Too Complex to Fail International Financial Conglomerates

1
Too Complex to FailInternational Financial
Conglomerates the Design of National
Insolvency Regimes

• Richard J. Herring
• Director of the Lauder Institute
• Co-Director The Wharton Financial Institutions
  Center

5th Annual International Seminar on Policy
Challenges for the Financial Sector
International Financial Conglomerates Issues
and Challenges June 1- 3 2005 Sponsored by T
he World Bank International Monetary Fund and
Federal Reserve Board
2
Overview

• Why form financial conglomerates
• What if an international financial conglomerate
  should fail
  
• The problem legal regulatory and geographic
  complexity
  
• Glimpses into the Abyss
• Barings
• BCCI
• The too-complex-to-fail issue

3
Will Financial Conglomerates Dominate Financial
Markets

• Diseconomies of scope
• Sheer size necessitates bureaucratic procedures
  that inhibit innovation
  
• Complexity of managing different businesses in an
  integrated structure
  
• Organizational structures
• Incentive systems
• Costs of reassuring customers that they will be
  be disadvantaged vis-a-vis firm
  
• Conflicts of interest and franchise risk

4
What if an international financial conglomerat
e
should fail
5
The Problem

• Limited international agreement on bankruptcy
  procedures
  
• But broad agreement on the objectives that they
  should accomplish
  
• Ex post efficient outcomes
• Ex ante efficient outcomes
• Maintenance of the absolute priority of claims in
  the bankruptcy state
  
• Limitation of systemic costs

6
Delay Can Undermine Even Good Procedures

• Delays in recognition of insolvency may lead to
  acceleration of loss
  
• Delays in resolution may lead to deterioration of
  asset quality
  
• Delays may increase the risk of spillovers
• Loss of access to funds
• Loss of access to collateral or undrawn
  commitments
  
• Lack of clarity about positions and how they can
  be hedged

7
A Conglomerate Structure May Contribute to Delays

• Differences among banks securities firms
  insurance companies are reflected in regulatory
  traditions and practices
  
• Impede recognition of insolvency of conglomerate
  firms

8
Differences are profound and pervasive

• Differences in regulatory objectives
• Differences in scope of capital requirements
• Differences in definition of regulatory capital
• Differences in regulatory capital charges

9
Differences in objectives and scope of regulation

• All emphasize consumer/investor protection
• Differ re systemic risk
• Traditional preoccupation of bank regulators
• Emphasis on consolidated prudential supervision
• Not a traditional concern of insurance
  regulators
  
• Focus on solvency of individual legal entities
  not group
  
• Not a principal concern of the SEC
• Focus on broker/dealer not holding company
• EU same rules to banks and securities firms
• Proposal to apply bank-like regulation to
  insurance firms.

10
Philosophical differences about what should count
as capital

• Differing assumptions about how to deal with a
  faltering firm
  
• Securities regulators liquidate without loss to
  customers or recourse to bankruptcy proceedings
  emphasis on subordinated claims
  
• Bank regulators want time to detect and
  remediate emphasis on patient money
  
• Insurance regulators ring-fence for protection
  of customers emphasis on adequacy of technical
  reserves

11
Differing definitions of capital

• Net Worth similarities more apparent than real
• Mark to market accounting in securities firm
• Mix of mark to market book value in banks
• Statutory accounting in insurance companies

12
Definition of capital contd

• Reserves
• Prohibited (irrelevant) in securities firms
• Loan loss reserves up to 1.25 of risk-adjusted
  assets in banks but Tier 2
  
• Principal buffer against loss in insurance
  companies
  
• Liability not allocated retained earnings
• Another term for net worth in mutual companies

13
Definition of capital contd

• Subordinated debt
• Securities firms heavy reliance minimum
  maturity of one year
  
• Banks
• With minimum maturity of 5 years up to 50 of
  Tier 2
  
• With minimum maturity of 2 years permitted as
  Tier 3 almost never used
  
• Insurance companies
• Permissible within limits
• Often issued by parent and downstreamed as equity
  in insurance company subsidiary
  

14
A Global Corporate Structure Also Exacerbates
Delays

• Fragmentation of oversight may delay recognition
  of insolvency
  
• Additional time to initiate insolvency
  proceedings
  
• Additional time to coordinate insolvency
  proceedings in several different countries

15
Management Practices Exacerbate Problem of Delays

• An international financial conglomerate is likely
  to be managed in an integrated fashion along
  lines of business without regard for
  
• Legal entities (perhaps several 100)
• National borders (perhaps 100)
• Functional regulatory domains (perhaps 3 or more
  per country)
  
• With substantial intra-group transactions that
  are difficult to disentangle
  

16
Ambiguity re allocation of business units to
legal entities regulatory domains raises
questions

• Who allocates assets to legal entities
• Who allocates legal entities to regulatory
  authorities
  
• Who allocates legal entities to bankruptcy
  authorities if different

17

• Case 1 Barings
• How conglomerate structure delayed insolvency
  recognition

18
Corporate Structure of Barings PLC
19
Losses Concealed in Account 88888
( in millions of s) Baring Group capital 350
m
Source Körnert (2003 p. 198)
20
The Collapse of Barings

• Rogue trader at Baring Futures in Singapore lost
  1.4 billion using futures contracts to bet on a
  rise in the Nikkei Index
  
• Leeson back office functions and trading
• Baring Brothers Co advanced 1.2 billion during
  Jan-Feb 1995 to cover payments
  
• Fragmented oversight delayed recognition of
  insolvency
  
• Friday 2/24/95 informed B.of England that would
  not make Monday margin calls
  
• Extent of fraud and losses unclear
• B. of E. judged not of systemic importance
• Turned to bankruptcy court Sunday evening
• B. of E. facilitated unwind like DBL case

21
FT The Barings CrisisBank Decides a Rescue is
the Only Option February 27 1995.

• If Barings had been allowed to fail it could
  have had enormously destabilizing effects on
  world financial markets there was a dnager of
  spiraling fals in world financical markets on
  fears over the possibility of linked collapses of
  banks as well as the uncapped liability of
  Barings contracts

22
The Collapse of Barings

• Raised old questions about sharing of supervisory
  responsibility
  
• Between host and source country supervisors
• Between bank and securities industry supervisors
• Raised new questions about contagion across
  exchanges trading derivatives
  
• Showed uneven enforcement of separation of
  customer funds from firms own funds
  
• Jeopardized customers in addition to
  counterparties

23
During brief interval before sale to ING

• A glimpse of the impact of the traditional stay
  on an active trading firm
  
• Many contracts traded round the clock
• If failing firm unable to continue trading to
  hedge its exposure firms losses will mount
  
• Because of failure to segregate omnibus accounts
  from firms own funds customers at risk as well
  
• Counterparties and creditors may find themselves
  unhedged and incur losses when positions frozen
  but markets continue to fluctuate

24
ISDA Master Agreements

• A statutory exception to override the automatic
  stay provisions in most bankruptcy laws
  
• In the event of default may close out all
  contracts with defaulting counterparty net them
  and liquidate the collateral
  
• In US applies to REPOs securities contracts
  commodity contracts swap agreements and forward
  contracts

25
Intended to limit systemic spillovers

• Ability to close-out net and liquidate
  collateral eliminates degradation of collateral
  that could occur in lengthy bankruptcy
  proceedings
• Permits counterparties to settle other
  transactions that may have been linked to
  positions with the failed firm
  
• But if collateral in illiquid instruments may
  exacerbate downward pressure on prices
  
• LTCM revealed the darker side of close-out netting

26

• Case 2 BCCI
• How Complexity of International Bankruptcy
  Proceedings Delays Resolution

27
n substantial stake or ownership
secret stake or ownership
International Credit Investment Group (Cayman
Islands)
Abu Dhabi
77.4
Credit Commerce American Holdings (Dutch Antil
les)
BCCI SA (Luxembourg) 47 branches in 13 countries
(24 in Britain) Subsidiaries in Canada and G
ibraltar
BCCI Holdings (Luxembourg)
100
Credit and Commerce American Investment BV (Holl
and)
100
CenTrust Savings Bank (Miami FL)
BCCI Overseas (Cayman Islands) 63 branches in 28
countries
First American Corps. (Washington DC)
Independence Bank (Encino CA)
29 subsidiaries and affiliates in 28 countries
First American Bankshares (Washington DC) Bank
in 7 states
National Bank of Georgia
28
As of July 5th 1991 BCCI consisted of

• BCCI Holdings SA in Luxembourg
• BCCI SA (Luxembourg) one principal operating
  subsidiary with 47 branches and two subsidiaries
  in 15 countries
  
• BCCI Overseas Ltd. (Cayman Islands) the other
  principal operating subsidiary with 63 branches
  in 28 countries
  
• Other subsidiaries and affiliates with 255
  banking offices in 30 countries
  
• TOTAL 255 banking offices with operations in 69
  countries

29
Conflicting approaches to bankruptcy

• US separate entity doctrine
• A branch or agency may be treated as a separately
  incorporated legal entity
  
• Branch or agency liquidated separately from the
  entity as a whole
  
• US liquidator would marshal not only assets of
  branch worldwide but also all assets of the bank
  in US

30
Conflicting approaches (contd)

• Cayman Islands Luxembourg and UK follow single
  entity doctrine
  
• Banks are wound up as one legal entity
• Claims of creditors on branches worldwide have
  equal standing
  
• Liquidators will attempt to collect worldwide
  assets of entity

31
Conflicting approaches (contd)

• In US general bankruptcy law does not apply and
  bank supervisor liquidates branch or agency
  
• After creditors of branch paid excess if any is
  turned over to liquidator of parent
  
• In UK apply liquidation law as for any
  commercial entity
  
• Supervisor is not the liquidator

32
Conflicting approaches (contd)

• Set-offnon-judicial process in which mutual
  claims are extinguished
  
• In US set-off is permitted between claims in the
  same currency that appear on the books of the
  same branch
  
• In UK no requirement that same currency branch
  or country
  
• In Luxembourg may not be exercised after
  liquidation order

33
Another wildcard in the bankruptcy deck

• After start of bankruptcy proceedings BCCI
  prosecuted under the RICO Act (Racketeer
  Influenced and Corrupt Organizations Act)
  
• Gathered all US assets of BCCI (1.2bn)
• Imposed fines for criminal conduct
• Turned over excess to banking authorities
• More than half turned over to Luxembourg
  liquidator
  

34
Proceeds from Liquidation

• Liquidators had recovered 5.7 billion
• Greatly aided by criminal proceedings in the US
• Liquidators and legal fees now exceed 1.2
  billion
  
• Related suits keep grinding on
• One from 358 former employees for the stigma
  caused to their careers
  
• Liquidators have sued the Bank of England for
  1.2 billion
  
• Queens Counsel just concluded opening statement
  for the defense lasting 119 days a record.

35
Looking ahead challenges of unwinding financial
firms are likely to increase

• Formation of financial conglomerates
• Globalization in market involvement and corporate
  structure
  
• Consolidation
• Increased involvement in trading especially OTC
  derivatives
  
• Markets move faster but courts do not

36
Conflicts are not just potential

• Even the US has multiple regimes
• A failed insured depository institution is
  subject to FDIC procedures
  
• Constrained by least cost resolution requirements
  of FDICIA (1991)
  
• Domestic depositor preference law (1993)
• A failed broker/dealer is subject to Securities
  Investor Protection Act
  
• An Edge Act subsidiary could be liquidated by the
  Fed
  
• A failed insurance subsidiary may be subject to
  special state-specific procedures
  
• The parent holding company most non-bank
  entities subject to bankruptcy proceedings
  
• RICO proceedings may trump other procedures

37
The result is likely to be

• Multiple bankruptcy actions in multiple
  jurisdictions
  
• A grab for assets
• National authorities or functional regulators may
  ring-fence parts of the firm to protect the
  interests they represent
  
• Close-out netting and liquidation of collateral
  in derivatives contracts
  
• Spillover impacts on other institutions and
  markets
  
• Such institutions may be too complex to fail

38
In the absence of credible bankruptcy procedures

• Ill-considered bail-outs
• Too big to fail
• Too complex to fail
• Moral hazard exacerbated
• Dulls incentives to demand disclosure
• Weakens market discipline
• Inefficient crisis management procedures may
  undermine crisis prevention efforts
  

39
A credible procedure must address a series of
questions

• Within financial conglomerates how to map lines
  of business into the legal entities to which
  bankruptcy procedures must be applied
  
• Within countries how to coordinate actions of
  various functional regulators

40
Issues continued

• Across countries how to harmonize national
  approaches to ensure a cooperative process
  
• Across OTC derivatives markets and clearing
  settlement systems how to meet the needs of the
  bankruptcy administrator for time without
  impeding ability of market participants to
  continue trading

41
Need to consider

• Special bankruptcy procedures for systemically
  important financial firms
  
• Authorization for bridging institution that can
  unwind the affairs of a failing firm in a orderly
  way
  
• Maximize going-concern value
• Avoid scramble for assets or forced liquidations
• For market discipline to work the system must be
  made safe for the failure of any financial firm