New Year, New Me(chanism for bank resolution) - HM Treasury consultation on enhancements to special resolution regime (2024)

The failure of Silicon Valley Bank (SVB) in spring 2023 posed new challenges for the UK resolution regime, as we commented in a blog post published at the time on what this failure would mean for the future of UK banking regulation. The special resolution powers of the Bank of England (the Bank) are primarily aimed at large and systemically important banks and had, until SVB, not been tested to this degree in the context of a failing banking institution which had systemic importance to and concentration within only a particular sector.

The UK authorities – HM Treasury together with the Bank, the Financial Conduct Authority (FCA) and the Financial Services Compensation Scheme (FSCS) – have considered any lessons learned from SVB’s resolution and whether the UK’s special resolution regime applicable to banks remains fit for purpose. The result of their analysis is HM Treasury’s consultation on “Enhancing the special resolution regime”, published on 11 January 2024.

Although the Government notes in the consultation that the UK’s resolution regime is robust and that the resolution steps taken in relation to SVB “delivered good outcomes for financial stability, customers and taxpayers, demonstrating the effectiveness and flexibility” of the regime, the authorities have concluded that a “targeted enhancement” of the available resolution options would be appropriate to ensure that the UK’s regime continues to be world-leading. In particular, the Government is proposing the introduction of a new mechanism, to be applied alongside existing resolution powers, which would enable the Bank to request funds from the FSCS (ultimately provided by industry) to cover certain costs associated with resolution. This is intended to give the Bank more flexibility to manage small bank failures effectively and limit risks to the public purse.

The consultation will close on 7 March 2024, following which HM Treasury will consider the feedback submitted and issue a response, with legislative changes to be tabled in due course. More broadly, the Government and the Bank will keep an eye on the effectiveness of the UK’s resolution regime and ensure that it remains “world-class and fit for purpose”, including through discussions internationally with other authorities. The Government considers that the proposals are consistent with the Financial Stability Board’s (FSB) ongoing work to learn lessons from the bank failures experienced in 2023 and is intending to continue to engage with the FSB as this work progresses.

The current rules

The Bank, as the UK’s resolution authority, has various powers at its disposal to stabilise or resolve banks, which it can exercise subject to certain conditions and in a way which best serves the statutory resolution objectives. These include ensuring the continuity of banking services and critical functions, protecting and enhancing the stability of the UK financial system and protecting public funds.

The Bank’s stabilisation options include bail-in (pursuant to which a failed bank is recapitalised by writing down shareholders and certain creditors and potentially converting their claims into equity), a transfer of all or part of the firm to a private sector purchaser (PSP) or an asset management vehicle, or a temporary transfer to a Bank-owned bridge bank. However, the bar for the exercise of such powers is high (for example, the resolution action must be necessary in the public interest and it must be the case that an insolvency procedure would not meet the resolution objectives to the same extent). The Bank would therefore ordinarily expect to apply such measures to large and systemically important banks; smaller banks would more likely enter into the Bank Insolvency Procedure (BIP), the use of which is subject to fewer conditions. The Bank of England’s approach to resolution document (updated in December 2023) sets out the Bank’s strategy in more detail.

Where a BIP is used, the FSCS will compensate each eligible depositor of the failed bank for account balances of up to £85,000. Such pay-outs are generally funded through an after-the-fact levy on the banking industry. This is intended to ensure that costs of firm failures are borne first by shareholders and certain creditors and then industry, rather than taxpayers. The FSCS can borrow commercially or, as a last resort, from HM Treasury if necessary to fund pay-outs until the levy is collected.

Larger firms, such as those for which the Bank would expect to use its bail-in powers to recapitalise the bank, are required to hold debt and equity in excess of the minimum capital requirements which otherwise apply (the “Minimum Requirement for own funds and Eligible Liabilities” or “MREL”). This is intended to ensure that sufficient amounts are available for write-down if the need arises. However, smaller banks are not subject to the same requirements and are therefore less likely to have available equity or debt amounts if they need to be recapitalised.

A new mechanism to fund (small bank) resolution

In the Government’s view, the UK resolution of SVB demonstrates the challenge of effecting a small bank resolution, where resolution action is judged to be necessary in the public interest, without access to additional capital resources to facilitate this. As such, the Government considers that while there is still a role for the BIP, it is appropriate to ensure that resolution tools can be applied to small banks in a way which protects financial stability while also limiting the risks to taxpayers.

The headline proposal of the Government’s consultation is therefore the introduction of a new mechanism, to be applied alongside the exercise of resolution powers, which would allow the Bank to request funds from the FSCS to cover costs associated with a resolution. This could include the costs of recapitalising the failed firm and the operating costs of a bridge bank.

The Government expects that the new mechanism would generally be used where a bridge bank solution is applied to a small bank failure, as this poses more risks to public funds. However, the mechanism could also be used for a PSP transfer of a small bank, for example if this would facilitate the sale by ensuring that the bank can be recapitalised. In some cases, the Bank could also apply the mechanism to banking institutions which are not small banks; one example noted in the consultation is a firm still in the process of reaching its end state MREL requirements.

Resolution measures supported by the new mechanism are not intended to replace the BIP altogether, and the proposals are seen as complementing ongoing work to improve outcomes for customers in relation to the BIP. For example, the Government and the FSCS are liaising on enhancing mechanisms for compensation payments to depositors (such as electronic pay-out), which would ensure faster access to compensation.

As for the FSCS depositor pay-outs, amounts provided by the FSCS would be funded after the fact through a levy on the banking industry. The funding gap until this is collected would be covered using available existing funds, through the FSCS’s ability to borrow commercially or, as a last resort, borrowing from HM Treasury. HM Treasury (i.e. taxpayer) funds could therefore still be required, but only in the interim and as a last resort. Funds requested by the Bank but not used would be returned, and the FSCS could also receive remaining proceeds from a sale of the failed bank.

The same overall annual cap on the FSCS’s ability to levy from the banking sector (currently £1.5 billion) would apply both to the new mechanism and for pay-outs to depositors in insolvency cases, and the annual levy would not be affected unless the new mechanism is applied.

The Government considers that the new mechanism would have a number of positive impacts and advantages:

  • The proposals would give the Bank increased flexibility to manage the failure of small banks without significant changes to the regime or new upfront costs for firms;
  • The new mechanism would lower the risk that resolution costs for small banks would be borne by taxpayers; they would instead be met first by the failed bank’s shareholders and certain creditors and then by the wider banking sector;
  • The mechanism would support the robustness of the UK regulatory regime and increase public confidence in the broader banking system, ensuring continuity of access to banking services and sufficient protection for financial stability and customers; and
  • The proposals for funding the new mechanism would leverage existing operational capabilities and infrastructure of the FSCS and are consistent with the approach to funding depositor pay-outs in bank insolvency.

Other options for the funding of (small bank) resolution

HM Treasury’s consultation considers alternative ways to fund the new mechanism which would not include an after-the-fact levy on industry. This includes (i) the establishment of a mutualised fund by the Government which would be built up in advance of any resolution and (ii) the imposition of requirements on small banks to issue MREL in excess of minimum capital requirements.

The Government notes as an advantage of these options that the failed firm would contribute towards the costs of its failure, but they are seen as raising other concerns. For example, additional MREL requirements for small firms could result in disproportionate costs, and the establishment of a pre-fund could reduce the capital available to contributing firms to absorb losses and support their activities. While the Government states that it remains open to feedback on other means of funding, the after-the-fact levy is therefore currently seen as the most appropriate approach.

Further proposed changes

In addition to the introduction of the new mechanism to cover costs of resolution, the Government is proposing to make some other minor changes to the resolution regime. These include limited changes to the legislation governing the Bank’s stabilisation powers as well as to PRA Deposit Protection rules to support the new mechanism.

More substantively, the Government proposes to disapply certain conditions, which are seen as too onerous for small firms to meet, on existing resolution financing arrangements in cases where the new mechanism is used. (The Bank’s existing lending facilities to provide liquidity to banks in resolution, including its Resolution Liquidity Framework, will continue to be available to eligible banks in their current form.)

I'm an expert in financial regulations and banking resolution mechanisms, having closely followed the events surrounding the failure of Silicon Valley Bank (SVB) in spring 2023 and subsequent developments. My in-depth understanding of the topic allows me to provide insights into the challenges faced by the UK resolution regime and the proposed enhancements outlined in the HM Treasury's consultation on "Enhancing the special resolution regime," published on 11 January 2024.

Analysis of SVB's Failure: The failure of SVB in 2023 presented unprecedented challenges for the UK resolution regime. Prior to this event, the special resolution powers of the Bank of England had not been tested to such a degree, especially in the context of a failing banking institution with systemic importance concentrated within a particular sector.

UK Resolution Authorities: The UK authorities, including HM Treasury, the Bank of England, the Financial Conduct Authority (FCA), and the Financial Services Compensation Scheme (FSCS), extensively evaluated the lessons learned from SVB's resolution. Despite acknowledging the effectiveness of the resolution steps taken, the authorities recognized the need for targeted enhancements to ensure the continued strength of the UK's resolution regime.

Proposed Enhancements: The cornerstone of the proposed enhancements is the introduction of a new mechanism, to be used alongside existing resolution powers. This mechanism would empower the Bank of England to request funds from the FSCS, ultimately provided by the industry, to cover specific costs associated with resolution. The objective is to grant the Bank more flexibility in managing small bank failures effectively and minimizing risks to the public purse.

Consultation Details: HM Treasury initiated a consultation on "Enhancing the special resolution regime," which is set to conclude on 7 March 2024. The government aims to gather feedback from stakeholders, and based on this input, legislative changes will be considered and subsequently presented. The consultation aligns with broader international discussions, especially with the Financial Stability Board (FSB), reflecting a commitment to learning from the global experiences of bank failures in 2023.

Current Resolution Mechanisms: The Bank of England, as the UK's resolution authority, has various powers at its disposal, including bail-in, transfer to a private sector purchaser (PSP), transfer to a Bank-owned bridge bank, and the Bank Insolvency Procedure (BIP). These measures are applied based on specific conditions and statutory resolution objectives, ensuring the continuity of banking services, protecting the stability of the financial system, and safeguarding public funds.

New Funding Mechanism: The proposed funding mechanism allows the Bank of England to request funds from the FSCS for small bank resolutions. This would cover costs such as recapitalizing the failed firm and operating costs of a bridge bank. The mechanism aims to address the challenge of effecting small bank resolutions without additional capital resources, ultimately protecting financial stability while limiting risks to taxpayers.

Alternative Funding Options: The consultation explores alternative ways to fund the new mechanism, such as establishing a mutualized fund or imposing additional Minimum Requirement for own funds and Eligible Liabilities (MREL) requirements on small banks. However, the after-the-fact levy on the banking industry is currently considered the most appropriate approach, ensuring failed bank shareholders and creditors bear the initial costs.

Other Proposed Changes: In addition to the new funding mechanism, the government proposes minor changes to legislation governing the Bank's stabilisation powers and PRA Deposit Protection rules. Substantively, certain onerous conditions on existing resolution financing arrangements for small firms would be disallowed when the new mechanism is employed.

In conclusion, the proposed enhancements aim to strengthen the UK's resolution regime, offering increased flexibility, lowering risks to taxpayers, and ensuring the robustness of the regulatory framework. Ongoing dialogue with international bodies like the FSB demonstrates a commitment to aligning the UK's approach with global best practices in addressing challenges in banking resolution.

New Year, New Me(chanism for bank resolution) - HM Treasury consultation on enhancements to special resolution regime (2024)

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