In its recent consultation on SPOE, the FDIC asked questions that touched on key elements of the MPOE model, including geographic ring-fencing of capital and businesses (such ring-fencing has become an increasing trend across the industry). In turn, this article seeks to answers some of the most frequently asked questions about MPOE: What are the characteristics of an MPOE group? How does the MPOE approach work in resolution? Why do some banks and regulators prefer the MPOE model?

What are the characteristics of an MPOE group?

Management preference, efforts to expand internationally, and regulatory requirements have all combined to determine the structure of today’s global banking groups; and therefore, it is clear that a range of different approaches to resolution were required to deal with the variety of legal structures and business models that exist today. The two approaches outlined by the Financial Stability Board in its Key Attributes paper were therefore stylized—at opposite ends of a spectrum for theoretical purposes—and the definition of MPOE was naturally broad:

“…the application of resolution powers by two or more resolution authorities to multiple parts of the group (ideally simultaneously), including strategies in which the group is broken up into two or more separate parts. While the resolution of these parts would be under the direction of host authorities, the home authority should play a role in ensuring that the resolution process is coordinated.”1

In reaching an assessment that a group is organized so that resolution can be effected on an MPOE basis, there are four key characteristics to be considered.

SUBSIDIARIZATION

Subsidiarization can be a key element of the MPOE strategy, because it neatly defines the point-of-entry at which local supervisors and resolution authorities can intervene, and the legal entity is the corporate vehicle that is placed into resolution. The MPOE model is, therefore, understandably favored by banks that have developed their businesses through a network of locally incorporated banks that are capitalized by their holding company to meet all local requirements, but which are then individually responsible for their own funding requirements and liquidity facilities.

These local banks are typically entities that have been acquired by their holding company as the holding company expands its geographic footprint; and, in many cases, these local banks retain the characteristics of local retail banks. They are often funded almost entirely by local retail deposits and local wholesale funding from domestic markets in local currency. Such banks will be locally supervised so that the host country determines the prudential rules under which they operate—often creating reporting issues for the group as different regulations are overlaid further up the corporate chain. The local banks will also be involved fully in the local deposit guarantee scheme, and any resolution process would be led locally.

As separately incorporated entities, these banks will have their own boards of directors, including non-executive directors, and a bank-specific governance process. But this model in no way precludes the development of a common culture across entities under common control and approaches to business and risk can be applied across these subsidiaries within a global framework. While this requires a degree of coordination and cooperation, done well, this can produce a very effective blend of local implementation under global direction within global standards.

Intra-Group Exposures

To make subsidiarization effective, and to have the capability of ring-fencing these local operations for resolution purposes, there need to be strict controls on intra-group financial interdependencies and other exposures between group entities. If these were widespread, this would undermine subsidiarization and hamper the clean separation and resolution of a troubled subsidiary, risking contagion throughout the group. As a result, the FSB guidance on MPOE structures says, “…exposures between group entities may need to be reduced and any intra-group funding should be provided at ‘arm’s length’ and subject to appropriate large exposure limits.”2

This does not mean that there can be no financial links between members of the same group. All banks have intra-group arrangements with domestic and international counterparties to facilitate their business. It is natural that a bank within a wider group should create financial links with its affiliates as they will have common standards on products and customer service and share business goals and risk appetite. For an MPOE firm, however, these exposures are necessarily monitored as if the counterparties were fully at arms’ length with appropriate documentation and risk management requirements and in compliance with the relevant large exposures regulations.

Within this framework, the holding company at the head of the financial group can still operate as a source of strength and provide capital support for its subsidiaries. The large, geographically diverse franchise it heads offers considerable scope for the parent company to raise funds both internally and externally to provide capital support to an ailing subsidiary. Dividends can be raised from other subsidiaries, businesses can be sold to raise cash, and shareholders can be asked to contribute cash, capital or reduced dividends, which is perhaps likely for wider, well performing business.

In troubled times, parent companies and their shareholders will have a clear interest in ensuring that their subsidiaries remain solvent, because, for example, they will have made considerable investments in these businesses and supporting them will offer the best opportunity to maximize the return on that investment. In addition, any banking group will be aware of the possible long-term negative reaction from markets, customers, staff and other stakeholders if the parent is seen as not providing support to its subsidiary where it has the resources to do so.

Operational Resilience

Achieving clarity on financial linkages sets boundaries on the potential financial contagion that could arise within a financial group; it is also critical that during a stress event, all businesses continue to receive core services, even if they leave the group or if another group member fails. Again, the Financial Stability Board is clear that a credible resolution strategy will require that “…critical services be provided through structures that are resilient and adequately protected from failure of different parts of the group.”3 In the failure of Lehman, it was operational linkages between subsidiaries that caused some of the greatest disruption in the early hours and days of resolution.

Continuity of critical services could be addressed at the regulatory level, where supervisors and prospective resolution authorities could agree to use their ‘best endeavors’ to ensure that systems and services remain in place provided that the banks continue to pay. But the promises of regulators may not be sufficient to quell concerns about operational continuity, and many MPOE firms are focusing on creating separate operational subsidiaries.

These are companies within the financial group with the sole function of providing services, including IT systems, back office processing and other support services, which are shared across the members of the group. These services would be provided under contracts that would survive the resolution of any bank within the group and allow for that bank to leave the group if that is the consequence of its resolution. Tax rules, as well as their own operational integrity, will mean that these operational companies have a degree of financial separation—they will charge for their services with a profit margin and hold a cash buffer so there is no danger of bankruptcy even if some customers and revenues disappear. The cash buffer will also allow the company time to adjust its operating model while continuing to provide services to the remaining banks.

Provision of Information

To meet regulatory requirements, MPOE firms need to be able to produce “…legal entity specific information upon request in respect of their recovery or operational resolution plans for all legal entities that are systemic in the home or any host jurisdiction” and prove that “Management Information Systems should be readily separable from the rest of the corporate organization so that they can be used at the local subsidiary or bloc level.”4

This is consistent with the core principle that resolution shall be conducted at the local level. These separate banking subsidiaries will have a full set of local information, and they must inform their local regulators of their activities and risk exposures (on local GAAP and under local supervisory rules), as well as have local internal governance processes covering all areas of the firm culminating in oversight from the local board with non-executive representatives, sitting alongside group executives.

For resolution purposes, they will prepare an individual resolution plan since the process may vary from country to country, even if it complies with the FSB’s Key Attributes. These plans will be approved locally but they will also form part of the wider group resolution strategy, to be agreed between the various regulators and coordinated by the home supervisor through the Crisis Management Group. This group is a sub-set of the Supervisory College and will contain the regulators for all the major banking entities within the group.

How does the MPOE approach work in resolution?

Having considered the characteristics of MPOE banks, it is worth rehearsing how an MPOE approach to resolution works in practice, illustrating why the above attributes are important to making this model work.

Emerging Issues and Support from the Group

In any banking group, the issues will be at the front-line—where loans are made, risks are taken and losses incurred. As these emerge, steps will be taken in the ordinary course of business or under a Recovery Plan to address the deficiencies. This may mean changes in the scale or nature of the business undertaken to reduce costs or capital requirements or additional capital resources being requested from the group.

At this stage, the wider group is a considerable source of strength for the ailing subsidiary given a diverse range of strategies available to find additional capital. Ultimately, however, there will be limits on the support that can be provided. Capital cannot be stripped from any other bank in the group without supervisory approval, and there will eventually be limits on what the market is prepared to provide to the wider franchise. Any final determination not to provide additional support would be made only after the most searching internal consideration, given the reputational impact; but at some point, in extremis, the holding company may be forced to inform the local bank and its supervisors that it cannot provide any further cash.

Local Resolution

At this point, the troubled bank subsidiary would be placed into local resolution where the outcome could vary considerably depending on the nature of the bank and the local resolution regime, including its approach to gone-concern loss absorbing capacity (“GLAC”).

Where the local operations are not domestically significant, it is likely they could be either wound-up or transferred within the private sector through a purchase-and-assumption agreement, much as smaller banks are resolved by the FDIC in the U.S. For larger and more systemically important banking operations, other steps will need to be taken. These will critically depend upon the local resolution regime in place at the start of the crisis in any country, but they may also be affected by much wider issues including:

• The nature of the crisis affecting the bank—is it systemic within that country or idiosyncratic?
• The social and political stance to the banking system—is public ownership considered feasible and how should moral hazard be addressed?
• The structure of the financial system—who will suffer in different resolution scenarios and is that fair, and what are the safety nets?
• The scale of liquidity support which is available—how much time will the central bank give for assets to be realised and will this improve long-term solvency?

These are significant issues that must be considered when the local resolution regime is established and its GLAC strategy is put in place. At present, the FSB is only working on proposals for a GLAC framework for G-SIBs, but for local banks, we would expect the strategy which any country adopts to be heavily influenced by the above questions and fundamental decisions about the nation’s risk appetite for bail-out as opposed to bail-in. Any loss-absorbing capacity is not free and countries need to balance the benefits of financial stability with the economic consequences of curtailing credit creation through regulation. As the UK Chancellor observed, there is a need to avoid “the financial stability of a graveyard”. Where the ultimate decisions on these issues are local—as they are for capital support for a locally incorporated bank—a consolidated metric for GLAC across an MPOE group may not be an appropriate measure.

Where bail-in is adopted, control of the bank could pass outside of the group to another set of shareholders. This was the outcome when the Cooperative Bank in the UK was restructured in 2013 with external shareholders holding 70% of the shares while the original parent retains a 30% interest. Of course, in a resolution scenario, the bank may leave the group in other ways, for example through temporary conservatorship by resolution authorities or by direct public intervention.

In any circumstances, the bank has to retain its access to the shared services provided by the group’s operational subsidiaries, subject to continuing to pay. As discussed above, the contracts underpinning these services need to account for both the resolution of the bank, as well as a continuing situation where it ceased to be a member of the original group.

Impact on the Remaining Group

The supervisors of other banks within the impacted group have to be kept up to date with the decisions taken at a local level through the Crisis Management Groups and any institution specific Cross-Border Cooperation Agreements (“COAGs”).

The absence of significant financial linkages in MPOE groups will act as a natural firewall to avoid negative spillover effects to other jurisdictions. Inevitably, there will be questions of confidence for the remaining bank subsidiaries within the group, but systemic issues typically arise within jurisdictions and asset classes rather than idiosyncratically within a banking group. Where there are no troubles outside the failed subsidiary, the other banks in the group will remain solvent. Their liquidity buffers and, ultimately, central bank liquidity facilities should be sufficient to address increases in retail customer withdrawals and curtailed wholesale funding. Ironically, in a globally connected world, ‘bad news’ from other banks in the same country may have more impact than problems within the group that arise overseas.

Why might some banks and regulators prefer the MPOE model?

Given the characteristics outlined above, there are some banks that naturally favor an MPOE model. History and business models are key determinants of how the structure of financial groups has developed. Those who have grown through acquisition and through more locally focused delivery of products or services tend to favor MPOE. For example, the HSBC Group has two home markets and a further 20 markets that are priorities for growth in which there is significant local presence, albeit not necessarily for all customers and products in all markets.

Critics of this model point to drawbacks such as the lack of fungibility for capital and funding across the various entities within the group and note that this can lead to inefficiencies where excess resources are trapped within a local entity and cannot be deployed. But, with experience, these issues can be managed, and an acceptable return can be delivered to shareholders. Banks structured on an MPOE model have proved to be enduring and resilient in recent years. And for these banks and their regulators, the MPOE model can offer material advantages:

• Most banks within an MPOE structure operate predominantly within a single country, even when serving internationally orientated customers. This allows for a greater alignment between the corporate structure and the mandates of supervisors and resolution authorities on issues such as capital, loss-absorbency, and resolution strategies where they are locally focused.
• While there will still be coordination amongst regulators in any resolution scenario, local regulators have clear and direct control over the local process without needing to rely on resources or actions from other countries to be able to implement their preferred strategies.
• For national regulators and governments, subsidiarization provides them with a mechanism to ensure that resources cannot be extracted from jurisdictions to support a troubled business to the detriment of local solvency. There is also clarity for central banks about who will benefit if they provide liquidity facilities to support that solvent bank if it suffers contagion effects.
• Ultimately, it enables the group and its shareholders to limit their financial exposures to particular jurisdictions. Resolution at the level of the local subsidiaries (and avoiding pushing losses to the holding company) limits the group exposure to the equity investment that has already been made and any additional investment which those shareholders voluntarily chose to make or are required by regulators to make.
• This also reduces the extent to which creditors, such as debt holders in a consolidating entity that may be disproportionately from that jurisdiction, will suffer from a failure in another country. This in turn reduces the secondary contagion risks from resolution into this investor community and beyond.

The MPOE model is not suited to all banks, but, I believe that it is important that there is diversity of model in the financial system. Systemic risks increase if all providers of finance are organized in a similar fashion and rely on the same pools of capital, liquidity and funding. MPOE clearly requires a particular structure that many banks do not have, and they would incur significant costs and operational risks in moving to this model. However, if implemented in the right group, and in the right way, it can be an effective approach to resolution by providing greater certainty on resolution outcomes. •