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International Insolvencies in the Financial Sector; Study Group Discussion Draft

Introduction

When any large financial firm becomes insolvent, it can cause widespread disruption in the financial system. This has always been a potential risk at the national level. It is becoming increasingly serious at the international level too, as links between financial systems grow. Whether or not the danger of a major financial failure has risen in recent years, the difficulties it would create have definitely multiplied. When Barings failed in February 1995, several problems arose during the week of the insolvency. If it had been a larger, more complex firm, if those involved had been less adroit, or if the insolvency had been more protracted, the danger could have become grave.

How international financial insolvencies should be managed is an important subject. It obviously matters to insolvency practitioners -- the judges who oversee these cases and the lawyers and accountants they appoint to manage them. But the risk to the system makes it a central concern for financial policymakers, central bankers and regulators too. Many central banks have broad discretion to provide financial assistance to systemically significant commercial banks threatened by failure, but they face new challenges as non-bank institutions assume a bigger role. Furthermore, the potential for loss and the need for preventive measures in individual firms are reasons why senior management at every internationally active financial firm should consider this subject as well.

This report contains recommendations for all those groups. It has been prepared by a small study group set up jointly by the Group of Thirty and the International Insolvency Practitioners Association (INSOL International) in mid-1995 (Attachment I describes the two organizations and the membership of the study group). The group's terms of reference were to examine the issues surrounding the Barings failure and to make recommendations for reducing the systemic risks associated with the insolvencies of internationally active financial firms.1

The scope of this report is limited in several respects.

  • Its recommendations are aimed at internationally active firms whose failure could threaten the global financial system.

  • It focuses on measures intended to limit disruption after an insolvency begins rather than on what might reduce the chances of an insolvency in the first place. It complements other recent studies and initiatives aimed at improving risk management generally (Appendix II describes other studies undertaken since Barings' failure);

  • It concentrates on the direct effect of a financial insolvency on other financial firms. The losses caused by the exposures of creditors and counterparties are an obvious mechanism through which systemic risks can develop. The recommendations made here may also reduce the chance of systemic risk arising through other channels, such as a loss of confidence in firms similar to the one that failed, but that is not their primary aim in the context of this report;

  • It does not deal with sovereign default. Although this is also of interest to the Group of Thirty, it raises different issues and calls for a different approach.

However, this report is not limited to commercial banks. It deals with insolvencies of financial conglomerates, investment banks and insurance companies as well, whenever failure might pose a systemic threat. It is intended to be relevant to both developed and emerging economies.

The recommendations in this report are meant to be practical. So, for example, there is no recommendation for the international harmonization of insolvency law. That would indeed reduce systemic risks, but it is unlikely to happen in the foreseeable future.2

Footnotes:

1. This report often refers to a single insolvent firm. In principle, much of the analysis and many of the recommendations would also apply to a group of firms that became insolvent for some common reason such as severe macro-economic problems in a particular country or region.

2. The European Community has made a serious effort over the past three decades to negotiate insolvency harmonization. Even there, where countries are neighbors and share economic and political objectives, the historic differences in insolvency law have made progress extremely difficult, with a treaty on insolvency harmonization having only recently been reached after decades of work.

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