After watching regional banks fail in 2023, it is obvious that something must be done to prevent the harm these failures cause — indeed, the too-big-to-fail concept needs to be replaced by “recovery planning” to protect the interests of those with a financial interest in the bank
Having an effective recovery planning process would be helpful to banks facing financial problems, and such planning could ideally avoid the harms associated with rescuing too-big-to-fail institutions, a top US banking regulator said.
Speaking at a Swiss banking conference, Michael Hsu, Acting U.S. Comptroller of the Currency, said that last year’s regional banking crisis, marked by the collapse of Silicon Valley Bank, showed that financial institutions need to plan for contingencies and have a range of policy responses available. “As last year showed… depositors, counterparties and investors may lose confidence in a large bank. When that happens, the risk of disorderly failure increases,” Hsu said. “Recovery actions can provide a way out. A robust recovery plan provides a bank and its regulators with options to stabilize the institution and shore up confidence when it is under stress — actions may include limiting growth or reducing risk-weighted assets, selling certain portfolios or businesses, increasing and terming out liquidity or raising capital.”
Since the 2023 banking turmoil, US banking regulators have been working to enhance supervision and escalate deficiencies more quickly to firms’ senior management when problems arise.
Michael Barr, the Federal Reserve vice chair for supervision, has described how the central bank’s supervisory process has become more proactive, one of the lessons learned from a review of Silicon Valley Bank’s collapse.
Past crises serve as guide
Hsu referenced the 2008-‘09 financial crisis, observing that some banks were able to withstand the turmoil by actively taking steps to mitigate financial stress. “For example, in the spring of 2009, at the height of the financial crisis, Barclays sold its asset management business — Barclays Global Investment — to BlackRock for $13.5 billion,” Hsu explained. “The sale provided Barclays with much-needed capital, helping to stabilize it and restoring confidence during a particularly perilous time in the market. Having actionable recovery options effectively creates new tracks that a bank can switch to when it is in stress, enabling it to avoid disorderly failure.”
Unfortunately, banks under stress often do too little too late, and the sense of urgency that triggers recovery action often arrives after the window for acting has closed.
“As last year showed… depositors, counterparties and investors may lose confidence in a large bank. When that happens, the risk of disorderly failure increases. Recovery actions can provide a way out. A robust recovery plan provides a bank and its regulators with options to stabilize the institution and shore up confidence when it is under stress.”
To better prepare for such events, Hsu advised bank leaders to consider future triggers, options, and impact assessments. “Triggers can be quantitative or qualitative,” he said. “Quantitative triggers may be related to a bank’s liquidity and capital levels or to its stock price… Qualitative triggers might include credit rating downgrades, severe financial stress at major counterparties, or significant operational risk events.”
Actionable options are also critical to effective recovery plans and can help restore confidence in a bank by improving its liquidity or capital position, reducing uncertainty, or simplifying operations. “Options can range from sales of portfolios or lines of business to [the] securing of long-term funding to capital preservation measures,” Hsu noted. “The more numerous and wide-ranging the options a bank has, the better.”
Finally, impact assessments are important so that managers and boards of directors can understand the full range of consequences attached to certain actions. Hsu added that selling a portfolio of assets to generate liquidity could result in a hit to capital and loss of earnings power, risking a rating downgrade, or disproportionately affect a material legal entity.
Bank leaders should analyze the direct and indirect impacts of each alternative to better assist planning and limit the risk of surprise.
Mitigating failure with recovery planning
The too-big-to-fail problem has vexed bank regulators for decades. As large banks have grown even larger — either organically or through acquisitions, often at the behest of regulators seeking to salvage a distressed bank — the problem remains high on regulators’ radar.
For Hsu, recovery planning can be a tool for regulators to avoid unattractive policies and outcomes during periods of financial instability. Again, referring to the 2008 financial crisis and the failures of Lehman Brothers and insurance firm AIG, Hsu said both outcomes could have been avoided if the firms had established strong recovery plans.
“Strong and effective recovery planning… could have helped in two ways,” he explained. “First, well-designed triggers and proper governance could have prompted timely consideration of recovery options and compelled each firm to act much earlier. Such actions, instead of mere words or aspirations, might have provided investors and counterparties with enough confidence to stay the course instead of cutting lines and running.”
Additionally, well-prepared recovery options to sell portfolios and lines of business would have enabled both firms to shrink quickly and in an orderly manner, even after failure, he added.
You can find more information about Regulatory Intelligence here.
