In the UK, the FSA has recently issued a consultation paper on RRPs, and an important initial pilot exercise will involve reviewing the contingency plans and procedures of the major firms as they draw them up over the coming months. The timetable for this work is ambitious with the plans being drawn up in the first quarter of next year, but that is necessarily so. The FSA and the Bank of England, working together, will review and challenge the submissions to assess their credibility. RRPs need to be owned by financial institutions at Board level. They should be of such importance that Boards need to understand that they are responsible for them. At the heart of the role of these plans is taking a forward-looking view of the threats that should be tackled. This is a clear change of approach. It builds from the work already done to embed stress testing into the toolkit. Stress tests are useful but limited tools. They provide a forecast of what we think is most likely to happen in the future conditional on a set of assumptions on what the future will bring. There are three obvious limitations to stress tests used on their own. First, typically they are a single point forecast of what could happen rather than a distribution of outcomes conditional on a range of stresses.
Had there been one, the Northern Rock recovery plan should have challenged the management and the Board on how its business model could adapt to and survive the closure of its key funding markets, given the sheer scale of its dependence on securitisation. Likewise, how could it have handled a serious stress when it had pursued a business model of aggressively taking market share by squeezing its net interest margin and accepting more borrower default risk? And then moving further into the guts of the bank, how would it deal with stress to a funding model where the bank was excessively dependent on cash deposits from the securitisation master trust but with a hard rating agency trigger linking that funding to the position of the bank, thus creating a severe amplification of any stress? Finally on Northern Rock, how would the bank deal with a funding stress when it was having to encumber such a high proportion of its good quality assets in order to over-collateralise its securitisation master trust? A very good example of the need for resolution plans is the case of Lehmans in Europe. Two questions are relevant here: what should the resolution plan have contained; and what changes to its organisation and operations might have made the massive task of dealing with Lehmans more straightforward? You will, I hope, appreciate that I can only scratch the surface of the Lehmans case in the time available so I apologise for the laundry list approach.