‘least cost’ principle, and should cooperate closely with authorities in other such that the deposit insurance scheme does not jurisdictions where firms have a systemic presence. contribute more to a resolution than would have been paid to reimburse insured depositors on a least-cost basis. KA9 - Institution-specific cross- border cooperation agreements KA7 – Legal framework 19. In the case of financial institutions with conditions for cross-border significant cross-border operations, the home and host resolution authorities are encouraged cooperation to enter into institution-specific cross-border cooperation agreements. These agreements should 17. In the case of financial institutions with set out the protocols to facilitate cooperation and significant cross-border operations, effective coordination in resolution, as well as information resolution requires cross-border cooperation exchange and coordination in resolvability between home and host authorities. The statutory assessments and resolution planning. In a financial mandate of a resolution authority should empower stress or crisis situation, the agreements should set and strongly encourage the authority wherever out the escalation procedures to be followed by home possible to act to achieve a cooperative solution and host authorities and the means by which the with foreign resolution authorities. Legislation authorities will coordinate their respective remedial and regulations in jurisdictions should not contain and resolution actions. provisions that trigger automatic action in that jurisdiction as a result of the initiation of resolution in another jurisdiction, while reserving the right of discretionary national action if necessary to KA10 – Resolvability achieve domestic stability in the absence of effective international cooperation. Where a resolution assessments authority takes discretionary national action, it should 20. For any financial institution that is systemically consider the impact on financial stability in other significant, the resolution authority should jurisdictions. Where feasible, the law should facilitate undertake a resolvability assessment. The purpose mutual recognition of home/host authority resolution of the resolvability assessment is to identify the actions, subject to the agreement of the respective potential impediments to the cost-effective resolution resolution authorities. of a financial institution (including its regulatory group) and the means by which the impediments can be reduced or eliminated. KA8 – Crisis Management 21. In undertaking resolvability assessments, Groups resolution authorities should in coordination with other relevant authorities assess: (i) the extent 18. Cross-border cooperation is facilitated by to which critical financial services, and payment, home authorities establishing Crisis Management clearing and settlement functions can continue to be Groups (CMGs). In the case of financial institutions performed; (ii) the nature and extent of intra-group with significant cross-border operations, CMGs can exposures and their impact on resolution if they need assist in enhancing preparedness for, and facilitating to be unwound; (iii) the capacity of the firm to deliver KA12 – Access to information sufficiently detailed accurate and timely information to support resolution; and (iv) the robustness of and information sharing cross-border cooperation and information sharing arrangements. 25. Effective resolution requires close cooperation and coordination between relevant agencies 22. Resolution authorities should have powers domestically and on a cross-border basis. This to require, where necessary, the adoption of requires robust arrangements for information appropriate measures to reduce the complexity exchange. Jurisdictions should ensure that no legal, and costliness of resolution. To enable the regulatory or policy impediments exist that hinder the continued operations of systemically important appropriate exchange of information, including firm- functions, authorities should evaluate whether to specific information, between supervisory authorities, require that these functions be segregated in legally central banks, resolution authorities, finance and operationally independent entities that are ministries and the public authorities responsible shielded from group problems. for deposit insurance schemes. In particular: (i) the sharing of all information relevant for recovery and resolution planning and for resolution should be possible in normal times and during a crisis at KA11 – Recovery and resolution a domestic and a cross-border level; and (ii) the planning procedures for the sharing of information relating to financial institutions with significant cross-border 23. For any financial institution of systemic operations should be set out in institution-specific importance, the resolution authority should cooperation agreements. prepare and maintain a resolution plan that sets out a cost-effective means of resolution. The resolution plan will be informed by the resolvability assessment. It is intended to facilitate the effective use „ RESOLUTION OBJECTIVES of resolution powers to protect systemically important functions, with the aim of making the resolution of any 26. As noted in the Key Attributes, clearly defined firm feasible without severe disruption and without objectives are a critical element in the framework exposing taxpayers to loss (to the extent feasible). for dealing with bank distress and failure. The 24. The resolution plan should include a legislation governing resolution should establish substantive resolution strategy and an operational objectives that are clear and consistent with sound plan for its implementation, and identify: (i) financial stability outcomes. financial functions for which continuity is critical; (ii) 27. The Key Attributes provide a useful suitable resolution options to preserve those functions reference point for authorities to assess their or wind them down in an orderly manner; (iii) data resolution frameworks and identify areas where requirements on the firm’s business operations, improvements may be necessary. As noted later structures, and systemically important functions; (iv) in this paper, the World Bank suggests that the PIC COVID-19 and Financial Stability: Bank Resolution potential barriers to effective resolution and actions to authorities undertake (or refresh previous) self- mitigate those barriers; (v) actions to protect insured assessments of their resolution frameworks using depositors; and (vi) clear options for exit from the the Key Attributes as guiding points. This analysis can resolution process. Resolution plans should be kept usefully draw on findings and recommendations from under regular review and subject to periodic testing. any FSAP, FSSR or TA missions the PICs have received to the extent that the missions included assessments of resolution frameworks. 120 121 COVID-19 and Financial Stability: Bank Resolution the framework for determining critical functions „ RESOLUTION TOOLKIT  that would need to be maintained (either in the failing bank if it is recapitalized, another bank or 28. As noted in the discussion of the Key a bridge bank) in order to maintain continuity of Attributes, a comprehensive set of legal powers, systemically important business; anchored to well-defined statutory objectives,  the process for determining whether provide the essential foundation for an effective compensation might need to be paid to resolution regime. However, even the best legal shareholders and creditors of a resolved bank, powers are not sufficient unless the authorities know to the extent that they are left worse off under how to use them. And this is where the development the resolution than they would have been under of a ‘resolution toolkit’ becomes critical, given that it conventional bankruptcy, including the means by provides guidance on the resolution process and how which such compensation risks can be reduced the resolution powers should be applied. The generic (e.g. robust valuation processes, options for resolution guidance would be expected to cover structuring a bail-in to enable affected creditors to critical aspects of the resolution process, including the benefit from asset sales conducted as part of the items set out below. Key elements would include: failed bank’s liquidation, etc);  the framework for assessing solvency and liquidity,  the coordination required between the including under acute time pressure, and (taking resolution authority, supervisory authority, into account solvency and liquidity) the framework deposit insurance agency and finance ministry for assessing viability; in respect of each stage of the resolution  the methodology for assessing the likely systemic process, and the arrangements for equivalent and economic impact of a bank’s failure, drawing cross-border coordination, which might include on the OJK’s existing methodology for determining the establishment of a multilateral bank crisis D-SIBs, but supplemented by additional management MoU between the agencies considerations at the time of bank distress;  the selection and appointment of advisers to assist  the resolution options available, and guidance on in the resolution process; and the determination of their appropriateness under  communication strategies for each resolution particular situations, having regard to the type of option, by reference to stakeholders and their bank and its systemic importance at the time; information needs.  the framework for determining the ‘least cost’ for the purpose of assessing the appropriate 29. The resolution toolkit should set out the resolution option for a particular bank and the guidance for each resolution option both in amount of funding to be obtained from the deposit respect of banks and their respective banking insurance agency, subject to the safeguards set out groups. This recognizes that effective resolution of a in the law; bank, especially a D-SIB, will inevitably entail resolving  the step-by-step processes by which each subsidiaries of the bank (or a holding company) resolution option could be applied, including the where the subsidiaries perform critical functions necessary prepositioning; and services, as is often the case. On that basis, the resolution toolkit should include guidance on both  the process for appointing an administrator or ‘Single Point of Entry’ (SPE) basis and ‘Multiple Points otherwise assuming control of the bank, the pre- of Entry’ (MPE) basis. identification of possible candidates for that role and draft terms of reference; 30. In the context of a generic resolution toolkit,  the process by which a bridge bank would be banks could usefully be classified into categories, established, including the preparation of necessary such as: draft documentation, governance arrangements  Domestically-owned D-SIBs with significant foreign and the identification of possible candidates for operations (which, in the case of the PICs, is board and managerial appointments; pertinent only to PNG currently)  Foreign-owned D-SIBs, either as subsidiaries or if the core functions and services were terminated branches of foreign banks (which is a core category or suspended for a sustained period. Open of bank for many of the PICs, given the dominance resolutions are generally applied to systemically of foreign-owned banks in the PICs) important banks.  Medium-sized domestic banks  For the purpose of this paper, a closed resolution refers to a form of resolution in which the  Medium-sized subsidiaries or branches of foreign failing bank is closed and its core functions and banks services are terminated and the bank is placed  Small domestic banks into liquidation. In this resolution, insured  Small subsidiaries or branches of foreign banks depositors would be paid out or their deposit accounts transferred to another bank (possibly with some viable assets). A closed resolution is 31. The toolkit would identify the generic resolution generally applied only to small banks, given that options (see below) which might be suitable for each the discontinuation of their functions and services category of bank, depending on the systemic impact of would cause no or little disruption to the financial the bank at the time of its distress or failure. system. 33. The main resolution options are summarized below. Later in this paper there is a discussion on the „ RESOLUTION OPTIONS criteria that can be used to determine when particular resolution options would be applied. 32. The resolution toolkit needs to identify the main resolution options that can be applied, together with the associated selection criteria. Such stylized strategies, which provide the starting Closed resolution options point for the development of bank-specific resolution plans, can be broadly classified into ‘closed resolution’ 34. Closed resolution options generally take two and ‘open resolution’ options. In most cases, a failed forms: bank whose closure would not have significant a. Closed Resolution Option 1 – Closure and systemic impact would be resolved via a closed payout. This involves the closure of the bank resolution. In contrast, where a bank is assessed as and payout of insured deposits, with liquidation being systemically important, its resolution would via the courts or sale via tender processes of likely take the form of open resolution. The resolution the remainder of the bank. Payout could take a toolkit should set out the detailed steps required number of forms, including payment via a bank to implement the various options. In the context of appointed as its paying agent, payment via the discussing closed resolutions and open resolutions, payment channels of the failed bank (including its the following definitional concepts are applied: branch network, ATMs and internet and telephone  For the purpose of this paper, an open resolution banking facilities), or payment by cheque or other refers to a form of resolution in which the failing instrument drawn on the resolution authority. COVID-19 and Financial Stability: Bank Resolution bank’s critical functions and services, such as b. Closed Resolution Option 2 – Closure and deposit-taking, lending and payments functions, business transfer. This involves the closure of are maintained in a continuous manner, either the bank and transfer of insured deposits and within the failing bank in resolution (e.g., via a viable assets (and potentially other liabilities) via a recapitalization) or via another bank (e.g., a bridge ‘purchase and assumption’ transaction to another bank or another existing bank to which the failing bank with the prudential and operational ability to bank’s core functions and services have been assume the business in question, through a tender transferred). An open resolution seeks to minimize process, with liquidation of the remainder of the disruption to the financial system that would arise failed bank. 122 123 COVID-19 and Financial Stability: Bank Resolution viable business to a bridge bank established for the Open resolution options purpose, and capitalized by a dedicated systemic resolution fund (and deposit insurance fund on 35. Open resolution options are generally reserved a ‘least cost principle’ basis) or public funds after for systemically important banks. The main open all shareholders and other capital holders first resolution options are: absorb losses to the full extent of their liability. a. Open Resolution Option 1 – Recapitalization via The remainder of the bank could be liquidated bail-in. This involves recapitalization of the bank or impaired assets could be transferred to asset (or at least the bank comprising its critical functions management companies established for the and systems) via bail-in of eligible unsecured purpose or already in existence. liabilities (such as non-equity forms of tier 1 or f. Open Resolution Option 6 – Transfer of tier 2 capital, and subordinated debt) after all critical business to another bank. This involves shareholders and other capital holders have first transferring critical functions and systems, and absorbed losses to the full extent of their liability). other viable business, to another willing bank, with b. Open Resolution Option 2 – Recapitalization other business of the failed bank being liquidated via private sector capital injection. This involves or transferred to asset management companies. recapitalization of the bank (or at least the bank Losses would first be absorbed by shareholders comprising its critical functions and systems) via and other capital providers to the full extent injection of capital by another bank or institutional of their liability. If there is a shortfall in funding investor, after all shareholders and other capital to finance the transfer of critical functions and holders have first absorbed losses to the full systems, and other viable assets, to the acquiring extent of their liabilities. The resolved bank (now bank, the shortfall would be made up from a recapitalized) then becomes either a wholly-owned dedicated systemic resolution fund (and deposit subsidiary or majority-owned subsidiary of the insurance fund on a ‘least cost principle’ basis) acquiring bank or other acquiring entity. and public funding unless bail-in of liabilities is c. Open Resolution Option 3 – Recapitalization possible. via a dedicated resolution fund or using public funds. This involves recapitalization of the 36. In all of the resolution options, there is a bank (or at least the bank comprising its critical presumption that losses will be absorbed by functions and systems) via a dedicated systemic ordinary shareholders and then preference bank resolution industry fund (together with shareholders, followed by creditors in the reverse funds drawn from the deposit insurance fund on a order of their ranking in a liquidation (i.e., such ‘least cost principle’ basis) or public funds, after all that lowest-ranking creditors are required to shareholders and other capital holders have first absorb losses to the full extent of their liability absorbed losses to the full extent of their liability. before any further losses are absorbed by higher- ranking creditors). d. Open Resolution Option 4 - Bridge bank capitalized via bail-in. This involves the transfer 37. The “no creditor worse off” principle would of the failed bank’s critical functions and systems apply to any of the above resolution options, and other viable business to a bridge bank as would the same principle in respect of established for the purpose, and capitalized by shareholders being no worse off than under the bail-in of creditors after all shareholders and a conventional winding up. On this basis, the other capital holders first absorb losses to the resolution outcomes for each party would be full extent of their liability. The remainder of the compared to the outcomes that would have applied in bank could be liquidated or impaired assets could a conventional winding up, with compensation being be transferred to asset management companies paid to shareholders or creditors left worse off under established for the purpose or already in existence. the resolution than would have applied in a winding e. Open Resolution Option 5 – Bridge bank up. Any compensation paid by the government would capitalized via special resolution fund or public appropriately be recovered via a levy on the financial funds. This involves the transfer of the failed sector or through a financial stability fund. bank’s critical functions and systems and other 38. The resolution of branches of foreign banks parent entity could occur via bail-in or bail-out, or a would generally be led by the home resolution combination of the two. If bail-in, it could be achieved authority, such that the branch would either via bailing-in liabilities in the parent entity (subject to be resolved through the foreign bank’s compensation for the ‘no creditor worse off’ principle) recapitalization or by business transfer. The host and/or by bailing-in liabilities at subsidiary level, authorities need to engage with the home authorities where, in either case, the liability holders are given to understand and assess how the branch would be equity in the parent entity in exchange for the ‘haircut’ affected by each possible resolution option. The host portion of their liability or as a result of a contractual authorities need to be satisfied that the resolution conversion of a debt instrument to equity. plan for the foreign bank will adequately meet the financial stability needs and depositor protection 41. Under a MPE model, recapitalization of the objectives in the host country. The host authorities bank and each essential subsidiary individually should develop a fallback resolution option to address occurs by directly injecting capital into each entity, a situation in which the home authority resolution either by bail-in or bail-out, or a combination of plan does not adequately meet the resolution the two. Under a MPE model, it would be necessary objectives of the host country. The fallback resolution to ensure that there is continuity of functionality plan would either involve the transfer of the critical support between entities, especially if, as a result of business of the branch to a bridge bank or to another the separate capitalization processes, the subsidiaries existing willing bank, if the branch is of systemic cease to be subsidiaries and no longer form part of importance, or the liquidation of the branch if it is the regulated group. not systemic. In the case of systemic branches, the host authorities need to ensure that the branches are legally and operationally pre-positioned to facilitate business transfer resolution options. Criteria for selecting resolution options 42. The selection of the resolution option will Group resolution depend on many considerations. The relevant factors will typically include the following: 39. Group resolution is an important aspect of the a. The impact of the potential closure of the bank bank resolution framework for countries with (especially its critical functions and services) banks which have subsidiaries or branches, or are on the stability of the financial system and part of a wider financial group. This is especially economy. In general, a bank whose closure would relevant in the PICs, given the dominance of foreign- have little impact on the stability of the financial owned banks. In the case of a group open resolution, system and real economy could be subject to a where the resolution extends to a bank and other closed resolution, whereas a bank whose closure entities in the financial group (e.g. a holding company, would have significant adverse impact on the foreign bank subsidiaries and other subsidiaries financial system or economy would generally be required for the maintenance of critical functions and subject to an open resolution (at least in respect services), there are two main options for resolution: of its critical functions and services). For banks ‘Single Point of Entry’ (SPE) and ‘Multiple Points of with significant potential adverse impact on the Entry’ (MPE). In both cases, the objective would be to stability of the financial system and real economy, COVID-19 and Financial Stability: Bank Resolution maintain continuity of at least critical functions and the key focus should be to ensure that the form of services of the group, possibly together with other resolution adopted maintains continuity of critical commercially viable (but non-critical) business. functions and services with minimum interruption 40. Under a SPE model, the parent entity would and disruption. It should also seek to avoid or be recapitalized to the extent required to restore at least minimize contagion risk and adverse the bank and group to financial soundness and impacts on confidence in the financial system capital compliance. Capital would be cascaded from and economy. See the next section for a brief the parent entity to subsidiaries (or branches in the discussion on the factors relevant for assessing form of net assets) as necessary. Capitalization of the systemic impact. 124 125 COVID-19 and Financial Stability: Bank Resolution b. The cost of resolution. Subject to meeting public funding is generally achieved by ensuring financial stability and real economy impact that shareholders and other capital providers considerations, the resolution option selected absorb losses to the maximum extent of their should generally be the one which involves the legal liability and that, where practicable, other lowest cost of implementation, including the costs liabilities are bailed-in to absorb remaining losses (measured in terms of Net Present Value (NPV)) of: if necessary. However, in some situations, public funding might be unavoidable – e.g. in an open ƒ loss of value from assets upon disposal; resolution in which losses exceed shareholders’ ƒ cost of recapitalization (if applicable); funds and other capital, and where bail-in is ƒ costs associated with guarantees and considered to be destabilising for the financial indemnities (if applicable); system. In that situation, if public funding is provided, then it should be on the basis of ƒ legal, accounting and other professional fees; commercial pricing (e.g. for capital funded by the ƒ tender costs (where applicable); taxpayer and for guarantees and indemnities) and with any amounts in NPV terms being recovered ƒ administration costs. from levies on the banking industry to the extent c. Protection of insured depositors. Whichever that the assets of the resolved bank are insufficient form of resolution is selected, it should ensure to meet these amounts. that insured depositors (if a deposit insurance e. Impact on moral hazard and market discipline. scheme exists) are provided with prompt access The resolution option selected should seek to to 100% of their insured deposits at minimum minimise moral hazard risks and preserve or inconvenience. Any closed resolution option enhance market discipline on the financial system. should be designed to achieve this, either via This is best achieved by ensuring that losses are prompt payout to insured depositors (e.g. via an borne by shareholders, other capital instrument agency bank selected by the deposit insurance holders and then creditors in the order of their agency or the payment infrastructure of the failed claims in a winding up, with zero or minimal bank) or transfer of insured deposit accounts to contribution from the taxpayer. another bank via a purchase and assumption process. Under an open resolution, insured f. Impact on competition and financial system deposits, as with most other deposits, would be efficiency. The resolution option selected should preserved with minimal interruption to access be designed to minimize adverse impacts on through either a recapitalisation of the bank, or competition and financial system efficiency. a bridge bank or transfer of deposit accounts Resolution options that lead to significantly (insured and uninsured) to another bank. In any reduced competition tend to have adverse impacts of these options, the deposit insurance agency’s on financial system efficiency – e.g. via higher contribution to the resolution should be on a margins, reduced range of financial services, ‘least cost’ basis – i.e. the least amount required greater market concentration. The closure of to be disbursed from the deposit insurance fund many small banks create this risk. Likewise, the to ensure prompt access to insured deposits merger of large or medium-sized banks can result (including accrued interest thereon), net of in excessive market concentration and reduced recoveries from the balance sheet of the bank. competition and efficiency in the financial system. d. Impact on public funding. The resolution option selected should generally involve zero 43. Drawing on the resolution options referred public funding (including the costs and risks to earlier in this paper, the table below provides associated with guarantees and indemnities). an indication how each option potentially rates For closed resolutions, this would generally be against the above criteria. However, as with most achieved by ensuring that the deposit insurance things, the ‘devil lies in the detail’. In other words, the fund is sufficient to meet expected claims under costs and benefits of each resolution option would a plausible range of bank failure situations and need to be assessed on the specific details of that that any supplemental funding required is fully option in the prevailing circumstances at the time, reimbursed (in NPV terms) from the banking rather than ex ante. Accordingly, Figure 3 is merely industry. For open resolutions, the least impact on illustrative and indicative. FIGURE 3. Resolution options assessed against selection criteria CLOSED RESOLUTION OPTION 1 – CLOSURE AND PAYOUT IMPACT ON FINANCIAL STABILITY AND ECONOMY Minimal adverse impact provided that the bank is small and contagion risk is low. Not a suitable option for large banks. RESOLUTION COSTS Generally low cost for the deposit insurer, but might be more expensive than Option 2 due to lower asset values and collapse of franchise value. Resolution costs reasonably high for uninsured creditors and shareholders due to adverse impact on asset values and franchise value. IMPACT ON INSURED DEPOSITORS Not generally the quickest or most efficient means of providing insured depositors with their funds unless the payout mechanism is very efficient. IMPACT ON PUBLIC FUNDING Generally zero to low impact on public funding, provided that the deposit insurance fund (if it exists) is well funded. If there is no deposit insurance fund, then public funding is likely to be needed to facilitate payout to target categories of depositors (i.e. deposits held by households and SMEs up to a defined amount), with recovery from the assets of the failed bank. IMPACT ON MORAL HAZARD AND MARKET DISCIPLINE Generally low moral hazard risk and positive effect on market discipline, especially if the deposit insurance fund is financed by risk-based levies. COVID-19 and Financial Stability: Bank Resolution IMPACT ON COMPETITION, FINANCIAL SYSTEM EFFICIENCY Generally little adverse impact on competition and financial system efficiency unless many small banks are closed, leading to lowered competition. 126 127 COVID-19 and Financial Stability: Bank Resolution CLOSED RESOLUTION OPTION 2 – CLOSURE AND BUSINESS TRANSFER IMPACT ON FINANCIAL STABILITY AND ECONOMY Minimal adverse impact provided that the bank is small and contagion risk is low. Not a suitable option for large banks. RESOLUTION COSTS Generally low cost for the deposit insurer, and might be less expensive than Option 1 if there are competitive bids for assets and franchise value. Resolution costs reasonably high for uninsured creditors and shareholders due to adverse impact on asset values and franchise value, but less so if there are competitive bids for the loan portfolio and deposit book. IMPACT ON INSURED DEPOSITORS Generally a more efficient, faster and less disruptive way of giving insured depositors access to their funds than for Option 1. IMPACT ON PUBLIC FUNDING Generally zero to low impact on public funding, provided that the deposit insurance fund is well funded. If there is no deposit insurance fund, the public funding arrangement referred to under Option 1 would apply. IMPACT ON MORAL HAZARD AND MARKET DISCIPLINE Generally low moral hazard risk and positive effect on market discipline, especially if the deposit insurance fund is financed by risk-based levies. IMPACT ON COMPETITION, FINANCIAL SYSTEM EFFICIENCY Generally little adverse impact on competition and financial system efficiency unless many small banks are closed, leading to lowered competition. If many small banks are merged into larger banks, this could have adverse competitive impacts. OPEN RESOLUTION OPTION 1 – RECAPITALIZATION VIA BAIL-IN IMPACT ON FINANCIAL STABILITY AND ECONOMY Limited adverse impact on financial system, provided that critical functions are maintained. However, there could be adverse impacts via contagion risk in situations of financial system fragility, given a concern that other banks might be resolved by bail-in. Bail-in might not be suitable for system-wide banking crises; it is better suited to idiosyncratic bank failures in otherwise stable banking systems, and where banks have sufficient debt capable of bail-in. Bail-in can also have adverse impacts on banking system liquidity, but this can be countered by liquidity support from the central bank. RESOLUTION COSTS Resolution costs potentially high for creditors subject to bail-in, but costs will be less if franchise value is preserved by keeping the bank largely intact and if asset recoveries are maximized by keeping the bank as a going concern. Creditor losses can be further contained by giving them access to upside asset recoveries (e.g. via shares). Costs for deposit insurance agency should be relatively low – no more than the ‘least cost’ contribution under a closed resolution. Costs for a resolution fund will depend on the extent to which liabilities are exempted from bail-in, the possible need for compensation for creditors rendered worse off than under a liquidation, and the possible need for interim guarantees and indemnities. IMPACT ON INSURED DEPOSITORS Insured depositors would have unimpeded access to their funds under any form of open resolution so long as the deposit book is retained in the bank as a going concern. IMPACT ON PUBLIC FUNDING Generally low impact on public funding, although some funding might be required if guarantees or indemnities are needed and if there is no industry resolution fund. Public funding might be required to the extent that some liabilities are exempted from bail-in, in the absence of an industry resolution fund. Public funding (in the absence of a resolution fund) might be required for compensation under the ‘no creditor worse off’ principle, but this could possibly avoided if creditors are given access to upside asset recoveries (e.g. via shares). COVID-19 and Financial Stability: Bank Resolution IMPACT ON MORAL HAZARD AND MARKET DISCIPLINE Low moral hazard risk and positive impact on market discipline, provided that there are few exemptions from bail- in. If public funds are used for guarantees or indemnities, or to compensate for no creditor worse off arrangements, or to fund capitalization due to some liabilities not being bailed in, then this will exacerbate moral hazard and reduce market disciplines. Market pricing and recovery of public funding outlays would reduce these risks. IMPACT ON COMPETITION, FINANCIAL SYSTEM EFFICIENCY Unlikely to have significant adverse impacts on competition or efficiency, given that market concentration is not increased and the bank’s critical functions are maintained. 128 129 COVID-19 and Financial Stability: Bank Resolution OPEN RESOLUTION OPTION 2 – RECAPITALIZATION VIA PRIVATE SECTOR CAPITAL INJECTION/MERGER IMPACT ON FINANCIAL STABILITY AND ECONOMY Limited adverse impact on financial system, provided that critical functions are maintained. RESOLUTION COSTS Resolution costs potentially high for any creditors left out of the recapitalized bank, but costs will be less if franchise value is preserved by keeping the bank largely intact and if asset recoveries are maximized by keeping the bank as a going concern. Costs for deposit insurance agency should be relatively low – no more than the ‘least cost’ contribution under a closed resolution. Costs for a resolution fund will depend on the possible need for compensation for creditors rendered worse off than under a liquidation, and the possible need for interim guarantees and indemnities. IMPACT ON INSURED DEPOSITORS Insured depositors would have unimpeded access to their funds under any form of open resolution so long as the deposit book is retained in the bank as a going concern. IMPACT ON PUBLIC FUNDING Generally low impact on public funding, although some funding might be required if guarantees or indemnities are needed and there is no industry resolution fund. IMPACT ON MORAL HAZARD AND MARKET DISCIPLINE Low moral hazard risk and positive impact on market discipline, provided that public funding is avoided or minimized (and priced at market if used at all). IMPACT ON COMPETITION, FINANCIAL SYSTEM EFFICIENCY Could have adverse impacts on competition and efficiency if it leads to excessive market concentration – e.g. if the recapitalization is achieved via a merger with/acquisition by another bank. OPEN RESOLUTION OPTION 3 – RECAPITALIZATION VIA A DEDICATED RESOLUTION FUND OR USING PUBLIC FUNDS IMPACT ON FINANCIAL STABILITY AND ECONOMY Limited adverse impact on financial system, provided that critical functions are maintained. RESOLUTION COSTS Resolution costs potentially high for any creditors left out of the recapitalized bank, but costs will be less if franchise value is preserved by keeping the bank largely intact and if asset recoveries are maximized by keeping the bank as a going concern. Costs for deposit insurance agency should be relatively low – no more than the ‘least cost’ contribution under a closed resolution. Costs for a resolution fund or public funding will depend on the size of the recapitalization needed and its pricing, and whether the bank is negative or positive equity as a starting point. Funding costs will also depend on the possible need for compensation for creditors rendered worse off than under a liquidation, and the possible need for interim guarantees and indemnities. IMPACT ON INSURED DEPOSITORS Insured depositors would have unimpeded access to their funds under any form of open resolution so long as the deposit book is retained in the bank as a going concern. IMPACT ON PUBLIC FUNDING Public funding would depend on whether there is a resolution fund to meet capitalization needs, guarantees and compensation to creditors rendered worse off. If there is no resolution fund, then public funding could be high, depending on the capitalization requirement, but costs can be reduced through market-based pricing and capacity for ex post recoveries from the industry. IMPACT ON MORAL HAZARD AND MARKET DISCIPLINE Moral hazard risk is high and market disciplines will be eroded if public funding is used to any significant degree. COVID-19 and Financial Stability: Bank Resolution Hence, a resolution fund can reduce these risks, as can market-based pricing of any public funding and recovery from industry. IMPACT ON COMPETITION, FINANCIAL SYSTEM EFFICIENCY Unlikely to have significant adverse impacts on competition or efficiency, given that market concentration is not increased and the bank’s critical functions are maintained. 130 131 OPEN RESOLUTION OPTION 4 - BRIDGE BANK CAPITALIZED VIA BAIL-IN COVID-19 and Financial Stability: Bank Resolution IMPACT ON FINANCIAL STABILITY AND ECONOMY Limited adverse impact on financial system, provided that critical functions are maintained. However, there could be adverse impacts via contagion risk in situations of financial system fragility, given a concern that other banks might be resolved by bail-in. Bail-in might not be suitable for system-wide banking crises; it is better suited to idiosyncratic bank failures in otherwise stable banking systems, and where banks have sufficient debt capable of bail-in. Bail-in can also have adverse impacts on banking system liquidity, but this can be countered by liquidity support from the central bank. The establishment of a bridge bank may create temporary market uncertainty and adverse confidence effects until the bank becomes established. This might require interim guarantees. RESOLUTION COSTS Resolution costs potentially high for creditors subject to bail-in, but costs will be less if franchise value is preserved by keeping the bank largely intact and if asset recoveries are maximized by keeping the bank as a going concern. Creditor losses can be further contained by giving them access to upside asset recoveries (e.g. via shares). Creditor losses likely for those left outside of the bridge bank. Costs for deposit insurance agency should be relatively low – no more than the ‘least cost’ contribution under a closed resolution. Costs for a resolution fund will depend on the extent to which liabilities are exempted from bail-in, the possible need for compensation for creditors rendered worse off than under a liquidation, and the possible need for interim guarantees and indemnities. IMPACT ON INSURED DEPOSITORS Insured depositors would have unimpeded access to their funds under any form of open resolution so long as the deposit book is retained in the bank as a going concern. IMPACT ON PUBLIC FUNDING Generally low impact on public funding, although some funding might be required if guarantees or indemnities are needed and if there is no industry resolution fund. Public funding might be required to the extent that some liabilities are exempted from bail-in, in the absence of an industry resolution fund. Public funding (in the absence of a resolution fund) might be required for compensation under the ‘no creditor worse off’ principle, but this could possibly avoided if creditors are given access to upside asset recoveries (e.g. via shares). IMPACT ON MORAL HAZARD AND MARKET DISCIPLINE Low moral hazard risk and positive impact on market discipline, provided that there are few exemptions from bail- in. If public funds are used for guarantees or indemnities, or to compensate for no creditor worse off arrangements, or to fund capitalization due to some liabilities not being bailed in, then this will exacerbate moral hazard and reduce market disciplines. Market pricing and recovery of public funding outlays would reduce these risks. IMPACT ON COMPETITION, FINANCIAL SYSTEM EFFICIENCY Unlikely to have significant adverse impacts on competition or efficiency, given that market concentration is not increased and the bank’s critical functions are maintained. OPEN RESOLUTION OPTION 5 – BRIDGE BANK CAPITALIZED VIA SPECIAL RESOLUTION FUND OR PUBLIC FUNDS IMPACT ON FINANCIAL STABILITY AND ECONOMY Limited adverse impact on financial system, provided that critical functions are maintained. However, the establishment of a bridge bank may create temporary market uncertainty and adverse confidence effects until the bank becomes established. This might require interim guarantees. RESOLUTION COSTS Resolution costs potentially high for any creditors left out of the recapitalized bank, but costs will be less if franchise value is preserved by keeping the bank largely intact and if asset recoveries are maximized by keeping the bank as a going concern. Costs for deposit insurance agency should be relatively low – no more than the ‘least cost’ contribution under a closed resolution. Costs for a resolution fund or public funding will depend on the size of the recapitalization needed and its pricing, and whether the bank is negative or positive equity as a starting point. Funding costs will also depend on the possible need for compensation for creditors rendered worse off than under a liquidation, and the possible need for interim guarantees and indemnities. IMPACT ON INSURED DEPOSITORS Insured depositors would have unimpeded access to their funds under any form of open resolution so long as the deposit book is retained in the bank as a going concern. IMPACT ON PUBLIC FUNDING Public funding would depend on whether there is a resolution fund to meet capitalization needs, guarantees and compensation to creditors rendered worse off. If there is no resolution fund, then public funding could be high, depending on the capitalization requirement, but costs can be reduced through market-based pricing and capacity for ex post recoveries from the industry. A bridge bank is more likely to require a temporary guarantee and liquidity funding than would a recapitalized existing bank. IMPACT ON MORAL HAZARD AND MARKET DISCIPLINE COVID-19 and Financial Stability: Bank Resolution Moral hazard risk is high and market disciplines will be eroded if public funding is used to any significant degree. Hence, a resolution fund can reduce these risks, as can market-based pricing of any public funding and recovery from industry. IMPACT ON COMPETITION, FINANCIAL SYSTEM EFFICIENCY Unlikely to have significant adverse impacts on competition or efficiency, given that market concentration is not increased and the bank’s critical functions are maintained. 132 133 COVID-19 and Financial Stability: Bank Resolution OPEN RESOLUTION OPTION 6 – TRANSFER OF CRITICAL BUSINESS TO ANOTHER BANK IMPACT ON FINANCIAL STABILITY AND ECONOMY Limited adverse impact on financial system, provided that critical functions are maintained. However, there could be market uncertainty on the stability of the arrangement for a period. RESOLUTION COSTS Resolution costs potentially high for any creditors left out of the transfer to the acquiring bank. Costs for deposit insurance agency should be relatively low – no more than the ‘least cost’ contribution under a closed resolution. Costs for a resolution fund will depend on the possible need for compensation for creditors rendered worse off than under a liquidation, and the possible need for interim guarantees and indemnities. If there is negative equity, and bail-in is not feasible (or insufficient liabilities can be retained in the old bank), then a resolution fund would need to absorb those losses as part of the business transfer arrangement. IMPACT ON INSURED DEPOSITORS Insured depositors would have unimpeded access to their funds under any form of open resolution so long as the deposit book is part of the business transferred to the acquiring bank. IMPACT ON PUBLIC FUNDING Depending on whether a resolution fund is established, public funding might be required for compensation of creditors under the ‘no creditor worse off’ principle, and for indemnities and guarantees if needed. Any public funding should be market priced and subject to recovery from the assets of the resolved bank or ex post levies on the industry. IMPACT ON MORAL HAZARD AND MARKET DISCIPLINE Moral hazard risk is high and market disciplines will be eroded if public funding is used to any significant degree. Hence, a resolution fund can reduce these risks, as can market-based pricing of any public funding and recovery from industry. If the business transferred is funded by the assets of the failed bank, with little need for public funding or guarantees, then then moral hazard risk would be low. IMPACT ON COMPETITION, FINANCIAL SYSTEM EFFICIENCY Could have adverse impacts on competition and efficiency if it leads to excessive market concentration. 46. The systemic impact assessment should be „ ASSESSING SYSTEMIC undertaken not just for the bank on a solo entity IMPACT basis, but also on a banking group basis (i.e. taking into account the systemic impact of the failure of subsidiaries of the bank), where banks have significant 44. A key element in determining whether a business in subsidiaries. bank should be resolved using a form of closed resolution or open resolution is the assessment 47. As part of the systemic impact assessment, of its systemic impact upon failure. All else being contagion risk should be assessed. The analysis equal, a bank with significant systemic importance would appropriately include an assessment of: would be resolved via a form of open resolution in order to minimize adverse impacts on the stability of  contagion via inter-bank exposures; the financial system and wider economy. Conversely,  contagion arising from related party exposures, in the absence of merger options, a bank with an such as credit exposures to parent banks and insignificant systemic importance would generally be other substantial shareholders; resolved via a form of closed resolution unless there was a concern over significant contagion effects (i.e.  credit rating downgrade risks associated with where the failure of one small bank could result in the parent bank stress; multiple failure of other small banks). If a significant  reputation impacts associated with parent bank or contagion risk was thought to be present, then the other major shareholder distress; resolution authority might consider a form of open  contagion risks associated with functional resolution – such as merger with another bank – in dependencies between banks with common order to minimize the risk. shareholdings; 45. Systemic impact assessments would  contagion via banks having common credit appropriately draw on the criteria applied in the exposures (e.g. syndicated lending, where the D-SIB framework developed by the BCBS. The failure of one bank to meet commitments under analysis would therefore take into account: a syndicated loan could impact the other banks in  the market share of each bank in each of the key the syndicate); lending sectors;  the contagion impact of bank defaults on interest  the market share of each bank in the deposit rate and foreign currency derivatives (i.e., requiring market (differentiating between retail and other banks to replace interest rate and currency wholesale deposits); contracts they had with the failed bank, and the potential difficulty in doing so under stressed  the share of payments services, differentiated by conditions, possibly leaving them with unhedged payment system and payments product; exposures); and  the share of lending to economic and social  confidence-linked contagion risks and the potential infrastructure providers; for a generalized depositor run on banks.  inter-connectedness (including intra-group and between banks); 48. The appendix to this paper provides further guidance on when particular types of resolution COVID-19 and Financial Stability: Bank Resolution  potential for the bank to cause contagion (drawing on the contagion analysis referred to earlier); option could be considered, taking into account the systemic importance of the bank and other  substitutability of systemically important financial considerations. functions (including considerations related to the concentrated nature of the banking sector); and  complexity (including any complexities arising from group structures and the location of essential banking functions in subsidiaries, and cross-border activity). 134 135 COVID-19 and Financial Stability: Bank Resolution 52. Critical functions will typically include „ RESOLVABILITY functions relating to: ASSESSMENTS AND  Deposit-taking, particularly the capacity to receive RESOLUTION PLANNING deposits into transaction accounts.  Transactions capacity – the ability to make and 49. For any bank of potential systemic importance, receive payments, retail and wholesale. the resolution authority should pre-identify  Clearing and settlement functions. the appropriate resolution option for that bank and ensure that the resolution option  Wholesale funding, particularly the ability to can be implemented effectively. To achieve this, receive funding via on-call wholesale deposits. it is necessary to undertake regular resolvability  Correspondent banking functions. assessments of any bank (other financial institution)  Treasury functions. that is or has the potential to be systemically important. Resolvability assessments should be  Derivatives servicing – e.g. with respect to interest conducted by the resolution authority on the basis rate and currency swaps, forwards and options. of data and qualitative information provided by the  Provision of credit under committed credit bank (and wider group if necessary). The purpose of facilities. the resolvability assessment is to identify potential impediments to resolvability for the particular  Loan servicing. financial institution, based on the resolution option  Provision of risk hedges to customers. (or more than one option) considered to be feasible  Provision of financial services to markets in which and appropriate for that institution. The assessment the bank is the sole or predominant provider and should also include an identification of the means where significant disruption to the financial system by which impediments to resolution can be reduced or economy would result if the services were or removed so as to enable the selected resolution discontinued. option(s) to be able to be implemented cost-effectively and in a timely manner. 53. Resolvability assessments need to identify the 50. A key focus of resolvability assessments is critical functions and services of each bank and to identify a bank’s/group’s critical functions the potential impediments to their continuity in and services. These represent the parts of a bank/ a resolution. These include the relevant systems group that need to be continued in order to minimize and controls, the entities in which the functions and adverse impacts on the financial system and economy. services are performed, the jurisdictions in which they Any form of resolution for a bank assessed as being operate and the inter-dependencies (functional, legal systemically important should ensure that critical and financial) between the entities in question. The functions and services are continued, either in the assessments need to identify the means by which bank itself or in another entity (i.e. a bridge bank or critical functions and services can be maintained another bank). with no or minimal interruption, at least cost, and any factors that could impede such continuity. 51. The FSB notes that a critical function has the Drawing on the resolvability assessment, resolution following two elements: plans pull together the operational details required a. it is provided by a bank/group to third parties not for continuity of operation of critical functions and affiliated to the bank/group; and services for each resolution option. b. the sudden failure to provide that function would 54. The resolvability assessment for a particular be likely to have a material impact on the third bank/group needs to identify, for each critical parties, give rise to contagion or undermine the function: general confidence of market participants due to:  the details of the functions provided, including ƒ the systemic relevance of the function for the scale, scope, nature of clients, etc; third parties; and  participation in particular FMIs; ƒ the systemic relevance of the bank/group in  the legal entities performing the functions; providing the function.  the IT and other systems used to perform and 58. Once a resolvability assessment has been support the functions; completed, the resolution authority then needs to prepare a resolution plan for the bank in question.  the jurisdiction in which the entities are located; The resolution plan sets out the details of how each and element of the resolution option(s) selected for that  the inter-dependencies (legal, financial and bank would be implemented, based on the data from operational) of these entities required for them to the resolvability assessment. If there are impediments continue to maintain these functions. to resolution, these should have been identified in the resolvability assessment and the bank should be 55. Critical services also need to be identified. required to put in place the necessary arrangements, Critical services (including services shared between including restructuring of operations if necessary, to or among entities within a group) are activities reduce or eliminate the impediments. The resolution performed within the firm or outsourced to third plan would set out these arrangements. It would parties where failure would lead to the inability to identify, for each phase of the resolution process, the perform critical functions and, therefore, to the actions that would need to be taken to implement the disruption of functions vital for the functioning of the selected resolution option for that bank. real economy or for financial stability. 59. Resolution plans should be reviewed and 56. The critical services will include systems, data updated on a regular basis. This is done by and other functionality required to: the resolution authority on the basis of periodic resolvability assessments that take into account any  perform critical functions; material changes to the business operations of the  maintain customer accounts; bank.  maintain financial records;  meet financial obligations as they become due and payable; „ CROSS-BORDER  maintain payroll and other employee obligations;  maintain operational security, including the COOPERATION AND security of all premises required for critical COORDINATION functions and services;  maintain all assets required for the performance of 60. In the case of a bank with cross-border critical functions and services; operations, the resolvability assessment and resolution planning processes should be led by  identify, measure, monitor and manage all material the home resolution authority at group level. The risks; resolvability assessment should be undertaken for  comply with prudential requirements; and the parent entity in the home country and for the  comply with other legal requirements. global group as a whole. The resolution plan should include the resolution plan for the parent bank in the home country and for the global group. Clearly there 57. Critical shared services should be structured is a need for close cooperation between the home COVID-19 and Financial Stability: Bank Resolution to ensure the continued availability of shared resolution authority and host resolution authorities services to all relevant parts of the bank or in the undertaking of resolvability assessments group under the chosen resolution option. and development of resolution plans. The home Examples of arrangements which can achieve that authority needs to involve the host authorities objective include, but are not limited to, performing in the resolvability assessment and resolution shared services out of separate legal entities or planning processes, with particular emphasis on preparing in advance for a carve out in a crisis. If the the means by which the resolution would deal with service arrangement is with an external provider, foreign subsidiaries and branches. Cooperation arrangements should be in place in order to ensure and coordination are best achieved on the basis a continuation of the services. 136 137 COVID-19 and Financial Stability: Bank Resolution formalised MOU or similar document that sets out or performed through a shared services company the respective responsibilities of the home and host in the parent group and structured so that there authorities, including for the home/host authority is reasonable certainty of the ability to maintain input into the group resolvability assessment and continuity if the subsidiary/branch is separated from resolution plan, and the actual process of resolution the parent. This resolution option would also likely implementation in an actual bank failure situation. involve the transfer of the relevant business functions Crisis management groups and supervisory colleges of the subsidiary/branch to either another bank can also be effective vehicles through which home/ in the host country (if feasible) or to a bridge bank host resolution authority resolvability assessments, established for the purpose. In such a case, some host resolution planning, and resolution implementation resolution authorities require foreign subsidiaries can be coordinated. or branches to be pre-positioned to enable them to maintain critical functions and services on a stand- 61. In the case of foreign-owned banks, the parent alone basis so that, in a resolution, they could be fully entity resolution plan should focus primarily separated from the parent entity if necessary. on how a whole-of-group resolution would be implemented. This would generally be done in ways 63. These are complex issues and require careful that enable the parent entity to provide the required consideration and planning by the home and capital, liquidity funding and operational support to host authorities. The development of cross-border the operations in the host country. This might involve banking group resolution plans needs to recognize some form of ‘Single Point of Entry’ (SPE) resolution, that the home and host countries have overlapping under which any capital and liquidity injections interests, with both seeking to achieve cost-effective needed by the bank subsidiary/branch in the host financial stability outcomes in the home and host country would be facilitated via the parent entity countries. However, there also needs to be a clear (either through some form of bail-in at parent level recognition of divergent interests between the home or alternative capital-raising mechanism). Likewise, if and host countries. The home country authority’s the parent resolution involved a sale of the bank to primary focus is the financial stability of its own another party or the transfer of some of its business to country and the achievement of a least-cost resolution a bridge bank in the home jurisdiction, the resolution for the home country. In contrast, the host authority’s plan would desirably set out the means by which the primary focus is on protecting the financial stability subsidiary/branch in the host country is integrated impact in the host country and minimizing resolution into the parent bank resolution strategy, including by costs at a local level. These divergent and competing way of appropriate recognition or facilitation by the interests should be dealt with openly, with a view to host resolution authority of resolution actions needed seeking to strike a workable whole-of-group resolution in the host country to accommodate the parent that meets the needs of home and host countries, but resolution strategy. with an understanding of the likely need for the host authority to establish a fallback resolution option that 62. Resolution plans also need to cater for can be implemented by the host resolution authority situations where the home authorities do not in the event that the home authority’s proposed implement a form of resolution that meets the approach does not adequately meet the needs of the financial system and depositor protection needs of host country. In countries, such as some of the PICs, in the host country. In such cases, it will be important which the operations of a foreign bank are very small to incorporate into resolution plans a host country relative to the global banking group, it can be difficult ‘fallback’ resolution option that enables the subsidiary/ for the host authorities to engage meaningfully with branch in the host country to be separated from the home resolution authorities on resolution planning parent banking group and resolved in a manner that matters. However, guidance has been developed by maintains continuity of critical functions and systems the FSB to assist in this process. It is best done either in the host country so as to minimize disruption to bilaterally between the home and host authority or the domestic financial system. This is likely to involve multilaterally via the home authority and a group of consideration of the means by which critical services small host authorities. can either be performed by the subsidiary/branch as the PICs, the ability of banks to issue tranches „ RESOLUTION FUNDING of debt of this nature is very limited due to lack of investor demand and the absence of secondary 64. An important issue arising in a bank resolution markets for such instruments at a local or regional is the need for funding to facilitate some forms of level. Accordingly, the most practical solution is for the resolution. This arises in both closed resolutions and authorities to require large banks to have a relatively open resolutions. high standard capital requirement so as to achieve a very low probability of bank failure and to provide a 65. In the case of a closed resolution involving a source of funding in resolution. small bank, funding will be required to facilitate prompt pay-out to depositors or the transfer 68. Even if the larger banks are strongly capitalized of their deposit accounts to another bank. In or have a tranche of bail-in debt available, there most countries, this is achieved through a deposit is still the possible need for external resolution insurance, under which a dedicated deposit insurance funding. Resolution funding may be required in funding mechanism is established, financed by levies various forms of bank resolution, – e.g., to provide a on banks and supplemented with a funding line with temporary guarantee of a resolved bank’s liabilities, the government or a similar arrangement. Deposit an indemnity to particular parties, or funding for insurance schemes provide the principal source recapitalization or business transfers (e.g. the transfer of funding for small bank resolutions, whether to of impaired assets to an AMC). As a general rule, facilitate payout of insured deposits or the financing external funding should only be provided once all of the transfer of insured deposit accounts to another assessed losses in the failed bank have been fully bank. absorbed by shareholders and then by creditors in accordance with the ranking of claims in a winding up 66. Most PICs do not have deposit insurance (i.e., lowest ranking debt claims absorb losses before schemes. This is one of the large gaps in the bank higher ranking debt claims). In some countries, such resolution framework in the PICs. The absence of as the member states of the EU, dedicated resolution deposit insurance complicates bank resolution and funds have been established for this purpose, would require the authorities to consider alternative whereby banks are levied to contribute to the build-up funding sources for bank resolution, including the risk and maintenance of the funds. However, for smaller of drawing on government funding, with attendant countries, the creation of pre-funded resolution funds moral hazard risk and adverse implications for public (on top of deposit insurance) is not practical, given the debt. Deposit insurance is an issue to be discussed in costs to the banking system and the opportunity costs a future ‘deep dive’ paper. of diverting bank funds into a scheme that can only be used for events of very low probability. A viable 67. Even in countries with deposit insurance alternative is to establish a legislative framework that schemes, the scheme is unlikely to be sufficient empowers the government to obtain special-purpose to provide an effective funding source in the case appropriation from the legislative body to use public of a systemically important bank resolution. For funding for resolution purposes, but subject to robust a large bank resolution, the general objective is to safeguards. These safeguards would include well minimize the need for any external funding by seeking defined objectives (anchored to financial stability and COVID-19 and Financial Stability: Bank Resolution to ensure that the banks are strongly capitalized. In the maintenance of continuity of critical functions and many countries, normal bank capital requirements services), specific purposes for which the funds may are supplemented with a loss-absorbing capital be used, preconditions for drawdown of the funds requirement under which a bank is required to issue (including that all other funding options have been a tranche of unsecured, subordinated debt capable of exhausted), conditionality on the bank in resolution, bail-in – e.g. where the debt converts to CET1 equity and a mechanism for ex post recovery of funding upon a non-viability event or where the CET1 ratio outlays (including potentially levies on banks). falls below a defined level. In small countries, such 138 139 COVID-19 and Financial Stability: Bank Resolution j. Most PICs have not undertaken regular crisis „ FINDINGS AND management simulation exercises, either RECOMMENDATIONS FOR domestically or involving cross-border exercises. PICS 70. These findings are not surprising given the small size of the PICs and the limited resources 69. Various IMF/WB FSAP, FSSR and TA missions available. Many small countries (and some to PICs have included an assessment of bank larger ones) have similar gaps in their resolution resolution frameworks. The findings vary country to frameworks. Progress in the development of bank country, as one would expect. However, some findings resolution frameworks globally is patchy, especially are common to most of the PICs covered by such outside the G20. However, the gaps identified for the missions. The common findings include: PICs identify a vulnerability in the event that the PICs a. In the PICs assessed by IMF/WB missions, most face banking distress situations in the years to come. have inadequately developed legal frameworks Many of the PICs would struggle to implement cost- for resolution, including insufficient legal powers effective and timely bank resolutions given the general to implement a range of resolution options or inadequacy of legal powers, the under-development to require resolution pre-positioning. Resolution of resolution policies and procedures, and the lack of powers are overly dependent on court-based effective cross-border coordination arrangements. processes. There is an absence of sufficient legal These deficiencies create a risk that governments in safeguards, including no ‘no creditor worse off’ the region may need to resort to potentially expensive framework. publicly funded bail-outs in the event of any major banking system distress, with consequences for public b. There is no designated resolution authority with a debt and moral hazard. clearly specified resolution mandate, although in most PICs it is clear that the supervision authority 71. These issues are generally well understood has most of the resolution functions. by the PIC authorities. Some are making progress c. There is inadequate separation of supervision to address the deficiencies in their resolution from resolution within central banks/supervisory frameworks. However, much further progress is authorities, and inadequate arrangements in place needed. Accordingly, it is recommended that the PIC to minimize potential internal conflicts. authorities take the opportunity, sooner than later, to review their resolution frameworks by reference d. There is a lack of resourcing of the resolution to the Key Attributes and identify the key areas function, with staff generally under-trained on where there are gaps or deficiencies. Having done resolution matters. this, it is suggested that the authorities establish e. Resolution policies and procedures have not work programs that set out a prioritized sequence generally been well developed. of reforms needed to implement effective resolution f. No arrangements are in place for bank-specific frameworks. These reforms will likely include the need resolvability assessments or resolution plans. for: g. There is no deposit insurance in most of the  strengthening resolution law and associated PICs and no other dedicated source for resolution safeguards; funding.  increasing the level of staff attention and h. Domestic coordination arrangements for resourcing for resolution-related issues; resolution and financial crisis management are  developing a resolution ‘toolkit’ that sets out under-developed, especially between the central guidance on the selection and implementation of bank/supervision authority and ministry of finance. resolution options; i. Cross-border cooperation and coordination  undertaking resolvability assessments and arrangements are under-developed, with no developing resolution plans for the larger banks; substantive home/host authority engagement  establishing cross-border cooperation and on whole-of-group resolvability assessments and coordination arrangements; and resolution planning.  establishing appropriate resolution funding resolution planning arrangements. The resolution arrangements especially the need for deposit toolkits developed by the authorities do not need to insurance or an alternative mechanism that be overly complicated – they just need to cover the provides depositors with prompt access to at least basics, such as the identification of a small number a proportion of their on-call deposits). of practical resolution options for the different categories of banks and the key procedures needed 72. Given the limited resources available in the to implement resolution options. Resolution plans PIC authorities, and the small size of PIC financial should also be kept as simple as possible and be systems, it is recommended that the authorities closely coordinated with home authorities in the apply relatively simple and prioritized approaches case of the cross-border banks. If deposit insurance to the development of resolution frameworks. In is established (which we generally recommend), small countries, such as the PICs, there is no need for then it should be kept relatively simple in design and overly complex resolution arrangements. Complex administration – as we will discuss in a future deep resolvability assessments and resolution plans can dive paper on this topic. generally be avoided in favour of relatively simple „ APPENDIX 1. SELECTION OF PARTICULAR RESOLUTION OPTIONS This appendix provides broad guidance on when This option would generally be appropriate where: particular types of resolution option could be a. The bank is small and has no systemically considered, having regard to the systemic importance significant business. Its business functions are of a bank and other considerations. easily replaceable by other banks. Closure of the bank would not have a significant adverse impact on the stability of the financial system or economy, Closed Resolution Option 1 – or give rise to contagion risk. Closure and Payout b. The bank is insolvent (i.e. negative equity) or close to insolvent, or otherwise very substantially below This involves the closure of the bank and payout minimum capital requirements. of insured deposits, with liquidation via the courts c. The bank cannot recover – i.e. there is no prospect or sale via tender processes of the remainder of of shareholder support or external financial private the bank. Payout could occur via cash, electronic sector support in the required timeframe. payments or paper-based payments (e.g. cheques) COVID-19 and Financial Stability: Bank Resolution d. No bank is willing or able to acquire the insured drawn on an agency bank appointed by the deposit deposit liabilities from the failing bank. insurance agency or using the payments facilities of the failed bank (under the control of the deposit e. The net cost to the deposit insurance agency insurance agency). Other payout options could also (i.e. the NPV of all payments minus recoveries) be used, such as enabling depositors to open bank of payout is less than the estimated net cost of accounts in other banks upon being provided with Option 2 (below) or a subsidized merger with a the required information and verification data by the larger bank. deposit insurance agency to do this, where the deposit insurance agency funds the banks in question for the amounts involved. 140 141 COVID-19 and Financial Stability: Bank Resolution combination of deposit insurance funding and Closed Resolution Option 2 – assets transferred to the acquiring bank. If there Closure and business transfer was sufficient time available, the deposit insurance (purchase and assumption) agency would seek competitive bids from banks to select the least-cost bid from banks with the This option is often referred to as a ‘purchase and prudential and operational capacity to acquire the assumption’ form of resolution and is often used for insured deposits and potentially other business. small to medium-sized banks if merger into a larger f. The net cost to the deposit insurance agency (i.e. bank is not feasible. This involves the closure of the the NPV of all payments minus recoveries from the bank and transfer of insured deposits (including assets of the failed bank) is less than the estimated associated IT systems), plus viable assets and net cost of Option 1 (above). possibly other liabilities (e.g. uninsured deposits) via a ‘purchase and assumption’ transaction to another bank with the prudential and operational ability to Open Resolution Option 1 – assume the business in question. This would occur through a tender process, with liquidation of the Recapitalization via bail-in remainder of the failed bank. The deposit accounts would operate as usual, with no change of account This involves recapitalization of the bank via the bail-in numbers, once transferred to the receiving bank. The of liabilities after all shareholders and other eligible receiving bank would purchase assets from the failed capital holders have first absorbed losses to the full bank at market value if it wished to do so. The net cost extent of their liability. Bail-in could be implemented (if any) to the acquiring bank of assuming the insured via a number of routes, including by write-down deposit liabilities would be funded by the deposit of the liabilities or by conversion of liabilities to an insurance agency. The failed bank would then be equity instrument that ranks equally to the ordinary wound up through the insolvency law arrangements shares of existing shareholders or converted to or managed by the deposit insurance agency, and the preference shares that rank above existing ordinary deposit insurance agency would have a subrogated shares. Liabilities would be bailed-in consistent with claim on the insured depositors on the assets of the their ranking in a winding-up – i.e. the lowest ranking bank in liquidation. liabilities (such as subordinated debt) would be bailed-in first, followed by senior unsecured bonds, This option would be appropriate where: followed by uninsured deposits, etc. Insured deposits would either be exempted from bail-in or the deposit a. The bank is small and has no systemically insurance agency would bear the bail-in cost if it were significant business. Its business functions are applied to insured deposits. Some other liabilities easily replaceable by other banks. Closure of the might also be exempted from bail-in, potentially bank would not have a significant adverse impact including liabilities payable to suppliers of essential on the stability of the financial system or economy, services and liabilities in relation to derivatives or give rise to contagion risk. required to maintain balance sheet hedges. Secured b. The bank is insolvent (i.e. negative equity) or close debt is exempted from bail-in to the extent of the to insolvent, or otherwise very substantially below security backing the debt. minimum capital requirements. This option might be appropriate where: c. The bank cannot recover – i.e. there is no prospect of shareholder support or external financial private a. The bank is systemically important at the time of sector support in the required timeframe. its distress or imminent failure. The closure of the bank (or at least a discontinuation of its critical d. No other bank is prepared to acquire equity in the functions and services) would have a significant failing bank or to assume all or most liabilities and adverse impact on the stability of the financial acquire all or most assets from the failing bank. system. e. One or more banks are willing to assume the b. The bank is insolvent (i.e. negative equity) or close insured deposits, funded either fully by the to insolvent, or otherwise very substantially below deposit insurance agency or funded through a minimum capital requirements c. The bank cannot recover – i.e., there is no prospect Open Resolution Option 2 – of shareholder support in the required timeframe. d. No suitable new private sector shareholder (e.g. Recapitalization via merger/ a bank or institutional investor) is available to private sector injection of capital provide all of the required amount of capital (but might be prepared to inject some capital, provided This involves recapitalization of the bank via injection that losses have been absorbed by existing of capital by another bank or another private sector shareholders, other capital providers and creditors entity after all shareholders and other eligible capital at least to the extent of restoring equity from holders have first absorbed losses. This could be negative to zero). done by cancelling existing shares (assuming the powers were in place to do this), with compensation e. It is assessed to be easier (more practicable and to shareholders for the assessed value of the shares, possibly lower cost) to retain the bank substantially and issuing new shares to the acquiring bank/ whole, rather than separate out its critical institutional investors. Alternatively, it could be functions and systems – e.g. where there is a high achieved by issuing new shares to an acquiring bank degree of integration of critical and non-critical or other investors and diluting existing shares to their functions and systems, or where the bulk of the assessed market value, resulting in the acquiring bank comprises critical functions and services. (If entity assuming a controlling shareholding. In either this were not the case, then it might be more cost- case, the distressed bank would be recapitalized to the effective to separate out the critical functions and appropriate target level (i.e. sufficient to comfortably systems to a bridge bank and capitalize the bridge exceed the regulatory requirements and to maintain bank or remove non-critical functions into another an acceptable credit rating and maintain depositor entity for liquidation.) and investor confidence). Non-critical functions and f. Merger with an existing bank is undesirable impaired assets could either be retained in the bank if because it would lead to excessive market there is commercial incentives for the acquiring party concentration, reduced competition and greater for this to occur or could be transferred to an asset risk of ‘too big to fail’. management entity or other vehicles. g. The bank has sufficient subordinated debt and This option might be appropriate where: senior unsecured debt (excluding insured deposits) to be a source for recapitalization, either through a. The bank is systemically important at the time of conversion to equity or other eligible capital its distress or imminent failure. The closure of the instrument or write-down, after first writing down bank (or at least a discontinuation of its critical existing equity. Bail-in is more difficult to achieve if functions and services) would have a significant there is little subordinated debt or little in the way adverse impact on the stability of the financial of senior unsecured TLAC debt. system. h. Bail-in would not trigger contagion or other b. The bank is either close to insolvent (but still has systemic disruption on a significant scale. Bail- positive equity) or otherwise very substantially in is more likely to be a viable solution for an below minimum capital requirements. idiosyncratic bank failure, where the other banks c. The bank cannot recover – i.e. there is no prospect COVID-19 and Financial Stability: Bank Resolution in the financial system are in a prudentially sound of shareholder support in the required timeframe. condition and market confidence in the banking system as a whole is reasonably strong. Bail-in is d. At least one bank or an institutional shareholder less likely to be an attractive option in the case of (e.g. mutual fund, pension fund, corporate multiple bank distress and where the bail-in of investor) has the prudential and operational one bank could trigger a contagious run on other capacity to acquire either 100% or a majority banks. shareholding in the bank, and willingness to invest, sufficient to recapitalize the bank to the required target level. 142 143 COVID-19 and Financial Stability: Bank Resolution e. Bail-in is either not feasible (e.g. due to lack of funded bail-out or a resolution fund-financed capital sufficient bail-in-able debt) or would be likely injection is required for the purpose of meeting to have an adverse impact on financial system resolution objectives. It should be applied with robust stability or create a significant contagion risk. safeguards, as discussed below. (However, bail-in could potentially be used to absorb losses to restore the bank from negative to If public funding is used, recapitalization would zero equity if it were in a state of negative equity. be implemented by the issuance of shares to the This would facilitate the injection of capital by an government (either directly or via a government- external party.) owned entity) sufficient to achieve the target capital ratio. Government-funded recapitalization should f. It is assessed to be easier (more practicable and occur only after existing shareholders have been fully possibly lower cost) to retain the bank substantially bailed-in, such that their shares are either cancelled whole, rather than separate out its critical (if of no value or very little value) or diluted to the functions and systems – e.g. where there is a high assessed market value. Subordinated debt should also degree of integration of critical and non-critical be bailed-in. The Government’s shareholding could functions and systems, or where the bulk of the either take the form of ordinary shares with full voting bank comprises critical functions and services. (If rights or preference shares with full or limited voting this were not the case, then it might be more cost- rights (where existing shareholders and bailed-in effective to separate out the critical functions and creditors hold a substantial proportion of total equity). systems to a bridge bank and capitalize the bridge In either case, the Government should ensure that it bank or remove non-critical functions into another prices its shares, and any other support it provides entity for liquidation.) (e.g. guarantees or indemnities), at appropriate g. The acquisition of the failed bank by the acquiring commercial pricing to ensure that taxpayers are entity would not lead to excessive market compensated for the risks involved. It should also concentration, reduced competition or increased ensure that it has sufficient control of the bank to systemic risk. manage all risks arising from its equity stake and other forms of support it provides. h. There is sufficient time to enable due diligence for the acquisition process while avoiding disruption If a systemic resolution fund exists, then this could to critical functions and services, and maintaining be used to fund the recapitalization and guarantees. confidence in the bank by depositors and other It could take the form of establishing a government- creditors. controlled entity or a resolution authority-controlled entity, funded by the resolution fund, as the shareholder in the recapitalized bank. Once the Open Resolution Option 3 – bank has been stabilised and market conditions are Recapitalization via resolution suitable, the shareholding entity, under the control of the government or resolution authority, would sell its fund or public funds shares and pay the proceeds (net of applicable costs) to the resolution fund. This involves recapitalization of the bank through external funding. The funding could be obtained Under either funding option, ownership of the bank from a dedicated source of resolution funding (such would ideally only be in the hands of the government as a deposit insurance fund on a ‘least cost principle’ or resolution authority for a relatively short period basis) or public funds, after all shareholders and other of time. This is generally between one and three eligible capital holders have first absorbed losses years before being sold to suitable private sector to the full extent of their liability. This is generally shareholders. However, the period should be long a last resort option and would only be used where enough to fully stabilise the bank and take advantage Options 1 and 2 are considered to be impracticable of suitable market conditions for selling the shares in or undesirable and that some form of government- the bank at an attractive price. This option might be appropriate where: Open Resolution Option 4 - a. The bank is systemically important at the time of its distress or imminent failure. The closure of the Bridge bank capitalized via bail- bank (or at least a discontinuation of its critical in functions and services) would have a significant adverse impact on the stability of the financial The ‘bridge bank’ option is sometimes used in bank system. resolution. This involves the transfer of the failed bank’s critical functions and systems, and other b. The bank is insolvent (i.e. negative equity) or close viable business, to a bridge bank established for the to insolvent, or otherwise very substantially below purpose, and capitalized by the bail-in of creditors minimum capital requirements after all shareholders and other capital holders first c. The bank cannot recover – i.e., there is no prospect absorb losses to the full extent of their liability. The of shareholder support in the required timeframe. remainder of the bank could be liquidated or impaired assets could be transferred to asset management d. No suitable new private sector shareholder (e.g. companies established for the purpose or already in a bank or institutional investor) is available to existence. provide the required amount of capital or merger with an existing bank is undesirable because it This option might be appropriate where: would lead to excessive market concentration, reduced competition and greater risk of ‘too big to a. The bank is systemically important at the time of fail’. its distress or imminent failure. The closure of the bank (or at least a discontinuation of its critical e. Bail-in is either not feasible on the scale required functions and services) would have a significant or would likely trigger contagion or other systemic adverse impact on the stability of the financial disruption on a significant scale. system. f. It is assessed to be easier (more practicable and b. The bank is insolvent (i.e. negative equity) or close possibly lower cost) to retain the bank substantially to insolvent, or otherwise very substantially below whole, rather than separate out its critical minimum capital requirements functions and systems – e.g. where there is a high degree of integration of critical and non-critical c. The bank cannot recover – i.e., there is no prospect functions and systems, or where the bulk of the of shareholder support in the required timeframe. bank comprises critical functions and services. (If d. No new suitable private sector shareholder (e.g. this were not the case, then it might be more cost- a bank or institutional investor) is available to effective to separate out the critical functions and provide all of the required amount of capital (but systems to a bridge bank and capitalize the bridge might be prepared to inject some capital, provided bank or remove non-critical functions into another that losses have been absorbed by existing entity for liquidation.) shareholders, other capital providers and creditors g. The resolution is structured to ensure that existing at least to the extent of restoring equity from shareholders and subordinated creditors are negative to zero). required to absorb all losses to the extent of e. Merger with an existing bank is undesirable COVID-19 and Financial Stability: Bank Resolution their holdings before any government-funded or because it would lead to excessive market resolution fund-financed support is provided. concentration, reduced competition and greater h. All funding provided to the resolved bank is priced risk of ‘too big to fail’. at market and the shareholding entity has at least f. The critical functions and systems, and viable majority control of the bank. business, can be cost-effectively separated into a bridge bank, thereby reducing the cost of capitalization and enhancing the future sale prospects of the bridge bank. 144 145 COVID-19 and Financial Stability: Bank Resolution g. The bank has sufficient subordinated debt and b. The bank is insolvent (i.e. negative equity) or close senior unsecured debt (excluding insured deposits) to insolvent, or otherwise very substantially below to be a source for capitalization of the bridge minimum capital requirements bank, either through conversion to equity or other c. The bank cannot recover – i.e., there is no prospect eligible capital instrument or write-down, after of shareholder support in the required timeframe. first writing down existing equity. Bail-in is more difficult to achieve if there is little subordinated d. No suitable new private sector shareholder (e.g. debt or little in the way of senior unsecured TLAC a bank or institutional investor) is available to debt. provide the required amount of capital or merger with an existing bank is undesirable because it h. Bail-in would not trigger contagion or other would lead to excessive market concentration, systemic disruption on a significant scale. Bail- reduced competition and greater risk of ‘too big to in is more likely to be a viable solution for an fail’. idiosyncratic bank failure, where the other banks in the financial system are in a prudentially sound e. Bail-in is either not feasible on the scale required condition and market confidence in the banking or would likely trigger contagion or other systemic system as a whole is reasonably strong. Bail-in is disruption on a significant scale. less likely to be an attractive option in the case of f. The critical functions and systems, and viable multiple bank distress and where the bail-in of business, can be cost-effectively separated one bank could trigger a contagious run on other into a bridge bank, thereby reducing the cost banks. of capitalization and enhancing the future sale prospects of the bridge bank. g. The resolution is structured to ensure that existing Open Resolution Option 5 – shareholders and subordinated creditors are Bridge bank capitalized via required to absorb all losses to the extent of their holdings before any government-funded or special resolution fund or public resolution fund-financed support is provided. funds h. All funding provided to the bridge bank is priced at market and the shareholding entity has at least The bridge bank option can also be used with funding majority control of the bank. from external sources. This involves the transfer of the failed bank’s critical functions and systems and other viable business to a bridge bank established for the purpose, and capitalized by a dedicated systemic Open Resolution Option 6 – resolution fund (and deposit insurance fund on a Transfer of critical business and ‘least cost principle’ basis) or public funds after all shareholders and other capital holders first absorb other viable business to another losses to the full extent of their liability. The remainder bank of the bank could be liquidated or impaired assets could be transferred to asset management companies This involves transferring critical functions and established for the purpose or already in existence. systems, and other viable business, to another willing bank. The other business of the failed bank This option might be appropriate where: would either be liquidated or transferred to an a. The bank is systemically important at the time of asset management company. Losses would first be its distress or imminent failure. The closure of the absorbed by shareholders and other capital providers bank (or at least a discontinuation of its critical to the full extent of their liability. If there is a shortfall functions and services) would have a significant in funding to finance the transfer of critical functions adverse impact on the stability of the financial and systems, and other viable assets, to the acquiring system. bank, the shortfall would be made up from either a write-down in bail-in-able debt transferred to the c. The closure of the bank would have a significant acquiring bank (if sufficient amounts are available) adverse impact on the stability of the financial or from a dedicated systemic resolution fund (and system. deposit insurance fund on a ‘least cost principle’ basis) d. Options 1 and 2 are assessed to be not feasible. or from public funding as a last resort. e. At least one suitably capitalized bank is able and The failed bank would be closed and its residual willing to acquire the systemically important business wound up under insolvency law or via the business of the bank, but not able or willing to resolution authority. Ex post compensation would acquire the remainder of the bank’s business. be paid to shareholders and creditors, respectively, f. The transfer of the systemically important business to the extent they were rendered worse off than to another bank would not create excessive market under a conventional winding up had the bank been concentration, reduced competition or an increase retained whole and wound up, applying the statutory in the ‘too big to fail’ problem. ranking of claims in a winding up. Non-performing loans (NPLs) could either be retained in the failed bank g. It is technically feasible to separate out the critical or transferred to an asset management company functions and systems from the other business established for the purpose, or to an existing private of the bank, and technically feasible for these sector entity in the business of acquiring and working functions and services to be operated within the out impaired assets. acquiring bank. h. This option is assessed as being at least as cost- This option might be appropriate where: effective in meeting resolution objectives as the a. The bank is insolvent or very substantially under- other options. capitalized. b. The bank cannot recover – i.e., there is no prospect of shareholder support in the required timeframe. COVID-19 and Financial Stability: Bank Resolution 146 147 FINANCIAL STABILITY IN THE PACIFIC ISLANDS: FINANCIAL SAFETY NETS June 2022 (i.e. where a particular bank is impacted but the „ INTRODUCTION financial system is operating normally) or through a system-wide liquidity shock. In either situation, if the 1. The paper provides an overview of the issues liquidity shock is sufficiently severe, banks might not relating to two key components of the financial be able to maintain sufficient liquid funds to meet safety net: emergency liquidity assistance and their financial obligations as they become due. Market deposit insurance. Both are important elements in sources of liquidity may help in these situations, but the framework for dealing with financial institution can sometimes be insufficient, as when the financial distress and failure, and for maintaining the stability markets become inherently illiquid, banks decline to of the financial system. The first part of the paper lend to one another, or deposit withdrawals reach discusses emergency liquidity assistance, while extreme levels. It is in these situations that the only the second part discusses deposit insurance. The source of liquidity is likely to be the central bank. purpose of the paper is to assist the PIC financial sector authorities in their initiatives to review and 4. Central banks have traditionally had as one of strengthen the financial safety net arrangements in their core functions the provider of liquidity to their countries. banks and to the banking system in a ‘lender of last resort’ capacity. This recognizes that, in a fiat currency system, the central bank is the only entity in a country with an unlimited ability to provide liquidity. „ PART A: EMERGENCY Constraints on the provision of liquidity arise only if the central bank is operating under a common LIQUIDITY ASSISTANCE currency (such as the Euro) or a currency board (where the domestic currency is rigidly pegged by a fixed ratio to an anchor currency). Context for Emergency Liquidity Assistance 5. In many countries, central bank law confers a mandate on the central bank to provide 2. One of the key risks in banking is liquidity. emergency liquidity assistance (ELA), also known Banks are inherently vulnerable to liquidity risk as lender of last resort. The general principles for due to the maturity mismatch between their assets the provision of ELA – whether set out in statute or and liabilities; they borrow ‘short’ and lend ‘long’. In in central bank policy – are that ELA should only be recognition of this, banks have long been attentive to provided for the purpose of maintaining the stability the need to manage liquidity risk in order to minimize of the financial system and only to a bank or other the possibility of having insufficient funds to meet financial institution which is economically solvent their financial obligations as they become payable. (i.e. as a surplus of assets over liabilities). A further Prudential regulation and supervision reinforce the principle is that a central bank should lend only on the management of banks’ liquidity risk by imposing basis of collateral provided by the borrowing entity regulatory requirements designed to strengthen (or by another party if necessary); lending should not liquidity. Typical regulatory requirements include be on an unsecured basis. It is also generally agreed the Basel III Liquidity Coverage Ratio (LCR) and the that ELA should be provided only if a bank or other Financial Stability in the Pacific Islands: Financial Safety Nets Net Stable Funding Ratio (NSFR), as well as other financial institution has exhausted all internal and requirements, such as liquid asset-to-liabilities ratios, market-based sources of liquidity. stress testing requirements, and liquidity contingency plans and recovery plans. Taken together, these regulations and an effective level of supervisory oversight help to keep liquidity risk within reasonable Circumstances in which ELA bounds. might be needed 3. Although the prudent management of risks and 6. There are three main situations in which ELA effective regulation and supervision help to reduce from a central bank might be needed. In each liquidity risk, there are inevitably circumstances case, it can be presumed that a bank in need of when banks encounter unusually severe liquidity ELA would first have fully utilised all of its available risk events. These can arise either idiosyncratically liquidity sources, including having utilised its liquid 148 149 Financial Stability in the Pacific Islands: Financial Safety Nets assets, drawn down under any standby facilities and c. Scenario 3 – Where a bank has become non- inter-bank credit lines it might have in place, sold all viable and cannot recover, and has been placed marketable securities and accessed parent bank or into resolution. In this situation, a bank is both other shareholder liquidity support facilities where illiquid and severely below capital requirements available. (and might even have negative capital). The resolution authority is implementing a resolution 7. The three main scenarios for ELA are: under which the bank is to be recapitalised a. Scenario 1 - Where a bank is adequately or its systemically important business is to be capitalised, but illiquid. In this scenario, the bank transferred to a bridge bank. In either of these in question is in compliance with its regulatory resolution options the bank or bridge bank will capital requirements but is experiencing acute need to have sufficient liquidity to meet obligations liquidity stress to the point where it is unable to as they become due and payable. Until the bank maintain sufficient liquidity to meet its financial or bridge bank has been fully recapitalised and obligations. This might be because of operational enjoys market confidence, it is likely that the only difficulties that have prevented a bank from source of liquidity (once liquid assets have been receiving due payments (e.g. such as a payment exhausted) is ELA from the central bank. system breakdown or problems with a bank’s IT systems), tight liquidity conditions in the 8. In each of these scenarios, the prerequisites markets, or reputation factors applicable to that for the central bank to provide ELA are likely to bank or its parent. In the latter case, reputation include the central being satisfied that: concerns could relate to any number of factors,  the bank has exhausted all of its own liquid assets including concerns over deteriorating asset quality and market-based liquidity (including parent entity (notwithstanding that the bank is compliant with support); capital requirements), a substantial reduction in credit rating, a major fraud or other operational  the bank is economically ‘solvent’ (i.e. a surplus risk event, or concerns over the financial of assets over liabilities) or that measures are in soundness of a parent bank (where applicable). place to provide an assurance that solvency is This category is the ‘classic’ scenario in which ELA being restored through recovery or resolution is considered to be an appropriate response – i.e. procedures; and where a bank is in liquidity stress, but its economic  the bank has sufficient collateral of acceptable solvency (i.e. a surplus of assets over liabilities and quality to cover all credit and market risk therefore its capacity, aside from liquidity issues, to exposures arising under ELA (or, in the absence pay its liabilities) is not in doubt. of sufficient collateral, an indemnity from the b. Scenario 2 – Where a bank has both liquidity government or another suitable party). and capital difficulties, but is in recovery mode. In this situation, a bank is below applicable capital 9. ELA is most commonly provided to a bank regulatory requirements and is in liquidity stress, that is assessed as being solvent and is either but its recovery plan or liquidity contingency plan in compliance with capital requirements or on has been activated and the supervisory authority a path back to compliance. However, in some is confident that the bank is on a path back to full circumstances, ELA may need to be provided to a capital compliance. During the recovery period the bank in resolution, including potentially where the bank might not be able to access liquidity from bank is not solvent. In such a situation, ELA can be the inter-bank market and might be experiencing made available in a resolution situation, provided higher-than-usual funding withdrawals and lower- that the central bank is satisfied, on the assurance than-usual deposit renewals/new deposits. In of the supervisory authority/resolution authority, such circumstances, ELA might be the only viable that the bank or a bridge bank will, in the course of source of liquidity pending the bank’s restoration the resolution process, be capitalised back to a level to capital compliance and a resumption of market commensurate with that required of other banks confidence in the bank. of a similar nature. In such a situation, it would be entirely reasonable for the central bank to require projections for liquidity over a defined horizon period. an indemnity from the government to immunise the In the third scenario, the ELA decision-makers would central bank from all credit and market risks arising be seeking assurance from the resolution authority/ from ELA to the extent that collateral is not sufficient. resolution department (if in the central bank) that the resolution process being implemented will restore the 10. It is important for the prerequisites for ELA bank or bridge bank to capital soundness and general to be clearly specified by the central bank and viability. understood by all relevant parties, including the supervisory authority and finance ministry. 12. It is therefore important for the supervisors/ Ambiguity on prerequisites for ELA is not helpful and resolution staff to establish an agreed framework only gives rise to confusion and potentially muddled for the form and content of the information and decision-making in a financial crisis. In particular, assessment of viability that the central bank ELA clarity is needed on the: decision-makers might reasonably require. This would need to cover the following matters: a. solvency and/or capital adequacy requirement and viability requirement specified by the central a. A definition of viability. This is fundamental bank for eligibility for ELA, and the information and to the determination of whether ELA should be attestation from the supervisory authority that the provided to a bank in all scenarios (either on central bank would reasonably require; the basis of current viability or expected future viability post-recovery or post-resolution). ELA b. collateral requirements for ELA, including valuation should only be provided to a bank if it is assessed processes and legal arrangements to enable the by the supervisor as being viable at the time of central bank to acquire unambiguous access to the ELA application or in the near future as a result assets comprising the collateral; and of recovery or resolution actions. It is therefore c. the nature of a government indemnity that the desirable for the authorities to determine what central bank might be willing to accept where viability means in this context. Viability would collateral is insufficient or there is otherwise a generally include the following attributes: reasonable basis for concern by the central bank ƒ The bank has or will shortly have sufficient over the credit risk it would be taking if it were to capital to enable it to absorb expected losses lend to a bank. and remain economically solvent (i.e. assets in excess of liabilities) in a plausible range of scenarios so as to be able to meet its expected Viability assessment financial obligations for the foreseeable future in the range of scenarios considered. 11. In most ELA situations, it will be necessary for the supervisory authority (or supervision ƒ The bank has sufficient liquidity to meet department of a central bank) to provide liabilities as they become due and payable, the central bank with an assessment of, and including under stressed conditions, other information on, the bank’s viability. In the first than temporarily in a situation where ELA is scenario referred to above, the central bank ELA necessary. decision-makers would be seeking a formal assurance Financial Stability in the Pacific Islands: Financial Safety Nets ƒ The bank has sound governance and from the supervisory authority/department that management arrangements, including a the bank in question is compliant with capital competent Board of Directors, or will soon requirements and is viable in all other respects. In meet these requirements under recovery or the second scenario, the central bank ELA decision- resolution arrangements. If the supervisory makers would be seeking a formal assurance authority has any doubts in these respects, from the supervisory authority/department as to recovery actions and supervisory interventions the bank’s capital position and the supervisory would need to include changes to the Board as authority’s confidence that the bank is on a path needed. back to full compliance with capital requirements. ƒ The bank has or will shortly have as a result In addition, the central bank would also be seeking of recovery or resolution initiatives sound risk detailed information from the supervisory authority/ management arrangements to ensure that department on the bank’s liquidity position, including the bank can identify, measure, monitor and 150 151 Financial Stability in the Pacific Islands: Financial Safety Nets manage all material risks. If the supervisory of governance and management – including as authority has any doubts in these respects, to particular members of the Board or senior recovery actions and supervisory interventions management team, and systems and structures would need to include changes to the risk for governance and management – then the management arrangements as needed. supervisory authority would be expected by the central bank to identify those deficiencies and the b. Capital assessment. In scenarios 1 and 2 the actions to be taken (or being taken) to address the supervisory authority would need to undertake an deficiencies. assessment of the capital position of the bank in question. In scenario 1, this would be to determine e. Assessment of risk management systems and whether the bank remains compliant with capital controls. The supervisory authority/department requirements. In scenario 2, the supervisory would need to undertake an assessment of the authority would need to determine the current bank’s risk management systems and controls capital position (at the time of an ELA request) and (covering all material risks) in order to identify form the view as to whether the bank will be able any deficiencies against supervisory expectations, to return to capital compliance within a specified taking into account the causes of the bank’s timeframe. The capital assessment would need to current situation. It would need to provide the ELA be on a risk weighted basis in accordance with the decision-makers with its assessment, including capital requirements applied by the supervisory any identified deficiencies and the measures being authority. In addition, in an ELA situation, the implemented to address those deficiencies. supervisory authority would probably also need to assess the leverage ratio (i.e. equity relative to 13. Scenario 2 (recovery plan activation) requires non-risked weighted assets), as this provides a some additional assessment by the supervisors. better indication of solvency (surplus of assets over In the case of scenario 2, the supervisory authority/ liabilities) than does a risk weighted capital ratio. department would need to provide the central bank In scenario 3, the resolution authority would need with its assessment of the adequacy of the recovery to determine whether the capital position of the measures being taken by the bank in its recovery bank or bridge bank, post resolution, would meet plan to restore itself to capital compliance, liquidity designated capital adequacy requirements. compliance and overall financial soundness, in c. Liquidity assessment. The supervisory authority/ accordance with the restoration points prescribed department would need to provide the ELA by the supervisory authority in the recovery planning decision-makers with an assessment of the current regulations. In particular, it would need to provide and expected future liquidity position of the the ELA decision-makers with an assessment of how bank. This would include a projected set of cash long the supervisory authority believes the bank will outflows and cash inflows, taking into account require to restore itself to full capital compliance and contractual maturities of assets and liabilities and to a position in which it could meet its liquidity needs any modifications to those maturities based on from its own resources and market-based funding. scenarios under stressed conditions. It would take 14. Scenario 3 (resolution) would require a range into account existing liquid assets and the capacity of assurances from the resolution authority/ for the bank to draw down under standby facilities resolution staff in the central bank. In particular, and to access liquidity via repos or outright asset the would be a need to demonstrate to ELA decision- sales. It is common for central banks to want makers that the bank in resolution or bridge bank liquidity projections for at least one month out, and is being restored to capital soundness under new for this to be renewed regularly based on updated management and governance, and the timeframe data. within which compliance with applicable capital d. Assessment of governance and management requirements can be achieved. The resolution quality. The supervisory authority/department authority/staff would also need to provide the ELA would need to provide the ELA decision-makers decision-makers with detailed analysis of the liquidity with its assessment of the quality of the bank’s profile of the bank in resolution/bridge bank, liquidity Board and management, taking into account the gaps relative to the expected level of liquidity needed, difficulties the bank may be in at the time ELA is and the timeframe within which the bank/bridge bank requested. If there are deficiencies in the quality is expected to be able to fund in the financial markets. 15. An agreed data and assessment framework by the central bank (generally in liaison with the is necessary. It is desirable for the supervisors/ supervision authority/department), including the resolution staff and ELA decision-makers to agree on ability to undertake valuations in a short timeframe set of information requirements that the supervision and under a range of stress scenarios. authority/department and resolution staff (where applicable) will provide to the ELA decision-makers in 18. A central bank may need to take collateral order to enable the central bank to make a decision from another party if the bank requesting ELA as to whether to provide ELA to a bank. This would has insufficient collateral. For example, this may include agreeing on: be necessary where a subsidiary or branch of a foreign bank lacks sufficient collateral in its own local  the meanings to be applied to viability and operations to meet ELA collateral requirements. In solvency; such a situation, the central bank in the host country  the measurement frameworks for capital could make arrangements with the home supervision assessment and solvency assessment; authority of the parent bank to enable the parent bank to pledge its own assets as collateral or to  the measurement frameworks for liquidity issue guarantees in lieu of collateral. Accordingly, projections; it is desirable for central banks in host countries to  the data templates that the central bank would identify the scenarios in which it may be necessary expect the supervisory authority to use in to access parent bank or other shareholder sourced providing the central bank with the required collateral, and to put in place the legal and operational information on capital ratios, solvency position and arrangements to take possession of the collateral in projected liquidity positions. an ELA situation. 16. Testing is important. Once these arrangements have been agreed on, it is important to undertake regular exercises to test the viability, solvency and Terms and conditions for ELA liquidity assessment arrangements. Testing should 19. It is desirable for a central bank to prepare ideally be undertaken every year or two in order to draft documentation for ELA, including build and maintain capacity in this area. indicative terms and conditions. Although the draft documentation would need to be modified on a case-by-case basis, having a pre-prepared set of Collateral requirements loan documentation and a term sheet for terms and conditions enables the ELA decision-makers to move 17. An important part of ELA policy is the quickly and with a lower risk of error if these materials specification of collateral requirements that banks are in place. The draft documentation would typically will need to meet in order to obtain ELA from the include: central bank. Standard collateral for ELA includes a. Purposes of the ELA facility (with emphasis on it a bank’s holding of marketable debt securities, but being a short-term facility which will be terminated Financial Stability in the Pacific Islands: Financial Safety Nets also typically extends to a bank’s loan portfolio and as soon as possible once the bank in question can fixed assets. In the case of the loan portfolio, it will fund adequately through market-based sources). generally be necessary for banks to be pre-positioned operationally and legally to enable them to segment b. Preconditions for eligibility for accessing the ELA the parts of their loan portfolio that the central bank facility (such as demonstrable economic solvency is willing to take as collateral and to enable sale and or capital adequacy, viability or progress back repurchase arrangements to be established in respect to viability, exhaustion of market-based sources of those loans. The central bank should identify the of liquidity), and sufficient collateral to cover the haircuts that it would apply to each type of collateral, central bank’s expected credit and market risks. taking into account expected credit risk and market c. Maximum amount able to be drawn down under risk on the assets in question. The methodology for the ELA facility. the valuation of collateral also needs to be specified d. Preconditions for drawdown under the ELA facility. 152 153 Financial Stability in the Pacific Islands: Financial Safety Nets e. Maturity of the loan and capacity for roll-over central bank responsible for the management of the (where it is common for an ELA loan to have a central bank’s credit risks and market risks, as well as short maturity of one to two months, but with reputation risk, have incentives to take a very cautious scope for short-term roll-over). approach to any decision to lend. It is therefore important that central bank management recognises f. Preconditions for roll-over (generally similar to the these potential conflicts or tensions and establish preconditions for eligibility for the ELA facility and policies and procedures to manage them. Policies demonstrable need for continued ELA support). and procedures are important in this regard, with g. Interest rate on amounts drawn down under a clear demarcation between those responsible for the ELA facility. (It is common practice for the supervision, resolution, and ELA recommendations. interest rate to be priced at least ‘at market’, Separate reporting lines to the head of the central taking into account the risk profile of the bank bank also help to manage these risks. Internal audit and its collateral. In some cases, ELA funding also has an important role to play in reviewing the might be priced at a premium above market rates policies and procedures for ELA decision-making and to take into account the risk involved, to create checking to ensure that they are correctly complied disincentives for banks to resort to ELA borrowing with. and to penalise banks that have accessed ELA due to mismanagement of their liquidity risk or other risks.) h. Fees – such as administration fees, reimbursement Managing moral hazard risk of central bank legal fees, drawdown fees, etc. associated with ELA i. Conditions relating to actions to be taken by the 21. The existence of ELA creates a potential moral bank to rectify the causes of its liquidity stress. hazard by arguably reducing the incentives for j. Reporting requirements, which would usually banks to management their liquidity risks with include a requirement for the bank to report appropriate caution. In recognition of this, it is detailed liquidity data to the central bank on a daily important to ensure that supervisory arrangements basis, as well as reports on progress in addressing are in place to promote sound liquidity risk actions required under the ELA facility – e.g. to management by banks and to impose consequences rectify specific weaknesses associated with liquidity on banks if they need to access ELA (other than in risk management arrangements. circumstances which are beyond their control, such as extreme market instability). Standard prudential k. Events of default. regulatory requirements designed to promote sound l. Remedies and penalties associated with events of liquidity risk management in banks include: default being triggered.  Liquidity buffers, such as the LCR or a minimum m. Market disclosure requirements. ratio of liquid assets to liabilities.  Requirements to reduce undue reliance on short- term funding, such as the NSFR. Conflicts of interest in a central  Maximum limits on maturity mismatches between bank assets and liabilities. 20. If a central bank performs a range of functions,  Liquidity stress testing requirements. as most do, ELA can present potential conflicts or  Requirements for banks to set liquidity tolerances tensions of interest. This is particularly the case if in their risk appetite statements. the central bank performs the prudential supervision  Requirements on liquidity risk management function and resolution function. For example, if policies and practices. the central bank performs the supervision of banks, the supervisory staff arguably have incentives to  Requirements for contingency plans and recovery encourage lending under the ELA facility in order to plans to enable a bank to restore liquidity to target reduce the risk of bank failure. In contrast, those in the levels under stressed conditions. Internal audit arrangements in respect of reviewing ELA arrangements in the Pacific  ELA policies and procedures, management of Islands conflicts of interest, and reviewing compliance with ELA policies and procedures are generally 22. Various IMF and World Bank FSAP, FSSR and inadequate. TA missions have included an assessment of ELA  There is no regular testing of ELA procedures in arrangements in the PICs. The findings vary from most of the PICs – e.g. via desk-top reviews or live country to country in recognition that each country crisis simulation exercises. has different statutory, institutional and policy frameworks in place. However, some genera findings  Although most of the PICs have liquidity can be summarised, including: requirements in place for banks, there is room for improvement in these requirements, including  In most of the PICs with their own currency, central strengthening liquidity buffers (e.g. along the bank law includes a provision that empowers lines of the Basel III liquidity rules), strengthening the central bank to provide ELA to banks in liquidity stress testing in banks (including circumstances where this is necessary for financial enterprise-wide stress tests and reverse stress stability purposes. The quality of the laws vary tests), legal and operational pre-positioning for from country to country, but in general some accessing loans and parent entity assets for ELA weaknesses include: a lack of clarity of statutory purposes, and strengthening the responsibilities objectives for ELA; inadequate specification in the (and legal consequences) for directors and senior law as to the preconditions which must be met management of banks for the management of in order for the central bank to lend; inadequate risks. specification of the types of financial institution that may receive ELA; and a narrow specification of eligible collateral (often limited to government securities and not extending to banks’ loan portfolios, fixed assets and parent entity pledged „ PART B: DEPOSIT assets). INSURANCE  Central banks in the region generally have developed some policies and procedures for ELA, Context for deposit insurance but these tend to be incomplete. For example, it is uncommon for central banks to adequately 23. Deposit insurance is a key element in the specify the preconditions for eligibility for ELA, the promotion of financial system stability. The information and attestations required from the existence of a robust and credible deposit insurance applicant bank and its supervisors, and the ELA system helps to promote depositors’ confidence that decision-making procedures in the central bank. their funds are protected. It therefore reduces the risk  It is uncommon for central banks in the region of pre-emptive depositor runs on banks and reduces to have prepared draft ELA documentation and the possibility of contagion between banks. In a bank associated terms and conditions for ELA. failure, deposit insurance plays an important role in the resolution process by providing depositors with Some central banks in the region are constrained Financial Stability in the Pacific Islands: Financial Safety Nets  prompt access to their deposits, either by payout or in the nature of the collateral they can take for by funding the transfer of protected deposit accounts ELA purposes, particularly as regards banks’ loan to another bank or a bridge bank. If structured portfolios and parent entity assets. appropriately, deposit insurance provides a source of  There is generally inadequate legal and operational funding for the resolution of large banks, including by prepositioning in banks to enable the central bank funding some or all of the transfer of critical functions to readily access banks loans and parent bank and services to a recipient bank or by contributing to assets for collateral. a recapitalisation of the failed bank or a bridge bank.  Disclosure policies on ELA are generally poorly In these ways, deposit insurance helps to lower the specified, including as to when a central bank probability of a government-funded bailout of a failing would disclose that it has provided ELA to a bank bank. It also makes it easier to implement a bail-in and the nature of the ELA in question (even if just of creditors in the resolution process by immunising on an ex post basis). small depositors from loss in the bail-in process. 154 155 Financial Stability in the Pacific Islands: Financial Safety Nets 24. Most of the PICs covered in the World Bank 27. The Core Principles cover a number of study do not have deposit insurance. It is a important elements. These include: significant gap in the financial stability framework. a. The need for a deposit insurance scheme to have The absence of deposit insurance increases the risk clearly specified statutory objectives. The core of depositor runs in periods of financial stress and objective is to protect depositors and promote increases the possibility of inter-bank contagion. In financial system stability. order to avoid these outcomes, governments in the PICs are arguably more likely to consider bailout as a b. The need for a statutory mandate for the deposit means of resolving bank failure rather than a more insurance scheme and legal powers to perform its efficient and less expensive option that involves functions. The powers include: the need to require a combination of deposit insurance and bail-in or banks to be pre-positioned for deposit insurance selective business transfer. The absence of deposit (including matters such as ‘single customer view’ insurance therefore increases the fiscal risk in bank and the ability to transmit deposit data to the resolution and is likely to increase moral hazard by deposit insurer); the power to set and collect creating a presumption of government bailout. levies from banks and to obtain supplementary funding; the power to make payouts to depositors 25. This section of the paper looks at deposit and to contribute to the funding of ‘purchase insurance issues. It includes a summary of the and assumption’ transactions; and the power to relevant international principles and key architectural recover funding outlays from the assets of a failed features of deposit insurance. It concludes with an bank. overview of the issues that the PIC authorities might c. The importance of robust governance usefully consider in assessing the benefits and costs of arrangements, as well as operational deposit insurance, and the design of effective deposit independence, transparency and accountability. insurance frameworks. d. The ability to coordinate effectively with other financial sector agencies, such as the banking supervision authority, central bank, finance International Principles ministry, and bank resolution authority. e. The need for effective cross-border cooperation 26. The International Association of Deposit and coordination, especially with foreign resolution Insurers (IADI) and the Basel Committee on authorities and deposit insurance agencies. Banking Supervision (BCBS) have developed international principles on deposit insurance. The f. The importance of comprehensive contingency Core Principles for Effective Deposit Insurance Systems planning for dealing with a range of bank failure (Core Principles) was first issued in June 2009 and then situations. revised in November 2014. The Core Principles are 53 g. The need for clarity over the participation of banks used by jurisdictions as a benchmark for assessing and coverage of deposits. The Core Principles the quality of their deposit insurance systems and for recommend that all retail deposit-taking banks identifying gaps in their deposit insurance practices should be required to be participants in the and measures to address them. The Core Principles deposit insurance scheme. The Principles also are also used by the IMF and the World Bank in recommend broad coverage of retail deposits, with FSAP and technical assistance missions to assess a view to ensuring that the bulk of small depositors the effectiveness of jurisdictions’ deposit insurance are covered for most or all of their deposits. systems and practices. The Core Principles are not binding on countries; authorities have complete h. The need for effective legal protection of the latitude to depart from the Principles as they see deposit insurance scheme, its governance fit. However, they do provide a valuable source members, staff and agents. of guidance and benchmarking for authorities in i. The need for a robust funding structure. This designing, implementing and reviewing their deposit generally involves the establishment of a target insurance arrangements. size for the deposit insurance fund (based on the  53  See https://www.iadi.org/en/core-principles-and-guidance/core-principles/ expected value of deposit insurance payouts over 32. In developing the objectives for deposit the medium to longer term), financed primarily by insurance, care should be taken to ensure that levies on participating banks, and with a capacity the objectives are based on the conceptual to access supplementary funding when needed. rationale for deposit insurance. In this regard, the However, some deposit protection schemes are key rationale for deposit insurance is information funded on an ex post basis, with the government asymmetry on the part of retail depositors and providing the funds needed for payout and with the potential for uninformed or partially informed the scheme having the capacity to repay those depositor reactions to exacerbate a financial distress funds through an ex post levy on banks if there situation and threaten financial stability. The is a shortfall in assets of the failed bank. In some objectives should be realistic and achievable. Caution cases, deposit protection schemes operate on a needs to be exercised in broadening the objectives hybrid form of funding, with some ex ante funding into areas that may be beyond the scope of a deposit by banks and a capacity for borrowing from the insurance scheme to achieve or to specify objectives government. that may be better met via a different policy. j. The need for a high level of public awareness 33. Taking into account these considerations, the of the deposit insurance scheme, given that objectives for a deposit insurance scheme might its effectiveness in reducing the incentives for appropriately be: depositor runs much depends on depositors being aware of the scheme and having confidence in the  to promote the stability of, and confidence in, the scheme’s effectiveness. banking system; and  to protect (retail) depositors; 28. See the appendix for a reproduction of the IADI by insulating depositors from loss on their deposits up Core Principles. to a specified amount and providing for the prompt repayment of, or access to, those deposits following the closure of a bank. Objectives of deposit insurance 34. Subject to those primary objectives, the deposit insurance scheme should be designed with a view 29. The design features of a deposit insurance to minimising moral hazard risks, compliance scheme much depend on the objectives the costs for banks, and administrative costs for the scheme is intended to meet. It is therefore scheme. It should also be designed to avoid potential important that there is clarity in the objectives of financial system inefficiencies, such as those that the proposed deposit insurance scheme. Poorly can arise through the distortion of financial product conceived objectives create a risk of impeding the pricing and industry competitiveness, or through design, implementation and operation of the scheme, arbitrary boundaries between insured and uninsured potentially leading to costly outcomes. financial products. As discussed later, these factors 30. In the IADI Core Principles it is stated that: suggest keeping the scheme relatively simple, narrow in focus, and small in organisational structure. Financial Stability in the Pacific Islands: Financial Safety Nets “The principal public policy objectives for deposit insurance systems are to protect depositors and contribute to financial stability. These objectives should be formally specified and publicly disclosed. Institutional coverage of the The design of the deposit insurance system should deposit insurance scheme reflect the system’s public policy objectives.” 35. The financial institution coverage of the 31. The Core Principles also refer to other possible deposit insurance scheme needs to be defined. policy objectives for deposit insurance, such as The general approach internationally is that deposit providing a mechanism for deposit-taking financial insurance schemes apply only to banks and other institutions to fund the cost of failures (rather than deposit-taking institutions that are licensed and this cost being borne by taxpayers) and/or to promote supervised (desirably to a level consistent with the competitiveness in the financial system. 156 157 Financial Stability in the Pacific Islands: Financial Safety Nets Basel Core Principles). Non-bank deposit-taking Definition of eligible depositor financial institutions that are not regulated and supervised in accordance with standard banking 38. Deposit insurance law needs to define who is supervision arrangements should not be covered by an eligible depositor under the deposit insurance deposit insurance, given the moral hazard that this scheme. Consistent with the objectives of protecting can create. Accordingly, if the intention is to bring non- small depositors who lack the information needed to bank deposit-takers into a deposit insurance scheme protect their deposit, most deposit insurance schemes in order to afford protection to their depositors, these extend deposit protection to deposits held by natural institutions should be brought into a regulatory and persons, small businesses, non-profit organisations supervisory framework that is the same or similar to and trusts. Deposits held in the name of a bank or that applicable to banks. other financial institution are generally excluded from a deposit insurance scheme. Although some countries’ 36. The design of a deposit insurance scheme also deposit insurance schemes differentiate between needs to consider whether membership of the deposit accounts held in the name of citizens/ scheme should be voluntary or mandatory. Most permanent residents and those held by non-residents countries with deposit insurance make membership (with the latter being excluded from the scheme), the compulsory for all banks that take retail deposits – i.e. general tendency is to not make a differentiation on there is no ‘opt out’ capacity. This accords with the grounds of residency or citizen. This is consistent with objectives of promoting financial stability, protecting the overall objectives of deposit insurance. Applying depositors and minimising distortions to the efficiency the scheme to any holder of an eligible deposit is also of the financial sector. It also avoids an adverse consistent with the objective of avoiding excessive selection problem, such that weaker banks would opt compliance and administrative costs, given that it in and stronger banks would opt out, thereby making obviates the need for banks to establish systems the deposit insurance scheme more vulnerable than it that distinguish between deposits on the basis of the otherwise would. nationality or residential status of the holder. Product coverage Currency denomination of the 37. A further design feature that needs to be deposit considered with deposit insurance is the coverage of the deposit products to be included in the 39. There is a need to determine whether the scheme. The statute establishing the scheme deposit insurance scheme applies only to local generally specifies product coverage by reference currency deposits or also to deposits denominated to the definition of a deposit, with the scope for in a foreign currency. In most countries with deposit specific deposit product types to be specified either insurance the scheme applies only to local currency by regulations made under the statute or by an deposits. This helps to simplify the administrative administrative instrument, or by approval of the costs of the scheme and provides an effective level deposit insurance scheme administrator. The product of deposit coverage to meet the scheme’s objectives coverage should be specified with clarity, so that there if the bulk of retail deposits are in local currency. is no confusion as to which products are protected However, in countries with a substantial proportion and which are not. The coverage of products should of deposits denominated in foreign currency, it is be largely driven by the objectives of the scheme. In common for the deposit insurance scheme to apply that regard, it is common for deposit insurance law to to foreign currency deposits in specified currencies. make provision for the scheme to apply to deposits In such cases, the deposit insurance cap is generally that are unsecured, senior debt claims on the bank expressed in terms of the local currency amount, such held in the name of an account-holder. Secured debt, that the deposit account-holder bears the currency subordinated debt, and non-deposit liabilities are risk and the deposit insurance scheme pays no more excluded from deposit insurance schemes. than the local currency insurance cap. the objectives of deposit insurance are to be achieved, Interest accruals this suggests that the insurance cap needs to be sufficiently large as to protect most retail depositors 40. It is common practice for a deposit insurance from loss on their deposits in a bank – ie it needs scheme to apply deposit accounts that include to cover a substantial majority of deposits of the accrued interest. This is consistent with the objective household sector and, arguably, the small business of promoting depositor confidence, given that a sector. However, the deposit insurance cap should not potentially significant proportion of a deposit might be be so large as to create excessive moral hazard risk in the form of accrued interest. In some cases, deposit or to go beyond that which is required to meet the insurance schemes deduct account fees from the objectives of the scheme. That would suggest that the accrued balance to determine the net amount payable deposit insurance cover should not extend to deposits to the depositor. of a size where the depositors in question could be expected to have the capacity to protect their own interests. Gross versus net payments 43. The size of deposit insurance caps varies 41. An issue arising in the design of deposit greatly across countries. The IADI survey of insurance is whether the amount payable to a deposit insurers (completed most recently in 2019) depositor should be gross or net. Some deposit provides useful information on the range of deposit insurance schemes work on the basis that the insurance limits across many countries. It reveals a protected amount is the balance in the eligible deposit wide variance in terms of absolute size of limit and account (aggregated on a ‘single customer view’ basis) size of limit relative to a common metric, such as per minus any amounts owed by the depositor to the capita GDP. There are some outliers, with very high bank – e.g. on an overdraft facility, unsecured loan deposit insurance limits relative to per capita GDP, or mortgage debt. Although this makes conceptual and some with very low limits, but most fall between sense from the perspective of standard set-off 50% and 400% of per capita GDP. The Table 14 below arrangements in a liquidation process, it complicates summarises deposit insurance caps (per depositor the administration of the scheme, increases per bank) for a number of countries, and Table 15 compliance costs and impedes the ability to make provides data on the distribution of deposit insurance prompt payments. Protecting deposits on a net basis caps relative to per capita GDP. also risks undermining the objectives of deposit 44. There is no perfect answer to what is an insurance, given that many depositors would not appropriate deposit insurance cap. The answer will have much, if any, protection under such a scheme. depend on several factors, including the average size Accordingly, the prevailing practice in most countries and distribution by size of household and SME bank with deposit insurance is to make payments on a gross deposits per bank, the proportion of retail deposits basis – i.e. the depositor is paid the aggregate amount that the authorities want to protect in order to meet in their protected accounts, including accrued interest, deposit insurance objectives, and the affordability without any deduction for amounts they might owe of the level of protection. With respect to the latter, to the bank by way of borrowings. This is simpler the higher the deposit insurance cap, the greater is Financial Stability in the Pacific Islands: Financial Safety Nets to administer and enhances the ability for rapid the amount of potential payout required of a deposit payout or deposit account transfer. On this basis, any insurance scheme. This has implications for the target amounts owed by the depositor are recovered in the size of the deposit insurance fund (if it is a pre-funded liquidation process or become debts payable to bank scheme), and hence the amount of levies on banks. or other entity that acquires the debt. If the scheme is funded initially by government, the higher the deposit insurance cap is the higher are the contingent liabilities for the government and the Deposit insurance cap potential amount of ex post levies on banks needed to repay the government for any shortfall in the failed 42. One of the key design features of a deposit bank’s assets. These are factors that would need to insurance scheme is the need to specify a cap to be carefully considered in the design of a deposit the protection on a per depositor per bank basis. If insurance scheme. 158 159 Financial Stability in the Pacific Islands: Financial Safety Nets TABLE 14. Deposit insurance caps for selected Deposit insurance payments countries54 45. A key aspect of a deposit insurance scheme Deposit insurance cap Country is the payment or deposit transfer mechanism. (local currency) Consistent with the objectives of the scheme, the Australia A$250,000 scheme should be designed to enable depositors to access their protected funds as soon as practicable Canada C$100,000 after the scheme has been invoked. Internationally, the aim is to achieve payment to depositors at least France E100,000 within 20 days after the closure of the bank and the invoking of the scheme. In some countries, such as India Rp500,000 Australia and the UK, the aim is to achieve payment Indonesia Rp100 million within one week after closure. In the US, the norm is to provide depositors with access to their funds on the Italy E100,000 first business day after the failed bank has been closed (generally following a so-called ‘resolution weekend’ Malaysia RM250,000 when a purchase and assumption transaction is New Zealand NZ$100,000 implemented by the US FDIC, leading to the transfer of insured deposit accounts to a recipient bank). In view Philippines PhP500,000 of the importance of depositors having prompt access to their funds (at least in respect of their transaction Singapore S$50,000 balances), it is suggested that a deposit insurance scheme be designed to provide depositors with access South Korea W50 million to at least transaction accounts and other on-call UK GBP85,000 accounts within one week of the bank being closed and the scheme being invoked. US US$250,000 46. A number of payment options can be considered. Broadly, these fall into three categories: TABLE 15. Deposit insurance caps relative to per  Option 1 - Transfers of deposit accounts from capita GDP55 the failed bank to another bank or to a bridge bank established by the resolution authority Deposit insurance Percentage of or government. The deposit accounts, together cap as a percentage countries responding with required IT systems, become the property of per capita GDP to IADI survey of the receiving bank. Payment facilities linked to Under 100% 18.4 deposit accounts, such as direct credit and debit facilities, are included in the transfer. The result is 100% to 200% 21.8 that depositors have relatively seamless continued operation of their bank accounts, aside from a 200% to 300% 18.4 brief suspension to enable the transfer to occur. 300% to 400% 10.3 In this case, the deposit insurance scheme administrator pays the receiving bank the amount 400% to 500% 11.5 required to fund the deposit accounts transferred to that bank. The amount of funding required Over 500% 19.5 depends on the extent to which any of the assets  54  Source: Websites of deposit insurance schemes in the countries covered in the table and, in the case of New Zealand, the NZ Treasury and RBNZ in respect of the proposed deposit insurance scheme under development.  55  Source: IADI of the failed bank are also transferred to the  Under Option 2, banks would need to be pre- receiving bank. The scheme administrator then positioned to enable them to temporarily enter the recovers the amount paid from the failed bank in payment system (under the control of the scheme the liquidation process. administrator) after eligible deposit balances had been calculated on a SCV basis to enable  Option 2 - Paying depositors from the failed depositors to access a proportion of their deposit bank by re-entering the failed bank into the balances in cash by ATM or via the branch network payment system for a limited period. Under (up to a daily limit), and to transfer deposits from this option, the failed bank, under the control of a their transaction accounts to another bank via statutory manager or the scheme administrator, is internet banking or cheques drawn on the failed initially suspended from the payment system upon bank. This option would require the ability to its closure and the invoking of the scheme. Eligible impose daily limits on the amounts able to be deposit balances are calculated. The bank is then withdrawn in cash via ATMs (e.g. the usual daily re-entered into the payment system for a limited limit applied), and the ability to place a cumulative period to enable depositors to withdraw funds via limit on all amounts able to be withdrawn (such the branch network, ATMs and internet banking that the total amount does not exceed the deposit channels. After a period, the bank is withdrawn insurance limit on a SCV basis). It would also from the payment system and liquidated. Any require the ability of the failed bank to recalculate protected deposits not fully withdrawn by the SCV balances following the final withdrawal depositors are paid to them by the scheme of the bank from the payment system, and the administrator or its paying agent. ability to transmit payment instructions to the  Option 3 - Paying depositors by the scheme scheme administrator’s paying agent for remaining administrator or its paying agent. Under this balances to be paid to depositors. option, payments could be made to depositors via  Under Option 3, banks would need to be pre- a number of options, including: positioned to submit payment instructions to the ƒ payment by electronic funds transfer into scheme administrator’s paying agent for the full deposit accounts (in other banks) nominated by amount of the SCV balance for each depositor, to the depositors of the failed bank; enable payments to be made. ƒ payment by the scheme administrator to new bank accounts opened in a recipient (normally the nominated paying agent); Ranking of claims in the winding ƒ cash payments to depositors (for small up of the failed bank amounts) through government welfare 48. An important issue that arises in the context agencies. of deposit insurance is depositor preference. In some countries, such as Australia and the United 47. In each case, the payment options would States, there are long-established laws that confer a require extensive pre-positioning of banks in preference of deposits in the winding up of a bank, order to be feasible in the timeframe required such that deposits are paid in full before any other for prompt payment. Depending on the option(s) Financial Stability in the Pacific Islands: Financial Safety Nets senior unsecured claims on the failed bank. The chosen, pre-positioning is likely to include the European Union has recently adopted laws of a similar following: nature. However, there are many countries (including  In the case of Option 1, it would be necessary to in the Pacific region and Asia) where depositors rank pre-position the failing bank weeks in advance of equally with other senior unsecured creditors. its closure to enable the ownership and control of deposit accounts and associated IT systems to 49. Depositor preference has a number of benefits be transferred to a receiving bank or bridge bank, for financial stability and a deposit insurance for amounts up to the protected balance (ie the scheme. If the preference is established in law, with deposit cap). Any amounts above the deposit cap clarity, and is well publicised, it can help to reinforce would be retained in the failed bank, which would deposit insurance by promoting depositor confidence require the bank in question to have systems in and reducing the probability of a run on a bank. It also place to record the remaining amounts payable to offers a benefit to the deposit insurance scheme, given each depositor in the liquidation process. that the scheme would typically have a subrogated 160 161 Financial Stability in the Pacific Islands: Financial Safety Nets claim on the bank’s assets of the same nature as  ‘Risk minimiser’ mandate, where the deposit the depositor. In a bank failure, under a depositor insurer has comprehensive risk minimization preference arrangement, the deposit insurance functions that include a full suite of resolution scheme would stand in the shoes of depositors powers as well as prudential oversight and derive the benefit of the deposit preference in responsibilities. South Korea and the United States recovering funds the scheme paid out to insured are examples of these. depositors. 52. The ‘paybox plus’ form of deposit insurance 50. It is therefore suggested that depositor is the most widely used globally, with 43.8% of preference be considered by the PIC authorities deposit insurance schemes surveyed by IADI in the context of whether to establish a deposit being in this category. ‘Paybox’ schemes were the insurance scheme. In assessing this issue, the details next most widely used form of deposit insurance, of depositor preference would need to be carefully with 28.6% of schemes surveyed by IADI being in assessed, including whether the preference would this category. In contrast, ‘loss minimiser’ schemes apply only to retail deposits of the nature covered by represented only 16.1% of deposit insurance schemes the deposit insurance scheme or to a wider range of in the IADI survey, with ‘risk minimiser’ being only deposits, and whether it would be subject to a cap in 11.6% of schemes surveyed. amount. 53. In IMF and World Bank missions undertaken in the PICs, the general recommendation is that, if deposit insurance is to be established, the ‘paybox Main types of deposit insurance plus’ model would be the most appropriate. This schemes recognises that such schemes enable the deposit insurance funds to be used flexibly in a range of bank 51. There are several different types of deposit resolutions, including to fund business transfers, insurance schemes around the world in terms of such as purchase and assumption transactions. They their scope of functions. IADI identifies four main therefore offer greater scope to use the deposit types: insurance fund to structure the optimal resolution  ‘Paybox’ schemes. These are the narrowest in any given situation, subject to ensuring that the scope of deposit insurance schemes and involve scheme does not contribute more to a resolution than the scheme only making payments to insured it would have done under the least cost amount for a depositors upon a bank failure; the funds in simple deposit payout. Any use of deposit insurance the scheme are not able to be used for wider funds for resolution should be subject to a ‘least cost’ purposes. Germany, Hong Kong, India and test, such that the amount the fund contributes to a Singapore are examples of this form of deposit resolution should be limited to the maximum amount insurance arrangement. that would have been paid to insured depositors under a least cost form of payout. In general, it would  ‘Paybox plus’ mandate, where the deposit insurer be inadvisable to use a deposit insurance fund to has the ability to make payments to insured finance recapitalization if that option is used. Rather, deposits but to also contribute to other forms of recapitalization should be funded by the write-down resolution, such as purchase and assumption. of liabilities, if possible, followed by separate external Argentina, Brazil and the United Kingdom are funding (e.g., a special purpose government funding), examples of this type of scheme. with appropriate recovery for any public funding  ‘Loss minimiser’ mandate, where the deposit applied. insurer actively engages in the selection from a full suite of appropriate least-cost resolution strategies, with a view to seeking to apply the form of resolution that involves the lowest cost to the Funding of deposit insurance deposit insurance scheme, subject to meeting 54. Deposit insurance schemes can be funded in defined resolution objectives. Canada, France, a number of ways. The most common arrangement Indonesia, Italy, Japan, Mexico, Russia, Spain and is for the scheme to be funded by regular levies on Turkey are examples of this type of mandate. banks on the basis of achieving and maintaining a target size of fund. The size of fund is determined by assessed probability of failure of a bank. It creates reference to the expected value of payouts over the incentives for banks to manage their risks prudently medium to long term, having regard to the expected and hold higher capital and liquidity buffers if probability of bank failure and the aggregate amount warranted by their risk profile. However, risk-based of deposits covered by the scheme. When establishing levies involve administrative complexity and create a a new deposit insurance scheme, it is common risk of ‘adverse signalling’ to the extent that the levies practice for the authorities to set a timeframe to are publicly disclosed. For these reasons, most deposit achieve the target size for the fund – normally 7 to 10 insurance schemes operate on the basis of uniform years from inception. This avoids placing an excessive levies, at least in the early stages of their formation. funding burden on banks. Based on IADI survey data, Over time, a greater number of deposit insurers are around 86% of deposit insurance schemes are funded transitioning to risk-based levies, as revealed in IADI on an ex ante basis through regular levies on banks, surveys. with only 14% of schemes being funded on an ex post basis (see below). 57. In recognition that ex ante funded schemes are costly, some countries operate deposit 55. With an ex ante funded scheme there is protection schemes that are ex post funded. Under always a risk that the fund will not necessarily be this arrangement, the government is generally the sufficient in a bank failure situation. Accordingly, it provider of funding to the deposit insurance agency is common practice for deposit insurance schemes to when a bank failure occurs; there is no deposit have a supplementary funding mechanism to enable insurance fund and therefore no regular levies on additional funds to be accessed when required. The banks. The government funds are recovered from options for obtaining supplementary funding range the assets of the failed bank. Any shortfall in assets from country to country, but the most common relative to government funding is met through ex post arrangements involve a credit line under which the levies on banks, such that the government recovers deposit insurer can borrow from the government or the full net present value of the amount it lent to central bank (and if the latter, with the central bank the deposit insurance scheme. Hybrid models also being indemnified by the government). This is best exist, whereby banks contribute limited funding ex achieved by having statutory powers to enable the ante – e.g. to meet a deposit insurer’s administrative borrowing arrangement to be established and then costs – but where the bulk of funding for a payout or entering into a formal standby facility in normal times other form of depositor reimbursement is from the that can be quickly accessed in periods of stress. Other government. supplementary funding options include the ability of a deposit insurer to sell securities to the markets, to 58. Ex post funding arrangements have some borrow from healthy banks or to borrow from foreign advantages. They are lower cost for the scheme counterparties. Of all the options, the most robust administrator because there are no ex ante levies to is to have an established standby facility with the collect and no funds to invest and manage. They are government or central bank, as this provides greatest lower cost for the banks because they require no or certainty of prompt access to funding. little ex ante funding via levies. These arrangements also avoid the build up of a fund that might never be 56. Under an ex ante funding arrangement, levies used. Hence, they avoid the ‘deadweight’ cost of funds Financial Stability in the Pacific Islands: Financial Safety Nets on banks are set by the deposit insurer or the being siphoned from the banks which could otherwise government. The levies are normally set in the form be used by banks to lend to borrowers. These factors of x basis points per currency unit of deposit based make ex post schemes attractive to small countries, on the total eligible deposits in each bank. Levies such as the PICs, given that they offer a low-cost are generally collected annually or six monthly. In option for depositor protection. some schemes, the levy is risk-based, such that the levy rate is higher for banks deemed to be of higher 59. However, there are some disadvantages with risk, and lower for banks assessed as being of lower ex post funded deposit insurance that need to be risk. The risk assessment is generally based on borne in mind. These include the (temporary) fiscal either the supervisory rating of a bank or an external burden associated with government-funded schemes assessment, such as a credit rating. Risk-based levies and the perverse incentives on the banking system as have the advantage of aligning the levies with a risk a result of the better managed banks – the banks that metric that approximates (however imperfectly) the do not fail – bearing the final cost of disbursements to 162 163 depositors of the less well-managed banks – the banks to be operationally independent in the performance Financial Stability in the Pacific Islands: Financial Safety Nets that did fail. It is therefore important to weigh the of its functions, especially if it is a department in pros and cons of the different funding options before the central bank rather than a separate legal entity, reaching a decision on funding structures. such as a subsidiary with its own governing board and statutory mandate. Conflicts of interest can also arise if the deposit insurance function is located in the central bank, such as the risk that the deposit Administrative arrangements for insurance fund is used to finance a resolution the deposit insurance agency transaction on other than ‘least cost’ terms, to the detriment of banks funding the scheme. It is therefore 60. There are several options for the important to ensure that these conflicts are avoided or administrative arrangements of deposit insurance managed through the arrangements put in place, such agencies. In some countries, deposit insurance as robust governance requirements for the deposit agencies are independent government bodies insurance scheme, the requirement for it to have its established under statute, with their own governing own balance sheet, separate audit arrangements, board, staff and funding. This is the case in many and separate public reporting arrangements. In large countries, such as Canada, Japan, Thailand recognition of these factors, one formulation that is and Thailand. In some cases, the deposit insurer has often used is for the deposit insurance agency to be adjunct functions, such as bank resolution planning established as a subsidiary of the central bank with its and implementation, as with Indonesia, for example. own board (but with some central bank staff on the In some countries, such as the United States, the board), statutory mandate, separate risk management deposit insurance agency is also the supervision framework, separate internal audit and external audit, authority and resolution authority. and its own public reporting requirements. 61. In some countries, the deposit insurance function is located in one of the existing financial sector agencies, such as the central Issues for the PICs bank or supervision authority, in order to derive operational efficiencies and to take advantage of 64. As previously noted, the PICs do not have closely linked functions (such as resolution). For deposit insurance arrangements in place. This example, in South Africa the deposit insurance agency creates risks for the financial stability of the countries is part of the central bank and in New Zealand the by increasing the possibility of depositor runs in intention is to establish the deposit insurance function periods of stress and associated risks of inter- in the RBNZ. In Australia, APRA runs the deposit bank contagion. The absence of deposit insurance protection scheme. also increases the pressure on governments to bailout failing banks rather than resolving them 62. For small countries, such as the PICs, there via a combination of deposit insurance to protect are efficiency and cost-saving arguments for small depositors and bail-in or selective business the deposit insurance agency to be located in transfer. For these reasons, it is suggested that the the central bank. This recognises that, in the PICs, PIC authorities give active consideration to the costs it is generally the central bank that performs the and benefits of establishing some form of deposit key financial sector regulatory functions, including insurance. In that context, consideration also needs to supervision, resolution and ELA. There would be some be given to the establishment of depositor preference. efficiency gains in locating the deposit insurance function in the central bank to take advantage of the 65. The issues that warrant consideration include: close linkages between these functions. Locating the a. the risks associated with bank distress and failure deposit insurance function in the central bank would in the absence of depositor preference and deposit also help to minimise operational costs and therefore insurance, including the potential risk of retail minimise the pass-through of those costs to the banks depositor runs, inter-bank contagion, contagion via levies (depending on how the scheme is funded). between the banking sector and non-bank deposit- takers, confidence impacts and risk of government 63. However, there are also risks associated in bail-out, and an assessment of the extent to which locating the deposit insurance function in an deposit insurance and/or depositor preference existing agency, such as the central bank. One risk would reduce these risks; is that it could reduce the ability of the deposit insurer b. the costs and risks associated with establishing h. the funding options for a deposit insurance deposit insurance, depending on the design scheme, including the costs and benefits of ex ante features of the deposit insurance scheme, funding versus ex post funding or a hybrid model; including funding costs for banks and flow-on i. if an ex ante funding model is adopted, the target impacts to bank customers, administrative costs size of a deposit insurance fund; and moral hazard risks; j. the methods of payout needed, as well as c. the means by which such costs and risks can be purchase and assumption options, and the likely minimized while still meeting defined financial operational prepositioning in banks for these stability and depositor protection objectives; arrangements; d. the coverage of a deposit insurance scheme in k. the nature of the domestic and cross-border terms of financial institutions covered, types of cooperation and coordination needed between deposits covered and eligible deposit account- a deposit insurance agency and other financial holders; sector agencies; e. the deposit insurance limit needed to ensure l. governance, accountability and transparency effective coverage of small depositors for the bulk arrangements. of their deposits; f. the functions of a deposit insurance scheme 66. These issues should be assessed in close (based on an assumption that the scheme is conjunction with related matters, such as the limited to a simple ‘paybox’ or ‘paybox plus’ model); refinement of bank resolution frameworks in the g. institutional arrangements, such as whether the PICs. In that regard, the development of a deposit insurance scheme should be operated through insurance function should not occur in isolation from a new agency or as part of the central bank, and the wider issues relating to bank resolution; it should if the latter, whether it should be operated via a be progressed in an integrated manner that anchors subsidiary of the central bank rather than within to the overall objective of promoting financial stability the central bank itself; while also minimising the costs associated with resolution and deposit insurance arrangements. „ APPENDIX 1. IADI CORE PRINCIPLES FOR EFFECTIVE DEPOSIT INSURANCE SYSTEMS This appendix summarises the main features of the Principle 1 – Public Policy Core Principles for Effective Deposit Insurance Systems issued by the International Association of Deposit Objectives Financial Stability in the Pacific Islands: Financial Safety Nets Insurers. The Core Principles also include assessment criteria (not included in this appendix), which provide The principal public policy objectives for deposit important context for understanding the principles. insurance systems are to protect depositors and It is therefore suggested that the PIC authorities contribute to financial stability. These objectives make reference to the Core Principles and associated should be formally specified and publicly disclosed. assessment criteria by accessing the Core Principles The design of the deposit insurance system should document from the IADI website.56 reflect the system’s public policy objectives. The Core Principles are set out below (excluding the assessment criteria).  56  https://www.iadi.org/en/core-principles-and-guidance/core-principles/ 164 165 Financial Stability in the Pacific Islands: Financial Safety Nets Principle 2 – Mandate And Principle 5 – Cross-Border Powers Issues The mandate and powers of the deposit insurer Where there is a material presence of foreign banks should support the public policy objectives and be in a jurisdiction, formal information sharing and clearly defined and formally specified in legislation. coordination arrangements should be in place among deposit insurers in relevant jurisdictions. The powers of the deposit insurer include, but are not limited to: a. assessing and collecting premiums, levies or other charges; Principle 6 – Deposit Insurer’s b. transferring deposits to another bank; Role in Contingency Planning c. reimbursing insured depositors; and Crisis Management d. obtaining directly from banks timely, accurate and The deposit insurer should have in place effective comprehensive information necessary to fulfil its contingency planning and crisis management policies mandate; and procedures, to ensure that it is able to effectively e. receiving and sharing timely, accurate and respond to the risk of, and actual, bank failures and comprehensive information within the safety-net, other events. The development of system-wide crisis and with applicable safety-net participants in other preparedness strategies and management policies jurisdictions; should be the joint responsibility of all safety- net participants. The deposit insurer should be a f. compelling banks to comply with their legally member of any institutional framework for ongoing enforceable obligations to the deposit insurer communication and coordination involving financial (e.g. provide access to depositor information), or safety-net participants related to system-wide crisis requesting that another safety-net participant do preparedness and management. so on behalf of the deposit insurer; g. setting operating budgets, policies, systems and practices; and Principle 7 – Membership h. entering into contracts. Membership in a deposit insurance system should be compulsory for all banks. Principle 3 – Governance The deposit insurer should be operationally independent, well-governed, transparent, accountable, Principle 8 – Coverage and insulated from external interference. Policymakers should define clearly the level and scope of deposit coverage. Coverage should be limited, credible and cover the large majority of depositors Principle 4 – Relationships with but leave a substantial amount of deposits exposed to market discipline. Deposit insurance coverage should Other Safety-Net Participants be consistent with the deposit insurance system’s public policy objectives and related design features. In order to protect depositors and contribute to financial stability, there should be a formal and comprehensive framework in place for the close coordination of activities and information sharing, on an ongoing basis, between the deposit insurer and other financial safety-net participants. Principle 9 – Sources and Uses Principle 13 – Early Detection of Funds and Timely Intervention The deposit insurer should have readily available The deposit insurer should be part of a framework funds and all funding mechanisms necessary to within the financial safety-net that provides for the ensure prompt reimbursement of depositors’ claims, early detection of, and timely intervention in, troubled including assured liquidity funding arrangements. banks. The framework should provide for intervention Responsibility for paying the cost of deposit insurance before the bank becomes non-viable. Such actions should be borne by banks. should protect depositors and contribute to financial stability. Principle 10 – Public Awareness Principle 14 – Failure Resolution In order to protect depositors and contribute to financial stability, it is essential that the public be An effective failure resolution regime should enable informed on an ongoing basis about the benefits and the deposit insurer to provide for protection of limitations of the deposit insurance system. depositors and contribute to financial stability. The legal framework should include a special resolution regime. Principle 11 – Legal Protection The deposit insurer and individuals working both Principle 15 – Reimbursing currently and formerly for the deposit insurer in Depositors the discharge of its mandate must be protected from liability arising from actions, claims, lawsuits The deposit insurance system should reimburse or other proceedings for their decisions, actions or depositors’ insured funds promptly, in order to omissions taken in good faith in the normal course contribute to financial stability. There should be a of their duties. Legal protection should be defined in clear and unequivocal trigger for insured depositor legislation. reimbursement. Principle 12 – Dealing with Financial Stability in the Pacific Islands: Financial Safety Nets Principle 16 – Recoveries Parties at Fault in a Bank Failure The deposit insurer should have, by law, the right to The deposit insurer, or other relevant authority, recover its claims in accordance with the statutory should be provided with the power to seek legal creditor hierarchy. redress against those parties at fault in a bank failure. 166