Hong Kong Financial Reform – Viva La Resolutión!

The international financial community, through the G20 process and Financial Stability Board, has committed to ensuring that recovery and resolution regimes have been introduced across the board.

This is in response to the so-called ‘too big to fail’ (TBTF) risk posed by major financial institutions, which came to a head during the recent global financial crisis (GFC).

During the GFC, around the world, a number of financial institutions suffered extreme losses and liquidity shortages, such that their viability was threatened. The international moves towards a more defined network of resolution regimes are to ensure as far as possible that no further system shocks occur.

Major inter-connected institutions that could have a domino effect on the global market, and indeed on local domestic markets, are intended to be subject to frameworks that essentially allow institutions to fail gracefully, rather than creating instability or triggering government buy-ins to head off potential crises. This has affected places like Hong Kong, even where the GFC did not result in failed banks or other institutions.

Hong Kong is keen to demonstrate its ‘good citizen’ credentials as part of the zeitgeist. The Hong Kong Government and its three main financial regulators, the Hong Kong Monetary Authority (HKMA) (banking), the Securities and Futures Commission (SFC), and the Insurance Authority (IA), have launched the first stage of a public consultation on establishing a resolution regime for financial institutions in Hong Kong. There will be a further stage of consultation later this year, taking note of the initial market responses, followed by a raft of changes in legislation next year so as to keep on track for the end-2015 deadline. 

The first shot from the regulators is broadly in line with international trends: shotgun rather than pistol. It is designed to cover a wide range of regulated financial institutions. That would include all Hong Kong’s ‘authorized institutions’, ie, banks (although there appears to be room for debate around the inclusion of restricted licence banks and deposit-taking companies), certain SFC-Licensed Corporations (particularly those within banking or insurance groups), financial market infrastructure entities such as clearing houses, and most authorised insurers.

Other entities are also likely to be swept up, to allow as far as possible for Hong Kong structures and operations to be reasonably easily ‘resolvable’. That would include Hong Kong-incorporated holding companies of institutions within the scope of the regime, and affiliated companies that provide operationally critical services to the institutions, including outsourced service providers such as Indian call centres and IT companies.

The contemplated scope is clear, affecting multinational institutions and smaller local entities alike. As and when they fall on hard times, they would need to be sufficiently clearly defined at the Hong Kong level to allow them to be assessed and for swift measures to be taken to handle any crisis that may adversely affect Hong Kong. There is likely to be no room for lack of clarity going forward as to how Hong Kong operations are packaged and tagged.

Starting the Resolutión

Two conditions are expected to be placed on triggering a resolution exercise: (i) a Non-Viability Condition and (ii) a Financial Stability Condition.

The Non-Viability Condition contemplates that the institution in question is, or is expected to become, ‘no longer viable’ in either a financial or a non-financial sense. This trigger is intended to catch major adverse changes in the condition of the Hong Kong businesses from which they will not recover or have no reasonable prospect of recovering. It is viewed as broader than merely financial in the sense that, for example, sufficiently serious regulatory breaches that call into question continuing authorisation of the institution could fall within scope.

That, however, is not the end of it. If only this trigger were in place, then ‘standard’ insolvency principles could be brought into play. The crucial difference with the resolution regime from the current environment is that it can only be invoked where the second condition – the Financial Stability Condition – is also satisfied. This is to ensure that the resolution regime, given its Draconian powers, can only take effect where viewed as necessary to contain risks posed by the institution’s inability to continue with the provision of vital financial services, or is serious enough to interrupt the provision of critical financial services - such as payment, clearing and settlement functions – or indeed the more nebulous possibility of affecting the general stability and effective working of the financial system. This looks at whether an institution that is about to fail would, for example, cause a ‘run on banks, in Hong Kong.

All of this is designed to allow a degree of peace of mind within institutions: only the most serious problems would fall to be dealt with under the resolution regime, and even then the system would be calibrated to ensure as far as possible ‘NCWOL’, ie, no creditor worse off than in liquidation.

The setting of the threshold for the Financial Stability Condition is one of the biggest issues in relation to the regime. Keeping market confidence is essential in the context of the timing and approach to the use of the tools available to the regulators. At all costs, the introduction of a resolution regime needs to avoid any perception of possible arbitrary use of those powers for inappropriate purposes.

The test should be that the criteria for pushing the button on the resolution regime should be as clearly stated as possible to match the more established position with regard to winding-up.

A Smorgasbord of potential resolution powers has been included in the initial consultation for use by the regulators, ranging from compulsory transfer/sale to a private purchaser, to transfer to a ‘bridge’ institution (ie, a temporary holding entity), statutory bail-in, and as very much a last resort (seemingly for the sake of completeness), temporary public ownership. Interference with and temporary suspension of early termination rights under derivatives contracts and the possible automatic stay of litigation to avoid the de-railing of resolution, have been included in the consultation package, demonstrating the wide–ranging and overwhelming power of the regime, once triggered.

More details of what is intended will form part of the further consultation later this year, but it is unlikely that the options available to the authorities will be curtailed; it seems more important to focus on, as indicated above, when and how they would be put into action.

How Can and Should Market Confidence be Maintained?

• It is critical that the regime is not viewed as trying to ‘gold plate’ the internationally evolving basis for resolution regimes.

• There needs to be sufficient collective commitment from global regulators to enable institutions, covered by multiple resolution regimes across various jurisdictions, to be comfortable as a practical matter and that there will be reasonable predictability of responses by those regulators in line with international thinking rather than local expediency.

• Very importantly, sufficient lead time must be given to the market to plan for and comply with the new requirements, so the sooner the better for the follow-up consultation exercise later this year and the crystallisation of the proposed regime, to avoid the pit-falls evident as a result of the piecemeal evolution of Dodd Frank.

• Resolution objectives and priorities will need to be set, articulated clearly and pursued where the relevant resolution authority (likely to be whichever of the three main industry regulators is most on point) is minded to use its powers. The two main resolution objectives proposed are to promote and seek to maintain the general stability and effective working of the financial system in Hong Kong, and to seek an appropriate degree of protection for depositors, investors, and policyholders. There is also a subsidiary resolution objective proposed, which requires a resolution authority to seek to contain the costs of resolution and, in so doing, protect public funds.

• Proper consultation by a resolution authority with ‘a higher authority’ is suggested before exercising any resolution options. At this stage it is not clear who this higher authority will be, although it is conceivable for this responsibility to fall to either the Financial Secretary of Hong Kong or the Financial Services and Treasury Bureau. This would in theory prevent any ‘hair trigger’ responses from regulators and consistency across the various resolution authorities (although that needs to be balanced with the need for quick, decisive action in times of crisis) – inevitably, there will need to be an updated memorandum of understanding between them to codify that as far as possible.

The Elephants in the Room

Aside from those anchors for market confidence, there are two elephants in the room: ‘resolvability’ and the international community ‘playing nicely’ at times of crisis.

The need for groups to know themselves is obvious. It is not, surprisingly, implicitly hard-wired into the proper systems and controls requirements for institutions. However, groups are often sprawling in nature with multiple entities and dependencies, which, if they need to be un-picked at times of trouble for the organisation, would potentially sink any chance of proper resolution. Accordingly, as a matter of good practice, essentially regardless of the introduction of the new resolution regime, institutions need to take time to assess ‘what they have’ and how it is deployed, for the sake of good risk management and operations. Clearly, the new regime brings that need into sharp focus, and there is an intimation, presumably for the most significant institutions, that if self-help is not practised then it could be visited upon them.  

The second elephant is the niggling – or maybe not so niggling – doubt as to how this will all play out as and when a crisis looms. The crux of the new resolution regimes, globally, is orderly and timely action by resolution authorities to protect markets against instability. The reality – of which the Financial Stability Board is clearly conscious – is to try to tie up home and host resolution authorities to pursue resolution across boundaries in a predictable and non-self serving manner. The temptation for host resolution authorities (for example, Hong Kong in relation to a UK-established group), where their markets are threatened, is to do the reverse and protect their home patch. There is a very difficult balance between ‘supporting’ offshore regulators and protecting the domestic market, and it remains to be seen how achievable that balance can really be when the darkness threatens. Mutual trust among global regulators will be key.

Change is Good (?)

Before the traditional shelling of the Presidential Palace that heralds a revolution against the incumbent regime, or in this case the introduction of a regime relating to resolution, a relatively smooth and uncontroversial consultation process is needed. This should then be followed up promptly with concrete proposals to set out how it will be framed and operated, to allow any chance of keeping to the 2015 international timetable. That will allow institutions to take a long hard look at their Hong Kong operations to assess how ‘resolvable’ they are and (given the breadth of the exercise) to allow time to re-organise themselves where necessary and set up compliance systems in time.

This change is inevitable in the context of the international developments. Provided in particular that it is handled properly in the light of the inter-connections, and priorities and pressing needs, of the ‘global markets’ and individual jurisdictional interests, then it may provide additional resilience to those markets when problems arise.

Viva La Resolutión! 

Alan Ewins
Alan Ewins, a partner in Allen & Overy, experience includes advising numerous financial institutions on a wide range of product, risk management and compliance issues, on the regulatory aspects of sales and purchases of companies and businesses, and on establishing and offering interests in collective investment schemes. Alan also works closely with Allen & Overy's regulatory disputes and derivatives teams, particularly in Hong Kong, in the financial services area.