Ring Fences, Rustlers and a global bank insolvency

In this week which has seen so much speculation on the fate of Lehman Brothers, it seems only sensible to review how an international insolvency of a major bank works and what it might mean for international creditors.  The insolvency treatment of international banks has remained one of the stubbornly difficult areas of law to harmonise and huge uncertainty and complexity remains.  For excellent background, see Cross-border bank insolvency by Rosa Maria Lastra of Queen Mary, University of London.

Although markets are global, and Lehman Brothers operations span the globe, all insolvency is local.  The basic premise is that each jurisdiction buries its own dead and keeps whatever treasure or garbage it finds with the corpse.  Local creditors get to recover their claims out of the locally available assets.  If, and only if, there are any assets left over will international creditors be invited to make a claim for the rest.  Europe has managed to harmonise cross-border insolvency for banks under directives and local law to embody principles of universality and unity within the EU, but that only works equitably if enough assets are in the EU when the bank fails, and local insolvency law still applies in all its divergent complexity.

Claims against a bank are deemed located wherever the contract creating the claim is undertaken.  If it is under US law then the claimant must look to the liquidator in the United States and assets under his control for recovery.  If the claim is in Hong Kong, then the claimant looks to the Hong Kong receiver and assets.

The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by your liquidators on behalf of your creditors.  Everyone else outside your borders is on their own.  As the US dollar is the reserve currency of banking and US Treasuries, Agencies and other assets are the highest preferred asset class, the US is almost always in a good position in an international bank failure.

The principle of using local assets for local recovery is known as the “ring fence” – the idea being that insolvency drops an invisible “ring fence” around any valuable assets at the borders to meet claims arising within the borders.  No country is more assiduous in weaving the ring fence than the United States of America.  It is a very successful strategy for US creditors.  US creditors of failed international banks tend to recover disproportionately relative to creditors anywhere else.  The ring fence contains all these choicest assets for US creditors, and all the international creditors are forced to pick among the dross of foreign assets to eke out a recovery, only receiving any residual US assets remaining after US creditors get 100 percent recovery.

Lehman has been deeply troubled and subject to speculation since the early spring.  That was just about the time that we started to see a marked sell off in foreign markets where Lehman has long been a major player.  Recently, along with intensification of that sell off, we have seen a strengthening of the US dollar and US asset markets.

If one were cynical, and one believed that Lehman was going to be allowed to fail pour encouragement les autres one might wonder if Lehman was quietly bidden – or even explicitly ordered – to sell off its foreign holdings and repatriate the proceeds to asset classes within the US ring fence.  This would ensure that US creditors of Lehman received a satisfactory recovery at the expense of foreign creditors.  It would also contribute to a nice pre-election illusion of a “flight to quality” as US dollar and assets strengthened on the direction of flow.

If one were really cynical, one might even think that a wily bank supervisor might arrange to ensure 100 percent recovery for its creditors with a bit of creative misappropriation thrown in the mix.  Broker dealers normally hold securities and other assets in nominee name on behalf of their investor clients.  Under modern market regulation, these nominee assets are supposed to be held separately from a firm’s own assets so that they can be protected in an insolvency and restored to the clients with minimal loss and inconvenience.   Liberalisations and financial innovations have undermined the segregation principle by promoting much more intensive use of client assets for leverage (prime brokerage and margin lending) and alternative income streams (securities lending).  As a result, it is often very difficult to discern in a failed broker who has the better claim to assets which were held to a client account but reused for finance and/or trading purposes.  The main source of evidence is the books of the failed broker.

On the wholesale side, margin and collateralisation in connection with derivatives and securities finance arrangements mean that creditors under these arrangements should have good delivery and secure legal claims to assets provided under market standard agreements.  As a result, preferred wholesale creditors could have been streamed the choicest assets under arrangements that will look above suspicion on review as being consistent with market best practice.

If Lehman were to go into insolvency, I will be interested to discover whether US creditors achieve a much higher proportion of recovery than their global peers in other locations where Lehman did business.  If so, it will likely be because of the US ring fence and the months of repatriation of assets and funds back into the confines of the ring fence before the failure was finally orchestrated.  It will also be because the choicest assets were preferentially delivered  to preferred US creditors under market standard margin and collateral arrangements.

Unfortunately, the pace of an international insolvency means that any retrospective evaluation will be so far down the road that I will likely be almost alone in looking backwards to see what the final distribution effects are and what they mean for equitable principles of international banking practice.

19 Responses to "Ring Fences, Rustlers and a global bank insolvency"

  1. Guest_Dr.Dan   September 12, 2008 at 6:22 am

    First

    • Anonymous   September 12, 2008 at 7:00 am

      Now I’m second :)

  2. Guest   September 12, 2008 at 6:51 am

    Second

  3. Guest   September 12, 2008 at 8:17 am

    The true core nature of mankind is revealed in crises like these. The faith and credit of the system was built up for years, and is to be taken down in a series of rapacious plunders. When the US eventually defaults, it will be the most egregious “redistribution” of wealth ever seen, bar nothing including war, slavery, and conquest. The US will be considered by the world to have been a plague of locusts that so fully purloined their treasure that not a blade of grass remains.

    • Guest   September 13, 2008 at 6:40 am

      You are assuming too much intelligence remains. These institutions were run by incompetence and greed. It is quite possible (and likely) that the bulk of the assets were already pledged ashore.Really surprised at you and LB’s comments.

  4. Mark   September 12, 2008 at 11:24 am

    Assuming that US creditors do make out with a higher percentage of the recoverable assets would this not eventually sour foreign investors (who are already starting to get rather fed up with US activities in the global arena) on dealing with US corporations?

  5. Miss America   September 12, 2008 at 4:41 pm

    Hey there LB,Nice job again. The viscous cycle of debt is cyclical in many ways. I discussed the parallel of what you are talking about back in March. (I’ll paste it below) What I said (based on foreign institutions/Gov’ts leaving the USD runs exactly parallel, in that we see the US patriot selling overseas to either cover losses or chase gains.)It’s a game of chicken, and as long as the USD is the world currency, the flight to safety, and what most things are priced in… you will see the USA maintain its position in the OODA loop. Its downside becomes its upside, on each next move.Miss America…as promised, my stroll down memory lane:RGE Time stamp : 2008-03-19 12:09:32@ Anonymous – “Investors are beginning to wonder where America will get the money from to pay back all its debt when the margin calls come in.”Huh???Sorry… but it doesn’t work like that. There is no “margin call” on US Debt.When maturities come around, they are paid in USD. Not foreign dollars for those overseas. So as the USD collapses, all those foreign investors get back is a cheaper dollar. What they do with that dollar is tricky.Exchange it back to their own currency (at a major loss)-or-just keep it in play and hope for this being the “dip” on the USD.Either way, the foreign investor holding USD issues is losing. It’s not the USA losing.…but here’s one of the caveats. The maturities that are paid out, are funded by new issues. (so people say, what if no one buys these new issues. For example, foreign countries like china will stop funding the UST’s…) Well then there would be a problem right…???Not exactly. You see, currently, there is more USD abroad chasing higher profits, then most people realize. If the UST’s where in danger of defaulting, the new issues would have to offer higher rates. Higher rates, would bring those patriot foreign investors back home. (while at the same time causing mass selling in foreign markets. What does selling do to a market???) …at the same time, those patriot foreign investors catch the profit of the FX upon repatriation.So the foreigners leaving UST’s catch their own falling knives.It’s a vicious cycle that is keeping the debt going. The only thing that breaks it (IMO) is if OIL ever becomes unhinged.The greenback (which people falsely say I’m love with) and its UST’s are still the “flight to quality” in true chaos. …and our current chaos (mostly fear) is keeping the rates low (demand high) on the UST’s.****important****I’m not defending the USA, the dollar and in NO WAY SHAPE OR FORM our current policies… …but I thought it was necessary for some people to see the bear trap that exists, that has helped keep the USA floating along.This is a great country, but it has problems like every other one out there. Are our problems larger? Maybe? If they are… then our upside is greater too. (that’s the way it works!) If you’re out there displaying schadenfreude towards the USA, hoping for its economic collapse, be warned that if it does actually collapse, you will be in the rubble!08 elections can’t come soon enough! Hopefully the changes the new admin will work towards bettering the USA and the rest of the world. In the meantime, be safe, be smart, and be right!!! And hope you’re not in this financial war’s crosshairs.Miss Americap.s. I still don’t believe “insolvency” exists. (I wrote a fairly detailed and lengthy post about it a couple of months ago which was harshly criticized.) My argument is that the systems always been insolvent, so it can’t “become insolvent”. That’s what keeps us going. Insolvency is like saying: there’s no future or hope for it.

    • Stormy   September 12, 2008 at 8:30 pm

      Excellent comment to a superb and lucid post.In terms of Fannie and Fred, were not the foreign central banks protected? The ring failed here? China, for example, did not find any knives in Fannie and Freddie’s fall.

    • Alessandro - http://castellidicarte.blogspot.com/   September 13, 2008 at 6:52 pm

      “My argument is that the systems always been insolvent, so it can’t “become insolvent”. That’s what keeps us going. Insolvency is like saying: there’s no future or hope for it.”To some extent I agree. As the future is being shut at Lehman, its insolvency finally come to the surface. Just like with Bear.I start to think like a banker. I must be sick.

  6. Guest   September 12, 2008 at 5:03 pm

    MAYou are not making my life any easier. The links I posted today By Guest on 2008-09-12 15:16:58 are no longer providing me with the confidence on the future dollar outcome. Thanks for the counterbalance I was hoping not to find.)hlowe

    • Guest   September 12, 2008 at 6:22 pm

      Clarification: I will be happy not to be in the rubble!hlowe

  7. pablothecajun   September 12, 2008 at 10:19 pm

    London Banker is confused on both FDIC receivership of a national bank and a Chapter 7 or 11 bankruptcy of a bank or bank holding company. They are different legal animals. In no instance is a foreign creditor treated differently than a domestic creditor. As outside counsel to the First City receivership of 1992 and a former RTC outside counsel, there is absolute no difference in treatment of foreign or domestic creditors.There is a practical problem if a bank has assets overseas in bringing them into any receivership. First City actually had assets that were located in Span.The most recent example of a FDIC receivership and federal bankruptcy is the Indymac shutdown earlier this summer. Indymac was taken under by the FDIC and the carcass was put into federal bankruptcy, of which little or nothing will be recovered for any creditor.Whether its Lehman Bros or Etrade or WAMU, foreign creditors will be treated the same as domestic.

  8. London Banker   September 13, 2008 at 9:34 am

    @ pablothecajun on 2008-09-12 22:19:31With all respect, I think you miss the point. Claims against foreign affiliates in the Lehman Brothers group will have their situs (place of legal validity) where they are created by contract. As most exchanges require local subsidiaries with local capitalisation, most claims against foreign broker-dealer affiliates will be only exerciseable in the jurisdiction of the affiliate. If the assets are somewhere else, the claimants can’t just go there to pursue the assets. This is why it would be significant if assets were being moved to a jurisdiction (like the US) where they would favour some claimants (e.g., US claimants) over others around the world.Obviously Lehman Brothers is not a commercial bank, will not come under FDIC (will come under SIPIC, but only for US investor claims), and has many exchange and OTC obligations in wholesale markets where US wholesale counterparties have a huge interest in improving their recovery in an insolvency.We will see how it plays out. These are interesting times.

  9. Guest   September 13, 2008 at 10:10 pm

    LB–Looks like we got the Chinese curse, all right.

  10. London Banker   September 15, 2008 at 10:01 am

    Japan’s FSA is a bit late at shutting the barn door, but that isn’t stopping them from trying:

    Even as the turmoil on Wall Street is reminding many in Japan of the bad, old post-bubble days, some of Japan’s banks are finding themselves back in a financial nightmare.Japan’s Financial Services Agency on Monday ordered Lehman Brothers’ Japanese subsidiary to retain assets in the country as it emerged that Japanese banks were the US group’s top unsecured lenders. Lehman’s Chapter 11 filing for bankruptcy protection reveals that Japan’s Aozora Bank – controlled by US private equity group Cerberus – is owed $463m in unsecured bank loans, more so than any other bank, while Mizuho is in second place with $289m owed, reports the FT.

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