Recovery and resolution plans
Although often used interchangeably, Recovery and Resolution Plans are two distinct plans designed to be invoked at different stages of a SIFI’s distress.
Recovery plans are detailed strategies for rapid, orderly and least cost recovery of a financial institution in the event of severe distress. An effective plan sets out the menu of actions a bank can use to recover from either idiosyncratic or systemic financial stress or both. Resolution plans, on the other hand, are designed to facilitate the effective wind-down of financial institutions without severe systemic disruption and without exposing tax payers to any loss.
An event may trigger a liquidity or capital crisis, which takes an institution below a ‘crisis threshold’. Below this threshold, and if reacted to on time, is the ‘recovery zone’, where pre-determined actions can be employed to recover from the negative shock. If allowed to continue, the institution crosses the ‘failure threshold’, at which point efficient resolution activities will have to be used to facilitate its effective wind-down. As a start, CBN and NDIC framework requires all DSIBs to submit only recovery plans.
Key components of a recovery plan
Recovery plans should be realistic, challenging and should force financial institutions to consider taking bold, and potentially unpalatable, actions in advance of a stress to avoid failure. A recovery plan should describe the actions to be taken when severe stress is indicated. The stress indicators need to be clearly established to provide the board and management with knowledge of the urgency of implementing a plan should it become necessary. The timing of implementing the plan is critical as once the market gets wind of the state of distress, stopping the slide, as with Lehman’s, becomes almost impossible. A credible recovery plan should include:
Strategic analysis: A background on the bank, its legal structure, and existing strategy. Its risk profile and framework already in place to address the various risks. The strategic analysis identifies the bank’s core business, critical economic functions and material entities. Recovery indicators and triggers are selected and developed along the bank’s framework for qualitative and quantitative indicators. This section of the plan details how indicators will be monitored regularly.
Robust scenario and stress testing: Scenario definition including market-wide, idiosyncratic, and combined scenarios; identifying the impact of events on capital, liquidity, profitability and operations. Recovery plans should include the definition, analysis and quantification of specific scenarios in order to determine and test the efficacy of the recovery options. The plans establish the metrics that will trigger the consideration of the implementation thereof. Unlike standard stress tests, scenario testing under recovery planning should be approached more robustly and should cover the entire stress spectrum. It should analyse the firm’s ability to respond to a wide range of internal and external stresses.
Recovery options: Selected options are broken down to granular details with a rationale provided for each. There should be a quantitative and qualitative evaluation of these options under business as usual and stress scenarios. DSIBs have to ensure the credibility of their plan through analysis of the impact of each recovery option on counterparties, creditors, clients, depositors, and market confidence.
Governance and communication: A plan for decision making during a crisis is important. Identify responsible persons and description of the escalation and decision-making process, as well as of the indicators which would trigger this process.
Document release: This is where sign-off and approval requirements by senior executives and the board are documented. From our experience in other jurisdictions, regulators typically expect to see well thought-out robust plans which demonstrate the below attributes: ownership of a plan; full integration into the risk management and crisis management framework; early warning indicators which are not set too late or too low to risk execution; a broad mix of relevant quantitative and qualitative indicators; indicators on group financial position; ready to be used operationally; any barriers to implementation removed; and operational interconnectedness fully understood by banks.
Conclusion
Recovery planning could have prevented the desperate panic at Lehman’s that engulfed the board, management and staff, and quite possibly helped to avert the firm’s demise. The cracks that were appearing in the US housing market as far back as early 2007 should have been an indicator. The sharp fall in share price following the collapse of two Bear Stearns hedge funds that were heavily exposed to MBS (just as Lehman was) was another indicator. By the time Bear Stearns was sold, the market was aware of Lehman’s plight so all recovery actions subsequently proved futile.
In Nigeria, the global financial crisis that was taking shape internationally should have served as an indicator for the banks. Liquidity was drying up fast in the traditional markets. Several banks in Nigeria had offshore credit lines and hedge funds that had exposure in the Nigerian Stock Exchange began withdrawing funds. All these were potential indicators and trigger points which with a robust plan could have resulted in action to avert the crisis that unfolded.
The Nigerian economy is currently fragile, with the fall in oil prices, ever depreciating currency and recent political changes. Many businesses are struggling to remain profitable, service their debt, and even stay afloat. Financial institutions would do well to sit up and treat recovery planning as a critical and indispensable tool for survival irrespective of whether or not they are a D-SIB.
Emeka Ilomechina
