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Too Complex to Fail?Too Complex to Fail?International Financial ConglomeratesInternational Financial Conglomerates

& & the Design of National Insolvency Regimesthe 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, 2005Sponsored by

The World Bank, International Monetary Fund, and Federal Reserve Board

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OverviewOverviewWhy 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

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Will Financial Conglomerates Dominate Will Financial Conglomerates Dominate Financial Markets?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

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What if an What if an international international

financial conglomeratefinancial conglomerateshould fail?should fail?

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The ProblemThe 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

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Delay Can Undermine Even Good Delay Can Undermine Even Good ProceduresProcedures

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

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A Conglomerate Structure May A Conglomerate Structure May Contribute to DelaysContribute to Delays

Differences among banks, securities firms & insurance companies are reflected in regulatory traditions and practices

Impede recognition of insolvency of conglomerate firms

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Differences are profound and pervasiveDifferences 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

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Differences in objectives and Differences in objectives and scope of regulationscope of regulation

All emphasize consumer/investor protectionDiffer 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.

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Philosophical differences about Philosophical differences about what should count as capitalwhat 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

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Differing definitions of capitalDiffering 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

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Definition of capital cont’d…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

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Definition of capital cont’d…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

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A Global Corporate Structure Also A Global Corporate Structure Also Exacerbates DelaysExacerbates 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

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Management Practices Exacerbate Management Practices Exacerbate Problem of DelaysProblem 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

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Ambiguity re: allocation of business Ambiguity re: allocation of business units to legal entities & regulatory units to legal entities & regulatory

domains raises questions…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?

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Case 1: BaringsCase 1: Barings How conglomerate How conglomerate

structure delayed structure delayed insolvency recognitioninsolvency recognition

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Corporate Structure of Barings PLCCorporate Structure of Barings PLC

S u b sidia ries in F ra n c e,G e rm a n y , Ita ly & Ja p an

B a rin g S te rlingB o n d s

B a ring C ap italIn v e s to rs L td .

B a rin g V e n tu reP a rtn e rs , L td.

B ra n c h e s in H o n g K o nga n d S ing a p o re

R e p rese n tativ e O ffic esin A rg e n tin a,

Ja p a n , K o re a , a nd M e x ico

B a rin g B ro the rs & C o m pa n y (B B & C )a u th o rize d b a nk

h e a d q u a rte red in L o n d on

B a rin g s F u tu resS in g a p o re

(B F S)

S u b sidia riesin F ra n c e,

H o n g K o n g , Ja p a n& S ing a p o re

B a rin gs S e c uritie s L im ite d (B S L)in c o rp o ra ted in C a y m a n Is la n ds

h e a d q u a rte red in L o n d on

S u b sid ia rie s a n d o ffic e s in L o n d o n,H o n g K o n g , T o k y o , B o s to n ,

T o ro n to , S an F ra n c isco , S y d n e y,P a ris , D u b lin , G u e rn se y, & G e n e va

B a rin g A ssetM a n a ge m e nt

B a r in g s P L C

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1992II&IV 1993 1994 I&II 1994 III&IV 1995 to February 27

Loss from previous period

- 2 23 116 208

Period Loss 2 21 93 92 619 Total loss 2 23 116 208 £ 827 m + Additional losses resulting from market movements after February 27th, 1995

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+Losses resulting from foreign exchange (¥ against £)

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+SIMEX costs 3 = Total loss after liquidation

£927 m

Losses Concealed in Account 88888*Losses Concealed in Account 88888*( in millions of £s)

Baring Group capital ≌ £350 m

*Source: Körnert (2003, p. 198)

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The Collapse of BaringsThe Collapse of BaringsRogue 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 paymentsFragmented oversight delayed recognition of

insolvencyFriday, 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

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FT, “The Barings Crisis—Bank Decides a FT, “The Barings Crisis—Bank Decides a Rescue is the Only Option,” Rescue is the Only Option,”

February 27, 1995. 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…”

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The Collapse of BaringsThe Collapse of BaringsRaised oldold questions about sharing of supervisory

responsibility– Between host and source country supervisors

– Between bank and securities industry supervisors

Raised newnew 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

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During brief interval, before sale During brief interval, before sale to INGto 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

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ISDA Master AgreementsISDA 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

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Intended to limit systemic Intended to limit systemic spilloversspillovers

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

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Case 2: BCCICase 2: BCCI How Complexity of How Complexity of

International Bankruptcy International Bankruptcy Proceedings Delays Proceedings Delays

ResolutionResolution

International Credit & Investment Group(Cayman Islands)

Abu Dhabi

Credit & CommerceAmerican Holdings

(Dutch Antilles)

Credit and CommerceAmerican Investment BV

(Holland)

First American Corps.(Washington, DC)

First American Bankshares(Washington, DC)

Bank in 7 states

Independence Bank(Encino, CA)

BCCI Holdings(Luxembourg)

CenTrust Savings Bank(Miami, FL)

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

n = substantial stake or ownership = secret stake or ownership

77.4%

100%

100%

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As of July 5As of July 5thth, 1991 BCCI , 1991 BCCI consisted ofconsisted of

BCCI Holdings SA in LuxembourgBCCI 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

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Conflicting approaches to Conflicting approaches to bankruptcybankruptcy

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

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Conflicting approaches (cont’d)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

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Conflicting approaches (cont’d)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

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Conflicting approaches (cont’d)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

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Another wildcard in the Another wildcard in the bankruptcy deck…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

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Proceeds from LiquidationProceeds from Liquidation

Liquidators had recovered $5.7 billion– Greatly aided by criminal proceedings in the US

Liquidators’ and legal fees now exceed $1.2 billionRelated 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.

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Looking ahead: challenges of unwinding Looking ahead: challenges of unwinding financial firms are likely to increasefinancial 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

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Conflicts are not just potentialConflicts are not just potentialEven 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

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The result is likely to be…The result is likely to be…Multiple bankruptcy actions in multiple

jurisdictionsA 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

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In the absence of credible In the absence of credible bankruptcy procedures…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

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A credible procedure must A credible procedure must address a series of questions…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?

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Issues continued…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?

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Need to consider…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