How Do Resolution Authorities Manage the Contagion Risk Associated with Bailing in Derivative Contracts?

Concept

The global financial architecture underwent a seismic shift following the 2008 crisis. A central element of this transformation was the introduction of the bail-in mechanism, a tool designed to prevent the taxpayer-funded bailouts of failing financial institutions. Instead of external rescue, a bail-in imposes losses on the institution’s shareholders and creditors to recapitalize it from within.

This process, while elegant in theory, presents a formidable challenge for resolution authorities ▴ how to execute a bail-in without triggering a catastrophic contagion that spreads through the intricate web of the financial system. The bailing-in of derivative contracts, with their complex and often opaque webs of interconnectedness, represents a particularly acute pressure point in this delicate operation.

The core challenge for resolution authorities is to wield the powerful tool of bail-in with surgical precision, severing the failing institution from the financial system without causing a cascade of failures.

At its heart, the contagion risk associated with bailing in derivative contracts stems from the very nature of these instruments. Derivatives are contracts whose value is derived from an underlying asset, such as a stock, bond, or commodity. They are used for a variety of purposes, including hedging, speculation, and arbitrage. The vast and intricate network of derivative contracts creates a high degree of interconnectedness among financial institutions.

The failure of one institution can trigger a chain reaction of losses and defaults, as counterparties find themselves unable to collect on their claims. This is the essence of contagion risk ▴ the spark of a single failure igniting a wildfire that consumes the entire financial system.

Resolution authorities, therefore, find themselves in a precarious position. They must act decisively to resolve a failing institution, yet they must also be acutely aware of the potential for their actions to unleash a torrent of contagion. The bailing-in of derivative contracts is a particularly fraught exercise, as the complex and often bespoke nature of these instruments makes it difficult to assess the full extent of their interconnectedness. A seemingly isolated failure can have far-reaching and unforeseen consequences, as losses ripple through the system, eroding confidence and triggering a flight to safety.

Strategy

The strategic framework for managing contagion risk in the context of a derivative bail-in is a multi-faceted and dynamic construct. It is not a monolithic, one-size-fits-all approach, but rather a carefully calibrated set of tools and principles that can be adapted to the specific circumstances of each case. The overarching goal is to strike a delicate balance between the need to impose losses on creditors and the imperative of maintaining financial stability. This requires a deep understanding of the complex interplay of legal, economic, and operational factors that shape the resolution process.

The Principle of Proportionality and the “no Creditor Worse Off” Safeguard

A cornerstone of the resolution framework is the principle of proportionality, which dictates that the measures taken should be no more than what is necessary to achieve the resolution objectives. This principle is closely linked to the “No Creditor Worse Off” (NCWO) safeguard, which provides that no creditor should be left in a worse position than they would have been in a conventional insolvency proceeding. The NCWO principle is a critical backstop that helps to ensure the fairness and legitimacy of the resolution process. It also plays a crucial role in mitigating contagion risk, as it provides a degree of certainty to creditors and helps to prevent a disorderly rush for the exits.

The application of the NCWO principle in the context of a derivative bail-in is a complex undertaking. It requires a detailed valuation of the failing institution’s assets and liabilities, as well as a forward-looking assessment of the likely outcome of a hypothetical liquidation. This is a highly uncertain exercise, and there is always a risk that the valuation will be challenged in court.

To mitigate this risk, resolution authorities must be transparent in their methodology and be prepared to defend their decisions. They must also have a clear and credible plan for compensating creditors who are found to have been made worse off by the resolution process.

The Critical Role of “Bail-In Playbooks”

In recent years, there has been a growing recognition of the need for financial institutions to develop their own “bail-in playbooks.” These are detailed operational plans that set out the steps that the institution will take to facilitate a bail-in. The playbooks are designed to ensure that the institution is able to provide the resolution authority with the information and support that it needs to execute the bail-in in a timely and effective manner. The development of these playbooks is a collaborative process, with the institution working closely with the resolution authority to ensure that the plan is realistic and achievable.

The bail-in playbooks are a critical component of the overall strategy for managing contagion risk. They help to ensure that the resolution authority has a clear understanding of the institution’s operations and that it is able to make informed decisions about how to structure the bail-in. The playbooks also help to reduce the operational risk associated with the bail-in process, as they provide a clear roadmap for the institution to follow. This can help to prevent the kind of confusion and delay that can exacerbate contagion risk.

Key Elements of a Bail-In Playbook

• Data Provision ▴ The playbook must include a detailed list of the data points that the institution will provide to the resolution authority. This data is essential for calculating the bail-in perimeter, assessing the potential for contagion, and valuing the institution’s assets and liabilities.
• Communication Plan ▴ The playbook must set out a clear communication plan for keeping internal and external stakeholders informed about the bail-in process. This is critical for maintaining confidence and preventing the spread of misinformation.
• Operational Procedures ▴ The playbook must detail the operational procedures that the institution will follow to execute the bail-in. This includes procedures for identifying and valuing derivative contracts, as well as for transferring assets and liabilities.

The Strategic Use of Discretionary Exclusions

One of the most powerful tools at the disposal of resolution authorities is the ability to make “discretionary exclusions.” This allows them to exclude certain liabilities from the scope of the bail-in, even if they are legally bail-inable. The decision to exclude a liability is a complex one, and it must be carefully weighed against the need to ensure that the bail-in is credible and that it achieves its objectives. However, in certain circumstances, discretionary exclusions can be a vital tool for managing contagion risk.

The bailing-in of derivative contracts is a prime example of a situation where discretionary exclusions may be warranted. The complex and interconnected nature of these contracts means that their inclusion in a bail-in could have unpredictable and potentially systemic consequences. By excluding certain derivative contracts from the bail-in, resolution authorities can help to break the chains of contagion and prevent a localized failure from escalating into a full-blown crisis.

However, the use of discretionary exclusions is not without its risks. It can be seen as a form of regulatory forbearance, and it can create a moral hazard by encouraging creditors to believe that they will be protected from losses.

Factors to Consider When Making Discretionary Exclusions

1. Systemic Importance ▴ The most important factor to consider is the systemic importance of the liability in question. If the failure to exclude a liability would be likely to trigger a wider crisis, then there is a strong case for its exclusion.
2. Operational Complexity ▴ Another key consideration is the operational complexity of bailing in the liability. If the process of bailing in a liability would be so complex and time-consuming as to be impractical, then it may be better to exclude it.
3. Fairness and Equity ▴ The decision to exclude a liability must also be fair and equitable. It would be difficult to justify the exclusion of a liability if it meant that other creditors were forced to bear a disproportionate share of the losses.

Execution

The execution of a derivative bail-in is a high-stakes, high-pressure operation that requires a level of precision and coordination that is unprecedented in the history of financial regulation. It is a process that unfolds in real-time, with resolution authorities making critical decisions under intense scrutiny and with incomplete information. The successful execution of a derivative bail-in depends on a number of factors, including the quality of the resolution plan, the cooperation of the failing institution, and the ability of the resolution authority to communicate effectively with all stakeholders.

The Resolution Weekend ▴ A Race against Time

The execution of a bail-in typically takes place over a “resolution weekend,” a frantic 48-hour period during which the resolution authority must take control of the failing institution, assess its financial position, and implement the resolution plan. The resolution weekend is a race against time, as the resolution authority must complete its work before the markets reopen on Monday morning. Any delay or misstep can have serious consequences, as it can erode confidence and trigger a wave of selling that can destabilize the entire financial system.

The resolution weekend is the crucible in which the theoretical constructs of resolution planning are tested against the harsh realities of a real-world crisis.

The first step in the resolution weekend is to establish a clear chain of command. The resolution authority will appoint a team of experts to oversee the process, and it will work closely with the management of the failing institution to ensure that it has the information and support that it needs. The next step is to conduct a rapid but thorough assessment of the institution’s financial position. This includes a detailed valuation of its assets and liabilities, with a particular focus on its derivative portfolio.

This is a challenging task, as many derivative contracts are bespoke and difficult to value. The resolution authority will often rely on a combination of internal models and external experts to arrive at a fair valuation.

The Bail-In Cascade ▴ A Step-by-Step Process

Once the valuation is complete, the resolution authority will begin the process of bailing in the institution’s liabilities. This is a carefully sequenced process that follows a strict hierarchy of claims. The first losses are absorbed by the shareholders, followed by the holders of subordinated debt, and then the senior unsecured creditors.

The bail-in of derivative contracts is a particularly complex part of this process, as it involves the termination and close-out of a large number of contracts. The resolution authority will work closely with the central counterparties (CCPs) that clear many of these contracts to ensure that the process is orderly and that it does not trigger a wider market disruption.

The Bail-In Process for Derivative Contracts

• Step 1 ▴ Identification and Valuation ▴ The resolution authority will identify all of the failing institution’s derivative contracts and will work with the CCPs and other counterparties to value them.
• Step 2 ▴ Termination and Close-Out ▴ The resolution authority will then terminate the contracts and calculate the net amount that is owed to or by each counterparty.
• Step 3 ▴ Set-Off and Netting ▴ The resolution authority will then set off the amounts that are owed to and by each counterparty, resulting in a single net payment.
• Step 4 ▴ Bail-in of Net Claims ▴ Any remaining net claims that are owed by the failing institution will be bailed in, with the creditors receiving new shares in the recapitalized institution in exchange for their claims.

The Post-Resolution Landscape ▴ A New Beginning

The successful execution of a derivative bail-in is not the end of the story. The recapitalized institution will emerge from the resolution process with a clean balance sheet and a new lease on life. However, it will also face a number of challenges.

It will need to rebuild its reputation, regain the trust of its customers and counterparties, and adapt to a new regulatory landscape. The resolution authority will continue to play a key role in the post-resolution period, as it will oversee the implementation of the restructuring plan and will monitor the institution’s progress.

The post-resolution landscape is also likely to be shaped by the lessons learned from the crisis. The experience of executing a derivative bail-in will provide valuable insights into the strengths and weaknesses of the resolution framework, and it will help to inform future reforms. The goal is to create a more resilient financial system, one that is better able to withstand the failure of a major institution without triggering a systemic crisis.

Reflection

The evolution of the bail-in mechanism represents a fundamental rethinking of the social contract between the financial system and the society that it serves. It is a recognition that the era of “too big to fail” is over and that the costs of failure must be borne by those who have benefited from the upside. The bailing-in of derivative contracts is the ultimate test of this new paradigm. It is a complex and challenging undertaking, but it is one that is essential for the long-term health and stability of the financial system.

The ability to execute a derivative bail-in without triggering a systemic crisis is the ultimate measure of a resolution authority’s competence and credibility.

The journey towards a more resilient financial system is far from over. There will be new challenges and new crises, and the resolution framework will need to continue to evolve and adapt. But the progress that has been made since the 2008 crisis is undeniable.

The development of the bail-in mechanism, the creation of dedicated resolution authorities, and the growing recognition of the importance of international cooperation have all helped to make the financial system safer and more stable. The road ahead will be long and arduous, but the destination ▴ a financial system that is both dynamic and resilient ▴ is well worth the journey.