Introducing the role of the Bank Recovery and Resolution Directive (BRRD) and its potential for preventing, managing, and resolving crisis.
It was on September 15 in 2008 when the US witnessed the largest filing of bankruptcy in its history, being done by at the time, the fourth largest investment bank Lehman brothers only behind Goldman Sachs, Merrill Lynch, and Morgan Stanley. Its involvement in illiquid assets and subprime mortgages resulted in severe losses in its stock, and devaluation of its assets when the US housing market hit a sharp decline, making it an important player in explaining the latest global financial crisis to date.
Following the crisis, various measures and regulations have gradually been imposed on financial institutions in order to improve their financial stability and prepare them for future uncertainties.
A framework that everyone is already well familiar with is The Basel accords which require financial institutions to have adequate capital by imposing minimum capital requirement measures with the objective to ensure that the institutions protect their solvencies for economic stability.
The BRRD framework
In 2014 the European Parliament introduced a new framework called the Bank Recovery and Resolution Directive (BRRD) to ensure that financial institutions acquire the capabilities to easier become solvent during a crisis as to support authorities enhancing financial stability, protecting public money, preventing moral hazard, ensuring the ongoing of the critical functions, and restoring the capability of the financial institution.
According to the European Commission “a bank resolution occurs when authorities determine that a failing bank cannot go through normal insolvency proceedings without harming public interest and causing financial instability.“(https://ec.europa.eu/info/business-economy-euro/banking-and-finance/financial-supervision-and-risk-management/managing-risks-banks-and-financial-institutions/bank-recovery-and-resolution_en).
The main purpose of the BRRD framework is to create order and smooth handling during a resolution procedure, and in order to make it happen, financial institutions need to have e.g. better view of individual agreements on the liability side of the balance sheet, and deposit-guaranteed funds as well as have better grip of the system critical functions in the organisation knowing which functions that are critical and how to decompose them during a resolution in order to prevent a system collapse.
Furthermore, the directive aims to ensure that authorities are provided with broad and effective measures to address failing banks at national level, and support measures to deal with cross-border banking failures. In essence, banks and other financial institutions are required by the directive to have solid recovery plans to overcome financial distress, meaning better insight about their information regarding their liabilities and, and having it available in a timely manner and on an ad-hoc basis.
To ensure that financial institutions have better view of their liabilities, the framework consists of resolution reporting templates aka the “T-reports” which institutions are mandated to use for reporting to national authorities. Each of the reporting templates (T-reports) requires different type of liability information at attribute level and level of granularity. Also, to ensure consistency among financial institutions in different jurisdictions, the European Banking Authority EBA has issued a Data Point Model tool to be used as a guidance as it describes the attribute required to be reported for each reporting template.
Reasons for change
Looking into the details there are several reasons why the BRRD framework has been established: Firstly, there have been major challenges for Member States to manage effectively with failing and unstable financial institutions such as investment and credit institutions, respectively, because there is a substantial lack of sufficient tools at Union level to address these challenges. Consequently, Member States had to bail out institutions by using taxpayer’s money during the financial crisis. Therefore, the recovery and resolution framework has been instigated to prevent the need for authorities having to use public money as a means to save failing institutions to the greatest extent possible by providing Member States and financial institutions with sufficient tools that would help to prevent insolvency, or minimise the economic damage when insolvency occurs and safeguard systematically important functions.
Secondly, the high degree of association and correlation among financial institutions is the result of a complex network underlying their structure that extends well beyond the national borders. Hence, disruption to the network due to the failure of a constituent financial institution is a highly probable event caused by the interconnected nature and comovement of the above-mentioned institutions in Member States in which they operate. Consequently, in the event of the failure of an institution, a systematic shock rattles the entire network, which may undermine the mutual trust inherent in this complex financial system. Henceforth, to preserve the smooth functioning and integrity of this organic structure, it is vital that the Member States collectively work in pursuit of stability of the constituent institutions.
Thirdly, staggering evidence suggests the absence of a harmonised protocol aimed at resolving institutions at the union level; and although a number of Member States implement and adapt improvised insolvency strategies for the constituent institutions, these have proven to be inadequate. The tailored insolvency procedures simply do not address the distinctions present among the laws, regulations and administrative provisions of the institutions in the Member States. Finally, the regulatory framework continuously evolves to address the threat of destabilising and crippling effects that stem from systematic and idiosyncratic shocks to the financial system, to reduce the likelihood of future crises. This is partly achieved by diverting attention to strengthening the capital and liquidity buffers, as well as equipping member states with better macro-prudential policies.
As useful and beneficial as the BRRD framework seems to be, there are a few key challenges facing the financial institutions trying to implement the BRRD framework in their business, first being the high complexity of both organisational and data mapping. For a large-scale institution, this is challenging in terms of identifying the roles and responsibility of data owners and processes as well as documenting the systems data flow in order to know where the required data originate from. Hence, the mapping of data is a complex task at hand, an even more complex for financial institutions that have branches in different jurisdictions in which the systems and data mapping is very likely highly fragmented.
Furthermore, institutions need to know how systems are integrated with each other and which ones are system critical functions as the institutions need to acquire the capability of being able to be decomposed by resolutions authorities during a crisis so that they can take over the critical functions as a means to enable the institutions to be operational. To acquire the capability of being decomposable is very difficult due to the complexity of identifying which systems that are critical given the numerous automatic and manual processes and integrations that need to be well understood.
Although the implementation of the BRRD framework requires the institutions to make large capital investments taking into consideration the challenges, there are several potential opportunities for improving their business as a result: as the institutions identify critical functions in their organisations, it would enable them to understand their business and functions better and be able to manage their operations more effective and efficient by making sounder business decisions. Also since institutions do have to perform comprehensive mapping and analysis of data as well, there is a potential opportunity to reduce and remove inefficient and ineffective processes by e.g. automatize the provision of data and hence remove redundancies as to avoid people doing overlapping work, and assigning ownership of data to the right people. Additionally, there are numerous reports for different regulations to report, the business can improve the coordination of the reporting process by removing the overlaps regarding different business areas having to prepare the same information, potentially resulting in operational efficiency and cost savings.
Due to its complexity and the level of details required, BRRD has the potential to be difficult and expensive to live up to. However, by working towards implementing the BRRD framework, financial institutions are forced to map out the interconnectedness of functions, services and systems. This opens up possibilities in terms of improving processes and reducing overlap in the organisation. Furthermore, the focus on granular liability data opens up increased possibilities of data driven decision making which has been predominantly reserved for the asset side of the balance sheet. As with many regulation, reducing the cost of compliance often is the main goal and hence strategic opportunities are often overlooked. A successful bank finds a way to optimise both.