Recovery and resolution planning: Meaning, Criticisms & Real-World Uses

What Is Recovery and Resolution Planning?

Recovery and resolution planning refers to a critical component of modern financial regulation designed to ensure that large, complex financial institutions can fail in an orderly manner without triggering a broader financial crisis or requiring a taxpayer-funded bailout. It falls under the umbrella of systemic risk management, aiming to mitigate the "too big to fail" problem. This process involves two distinct but interconnected parts: recovery plans, developed by the institutions themselves to restore their financial health during times of severe stress, and resolution plans, crafted by regulatory authorities to facilitate an orderly wind-down if recovery efforts fail. The ultimate goal of recovery and resolution planning is to safeguard financial stability and protect essential economic functions.

History and Origin

The concept of recovery and resolution planning gained significant traction in the wake of the 2008 global financial crisis. Before this period, there was often no clear, pre-defined framework for how to manage the failure of large, interconnected financial firms other than through government intervention, leading to massive public bailouts. The crisis highlighted the systemic risks posed by institutions deemed "too big to fail," meaning their disorderly collapse could severely destabilize the entire financial system²⁰.

In response, international bodies and national governments began developing robust frameworks to address this challenge. A key milestone was the Financial Stability Board (FSB)'s adoption of the "Key Attributes of Effective Resolution Regimes for Financial Institutions" in October 2011, endorsed by G20 leaders the following month¹⁸, ¹⁹. These attributes set out core elements necessary for effective resolution regimes, including requirements for recovery and resolution planning¹⁶, ¹⁷.

In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandated that large banking organizations and other systemically important financial companies submit "living wills," which are essentially resolution plans, to the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC)¹⁴, ¹⁵. Similarly, in Europe, the Bank Recovery and Resolution Directive (BRRD), adopted in June 2014, aimed to harmonize resolution frameworks across European Union member states and required banks to prepare recovery plans and granted authorities powers for orderly resolution¹², ¹³. This legislative push marked a global shift towards proactive crisis preparedness rather than reactive crisis management.

Key Takeaways

Proactive Preparedness: Recovery and resolution planning mandates financial institutions to develop strategies for managing severe financial distress and enables authorities to plan for their orderly failure.
Mitigating Systemic Risk: The primary objective is to prevent the collapse of a large financial institution from causing widespread disruption to the broader financial system.
"Living Wills": These plans, often referred to as "living wills," detail how a firm can be resolved without resorting to taxpayer bailouts.
Separation of Functions: Recovery plans are internal to the institution, while resolution plans are developed by regulatory authorities.
Global Harmonization: International standards, such as those by the Financial Stability Board, aim to ensure consistency in recovery and resolution frameworks across jurisdictions.

Interpreting Recovery and Resolution Planning

Recovery and resolution planning serves as a blueprint for action when a financial institution faces severe stress or failure. The interpretation of these plans revolves around their credibility and feasibility. For regulators, a well-structured recovery plan indicates that an institution has a clear strategy to restore its viability under adverse conditions, potentially averting the need for external intervention. This includes identifying critical functions, assessing potential liquidity shortfalls, and outlining steps to restore capital requirements.

Conversely, a robust resolution plan, often involving mechanisms like bail-in (where creditors absorb losses), demonstrates that authorities can manage a failure without creating contagion or requiring public funds. The assessment of these plans involves rigorous analysis by regulatory bodies to ensure they are actionable and effective, providing a clear path to an orderly resolution even in complex, cross-border scenarios. The ultimate success of recovery and resolution planning is measured by the ability to manage distress with minimal disruption to the financial system and taxpayers.

Hypothetical Example

Consider "Global Bank Inc.," a large, internationally active financial institution. As part of its recovery and resolution planning, Global Bank Inc. regularly updates its recovery plan.

Recovery Plan Scenario: A severe, unexpected geopolitical event causes a sharp decline in market confidence, leading to significant deposit outflows and a sharp drop in Global Bank Inc.'s stock price.

Steps in the Recovery Plan:

Trigger Event: A pre-defined threshold for liquidity depletion is breached.
Internal Actions:
- Management Actions: The bank's crisis management team convenes.
- Liquidity Management: Activate emergency funding lines, access collateralized borrowing from the central bank (if eligible), and implement a temporary freeze on discretionary lending.
- Capital Restoration: Announce a plan to issue new equity or contingent convertible bonds (CoCos) to bolster its capital base, potentially through a rights offering to existing shareholders.
- Asset Sales: Identify and prepare for the orderly sale of non-core assets or business lines to generate cash and reduce risk exposure.
- Operational Resilience: Ensure critical operations, such as payment systems and client services, remain functional despite the stress.

If, despite these recovery actions, Global Bank Inc. continues to deteriorate and is deemed no longer viable, the resolution plan would be activated by the regulatory authority. This plan would detail how the bank's critical functions could be maintained, potentially through a temporary "bridge bank" or a strategic transfer of assets and liabilities, while non-critical parts enter standard insolvency proceedings.

Practical Applications

Recovery and resolution planning is a fundamental aspect of contemporary financial oversight, manifesting in several key areas:

Regulatory Oversight: Supervisors, like the Federal Reserve, FDIC, and the European Banking Authority (EBA), continually review and assess the adequacy of these plans submitted by financial institutions¹⁰, ¹¹. This includes conducting resolvability assessments to identify and remove any impediments to an orderly resolution⁹.
Cross-Border Cooperation: For global financial institutions, recovery and resolution planning necessitates extensive international cooperation among various national regulators. This collaboration aims to ensure that a firm's failure in one jurisdiction does not create unmanageable problems in others⁸. The Financial Stability Board's "Key Attributes" specifically address legal framework conditions for cross-border cooperation and institution-specific cross-border cooperation agreements⁷.
Financial Market Infrastructure: The principles of recovery and resolution planning extend beyond traditional banks to other critical financial market infrastructures, such as clearinghouses, given their systemic importance.
Contingency Planning: Banks themselves use recovery plans as internal blueprints for how they would respond to a severe crisis, outlining potential actions to restore viability without external support. This enhances their internal risk management capabilities.
Stress Testing Integration: Recovery and resolution planning is often integrated with stress testing exercises, where hypothetical adverse scenarios are used to evaluate the resilience of a financial institution's business model and the effectiveness of its recovery strategies.

Limitations and Criticisms

Despite its crucial role in financial stability, recovery and resolution planning faces several limitations and criticisms:

Complexity of Execution: Resolving large, globally interconnected financial institutions is inherently complex. Critics argue that even the most detailed plans might struggle to account for the dynamic and unpredictable nature of a real-world crisis, especially those involving rapid market discipline events⁵, ⁶. The sheer volume of information and coordination required across multiple jurisdictions can be overwhelming.
Cross-Border Challenges: Achieving seamless cross-border cooperation remains a significant hurdle. Legal differences, varying national interests, and the difficulty of coordinating simultaneous actions across different regulatory authorities can impede an orderly resolution³, ⁴.
Credibility of Bail-in: While bail-in is a central tenet of resolution frameworks, its practical application during a severe crisis, particularly concerning certain types of liabilities or retail investors, can be politically and economically challenging².
Operational Readiness: The operational capabilities of firms and authorities to execute resolution plans, including rapid access to information and the ability to maintain critical functions, have been highlighted as areas needing further development¹.
Moral Hazard Persistence: Some argue that even with recovery and resolution planning, an implicit guarantee for very large institutions might persist, potentially perpetuating moral hazard by reducing the incentive for market participants to monitor these firms stringently.
Information Asymmetry: Regulators face challenges in obtaining real-time, comprehensive data from complex institutions, which is essential for effective planning and intervention.

Recovery and Resolution Planning vs. Crisis Management

Recovery and resolution planning (RRP) is a specialized and proactive component within the broader discipline of crisis management in finance. Crisis management encompasses all actions and strategies taken by financial institutions and authorities to prevent, mitigate, and respond to financial crises or severe disruptions. This can include immediate liquidity provision, emergency lending, market interventions, and coordinated policy responses.

RRP, specifically, focuses on the preparedness phase for potential failures. Recovery plans are developed by the institutions themselves, outlining their internal strategies to restore viability under stress. Resolution plans, on the other hand, are designed by regulatory authorities to facilitate the orderly wind-down of a failing institution, typically involving tools like receivership or bail-in, to avoid systemic disruption and taxpayer cost. While crisis management deals with the immediate, unfolding events and reactive measures, recovery and resolution planning represents the strategic foresight and pre-emptive arrangements put in place to manage the failure of systemically important entities in a controlled manner, thereby minimizing the need for extraordinary crisis management interventions.

FAQs

What is the purpose of a recovery plan?

A recovery plan is an internal document prepared by a financial institution that outlines its strategy and actions to restore its financial soundness and viability during a period of severe financial stress. It aims to prevent the institution from failing by addressing issues such as liquidity shortfalls or capital depletion through pre-defined measures.

Who is responsible for creating resolution plans?

Resolution plans are developed by regulatory authorities, such as the Federal Reserve and the FDIC in the United States, or national resolution authorities in the European Union, rather than by the financial institutions themselves. These plans detail how a firm would be wound down in an orderly fashion if its recovery efforts fail, aiming to protect financial stability.

What is a "living will" in finance?

A "living will" is another term for a resolution plan. It describes a comprehensive strategy that a large financial institution would use for its rapid and orderly resolution in the event of material financial distress or failure. The goal is to ensure that the institution can be dismantled or restructured without causing significant disruption to the financial system or requiring government bailout funds.

How does recovery and resolution planning protect taxpayers?

By enabling the orderly failure of large financial institutions, recovery and resolution planning aims to prevent the need for public funds to support or rescue these entities. Mechanisms like bail-in ensure that shareholders and creditors bear the losses, rather than taxpayers. Additionally, the maintenance of critical functions minimizes broader economic damage that could lead to indirect costs for the public.

Does recovery and resolution planning apply to all financial institutions?

Typically, recovery and resolution planning requirements are applied to large, complex, and systemically important financial institutions (SIFIs) whose failure could pose a significant risk to the broader financial system. Smaller institutions may be subject to different, less extensive supervisory frameworks, though all regulated institutions have some form of contingency planning and are subject to deposit deposit insurance schemes where applicable.