As we know only too well large financial institutions are of "systemic" importance to any economy. When a large bank fails it has the potential to infect other banking institutions in an economy and this contagion can cripple a country and cause political and social upheaval. As a result of the ongoing financial crisis other jurisdictions, not least the US and Britain have recognised this and have legislated for "Special Resolution Regimes" (SRRs) through the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Banking Act 2009 respectively. SRRs are a legislative instrument the IMF have been advocating for Ireland for some time.

Now, following the finalisation of the Memorandum of Understanding (MOU) underpinning the recent stability package agreed between Ireland, the European Central Bank (ECB) and the International Monetary Fund (IMF), Ireland is indeed obligated to introduce draft SRR legislation before the end of February 2011.

So what are SRRs and how do they work? More importantly should Ireland have introduced a SRR already and is it now too late?

Put simply, SRRs enable a more orderly resolution of failing banks. Banks are not like other non-financial institutions. Banks are not suited to the normal insolvent winding up and bankruptcy procedures set out in legislation applicable to normal trading companies.

Key to ensuring an effective SRR is the enactment of proper facilitative legislation. The legislation underpinning an SRR must specifically contemplate how the banks shareholders, creditors and depositors are dealt with if a bank fails. Ideally an SRR will be comprised of a number of elements:

1. The minimisation of financial and economic costs (including the protection
   of the supply of credit to the economy);
   
   
2. Ensuring a minimum level of protection to depositors;
   
   
3. Does not bail out shareholders; and
   
   
4. Capable of implementation in a transparent and timely fashion.

The legislation should also contemplate how authorities can intervene in order to save a bank which, while on the verge of collapse, is still capable of being recovered should an appropriate purchaser emerge. This may involve splitting the bank into a good bank and a bad bank. It may also contain provisions for the creation of a bridge bank where no purchaser emerges during the resolution process. The legislation may also contain a level of immunity for the authorities protecting against prosecution by any party who feels they were compromised by the process. This is usually provided for on public policy grounds. The more tools available to the authorities, the greater the chance of a speedy and orderly resolution of the bank.

Britain did not have SRR legislation in place at the time of the Northern Rock crisis in late 2007. The Banking Act, enacted in February 2009 was the response to the risk of large financial institutions failing. The legislation created a SRR built upon the tripartite authority of the Bank of England, HM Treasury and the Financial Services Authority (the FSA).

The SRR gives these authorities the power to:

1. Transfer all or part of a failing bank to a private sector purchaser;
   
   
2. Transfer all or part of a failing bank to a bridge bank, a subsidiary of the
   Bank of England, pending a future sale;
   
   
3. Place a bank into temporary public ownership (HM Treasury's decision);
   
   
4. Apply to put a bank into the Bank Insolvency Procedure which is designed to
   allow for rapid payments to the Financial Services Compensation Scheme
   insured depositors; and
   
   
5. Apply for the use of the Bank Administration Procedure to deal with a part of
   a bank that is not transferred and is instead put into administration.

Not long after its introduction the SRR was called into action. On the 28 March 2009 the FSA issued a statement that Dunfermline Building Society (DBS) was likely to fail to meet the FSA's threshold conditions for authorisation.

Over the weekend that followed the various powers available under the legislation were used to transfer much of assets and liabilities of DBS to Nationwide Building Society. Any assets and liabilities remaining were transferred to a bridge bank and this was then placed into special administration - a process to administer the run-off and potential sale of the remaining assets. On the 30 March 2009 the Bank of England issued a press release confirming that it was business as usual for the customers of DBS.

In its report Ireland 2010 Article IV Consultation published in July 2010, the IMF noted that Ireland should "take early action to introduce a special resolution mechanism ... to meet contingencies and strengthen the stability framework". The Irish government is now under an obligation to reform the banking sector following the recent MOU entered into with the ECB and the IMF. Under the terms of the MOU the Irish government must present draft legislation before the Dail by the end of February 2011 to facilitate the introduction of a SRR.

With the effective nationalisation of the largest Irish banking institutions an SRR might well be regarded as locking the gate after the Celtic Tiger has bolted. Had the process been in place at the outset of the banking crisis in 2008 it is very possible that an institution such as Anglo Irish Bank could have been resolved far more efficiently and without the enormous expense which ultimately resulted to the Irish taxpayer.

While it may seem toothless now, an SRR is one pillar of effective banking regulation that modern, developed economies must have in place. The ECB and the IMF have recognised this. Patrick Honohan recently made a speech to the Institute of Chartered Accountants in Ireland whereby he stated that the Irish banks were for sale. While there may not be too many willing buyers currently in the market we must plan now for a scenario where privately owned banks of systemic importance require an effective resolution process.

It will be interesting to see how the proposed SRR legislation will deal with the transfer of the property and shares of large financial institutions. The section in the MOU dealing with the SRR also notes that the Irish legislature will need to ensure the legislation is "consistent with similar initiatives going on at EU Level". This would appear to be a reference to recent developments in the EU regarding the resolution of crisis where cross-border financial institutions are at risk of failing. In any event the next few months will be full of interesting developments in this area.

For further information please contact Damien Barnaville.

December 2010.