Transcript Document 7417586

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 1
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
2
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
3
What if an
international
financial conglomerate
should fail?
4
The Problem
 Limited international agreement on bankruptcy
procedures
 But broad agreement on the objectives that they
should accomplish
1. Ex post efficient outcomes
2. Ex ante efficient outcomes
3. Maintenance of the absolute priority of claims in the
bankruptcy state
4. Limitation of systemic costs
5
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
6
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
7
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
8
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.
9
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
10
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
11
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
12
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
13
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
14
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
15
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?
16
Case 1: Barings
How conglomerate
structure delayed
insolvency recognition
17
Corporate Structure of Barings PLC
Barings PLC
Baring Brothers & Company (BB&C)
authorized bank
headquartered in London
Barings Securities Limited (BSL)
incorporated in Cayman Islands
headquartered in London
Subsidiaries in France,
Germany, Italy & Japan
Branches in Hong Kong
and Singapore
Barings Futures
Singapore
(BFS)
Baring Sterling
Bonds
Representative Offices
in Argentina,
Japan, Korea, and Mexico
Subsidiaries
in France,
Hong Kong, Japan
& Singapore
Baring Asset
Management
Subsidiaries and offices in London,
Hong Kong, Tokyo, Boston,
Toronto, San Francisco, Sydney,
Paris, Dublin, Guernsey, & Geneva
Baring Capital
Investors Ltd.
Baring Venture
Partners, Ltd.
18
Losses Concealed in Account 88888*
( in millions of £s)
Baring Group capital ≌ £350 m
Loss from previous
period
Period Loss
Total loss
+ Additional losses
resulting from market
movements after
February 27th, 1995
+Losses resulting from
foreign exchange
(¥ against £)
+SIMEX costs
= Total loss after
liquidation
1992II&IV
1993
1994 I&II
1994 III&IV
-
2
23
116
2
2
21
23
93
116
92
208
1995 to
February 27
208
619
£ 827 m
42
55
3
£927 m
19
*Source: Körnert (2003, p. 198)
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
20
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…”
21
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
22
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
23
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
24
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
25
netting
Case 2: BCCI
How Complexity of
International Bankruptcy
Proceedings Delays
Resolution
26
n = substantial stake or ownership
International Credit &
Investment Group
(Cayman Islands)
= secret stake or ownership
Abu Dhabi
77.4%
Credit & Commerce
American Holdings
(Dutch Antilles)
BCCI Holdings
(Luxembourg)
Credit and Commerce
American Investment BV
(Holland)
First American Corps.
(Washington, DC)
100%
CenTrust Savings Bank
(Miami, FL)
Independence Bank
(Encino, CA)
First American Bankshares
(Washington, DC)
Bank in 7 states
100%
BCCI SA
(Luxembourg)
47 branches in 13 countries
(24 in Britain)
Subsidiaries in Canada and
Gibraltar
BCCI Overseas
(Cayman Islands)
63 branches in 28 countries
29 subsidiaries and affiliates
in 28 countries
National Bank of Georgia
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
28
69 countries
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
29
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
30
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
31
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
32
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
33
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.
34
Looking ahead: challenges of unwinding
financial firms are likely to increase
1. Formation of financial conglomerates
2. Globalization in market involvement
and corporate structure
3. Consolidation
4. Increased involvement in trading,
especially OTC derivatives
5. Markets move faster, but courts do not
35
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
36
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 fail37
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
38
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?
39
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?
40
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
41