This post started out as a defense of Dodd-Frank’s resolution authority, and a description of what the liquidation of one of the major US banks would likely look like under the new law. But I quickly realized that in order to understand how a resolution of one of the major banks would work in practice, you really have to have an understanding of how the major banks/investment banks are structured, legally, and why that structure causes so many problems in bankruptcy. I don’t think this is something that’s ever been explained in the blogosphere (I’d be extremely surprised), but it’s crucial to understanding the real issues surrounding financial reform and the major banks, so I think this post can be useful. Anyway, this is part one of a two-part post; part two will describe what an orderly liquidation of a major US bank under the Dodd-Frank resolution authority would actually look like. That post will come sometime tomorrow (I’m too tired to finish it right now).
Major international banks are organized as holding companies — in the US, the major banks are all financial holding companies (FHCs). The holding company (known as the “holdco”) sits at the top of the legal structure. Right below the holdco is the layer of primary regulated entities, which conduct the vast majority of the bank’s day-to-day business, and employ most of the bank’s employees. The most important primary entities at the major US banks generally include registered broker-dealers in New York, London, and Asia, a chartered US commercial bank, a smaller continental European bank, and an asset manager.
Below the primary entities is a layer of product-specific “booking entities.” (See my very rough org chart below.) These entities are structured to hold specific types of instruments that the primary entities deal in (e.g., FX spot, interest rate swaps, crude oil futures), and are set up for regulatory, capital, tax, or other such noble reasons. Booking entities are generally fully guaranteed by the holdco as well. Here’s how this works: when a trader in New York enters into, say, an foreign exchange swap with a hedge fund, the primary broker-dealer or commercial bank is usually the initial counterparty; however, the bank can immediately assign the swap (which is sometimes done automatically) to the designated booking entity for foreign exchange swaps, as there will likely be a clause in the bank’s ISDA Master Agreement with the hedge fund that allows the bank to unilaterally assign the swap to any subsidiary that’s guaranteed by the holdco. (Sometimes traders execute the trade directly on behalf of the booking entity, although for reasons having a lot to do with excessive laziness and/or ignorance at the trader level, this used to happen a lot less than it should have.)
(Yes, I’m ignoring things like intermediate holding companies and captive issuers in this org chart, but they’re not important for our purposes.)
Booking entities are generally funded by a combination of intercompany repos and securities loans with the main commercial bank and broker-dealer, and unsecured loans from the holdco. So, for example, if a client of the US broker-dealer wants to borrow a security, the broker-dealer might actually enter into back-to-back repos with the booking entity and the client — in effect, the broker-dealer would borrow the security from the booking entity and then lend it to the client. The bank’s primary entities engage in significant intercompany transactions with each other as well. For example, one standard practice at large banks is “local settlement,” the main result of which is that the US commercial bank or broker-dealer clears and settles US securities trades for the European broker-dealer, and the European broker-dealer clears and settles European trades for the US entities.
The reason all of this is important is that the major banks, and particularly the major broker-dealers, are all responsible for customer assets in the hundreds of billions (out of proportion to the banks’ total assets, which is a truly silly metric for systemic risk). The fact that the banks are constantly shifting assets — some of which are the bank’s, some of which are client assets that have been rehypothecated — among their primary entities, booking entities, and holding company makes it difficult, when a major bank fails, to quickly sort out which entity controls which assets, and what rights each party has in those assets. And sorting this out is a precondition to a successful resolution of the bank.
Now, it’s easy to overstate the complexity of all this. There are a lot of moving parts, but 99% of the cash flows follow a standard protocol, and are repeated hundreds of times a day. It’s even easier to overstate the difficulty of dealing with the failure of one of the major banks, given these complicated interrelationships. Will resolving a major bank be a difficult task? Of course. Can it be done? Absolutely.
What’s important to understand — and I don’t think enough people do understand this — is that one of the biggest reasons that Lehman’s failure was such a catastrophic event for the markets was Lehman’s complete and total lack of preparation for a bankruptcy filing. I know this isn’t what most people want to hear or believe, since it doesn’t fit neatly into any of the popular narratives, and fixing it wouldn’t be gut-wrenchingly painful for the banks. But it’s the truth — and if you ask people who worked through the Lehman failure, they’ll all tell you the same thing: the complete lack of preparation was devastating.
It was honestly as if no one in the entire Lehman organization had thought about what they’d need to do in the event of a bankruptcy filing until the moment they filed. As a result, it was the most chaotic, uncontrolled failure imaginable.
To take one example: Lehman’s holding company (LBHI) filed for bankruptcy, but at the last minute its US broker-dealer (LBI) was kept out of bankruptcy by the NY Fed. The problem was that no one knew about this — most people thought LBI had filed too. Lehman had all sorts of problems getting employees to even show up for work; JPMorgan, which was LBI’s clearing bank, unilaterally shut off LBI’s access to its accounts for several days, and actually started seizing assets of LBI’s prime brokerage clients (a huge no-no); clearinghouses improperly limited LBI’s trading activity; the NSCC mistakenly seized a large amount of LBI’s customer securities; Lehman’s European broker-dealer (LBIE) stopped payments to LBI’s omnibus account even though LBI continued to make payments to LBIE; incoming customer securities to LBI weren’t getting properly segregated; counterparties simply stopped posting collateral they owed on OTC derivatives with LBI; and so on. That first week, the biggest challenge was simply getting someone at Lehman on the phone. (I saw a 63-year-old senior partner do a fist-pump you’d have to see to believe when he finally got an account executive at Lehman on the phone. Unquestionably the highlight of my week.)
You get the picture: it was utter chaos, in no small part due to sheer confusion about what was going on. Another crucial consequence of Lehman’s lack of preparation was that there was no sustained effort on Lehman’s part prior to bankruptcy to make sure that client assets were in the right place to effect a smooth transition at the time of the bankruptcy filing. This led to one of the biggest problems of the entire episode, when a large number of US hedge funds discovered, to their surprise, that their assets had been transferred to LBIE, and had been frozen when LBIE filed for insolvency. The LBIE debacle effectively caused about $40bn to unexpectedly disappear from the market at the worst possible time.
What all this shows is that the failure of a major bank is not some deep-seated, inherently insurmountable problem, as some people would have you believe. By contrast, it shows that a well-planned and well-executed resolution would have avoided many of the most significant problems that arose in the Lehman bankruptcy.
And tomorrow, I’ll explain how this can be done under the Dodd-Frank resolution authority.