Empowering Financial Bankruptcy

CAMBRIDGE – Four of the world’s most important financial regulators – the Bank of England, Germany’s Federal Financial Supervisory Authority (BaFin), the US Federal Deposit Insurance Corporation, and the Swiss Financial Market Supervisory Authority – recently asked the world’s derivatives industry to change the way it does business. The question now is whether the regulators can make that happen with a request, as opposed to something more substantial. That will not be easy.

The regulators’ tersely worded letter to the International Swaps and Derivatives Association (ISDA) asked it to renounce a core component of the industry’s multi-decade effort to exempt itself from financial debtors’ bankruptcy – an exemption that worsens not only the debtor’s stability, but also that of the global economy. Many observers believe that these exemptions hit the world’s financial system especially hard when Lehman Brothers collapsed in 2008.

The regulators are focusing on an important feature of derivatives contracts that allows the derivatives industry to close out their dealings abruptly with a financially distressed entity, thereby making the institution incapable of recovering. Other creditors typically cannot do that; in a US bankruptcy, for example, they must first wait for a court to decide whether the debtor company can be restructured. Only then can they collect their debts.

Regulators around the world have worked hard to make the financial system safer. With the recent missive to the derivatives industry, they are now starting to deal with bankruptcy – and well they should.