Introduction to the Recovery and Resolution Directive
By David Blair
Earlier this month, the European Commission published a draft Recovery and Resolution Directive to establish a framework for dealing with failed and failing financial institutions. The measure reflects a commitment undertaken by the G20 members in the wake of the Lehman crisis to ensure a more orderly wind-down of collapsing banks.
The UK has been particularly active in attempting to distil the lessons learned in the wake of the financial crisis and most of the proposed Directive’s content bears a close resemblance to the “Living Wills” regime developed by HM Treasury and the FSA over the past three years. 
The essence of the UK approach has been to increase firms’ obligations to plan for insolvency as part of their every-day business and to provide a protocol that firms and their regulators should adhere to in the event of financial difficulties (recovery planning) or insolvency (resolution planning). The mechanisms proffered to achieve these ends are generally well conceived and the method of testing the rules through a pilot project involving six large financial institutions is a model for delivering proportionate regulation.
Global Application of the UK Regime
The wider application of the regime that has evolved in UK to the major global financial centres is therefore to be welcomed in principle. Most of the financial institutions that pose the greatest risks to financial stability have a global reach, so co-ordination of international recovery and resolution standards should help to prevent regulatory arbitrage and confusion.
There are certain divergences from the UK model, many of which are unwelcome developments. For example, the Directive threatens to undermine the proportionate UK approach of only applying the living wills rules to non-banking investment firms which have a minimum of £15 billion in assets. The European Commission’s proposal to apply the rules to all investment firms with a principal trading book regardless of size indicates that the consumer protectionist lobby has its hands on the wheel even when the supposed destination is a reduction in global systemic risk.
In addition to ill-advised amendments, the EU’s proposed Directive includes an extremely political dimension, which has the potential to make it a significant battleground in the continuing ideological war between the Euro commissars and Euro-sceptics.
Funding and Implications of the Directive
The issue arises in the context of funding the resolution tools that EU regulators are to have at their disposal. One of the purposes of the Directive is to ensure that the shareholders of financial institutions bear the cost of failure rather than the taxpayer, so the Directive requires each member state to build a resolution fund of 1% of all bank deposits over the next 10 years by raising a tax on the financial institutions.
The European Union has never been shy about creating new budgets or been renowned for its efficiency in delivering value for money, so the size of the resolution fund it is seeking to establish may raise the temperature at banks that are already under orders to increase the capital costs of their deposit base. The levels of the UK’s recently-imposed banking levy were set at 0.044% of long-term liabilities (mostly fixed-term deposits) and 0.088% of short-term liabilities. These levels were carefully agreed with the banks to strike a balance between increasing the banks’ moral hazard, whilst retaining UK competitiveness. If the banking levy were to be replaced by a resolution funding charge, the current level appears to be well short of the 0.1+% annual charge that would be required to build a resolution fund up to the 1% level in 10 years. The 1% proposal should be seen in the context of a spat between Westminster and Brussels/Paris about raising an EU-wide financial transaction tax on the banks and may represent an unsubtle compromise.
However, whilst the quantum of the fund may have extremely serious consequences for the competitiveness of Europe as a financial centre, it is not the point that breaks new ground in the development of a federal Europe. Article 97 of the proposed Directive provides that each country’s resolution fund shall be obliged to lend to any other country whose resolution fund is insufficient. The obligation to contribute would obviously not apply to the extent that a country was under-funded itself, so the conclusion that countries may draw is that resolution funds should be kept at a minimum level to decrease the potential impact of foreign raiders.
Resolution Planning for Trans-National Groups
Another development for trans-national groups is that a resolution financing plan be drawn up by the regulator in the group’s centre of operations. Article 98 provides that the plan would have to be agreed in consultation with each local regulatory authority, but the lead regulator would be able to determine the contributions that each national resolution fund would need to contribute towards the plan.
European Banking Union and Regulatory Cooperation
The proposed Directive has been issued against the backdrop of a proposal to create a European Banking Union under which a European super-regulator would be granted the power to use the resolution plan tools available to national regulators. The UK has identified concerns that such a plan could effectively result in the UK funding the bail-out of Eurozone banks and Brussels has reluctantly acknowledged that the UK should be able to opt out. The funding proposals in the draft Directive raise precisely the same issues, albeit without providing for the role of a super-regulator, so article 97 should logically be contested by the UK and the development of the detail supporting article 98 be closely scrutinised.
The Directive highlights a philosophical split between the level of regulatory cooperation that is appropriate between the member states inside and outside of the Eurozone. The proposed Directive appears to follow the “remorseless logic” of the single currency that Chancellor George Osborne recently alluded to. However, the Directive is clearly intended to apply to Eurozone and non-Eurozone members alike. For the sake of the UK’s financial services industry, it is to be hoped that the logic that led Britain to abstain from adopting the Euro will be equally remorseless in declining to pay for the consequences of the ideology it opposed. As Germany baulks at the financial realities of fiscal union, the UK can rest assured that the supposedly isolated plot it inhabits on the side-lines of Europe is developing into a coveted piece of land.
David Blair is Head of Financial Regulation at law firm Osborne Clarke
