Both the United States and United Kingdom have developed viable approaches to seizing and unwinding failing global financial institutions, but more work is needed on the UK side to ensure that losses can be adequately absorbed, American and UK regulators said on Sunday.
The Bank of England and the U.S. Federal Deposit Insurance Corp said in a joint paper that each country's plans for dealing with the types of cataclysmic financial failures that marked the 2007-2009 financial crisis would reduce risks to financial stability.
"The FDIC and the Bank of England have developed resolution strategies that take control of the failed company at the top of the group, impose losses on shareholders and unsecured creditors - not on taxpayers - and remove top management and hold them accountable for their action," they said in the paper.
The new authorities to seize and resolve so-called global systemically important financial institutions came in the United States from the 2010 Dodd-Frank financial reform law, and in Britain from the anticipated approval by early 2013 of the European Union Recovery and Resolution Directive.
Both the U.S. and UK approaches ensure continuity of all critical services of the failing firms and minimize cross-border contagion, the regulators said.
In both approaches, equity holders would likely be wiped out, and unsecured debt holders would face writedowns and conversion of at least part of their holdings to new equity to recapitalize the institutions as part of the restructuring.
In the United States, this is a relatively straightforward process, because in most large financial institutions, the capital structure is largely made up of equity and unsecured debt issued at the holding company level. There is often limited debt issued directly by operating subsidiaries that may be the source of the financial distress that brings down the company.
In the UK, however, financial holding companies at the top of the group do not typically issue much debt - more tends to be issued at the subsidiary level.
"For a top-down approach to work, there must be sufficient loss-absorbing capacity available at the top of the group to absorb losses sustained within operational subsidiaries," the regulators said.
UK companies could restructure to issue more debt at the holding company level, they said. UK authorities also need to find better ways of assigning subsidiary losses to unsecured creditors throughout the group.
A statutory tool to "bail in" such losses proposed under the EU directive would need to prevent counterparties from terminating dealings with the failing firm as it is seized.
In the 2008 crisis, the sudden pullout by Wall Street counterparties from some large firms helped accelerate their failure and magnified losses later borne by taxpayers.
Valuing a failed financial firm's assets is also critical to writing down losses and determining which classes of creditors will face conversion to new equity. Both the United States and United Kingdom are working on ways to develop a credible valuation process that can be applied quickly and flexibly.
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