What’s the link between solvent wind down exercises and resolution valuations?
October 07, 2016
Stress testing has been applied to the UK banking system since December 2014 to assess capital adequacy, but only on the seven largest UK banking institutions rather than on the Prudential Regulation Authority (PRA) regulated UK subsidiaries of overseas banks.
Since 2015 these overseas banks have been requested to conduct Solvent Wind Down (SWD) exercises by the PRA. This is seen as an alternative to stress testing and can be considered as a deep recovery or a resolution option.
The PRA is using these SWD exercises to understand the costs of winding down a business. In the case of overseas banks, these costs would mainly relate to the trading book e.g. additional exit costs due to the loss of market maker exemption, concentration of positions, capital value adjustments and operational costs. SWD also provides a view on the business model and intercompany dependencies, an understanding of the maturity and complexity of the trading book as well as a view on the funding and liquidity implications resulting from the wind down. Given the usefulness of the SWD exercise from a supervisory, recovery and resolution perspective, don’t be surprised if it expands to other UK banks as well as European banks….
BoE gathering insight on SWD exercises
So how do these SWD exercises interact with resolution valuations? The SWD guidance in 2016 includes a requirement to assess the economic hold value of amortised cost assets (i.e. loan books), which suggests that the Bank of England (BoE) is exploring how insights from SWD exercises can be applied for resolution planning. The wind-down costs that are derived as part of the exercise are a useful way for the authorities to assess the destruction in value under the Bank Recovery and Resolution Directive’s (BRRD) Article 49 and whether a derivative liability subject to a netting agreement could be included or excluded from bail-in.
Increasing frequency of SWD exercises
SWD exercises assist resolution authorities in understanding the cost of winding down trading books whilst aligning finance and risk systems (similar to stress testing). As such, recovery and resolution planning can be seen as a positive force in improving business-as-usual risk management. We are likely to see SWD exercises being requested from a wider population of banks on an annual basis by regulatory authorities.
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