In September 2008 as Lehman Brothers Holding Inc. was reaching a state of crisis, it looked like the company might be able to avoid bankruptcy by completing the sale of certain assets to Barclays PLC. The sale would have provided Lehman with much-needed capital and additional time to plan for an orderly wind-down. After days of frenzied negotiations involving Lehman, Barclays and U.S. regulatory entities, a deal was agreed to in principal. Only one critical step remained: obtaining regulatory approval of the Financial Services Authority (FSA)[1]. The FSA given little detail or time to review the proposed transaction and facing its own issues domestically, was concerned that the deal might leave Barclays undercapitalized. The FSA indicated that it would not be able to approve the deal without further review. The FSA’s refusal effectively ended any hope Lehman had in avoiding bankruptcy and the company filed for chapter 11 protection in the U.S. Bankruptcy Court for the Southern District of New York the next morning.
We all know what happened next. Some estimates suggest that Lehman’s free-fall bankruptcy cost creditors as much as $75 billion,[2] a loss that might have been significantly reduced or eliminated altogether if Lehman had been able to resolve itself via an orderly wind-down process. Also, while Lehman’s free-fall bankruptcy alone did not cause the 2008-09 financial crisis, it did make it worse. In addition, many more global financial institutions came close to resolution but managed to avoid the Lehman’s fate as a result of unprecedented government intervention.
A recent report showed that 30 of the world’s largest international financial institutions (ranked by assets) on average had operations in 53 separate countries.[3] As global expansion continues, it is becoming more important to find ways to improve international cooperation when dealing with a troubled global systematically important financial institutions (SIFI).[4] These SIFIs are at the very heart of the global financial system, and currently there is no international insolvency framework to handle their orderly resolution.
Recognizing this, there are no fewer than six official and private sector groups involved in reviewing the current state and preparing proposals for how to improve.[5] Each has produced reports identifying various obstacles to improving international coordination and recommending solutions. Their findings are summarized below.
Obstacles
Differences in global resolution schemes. Different countries and regions have different insolvency or regulatory systems in place, making it unlikely that a comprehensive global structure can be adopted soon. Determining when and how to initiate insolvency proceedings as well as the priority waterfall for distributions to creditors also varies from state to state. While the United Nations Commission on International Trade Law (UNCITRAL) Model Law[6] has served to increase international coordination of cross-border insolvency proceedings significant differences remain.
Deficiencies in existing tools and processes. To date, the UNCITRAL Model Law has only been adopted by 19 countries. Notably, large SIFI-host countries such as Germany and the Netherlands have not yet implemented the Model Law. Even where it has been adopted there are many exceptions regarding financial institutions. For example, chapter 15 of the U.S. Bankruptcy Code does not cover several types of financial institutions often found in SIFIs, including insured depository institutions, insurance companies and broker-dealers.
Complexity of SIFI organizations. Modern-day global financial institutions have numerous legal entities in various jurisdictions around the world. A SIFI’s legal entity structure rarely reflects the operating and strategic alignment of the institution, making it increasingly difficult to identify the location of the home country or main center of interest.
National interests take precedence. Local regulators are more likely to look to protect their local national interests and focus on minimizing the economic impact at home rather than focusing on coordinating efforts in an attempt to minimize economic instability in another country. This is particularly true in a period of crisis when the local citizenry may be looking for a scapegoat to blame for their financial troubles.
Recommendations
While there have been numerous specific recommendations put forward by various parties they all seem to fall into one of these three general areas.
Develop common cross-border tools. National authorities should have appropriate tools to address all types of financial institutions in difficulty so that an orderly resolution can be achieved. These tools might be legal, regulatory or something else. We should continue to align state’s resolution schemes with the Model Law and work toward common guidelines for initiating insolvency proceedings, determining location of main proceedings and the treatment of creditors. As this is not likely to happen overnight, we should push to identify internationally coordinated temporary solutions, such as the establishment of protocols or memorandums of understanding. National laws should be amended to require national authorities to coordinate their resolution efforts with their counterparts in other jurisdictions. In addition, bridge institutions should be established to facilitate the transfer of assets and liabilities from a troubled SIFI and a temporary automatic stay should be imposed on the termination of certain financial instruments.
Increase depth and frequency of communication. Schedule regular meetings among the key players involved (government, regulatory and industry) with a focus on planning for crises, identifying specific issues and barriers to coordinated action, and improving information sharing. In a financial crisis, the health of a financial institution can deteriorate rapidly and having an open line of communication that allows for early and decisive action can be critical. Each entity involved should have a clear understanding of their respective responsibilities.
Require SIFIs to develop “living wills.” Each SIFI should prepare and maintain a contingency plan for authorities to use in a wind-down scenario. These plans should contemplate a period of severe financial distress and contain key information such as a map of its businesses and legal entities, obligations and liabilities for each entity and who the counterparty is, which parties would be involved in an orderly wind-down (legal authorities, regulators, attorneys, advisors, etc.), identify information systems and locations, etc.
Conclusion
Many of these recommendations will be adopted in some form over the next couple years as governments focus on installing a framework to resolve troubled SIFIs. Planning is already underway. In July, the Federal Deposit Insurance Corp. announced that it was delaying implementing portions of the Dodd-Frank Wall Street Reform and Consumer Protections Acts in order to coordinate its actions with other international parties. Whatever happens, the success of current efforts to improve cross-border coordination will likely have an important impact in the next global financial crisis.
1. The Financial Services Authority is an independent organization responsible for regulating the financial services industry in the United Kingdom.
2. Ann Cairns, “Breaking the Insolvency Mould,” International Corporate Rescue, Vol. 6, issue 2, page 116 (Chase Cambria Publishing, 2009).
3. In July 2011, the U.S. Government Accountability Office (GAO) published a report, “Bankruptcy: Complex Financial Institutions and International Coordination Pose Challenges,” page 36.
4. SIFI is a financial institution whose eventual failure (default) may pose systemic risks to the world economy. According to the Basel 3 framework, SIFIs may be subject to enhanced capital requirements.
5. The six groups are the (1) Financial Stability Board (FSB), (2) Basel Committee on Banking Supervision (Basel Committee) and the Cross-Border Bank Resolution Group (CBRG), (3) European Commission, (4) UNCITRAL, (5) International Monetary Fund (IMF) and (6) Institute of International Finance. The Board of Governors of the Federal Reserve System published a report in July 2011 entitled “Study on International Coordination Relating to Bankruptcy Process for Nonbank Financial Institutions” that summarizes the actions and reports from these six groups.
6. In 1997, the UNCITRAL adopted the Model Law that applies to the insolvency of a single firm with a presence in foreign jurisdictions. Chapter 15 of the Bankruptcy Code is based on the Model Law.