Too Complex to Fail? International Financial Conglomerates & the Design of National Insolvency Regimes

1. Too Complex to Fail?International 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 The 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 conglomerate 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 cont’d… • 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 cont’d… • 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 Crisis—Bank 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 firm’s 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, firm’s losses will mount • Because of failure to segregate omnibus accounts from firm’s 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 Antilles) BCCI SA (Luxembourg) 47 branches in 13 countries (24 in Britain) Subsidiaries in Canada and Gibraltar BCCI Holdings (Luxembourg) 100% Credit and Commerce American Investment BV (Holland) 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 (cont’d) • 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 (cont’d) • 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 (cont’d) • “Set-off”non-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