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International Insolvencies in the Financial Sector; Study Group Discussion Draft

Background

Finance and Regulation
The international financial system is changing rapidly. The changes have been driven by deregulation; by improvements in communications and technology that have increased the speed and volume of transactions enormously; and by widespread innovation in markets, organization structure, services and instruments. As a result, many financial institutions and activities that once were local are now international. Regulatory systems and insolvency law are not. Both regulation and law are diverse and inconsistent across countries. In some cases, neither regime is up to the task of coping with a major financial failure. Given these uncertainties, there is substantial risk that the insolvency of a major financial institution could cause significant difficulties to the world's financial system.

Similarly, the lender-of-last-resort role, intended to prevent damage to the banking system in the event of serious financial disruption, is limited by function and geography. The discretion conferred on many central banks to provide liquidity and capital to systemically significant banks generally does not extend to non-banking institutions of similar size. Nor is there a mechanism for coordinated assistance of this kind for a global institution with sizeable operations in a number of jurisdictions.

Nonetheless, progress has been made in recent years. There have been national and international efforts to strengthen financial risk management at the level of the individual firm. Initiatives are underway to strengthen market mechanisms, the payments system and the regulation of financial firms in several countries. Cooperation and coordination efforts by regulators have intensified, both across sectors and across national boundaries. These efforts were given added impetus last year by the call in the communiqué following the Halifax Summit for the G-7 finance ministers to review current arrangements and assess their adequacy.3

Insolvency
In most countries, a fiduciary (or trustee, or administrator) is appointed to manage an insolvency.4 The appointee is often a lawyer or an accountant; sometimes a businessman, an authorized trust company or a government official. The fiduciary must complete three tasks: first, gain control of the firm and its assets and, if it is still a going concern, stabilize its management structure and operations; second, sift through creditor claims, and value and prioritize them; and third, reorganize or liquidate the firm and ensure that the claims of the creditors are met in accordance with law. This third task may also involve valuation, if the firm is to be sold, in whole or in part.

Some regimes stress settling claims. Others put weight on preserving economic value and employment. In most jurisdictions the administrator has considerable powers, but often needs a court review before making certain major decisions, and particularly before the final resolution of an insolvency.

Many jurisdictions have special insolvency procedures for dealing with financial institutions, especially banks, stockbrokers and insurance companies. They are sometimes similar to non-financial insolvency procedures, but financial regulators often get deeply involved as the administrator or as "a friend of the court" and there are often special provisions for dealing with the claims of depositors.

There have been two recent initiatives to improve the international insolvency process.

First, insolvency practitioners have been developing measures short of full-blown harmonization. This effort encourages informal cooperation among judges, fosters the recognition of foreign insolvency proceedings and promotes access of foreign practitioners to the courts. INSOL International and Committee J of the International Bar Association have been actively involved. So too has the United Nations Commission on International Trade Law (UNCITRAL) which, in conjunction with INSOL International, has organized a series of papers and international meetings. In addition, UNCITRAL has established a working group to study cross-border insolvency issues with the objective of proposing model legislation on cooperation, recognition and access.

Second, financial firms and their lawyers have developed master agreements under which individual transactions can be regulated by identical contract terms. They have encouraged their use and sought to establish that their insolvency provisions are widely enforceable. These agreements now exist for several types of transactions. Two important examples are the International Foreign Exchange Master Agreement (IFEMA) and the International Swaps and Derivatives Association Master Agreement (the ISDA Agreement).5

Five Principles
With this as background, the study group concluded that, to reduce the systemic risks of an international financial insolvency, five basic principles would have to be observed:

  • Speed. International financial insolvencies must be dealt with as quickly as possible. Some financial assets, like options positions, waste rapidly; people, whose skills are a large part of the value of a financial firm, may leave; and protracted uncertainty about recoveries on creditor claims creates doubts about other financial firms and increases the risk of a contagious loss of confidence. Global markets now operate twenty-four hours a day, so that market reactions to a financial failure, whether it is rumored or real, unfold rapidly and continuously. Efforts to control the effects of financial insolvency must begin immediately, with regulators in a position to react around the clock and courts able to turn quickly to the legal issues involved.

  • Cooperation. More must be done to ensure cooperation. Although cooperation among regulators and insolvency practitioners has improved in recent years, it cannot be taken for granted. This cooperation is sometimes facilitated by establishing contacts and agreeing procedures beforehand. Formal arrangements, such as bilateral or multilateral treaties and conventions, can play a useful part. But they are not the only route to cooperation and, in practice, they can be difficult to arrange. Furthermore, much can be done informally. The key is to create an environment in which common objectives can be agreed and cooperation can begin.

  • Information. Critical information must be available to regulators, courts, insolvency practitioners, markets and other financial firms. As in any crisis, decisions will inevitably be taken without all the facts, but the lacuna should be as small as possible. Disseminating information effectively depends partly on understandings and agreements already being put in place on how to share whatever is available. In addition, key information must exist in the first place and be easily accessible. This is especially true at the beginning of an international financial insolvency as regulators work out the extent of the crisis and insolvency practitioners seek to get control of the insolvent firm. Dissemination of information to the market at large, as soon as it is available, then becomes an essential ingredient in stabilizing the situation. It can also be important later on, when (for example) a firm or its assets are valued for sale.

  • Size of Potential Losses. Every effort must be made to ensure that losses at counterparty and creditor financial firms do not cause a wider crisis. This depends mainly on the risk management practices in those firms. Once an insolvency has occurred, they are a major influence on whether its effects will spread. Regulators will need close contact with these firms, as well as the tools to offset the effect of excessive potential losses.

  • Standardization. Regulatory, insolvency and industry policy and practice should be standardized wherever possible. Where policies and practices touch on the handling of an international insolvency, establishment of standards can be helpful. Generally, global uniformity of approaches is not a realistic goal. But there is scope for convergence in a number of areas and, in some, true standardization would be useful in a crisis. Cooperation would be easier if all parties involved in an insolvency took the same approach to the problem.

These principles underpin all the recommendations in this report. Securing them, and implementing the recommendations, will involve both private and public costs. Nevertheless, the study group believes that there is room to improve current public policy and private practice; that the stakes are high; and that the costs of implementation should be reasonable in comparison with the benefits.

Footnotes:

3. The Halifax Communiqué said:

"Closer international cooperation in the regulation and supervision of financial institutions and markets is essential to safeguard the financial system and prevent the erosion of prudential standards. We urge:

  • "a deepening of cooperation among regulators and supervisory agencies to ensure an effective integrated approach, on a global basis, to developing and enhancing the safeguards, standards, transparency and systems necessary to monitor and contain risks; ... and

  • finance ministers to commission studies and analysis from the international organizations responsible for banking and securities regulations and to report on the adequacy of current arrangements, together with proposals for improvement where necessary, at the next Summit."
Para 21 of the Communiqué. (June 15-17, 1995)

4. In the US, shareholder-appointed management stays in place (subject to extensive court supervision) to operate the failed concern as 'debtor in possession' in the case of industrial, commercial, retail and certain financial-services houses (e.g., bank holding companies and consumer small-loan companies). However, there is no debtor-in-possession for most banks or securities firms. When a federally-insured bank fails, federal law requires that the Federal Deposit Insurance Corporation be appointed as receiver and liquidator. This replaces management. When a securities broker-dealer licensed by the Securities and Exchange Commission fails, management is taken over by a trustee appointed by a court at the request of the Securities Investor Protection Corporation.

5. The use of master agreements in over-the-counter derivatives was supported as good risk management practice in the Group of Thirty report "Derivatives: Practices and Principals" July 1993.

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