The continuing UK consultation on the post-Northern Rock proposals on dealing with failing banks is set to be hard-fought. Northern Rock remains firmly on the minds of politicians. There is a sense that something must be done, but the proposals, as they stand, risk being a UK Sarbanes-Oxley – hurried, kneejerk legislation that does far more harm than good. The threat to the UK banking industry is clear and present.

At the core of the proposals is a set of powers for the tripartite authorities – the Financial Services Authority, the Bank of England and the Treasury – to take wide-ranging powers to resolve a failing bank. This is the special resolution regime (SRR). As well as nationalisation (à la Northern Rock), the authorities want powers to force a sale of all or part of a failing bank to the private sector or to a bridge bank (a state-backed bank).

To keep investors and creditors out of the way of their solution, the authorities also seek wide-ranging powers to disenfranchise stakeholders in the failing bank. These include nullifying or varying the terms of securities and overriding contractual rights, subject to certain vague, undrafted nonstatutory “safeguards”.

The problem with the SRR as proposed is that the authorities seek to acquire powers – justified by the need to protect depositors and prevent systemic failure – that erode legal and commercial certainty. By removing stakeholders’ rights, the SRR casts doubt on the result of a bank rescue under the SRR for creditors and other stakeholders.

In particular, the authorities wish to be able to cherry-pick assets from the failing bank and transfer them to a private sector buyer or bridge bank. This splits creditors: some will become the fortunate creditors of the buyer and the rest will become the unlucky creditors of the residual bank, which will be in a far worse position for having lost its good assets. It also casts doubt on the ability of counterparties to contract with UK banks to manage their risks.

This matters because stakeholders need certainty about what they are buying into when they buy securities in, make a deposit with or enter into a swap with a British bank. This certainty extends to knowledge of their position on a default of the bank – in particular, that swaps and similar agreements can be closed out and that the stakeholder will be among the creditors waiting to receive the proceeds of the insolvency.

Uncertainty carries a cost. A bondholder who discovers that he may not form part of the orderly queue of creditors, or that the assets left for creditors may be much smaller than it would otherwise have been, will demand a larger risk premium – or simply be unwilling to invest. A swap counterparty who cannot manage his positions on a net basis will also charge a UK bank a larger risk premium.

A measure that widens credit spreads on UK banks at this time would impair the competitiveness of UK banks and their ability to raise funds or capital when they need both. This would be a damaging outcome, which, ironically, could decrease financial stability – the very thing that the authorities are setting out to address.

— Bob Penn is a regulatory partner with the law firm Allen & Overy

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