Banks play a key role in facilitating and providing liquidity for economic growth. During the global financial crisis in 2008, many foreign governments were forced to use large sums of taxpayer’s money to bail out troubled banks that were “too big to fail”. After the global financial crisis, the international community reached a consensus to carry out a series of reforms to avoid using taxpayer’s money to bail out troubled banks whilst maintaining financial stability during bank failures. In 2011, the Financial Stability Board established new international principles on a resolution regime, known as the Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes), for the orderly management of bank failure. Resolution differs from insolvency procedures in that it is designed to preserve the continued performance of critical financial functions by the failing financial institutions (FIs) whilst imposing the costs of failure on the shareholders and creditors of the FIs.
Financial Institutions (Resolution) Ordinance (Cap. 628)
The Financial Institutions (Resolution) Ordinance (FI(R)O), which came into effect on 7 July 2017, establishes the legal basis for a cross-sectoral resolution regime in Hong Kong. The FI(R)O is designed to be compliant with the Key Attributes and have the following resolution objectives:
|(i)||promote and maintain the stability and effective working of the financial system in Hong Kong, including the continued provision of critical financial functions;|
|(ii)||protect deposits or insurance policies;|
|(iii)||protect client assets; and|
|(iv)||contain the costs of resolution and protect public money.|
Under the FI(R)O, the Hong Kong Monetary Authority (HKMA), the Insurance Authority (IA) and the Securities and Futures Commission (SFC) are the designated resolution authorities (RAs) for the following “within scope FIs” in the banking, insurance and securities and futures sectors, respectively.
|a.||Banking sector: (i) authorised institutions (AIs) incorporated within or outside Hong Kong, (ii) non-governmental settlement institutions and system operators under the Payment Systems and Stored Value Facilities Ordinance (Cap. 584)|
|b.||Insurance sector: global systemically important insurers|
|c.||Securities and futures sector: licensed corporations (LCs) that are (i) non-bank non-insurer global systematically important FIs, or (ii) branches or affiliates of global systemically important FIs, (iii) clearing houses and exchange companies recognised under the Securities and Futures Ordinance (Cap. 571)
RAs are also empowered to resolve a holding company or affiliated operational entity of a within scope FI as if it were itself a within scope FI.
Under the FI(R)O, RAs may only initiate resolution against a within scope FI if 3 conditions are met: (i) the FI has ceased, or is likely to cease to be viable; (ii) there is no reasonable prospect that private sector action other than resolution would result in the FI becoming viable again within a reasonable period; and (iii) the non-viability of the FI poses risks to the stability and effective working of the financial system of Hong Kong and resolution will avoid or mitigate those risks.
RAs are granted extensive resolution powers under the FI(R)O to mitigate the risks posed by within scope FIs in case of failure. Central to the resolution powers are 5 stabilisation options, which an RA may exercise to secure the orderly resolution of a non-viable FI.
|1.||Transferring business to a purchaser
This option involves the compulsory transfer of all or some of the business of an FI to a purchaser, who shall be responsible for continuing to provide critical financial services to clients. This stabilisation option is applicable where there are willing and suitable purchasers in the market.
|2.||Transferring business to a bridge institution
This option involves the compulsory transfer of all or some of the business of an FI to a bridge institution owned by the Government. A bridge institution is created to receive a transfer and effect a timely disposal. Such transfer would allow the bridge institution to continue to provide critical financial services to clients in the interim pending completion of the transfer to a purchaser.
|3.||Transferring assets and liabilities to an asset management vehicle
This option involves the compulsory transfer of some of the FI’s assets, rights and liabilities to a special purpose vehicle. Such transfer would allow those assets, rights and liabilities to be wound down over time and is suitable where, after the application of another stabilisation option, the dealing of residual parts of an FI’s business (e.g. immediate sale or liquidation of assets) could have systemic consequences due to their negative impact on prices in the market. This stabilisation option is likely to be used in combination with other stabilisation options.
This option involves the compulsory recapitalisation of an FI (or its successors) by writing down claims of shareholders and unsecured creditors or imposing a debt-for-equity swap on unsecured creditors, in order to absorb losses and restore its capital position. The recapitalisation provides the FI with capital so that it may continue to provide critical financial services. This option is applicable where the other transfer stabilisation options are not feasible or desirable, due to the size or nature of the FI.
Under the FI(R)O, a bail-in is effected by way of bail-in instruments, which will contain provisions to cancel, modify or change the form of a liability of an FI. Certain liabilities are excluded from bail-in, e.g. deposits protected under the Deposit Protection Scheme, secured liabilities to the extent they are secured, liabilities owed to current or former employees, etc.
When exercising the bail-in or any of the bail-in exclusions, RAs must have regard to the hierarchy principles in insolvency laws. The idea is that no creditors should be worse off than in liquidation and there should be equal treatment of creditors within the same class. This protection is further extended to shareholders—section 102 of the FI(R)O provides that shareholders or creditors will be entitled to compensation if they are treated less favourably under resolution than they would have been in a winding up of the FI.
It should be noted that recapitalisation through bail-in can only stabilise the failing FI in the short term. In the long term, changes will need to be made to the structure and business model of the failing FI through a post-resolution business reorganisation plan, so that the FI can become viable again and continue as a going concern. Under the FI(R)O, the directors of a failing FI are required to prepare a business reorganisation plan and submit to the relevant RA within the prescribed period.
|5.||Transferring to a temporary public ownership company
This option involves the compulsory transfer of all the shares of an FI to a Government-owned company, with a view to transferring the business to the private sector in the future. This option is considered a last resort and the RA may not exercise this option unless it has considered all other stabilisation options and concluded that such transfer to a TPO company is most appropriate for the purposes of an orderly resolution. Approval from the Financial Secretary is required for RAs to exercise this option.
All of the stabilisation options can be exercised individually, in combination or sequentially, to some or all parts of the business of a failing FI. RAs can also choose not to exercise any of the stabilisation options, in which case they may apply the other general powers of resolution, for instance the power to manage the affairs, business or property of the FI, suspend certain obligations of the FI, make disclosure to non-Hong Kong RAs, recognise resolution actions made by non-Hong Kong RAs etc. Alternatively, RAs may exercise their ordinary powers to wind up the failing FI under the Banking Ordinance (Cap. 122), the Insurance Companies Ordinance (Cap. 41) or the Securities and Futures Ordinance (Cap. 571), respectively.
Capital Reduction Instruments (s.31 FIRO)
As a specific resolution tool applicable to the banking sector, the HKMA is further empowered to mandatorily write off or convert capital instruments in respect of a within scope AI. This is different from the recapitalisation in the bail-in stabilisation option and can only be exercised when the following 3 conditions are met: (i) the 3 conditions to resolution are satisfied, (ii) the HKMA has decided to initiate the resolution of the AI, and (iii) the principal amount of any Additional Tier 1 capital instrument or Tier 2 capital instrument has not been entirely written off or converted into ordinary shares under the point of non-viability provisions of the instrument.
Note that the power to make a capital reduction instrument is only applicable to the HKMA (as RA for the banking sector) but not to the other RAs.
Clawback Provisions (Part 8 of FIRO)
Although the resolution regime in the FI(R)O is different from the ordinary winding-up procedure, similar to winding-up where the Court has the power to reverse problematic transactions (e.g. transactions at an undervalue or unfair preferences etc.), there are specific provisions in Part 8 of the FI(R)O which allow RAs to apply to the Court to clawback the remuneration received by current or former officers (e.g. directors, CEOs, management) during the 3 years preceding the date of the resolution. The Court may order a clawback against an officer where the performance of the officer caused or contributed to the FI ceasing to be viable, and that performance was intentional, reckless or negligent. Note that Part 8 of the FI(R)O has yet come into force as of the date of this publication.
Some General Issues
The following are some general issues to note in order to prepare for resolution/in the course of resolution of a bank:
Resolution planning well in advance of a bank experiencing stress is crucial to ensure it can be resolved in an orderly manner in case of failure. Banks are expected to work with the HKMA throughout the whole resolution planning process and may be required to implement any necessary changes to its legal structure, business operations and/or structure of financial resources necessary for enhancing resolvability.
Broadly speaking, resolution planning for a bank involves the following actions by the HKMA: (i) gathering information from the bank; (ii) setting a preferred resolution strategy and developing a resolution plan that operationalises the preferred strategy for the bank; (iii) assessing the bank’s resolvability; and (iv) addressing impediments to resolution.
Valuation of bank assets can sometimes be problematic and generally each jurisdiction’s bank regulators will adopt or require their own particular valuation methodologies in calculating the present value of assets and the level of provisioning required to be made to the profit and loss account in respect of distressed assets.
Although carrying out this exercise at the outset will provide a picture of the bank’s financial position, whether there will be a further deterioration (or improvement) over time can be difficult to accurately assess.
Section 35 of the FI(R)O requires that a valuation must be made by the relevant RA before applying any of the stabilisation options or a capital reduction instruments.
A demarcation process by which assets are separated into different classes determined by their nature (and their propensity to deteriorate) will accordingly be embarked on.
The process comprises an examination of the core component of the bank’s assets: loans. This will include all corporate and commercial loans (including loans in some form of workout or restructuring process, whether in court or under a regulatory restructuring regime), guarantee payments in subrogation, bills bought, letter of credit bills, privately placed debentures and commercial paper, credit card receivables and other accounts receivable.
These loans will be broken down into various classes by reference to, among other things:
Other assets will be separated into different classes and similarly assessed. In particular, securities will need to be valued based on their liquidity and recovery rate.
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