With the collapse of Lehman Brothers in 2008, the world got a taste of the domino effect that can be created when a systemically important financial institution (SIFI) fails.
In the backlash that has occurred since, risk management has become the primary focus of the Financial Stability Board (FSB), and with good reason.
In an effort to prevent future economic crises resulting from SIFI failures, the FSB has developed a proposal for living wills, or effective resolution regimes, for financial institutions. The FSB criteria for an effective resolution regime are outlined in Key Attributes of Effective Resolution Regimes for Financial Institutions .
The objectives of living wills include: Ensuring continuity of financial services Protecting client assets Allocating losses to shareholders while respecting the hierarchy of claims Not relying on public solvency support Avoiding unnecessary destruction of value Providing speed, transparency and predictability for orderly resolution Legally mandating cooperation, coordination and information exchange with relevant resolution authorities Ensuring orderly market exits by non-viable firms Enhancing market discipline and offering incentives for market-based solutions
In the event that risk management measures fail and a financial institution becomes no longer viable, the FSB proposal recommends that the living will should have provisions for two important activities: stabilization and liquidation. Stabilization is necessary for ensuring the continuity of vital financial services and may be achieved through sale of the firm to a third party or creditor-financed re-capitalization.
After or concurrent with stabilization measures, the liquidation phase must protect insured depositors, insurance policy holders and other retail customers, while winding down business operations in an orderly manner. SIFIs are by definition critical to the success or failure of an economy. It is for this reason that measures beyond standard risk management practices should be required.
A living will allows authorities to resolve a failed financial institution or large company while minimizing risk to the taxpayer and ensuring continuity of critical financial services. However, implementing living wills as part of a larger risk management strategy should not be limited to just the 29 SIFIs that have been identified by the FSB. All large companies and financial institutions should have a living will in place in the event that existing risk management systems fail.
- By Robert Pestreich, Harrison, Stone & Associates
The basic objective of SIFI living will is to preserve going concern (GC) value of SIFIs in vicinity, or zone of insolvency. In addition, the concept of going concern is widely used in other financial regulations such as Basel III and Solvency II. However, GC is a regulatory compliance tool, not a risk reporting and disclosure tool by way of its binary “going concern” and “gone concern” structure. In IAS 1 of IFRS, it is management’s primary responsibility to provide GC assessment. However, FASB recently decided not to make GC assessment a primary responsibility for management in GAAP. In auditing, the AICPA’s SAS 59 has not converged with IAASB’s ISA 570 because they are waiting for FASB’s completion of the “Disclosure about Risks and Uncertainties” project. In S&P and Fitch’s rating methodology for SIFI Coco bonds, “going concern” and “going concern trigger” are left undefined.
It appears that the GC concept is ubiquitously present in financial regulations and credit rating methodology, but everyone left the foundation undefined. The challenge in implementing these regulations that are based on the GC concept, therefore, is who would decide what is “going concern” and dintinct it from “gone concern”. This is clearly beyond the current binary “pass or fail” GC audit model.
Going concern rating redefines the traditional concept of going concern rating by inserting a rating scale and the concept of zone of insolvency, and rates GC risk and credit risk on the same rating scale with dynamic equity-debt notching which is defined by actual allocation of and potential claims on cash flow. GC rating measures the gradation of GC risk on a rating scale, which provides a pre-defined path to insolvency and has significant analytical utilities to the new regulatory reporting and disclosure requirement.
Therefore, some of the challenges in implementing SIFI living will, such as insolvency declaration of global SIFI, could be simply resolved by a pre-defined GC rating trigger. My research is published at http://www.palgrave-journals.com/jdg/journal/v8/n4/abs/jdg201115a.html and I would be happy to further discuss.
Simon Hu