While OnTheRegs primarily sticks to asset management regulation, BBH is also a leading servicer of global banks. This week, we break from asset management to focus on an area of the market which has vast consequence for investors and asset managers, who of course, each use banks.
In response to the events leading to the financial crisis of 2008, the Financial Stability Board (FSB) developed international resolution standards applicable to very large banks known as Globally Significantly Important Banks (G-SIBs.) In line with this, various jurisdictions have been implementing their own version of the resolution requirements within their insolvency regimes to align with the key attributes set by the FSB to avoid a repeat of 2008 conditions over the course of the last few years.
“Moving of th’ earth brings harms and fears,
Men reckon what it did, and meant;
But trepidation of the spheres,
Though greater far, is innocent.”
Those are the words of the poet, John Donne, in his great poem “Valediction Forbidding Mourning.” Certainly no one must forbid mourning for the practices that lead to the 2008 market events, forbidding the practices is more appropriate.
In this passage Donne is essentially comparing the Big Bang Theory to “Did the Earth move for Thee.” He is making the point that we don’t feel distant events, even very large ones, as we feel smaller events that are closer to home.
There’s been a lot happening in this arena, including the Orderly Liquidation Authority (OLA) created under Title II of Dodd-Frank in the US and developments in connection with the Bank Resolution and Recovery Directive in the EU. So far, most of what has been happening is far away from G-SIB customer and counterparties in the sphere between G-SIBs and their regulators.
John Donne was something of a libertine in his youth who became Dean of Saint Paul’s at the end of his career. In this blog, we’ll look at one special resolution regime developed in accordance with the FSB international resolution and consider how the US attempts to turn their G-SIBs from rakes into reverends as modeled by the career of the estimable Doctor Donne.
The US OLA establishes an alternate resolution scheme which would apply to a G-SIB under bankruptcy rules. This statement from the Federal Reserve bank of Richmond Virginia sets out the broad purpose of OLA:
“OLA forces the Federal Deposit Insurance Corporation (FDIC) to balance two competing interests. On one hand, it is to pay creditors no more than what they would receive in bankruptcy and ensure that creditors bear losses in order to promote market discipline. On the other hand, it is to minimize adverse effects on financial stability.”
Trepidation of the Spheres: Basic Structure of OLA
As indicated, a lot has happened between G-SIBs and rule-making authorities. G-SIBs, for purposes of OLA, include US banking institutions, but also US branches and agencies of non-US G-SIBs.[i]
Under OLA, the FDIC (working with the primary regulator of the G-SIB such as the Federal Reserve or Security Investor Protection Corporation):
- Requires each G-SIB to prepare submit and continually update a plan (a living will) for orderly administration in the event of bankruptcy and submit this to the FDIC. Living wills detail the transfer of capital and the bridge structure that will be used in the event of liquidation under OLA.[ii]
- Establishes bridge financial companies or identifies successor companies to which to transfer all or any portion of the covered G-SIB’s assets and liabilities (including customer accounts and related “customer name” securities and customer property).
The process for invoking OLA was established by Title II of Dodd-Frank, signed into law in July of 2010. The Treasury Secretary, in consultation with the President must find at a minimum that:
- The G-SIB is “in default or in danger of default”
- Liquidation or administration of the G-SIB under normal insolvency laws to resolve entity “would have serious adverse effects on financial stability in the United States”
- The effect on of employing OLA versus normal bankruptcy provisions on creditors is “appropriate” in the context of risks to the financial stability of the market.
The action must also be recommended by two thirds of the Federal Reserve Board and the FDIC Board.
Since the passage of Dodd-Frank, a lot has happened:
- G-SIBS have already composed their “living will” liquidation plans, which are subject to annual review and assessment with the FDIC.
- G-SIBs have been required to maintain records of qualified financial contracts. This list should generally be determinative of financial contracts subject to QFC treatment.
- G-SIBS have been assessed additional capital requirements, the so-called G-SIB surcharge.
Down to Earth: One day Suspension of Qualified Financial Contracts
The most important aspect of OLA, and its greatest diversion from normal bankruptcy procedure is the ability of the FDIC (working with other regulators such as the Security Investor Protection Corporation in some cases) to assign outstanding assets and liabilities of the G-SIB to a successor or bridge that will assume the ongoing performance of outstanding transactions and obligations of the failing G-SIB. To allow time for the FDIC to transfer outstanding transactions to a bridge or successor, OLA suspends rights to the exercise of Qualified Financial Contracts (QFCs) for one business day.
QFCs are a creature of the bankruptcy law in the US. They are not a creature of OLA and they include contracts with financial counterparties generally. OLA applies special conditions to QFCs with G-SIBs. General bankruptcy rules in the US allow for the immediate execution in bankruptcy of transactions that are largely neutral to creditors of a failing institution, but the failure to perform which would likely create contagion of the financial failure of a bankrupt firm to counterparts and clients of the failing firm. There is no need to wait for bankruptcy trustee or other insolvency administrator permission to complete these QFCs. This represents the balancing of fairness to creditors versus containment of a firm failure referenced by the Richmond Federal Reserve above.
QFCs include: Commodities contracts, swaps, forward contracts (including forward contracts for currencies), repos and reverse repos, DVP/RVP securities purchases and sales for securities and securities lending transactions.
- Exercise of rights under QFCs, including default liquidation rights, are suspended for one day; and,
- The FDIC can transfer all of the QFCs running between a failing G-SIB to a bridge or successor without evoking default rights under the QFC. The FDIC cannot cherry pick among contracts between the FDIC and a particular counterparty, which preserves rights of offset and netting across QFCs.[iii]
Down to Earth: Prohibition of Certain Terms in QFCs
So far, these things have happened in the sphere of G-SIBs and the FDIC, but in the implementation of the central reorganization tool of OLA, things are beginning to move the ground under client contracts with G-SIBs. G-SIBs are now required to reach out to their customers to seek amendment to their contracts to make them consistent with the tools provided to the FDIC to support orderly liquidation of a G-SIB.
- The OLA regulations require that G-SIBs include in their QFCs provisions limiting default rights and restrictions on transfer to the extent the QFC terms are inconsistent with the U.S. stay and transfer rules that allow for the orderly transfer of contracts pursuant to OLA resolution structures.
- QFCs governed by US law between parties that are organized in the US are subject to a US nexus exemption because it is sufficiently clear that US rules would apply in the event of insolvency.
- The OLA regulations also prohibit G-SIBs from being a party to a QFC that includes insolvency related cross affiliate cross default provisions related, directly or indirectly to an affiliate of the GSIB entering insolvency proceedings. These were provisions that in the view of FSB and regulators contributed mightily to the contagion of failure that attended Lehman and other near failures in 2008.
Down to Earth: Amendment of Non-Conforming/Non-Exempt QFCs
Counterparties to QFCs with GSIBs will have to amend their QFCs to conform inconsistent provisions to the US resolution rules unless the contracts qualify for the US nexus exemption. This will have to happen between now and June 30. QFC counterparties to G-SIBs are starting to see what will be an increasing flurry of G-SIB requests to make these amendments.
The required amendment can be done on a bilateral basis, negotiating the terms with the G-SIB, or by executing the US Stay Protocol developed by the International Swaps and Derivatives Association (ISDA).
The ISDA US Stay Protocol enables amendment of covered agreements to ensure that these QFCs:
- Are subject to existing limits on the exercise of default rights by counterparties under the Orderly Liquidation Authority provisions of Title II of the Dodd-Frank Act and the Federal Deposit Insurance Act; and
- Limit the ability of counterparties to exercise default rights.
The US Stay Protocol has been developed based on the requirements of a safe harbored “US protocol” under the applicable US regulations.[iv]
Whether a contract needs to be amended or not may be tracked through the following chart:
Procuring the amendment to existing QFCs is the responsibility of the G-SIB and not its counterparty, and counterparties can expect to be approached by G-SIBs between now and the end of June if they have not been approached already. Despite that, it is the responsibility of the GSIBs, customers or counterparties that have non-conforming QFCs must pay some attention, because as of July 1, G-SIBs will no longer be able to trade or perform under non-conforming contracts. And if a counterparty’s or customer’s contract does not conform as of that date, a bell will toll, and G-SIBs will no longer be allowed to perform QFCs on the unamended terms and dealing would be suspended. In this circumstance, as John Donne also said: “Send not for whom the bell tolls. It tolls for thee.”
This article was contributed by BBH Senior Vice President in the Office of General Counsel Thomas Andrew.
[iii] But note that the transfer of QFCs to a bridge or successor may impact offset rights against non QFCs between a counterparty and a failing G-SIB (e.g. deposit obligations).