The Hong Kong Monetary Authority, the Securities and Futures Commission and the Insurance Authority might have sweeping new powers to allocate resources in the event of a financial meltdown, according to a consultative paper that the government has just released.

Hong Kong's Government and its financial regulators are asking interested parties for a second time about the issues involved in the establishment of a 'resolution regime' for financial institutions. This includes 'financial market infrastructures,' otherwise known as exchanges. The consultation period will be three months long.

The first stage of public consultation took place between January and April last year. During this period, the Government and financial regulators met Legislative Council members, trade bodies and professional associations, and received more than 30 submissions by the end of the consultation period. An overwhelming majority of respondents backed the idea of a resolution regime in Hong Kong.

This second stage of consultation seeks views on specific aspects of the regime including: further details of the resolution options and powers proposed in the first consultation paper; the 'governance arrangements' (especially the ones that are to govern 'resolution authorities'); and safeguards that might include a compensation mechanism that promises that no creditor will be worse off than in liquidation.

There may be a need to carry out a third, shorter consultative exercise later this year. It is not inconceivable that a bill will be on the stocks by the end of the year.

Enter the FSB

The impetus for the reforms comes from the Financial Stability Board, a successor body to the shadowy Financial Stability Forum whose guidance in the run-up to the financial meltdown of 2008 was not of the best. Jurisdictions, the FSB says, should evolve processes for recovery and resolution planning. Its latest paper on the subject of crisis resolution, published in 2011, calls for clear, transparent and enforceable set-off rights, contractual netting agreements, collateralisation agreements and (most importantly for wealth managers) client asset segregation.

Client assets, it says, are typically:

(i) money held on behalf of or owed to a client by a firm that is classified as “client money” under applicable national law;

(ii) financial instruments or other assets held for or on behalf of a client;

(iii) client collateral, i.e. assets received from a client and held by a firm for or on behalf of the client to secure an obligation of the client (other than under a title transfer transaction, see paragraph 3.2 (iii)); and

(iv) assets and other (contractual) rights arising from transactions entered into by a firm on behalf of a client (for example, mark-to-market accruals arising from the change in value of futures and options positions).

Interestingly, the FSB does not include the following:

(i) deposits held by banks, except in the case of deposits held by a firm with a bank that constitute 'customer funds' under national law and are labelled as such;

(ii) assets held by an insurer or policyholder, or claims and rights in connection with insurance business; and

(iii) assets delivered in a full-title transfer transaction, such as securities lending transactions, repurchase agreements or reverse repurchase agreements, "where neither the client nor clients collectively retain proprietary or similar rights to the assets."

Another stand-out section in the document is no 7.4, which says: "National laws and regulations should not discriminate against creditors on the basis of their nationality, the location of their claim or the jurisdiction where it is payable." We wish the FSB good luck when it tries to enforce that point.

What powers should resolution authorities have?

FSB section 3.2 lists a broad range of resolution powers for the authorities. They should be able to do the following at an afflicted firm.

(i) Remove and replace the senior managers and directors and recover monies from responsible persons, including claw-back of variable remuneration.

(ii) Appoint an administrator to take control of and manage the affected firm with the objective of restoring it, or parts of it, to viability.

(iii) Operate it, wielding powers to 'terminate contracts' (which might be the FSB's phrase for making them null and void), purchase or sell assets and write off debt.

(iv) Ensure the continuity of essential services and functions by requiring other companies in the same group to continue to provide essential services to the entity.

(v) Override the rights of shareholders.

(vi) Transfer or sell assets and liabilities, legal rights and obligations, including deposit liabilities and ownership in shares, to a solvent third party. (Some say that this is the whole point of having banking crises, as they are always likely to lead to a bonanza for the huge, 'in the know', policially connected financial institutions that cluster around the world's most powerful central banks.) The money could go to a newly established bridge institution.

(viii) Establish a separate asset management vehicle and transfer non-performing loans or assets that are difficult to value to it.

(ix) Carry out a 'bail-in,' defined by the Financial Times as 'the ability to impose losses on bondholders while ensuring the critical parts of the bank can keep running.'

(x) Temporarily stay the exercise of early termination rights.

(xi) Impose a moratorium of payments to unsecured creditors and customers (excluding central counterparties) and put the claims of creditors on ice for a while.

(xii) Effect the closure and orderly winding-up of a failing firm with timely payout or transfer of insured deposits and prompt access (perhaps within seven days) to transaction accounts and to segregated client funds.

What powers should go to whom in Hong Kong?

The reason why the Government thinks that there might be another consultative paper after this one is that the nations of today tend to march in lock-step behind the international instutions that the major banks set up at the end of the Second World War - the Bank for International Settlements, IOSCO and so on - and one of these might have to reach another set of decisions before Hong Kong can be happy that it has received a full set of instructions.

Neglecting this for a moment, then, the paper refers to its predecessor which set out two types of resolution regime. The first suggestion was for each of the sectoral regulators (the HKMA, the SFC and the IA) becoming the resolution authorities for financial institutions under their respective purviews. The second was to set up a stand-alone cross-sector resolution authority. Respondents backed the first proposal, partly out of a desire to suck up to their existing regulators and partly to comply with the maxim "better the Devil you know than the Devil you don't."