Banks Agree Not to Blow Each Other Up Too Quickly

The new ISDA rules are an exception to the cross-border exception to the Dodd-Frank Title II exception to the swaps exception to the automatic stay in bankruptcy.
You can still take the furniture though.

If a company goes bankrupt and owes you money, you will probably want your money back as soon as possible. But of course so will everyone else; that's why it's bankrupt. To deal with this inevitable conflict, the U.S. has evolved the following simple rules: 1

  • You can't just get your money back. Once the company files for bankruptcy, you can't demand repayment or sue it or terminate contracts or anything like that. You have to wait until the bankruptcy case is finished up and everyone gets (some of) their money back in some sort of equitable way.
  • Unless the company owes you money under certain derivatives contracts, in which case, you can terminate those contracts immediately, seize the collateral, offset amounts you owe and mostly protect yourself without having to deal with the bankruptcy process. 2
  • Unless the company is a big bank subject to the resolution process put in place by Dodd-Frank and administered by the Federal Deposit Insurance Corporation, in which case, you have to wait until 5 p.m. the next day to take your money back. 3
  • Unless the derivative contract you have with the bank is governed by foreign law, in which case you might enjoy looking at this series of question marks: ?????????? 4
  • Unless you are also a big bank and the derivative contract you have with the bankrupt big bank under foreign law is subject to the International Swaps and Derivatives Association protocol adopted this weekend by the 18 biggest global banks, in which case you again have to wait a day or two. 5

Isn't that neat? That last bit -- the ISDA bit -- is being touted as a big deal, "a major industry initiative to address the too-big-to-fail issue and reduce systemic risk." But it's also an exception to an exception to an exception to an exception to the normal rules of bankruptcy, which are in turn an exception to the normal rules of debt. No rational human would do important regulation that way. But no rational human did. This is a story of endless ping-ponging path dependence. 6 Roughly speaking:

  • The banks lobbied global regulators to give them special exemptions allowing immediate termination of derivatives in bankruptcy, and
  • then regulators lobbied the banks to give it back.

This is not how you'd make rules, if you were just a person making rules. Like, for one thing, you'd actually make rules, instead of asking banks to sign on to a voluntary protocol. (One lesson here might be that, however evil and too-big-to-manage they are, it's still easier to get them to coordinate globally to do the right thing than it is to get governments to do so.) For another thing, you'd make the rules applicable to everyone, rather than just the banks who signed on: Right now, in particular, asset managers and hedge funds can still close out their derivatives if a big bank goes bust. 7

But as silly as the mechanism is, the outcome seems reasonable. The point of the resolution process is to allow a bank's -- systemically important -- business to survive, even as shareholders and some creditors are wiped out or impaired. Every bank has two classes of claimants: People We Care About and People We Don't. We care about claimants whose claims are supposed to be safe; claimants who are either very sympathetic (small retail depositors) or systemically important (repo and derivatives counterparties). We don't care about people who knowingly took a risk on the bank: shareholders, mostly, but also, in the future, some kinds of holding-company unsecured creditors who know what they're getting into.

One way to protect the People We Care About is to allow them to take their money and run, which was pretty much the old approach to derivatives: The derivatives counterparties could terminate their contracts and seize collateral to minimize losses. But this is destabilizing, and also only a very rough protection: If they don't have enough collateral, or if they can only terminate at distressed prices in a freaked-out market, they end up in the bankruptcy soup with everyone else.

The other way to protect the People We Care About is to do what we do with depositors: Don't terminate their contracts, don't give them their money back, but instead just move them into a new bank that is properly capitalized at the expense of the People We Didn't Care About at the old bank, something like this:

That's a much more soothing approach. For one thing, it allows the bank to keep running its business, freed from the pesky debts that it ran up, um, running its business at the old bank. For another, it's probably a better way to ensure systematic stability. I mean, there's a reason deposits are treated that way: If the way to protect your deposits in a failing bank was just to go to the ATM and take your money back, then that would encourage bank runs. The way to protect your deposits is instead to chill for a day or two, after which your deposits will no longer be at a failing bank, they'll be at whatever functional bank has succeeded to the banking business of the old bank. The new regime for derivatives looks more or less like that. 8 Seems reasonable enough.

The new derivatives rules give me the opportunity to remind you of one of my favorite financial stories, JPMorgan's and Citi's pillaging of Lehman Brothers after Lehman filed for bankruptcy. Like all the best stories, this story has been litigated extensively, so we have a pretty good idea of what went on. Pretty much the inevitable went on:

  1. Lehman filed for bankruptcy.
  2. JPMorgan and Citi terminated their derivatives contracts and seized collateral, as they had every right to do.
  3. JPMorgan and Citi were responsible for closing out their derivatives and computing how much Lehman owed them.
  4. They did that in ways that were, let's say, maximally protective of their rights and maximally conservative as to the risks they faced.
  5. Meaning basically that JPMorgan and Citi were pretty piggish about running every assumption in their favor at the expense of Lehman.

Lehman's bankruptcy estate eventually sued, understandably enough, but JPMorgan's and Citi's behavior was pretty understandable too. It was September 2008! The world was imploding! Why take any risk at all closing out your positions with an already-imploded bank? Why not, instead, take Lehman's implosion as an opportunity to turn a profit? How else were you going to make a profit in September 2008?

Under the new regime, that wouldn't happen: Lehman's counterparties would never get to cancel their trades; they'd just move them over to New Lehman or Barclays or whatever and everything would continue as normal. Or that's the hope, anyway.

The point of the Lehman story is that, under the old rules, a systemic bank's failure was both a crisis and an opportunity. If you acted fast and played your cards right, you could come out of that failure with a nice profit. Allowing immediate termination of derivatives creates instability and fire sales and runs, sure, but it also rewards you for being smart and mean and self-interested. 9 The stay takes away those rewards, and just gives everyone the same calming results. You can see why regulators might prefer that set of incentives.

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  1. These are, like, the rules applicable to the thing I'm talking about. There are so many more rules! In particular, the derivatives things are perhaps the most financially systemic exception to the automatic stay in bankruptcy, but they are not necessarily the most interesting. There's stuff about child support and divorce and eviction and criminal cases, for instance, most (not all!?) of which don't obviously apply to banks.

  2. That is, if you're sufficiently collateralized. If not, you have a bankruptcy claim for the deficiency.

  3. This is in section 210(c)(10) of the Dodd-Frank Act. Here are some articles on Title II of the Dodd-Frank Act, the Orderly Liquidation Authority, which includes this section. The FDIC resolution authority is different from bankruptcy, and it's not clear that a big systemic bank would always end up in Title II rather than in bankruptcy; here is a law professor worrying about that.

  4. Here is the Financial Stability Board worrying about the issue a few weeks ago.

  5. Here is ISDA's background on the protocol.

  6. Here is an article on the path dependence that led to the exemption from the automatic stay for derivatives. The bankruptcy point is generally controversial. Here is Stephen Lubben objecting; here is a sort-of-debate about it between Darrell Duffie and David Skeel; here is a law-and-economics analysis of the exemption, which bases it in the fact that derivatives assets tend not to be firm-specific.

  7. From that ISDA background paper:

    Buy-side firms are not included in the first phase. These institutions are unable to voluntarily adopt the protocol due to fiduciary responsibilities to their clients. By voluntarily giving up advantageous contractual rights, they potentially leave themselves open to lawsuits. The FSB has recognised this issue, and FSB members have committed to encourage broader adoption of the protocol by imposing new regulations in their jurisdictions throughout 2015.

    This strikes me as a somewhat humorless reading of asset managers' fiduciary duties but whatever.

  8. In particular, it's not just a one-day delay in termination. It's that if the derivatives are successfully moved to a "bridge" bank -- the new thing with the old liabilities written down -- then you actually can't terminate for a bankruptcy event. There's no bankruptcy, you're back to having a contract with a functioning bank.

    One thing to ponder is that deposits are meant to be information-insensitive. Are derivatives? (I mean, as to credit risk?) Like, sure, kind of. If you buy a credit default swap on Argentina, you want it to pay off if Argentina defaults on its debt, and not if it doesn't. You don't want its payoff to be doubly contingent on (1) Argentina defaulting and (2) AIG or Lehman or whoever still being around.

    But that's just a generic "you." Maybe you actually do want to do the credit work on your derivatives counterparties, because you think that you have some advantage over the generic "you" in pricing that risk. Lots of people think that way! Other people just want their interest-rate swaps to reflect interest rates. You can see why regulators would want to protect the lazier ones, but I don't know if there's an obvious right answer.

  9. And, conversely, punishes you for being dumb or sleeping on your rights. Citi, despite some piggishness with its derivatives contracts, also seems to have been a bit sleepy in giving Lehman back a bunch of collateral that, in hindsight, it wishes it had held on to.

    Oh, also, there are other counterparties -- including, delightfully, some nonprofits -- that took the opportunity to charge Lehman a bit of a bid/ask on their way out of trades, and whom Lehman eventually sued. You can find evil smarts anywhere -- even at a nonprofit.

To contact the author on this story:
Matthew S Levine at

To contact the editor on this story:
Zara Kessler at

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