Repos and Resolution 2.0

Just a month ago, the Federal Reserve pumped USD 75b into the financial markets on 15 September and the two following days. This extraordinary measure was taken to address a sudden spike in the so-called ‘repo rate’, which corresponds to what borrowers have to pay in ‘repurchase agreements’ or ‘repos’. In essence, a repo is a type of secured inter-bank loan agreement, in which funds are typically provided against the transfer of a securities portfolio as collateral. The events of 15 September 2019 reminded observers of the repos that infamously pushed Lehman Brothers into insolvency, exactly 11 years ago. Then, the securities Lehman provided as collateral plummeted in value, so that Lehman’s counterparties demanded extra collateral, terminated their repos with Lehman or did not renew them. This caused an immediate liquidity problem at Lehman’s and its subsequent demise, followed by a Global Financial Crisis (GFC).

Several circumstances came together last month, amongst which the due date for US companies to pay their tax bills. This led to a sudden demand for funds, which sent the repo rate up. Whether or not current market circumstances are indeed similar to the ones 11 years before, and whether or not a new GFC is imminent, the Federal Reserve’s intervention of September 2019 requires us to consider whether the legislative and policy measures that have been taken since 2008 may help to avoid a next GFC.

On the one hand, much has happened since  the GFC of 2008. Before and at the earliest stages of the GFC, few jurisdictions across the globe had a specialist regime for bank insolvencies. Soon, however, it was generally acknowledged that the lack of an effective insolvency regime taking into account the specificities of bank insolvency posed a threat to financial stability. Since then, many jurisdictions have introduced specialist bank insolvency regimes, referred to as ‘resolution regimes’, and oftentimes inspired by recommendations of international standard setters such as the Financial Stability Board (FSB), the International Monetary Fund (IMF) and the Bank for International Settlements. As a notable example, the legal framework for the recovery and resolution of banks has been harmonised throughout the European Union with the Bank Recovery and Resolution Directive (BRRD), while the management of the resolution of cross-border operating banks in the Eurozone Member States has even been centralized. Consequently, the various new resolution regimes tend to share common characteristics.

However, as the concluding chapter of our new book ‘Cross-border Bank Resolution’ stresses, the effectiveness of any resolution of cross-border operating banks is still jeopardized by the absence of a global framework. This is specifically worrisome because banks with cross-border operations are the largest ones and the most intricately interconnected with the rest of the financial system. Therefore, any impediment to the effectiveness of the resolution of such cross-border banks represents a threat to (global) financial stability. Besides new, more stringent capital requirements for large banks, other factors may contribute to the challenges these banks currently face, including cyber-related operational risks and anti-money laundering related crimes. All these issues require global solutions. However, the recent rise of nationalism and increase of global political instability have erected significant hurdles to achieve an international approach. A binding global regime for the resolution of banks cannot, therefore, be expected in the near future.

In our opinion, four steps could be taken in parallel to address the risk to financial instability caused by the current absence of an effective global resolution regime: (i) contractual solutions to regulate the relationships between a bank and its counterparties, both ex-ante and ex-post resolution; (ii) cooperation by authorities responsible for early intervention and resolution; (iii) recognition by national courts of foreign resolution measures; and (iv) further international harmonisation of resolution laws. Ideally, these steps should be taken in parallel as the implementation of any of them will enhance legal certainty. While steps (i) and (ii) have been taken to a certain extent already, steps (iii) and (iv) have proven to be more difficult for political reasons, but also because it has proven difficult to reconcile the national recognition of foreign resolution measures with national financial stability considerations. Another reason for the reluctant approach to recognition and further harmonisation has been the interconnection of the resolution regimes with other areas of law that have remained predominantly national.

The legal framework for resolution is closely connected to —and some even say forms part of— national private and insolvency law. In addition to the recent increase in nationalism and geopolitical instability, this legal interconnection poses a significant barrier to accomplish the steps just discussed, because all steps require some form of harmonization of national private and insolvency laws. As an important example of this link between resolution regimes and private and insolvency law, reference can be made to the so-called ‘no creditor worse off than in liquidation’ or ‘NCWO’ principle. This principle was endorsed by the FSB in its 2014 Key Attributes and has been implemented in many of the new bank resolution regimes. In the EU, for instance, it has been codified as article 34(1)(g) BRRD. The NCWO principle dictates that creditors should receive in resolution as a minimum what they would have received in a liquidation under the otherwise applicable national insolvency regime. This principle may have served a political purpose, but it is acutely problematic from a practical perspective. It requires resolution authorities to calculate, for all measures that affect the failing bank’s creditors, the hypothetical result of the measure for the same creditors under the otherwise applicable, national insolvency regime. Consequently, each and every difference between national insolvency regimes—and there are many—becomes critical in a cross-border resolution. Moreover, foreign courts may use the NCWO principle to refuse recognition of foreign resolution measures and thus frustrate their effectiveness. This problem can only be mitigated by the harmonisation of national insolvency laws for banks, in particular with regard to the priority ranking of creditors’ claims.

Recently, the IMF has stressed the importance of a harmonisation of national insolvency laws for banks, specifically where it regards the priority ranking of creditors’ claims. The vehement emotions that the recently adopted EU Restructuring Directive has provoked, however, do not inspire confidence for any quick successes here. Do we really need another GFC to instil the sense of urgency that seems to be necessary to reach some form of consensus?

Matthias Haentjens is Hazelhoff Professor of Law at Leiden University.