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Enforceability of credit risk mitigation techniques in the context of bank insolvency and resolution

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Mecklenburg-Guzmán, Christian Alexander (2019) Enforceability of credit risk mitigation techniques in the context of bank insolvency and resolution. PhD thesis, University of Warwick.

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Abstract

Before the financial crisis of 2007, financial market participants enjoyed almost unrestricted autonomy in devising techniques to contractually allocate risks and consequences of default. Market participants document derivatives and securities financing transactions under a standardised framework agreement. These agreements promote certainty amongst users. The main consideration is the management of default and the subsequent allocation of costs. It mitigates credit risk by providing a contractual self-help remedy whereby transaction tos with defaulting counterparties are terminated or accelerated, valued and amalgamated or set off to produce one single net obligation. This obligation is owed by the party with the smaller notional amount. The payment, however, is subject to insolvency dispostion constraints. Thus, the collection of this amount is uncertain; however, its benefit is the certainty that the obligation will be a net figure. This mechanism is known as close-out netting and has been adopted for agreements governing a variety of contracts, including derivatives and securities financing transactions.

Without close-out netting, there is a risk that the insolvency practicioner enforces only profitable transactions while rejecting, disclaiming or reputating transactions unprofitable for the estate. In effect, close-out netting reduces the non-defaulting party's exposure to the defaulting party to the net figure. Any creditor that must perform on its obligations while being unable to enforce its claims would experience significant distress. It suggests that the mitigation of credit risk reduces consequetial defaults– thereby promoting to financial stability. Therefore, policymakers and regulators widely promote this mechanism as contributing to financial stability by mitigating the effects of a default. This promotion takes the form of a carve-out from the scope of otherwise compulsory suspensions and restrictions that apply in insolvency. Thus, close-out netting can operate despite any actual or impending insolvency proceedings or restructuring measures.

Financial institutions can reflect their exposure on a net basis. Close-out netting thereby ensures that potential loss will never exceed the net figure. However, it does not entail payment. Creditors benefiting from close-out netting must prove their claims like any other creditors in insolvency. The recovery depends on the relative priority within the creditors' hierarchy. Therefore, close-out netting arrangements are often combined with security in the form of collateral whose value can be realised to discharge the net amount obtained after the application of close-out netting.

Critics claim that close-out netting undermines the objectives of insolvency, is prejudicial to the general body of creditors and is, in fact, detrimental to financial stability. The financial crisis of 2007 seemed to support this rhetoric. In accordance with their contractual rights, parties sought to terminate their relationships with failing financial institutions as soon as possible, thereby causing payment obligations and appropriating assets producing a result akin to a bank run. The effect was that authorities were unable to intervene and rehabilitate the affected financial institutions enable them to continue operating as a going concern. This position seems irreconcilable with the presumed beneficial effects of close-out netting. Not surprisingly, the voices that seek to abolish the carve-outs of derivatives and their framework agreements became louder and more assertive.

To date, there is no analysis of the merits of close-out netting and collateral in the context of bank insolvency and resolution under English law. This thesis fills this gap by challenging various of the academic arguments against netting, discerning the principal risks and exploring how the evolving bank resolution regime mitigates adverse implications. It argues that contrary to critics' conception, close-out netting deprives neither the debtor nor the general body of creditors of assets or any other rights. Nor does it alter the insolvency hierarchy or otherwise offend insolvency law. English law does not prohibit clauses permitting termination due to insolvency. Such termination rights are firmly entrenched in the principles of contractual freedom and commercial reasonableness. This does not contradict, however, the argument that there are good reasons to temporarily restrict enforcement in order to stabilise financial institutions and thereby promote financial stability. Financial derivatives and securities financing transactions are utilities for financial institutions and integral to their survival, which was also agreed on a global level. Implementation of these standards has however gone too far. This regime also introduces administrative powers which undermine the regulatory framework in Europe and are detrimental to the international competitiveness of EU financial institutions.

Item Type: Thesis or Dissertation (PhD)
Subjects: H Social Sciences > HG Finance
Library of Congress Subject Headings (LCSH): Credit -- Management, Bankruptcy, Default (Finance), Risk assessment
Official Date: April 2019
Dates:
DateEvent
April 2019UNSPECIFIED
Institution: University of Warwick
Theses Department: School of Law
Thesis Type: PhD
Publication Status: Unpublished
Supervisor(s)/Advisor: Singh, Dalvinder, 1970-
Format of File: pdf
Extent: xvi, 17-198, xxvi leaves
Language: eng

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