Bankruptcy and Close-out Netting of Financial Contracts

The Bankruptcy Code contains provisions for close-out netting of financial contracts.  Explaining these provisions entirely would make for a long and boring post, but suffice it to say that for certain types of financial contracts, e.g., repos, securities contracts, forward contracts, and swaps, there is an exception from the automatic stay of the Code.  This means, with some exceptions, that counterparties to a institution that has filed for bankruptcy are permitted to net and liquidate these contracts with the failed institution immediately.  This is an exception to the general rule that creditors are not permitted to take this type of action until the bankruptcy court has approved such action.

The public policy justification for these provisions is the claim that they reduce systemic risk.  It was argued that in fast moving markets in which financial intermediaries may need the proceeds from one transaction to pay off another, waiting for a court to lift a stay could cause a domino effect, thus spreading financial problems to other firms, even those that had no trades with the failing firm.

When it comes to the failure of firms with large positions, there is now the fear that close-out netting could also cause problems.  If, upon the filing of bankruptcy of a large hedge fund or investment bank, all the counterparties liquidate eligible financial contracts and sell the collateral in their possession supporting these positions at the same time, this could cause market problems.

This is one of the reasons the Administration has proposed resolution authority.  Under current law, the FDIC has one business day to decide what to do about “qualified financial contracts.”  It can decide to transfer these contracts to a willing, solvent institution, and the counterparties would then not liquidate the contracts and the underlying collateral.

However, there is some doubt that resolution authority would work for multinational financial institutions.  Other countries would deal with those parts of the institution in their own way under their own laws.  That is one reason why ad hoc responses to any future crises involving the insolvency of a large financial institution are likely, no matter what legislation is passed now or what promises are made.

Attention needs to be focused on making such crises less likely.  Proposals being put forward include more stringent regulation, tougher capital requirements, limiting the permissible business activities of certain types of financial institutions, and capping the size of banks and forcing current large bank holding companies to split into smaller pieces.  The aim now, though, seems to be to pass anything that can be passed, in order to say that the government is addressing the issues raised by the financial crisis.  We can at least all hope that this political reality will result in legislation that will improve the financial system.