Friday, 12 September 2008

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.


Anonymous said...

Used to be that the ring barbed fences were to contain the wealth of cattle and protect them from predators and rustlers. Now the rustlers are using it to make claim and protect from the lawful owners. The system has been devised (as always, but particularly now) to enable the worst moral hazard--open daylight thievery. This is the modern equivalent of the Goth and vandal scourge and plunder of Rome...without the blood and mess of hand-to-hand combat. Smart, conniving cowards will make off with all value.

Thai said...

LB-- what a simply brilliant post! It fills an enormous hole/so many questions I have had concerning this whole debt debacle for a long time... It also makes me feel even sicker about what the western developed world MAY BE about to do to all those hard working citizens in developing countries... It really is one of those examples of "first passenger's to get onto the Titanic's lifeboats were the one's who surived" where in this case 'first' is an understanding of the rules of law.

Do you know, was this a major reason why England did so much better than the US during the great depression?

Jesse said...

Brilliantly insightful post LB. I had not been aware of these issues.

Jesse said...

JPM is said to be in advanced talks to buy Washington Mutual. Stick save with Lehman on Sunday?

That's two down, and AIG to go.

If any will be allowed to fail it would likely be Lehman. AIG is huge, but then again, they are not a bank.

Jesse said...


J.P. Morgan just denied takeover talks with WaMu according to Bloomberg TV.

At least they did not wait until after the close.

Anonymous said...

Yours is a first-class intellect; and by appearances your integrity follows suit. I raise a weekend toast to hoping that the architects of our next financial system is designed by peers of the same broadcloth quality and experience. Stand a glass to emerging someday to a better future.

Anonymous said...

Sorry, but I don't see why this was such an insightful, groundbreaking post. The risks of cross-border investment have been well-known since the days of John Law and Mississippi Company in 1717.

Rather than worry about private local creditors carrying off the choice assets of a bankrupt firm, worry more about the more common occurrence: governments carrying off the assets of a healthy firm. Think TNK-BP, Conoco & XOM-Venezuela, Gazprom-Yukos, and cross-border capital restrictions in general.

The US and UK have some of the best, relatively speaking, protections for foreign investors in the world. Let's focus on the more common problem first -- the one I just described.

Anonymous said...

The US changed their BK laws in October 2005 to incorporate the UNCITRAL MODEL.Japan, Mexico, Poland, Romania, South Africa and the UK have adopted this model.
I think the EU has its own regulations.

The assets have been repatriated because of deleveraging and deflation. You make a good point, but motives are not so sinister. As I said last winter, money has got to home cause it is needed here. It's not complicated.


Anonymous said...

Wouldn't such behaviour make it a little difficult for US banks to get foreign customers in future? Perhaps the future is being left to look after itself.

Thai said...


what do you think debt is in the first place? What do you think intergenerational debt is?

Sadly history is replete with examples of people who didn't think about the consequences of their actions on themselves.

And History has EVEN MORE examples where parents did not think about the consequences of there decisions on their children.

... In fact, if you think about it, ONE way of defining the word 'weathly' is to simply apply it to those who make economic decision looking at longer time intervals than those who do not.

Anonymous said...

all this speaks to me of a banking system that is impossible to place your trust in, me a simple depositor turns out to have the same fears as those much further up the chain in importance who you'd think would get special treatment. personally i've removed all my assets far away from any institution until I discover a bank that operates on traditional principles in the old fashioned manner
people are bemoaning leverage, but what else is a bank when it lends out your deposits?
fractional reserve means only one thing

you need one that doesn't ever need to borrow money for a start, why would it?
we all know when a bank reports a loss it's bust, end of story!

I hope Nationwide and the mutual model survives because it seems such a safe model with no shareholders to satisfy

I'm convinced sound banking will make a come back, some of these comments are dumb. how can you look at it from a distance?
people don't mess around with their money, although you wonder with hedge funds and reits, still it's not academic and practises that are unfair will destroy the trust that any bank depends on to exist

oh, and the foreign investors getting burned are the same ones who fund our government buying bonds. let's see how well that works out all you genuises

Jesse said...

China is not pleased.