With criminal penalties for bank mismanagement, the absence of clear standards for banks’ recovery plans leaves outliers feeling exposed, so what should you do?
The EBA recently received industry responses to two consultation papers it issued in May. They concern technical standards on scenarios banks should use to test their recovery plans, and how RRPs will be assessed by the regulator. The responses give us the first sense of where the herd is on this issue, but this means we can also now see who the outliers are. With prison sentences now on the cards for mismanagement, this will give boards and senior management cause for serious concern.
The basic picture revealed is one of wide variance of standards and a lack of consistency across the industry as firms prepare to meet the operational challenges RRPs present, as well as divergent levels of preparedness. Additionally banks are seeking to water down what they view as overly prescriptive and inappropriate conditions imposed by the draft rules.
In the responses there are persistent calls for recovery plan standards to be less prescriptive, so that recovery plans can be tailored to institution-specific factors and national context. In particular, banks are calling on the regulator to move towards a qualitative rather than quantitative view of the plans, ensuring that the lengthy list of metrics and data they are being asked to deploy be seen as optional suggestions rather than mandatory requirements for all scenarios. There is opposition developing to the requirement to model both fast and slow moving scenarios, and suggestion that the distinction between these is poorly defined. More generally, there is an argument developing that ‘less is more’ with regard to stress-testing scenarios and that it is a mistake to think that regulators can predict the next crisis.
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- What additional flexibility may regulators grant to ignore certain metrics in the preparation of recovery plans if they are deemed inappropriate to institution-specific factors?
- With the number of stress testing scenarios used by banks currently so divergent, where will the benchmark ultimately be set?
- Will the costs of RRPs be born disproportionately by smaller firm, and if so will this have any impact on competition in the banking sector?
Wide variance also appears to be developing in how many scenarios banks are modeling, with anywhere between one and ten reported. On average, banks developed between three and six scenarios, made up of a mix of system-wide, idiosyncratic and combined scenarios. On the one hand, this suggests the banks that are playing safe by using more scenarios may be wasting management time and resources preparing these tests. On the other hand, if this upper limit becomes a norm expected by regulators, those arguing that more scenarios are unnecessary may be in for a costly shock.
Many firms also oppose mandatory reverse stress-testing, which is included in the draft standards, on the grounds that this is inappropriate to recovery options. A common argument in the responses is that, since stress tests are supposed to establish the viability to restore an institution to health, testing them to destruction is nonsensical. Again, this approach assumes that we can predict future financial crises.
As could be expected, there is industry discontent over the costs of preparing complex recovery plans and testing them against multiple stress scenarios. In particular, the complaints focus on the possibility of duplication of efforts through producing plans at both the group and local level, with some blaming a lack of co-ordination on the part of EU regulators and uncertainty on when and where institution-specific plans are mandatory.
There are also arguments that costs are not proportionate to the size of a firm, and will fall more heavily on smaller institutions. The situation highlights the wider issue of the incompatibility between two major current aims of international regulators: on one hand seeking to encourage new market entrants and spur competition, while on the other hand wishing to ensure existing banks are more intensely supervised and regulated to safeguard the taxpayer against future crises. In developing prescriptive, detailed and costly standards which achieve the latter, regulators raise barriers to entry and baseline operating costs which preclude the former.
The next few months will be a crucial time in the formation of the European RRP regime, with the RRD due to be finalised during trialogue discussions in November. At stake are issues which could have crucial operational impacts as banks gear up for RRPs as BAU, such as the speed at which firms will have to respond to on-demand data requests for financial contracts required to assist resolution authorities. Member States will then have a year to transpose the directive into national law, meaning a likely implementation date of 2015. Time is running out for the industry to align expectations and best practice, and it is unclear how far the technical standards will be relaxed or loosened in this period.
The bottom line is, you need to decide what standards your firm is going to adhere to for your RRPs. This means talking to the board about their appetite, looking at what your competitors are doing and taking the initiative when it comes to engaging with regulators.
- Banks are resisting what they view as overly detailed and prescriptive rules on stress testing recovery plans
- There is wide variance developing in how banks are conducting stress testing for recovery plans, with the number ranging from 1-10
- Firms are increasingly questioning the utility of the use of reverse stress tests in the context of recovery plans