Banking And Capital Markets Insight, December 2009

Welcome to the December 2009 edition of Banking and Capital Markets Insight, which focuses on technical issues currently coming out of the banking, capital markets, securities and fund management arenas. I would normally undertake a review of the year at this stage, and a prediction of expectations for 2010. This year, however, the issues are so myriad and complex, that a compendium article will not do them justice or provide sufficient insights. Suffice it to say that the pace of change which we have seen in 2009 is not likely to diminish in 2010. Rather we will see the embedding of the regulatory and other changes which originated in 2009.

Our articles cover the following diverse areas:

Alan Chaudhuri/James Polson on the need for systematically important banks to devise effective resolution and recovery plans, both under the FSA and international requirements, and the scope of the project planning involved; Kush Patel on the IASB exposure draft on impairment and the approach proposed which will smooth the effect of expected losses over the life of the asset, and will require greater disclosure of the effect of impairment losses; Stephen Woodhouse on potential approaches to the remuneration of employees, in the light of the 50% tax rate, including acceleration of remuneration, deferral of taxation, pension replacements and rewards attracting capital appreciation; Andy Whitton on the significant challenges for deposit takers to be able to give a single customer view to the Financial Services Compensation Scheme within 72 hours of failure and to target payouts within 7 days of an FSCS request; and Eric Wooding on the challenges facing the medium sized and smaller investment firms in meeting the FSA Liquidity Risk Management requirements, the systems and controls element of which came into place on 1 December 2009. We look forward to your comments on the current edition and your suggestions for future articles. Best wishes for 2010.

Living Wills – Planning for bank recovery and resolution

There has been much recent public comment regarding dealing with firms which are 'too-big-to fail'. The FSA issued a Discussion Paper1 in October 2009 which set out initial proposals for the UK including:

A case for applying additional capital surcharges on the most systemically important banks. Greater emphasis on the standalone sustainability of national subsidiaries within global groups. Continuing activities to reduce the interconnectedness of the wholesale markets. Reforms to trading book capital, differentiating between basic market making activities and riskier trading activities. The production of recovery and resolution plans ('RRPs' or 'Living Wills'). There are two main components to a Living Will. Firstly, plan to prolong the ability of the firm to continue in business and secondly, a plan to ensure an orderly workout can occur in the event the firm fails. Producing recovery and resolution plans will be a complex exercise, we believe the key activities are likely to include:

Recovery

Determining when recovery plans should be 'activated'. Determining which businesses/assets could be sold and prioritisation of sale. Determining the impediments to any business/asset sales and how these could be reduced to facilitate future sales. Determining steps to 'de-risk' the business. Ensuring there are strong liquidity and capital recovery plans, including options to enhance capital in a crisis situation. Determining responses to other scenarios (e.g. rating downgrades, failure of large counterparties) likely to occur in a crisis situation. Resolution

Determining the key impediments to effective resolution (e.g. cross-border data reliance, staffing reliance, legal entity structure) and how these could be reduced. Determining detailed resolution plans for each business area including identification of data requirements and plans to ensure ongoing production of data. Determining appropriate actions to facilitate payment of compensation to depositors or return of client assets. Determining and mitigating the potential impact on market and payment infrastructures. Plans will need to be discussed and agreed with the regulator, approved by the Board and kept up-to-date.

There are a number of structural issues that are likely to require assessment:

Legal entity and operational structure. Systemically important banks are often global in nature with complex legal entity, operational and information technology structures and a large number of interdependencies. As a result, these may not be geared towards effective and efficient recovery and resolution. Deposit taking activities. A key question that has been raised by the FSA's proposals is whether any restructuring of complex integrated groups will require a clear separation (legally and operationally within the group) of the retail deposit-taking business from any business undertaking proprietary trading activities. The FSA has stated that a small number of major UK banking groups will begin work to produce their recovery and resolution plans in 2009 with first drafts submitted by the end of Q1 2010. This will be followed by a period of review by the authorities, who will consider both the adequacy of the plans for each firm and the wider policy implications. Eventually, the FSA expects the requirement to be extended to all UK deposit takers (in proportion to their nature and scale) as well as other systemically important firms.

Subsequent to the release of the Discussion Paper, HM Treasury has introduced the Financial Services Bill to Parliament. Amongst the many proposals included in the Bill is one to amend the Financial Services and Markets Act ('FSMA') to impose a duty on the FSA to introduce rules to require firms to produce RRPs.

The FSA Discussion Paper addresses topics which are the subject of significant international debate and study in which the FSA is closely involved with work being undertaken by bodies such as the Financial Stability Board and the Basel Committee on Banking Supervision. In addition to the UK proposals there are currently proposals in relation to Living Wills contained in the recently published discussion draft of the "Restoring American Financial Stability Act of 2009" from the US Senate Committee on Banking, Housing and Urban Affairs2 and in recent Communications from the European Commission.3 The UK Financial Services Bill proposes to amend FSMA to require the FSA to have regard to international developments in making rules around RRPs.

In the UK, there are currently open questions as to the requirements for foreign owned institutions with significant UK presence and the operations of UK banking groups in other jurisdictions. Whilst the UK is further advanced in terms of making the production of Living Wills a reality, the requirement seems likely to extend to many significant financial institutions internationally in one form or another in the near future.

The tables opposite set out some of the key proposals relating to Living Wills in the Discussion Paper and some considerations for management as they prepare these plans.

The challenges of developing a Living Will are as much to do with setting up a cross-disciplinary project team to deal with the required changes to existing legal entity, governance, tax and IT infrastructure, as they are to do with the development of an effective recovery and resolution plan going forward. All that systematically important banks can realistically hope to achieve by the end of Q1 2010 is an outline plan and a template for how they will develop the detailed Living Will project over the next 12-18 months.

There is nonetheless a lot of significant thought that will need to go into the development of that initial planning in the next 3 months.

Impairment rules rewritten

In the current economic environment the accounting rules on recognising and measuring impairment on financial assets has come under close scrutiny. Both the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) are in the process of rewriting the rules on accounting for financial instruments including when an impairment loss on a financial asset is recognised and how it is measured. The end goal is a common set of rules for use on both...