International Financial Conglomerates

The Rise and Fall of the Giants


Wissenschaftlicher Aufsatz, 2011

20 Seiten, Note: Distinction


Leseprobe

Contents

1. Introduction

2. Lehman Brothers in context of the financial crisis
The advent of international financial conglomerates
Systemic risk stemming from international financial conglomerates

3. Deficits in the US Bankruptcy Code and Procedures

4. Administration of insolvency of international financial conglomerates

5. Regulation and Credible Insolvency Procedure

6. Conclusion

7. References

1. Introduction

International financial conglomerates are the result of the last three decade’s policy of deregulation and globalisation. This meant the convergence of commercial banking, investment banking and sometimes insurance in the United States of America with a cross-border expansion. Yet, as has been seen in the recent 2007-2009 crisis (the crisis), those conglomerates create a wholly new host of challenges due to their activities, prime role as counterparty activities in the credit default market, size and structure. Especially their central role in market-financing of other financial institutions as well as other types of companies creates globally systemic risk.

A consistent policy which mitigates uncertainty during times of financial crises is essential; however, the rationale behind the US authority behind the ad-hoc responses dealing with AIG, Bear Stearns (BS) and Lehman Brothers Holdings Inc (LB)1 are very hard to distil, if at all. It can be claimed that there was no consistency in the rescue efforts.2 In the first case, US authorities injected capital into the ailing company to keep it alive. In the BS case, authorities supported the takeover by JP Morgan using public funds.3 In the last case, LB, since no potential buyer could be found and authorities did no facilitate any support, the company had to file a petition under Chapter 11.4

This shows the mechanisms but also difficulties authorities encounter when they deal with those systemic relevant institutions. They have to try to prevent moral hazard incentives, avoid spillovers to other industries and reduce costs to taxpayers. Constructive ambiguity in bail-outs is related to the prevention of moral hazard but increases simultaneously uncertainty, the chance of ill-considered bail- outs, spillovers and delays in regulatory actions. Other mechanisms like capital injections are very costly for taxpayers.

The orderly insolvency procedure of systemically relevant institutions seems an appropriate response which mitigates above-mentioned issues when preventing the deterioration of asset value. Existing legislation did not allow, however, the Federal Deposit Insurance Corporation (FDIC) to take the conglomerates under receivership to prevent spillovers and the value deterioration it would experience using the regular bankruptcy regime.

This essay will explore the insolvency5 regime of US financial conglomerates of systemic importance by exploring the LB insolvency. It will be claimed that the insolvency regime in the US during the crisis was inappropriate in dealing with the new structure of the financial institutions as well as there is a need for cross-judiciary coordination.

The next chapter which is divided in two sections will first look at the advent of conglomerates, then at the risks these pose to international financial markets. Thereafter, Chapter 3 shows the deficits of the US Bankruptcy regime in dealing with those conglomerates. Chapter 4 takes the insolvency procedure to an international plane. Chapter 5 gives recommendation. Chapter 6 concludes.

2. Lehman Brothers in context of the financial crisis

The advent of international financial conglomerates

Many commentators have referred to the recent financial crisis as the worst since the Great Depression in 1933. Yet, the recent financial crisis, however, originated from the financial market, ie from non-banking financial institutions. Nonetheless, the threats were the same - the failure of systemic important institutions and devastating consequences for the real economy.

Systemic risk has been related commercial banks. There has been a threat of contagious bank runs which as a self-fulfilling prophesy can even doom financial healthy institutions to fail. Therefore, the Federal Reserve (Fed) scrutinised banks’ risk for the financial stability. Also the Federal Deposit Insurance Corporation Act was enacted in order to help financially distressed company which pose systemic risk to the stability of the financial market.6

Traditionally, there has been in the US a strong barrier separating commercial and investment banks as result of the Glass-Steagal Act7 from 1933. The Gramm-Leach-Bliley Act8, also called the Financial Services Modernization Act, repealed this separation in 1999. This moment was the advent of universal banks which were and are common in European jurisdictions.9 Universal banks have been claimed as major factor for the recent crisis. Major universal banks with at least two of the businesses investment, security or insurance segments can be termed conglomerates.10 There is, however, no universal definition of the term financial conglomerates.

The emergence of conglomerates shifted this ‘old-style’ bank run to different variants of runs on other institutions with systemic relevance which became more important than depository institutions.11

Since the beginning of the century there has been a new trend of conglomeration, ie mergers and takeovers between depository and other financial institutions which ultimately blurred their separation. In addition, trans-national mergers created the problem of administrating different insolvency regimes on a global level.

In the last decade, there has also been a change in funding of the institutions which increasingly relied on short-term funding. Yet, the short-term funding does not refer to the traditional maturity transposition of callable deposits to long term loans made by banks. The new trend made financial institutions rely on repurchase agreements and the “secured” roll-over of these “loans”.12

Systemic risk stemming from international financial conglomerates

In the Bear Stearns and Lehman Brothers cases, both investment banks experienced solvency problems; however, in the later case the response differentiated substantially. Authorities decided to facilitate the merger with JP Morgan in the first case whereas they decided to apply market discipline with detrimental implications for the market in the latter case.

In the following section the bankruptcy of Lehman will be explored.

The results of the Lehman failure on financial markets were catastrophic13

Lehman Brothers Holding Inc is a prime example for the risk stemming from an international financial conglomerate. The financial conglomerate followed the US Model by having a holding company which administers globally three business segments: Capital markets, investment banking, and the investment management division. Thus there are two dimensions, (i) the global orientation with operations in over 40 countries and over 650 legally separable operation entities (ii) engaging in different business activities and thus being subject to different regulatory bodies.14

The investment bank LB had to file Chapter 11 of the US bankruptcy code15 on 15 September 2008.16 It held prior its default a “central position as a dealer and counterparty in a variety of financial markets” and hence caused globally systemic distress of financial markets due to three reasons.17

First of all, LB had a significant position as reference entity and counterparty in the credit default swap (CDS) market. The default inevitably caused a termination of all CDS contracts which used LB as reference as well as contracts LB concluded itself.18 The volume of the respective contracts was unknown to the public, which caused the already distressed market to experience further uncertainty19 about the market liquidity.20

Secondly, LB had a prime position in the commercial paper and other short term debts market21. These sources of finance have been used as investment vehicle of money market funds. In the aftermath of LB’s filing for Chapter 11 and the following distress for funds, investors promptly redeemed their shares? which drained the market for commercial papers.22 Since also companies use commercial papers as source of finance, the failure of LB caused distress in the real economy; however, the Federal Reserve could keep this market liquid.23

Lastly, LB’s position as prime broker attracted hedge funds as clients which left their assets with LB, which LB pledged as own collateral.24 Since LB filed insolvency in several jurisdictions, which includes also multiple countries, the assets that LB pledged as collateral were frozen. This prevented the hedge funds to access their assets. Hedge funds play a significant role as investors which as a result of mentioned international developments were paralysed.25 Inevitably, this led to a draining of the shadow banking system and hence the distressed illiquid market.

[...]


1 Interchangeably used with Lehman Brothers

2 K Ayotte and DA Skeel, ‘Bankruptcy or Bailouts?’(2010)35 Journal of Corporation Law 469, 470 <http://ssrn.com/abstract=1362639> accessed 20 April 2011

3 Eg see WD Cohan, House of cards: A Tale of Hubris and Wretched Excess on Wall Street (Doubleday, 2009)

4 Eg see L McDonald, A colossal failure of common sense: The inside story of the collapse of Lehman Brothers (Crown Business, 2009); The bankruptcy process of LB is claimed to be greatest so far, see B Wessels, ‘On globalisation of regulation’(April 24, 2009)1(3) Amsterdam Law Forum University Amsterdam <http://ssrn.com/abstract=1509351> accessed 20 April 2011

5 the terms insolvency and bankruptcy will be used interchangeably

6 Continental Illinois National Bank & Trust Co failure in 1984 distress marked one of the first moments of so-called too big to fail institutions after the Great Depression

7 Pub. L. 73-66, 48 Stat. 162

8 Pub.L. 106-102

9 However, the structure varies to the US holding model, see RM Lastra and R Olivares-Caminal, ‘Cross-Border Insolvency: The case of Financial Conglomerates’ in JR LaBrosse, R Olivares-Caminal and D Singh (eds), Financial Crisis Management and Bank Resolution (Informa Legal Publishing UK, London 2009), 272

10 Bank for International Settlements, ‘The Supervision of Financial Conglomerates”: A report by the Tripartie Group of Bank, Securities and Insurance Regulators’(July 1995) <www.bis.org/publ/bcbs20.pdf> accessed 20 April 2011; Lastra (n 9) 270

11 Not only the protection of depositors is important also systemic risk stemming from other kinds of financial institutions, like the hedge fund Long Term Capital Management (LTCM), proved to be a risk which could not be neglected.

12 Also given that most of the financial institutions, as will be seen later, did not have any access to deposits

13 Timony Geithner (US Treasury Secretary) in DG Tarr, ‘Lehman Brothers and Washington Mutual Show Too Big to Fail is a Myth - A Myth that Prolongs the Recession and Retards Growth’ (2010), New Economic School Mosow, 2 <http://ssrn.com/abstract=1533522> accessed 20 April 2011

14 Roe (n 31) 4, see Figure 1: Legal Proceedings as a Result of Lehman Brothers Holdings Inc. Bankruptcy Filing as of February 2009 on page 9 for global orientation

15 11 USC Title 11 - Bankruptcy

16 I Fender, A Frankel and J Gyntelberg, ‘Three Market Implications of the Lehman Bankruptcy’ (December 2008) Bank for International Settlements (BIS) Quarterly Review, 6

17 ibid 6

18 Ibid; AIG played a major role as counterparty in the CDS market, with institutions like Goldman Sachs relying solely on it. AIG had due to its investment-grade risk AAA prior to the financial crisis no requirement to pledge any collateral. During the crisis AIG was downgraded, hence counterparties started to require collaterals. AIG had problems to award these, which brought them into distress. See Roe (n 31) 9

19 Uncertainty is a very important phenomenon during times of crises. It differs to the notion of risk which in contrast is measurable, whereas uncertainty is entirely irrational and not measurable.

20 Fender (n 16) 6

21 Eg repurchase agreements (repos). Bear Stearns also relied heavily repos for financing purposes

22 Frender (n 16) 7

23 Fed commercial paper response find quote

24 Frender (n 16) 7

25 See shadow banking system

Ende der Leseprobe aus 20 Seiten

Details

Titel
International Financial Conglomerates
Untertitel
The Rise and Fall of the Giants
Hochschule
University of Warwick  (School of Law)
Veranstaltung
International Corporate Governance and Financial Regulation
Note
Distinction
Autor
Jahr
2011
Seiten
20
Katalognummer
V177258
ISBN (eBook)
9783640988402
ISBN (Buch)
9783640988372
Dateigröße
588 KB
Sprache
Deutsch
Schlagworte
international, financial, conglomerates, rise, fall, giants, distinction
Arbeit zitieren
Christian Alexander Mecklenburg-Guzman (Autor), 2011, International Financial Conglomerates, München, GRIN Verlag, https://www.grin.com/document/177258

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