FINANCE FINANCE EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Application of the Key Attributes of Effective Resolution Regimes for Financial Institutions to State-Owned Banks Bruno Meyerhof Salama Danilo Queiroz Palermo Eva M. Gutierrez © 2022 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. 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Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. Photo credits: iStock Warchi >>> Acknowledgments The authors are grateful for the extensive support, guidance, and comments received from Eva Hüpkes (Financial Stability Board Secretariat); Brian Akimanzi, Ana Maria Aviles, Alexander S. Berg, Miquel Dijkman, Laurent Gonnet, Syed Mehdi Hassan, Yevhen Hrebeniuk, Cedric Mousset, Angela Prigozhina, Diego M. Sourrouille, and Radu Tatucu (all World Bank); Marc Dobler (International Monetary Fund); Javier Torres Riesco (Fondo de Reestructuración Ordenada Bancaria, Spain); Fábio Lacerda Carneiro, Luciano de Souza Ferreira, and Vivian Grassi Sampaio (Banco Central do Brasil); Fanny S. Parinussa (Lembaga Penjamin Simpanan, Indonesia); Åsa Höijer and Daniel Westin (Swedish National Debt Office); João Cunha Marques (Banco de Portugal); Samy Harraz and Jordan Thursby (Single Resolution Board); and Vicente Vargas (Instituto para la Protección al Ahorro Bancario, Mexico). Special thanks to Pierre-Laurent Chatain (World Bank) for substantial contributions to the text and to peer reviewers Marianne Klumpp and Hans Sassen (Financial Stability Board Secretariat), Ismael Ahmad Fontan and Katia D’Hulster (World Bank), Jacques Botes (Reserve Bank of South Africa), and Mark Adams (International Monetary Fund). >>> Contents Abbreviations 6 Executive Summary 7 1. Introduction 9 2. Definition of SOB 12 2.1. State 12 2.2. Owned 13 2.3. Bank 13 3. A Taxonomy for Contributions of State Capital to Failing SOBs 14 3.1. The Key Variables: Financial Conditions and Timing 15 3.2. The Role of Laws in Distinguishing Ordinary Recapitalizations from 16 Bailouts 3.3. Bailouts and Bail-Ins 17 3.4. Summary 18 3.5. Policy Implications 19 4. Applicability of the KAs to SOBs 20 5. Practical Challenges to the application of the KAs to SOBs 21 5.1. Resolution Can Hurt a Government’s Reputation and Cause It to 21 Realize a Loss 5.2. SOBs Are Subject to Special Legal Frameworks 22 5.3. Resolution Can Reignite Debates about Privatization 22 5.4. Resolution Can Reignite Debates about Economic Nationalism 23 >>> Contents 6. Application of the KAs to SOBs 24 6.1. Application of KAs 1, 4, 5, and 12 to SOBs 25 6.2. Considerations Pertaining to KAs 2, 7, 8, 9, 10, and 11 25 7. Challenges to the Application of KA 3 28 7.1. Bail-Ins May Be More Complex to Implement in SOBs Than in POBs 28 7.2. RAs’ General Resolution Powers and Tools 30 8. Implementation of KA 6 33 9. Conclusion 34 >>> Abbreviations BRRD Bank Recovery and Resolution Directive (European Union) CGD Caixa Geral de Depósitos (Portugal) CMG crisis management group DGS deposit guarantee scheme D-SIB domestic systemically important bank FSB Financial Stability Board G-SIB globally systemically important bank G-SIFI globally systemically important financial institution IMF International Monetary Fund Key Attributes of Effective Resolution Regimes for Financial KAs Institutions LAC loss-absorbing capacity POB privately owned bank PONV point of non-viability RA resolution authority RRP recovery and resolution planning SOB state-owned bank SOE state-owned enterprise TLAC total loss-absorbing capacity >>> Executive Summary State-owned banks (SOBs) play an important role in financial sectors around the world, and several publicly owned financial institutions are domestic systemically important institutions. SOBs account for a significant part of financial sector assets in many emerging countries such as China, India, the Russian Federation, or Brazil, and in some developed countries as well, such as in Germany. The “Key Attributes of Effective Resolution Regimes for Financial Institutions” (the KAs) published by the Financial Stability Board provide a framework for dealing with failing systemic institutions. The KAs were a response to the public outrage caused by use of taxpayer funds to resolve failing banks (bailouts) during the 2007–2008 global financial crisis, which caused policy makers to design a new approach to deal with failing banks considered “too big to fail.” The application of the KAs to privately owned banks (POBs) has been extensively discussed, but the use of the same principles to resolve SOBs has received less attention. SOBs have important differences in relation to POBs, which gives rise to questions on how exactly to apply the KAs: the failure of an SOB can raise concerns about the solvency of the sovereign; SOBs are often subject to special legal frameworks, and their resolution may require parliamentary involvement; SOBs typically have public policy roles that go beyond merely commercial activities; and the resolution of a SOB may give rise to discussions related to privatization and economic nationalism. The purpose of this paper is to offer guidance to policy makers and resolution authorities regarding the application of the KAs to SOBs. It deals with banks that have passed the point of non-viability (PONV) but also discusses early-stage requirements and procedures prescribed by the KAs that aim to improve resolution if it should become necessary. The KAs were developed to apply to “any financial institution that could be systemically significant or critical,” which includes SOBs. The key potential issues that could affect the implementation of the KAs for the resolution of SOBs are identified and, where possible, alternatives to address them, or to mitigate their impact, are provided. Among them, the removal of barriers that prevent the resolution authority (RA) from placing a failing SOB under resolution features preeminently. Authorities should also address issues related to resolution funding, which tend to take a prominent role in the case of SOBs, given the fiscal EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 7 implications. The paper is also useful for bank resolution practitioners challenged with the implementation of resolution regimes for SOBs. The paper does not intend to be conclusive but rather to frame the discussion on the application of the KAs to SOBs, with the objective of feeding the necessary discussions of these issues by the international community. Whereas some of the KAs will apply in a straightforward way to SOBs, others will require that certain legal or operational barriers are removed to ensure they can be applied effectively to these institutions. The paper divides the 12 KAs into three groups, depending on the ease of applying them to SOBs. We conclude that four of the KAs can be applied irrespective of the ownership structure of a bank (whether POB or SOB), while six others can be applied to SOBs provided that certain barriers are adequately addressed. Only two KAs (KA 3 and KA 6), which deal respectively with the write-off or conversion of liabilities into equity (bail-in) and with the power of the RA to override shareholders’ rights, may require more substantial interventions, such as a delegation of powers from the Parliament to the RA, in order to be fully applied to SOBs. This paper also addresses the terminology pertaining to public sector capital injections into a failing SOB, which is sometimes inconsistent in different jurisdictions. To structure the discussion, we start from the premise that the first line of defense against a bank failure is capitalization by its shareholders, a principle that holds true for POBs and SOBs alike. Naturally, the capitalization of an SOB by its shareholder involves the use of taxpayer funds, but that does not automatically render such capital injection a “bailout.” As we see it, depending on the financial conditions and timing, the injection of taxpayers’ funds can be either an ordinary capitalization or a bailout. An ordinary recapitalization happens when government funding is provided in market terms before the initiation of resolution. In contrast, a bailout takes place whenever government funding is provided to the SOB outside of market terms, independently of the moment at which such funding is provided. The bail-in of liabilities held by the government and by parastatal entities could also be seen as a form of usage of taxpayer funds in resolution, especially when such liabilities are not acquired at arms’ length. . EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 8 1. >>> Introduction The bank bailouts put in place during the 2007–08 crisis brought an outcry against the politically unappealing and morally dubious dynamic of treating banks’ profits as the rightful property of shareholders but their losses as a burden that society at large must shoulder—the dynamic of privatizing gains and socializing losses, as the adage goes. In the soul-searching that followed, the lack of resolution frameworks—or the poorly designed frameworks then existing in some jurisdictions—were blamed for foreclosing the option of resolving failed banks and then forcing governments into the uncomfortable position of having no alternative but to rescue failed banks using taxpayers’ funds. The design of resolution frameworks was thus placed at the center of the “too big to fail” problem. To assist policy makers in establishing mechanisms to deal with failures of large institutions while preserving financial stability, the Financial Stability Board (FSB) published the Key Attributes of Effective Resolution Regimes for Financial Institutions (the KAs) in 2011. The KAs, which were formally endorsed by the G20, are a set of principles viewed as necessary for an effective resolution regime—meaning one that minimizes taxpayers’ exposure and mitigates moral hazard while allowing authorities to preserve financial stability and the financial institution’s critical functions. The KAs, as later revised and consolidated in 2014, stand today as the international standard for resolution regimes of financial institutions. Before the introduction of the KAs, countries typically had only “corner solutions” to deal with failed banks: bailouts or liquidation.1 Bailouts provoke a number of setbacks: they place the burden of failure on the shoulders of taxpayers, they create moral hazard and the expectation of an “implicit guarantee” to other banks in similar situation, and they may trigger fiscal problems. Liquidations, in contrast, cause a sudden interruption of a bank’s activities, destroy value, and are not a feasible option for institutions that perform critical functions because of the significant impacts upon the real economy. 1. The notable exception were those countries that had faced acute banking crises in the previous decades and had developed a wider range of tools to deal with them. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 9 The KAs provide a set of resolution tools and principles while mitigating the costs to taxpayers. The KAs consist of that allow authorities to deal with bank failures in a 12 principles, summarized in table 1.1. manner that ensures the continuity of critical functions >>> Table 1.1 Summary of the 12 Principles of the KAs KA Summarized description Establishes that the KAs are applicable to “any financial institution that could be systemically 1 Scope significant or critical if it fails”, including financial market infrastructure and insurance companies. Jurisdictions must have a designated RA tasked with exercising resolution powers. The RA must Resolution 2 be independent from supervision, and where the resolution and supervision functions fall within authority the same authority, they should have separate reporting lines. RAs should have a broad range of powers to allow them to deal with failing institutions, including the power to replace management, operate and resolve the firm, ensure continuity of essential Resolution 3 services and functions, override rights of shareholders, transfer assets and liabilities, establish a powers temporary bridge bank, stay early-termination rights, carry out bail-ins within resolution, impose moratoria, and conduct the orderly liquidation of the failing firm. Set-off, netting, Jurisdictions must have clear legal frameworks regarding set-off rights, netting and collateralization collateralization, agreements, and segregation of client assets, and such legal frameworks should be enforceable 4 segregation of during resolution and not hamper the implementation of resolution measures. Entry into resolution client assets should not, per se, trigger automatic set-off rights or constitute an event of default. Resolution should respect the hierarchy of claims while allowing the departure of pari passu treatment for systemic reasons and in a transparent fashion. Legal remedies should be limited 5 Safeguards to financial compensation rather than allowing courts to constrain the implementation of resolution measures. Jurisdictions should have access to temporary sources of funding to maintain essential functions Funding of firms needed for orderly resolution. They should have privately financed deposit insurance or resolution 6 in resolution funds. Any provision of government funds should be temporary (including placing a failing bank under temporary public ownership). Legal framework The legal framework should empower the RA to cooperate with foreign RAs to achieve conditions for 7 cooperative solutions. Legislation should enable the RA to recognize and give effect to foreign cross-border resolution actions. National laws should not discriminate against foreign creditors. cooperation Home and host authorities of all G-SIFIs should maintain CMGs to enhance preparedness and Crisis facilitate the management and resolution of a cross-border financial crisis affecting the firm. CMGs 8 management should include the members of the financial safety net of all jurisdictions that are material to the groups resolution of the firm. Institution- Home and relevant host authorities of G-SIFIs (at a minimum) must maintain institution-specific specific cooperation agreements to allow for the joint planning and managing of crises. Cooperation 9 cross-border agreements should define the roles and responsibilities of all authorities before and during crises, cooperation and set out information-sharing protocols, communication arrangements, among other matters. agreements RAs should engage in resolvability assessments at least of all G-SIFIs and should be empowered Resolvability to order banks to remove barriers to their orderly resolution, such as streamlining corporate 10 assessments structures, adjusting business practices, and so on—provided, however, that due care is taken with regard to the effects on the soundness and stability of their business. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 10 Recovery and Jurisdictions should have in place an ongoing process for RRP. There should be adequate 11 resolution provisions regarding the governance of RRP, and plans should be updated regularly. planning Access to Jurisdictions should eliminate any legal, regulatory, or policy barriers to the exchange of information and information between supervisors, central banks, RAs, ministries of finance, and deposit insurance 12 information schemes, and require firms to have in place systems that are adequate to produce information sharing needed for resolution in a timely manner. Source: World Bank compilation. Note: CMG = crisis management group, G-SIFI = globally systemically important financial institutions, KAs = Key Attributes of Effective Resolution Regimes for Financial Institutions, RA = regulatory authority, RRP = recovery and resolution planning. This discussion paper is concerned with the application The KAs aim to shift the cost of bank failures from of the KAs to state-owned banks (SOBs). SOBs often taxpayers—through bailouts—to shareholders and have some policy role, and their failure can unsettle creditors, through bail-ins. Capital injections by creditors investors and trigger “doom loops” between banking can be provided in the context of bail-ins. These creditors and sovereign insolvency. SOBs constitute a large share can be private or public (including parastatal entities such of the banking sector in many emerging and developing as pension funds). The bail-in of public creditors transforms countries (for example, China, India, Brazil, Turkey) and in them into shareholders of the failed bank, reinforcing public some developed countries (for example, Germany). SOBs control over the SOB. That raises questions about how to bail can operate on a commercial basis or have a developmental in any private creditors in a manner that ensures reforms in objective (such as development banks). In practice, there are the governance of the SOB. few purely commercial SOBs, since governments often use SOBs to promote a public purpose (for example, the provision In this context, the objectives of the paper are to (a) of financial services in rural areas, lending to underserved provide a taxonomy of different types of capital injections segments and to state-owned enterprises (SOEs), or by the state into an SOB, and (b) discuss the application countercyclical lending during recessions) alongside the of the KAs to SOBs with a view to contributing to goal of generating profits. Thus, SOBs become a part of implementation efforts being carried out by the World the governance and power structures, and their activities Bank, the IMF, the FSB, supervisors, and RAs worldwide. usually have great political as well as economic significance. At its core, the idea here is to provide guidance on how to tailor Furthermore, the failure of the government to recapitalize an national resolution regimes such that the goals established SOB can raise concerns about sovereign fiscal sustainability by the KAs can be attained in the least burdensome manner. and trigger rating downgrades. Our exercise is therefore one of optimization—maximizing the expected advantages and minimizing the potential When discussing the application of the KAs in the context obstacles to resolving SOBs. Although the authors recognize of SOBs, it is important to define what constitutes a the importance of adequate supervision of SOBs and that shareholder recapitalization, a bailout, and a bail-in. supervisors must treat SOBs in the same manner as POBs, Recapitalization by shareholders after loss recognition is bank supervision falls outside the scope of this paper and the first line of action in the event of bank failure and part of is not discussed. The paper proceeds as follows: Section the prompt corrective action (recovery) framework used by 2 defines SOBs. Section 3 discusses what is meant by supervisors prior to transferring the failed bank to the RA. In resolution and develops a taxonomy for capital contributions the case of SOBs, shareholder recapitalizations are ultimately to SOBs. Section 4 discusses the question of how the KAs done by taxpayers. A bailout involves the use of taxpayers’ apply to SOBs. Section 5 addresses the practical challenges resources to ensure that a failed bank that could not be in applying the KAs to SOBs. Sections 6, 7, and 8 cover the recapitalized by its shareholders in market terms can continue 12 principles contained in the KAs, discussing how they can to perform at least some of its obligations—especially those be applied to SOBs. Section 9 concludes. related to functions that are critical to the real economy.— The KAs discourage its use as a resolution technique. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 11 2. >>> Definition of SOB 2.1. State This discussion paper revolves around SOBs, which thus must be defined. To do that, we need to elaborate on each one of the three elements that make up the acronym—“state,” “owned,” and “bank.” The first element is the least problematic to define. The crucial aspect is that a sovereign entity, not a private one, rests as the beneficial owner of the bank. The state that owns the bank can in fact be any sovereign political entity participating either directly or indirectly, including through sovereign wealth fund holdings or other SOEs. Worldwide, banks have been owned at the federal, state, provincial, and local levels. There have also been cases of SOBs being jointly owned by two or more political entities, such as Brazil’s Banco Regional de Desenvolvimento do Extremo Sul, which is a development bank owned by the states of Rio Grande do Sul, Santa Catarina, and Paraná. Multilateral development banks— those controlled by more than one sovereign entity, such as the Asian Development Bank or the European Bank for Reconstruction and Development—fall outside of the scope of this paper, given their specificities. Attention must be paid to the type of sovereign entity, especially because regional and local SOBs tend to be easier to resolve than national SOBs. It is often less controversial to place a regional or local SOB under the same resolution framework applied by an authority at the national level to the banking system at large. The reasons for that are many. First, the failure of the subnational entity to recapitalize the institution does not necessarily affect the sovereign debt market. Second, regional and local authorities normally exercise less political pressure on the RA. Third, there are often differences in the legal framework applying to different types of SOBs. In Brazil, for example, the Central Bank exercised its authority to resolve several state SOBs in the 1990s, making widespread use of the asset separation tool and the subsequent sale to other banks. Nonetheless, the use of these same tools and strategies to resolve federal SOBs would require parliamentary approval. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 12 2.2. Owned provision of these public services raises additional considerations when resolving SOBs through private capital injection or The SOB is “owned” by the state, meaning that some privatization. Conversely, banks that were nationalized usually sovereign entity holds stocks or shares in the bank. This retain their commercial mission and are subject to common entity can be the Ministry of Finance (as in the case of Mexico’s corporate law, rendering them easier to resolve through outright development banks such as Nacional Financiera, Bancomext, privatization or through the bail-in of private creditors. and Banobras, among others), a special governmental vehicle or holding company (as in the case of the Development Bank of Singapore Limited, Russia’s Sberbank,2 and Turkey’s Ziraat), 2.3. Bank or other banks or companies owned by the government. The term “bank” is typically employed to refer to entities SOBs are often wholly owned by the state but not always. that take deposits and grant loans—that is, commercial When the bank has private shareholders alongside the state, banks—but in a discussion of SOBs the term should also one must define how much state ownership is needed to include development banks. Most SOBs take deposits from qualify the bank as an SOB. Some studies adopt a specific institutional investors, whereas commercial SOBs and some percentage as the threshold—sometimes 20 percent, development banks (especially those with a financial inclusion sometimes 50 percent of the voting stock—but a more mandate) offer retail deposits. Examples of large commercial practical way is to define as an SOB a bank over which the SOBs include Sberbank, Banco do Brasil, and Bank Rakyat state has corporate control. Corporate control is the ability Indonesia. Examples of development banks include KfW in to make decisions regarding a bank’s policies and business Germany, the Korean Development Bank, the Exim Bank of plans. This tends to happen when the state has more than the United States, and the Development Bank of South Africa. half of the voting stock, but it can also arise in cases in which Although the need is relatively uncommon, development the state has shares with special rights (for example, golden banks can be subject to resolution. For example, in 2017 shares) or in which the private shareholdings are atomized. Puerto Rico’s Government Development Bank was liquidated and its assets split between depositors and lenders. A bank can become an SOB by virtue of the state having acquired the majority of its voting stock, as sometimes That said, not every financial entity controlled by the happens in the context of a bailout. For example, in 2008 state that is involved with credit allocation should qualify the United Kingdom’s failed Northern Rock was nationalized as an SOB and be subject to the respective resolution and brought into state ownership after two unsuccessful framework. To understand why, consider that the KAs bids to take over the bank (the bank was then managed at deal with the problem of resolution in a holistic fashion and arm’s length by the government and eventually rebranded prescribe requirements for recovery and resolution planning and privatized in 2012). Another possibility of circumstantial (RRP) and intervention at an early stage before the institution state ownership—which in fact arises from the application reaches balance-sheet insolvency. In addition, the KAs deal of the KAs—is the case of bridge banks in which transitory with tools that require adequate preparation before they can government ownership follows from a previous resolution or is be implemented and whose use makes practical sense only intended as an intermediate vehicle for privatization. if the regulators (supervisors and RA) have continuous and ample access to relevant data. However, most SOBs are created ab initio as creatures owned by the state. Typically, their bylaws or some enabling It can be inferred, therefore, that a precondition to legislation will then determine that the state should always hold resolution is that the bank is subject to adequate control. This tends to happen even in banks organized as mixed supervision and regulation. Without that condition, it is corporations, that is, banks in which the government exercises impossible to implement the standards established by the KAs. corporate control but shares ownership with private stockholders. Policy makers must ensure that regulators and supervisory Also, banks that were created as SOBs are often involved with authorities treat SOBs in the exact same manner as POBs, the provision of public services (such as the provision of rural not only to make resolution possible, but also to ensure a level financial services, and so on). The need to ensure continuity in the playing field and a healthy competition environment.3 2. In the case of Sberbank, the Central Bank of Russia was the main shareholder until 2020. 3. For a complete discussion on the regulation and supervision of SOBs, see Mark Adams, Hanife Yesim Aydin, Hee Kyong Chon, Anastasiia Morozova, and Ebru S. Iskender, “Regulating, Supervising, and Handling Distress in Public Banks” (IMF Departmental Paper 2022/010, Washington, DC, 2022). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 13 3. >>> A Taxonomy for Contributions of State Capital to Failing SOBs The economic, political, and social relevance of SOBs means that their failure should be treated by authorities as a question of utmost concern. To safeguard reputation, preserve critical banking functions, and contain systemic failure, governments worldwide have responded to SOB failures with capital injections, relief of impaired assets, and similar measures. This does not mean that SOBs are never liquidated. An SOB liquidation happened, for example, in 2016 when the National Bank of Ukraine and the Ministry of Finance jointly decided to cease Rodovid Bank’s operations and place it in liquidation (the bank had been nationalized a few years previously). Moreover, policy preference is not the only reason why an ordinary recapitalization might turn out undesirable. For example, in the case of the German Landesbank, HSH NordBank, recapitalization in 2005 was blocked because of antitrust considerations. Government contributions are typically the first line of defense against SOB failure, but a fixation on recapitalization may simply create zombie SOBs and hamper fiscal sustainability. Recapitalization of SOBs, as for private banks, should be accompanied by a plan to ensure financial sustainability and management changes. SOBs that are not viable should be resolved. This includes banks that receive subsidies for their commercial operations through either budgetary resources or credit subsidies.4 It is also important to consider the fiscal implications of recapitalization, particularly repeated capitalizations, versus the implications of the resolution alternatives. Part of the controversies concerning state capital contributions to SOBs has to do with their economic merits and political implications, but part is a function of terminology. Government contributions to SOB capital are sometimes referred to as bailouts (in the sense that funding is ultimately shouldered by taxpayers), as bail-ins (or more precisely, bail-ins within resolution, in the sense that funding is provided through the conversion into equity of the SOB’s debt instruments held by the government, directly or through different agencies, within a resolution procedure), or simply as recapitalizations (an ordinary equity contribution). 4. Credit subsidies are received through the provision of funding at below-market rates from government entities or through private mandatory investments. Subsidization of commercial activities can have fiscal consequences and raise competition neutrality concerns. Subsidization of developmental activities can be justifiable but, for transparency considerations and to limit distortions, should be done through budgetary allocations. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 14 3.1. The Key Variables: Financial on liabilities, issues special securities to inject additional resources in the bank, provides funding at below-market Conditions and Timing rates to the bank, or adopts measures such as granting the bank the administration of certain funds6 so capital can be To clarify the terminology, we first need to understand accumulated from the difference between the return of these the flow of actions when a government comes across funds and the government securities in which resources are a failed bank. In any troubled bank, SOB or not, the invested, then these transactions would not be deemed to be actions by the prudential supervisor and the RA happen made on market terms. on a continuum. Typically, once a bank weakness is detected, the bank supervision authorities issue conditional An ordinary recapitalization happens when government approvals, written warnings, or remedial instructions. If funding is provided in market terms before the initiation the bank is undercapitalized, the supervisors require that of the resolution; a bailout takes place whenever shareholders restore the bank’s capital. If the shareholders government funding is provided to the SOB outside of respond by providing the necessary capital and making the market terms, independently of the moment at which other required adjustments, the weakness is eliminated such funding is provided. Sometimes, bailout funding and resolution is avoided. Thus, resolution proper comes will be provided to the SOB before the initiation of formal only after supervisors carry out the early interventions. In resolution proceedings. The bailout can also occur in the practice, resolution begins if the shareholders fail to provide context of an ongoing resolution. This takes place, for the required capital (and to comply with other remedial example, when the government provides resolution funding measures, as needed) and there are no credible alternatives to the SOB, allowing it to continue operating without a clear for avoiding that the bank becomes insolvent. plan for restructuring. The term “resolution” designates several types of Government bail-ins are capital contributions that take interventions and proceedings to deal with bank place by converting liabilities held by the government— insolvency. There are basically two types of proceedings. directly or through government agencies—into equity The first are those solutions in which the institution ceases in the context of a resolution proceeding. For example, to operate (for example, liquidation, merger with or sale if capital is restored by converting shareholders’ credits to another institution, purchase and assumption of certain into equity or by writing off claims of shareholders—that is, assets and liabilities of the institution by another institution without injecting new funds in the bank—that is considered with the subsequent liquidation of the rest). The second type a bail-in. The first liabilities expected to be converted in a of resolution arises when the institution continues to operate bail-in are instruments that, at the time of issuance, already but does so under different circumstances. For example, a contained specific clauses establishing their conversion or bridge bank is incorporated to take over the activities of the write-off, such as instruments that count towards a bank’s failed bank, to hold its assets and liabilities until a buyer is total loss-absorbing capacity (TLAC), as referred to in the found or the bank is finally liquidated. FSB TLAC Term Sheet.7 If these are insufficient, the bail-in can be extended to other unsecured and uninsured liabilities Government contributions to failing SOBs can be carried of the bank. out in market terms or outside of market terms. For example, if the government issues bonds on market terms or uses existing financial resources5 to contribute to the capital of the SOB, those can be considered transactions made on market terms (given that, in principle, the transactions would not be substantially different if done by a private shareholder). If the government instead provides a blanket guarantee 5. For example, from a sovereign wealth fund; for POBs, this would be the equivalent of the private shareholder tapping its own savings to recapitalize the bank. 6. For example, judiciary deposits or workers’ contributions to severance funds. 7. See the FSB’s website at https://www.fsb.org/wp-content/uploads/TLAC-Principles-and-Term-Sheet-for-publication-final.pdf. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 15 >>> BOX 1. TOTAL LOSS-ABSORBING CAPACITY (TLAC) On November 2015 the Financial Stability Board published the “Principles on Loss-absorbing and Recapitalization Capacity of G-SIBs in Resolution,” the TLAC Term Sheet. In principle, the TLAC Term Sheet is applicable solely to globally systemically important banks (G-SIBs), but several jurisdictions used the same principles to establish different loss-absorbing requirements for their domestic systemically important banks (D-SIBs). One example is the MREL (minimum requirement for own funds and eligible liabilities) introduced in the EU, which, despite a different calculation methodology, has the same objectives as the TLAC. TLAC-eligible securities include those issued and maintained by the entity subject to resolution, fully paid-in and unsecured, with a remaining maturity of at least one year. Several liabilities are expressly excluded by the TLAC Term Sheet and cannot count towards TLAC requirements: ● Insured deposits ● Liabilities callable on demand without supervisory approval ● Liabilities funded by the issuer or a related party ● Liabilities arising from derivatives or debt instruments with derivative linked features ● Non-contractual liabilities, such as tax liabilities ● Preferred liabilities ● Other liabilities that cannot be written down or converted to equity by resolution authorities 3.2. The Role of Laws in Without such independence, procedures tend to become less structured and the exact point marking the transition from pre- Distinguishing Ordinary resolution remediation to actual resolution becomes blurred. Recapitalizations from Bailouts Where the law and the regulatory structure fail to A clear distinction between ordinary recapitalizations and provide clear guidance, the distinction between ordinary bailouts requires that the boundary between recovery and capitalization and bailout is found only in the financial resolution be clearly spelled out in laws and regulations. conditions at hand. The crucial element is whether the In Europe, for example, the Single Supervisory Mechanism capital injection is done at market terms or not. As mentioned, controls the recovery phase that bank supervisors carry out a transaction in which the government issues bonds on market outside of resolution. If recovery is not feasible and resolution terms or uses existing financial resources is, in principle, is required, the Single Resolution Mechanism, under the remit considered to be made on market terms. If the government of the Single Resolution Board takes the lead in the process. instead provides funding through mechanisms that would not In many countries, the supervision and resolution functions be available to private shareholders, then those transactions are under the same entity; for those, as prescribed by KA 2, it would not be deemed to be made on market terms and could is important to ensure that the resolution function is exercised be considered a bailout. in an independent manner, which can be ensured by having its reporting line separate from that of the supervision function. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 16 >>> BOX 2. THE RECAPITALIZATION OF CAIXA GERAL DE DEPÓSITOS (PORTUGAL) Caixa Geral de Depósitos (CGD), established in 1876, is the second largest bank in Portugal and the largest Portuguese state-owned bank (SOB). In the aftermath of the global financial crisis, CGD twice required the intervention of its shareholder. The Portuguese government’s funding of CGD in 2012 and 2016 offers a good example of an SOB recapitalization that qualifies as being under market conditions and therefore not a bailout. The European Commission has a mandate to examine whether capital injections by authorities in any of its member jurisdictions are in line with the market economy investor principle. The Commission employed this principle to verify whether a market economy investor would have provided a share capital increase under the same conditions as the Portuguese state did. In its analysis, the Commission concluded (a) that a private investor would have needed additional remuneration, but (b) that CGD could offer a sufficient rate of return to convince a private investor to inject fresh equity into the bank.a The more general point is that ordinary recapitalizations such as that involving CGD will not fall within the scope of the key attributes (KAs). a. See European Commission, Procedure C(2017) 1698 final, Brussels, March 10, 2017, especially items 114, 122, and 179. https://ec.europa.eu/competition/state_aid/cases/267912/267912_1899392_142_2.pdf. The difference between ordinary recapitalization and measures that ensure that shareholders, and some creditors, extraordinary funding granted in resolution is therefore bear the first losses; this aim is further complicated by the fact clear. Ordinary recapitalizations follow standard corporate, that in an SOB shareholders and taxpayers are the same. This contract and banking law, and their financial terms are and other practical problems concerning the application of the consistent with market conditions. Extraordinary funding, KAs to SOBs are addressed later in this report. whether bailouts (by a government and outside of market conditions) or bail-ins (by converting liabilities into equity), are done in the course of a crisis management procedure. But 3.3. Bailouts and Bail-Ins bailouts can be done at any moment (that is, before or during a crisis), whereas the bail-ins dealt with under the KAs are “Bail-in” implies the write-off of existing shareholders always within a formal resolution procedure. and the conversion of liabilities into equity, which has the effect of diluting or completely wiping out existing Although the possibility of bailouts is not completely shareholders, triggering a change of control of the ruled out, they go against the spirit of the KAs and institution. In theory, bail-ins would not be considered a should be used solely when inevitable and in extreme form of “shareholder funding” of a failing bank, because the circumstances. These are the cases for which the tools recapitalization is done by creditors. set forth in the KAs are not deemed sufficiently credible to preserve financial stability and the bank’s critical functions In the specific context of an SOB resolution, a conceptual and generally fulfill the other goals of effective resolution set problem arises in distinguishing a bailout from a bail- out in the preamble of the KAs. Importantly, when a bailout in. The reason is that often government entities are large is needed, authorities must strive to minimize the risks of creditors of SOBs, not only directly (say, through deposits and wasting taxpayers’ money and spawning moral hazard. In that investments by government departments and subdivisions) sense, a bailout should be preceded by a bail-in or by other but also indirectly through parastatal organizations (such EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 17 as pension funds, social security funds, and the like) that exposures, as well as ensuring that private creditor bail- acquire bonds and other securities issued by the SOBs – a ins occur only when control is transferred to private practice that is not uncommon in many emerging markets hands. By ensuring that the LAC issued by an SOB is held and developing economies. In addition, in some instances, by a broader range of investors, bail-ins can be implemented SOB debt held by these institutions is not properly priced, in a manner that distributes losses more evenly across the amounting to a credit subsidy. economy, instead of affecting a small group of government agencies or organizations. The regulations should also ensure A criticism then could be that bailing-in these types of that private capital is bailed in only when the institution’s control public creditors produces a result that does not differ is transferred to private hands. One possibility could be to treat fundamentally from those of a bailout. As the argument public sector creditors as related party credits and, as such, goes, the bail-in of public creditors would again shift the bail them in before private creditors. Another possibility could burden of bank failure onto taxpayers (or subgroups thereof, be to ensure that private creditors are bailed in only when a such as pensioners) while not eliminating the government certain threshold of capital write-off has been reached and the control that led to the SOB’s demise in the first place. A similar liabilities to be bailed in are sufficiently distributed between the situation in which the practical effects of a bail-in resemble public and private sectors. those of a bailout can arise when the liabilities bailed in are held by both public and private creditors, with the majority held by the former. In this situation, private capital is bailed in, but 3.4. Summary the institution remains under state control. Table 3.1 summarizes the features of ordinary recapitalization, A solution might be strict regulations on the issuance of bailouts, and bail-ins in an SOB. LAC by SOBs, requiring transparent pricing and limiting >>> Table 3.1 Features of Recapitalization, Bail-in, and Bailout Recapitalization Bail-in Bailout Nature Non-resolution Resolution Non-resolution, resolution Outside of market terms Outside of market terms, but and less predictable (that is, Financial conditions On market terms typically set forth a priori in decisions are usually political the legal framework and uncertain) Voluntary: Can be determined by the government in Mandatory: Follows from response to supervisory Voluntary - Discretionary determination of the RA concerns in non-resolution Determination decision by the shareholder and could dilute the state’s procedures. In resolution, (that is, the government) participation in the SOB it involves the creation of (privatization) a rescue package by a government entity. Safeguards for minority Standard corporate and No creditor worse off than in None shareholders and creditors banking law liquidation EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 18 Increases capital in the Capital injections, blanket amount of the liabilities Capital injection, contingent guarantee schemes, relief of converted into equity and Tools convertible bonds, or similar impaired assets, extended dilutes shareholders. instruments liquidity support, below- Wipes out all or part of equity market rate loans holders. No change of control or Could lead to a change of Ownership structure No change of control change of control from one control public entity to another To prevent financial and To restore the capital position, economic disruption or to allow an SOB to expand its To prevent financial and collapse, and reduce moral Rationale balance sheet, or to prevent economic disruption or hazard and taxpayers’ financial and economic collapse exposure that is associated disruption with bailouts Source: World Bank compilation. Note: RA = resolution authority, SOB = state-owned bank. 3.5. Policy Implications When an SOB faces financial difficulties, the best scenario is for its shareholder to increase its capital before it reaches the point where resolution needs to be triggered (the so-called point of no viability, or PONV). As in a POB, this recapitalization avoids resolution, with all the associated market uncertainty and potential impacts to the real economy and to the remainder of the financial system. To avoid misuse of taxpayer funds, however, recapitalization should be done at arms’ length—that is, under conditions that would pass a test similar to the European market economy investor principle. The capitalization should be accompanied by a restructuring of the failing bank, with the elimination, where possible, of loss-making activities and adjustments to the SOB business model, to ensure its long-term sustainability. In situations where the government, as shareholder, is not in a position to recapitalize the SOB before the PONV, the RA should have the power to place the bank under resolution. This can arise because of either the government’s lack of financial capacity to recapitalize the bank (typically under situations of extreme financial stress) or its unwillingness to do so, for political or economic reasons. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 19 4. >>> Applicability of the KAs to SOBs The KAs’ stated scope of application is to “any financial institution that could be systemically significant or critical,” and, beyond that, to those financial institutions’ “holding companies” as well as to “non-regulated operational entities within a financial group or conglomerate that are significant to the business of the group or conglomerate”, and “branches of foreign firms.”8 As there are no written exceptions, there can be no question that systemically significant or critical SOBs fall squarely within the declared scope of the KAs. Application of the KAs to SOBs is also consistent with the position taken by other international organizations. For instance, a 2015 report by the Basel Committee on Banking Supervision titled Guidelines for Identifying and Dealing with Weak Banks emphasizes that “all banks should be subject to the same operational and supervisory standards regardless of their ownership.”9 The same document then clarifies that “for competitive reasons and in order to maintain credibility in the financial sector, it is imperative that the supervision and resolution of weak public sector banks be carried out in a manner that is not more favorable than that applied to private banks.”10 8. FSB, “Key Attributes of Effective Resolution Regimes for Financial Institutions” (Basel, Switzerland, 2014), item 1.1. 9. Basel Committee on Banking Supervision, “Guidelines for Identifying and Dealing with Weak Banks” (Basel, Switzerland, 2015), 57. 10. Basel Committee on Banking Supervision 2015, 58. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 20 5. >>> Practical Challenges to the Application of the KAs to SOBs The application of the KAs to SOBs means that local jurisdictions and authorities must uphold and incorporate into their resolution frameworks the specific rules, principles, and practices prescribed under the KAs, including those that aim to minimize taxpayers’ exposure and moral hazard. Doing that, however, highlights four practical challenges. 5.1. Resolution Can Hurt a Government’s Reputation and Cause It to Realize a Loss Whether done in a manner that is consistent with the KAs or not, the decision to place an SOB under resolution could affect fiscal accounts. According to the KAs, losses should be absorbed first by shareholders; given that, in placing an SOB in resolution the government stands to wipe out (or at least severely reduce) its own equity holding. A loss will be realized and, depending on its size, it can negatively or even very negatively affect the results and figures of the country’s public accounting. A main problem is that SOBs often operate under the implicit assumption that the state backs liabilities. Even when a state guarantee is not formally enshrined in the law or in the bank’s bylaws, investors and rating agencies typically tend to consider that SOB liabilities will be honored by the national treasury. To a certain extent, this can be addressed by having an adequate resolution framework and resolution planning for SOBs, in a manner that sends a clear message to the markets that, in case of failure, authorities do not expect to bail out the SOB. The requirement that the SOB issue debt earmarked to be bailed in, according to the FSB TLAC Term Sheet, is also an important element in adjusting investors’ expectations. Placing the SOB under resolution tends to create a great reputational cost for the government that can lead to increases in funding costs for all its SOEs. Specifically in jurisdictions that have more than one SOB in operation, the failure of one of them can have significant adverse impacts on the others, even if they are healthy. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 21 Taken together, these two considerations explain why alternative for dealing with this problem is to legislate an SOBs are often treated as too public to fail and why authorization for RA intervention, as was done for example in governments usually go to great lengths in terms of Brazil in the 1980s (but only for intervention in state and local spending public funds to recapitalize SOBs and avoid SOBs, not federal ones). Even so, the RA’s ability to move placing them into resolution. Once an SOB passes the quickly can still be restricted by other regulations applicable PONV, recapitalization should not be an alternative, and to SOBs, such as the need for audits and approvals by the authorities should resort to the resolution framework. This government’s accounting offices and similar bodies. is especially necessary when the SOB business model is flawed, in which case it becomes dependent on periodic A potential solution to the requirement of legislative capital injections or regulatory forbearance. However, authorization—under either public or private law governments tend to resist recognizing losses and tarnishing regimes—is to include provisions in the resolution their reputation, which explains in part why they often resist framework that stay the need for legislative authorization resolution and compliance with the KAs. once the PONV is reached and an SOB is put under resolution. Although this is an important measure to ensure the adequate exercise of resolution powers, much in line with 5.2. SOBs Are Subject to Special Legal the provision established by KA 3.2(v),11 in some cases it may be a sensitive issue. As discussed, placing an SOB in Frameworks resolution may have effects on the government’s reputation and finances, and the political establishment may be reluctant Lack of flexibility of the laws pertaining to SOBs is an to grant powers to the bank supervisors and the RA to take important hurdle for applying the KAs. SOBs can be such action without a broader discussion. incorporated under public or private law regimes. SOBs incorporated under public law receive the status of a state entity and are then defined as a statutory corporation, a public company, or a similar concept. Their liabilities are explicitly 5.3. Resolution Can Reignite Debates underwritten by the state, of which the SOB becomes an about Privatization integral part. Statutory corporations are notoriously difficult to resolve, first and foremost because each step of the resolution The application of the KAs to SOBs, and especially would, in many jurisdictions, require legislative approval. the use of bail-ins, may result in privatization of SOBs, Also, the single-share capital structures typical of statutory which is a thorny and politically loaded issue because of corporations prevent bail-in and other resolution techniques. the discussion of the role of SOBs. In international policy circles, the prevailing views on state ownership of banks have SOBs incorporated under a private corporate law regime fluctuated over time. In the postwar period, it was common to are theoretically easier to resolve. They are not statutory assume that the state should play a key role in the banking corporations, often have minority private shareholders, and sector—and indeed, the government did play an outsized are publicly listed and sometimes even cross-listed. These role in a significant number of banking systems. In the 1980s SOBs are regulated by corporate and banking law and typically and 1990s, however, the pendulum swung back, and SOBs subject to a limited liability structure, similarly to POBs. became increasingly associated with poor performance of credit markets, rent-seeking, and other evils that promote Yet, in most cases the creation of an SOB under a private credit misallocation and slow growth. A World Bank publication law regime does not preclude the legal obligation of the in 2001 famously noted that “whatever its original objectives, state to maintain control of the company. In this case, state ownership tends to stunt financial sector development, resolution is still subject to legislative authorization, in much thereby contributing to slower growth.”12 the same way as for statutory corporations. A practical 11. “3.2. Resolution authorities should have at their disposal a broad range of resolution powers, which should include powers to do the following: … (v) Override rights of shareholders of the firm in resolution, including requirements for approval by shareholders of particular transactions, in order to permit a merger, acquisition, sale of substantial business operations, recapitalisation or other measures to restructure and dispose of the firm’s business or its liabilities and assets.” 12. World Bank, Finance for Growth: Policy Choices in a Volatile World (Washington, DC: World Bank, 2001), 123. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 22 The 2008 crisis saw a sequence of failures and foreigners were excluded, but the privatized banks expanded mismanagement of POBs and a surge in the use of SOBs too rapidly and later had to be renationalized. 14 to revive lending and maintain money creation. As a result, confidence in SOBs started to rebound. Now, SOBs are Outside of an outright acquisition by a foreign investor, increasingly portrayed as playing an important and constructive issues related to economic nationalism may also arise role. A recent IMF paper indicates that SOBs are “likely to remain i bail-in. Many SOBs, especially those where domestic a feature of financial systems in a number of countries.”13 Yet, capital markets are not well developed, issue bonds in the the not uncommon episodes of mismanagement and poor international markets. If these bonds are used as LAC and governance within SOBs, alongside distortions commonly bailed in during a subsequent resolution, ownership of the attributed to the presence of SOBs in credit markets, keep institution may be transferred to foreign hands. the controversy over privatization alive. These debates matter a great deal because a discussion about privatization tends The longstanding debate on the openness of financial to resurface almost every time a resolution of an SOB is set markets to foreign capital consists in two opposing in motion. Ideological cleavages can then arise, complicating, visions: one that emphasizes the importance of sovereignty politicizing, and slowing resolution proceedings. and the prevalence of the national interest, and one that highlights the importance of promoting competition and Resolution is, by definition, a process that aims at taking attracting capital and banking know-how. Currently, this the control of the failed institution from its existing latter vision holds more currency within international financial shareholders, and this aim should not differ for an SOB. institutions. For example, a research paper published by Whereas selling a good, healthy SOB may trigger all sorts of the World Bank in 2018 concludes that “foreign-owned political debates, resolution deals with a bank that is no longer banks are more efficient than domestic banks in developing viable and that, without the use of resolution tools, will most countries, promote competition in host banking sectors, and likely need to interrupt its activities suddenly. That changes the help stabilize credit when host countries face idiosyncratic conversation, and the objections to privatization commonly shocks.”15 However, this same report also points out that raised in the sale of healthy state-owned entities should play “foreign-owned banks can transmit external shocks and might a smaller role in the context of resolution of unhealthy ones. not always expand access to credit.”16 This point is particularly true for credit to small and medium enterprises (SMEs), as several studies show that acquisition of domestic banks by 5.4. Resolution Can Reignite Debates foreign banks resulted in lower credit SMEs. about Economic Nationalism For the present purposes, an important takeaway is that debates concerning economic nationalism tend A closely related problem is that concerns about economic to reappear in the events leading to recapitalization or nationalism can resurface when SOBs fail. A market resolution of a failed SOB. For example, the failures of Caixa solution for recapitalizing banks—supposing one is available, Geral de Depósitos (CGD) in 2012 and 2016 discussed earlier a topic discussed later—can involve acquisitions by foreign dealt with recapitalizations carried out at market conditions to banks. Allowing foreigners to bid tends to help governments avoid the need for resolution and privatization. CGD had been reap more revenue, and foreign institutions can bring a symbol of the Portuguese state for many years. Although this additional banking skills. The downside is that acquisitions of historical record was not particularly relevant from a technical domestic SOBs by foreigners can elicit ideological reactions and formal point of view, from a political standpoint it possibly similar to those in response to privatizations. In part because helped to substantiate the reorganization plan presented to of that downside, privatizations are sometimes restricted to the European Commission by the Portuguese state. national investors. Yet this strategy can backfire. For example, during the first round of privatizations in Mexico in the 1990s 13. Mark Adams et al., “Regulating, Supervising, and Handling Distress in Public Banks” (IMF Departmental Paper No. 2022/010, Washington, DC, 2022). 14. See Gerard Caprio et al., eds., The Future of State-Owned Financial Institutions: Policy and Practice, (Washington, DC: Brookings Institution Press, 2005), 5. 15. Robert Cull, Maria Soledad Martinez Peria, and Jeanne Verrier, “Bank Ownership: Trends and Implications” (Policy Research Working Paper 8297, World Bank, Washington, DC, 2018). 16. Cull, Martinez Peria, and Verrier 2018. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 23 6. >>> Application of the KAs to SOBs This section aims to reconcile the goals under the KAs with the challenges spelled out in the previous section. The problem to be tackled can be described as follows. On one hand, the KAs are sound in prescribing that taxpayers’ money should not be used for a failed or weak bank. The reasons have to do with political accountability and fairness but also with incentives, because resorting to bailouts induces laxity in the use of public funds, fuels moral hazard, distorts market competition, rewards inefficient management practices, and promotes capital misallocation. Therefore, SOB resolution should be pursued with caution and should pay heed to the considerations and goals articulated under the KAs. On the other hand, an important takeaway from the preceding section is that the implementation of the KAs in SOBs can be complicated, slowed, and sometimes prevented by the operation of distinctive legislation that treats SOBs differently from POBs as well as by factors related to the political economy of SOBs. The implementation of the KAs in SOB resolution should uphold the KAs without imposing unjustified burdens on the authorities or counterproductive obligations on the SOBs. When implementing the KAs in SOBs, the overarching aim is to avoid the use of taxpayer money while preserving financial stability, taking into account the particular circumstances involved in SOB resolution. We divide the KAs into three groups according to the challenges posed to their application to SOBs. The first group comprises the KAs that can be implemented in full with no or minimal challenges (when compared with their implementation in POBs). We identify KA 1, KA 4, KA 5, and KA 12 as the relevant ones in this category, meaning that their provisions should apply equally to SOBs and POBs. The second group address the KAs for which their application to SOBs may present some challenges, and this is the case with KA 2, KA 7, KA 8, KA 9, KA 10, and KA 11. The third group comprises those whose application to SOBs presents challenges of a more sizeable nature; these are KA 3 and KA 6. For organizational purposes, KA 3 and KA 6 are discussed separately, in sections 7 and 8. The others are discussed in this section. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 24 6.1. Application of KAs 1, 4, 5, and 12 should be boosted by acknowledgment of adherence to the KAs with respect to SOBs. to SOBs Four KAs can be easily implemented in SOBs. The first is KA 1, which deals with the scope of application of the KAs. 6.2. Considerations Pertaining to KAs Under KA 1.1, the provisions of the KAs apply to any financial 2, 7, 8, 9, 10, and 11 institution whose failure could be systemically significant or critical for banking functions. In practice, concerns about KA 2 recommends the creation of an independent RA with orderly resolution and network effects often cause RAs to apply broad authority to carry out resolution. KA 2.3 lists certain the KAs broadly, extending them to smaller banks. Of special objectives to be pursued by the RA such as maintaining financial relevance here, these same concerns can be particularly stability, coordinating actions with deposit insurers, avoiding important when the weak bank is an SOB, because of the unnecessary destruction of value, and considering financial outsized impact their failure can have on confidence in the impacts in other jurisdictions. In practice, the resolution of solvency and soundness of the financial system. SOBs inevitably brings questions about the criticality of some of the functions that SOBs carry out. Considerations about the KA 4, which covers set-off, netting, collateralization, and criticality of functions also arise in the context of resolution of segregation of client assets, also applies easily to SOBs. systemically important institutions. These provisions have to do with the standard commercial obligations of the bank, regardless of its ownership structure The main challenge related to the application of this KA (that is, whether a SOB or a POB). to SOBs is that state ownership of the institution to be resolved may create additional political pressures on the KA 5, which centers on safeguards in the process of RA. However, this possibility only reinforces the need resolution, should also apply to SOBs without giving rise for independence of the RA, in line with the KAs. In that to any specific challenges. There are two such safeguards. context, it is recommended that, in designing the governance The first is the principle of “no creditor worse off” in resolution of the RA, policy makers consider mechanisms to shelter it than in liquidation. To uphold this principle, the law should from undue pressure. One of these mechanisms could be, for determine minimum requirements of independence and example, placing the resolution powers within an independent professional capacity by the individuals or entities that will central bank, whose senior managers have fixed mandates conduct valuations to determine the value of claims under and cannot be dismissed at the will of the government. liquidation. The second is the right of shareholders, creditors, clients, and stakeholders to seek remedy in court. A concern KA 7 outlines principles that aim to facilitate cross- with the preservation of financial stability means that any border cooperation and streamline resolution when such remedies should come in the form of compensation, not stakeholders are members of more than one jurisdiction, injunctions that may block, suspend, or reverse resolution spelling out a commitment to cooperative international measures. All of that should apply equally to the resolution of regulation, as opposed to the nationalistic approach SOBs and POBs. that once prevailed. These principles cover RA powers (KA 7.1), automatic action as a result of official intervention Finally, KA 12 sets out mechanisms and principles to or the initiation of resolution or insolvency proceedings in facilitate access to information and information sharing another jurisdiction (KA 7.2), RA powers over local branches with the RA. Not all SOBs are subject to supervision–a of foreign firms (KA 7.3), non-discrimination against creditors situation that does not comply with international standards on based on nationality (KA 7.4), recognition of foreign bank supervision17 —yet effective supervision is a prerequisite resolution measures (KA 7.5), and confidentiality (KA 7.6 and for resolution. As is the case for POBs, the members of a KA 7.7). In addition, in 2015 the FSB published its Principles country’s financial safety net—including supervisors and the for Cross-border Effectiveness of Resolution Actions, which RA—should have adequate mechanisms to exchange data on complements KA 7, especially KA 7.5. SOBs, to allow for proper crisis preparedness, an idea that 17. See the Basel Committee on Banking Supervision, “Basel Core Principles for Effective Bank Supervision,” available at https://www.bis.org/publ/bcbs230.pdf. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 25 KA 7 applies equally to SOBs and POBs; however, the certain resolution measures, it might be challenging to take way in which SOBs fall into international recognition actions to protect the foreign operations. One important task frameworks depends in part on the legal regime of the that CMGs of SOBs must address is adjusting the expectations failed SOB. In principle, if the SOB was incorporated under of what the home authority can feasibly do and what type of a private law regime (mercantile or commercial law), then challenges host countries can expect in case of resolution. it should fall within the concept of a merchant debtor under those frameworks. Yet the treatment applicable to statutory KA 9 deals with cross-border cooperation agreements companies can be more stringent. Because of that, SOBs involving G-SIBs, but political considerations related to incorporated under public law may find it challenging to SOBs may pose challenges to its implementation. As with implement a reliable statutory recognition framework, KA 8, circumstances may suggest expanding the use of such especially in cases where a foreign decision is deemed to agreements beyond G-SIBs; yet the public nature of SOBs go against a nation’s public order. The 2015 FSB Principles can create a few additional hurdles in such agreements. For for Cross-border Effectiveness of Resolution Actions contain example, the principles of information sharing for resolution examples of statutory recognition frameworks deemed purposes laid out in Annex 1 to the KAs may clash with national relevant for the application of the KAs. restrictions on the disclosure of government information or even with national security laws to which SOBs may be bound, KA 8 contains principles for home and host authorities or they may constitute a political liability for the government. to create crisis management groups (CMGs) to enhance preparedness and facilitate management and resolution KAs 10 and 11 deal, respectively, with resolvability of a cross-border financial crisis affecting the bank. KA assessments and RRP, and, like KA 8 and KA 9, focus 8 is focused on G-SIBs, but the 2021 FSB report titled Good primarily on G-SIBs. Nevertheless, their provisions are Practices for Crisis Management Groups (CMGs), which often assumed to apply to other banks as well, including details and complements KA 8, clarifies that “some authorities D-SIBs and SOBs—two categories that often overlap, as have established CMGs for domestic systemically important previously explained. banks (D-SIBs) that are not part of a G-SIB group and the practices described in this report may also be relevant to KA 11.1 establishes that jurisdictions should require them.”18 Indeed, SOBs are often D-SIBs. Sometimes, this the preparation of recovery and resolution plans “at a is so because of the SOB’s size and interconnectedness minimum” for those institutions that could be systemically at the domestic level, but other times SOBs become significant or critical if they fail. Many SOBs fall into this systemically relevant on failure—even if not necessarily category and should accordingly be fully bound by KA 11. KA so before—because their financial condition is assumed to 11.2 determines that the requirement for RRP should apply signal something about the situation of the public sector’s to G-SIFIs and to “any other firm that its home authority governance practices and overall financial position. assesses could have an impact on financial stability in the event of its failure.” Nonetheless, many jurisdictions prepare In internationally active SOBs, political factors and recovery and resolution plans only for D-SIBs (as defined by special legal regimes that affect SOB resolution also the Basel Committee on Banking Supervision), which is a affect crisis preparedness. Indeed, it seems relevant that more restricted group than the KAs recommend. the RA of the home jurisdictions of such banks keep close contact with their peers in host countries, given that a failure There are many reasons in favor of extending the can have impacts on host countries as well. However, some preparation of recovery and resolution plans to SOBs: problems already highlighted in this note—political issues, First, the preparation of plans is a relatively inexpensive form economic nationalism, and the like—can be exacerbated of compliance that can generate high benefits because it when these failures have a cross-border dimension. Moreover, can contribute greatly to orderly resolution, which is another in situations where parliamentary approval is required to adopt way of saying that applying KA 11 can generate net benefits 18. FSB, “Good Practices for Crisis Management Groups (CMGs)” (Basel, Switzerland: Financial Standards Board, 2021), 4. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 26 even in smaller SOBs. Second, because SOB intervention Some of the operational challenges related to the is exceptional and relatively rare, RRP with a well-planned continuity of critical functions may be more pronounced approach can anticipate some of the difficult discussions that in SOBs. For example, SOBs structured as statutory arise upon the distress and failure of the bank and increase corporations are viewed as an integral part of the government, the degree of formality of the recovery and resolution and their cooperation with other government branches might processes, also increasing the legitimacy of RRP and be structured informally (making it difficult to map beforehand) mitigating the risk of court challenges. Third, the experience or through legislation (making it inflexible). The general of drafting plans can help generate awareness of risks within message therefore is the recovery and resolution plans for the SOB, potentially contributing to improving the bank’s SOBs will probably end up somewhat different from those governance and risk management. generally drafted for POBs. The preparation of recovery and resolution plans for SOBs Another important challenge relates to the implementation can incorporate some of the important features that have of KA 10, which deals with resolvability assessments, been outlined and developed over the years for G-SIBs, and specifically with KA 10.5, which prescribes that potentially improving SOB governance. For example, a RAs should have the power to require a bank to remove 2013 FSB report titled Recovery and Resolution Planning barriers to resolution. These may include “changes to a firm’s for Systemically Important Financial Institutions: Guidance business practices, structure or organisation, to reduce the on Recovery Triggers and Stress Scenarios defines criteria complexity and costliness of resolution” and “require[ing] that for triggering senior management consideration of recovery [critical] functions be segregated in legally and operationally actions. Having the bank formalize the triggers for recovery independent entities that are shielded from group problems.” can be important in SOBs, as it limits the ability of senior Given the many challenges already pointed out in relation management to conceal the true financial situation of the bank to SOBs, the effective exercise of these powers by an RA and postpone serious deliberation about entry into resolution. requires the removal of any obstacles of an administrative or political nature that would preclude the RA from making this Sometimes, the features laid out by the FSB may have to type of determination about SOBs. be interpreted so as to better apply to SOBs. For example, the concept of critical functions, mentioned throughout the KAs, may need a broader interpretation, to include not only functions vital for the functioning of the real economy, but also public functions such as providing banking and payment services in rural areas, financing strategic sectors, and even financing special segments of the population (such as minorities, as intended for some SOBs whose creation is currently being discussed in the United States). This does not mean that the FSB report necessarily needs to be reworded to incorporate the critical functions that are typical of SOBs. The list of functions that could “exhibit some degree of criticality” is “not intended to be exhaustive,”19 so critical functions that are typical of SOBs are not necessarily excluded from the report. As a practical consideration, when implementing this KA in SOBs, authorities should take a broader view of what they consider critical to encompass those functions whose sudden failure is expected to have “a material impact on the third parties.” 19. FSB, “Recovery and Resolution Planning for Systemically Important Financial Institutions: Guidance on Identification of Critical Functions and Critical Shared Services” (Basel, Switzerland: Financial Standards Board, 2013), item 2.1(ii), 6. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 27 7. >>> Challenges to the Application of KA 3 KA 3 contains principles on the content of the RA’s resolution powers as well as the timing of and conditions for their exercise. Two aspects discussed in KA 3 raise questions for SOB resolution. The first has to do with the specific limitations to implementing bail-ins, which are difficult to implement in any bank, let alone in SOBs. The second has to do with general limitations to the RA’s powers and tools that follow from the government’s controlling position in SOBs as well as the public mission of SOBs. 7.1. Bail-Ins May Be More Complex to Implement in SOBs Than in POBs Bail-ins are the hallmark of the KAs. They were intended to resolve the problems that bailouts introduced—costs to taxpayers, moral hazard for banks, and lack of market discipline—and are now increasingly becoming part of resolution frameworks worldwide. The most noticeable examples of bail-in regimes can be found in the Orderly Liquidation Authority of the United States and the Bank Recovery and Resolution Directive (BRRD) of the European Union. The former was introduced in 2010 by the Dodd–Frank Act but has not yet been triggered and is of lesser relevance here, given the near absence of SOBs in the United States. The BRRD, enacted in 2014, responds to episodes of bail-ins that took place in Europe in preceding years. In 2013, the EU and international organizations required the bail-in of uninsured depositors of the Cyprus Popular Bank and the Bank of Cyprus as a condition for disbursing a €10 billion bailout package. In 2015, in Greece, creditors of the Cooperative Bank of Peloponnese were bailed in following the wiping-out of shareholders and the transfer of deposits to the National Bank of Greece. Bail-ins were also implemented in 2014 with subordinated debtholders of Banco Espírito Santo in Portugal, also after its equity holders were wiped out. Experience with bail-ins after implementation of the BRRD is limited. In 2015, when the BRRD was not in full effect in Europe but had already been adopted in Italy, bail-ins involved EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 28 equity holders and subordinated debtholders in Banca Moreover, the creation of non-voting stocks and write- Marche, Banca Popolare dell’Etruria, Cassa di Risparmio di offs may be challenged in court by disgruntled creditors Ferrara, and Cassa di Risparmio della Provincia di Chieti. In contending that the bail-in failed the “no creditor worse 2017 Banco Popular was the first failing bank resolved under off than in litigation” test. Furthermore, one of the goals of the BRRD with the adoption of bail-in.20 In addition to bail-ins bail-ins is precisely that of changing the failed bank’s corporate used within resolution, “burden-sharing” mechanisms applied governance, all in the hope of avoiding the repetition of the to shares and subordinated debt were implemented in Banca problems that led to its demise. Thus, a bail-in without a Monte dei Paschi di Siena. None of these experiences with bail- change of control is in some sense incomplete. To deal with ins involve SOBs, but they nonetheless serve as a benchmark that in SOBs, a solution could be to pass a law permitting or starting point for discussion of possible scenarios to be the SOB’s change of control independently of parliamentary included in the implementation of the KAs in SOBs. authorization in the specific case of bail-ins.21 Bail-ins tend to be implemented in the context of transfer As is the case for POBs, the successful implementation of control of the target bank, but transfers of control in of bail-in in SOBs requires loss absorbency capacity. Bail- SOBs are subject to additional legal hurdles, given that ins tend to be more useful in banks that have enough TLAC, the public character of these banks is typically enshrined or TLAC-like, instruments. In this sense, jurisdictions should in legislation. If a bail-in were implemented in an SOB, its consider extending their requirement of “resolution capital” creditors would have to become shareholders (subject to also to their SOBs—preferably with contractual provisions the safeguard of “no creditor worse off than in liquidation”) establishing write-off in case of failure, to avoid issues related and all or part of the equity of the state entity controlling the to the potential transfer of control. bank could be wiped out, which could amount to a de facto privatization of the bank. Thus, a bail-in that causes a change of A bail-in of private creditors of an SOB that does not result controlling shareholder can trigger the need for parliamentary in losing control of the institution could be considered authorization, where it will inevitably be analogized with a a “bailout” of the state by private creditors and trigger privatization and provoke political calculations. As mentioned political backlash. Not all bail-ins of private creditors will in section 5, a potential solution is to include provisions in result in SOB privatization or the state losing control, given the resolution framework staying the need for legislative that the state’s share will not necessarily be diluted to less authorization once the PONV has been reached and an SOB than 50 percent of the voting stock. This could also be the case is put under resolution, although passing such a provision may when a mix of public and private creditors are bailed in, which face political challenges. could be perceived as using private creditors’ funds to keep the institution afloat in public hands and could be politically Alternatives that can streamline the process, such as unpopular. Because of that, it is preferable to bail-in private converting debt into non-voting stocks or writing off creditors in tandem with a transfer of control of the entity by credits rather than converting them, are problematic. For wiping out first the capital of existing shareholders, including one, if only part of the existing bonds is bailed in, the affected capital held by the state. bondholders can question the transaction in court, as in 2015 when Portuguese authorities chose to bail-in only 5 out In contrast, forcing state bodies and parastatal of 52 unsecured bonds owed by the Banco Espírito Santo. organizations to acquire LAC of an SOB outside of market Moreover, issuing non-voting stocks to the creditors whose terms may put taxpayers’ funds at risk in a manner similar assets were bailed in is a solution that—if feasible would only to a bailout. The practice seen in some emerging markets and work for banks that are not legally bound to be 100 percent developing economies of forcing state bodies or parastatal state owned. organizations such as pension funds or social security funds to invest in LAC issued by SOBs outside of market terms 20. Banco Santander was authorized to acquire Spanish Banco Popular for €1, after the bank suffered massive deposit withdrawals during the preceding days. Not only did shareholders see their equity written off (€1.3 billion) but also holders of convertible contingent and subordinated bonds witnessed the value of their investment fall from more than €2 billion to zero. The restructured Banco Popular, a major SME lender and the fifth-largest bank in Spain, was able to open and operate normally on the day following the transaction. 21. The RA should also have the power to change the ownership structure of an institution if the institution cannot be effectively resolved under the current structure, whether through a bail-in or another resolution tool. This point has also been made in relation to resolution of cooperative banks. See, for example, Eva Gutiérrez, “The Reform of Italian Cooperative Banks: Discussion of Proposals” (IMF Working Paper 08/74, Washington, DC, 2008). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 29 amounts to a misuse of taxpayers’ funds to finance the SOB, or contagion effects. Successful experiences can also be in which it is very similar to a bailout. To avoid such misuse, found in Slovenia, where in 2013 bail-ins involved subordinated jurisdictions must have measures in place to ensure that any bondholders and shareholders of several local banks, and liabilities of SOBs are issued at arms’ length. in Spain, where in 2017 Banco Popular was resolved in accordance with the BRRD and without the use of public funds. Experiences with bail-ins also help us advance a second Moreover, there are partial solutions to the cases where those conclusion concerning the implementation of the KAs fears exist. For example, in Indonesia bail-in powers can be in SOBs: bail-ins, especially of retail investors,22 can be used only when a statement of systemic crisis is issued. Another met with great resistance and even public outcry, and partial solution is to pre-establish in the law a limited range of these effects will presumably also be strong in SOBs. credits that are amenable to bail-in. Yet, there is some evidence Here, the Italian experience offers a telling example. The that the adoption of resolution measures has real effects on the 2015 bail-ins in Banca Marche, Banca Popolare dell’Etruria, economy through declines in credit provision,24 although this Cassa di Risparmio di Ferrara, and Cassa di Risparmio della may be due not to the implementation of resolution itself, but to Provincia di Chieti involved retail customers who anticipated a correction of the failed bank’s underwriting practices after the having bought safe assets. These creditors then exerted replacement of managers. great political opposition to the bail-ins. As a result, in 2016 the Italian government enacted a decree refunding such In any case, bail-ins may be the only remedy available bondholders up to €100,000 (which is the same coverage when the sovereign’s fiscal position is weak and no other offered by the deposit insurance scheme). Moreover, in the funding mechanisms are available for the resolution of years that followed, Italian authorities often resorted to the an SOB. When the public purse is so heavily constrained, the BRRD permission to declare bail-ins not in the public interest alternatives accessible to regulators can become very limited. when they threatened financial stability, critical functions, Aside from bail-ins, the only alternative might be defaults, but or the protection of depositors. In particular, because of an the experience in places such as Iceland in 2008 shows that assessment by the Single Resolution Board, the liquidation of defaults tend to be anything but orderly. National jurisdictions the Banca Popolare di Vicenza and the Veneto Banca in 2017 could also use some creative solutions to overcome the were carried out without bail-ins. The point is that the blend political barriers against bail-ins. For example, to avoid a full of political and economic concerns that discouraged bail-ins privatization, the state could hold a gold share with limited but in these two cases can be assumed to come up as well when important powers after the bail-in is consummated. the failed banks in question are SOBs, probably with even greater strength. That assumption underlines the importance of requiring SOBs to maintain adequate LAC, following the 7.2. RAs’ General Resolution Powers TLAC standard, in a transparent manner, so as to mitigate the need to extend bail-ins beyond the instruments pre-assigned and Tools for that purpose. One of the overarching goals of enacting the KAs is to Despite some criticisms, bail-ins have proved effective empower RAs to make use of a range of powers and tools in preserving financial stability while reducing taxpayers’ to deal with bank failures without having to negotiate costs. It has been argued that bail-ins in one institution could or obtain consent of creditors and shareholders. In the create expectations for additional bail-ins in other banks, and interest of permitting effective resolution, protecting taxpayers, these dynamics can ultimately undermine investor confidence, and curbing moral hazard, this lineup of powers and tools even in healthy banks.23 But this is not always the case, as should be upheld to the fullest extent possible with respect demonstrated by the case of Banco Espírito Santo in Portugal, to SOBs. When dealing with SOBs, these powers must be where bail-in proved effective at limiting costs to taxpayers clearly stated in the legislation, and measures must be put in while preserving financial stability, with no short-term panic place to address opposing views between the RA and other 22. It should be noted that the KAs do not favor the bail-in of retail (insured) depositors, and the establishment of the TLAC standard aims at avoiding the conversion of the credits of retail investors into equity, but this is still a theoretical possibility in several jurisdictions. 23. Giovanni Dell’Ariccia et al., “Trade-offs in Bank Resolution” (IMF Staff Discussion Note 18/02, Washington, DC, 2018), 6. 24. See Thorsten Beck, Samuel Da-Rocha-Lopes, and Andre Silva, “Bank Bail-In: The Effects on Credit Supply and Real Economy,” VOXEU column, May 27, 2017, http:// voxeu.org/article/bank-bail-effects-credit-supply-and-real-economy. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 30 areas of the government. This is typically done by ensuring termination upon change in the SOB’s legal form or that the RA has sufficient independence and legal protection, corporate structure. A focal point for jurisdictions seeking to in line with the KAs. comply with the KAs is to include in their resolution laws a provision to stay the exercise of early-termination rights that Although KA 3.2(v) prescribes that the RA should have may be triggered upon entry of a firm into resolution, as set out the ability to override rights of shareholders of the firm under KA 3.2(x). Contracts signed by SOBs often contain early in resolution, in the case of SOBs parliamentary approval maturity clauses in case the bank should cease to be a part of of transactions resulting in private ownership will often the public sector. To mitigate this obstacle, and in addition to be needed. These include “requirements for approval by provisions to stay early-termination rights in accordance with shareholders of particular transactions, in order to permit a KA 3.2(x), the resolution framework should authorize the RA merger, acquisition, sale of substantial business operations, to declare such types of early maturity clauses ineffective or to recapitalisation or other measures to restructure and dispose stay their application. of the firm’s business or its liabilities and assets.” As it turns out, for reasons that have to do with the lack of flexibility of In the interest of enhancing resolution procedures, the laws governing SOBs, most of these actions will still need countries are well advised to have in place a deposit parliamentary approval and enactment of new legislation. guarantee scheme (DGS) and to ensure that it covers POBs as well as SOBs. KA 3.2(xii) prescribes that the RA should To speed resolution, legal changes should be introduced have powers to transfer insured deposits—and presumably, to place resolution powers over SOB in the hands of the the expectation is that a country will have in place some form RA, eliminating the need for parliamentary approval in the of deposit guarantee scheme. This is indeed the case in many context of resolution. One alternative would be to include in countries, even if only due to a recent development (Costa the resolution legislation a provision authorizing the government Rica, for example, introduced a DGS covering both POBs and (for example, the minister in charge of the institution, prime SOBs in 2020 in the context of OECD accession).25 However, minister, or president) to decide these matters independently and despite recommendations issued by the World Bank, the of the Parliament. Another possibility would be to grant the RA IMF and other international organizations, some countries the power to order that the legal form of the institution under have no deposit insurance scheme in place, and others do not resolution is changed to a joint stock corporation. This is the cover SOBs. case in Germany, where the law also establishes that the change of legal form is possible only if the resolution measure The application of the KAs to SOBs at large starts with could not otherwise be implemented successfully and if the integrating every SOB within the country’s broader change of legal form is not disproportionate. Yet another regulatory and supervision framework. Particularly alternative is to push for more restrained interpretations problematic for implementing effective resolution are the of the legislation requiring parliamentary approvals. For unsupervised SOBs, which still exist in some jurisdictions. example, the Brazilian Supreme Court has recently decided In unsupervised banks, failure can be met with only that the requirement for legislative authorization for the sale standard bankruptcy (which is often unsuitable and slow, of a parent SOE does not necessarily trigger a need for as illustrated by the 2008 case of Lehman Brothers, among legislative authorization when the SOE is selling subsidiaries. others), merger with other public institutions, or government On the basis of that decision, one could imagine a situation recapitalizations. In addition, lack of supervision is per se in which the parent SOB remains under government control, incompatible with the KAs. but its relevant assets are de facto privatized within a broader resolution process without legislative authorization. Application of bridge banks in resolution of SOBs may appear problematic from a conceptual point of view, given To be effective with respect to resolution of SOBs, the that both bridge banks and SOBs are controlled by the resolution law should also stay the exercise of early state. KA 3.2(vii) determines that RAs should have the power 25. It should be noted that Costa Rican SOBs also enjoy a broad and unlimited government guarantee, stated in the Organic Law of the National Banking System. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 31 to create bridge banks, but those would be curious cases in a failure of an SOB. Bridge banks are typically created, owned, and operated by the government to absorb the critical functions of failed organizations for which the RA has not been able to find a suitable private acquirer in the short term. After the “good bank” is transferred to a bridge bank, the non- performing assets, or “bad bank,” is set for liquidation. As can be seen, in the case of an SOB the structure of a bridge bank would ultimately allow the government to continue owning the good assets that it already owned through the SOB, while getting rid of the bad assets. Nonetheless, there is one important difference in the form in which those assets are owned by the government, in that an RA manages the bridge bank directly whereas an SOB tends to be controlled by a political entity such as the Ministry of Finance. The use of a bridge bank could make sense if the political entity that controls the SOB lacks banking expertise, which the RA has. This is particularly likely when dealing with local or regional SOBs. Moreover, the legislation must establish clear “sunset clauses” for bridge banks, which oblige the RA to either sell them or place them into liquidation within a determined time frame. These clauses are particularly important if a bridge bank is used to resolve an SOB. The use of an asset management vehicle (as set out under KA 3.2(viii)) would be subject to similar considerations, with the addition that the asset management vehicle can in theory be a private entity that in some cases and contexts, may have superior managerial capacity than either the political entity or the RA. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 32 8. >>> Implementation of KA 6 KA 6.1 prescribes that jurisdictions create policies to fund resolution in a manner that avoids having to resort to bailouts. The reduction of taxpayers’ exposure is one of the guiding principles of the KA, and perhaps the most important one. With that in mind, it becomes clear that adherence to the rules and principles of the KAs in relation to funding the resolution of SOBs should at least start a conversation about change of control and privatization. Ideological debates aside, a common problem of searching for market solutions for a failed bank is that they may simply not be available. The reasons for that may be the lack of development of local financial markets (a common problem in emerging markets and developing economies), the existence of a macroeconomic downturn that leads to flight to quality and reduction in appetite for riskier projects, or low quality of the assets held by the failing SOB. In any of these scenarios, the government will be in the position of having to find alternative funding mechanisms to offer support for what is overall qualified as a market solution. Whether a market solution is pursued or not, and whether the market solution counts on alternative funding arrangements, the existence of a sound regulatory framework tends to reduce the costs for the public purse. Two important tools for funding resolution are the existence of a resolution fund that can be tapped into during the crisis, and the existence of a DGS with a broad mandate that sets a ceiling to depositors’ claims (mitigating the risk of litigation) and may be tapped to facilitate private solutions as a means to reduce the need to compensate depositors’ claims (reducing the public outlays). The DGS should be funded by the banking industry and, importantly, it must cover SOBs, which is not always the case. Some jurisdictions also resort to resolution funds, in line with the KAs, but these are still rare and, as recommended by the IMF, resolution funds should be created only after a jurisdiction has a well-capitalized DGS.26 Bail-in is another important source of funding (although in itself it helps little in injecting new funds into the institution). However, as already explained, regulation plays an important role in making sure that creditors—and especially the holders of instruments earmarked for bail-in— understand the risks they are subject to, or else their bail-ins will result in political disputes, as in the case in Italy. Regulation will also reduce taxpayers’ exposure by forcing SOBs to maintain adequate levels of TLAC-like instruments and bank capitalization. 26. Oana Croitoru, Marc Dobler, and Johan Molin, “Resolution Funding: Who Pays When Financial Institutions Fail?” (IMF Technical Notes and Manuals, Washington, DC, 2018), 17. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 33 9. >>> Conclusion Although some KAs will be little affected by the fact that a bank is state-owned, other KAs will require that certain legal or operational barriers are removed to ensure they can be applied effectively. Table 9.1 describes the main considerations for policy makers when addressing the applicability of each independent KA to SOBs. >>> Table 9.1 Considerations for Applicability of KAs to SOBs KA 1 2 3 Description Scope Resolution authority Resolution powers Considerations in relation to SOBs No difference between POBs and SOBs. SOBs pose additional concerns regarding the independence of the RA. Policy makers should strive to have mechanisms in place to protect the RA from undue political pressure often associated with SOBs. Two of the powers listed in KA 3 raise questions in case of SOB resolution: the first is the implementation of bail-ins, which can be constrained by legal impediments to change of control and meet other forms of opposition. The second relates to the power of the RA to override rights of shareholders of the firm in resolution, which also may face legal barriers, usually in the form of required parliamentary approval for any significant changes in a SOB structure. Set-off, netting, 4 collateralization, No difference between POBs and SOBs. segregation of client assets EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 34 5 Safeguards No difference between POBs and SOBs. Common sources of funding for resolution include the conversion or writing off of Funding of firms in LAC instruments and financing from a resolution fund or deposit insurance fund. 6 resolution Policy makers should ensure that SOBs are subject to the same LAC requirements as POBs, and that SOBs participate in the deposit insurance and resolution funds. This KA aims at facilitating cross-border cooperation and facilitating resolution of cross-border institutions. The legal regime of a failed SOB may interfere with cross- Legal framework border recognition of resolution decisions, especially when arguments such as 7 conditions for cross-border “public order” may be invoked. This situation requires close cooperation between cooperation authorities to develop realistic expectations about the implementation of cross- border resolution of SOBs. Political issues and economic nationalism can be exacerbated when an SOB failure has a cross-border dimension. These issues need to be addressed and discussed 8 Crisis management groups in the CMG, so that member jurisdictions are aware of what to expect in case of resolution. Institution-specific cross- The public nature of SOBs can create hurdles in such agreements. For example, 9 border cooperation legislation may preclude authorities from exchanging information about SOBs with agreements foreign authorities. Although the KA recommends that RAs have the power to order firms to change their business practices, structure, or organization so as to reduce their complexity 10 Resolvability assessments in case of resolution, this may not always be feasible in SOBs that perform public- interest functions. The main challenge in preparing recovery and resolution plans for SOBs is the Recovery and resolution identification of critical functions. SOBs may have a broader mandate, performing 11 planning “public functions” side by side with their commercial operations, and RAs need to consider these activities when mapping what needs to be continued in a resolution. Access to information and 12 No difference between POBs and SOBs. information sharing Source: World Bank compilation. Note: CMG = crisis management group, LAC = loss-absorbing capacity, POB = privately owned bank, RA = resolution authority, SOB = state-owned bank. In view of these particularities, it seems that when length, under conditions that would likely be acceptable developing a policy to deal with crisis management to a private investor under the same circumstances. of SOBs, the following aspects should be taken into Jurisdictions should not resort to forceful recapitalization consideration: by parastatal entities (such as pension funds or social security funds) as a means to provide funding to SOBs. 1. As in the case of POBs, the best scenario when an SOB 2. In situations where the state, as shareholder, is not able to faces crises is for its shareholder to increase its capital prevent the SOB from reaching the PONV, the RA should before the SOB reaches the PONV. When dealing be able to place the bank under resolution. with SOBs, recapitalization should be done at arms’ 3. The KAs apply to the resolution of SOBs, although specific EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 35 circumstances and challenges must be dealt with. 12. Bridge banks in the resolution of SOBs should be used 4. The resolution framework should address and eliminate with caution and not as a mechanism to rid the SOB of its any special governance rules that apply to SOBs, bad assets, to the detriment of its creditors, while keeping sweeping away all the privileges and costs that create the good bank in the state’s hands. asymmetries between POBs and SOBs, including 13. SOBs should contribute to and be covered by deposit governance rights (for example, board appointments by insurance funds and—where they exist–resolution funds, the President or civil society). alongside POBs, as these can be reliable sources of 5. Lack of legal flexibility, and legislation requiring funding for resolution. parliamentary approval before transferring the control of an SOB or disposing of certain of its assets can be major obstacles to the effective resolution of an SOB, and the resolution framework should eliminate them. Where complete elimination is not feasible, a second-best solution would be to include in the resolution legislation authorization for the government to decide these matters independently of the Parliament. 6. Most SOBs develop functions that go beyond a purely commercial mandate, and an effective resolution strategy should foresee mechanisms for the continuity of such functions, provided that they are sustainable (otherwise, jurisdictions should transfer them to adequate government organizations funded by the state budget). 7. Given national interests associated with SOBs, special attention must be paid to cross-border arrangements for those SOBs that operate internationally, especially those related to recognition of decisions by a foreign RA. 8. Jurisdictions should extend the requirements for RRP and resolvability assessments to SOBs, although many RAs may find it challenging to decide on the removal of certain barriers to resolution, especially when these involve politically sensitive issues. 9. The implementation of bail-in in SOBs presents additional barriers related to the dilution of the public shareholder. 10. SOBs should be subject to LAC requirements similar to those of POBs, provided that in SOBs these should ideally have contractual provisions establishing their write-off in case of resolution, thus avoiding issues related to transfer of control. Moreover, government bodies and parastatal organizations should invest in such instruments only in arms’ length conditions and in an adequately diversified manner. 11. In addition to the temporary stays set forth in KA 3.2(x), the resolution framework of SOBs should also contain provisions to stay early-termination clauses associated with the SOB’s control structure. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 36