One of the vital lessons learned from our ongoing financial crisis is the difficulty in measuring the potential impacts of a large, cross-border bank failure. Variance in supervisory processes, regulatory and firm readiness, bankruptcy laws, resolution regimes, policy responses, and official sector coordination mechanisms exposed a vacuum of information necessary to reduce the amplification of stress. These gaps impose enormous un-funded costs to the system.
In the United States the Dodd-Frank Act attempts to enhance the government's ability to cope with stress events by requiring "living wills," formally known as "resolution" or sometimes "death" plans. The theory is that during the next material and potentially irrecoverable stress, the government will have a "roadmap" for how it might proceed to unwind a systemic, or firm-wide failure.
Resolution plans are helpful, but it remains somewhat unique to the United States that the financial reform legislation is so strongly focused on "resolution" and does not adequately address "recovery" planning.
Recovery plans focus on restoring health to a financial organization prior to being placed into a resolution framework. Like preventative medicine, it focuses an organization on remediation of potential health problems in order to avoid or mitigate the risk of a fatal heart attack.
Failure to emphasize recovery planning, and instead having an almost exclusive focus on death-plans, will likely increase the cost of a resolution and risks orienting a bank's scarce resources on internal paradigms that are not as mission critical as detection and prevention of emerging stress.
Knowing, as we do, that systemically important financial institutions require improved technology and risk infrastructure, the question exists: why so much focus on resolution rather than encouraging, indeed requiring, these firms to develop proper plans for crisis recovery?
Recovery plans could even include temporary open-bank assistance, so long as it avoids moral hazard by being sufficiently punitive to shareholders and management. Transparent funding, guarantees or other support mechanisms from the government may be superior to placing the firm into a Title II resolution.
No cogent national supervisor or industry participant wants to see more resolutions and firm-failure. As it stands today, increased resolutions would almost assuredly result in our large, money-center banks becoming larger, and result in these firms looking even more like government sponsored entities than may already be the case. It seems logical to focus on recovery, not risky and untested resolution.
Rather than prescriptive, bureaucratic rules in the form of an agency-controlled bankruptcy, a recovery plan focuses proper and necessary attention to the development of internal early warning systems, concentration management processes, stress-testing resiliency, risk appetite frameworks, and board and senior management risk governance, liquidity, and capital plans; these firm-specific recovery plans foster consolidated views into developing pockets of business risk, across the enterprise, that could cascade and amplify portfolio and systemic exposure.
This balanced approach seems a healthier and more realistic path, and one that banks should see benefit in pursuing. It focuses not on "death" but on the battle plan for "survival" in the event of a sufficiently severe internal or external market shock. Also, this puts more control into the private sector to innovate around recovery.
Recovery planning is even more critical from a macro-prudential perspective. If the invocation of a recovery plan requires official sector assistance, yet the plan is conducive to remediation not resolution, this will improve our overall system's resilience.
Therefore, one would expect the Federal Reserve System to be a strong advocate for recovery planning. Authorities can possibly reduce their overreliance on healthier SIFIs - those that are already too-complex-to-fail - to absorb their less healthy competitors. Over time, perhaps, this could act as a managed reduction in firm-size and contagion risks at those firms that, currently, could bring down the house.
Notably, some countries are taking a thoughtful and balanced approach toward recovery and resolution planning; one that is in alignment with the recommendations and direction of the Group of 20 finance ministers and central bankers, the Financial Stability Board, and the Basel Committee.
This can be clearly seen in the June 23, 2011 Swiss Financial Market Supervisory Authority paper that notes the regulator: "does not only focus on the resolution phase but also considers effective recovery arrangements as equally important."
This sentiment is echoed in the Financial Stability Board's October 2010 guidance on reducing systemic risk. They call for mandatory recovery and resolution plans, regular monitoring and analysis among bank supervisory crisis management groups and the ongoing use of supervisory colleges to assess these plans.
Globally, the G-20, the stability board, and the Basel committee are working toward the establishment of recovery and resolution mechanisms, and in July 2011 the Basel committee provided a comprehensive update on progress to date.
Simply put, much work remains. The consistency of application of recovery and resolution plans continues to need improvement and acceptable plans are likely to remain elusive in the short term. To some extent, the efforts to date have lagged at the firm and the national level, and many firms are in a "wait-and-see" mode with little productive guidance on how to proceed and what to expect.
A well thought-out, proactive framework for recovery, one that seeks a private-sector solution to a stressful external or self-imposed shock, is a more realistic and amenable standard and one that is consistent with the goal of establishing, enhancing and promoting higher standards of enterprise risk management.
Thomas Day is SunGard's in-house expert on risk management solutions and policy across the banking sector. He also serves as the vice-chairman of the board for the Professional Risk Managers' International Association.